Esc-Clermont Sup de Co

2^nd years, 1^st semester

Course: Corporate finance

Teacher: André Cabannes

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Final exam

December, 2005

3 hours, 20 questions, each worth 5 points. Write your answers on this document in the blank space below each question.

Question 1: The firm F sells computers. The firm G sells flowers. F sells a computer to G for 2000€, on credit. Let’s look at this transaction from F point of view: what are the two entries made for this transaction in F accounting system ?

Credit the sales account 2000€

Debit the debtors account 2000€

Now, let’s look at this transaction from G point of view: what are the two entries made in G accounting system ?

Credit the suppliers account 2000€

Debit the fixed assets (computers) account 2000€

Question 2: Is the asset side of the balance sheet of a firm the list of all the values today of what the firm owns? (Hint: Make comments on the Historical costs rule.)

No. The asset side of the balance sheet of a firm lists all the assets the firm owns, recorded at the historical cost. Typically, land acquired a long ago is usually undervalued.

Question 3: Why the credit and debit columns of a trial balance should add up to the same number?

Because, each transaction leads to an entry on the debit side of an account, and to another entry with the same value on the credit side of another account. So, globally, along the year, the debit entries and credit entries remain always equal, and so are their balances.

If they add up to the same number, does this prove that the trial balance is necessarily correct ?

No. There are mistakes which do not create imbalances ; for instance, to reverse a debit entry and a credit entry.

Question 4: A firm sells for 120€, cash, an item recorded at 90€ in its stocks : show the impact of this operation on the balance sheet.

The stocks account will decrease by 90€. The cash account will increase by 120€. And, on the liability side, the profit account will increase by 30€.

Can a firm sell something at a lower price than its purchasing cost ? (Discuss.)

Yes. It will result in a loss, for this operation. (In some economic sectors, it is, in theory, forbidden.)

Consider the following year end documents of a firm. Questions 5 to 8 refer to these data.

Question 5: What are the Net Fixed Assets at the end of 2002, 2003, and 2004 ?

End of 2002: 200

End of 2003: 200

End of 2004: 220

Assuming that the firm did not sell or otherwise remove any fixed assets from its balance sheets, what were the investments in fixed assets in 2003 and 2004?

2003: 50

2004: 100

Question 6: What is the ROCE ratio in 2003 and in 2004?

ROCE = result before interest charges and taxes / capital employed (or averaged capital employed)

Using simply end of year capital employed,

ROCE 2003 = 70 / 520 = 13,5%

ROCE 2004 = 90 / 550 = 16,4%

Question 7: What do we mean by “this firm doesn’t use much its free financing possibilities” ?

The free financing of a firm is (approximately) represented by its current liabilities, i.e. those liabilities which do not cost anything in terms of financial charges. In the example above, the current liabilities are much lower that the current assets. The liquidity ratios of the firm are very high. Presumably, the firm could obtain more credit from its suppliers and other “free” creditors.

Question 8: Prepare the Cash Flow statement of the firm for the year 2004.

Cash flow in: 930

Sales = 1000

Minus increase in debtors = – 70

Cash flow out: 900

Purchases = 500

Cash operating expenses = 250

LT Investments = 100

Taxes & Dividends = 50

Minus increase in suppliers and other creditors = – 60

Interest charges = 10

Increase in short term securities = 50

So, the net variation in cash is + 30.

Question 9: What distinguishes General Accounting and Cost Accounting ?

General accounting (IS & BS)

• Gives a very general view of the firm

• Legally required, and the year end docs must be published

• Turned toward the past

• Too global to be useful to manage the firm

• Comes late

Cost accounting (Sales per product lines and costs in every « cost centers)

• Useful to manage the firm

• Turned toward the future

• Very detailed

• More or less in real time

What is a cost center? What is a profit center?

A cost center is any small subdivision (physical or logical) of the firm where costs are generated.

A profit center is a subdivision of the firm to which we can associate not only costs but also sales, and therefore a (partial or complete) income statement.

Question 10: Why complete unit costs are artificial ?

Because they require “allocation keys”, to allocate fixed costs, to be computed, and they depend upon all the activities of the firm.

For instance, a workshop manufacturing 10 000 chairs per year, will have a complete unit cost per chair that depends on whether it also makes other pieces of furniture.

