Practice finals Name: 1 CORPORATE FINANCE FINAL EXAM, Exams of Corporate Finance

Download Practice finals Name: 1 CORPORATE FINANCE FINAL EXAM and more Exams Corporate Finance in PDF only on Docsity! Practice finals Name: 1 CORPORATE FINANCE FINAL EXAM: FALL 1992 1. You have been asked to analyze the capital structure of DASA Inc, and make recommendations on a future course of action. DASA Inc. has 40 million shares outstanding, selling at $20 per share and a debt-equity ratio (in market value terms) of 0.25. The beta of the stock is 1.15, and the firm currently has a AA rating, with a corresponding market interest rate of 10%. The firm's income statement is as follows: EBIT $150 million Interest Exp. $ 20 million Taxable Inc. $130 million Taxes $ 52 million Net Income $ 78 million The current riskfree rate is 8% and the market risk premium is 5.5%. a. What is the firm's current weighted average cost of capital? (1 point) b. The firm is proposing borrowing an additional $200 million in debt and repurchasing stock. If it does so its rating will decline to A, with a market interest rate of 11%. What will the Weighted average cost of capital be if they make this move? (1 point) c. What will the new stock price be if they borrow $200 million and repurchase stock (assuming rational investors)? (1 point) d. Now assume that the firm has another option to raise its debt/equity ratio (instead of borrowing money and repurchasing stock). It has considerable capital expenditures planned for the next year ($150 million). The company also pays $1 in dividends per share currently (Current Stock Price=$20). If the company finances all its capital expenditures with debt and doubles its dividend yield from the current level for the next year, what would you expect the debt/equity ratio to be at the end of the next year. (3 points) Practice finals Name: 2 2a. RYBR Inc., an all-equity firm, has net income of $100 million currently and expects this number to grow at 10% a year for the next three years. The firm's working capital increased by $10 million this year and is expected to increase by the same dollar amount each of the next three years. The depreciation is $50 million and is expected to grow 8% a year for the next three years. Finally, the firm plans to invest $60 million in capital expenditure for each of the next three years. The firm pays 60% of its earnings as dividends each year. RYBR has a cash balance currently of $50. Assuming that the cash does not earn any interest, how much would you expect to have as a cash balance at the end of the third year? (2 points) b. Assume that RYBR had financed 20% of its reinvestment needs with debt, estimate the cash balance at the end of the third year. ( 2 points) c. Now assume that stockholders in RYBR are primarily corporations. They are exempt from ordinary taxes on 85% of the dividends that they receive (Ordinary tax rate=30%), and pay capital gains on price appreciation at a 20% rate. If RYBR pays a dividend of $2 per share, how much would you expect the stock price change to be on the ex-dividend date? (2 points) 3. LOB Inc. is a firm with the following characteristics: Year 1 2 3 After year 3 Growth rate in EPS 20% 16% 12% 6% ROC 20% 20% 16% 12% D/E 0% 10% 25% 50% i NA 8% 8% 8% Beta 1.40 1.25 1.15 1.00 The firm has EPS currently of $2.00. The tax rate is 40%. The current riskfree rate is 6.5%. The tax rate is 40%. (The market risk premium is 5.5%) a. What would you project the EPS and DPS to be for the next three years? (2 points) b. What is the terminal price (at the end of the third year)? (2 points) c. What is your best estimate for the DDM Value per share? (2 points) Practice finals Name: 5 As part of your analysis, you are examining whether Boston Turkey should borrow $500,000 and buy back stock. If it does so, its rating will drop to A-. d. If it does so, what will the new cost of equity be? e. How much will the stock price change if it borrows $500,000 and buys back stock? 2. Boston Turkey was so impressed with your grasp of capital structure basics that they have come back to you for some advice on dividend policy. To save you the trouble of having to refer back to page 1, the latest financial statements are reproduced on this page. Income Statement Revenues $ 1,000,000 - Expenses $ 400,000 - Depreciation $ 100,000 EBIT $ 500,000 - Interest Expense $ 100,000 Taxable Income $ 400,000 - Tax $ 160,000 Net Income $ 240,000 Balance Sheet Assets Liabilities Property, Plant & Equipment $ 1,500,000 Accounts Payable $ 500,000 Land & Buildings $ 500,000 Long Term Debt $ 1,000,000 Current Assets$ 1,000,000 Equity (100,000 shares) $ 1,500,000 Total $ 3,000,000 Total $ 3,000,000 Boston Turkey expects its revenues to grow 10% next year, and its expenses to remain at 40% of revenues. The depreciation and interest expenses will remain unchanged at $100,000 next year. The working capital, as a percentage of revenue, will remain unchanged next year. The managers of Boston Turkey claim to have several projects available to choose from next year, where they plan to invest the funds from operations, and suggest that the firm really should not be paying dividends. The projects have the following characteristics -- Project Equity Investment Expected Annual CF to Equity Beta Practice finals Name: 6 A $ 100,000 12,500 1.00 B $ 100,000 14,000 1.50 C $ 50,000 8,000 1.80 D $ 50,000 12,000 2.00 The treasury bill rate is 3% and the treasury bond rate is 6.25%. The firm plans to finance 40% of its future net capital expenditures (Cap Ex - Depreciation) and working capital needs with debt. a. How much can the company afford to pay in dividends next year? b. Now asssume that the firm actually pays out $1.00 per share in dividends next year. The current cash balance of the firm is $150,000. How much will the cash balance of the firm be at the end of next year, after the payment of the dividend? c. The average investor in Boston Turkey is a wealthy individual, who pays 40% in taxes on ordinary income and only 28% on capital gains. How much would you expect the price to drop on the ex-dividend day, if the company pays out $1 per share as dividend? 