Sample Solutions Exam 2 Essay

FNCE 370
Overview of Corporate Finance
Sample Final Examination, Version 2 (Solutions)

Part I: Multiple Choice

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.

C
A
A
D
C
A
C
E
B
D
C
E
B
B
B
B
D
B
B
B
B
D
D
B
D

FNCE 370 Sample Examination (Solutions)
Version 2

1/9

May 2007

Part II: Written Response
26. Briefly describe the three forms of market efficiency in terms of the information available in the financial market. Which form of market efficiency do you think accurately represent the operations of the New York Stock Exchange and why?
Suggested Answer
The three forms of market efficiency are strong, semi-strong, and weak form market efficiency. In strong form market efficiency, all market participants have all the information available on any investment. No one has an informational advantage over another investor.

In semi-strong form market efficiency, some market participants have some information that is not generally available to other investors. It is possible for some investors to benefit from insider information. However, in general, investors cannot benefit from information that is widely available in the market (such as financial statements and reports).
In weak form efficiency, investors cannot benefit by studying and utilizing time series trends in stock returns.
The semi-strong form market efficiency would probably most accurately represent the operations of the New York Stock Exchange, since most information is widely available to market participants, and this information is analyzed by thousands of market analysts. As such, no one can benefit from widely available market and stock information.
27. In five sentences or less, outline the three reasons that may explain why the announcement of a new equity issue is often regarded as a negative signal to the securities market.
Suggested Answer
The announcement of a new equity issue is often regarded as a negative signal to the securities market because
•
•
•

management, with its superior information of the firm, knows that the firm is overvalued and so, a new equity issue will benefit existing shareholders. issuing new equity may signal to the market that the firm may have too much debt or too little liquidity. equity issues are usually associated with high issuing or flotation costs.

FNCE 370 Sample Examination (Solutions)
Version 2

2/9

May 2007

Part III: Problems
28. Neural Networks has just announced that it will not be paying dividends for the next 2 years.
Instead, the company will reinvest its earnings in a high return project. At the end of the third year, the company will pay a dividend of $1.50 per share. Starting in the third year, the company expects supernormal growth of 50% for 2 years, 40% for 2 years after that, and 25% for 1 year after that. After that, the company expects normal growth to resume at 8%. The required rate of return for Neural Networks’ competitors is 20%. What is the current price of
Neural Networks’ stocks? What will the price of Neural Networks’ stocks be in 3 years? In 10 years? Suggested Answer
D1 = D2 = 0
D3 = $1.50
D4 = $1.50(1.5) = 1.52
D5 = $1.50(1.52) = 1.53
D6 = $1.50(1.52)(1.4) = 1.53(1.4)
D7 = $1.50(1.52)(1.42) = 1.53(1.42)
D8 = $1.50(1.52)(1.42)(1.25) = 1.53(1.42)(1.25)
D9 = $1.50(1.52)(1.42)(1.25)(1.08) = 1.53(1.42)(1.25)(1.08) r = 0.2

0

1

P0 =

=

2

3
D3

4
D4

5
D5

6
D6

7
D7

8
D8

9
D9

10
D10

11
D11

∞

D3
D5
D6
D7
D8
D ⎛ 1 ⎞
D4
⎟
+
+
+
+
+
+ 9 ⎜⎜
3
4
5
6
7
8 r − g ⎝ (1 + r ) 8 ⎟⎠
(1 + r )
(1 + r )
(1 + r )
(1 + r )
(1 + r )
(1 + r )
1.50
1.5 2
1.5 3 1.5 3 (1.4) 1.5 3 (1.4 2 ) 1.5 3 (1.4 2 )(1.25) 1.5 3 (1.4 2 )(1.25)(1.08) ⎛ 1 ⎞
⎜⎜
⎟
+
+
+
+
+
+
8 ⎟
0.2 − 0.08
(1.2) 3 (1.2) 4 (1.2) 5
(1.2) 6
(1.2) 7
(1.2) 8
⎝ (1.2) ⎠

= 0.87 + 1.08 + 1.36 + 1.58 + 1.85 + 1.92 + 17.31
= 25.97

FNCE 370 Sample Examination (Solutions)
Version 2

3/9

May 2007

D5
D6
D7
D8
D9 ⎛ 1
D4
⎜
+
+
+
+
+
2
3
4
5
(1 + r ) (1 + r ) r − g ⎜⎝ (1 + r ) 5
(1 + r )
(1 + r )
(1 + r )

P3 =

⎞

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