Question 11: Consider a security S which can be purchased today. In one year, it will have a value X which is random (depending upon the state of the economy). The possible values of X, with their respective probabilities, are given in the following table :

Possible outcomes	80 €	90 €	100 €	110 €	120 €	130 €
Probabilities	10%	15%	25%	25%	15%	10%

If a money management fund purchases S today, for a price P, how will it record this transaction in its accounting system? (Debit and Credit.)

It will credit its cash or bank account with a value P. And it will debit a financial assets account with the same value P.

Question 12: What is the expected value of S in one year? (Explain your calculations.)

E(X) = 105€

It is the weighted average of the possible outcomes of X.

What is the standard deviation of the value of S in one year? (Explain your calculations.)

Std dev (X) = 14,3€

It is the square root of the variance of X. And the variance of X is the weighted average of the possible squared deviations of X around its mean.

Question 13: In the euro zone, in November 2005, what was the rate of return of a risk free security?

2%

What is the price today (at the date of preparation of this exam, in mid-November 2005) of a risk free security that will be worth 105€ in one year ?

105€ / 1,02 = 102,94€

Is S (of question 11) risk free?

No. Its value next year has variability.

Question 14: Suppose S sells today for a price P = 92€. What is the expected profitability of S?

r_S = (105 – 92) / 92 = 14,1%

Position S on the risk return graph?

We must compute the risk of S, defined as the std dev of its profitability : it is 15,6%

Question 15: Suppose we have 920€ to invest. We want to invest this sum into a “portfolio” constructed as follows : half of our money is invested into safe treasury bills and half into S. What is the expected value of our portfolio in one year ?

Answer: 469,2€ + 524,9€ = 994,1€

Position our portfolio on the risk return graph.

Question 16: Explain the concept of present value. Use the following example : why a sum of 100€ promised in one year is not worth 100€ today ? What happens to its present value if its future value is risky?

A promise for 100€ in one year is not cash today. Therefore we cannot use it as cash to make an investment, and earn money with our investment. Therefore, if we buy this promise today, we “give up” the possibility to have our own money work. So, we should buy this promise for less than 100€.

If the promise is risky, its price today is even less than if it is not risky.

The present value of a future cash flow is the maximum cash amount that we would be willing to pay today, to acquire the promise to receive the cash flow in the future.

Question 17: We are considering making an investment I, which will produce the following cash flows in the future for us :

(mio euros)	year 0	year 1	year 2	year 3	year 4
Future cash flows		50	100	130	80

Suppose this investment has the same risk pattern as S above, i.e. its opportunity cost of capital is r = 14,1%. What is the Present value of the stream of future cash flows of I? (Show your calculations.)

Answer: 255,35 mio euros.

Discount rate	14,1%
(mio euros)	year 0	year 1	year 2	year 3	year 4
Future cash flows		50	100	130	80
PV of future cash flows		43,82	76,81	87,52	47,20
Sum of PV	255,35

If we can make this investment with an initial cash-flow-out of 200 millions euros to be spent year 0, is it a good investment?

Yes, because 200 is less than 255,35, and therefore the Net Present Value of the investment is positive.

Question 18: Explain what we mean by the IRR of an investment.

If the initial cash flow to be invested (here 200 mio euros) is already known, it is the value of the discount rate which makes the NPV equal to zero.

Suppose we can make I with CF year 0 = 200 mio euros. What is the NPV of I, if the proper discount rate (i.e. the opportunity cost of capital) is 20%?

224,9 mio euros – 200 mio euros = 24,9 mio.

What is the NPV if r = 30% ?

184,8 mio euros – 200 mio euros

Estimate the IRR of I.

A geometric interpolation yields around 26%.

Question 19: What is one of the central ideas introduced by Finance which distinguishes it from Accounting?

The present value of future money is less than its face value.

Question 20: Suppose we want to buy 100% of a firm, which already exists and already has a few past income statements and balance sheets, from its shareholders. Why the “value of the firm” to the shareholders (and therefore the minimum price we will have to pay them) may be more than the total equity shown in the balance sheet (total assets minus liabilities to external agents)?

For the owners of the firm, i.e. the people owning its shares of capital, the value of these shares is the money they will generate for them in the future, properly discounted. It is not directly related to the balance sheet, which records the value of the assets and liabilities of the firm today.