3. You are now trying to value Boston Turkey. For purposes of simplicity, the relevant information about the company is reproduced here -- Current Numbers: Earnings per share = $ 2.40 Net Income = $240,000 Dividends per share = $ 1.00 Interest Expenses = $100,000 Market price per share = $ 20 Book Value of Debt = $1,000,000 Number of shares = 100,000 Book Value of Equity = $1,500,000 Market Value of Debt = 1,250,000 Tax Rate = 40% Due to its limited history, the beta of the stock cannot be estimated from past prices. You do have information about comparable listed firms and their betas -- Firm Kentucky Fried Chicken Beta 1.05 Debt/Equity Ratio 20% Hardee's 1.20 50% Popeye's Fried Chicken 0.90 10% Roy Rogers 1.35 70% Practice finals Name: 7 (The comparable firms all have a tax rate of 40%) [ This is the same information you were given in problem 1. You can use the beta estimated from that section in this problem.] a. Assuming that these numbers are sustainable for the next three years, what is the expected growth rate in earnings per share for this period? b. The growth rate after year 3 is expected to be 6% forever. What will the price per share be at the end of year 3? c. What is the value per share using the dividend discount model? Practice finals Name: 10 • The equity is trading in the market at two times the book value. The debt is composed of ten-year bonds, and is rated A (Typical A rated bonds are yielding 10% currently in the market). • Assume that Jackson-Presley intends to maintain its working capital at the same percentage of revenues for the next year, as it has this year. • Also assume that the following is the listing of the major investment opportunities that Jackson-Presley has for the next year. Project Total Investment IRR on project (using CF to Equity) Beta (Levered) A $ 15 million 16% 1.60 B $ 30 million 15% 1.25 C $ 25 million 12.5% 1.0 D $ 20 million 11.5% 0.5 a. If revenues, net income and depreciation are all expected to grow 20% next year, and the firm maintains its existing debt financing mix (in market value terms), how much can the firm afford to pay out as dividends after meeting working capital and capital budgeting needs? ( 5 points) b. The company's current cash balance is $10 million. What will happen to this cash balance if Jackson-Presley maintains its payout ratio at 25% next year? (1 point) 3. The managers at Jackson-Presley also believe that they are significantly undervalued, and want you to estimate how much the equity in the firm is truly worth. They provide you with the following additional information – • They believe that they can maintain 'high growth' for the next five years. • The beta calculated, using comparable firms, in problem 1b, is a good estimate of the beta for the next five years. • The dividend payout ratio will be maintained at 25% for the high-growth period. • The current (from the current income statement and balance sheet) return on capital, debt equity ratio and interest rate will be maintained for the high growth period. (The book value of equity at the beginning of the year was $ 100 million but the book value of debt is unchanged…) Practice finals Name: 11 • There are 12 million shares outstanding. • After the high-growth period, the earnings growth rate is expected to drop to 6%, and the firm's return on capital will also drop to 15%. The debt equity ratio and interest rate are expected to remain unchanged. The beta is expected to be 1.00 in the stable growth period. a. Estimate the expected growth rate in the high growth period. ( 2 points) b. Estimate the expected dividends in the high growth period. (1 point) c. Estimate the expected payout ratio in the stable growth phase. (2 points) d. Estimate the terminal price (at the end of the high-growth period) (2 points) e. Estimate the value today from the dividend discount model. (1 point) 4. Jackson-Presley is now planning a major restructuring involving the following actions • A division, producing records and cassettes, will be sold for $ 50 million. That division is currently earning $ 5 million before interest and taxes. As mentioned in problem 1, comparable firms in this business have an average beta of 1.15 and an average debt/equity ratio of 50%. • The cash from the sale of the divisions will be used to buy back stock. • The dividend payout ratio will be reduced to 15%. a. Estimate the new growth rate in earnings, after the restructuring, using fundamentals. (4 points) b. Estimate the new cost of equity for Jackson-Presley after the restructuring. (4 points) Practice finals Name: 12 Corporate Finance: Final Exam: Fall 1995 1. SDL is a firm manufacturing perfumes and other cosmetics and it sells its products world wide. The financial statements for the most recent two years are included below. Income Statements (All figures in millions) Balance Sheets (in millions) 1993 1994 1993 1994 Fixed Assets $150 $175 Current Liabilities $40 $50 Current Assets $60 $75 Debt $90 $100 Equity $80 $100 Total $ 210 $ 250 Total $ 210 $250 In addition, you are provided the following information – • The long-term treasury bond rate is 6%. • There are 10 million shares outstanding, trading at $ 40 per share currently; the stock has been traded for only two years. A regression of stock returns against market returns yields a beta of 0.9, with a standard error of 0.8. There are, however, five cosmetics firms which are publicly traded, with the following estimates of betas for each. Answer all questions on the exam. If you have additional work, please attach the work. 1993 1994 Revenues $ 150.00 $ 200.00 - Operating Expenses $ 115.00 $ 140.00 - Depreciation $ 10.00 $ 20.00 = EBIT $ 25.00 $ 40.00 - Interest Expenses $ 5.00 $ 6.50 = Taxable Income $ 20.00 $ 33.50 - Taxes $ 5.00 $ 13.50 = Net Income $ 15.00 $ 20.00 Practice finals Name: 15 3. You are trying to value a company using the dividend discount model. You have collected the following information on the firm – • The company has earnings per share currently of $2.00, and pays 20% of its earnings as dividends. Its book value of equity per share is $10.00, and it is trading at 2.5 times the book value. • The firm has no leverage currently, and is expected maintain this policy for the high growth phase, which is expected to last 3 years. During the high growth phase, the beta is expected to be 1.5. • After 3 years, the firm is expected to reach stable growth and earnings are expected to grow 6% a year. The fundamentals are expected to approach industry averages for return on capital (where the average is 14%), leverage (where the industry average debt/equity ratio is 25%) and unlevered beta (where the industry average unlevered beta is 0.8). The long term treasury bond rate is 6%. a. Estimate the expected growth rate during the high growth period. (2 points) b. Estimate the terminal value per share at the end of the high growth period. c. Estimate the value per share using the dividend discount model. (3 points) Practice finals Name: 16 Corporate Finance: Final Exam - Spring 1996 Aswath Damodaran 1. You have been hired by Samson Corporation, a mid-size company which manufactures luggage to assess their capital structure. You have been provided with the most recent income statement and balance sheet for the company – Income Statement Revenues $ 100 million - Cost of Goods Sold $ 60 million (Includes depreciation of $ 10 million) = EBIT $ 40 million - Interest Expenses $ 6 million = Taxable Income $ 34 million - Taxes $ 13.6 million = Net Income $ 20.4 million Balance Sheet Assets Liabilities Fixed Assets $ 100 million Current Liabilities $ 20 million Current Assets $ 40 million Debt $ 60 million Equity $ 60 million The company had 10 million shares outstanding trading at $24 per share. Nearly 40% of the outstanding stock is held by the founding family. You are also provided with the following additional information – • A regression of returns on the stock against a market index over the last 5 years yields a beta of 0.90, but Samson had no debt for the first four out of the five years. Its debt ratio in the fifth year was similar to its current debt ratio. • The debt is 10-year bank debt; however, based on its interest coverage ratio the firm would be rated AA and carry a market interest rate of 10%. The treasury bond rate is 8% and the market risk premium is 5.5%. a. Estimate the current cost of equity for Samson Corporation. ( 2 points) b. Estimate the current weighted average cost of capital for Samson Corporation ( 2 points). This exam is worth 30 points. Please answer all questions. Practice finals Name: 17 c. Assume now that Samson Corporation plans to double its debt ratio. The bond rating is expected to drop to BBB, with a market interest rate of 11.5%. Estimate the new cost of capital. ( 2 points) d. If Samson does decide to double its debt capacity immediately by buying back stock, estimate the dollar debt it would need to borrow. ( 1 point) e. If Samson decides to double its debt ratio over the next 3 years, and plans to use the new debt to finance new projects, estimate the total dollar debt that the firm will have to issue over the next 3 years. (Samson pays no dividends) ( 3 points) f. Based upon the most recent financial data, would you suggest that Samson take projects with the debt or return cash to stockholders. Explain. (You can assume that the book value of equity was $ 40 million at the beginning of the year, while the book value of debt was $ 60 million) (1 point) 2. You have been asked by Jupiter Corporation, a toy manufacturer, for advice on dividend policy. Jupiter Corporation had net income of $ 150 million in 1995 and reported depreciation of $ 20 million. Its balance sheets for 1994 and 1995 are provided below (in millions): Assets Liabilities 1994 1995 1995 1995 Net Fixed Assets $750 $ 800 Current Liabilities $50 $60 Current Assets Debt $ 200 $ 215 Cash $ 50 $ 100 Equity $ 650 $ 720 Non-cash Current Assets $100 $ 120 a. Estimate how much Jupiter paid out as dividends during 1995.( 2 points) b. Estimate how much capital expenditure Jupiter Corporation had in 1995. ( 1 point) c. Now assume that you have been given the following information on next year’s projections for Jupiter Corporation. • Net Income, depreciation and non-cash working capital are expected to increase 10% from 1995 levels. • The firm has four projects that it is considering for next year Project EBIT Investment Beta Practice finals Name: 20 share. If the beta before the stock buy back was 0.80, estimate the interest rate paid on the new debt. (The T.Bond rate is 7% and the company has a tax rate of 40%) ( 5 points) 4a. DelCash Inc., a discount retailer, has declared and paid a dividend of $ 500 million this year. You notice, looking over their financial statements, that they have net income of $ 2 billion for this year, and that the cash balance for the firm increased by $ 250 million. If the non-cash working capital was unchanged over the year, and the firm finances 30% of its net capital expenditures from debt, estimate the net capital expenditures that DelCash had during the year. ( 2 points) 4b. On the ex-dividend day, the stock price of Del Cash dropped by $ 1.80. If the typical stockholder in Del Cash paid 40% on dividend income and 20% on capital gains taxes, estimate the number of shares outstanding in the firm. ( 2 points) 5. PlayMania, a company that manufactures play equipment for children, has called you in as a value consultant. • The company has made and expects to continue to make a return on equity of 15% on its projects, and the beta of the stock is 1. • It pays out 60% of its earnings as dividends, and the firm views itself as stable. • The company has earnings per share of $ 2.00 in the current year. • The T.Bond rate is 7% a. Estimate the equity value per share of this company. ( 2 points) b. The company is planning to increase capital expenditures and lower its payout ratio to 50%. In doing so, it will also be taking projects with lower returns, resulting in a return on equity to 14%. Assuming that it can sustain this payout ratio and return on equity forever, estimate the value of equity per share. ( 3 points) 6. Answer the following true or false questions on valuation ( 1 points each) 1. Increasing the debt ratio of a firm will increase the value of the firm. TRUE FALSE 2. The FCFE value per share for a firm will always be greater than the dividend discount model. TRUE FALSE Practice finals Name: 21 3. When a firm increases its return on assets, without affecting its riskiness, it wll increase the value of the firm. TRUE FALSE 4. The value of a firm can never be lower than the value of the equity in the firm. TRUE FALSE Practice finals Name: 22 Final Exam: Spring 1998 All of the questions in this exam relate to a company called Mallinckrodt, which is head quartered in St. Louis, Missouri, and is a company involved in pharmaceuticals and specialty chemicals. The stock of the company, traded on the NYSE, is at a 52-week low of $ 32 per share. The CEO of the company, Mr. Ray Holman, has invited you to come in and do a corporate financial analysis of the firm, and has offered to pay you handsomely for your services. • Page 13 of this report has the income statements and balance sheets for the last 2 years • Page 14 of this exam has the statement of cash flows for the last 4 years • Page 15 has a summary table of interest coverage ratios, ratings and default spreads that you might find useful. • Page 16 has industry averages for betas, debt to equity ratios, returns on equity and capital, and capital expenditure/depreciation for the two segments that Mallinckrodt is in - pharmaceuticals and specialty chemicals. Additional Notes • You can ignore the preferred stock in the firm for your calculations. • Use a market risk premium of 5.5% throughout this analysis. • The long term treasury bond rate through out this analysis can be set at 6%. Practice finals Name: 25 4 a. To look at the firm's dividend policy, you look at Mallinckrodt's financial statements for the last 2 years. Based upon the income statement, balance sheet and statement of cash flows, estimate the FCFE in each of the last two years. (You can ignore other non-cash adjustments and cash from the disposal of assets each year) b. Using the statement of cash flows provided, estimate the percentage of the FCFE that was returned to stockholders (in the form of dividends and stock buybacks) in 1996 and 1997. (1 point) c. You have run a regression of dividend yields of pharmaceutical firms on after-tax return on capital and net capital expenditures as a percent of revenues. Dividend Yield = 0.03 - 0.053 (Return on Capital) – 0.15 (Net Cap Ex/Revenues) where • Return on Capital = EBIT (1-t)/(Last year’s Book Value of Debt + Last year’s Book Value of Equity) • Net Cap Ex/ Revenues = (Capital Expenditures - Depreciation)/ Revenues Mallinckrodt paid dividends of $ 0.66 per share in 1997, and the stock price is $ 32. Based upon this regression, estimate how much Mallinckrodt should pay in dividends per share. ( 2 points) 5 Mallinckrodt reported earnings before interest and taxes of $307 million in 1997. Capital expenditures were $170 milllion in that year, and depreciation was $ 128 million; Revenues were $1,861 million. Non-cash working capital is expected to remain at the same percentage of revenues that it was in 1997. (Non-cash Working Capital = Inventories + Accounts Receivable - Accounts Payable). a. Assuming that revenues, operating income and net capital expenditures are expected to grow 10% a year for the next 3 years, estimate the cash flow to the firm each year for the next 3 years. ( 2 points) b. After year 3, revenues and operating income will grow 3% a year. Assuming that capital expenditures as a percent of depreciation will drop to the pharmaceutical industry average after year 3, and that non-cash working capital will remain at the same percent of revenues after year 3 (as it is currently), estimate the terminal value of the firm. (The debt ratio of the firm is expected to rise to 40%, the beta to 1.00 and the pre-tax cost of debt will be 7.00%) (2 points) Practice finals Name: 26 c. Assume that the current beta for the stock is correctly estimated at 0.67, the current cost of debt is based upon the rating estimated from the interest coverage ratio and the long term treasury bond rate is 6%. Mallinckrodt has 73 million shares outstanding today, trading at $ 32 per share and $ 556.90 Million in debt outstanding (book as well as market). Estimate the value of the equity per share today. ( 2 points) Practice finals 27 Name: Page DG49 Equity DES Hit 1 <GO> for more income statement information (CH2). Inc STATEMENT ( Mil of $) Page 8 /10 MKG MALLINCKRODT INC 6/1994 6/1995 6/1996 6/1997 1940.10 2043.20 1754.40 +20 Cost of goods sold 1037.30 1102.80 956.80 1017.60 Sell, gen & adm exp 617.30 650.60 506.90 536.70 Operating inc(loss) 285.50 289.80 290.70 306.90 Interest expense 39.80 55.50 51.30 48.10 For exchange L (G) 4.20 =e 70. -00 Net non-op L (G) 70.10 -27.20 74.30 -29.20 Income tax expense 64.00 98.30 90.00 102.30 Reserve charges (cr) +00 00 +00 +00 Income bef XO items 107.40 163.90 153.70 185.70 XO L(G) pretax 3.60 16.40 -58.20 “4.40 Tax effect on XO items Minority interest +00 +00 +00 +00 Net income (loss) 103.80 180.30 211.90 190.10 Tot cash pref. dvd +40 +40 -40 -40 Tot cash comm. dvd 37.30 41.80 45.70 48.20 Avg # shares for EPS 77.61 77.46 76.34 75.06 EPS before XO items 1.38 2.11 2.01 2.47 EPS aft XO items 1.33 2.32 2.77 2.53 Copyright 1998 BLOOMBERG L.P. Frankfurt:69-920419 Hong Kong:2-977-6000 London: 171-330-7500 New York:212-318-2000 Princeton:609-279-3000 Singapore:226-3000 — Sydney:2-9777-8666 | Tokyo:3-3201-8900 Sao Paulo:11-3048-4500 6261-4-0 04-May-98 16:19:50 DG49 Equity DES Page #. oe <GO> ee more balance sheet information (CH3). BALANCE SHEET (Mil of $) Page 9 /10 MKG US MALLINCKRODT INC iz 671996 6/1997 | [ 6/1996 6/1997 | Cash & near cash 496.10 808.50 Accounts payable 147.00 169.30 Marketable sec +00 -00 ST borrowings 109.40 11.70 Acct & notes rec 336.80 356.00 Other ST liab 637.00 472.70 Inventorit 341.60 315.90 Cur liabilities 893.40 653.70 Other cur assets 78.00 136.40 Current assets 1252.50 1616.80 LT borrowings 558.00 545.20 Other LT liab 387.50 537.60 LT inv't & LT rec 2.50 4.20 Noncur liabilities 945.50 1082.80 Total liabilities 1838.90 1736.50 Depr fixed assets 1148.50 1213.10 Non-depr fixed ass 116.90 117.00 Preferred equity 11.00 11.00 Accum corre 434.50 502.20 Minority interest 00 +00 Net fixed ai 830.90 827.90 Share cap & APIC 370.60 393.00 Retained earnings 850.60 847.20 Other assets 985.20 538.80 Shareholder equity 1232.20 1251.20 Tot liab & equity 3071.10 2987.70 Total assets 3071.10 2987.70 ST part of LT debt +00 +00 Shares out 74.18 72.37 # treasury shares 12.84 Copyright 1998 BLOOMBERG L.P. Princeton:609-279-3000 Frankfurt:69-920410 Hong Singapore:226-3000 Sydney:2-9777-8666 Amt treasury stock 2-97-6000 London: 171-330- Tokyo:3-3201-B900 284.80 395.50 7500 New York Sao Paulo! 6261-4-0 04-1 Practice finals Name: 30 Corporate Finance: Final Exam - Spring 1999 1. The following is the beta calculation for PepsiCo, using monthly return data from the last 5 years: ReturnPepsico = 0.23% + 1.20 (ReturnS&P 500) You are given the following additional information: • The current market value of equity at Pepsi is $ 40 billion and the firm has $ 10 billion in debt outstanding. • During the last 5 years, Pepsi had an average market value debt to equity ratio of 10%. The firm’s marginal tax rate is 40%. a. Using the raw beta estimate from the regression above, and the information provided, estimate Pepsi’s current beta. ( 2 points) b. Now assume that Pepsi will be spinning off its bottling operations for $ 10 billion, borrowing an additional $ 2 billion and buying back $ 12 billion worth of stock. Estimate Pepsi’s new beta. (The unlevered beta of firms involved in just bottling operations is 1.35) ( 3 points) 2. You have been asked to analyze a project, which is expected to have a net income of $ 15 million on revenues of $ 200 million next year; the depreciation is expected to be $ 5 million next year. The project is expected to last forever, with no growth in revenues and earnings. The beta for the firm analyzing the project is 1.00, but this project is riskier than the rest of the firm and is expected to have a beta of 1.25. The initial investment needed for the project is $ 150 million, and the firm is expected to borrow 40% of this investment, at a pre-tax cost of 8%. The capital maintenance expenditure, each year, is expected to be equal to depreciation. There are no working capital needs. Estimate the net present value of this project. (The treasury bond rate is 5%, and the market risk premium is 6.3%). ( 5 points) 3. Campbell Soup is planning a major restructuring. Its current debt to capital ratio is 10%, and its beta is 0.90. The firm currently has a AAA rating, and a pre-tax cost of debt of 6%. The optimal debt ratio for the firm is 40%, but the firm’s pre-tax cost of Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. Practice finals Name: 31 borrowing will increase to 7%. The market value of the equity in the firm is $ 9 billion, and there are 300 million shares outstanding. (The treasury bond rate is 5%, the market risk premium is 6.3% and the firm’s current tax rate is 40%) a. Estimate the change in the stock price if the firm borrows money to buy stock to get to its optimal debt ratio, assuming that firm value will increase 5% a year forever and that investors are rational. ( 3 points) b. Estimate the increase in stock price, if Campbell Soup were able to borrow money to get to its optimal and buy stock back at the current market price. ( 3 points) c. As a final scenario, assume that Campbell Soup borrowed to get to 40%, but used the funds to finance an acquisition of Del Monte Foods. Assuming that they over pay by $ 500 million for this acquisition, estimate the change in the stock price because of these actions. (You can assume rationality again, in this case) ( 1 point) 4. You have been provided with three years of historical data for Tandem computers, a firm that has paid dividends. 1996 1997 1998 Net Income $150 $225 $315 Capital Expenditures $200 $250 $300 Depreciation $125 $190 $250 Non-Cash Working Capital $300 $330 $375 The firm started 1996 with a cash balance of $ 100 million, and raised 10% of its external financing needs from debt; it will continue to finance future reinvestment needs with the same debt ratio. The non-cash working capital in 1995 was $275 million. Each year the company pays out 20% of its net income as dividends. a. Assuming that the firm did not buy back any stock over the period, estimate how much cash the firm would have at the end of 1998. (Assume that cash balances earn no interest) ( 3 points) b. Assume now that the firm currently has 100 million shares outstanding, trading at $ 40 per share, and would like to announce a stock buyback program for the next 2 years. Practice finals Name: 32 Assuming that net income will grow 25% a year for the next 2 years, and that capital expenditures and non-cash working capital will grow at the same rate, estimate (in dollar terms) how much stock the firm can buy back. (It wants to keep its cash balance from the end of 1998 intact and continue to pay 20% of its earnings as dividends) ( 3 points) 5. You have been asked to estimate the value of General Communications, a telecomm firm. General Communications has a debt to capital ratio of 30%, a beta of 1.10 and a pre-tax cost of debt of 7.5%. The firm had earnings before interest and taxes of $ 600 million in 1998, after depreciation charges of $ 300 million. The firm had capital expenditures of $ 360 million, and non-cash working capital increased by $ 50 million during 1998. The firm also had a book value of capital of $ 2 billion at the beginning of 1998. (The treasury bond rate is 5%, the market risk premium is 6.3% and the firm has a tax rate of 40%). Assuming that the firm is in stable growth, and that the return on capital and reinvestment rates from 1998 can be sustained forever, estimate the value of the firm. ( 3 points) Practice finals Name: 35 5. You have been asked to value an entertainment company for a possible acquisition by AT&T. The firm's current pre-tax operating income is $ 150 million, and it has a 33.33% tax rate. The following table summarizes the estimates you have made for the firm for the next 3 years: 1 2 3 Term. year (4) Exp. Growth in Operating Income 15% 15% 15% 5% ROC 20% 20% 20% 15% Cost of Capital 12% 11% 10% 9% The firm will be in stable growth after year 3. a. Estimate the expected free cash flows to the firm every year for the next 3 years. (2 points) b. b. Estimate the terminal value of the firm, i.e., the value at the end of the third year (2 points) c. Estimate the value per share today, if the firm has $ 800 million in debt outstanding and 100 million shares. (2 points) Practice finals Name: 36 Spring 2001: Final Exam Corporate Finance : Final Exam 1. You have been asked to estimate the cost of capital for Simtel Enterprises, a firm with operations in different businesses. You are given the breakdown of the three businesses that Simtel is in below: Business Estimated Value Average Unlevered beta: Comparables Telecomm Services $ 2.0 billion 1.00 Computer Software $ 1.0 billion 1.25 Real Estate Management $ 1.0 billion 0.60 Simtel has 100 million shares outstanding, trading at $ 20 a shares; its remaining capital is in the form of corporate bonds with a BB rating, carrying a default spread of 4% over the riskfree rate. Simtel’s marginal tax rate is 40%. The long term treasury bond rate is 6% and the market risk premium is 4%. a. Estimate the cost of capital for Simtel. ( 2 points) b. Now assume that Simtel sells its real estate services division at its estimated value and uses the funds to retire debt. This will cause its rating to rise to A and the default spread on its bonds to drop to 1.5%. Estimate the new cost of capital for Simtel. (3 points) 2. You have been asked to assess the net present value of a project analysis done by analysts at Ludens Inc., a firm that operates in both retailing and apparel production. The project, which is in the apparel business, has a 10-year life with equal annual cash flows over the period and an initial investment of $ 1 billion. You notice two problems with the analysis: • The analyst used a cost of capital of 10% (which is the company’s cost of capital) in computing the net present value of $ 100 million. The cost of capital for the apparel business is 12%. Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. Practice finals Name: 37 • The analyst expensed the entire investment in year 0; you believe that this is not likely to get approval from the tax authorities, and that you would need to depreciate the investment straight line over 10 years to a salvage value of zero. The tax rate is 30%. Estimate the correct net present value of the project. ( 6 points) 3. Certiz Enterprises is considered a major recapitalization. The firm currently has a market value of $ 1billion, a debt to capital ratio of 10%, a beta of 0.90 and a pre-tax cost of borrowing of 7%. It is considering tripling its debt to capital ratio to 30% and it believes that doing so will increase its firm value by 15%. The firm has a tax rate of 40%, the riskfree rate is 6% and the market risk premium is 4%. What will the cost of debt have to be at the 30% debt to capital ratio for firm value to increase by 15%. (You can assume a 5% growth rate in savings in perpetuity) ( 6 points) 4. Needham Inc. is a steel company that reported $ 100 million in net income in the the just-completed financial year. The firm has a payout ratio of 30% and the dividends in the most recent year were exactly were exactly equal to the free cash flows to equity. The firm was all equity financed. a. Assume that you expect Needham to maintain a growth rate of 10% a year in net income and reinvestment (net cap ex and change in working capital) for the next year and that you anticipate that the firm will fund 20% of its new investments (net cap ex and working capital) with debt. If you maintain the policy of paying out the entire free cash flow to equity as dividends, what payout ratio can the firm afford next year? ( 2 points) b. Needham currently has a cash balance of $ 100 million. If Needham increases its payout ratio to 40% and buys back $ 50 million in new stock next year, estimate how much its cash balance will be at the end of next year. (You can use the net income, reinvestment and debt numbers that you estimated in part a) 5. You have been asked to assess the valuation of Robotronics Inc., a firms that manufactures metal parts. The analyst has valued the firm as a stable growth firm, based Spring 2002 Name: 2 the initial investment will be depreciated straight line over 10 years to a salvage value of zero) (6 points) 3. You are trying to analyze the optimal debt ratio for Lamont Hotels, a firm that owns and operates a number of small hotels all over the country. The firm has 50 million shares trading at $ 10 a share and $ 125 million in debt outstanding.(in market value terms). The current (and correct) levered beta for the firm is 0.90 and the pre-tax cost of borrowing is 7%. The riskfree rate is 5% and the market risk premium is 4%. (Corporate tax rate = 40%) a. Estimate the current cost of capital for Lamont Hotels. ( 1 point) b. The firm is planning to triple its dollar debt and use the proceeds to buy back stock. If it does so, it believes that its pre-tax cost of borrowing will rise to 8%. Estimate the new cost of capital for Lamont Hotels, if it does this. (3 points) c. If you were told that investors in Lamont Hotels were rational and that the stock price increased by $1.50 per share on the announcement of the buyback, estimate the expected growth rate in annual savings that the market must be assuming. (3 points) 4. You have collected two years of information on your company’s earnings and dividends, as well as the cash balance at the end of each year. Most recent financial year Previous year Earnings Dividends Cash Balance at year-end 110 100 44 40 100 78 The firm did not buy back any stock in either year. a. The firm is entirely equity financed, has no working capital needs and plans to stop paying dividends immediately because it views them as tax inefficient. It expects earnings from the most recent year to grow 10% a year for the next 3 years but net capital expenditures from the most recent year are expected to grow 20% a year for the next 3 years. If the firm plans a major stock buyback three years from now, estimate the cash balance it will have available for the stock buyback. (4 points) b. The firm based its conclusion that dividends were tax inefficient by examining its own stock price reaction to ex-dividend days over the last few years. On average, the stock price dropped 85 cents for every dollar paid in dividends. If the average capital gains tax rate over the period was 20%, estimate the tax rate paid on dividends (ordinary income) by investors in the company. ( 2 point) Spring 2002 Name: 3 5. Newhouse Publishing is a company that owns 2 newspapers and several weekly magaizines. The firm is family-run and reported $ 100 million in earnings before interest and taxes on revenues of $ 1 billion in the most recent financial year; the book value of capital invested in the company at the start of that year was $ 500 million. The capital expenditures during the year amounted to $ 80 million, depreciation was $ 50 million and non-cash working capital increased by $ 20 million during the year. The firm’s current cost of capital is 10%. (The tax rate is 40%) a. If the firm continues to earn its current return on capital for the next 3 years and maintain the reinvestment rate it had last year, estimate the expected growth rate in after- tax operating income over these 3 years. ( 2 points) b. Now assume that the return on capital will remain unchanged after year 3, but that the expected growth rate will drop to 4%. The cost of capital will drop to 9% after year 3. Estimate the terminal value of the firm. ( 2 points) c. Estimate the value of the firm today. ( 2 points) Spring 2003 Name: 1 Corporate Finance : Final Exam – Spring 2003 1. You are attempting to assess the cost of capital for Andersen Enterprises, a firm that manufactures window furnishings and also builds new houses; the window furnishings business accounted for 40% of the total revenues of $ 1 billion in the most recent year. The firm is publicly traded and has 15 million shares outstanding, trading at $ 40 a share and the market value of debt outstanding is $ 400 million. The company is rated BBB, and the typical default spread for BBB rated bonds is 1.8% over the riskless rate. You have obtained the unlevered betas and average firm value/sales ratios for the two businesses that Andersen operates in below by looking at comparable firms: Business Unlevered beta Firm Value/Sales Ratio House furnishing 1.30 1.6 Construction services 0.90 0.6 While Andersen has paid only 20% of its taxable income as taxes in the last three years, the marginal tax rate is 40%. The riskless rate is 5% and the market risk premium is 4%. a. Estimate the levered beta for Andersen. (2 points) b. Estimate the cost of capital for Andersen. (1 point) c. Now assume that Andersen is considering a plan to borrow $ 200 million and expand its construction business. Assuming that this plan goes through, estimate the new levered beta for Andersen. (3 points) 2. The New York Times is considering introducing a new monthly magazine. The company anticipates that it will cost $ 20 million in initial costs to create the infrastructure needed to produce the magazine, and that it can depreciate this cost straight line over the next 10 years to a salvage value of $ 5 million. The Times expects to price the magazine at $ 2 an issue on the newsstands and it expects advertising revenues of $ 1.50 per issue sold; the printing and production costs are expected to be $ 1 per issue. The magazine’s contents will be produced by the existing staff of the paper, but the Times will have to increase it’s total annual payroll cost, which is currently $ 20 million, by 10%. The cost of capital for the New York Times is 9% and it can be used for this investment as well. (The marginal tax rate is 40%.) Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. Spring 2004 Name: 1 Corporate Finance: Final Exam 1. You are reviewing the beta calculation for Trumpeter Inc, a publicly traded company. The beta of 1.20 was obtained from a 5-year regression of stock returns against a market index and you believe that notwithstanding the unreliability of regression betas that this is a good estimate of the beta of the company over the period. During the entire five-year period, Trumpeter maintained a debt to equity ratio of 25% and was in two businesses – chemicals and steel. In the last week, though, the company has gone through a major restructuring, selling off its steel business and using some of the cash to buy back stock. The tax rate for the firm is 40%. a. Estimate the unlevered beta for the company before the restructuring based upon the regression. (1 point) b. Now assume that the steel business (which has been sold off) represented 30% of the total value of the firm and that the unlevered beta for steel companies is 0.80. One third of the cash from the divestiture was used to pay down debt and the other two thirds was used to pay a special dividend. Estimate the beta for Trumpeter after the restructuring. (5 points) 2. You have been asked to review an investment analysis of a 10-year project with a big upfront investment of $ 10 million and equal annual after-tax cashflows for the next 10 years. The analyst has estimated a net present value for the project of $ 1.5 million, using the cost of equity of the firm of 12% as the discount rate. You notice three errors in the valuation: a. The cashflows being discounted are after taxes but before debt payments (interest and principal). The after-tax cost of debt for the firm is 4% and the firm has a debt to capital ratio of 30%. b. The analyst has depreciated the initial investment of $ 10 million straight line over 10 years to a salvage value of zero. You agree with the straight line depreciation but you believe that the asset should be depreciated down to an expected salvage value at the end of the 10th year of $ 2 million. Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. Spring 2004 Name: 2 c. The project is expected to have revenues of $ 15 million each year for the next 10 years and the non-cash working capital is expected to be 10% of the revenues over the entire period, with the investment in working capital being made at the beginning of each year. This investment will be fully salvaged in year 10. The tax rate is 40%. a. Given the estimates of net present value and assumption of no salvage, what was the analyst’s estimate of annual after-tax cash flow on the project? (2 points) b. What is the correct net present value for the project? (Make the necessary corrections to the cashflows and discount rates for the three errors noted on the last page) (4 points) 3. Salvatore Inc. is a motion picture production company. At the end of its most recent financial year, the firm had $ 500 million in interest bearing debt on its books (with interest payments of $ 35 million a year and an average maturity of 8 years). The firm has a rating of B+ and a pre-tax cost of debt of 8%. There are 50 million shares trading at $ 6 per share and the levered beta for the firm is 2.25. The tax rate is 40%, the riskfree rate is 4% and the market risk premium is 4.82%. a. Estimate the current cost of capital for the firm. ( 2 points) b. Assume now that Salvatore Inc. is able to issue enough stock to retire half of its outstanding debt (in market value terms). If the stock price does not change after this transaction, estimate the pre-tax cost of debt after the transaction. (4 points) 4. You have been asked to compare the dividend policies of three firms in the same business and have collected the following information on them for the most recent year: Halifax Donnelly Rutland Net Income $ 100 m $ 80 m $ 50 m Capital Expenditures $ 150 m $ 60 m $ 30 m Depreciation $ 60 m $ 30 m $ 15 m Increase in Non-cash Working Capital $ 10 m $ 10 m $ 5 m Spring 2004 Name: 3 Debt to Capital Ratio 0% 20% 20% Dividends $ 0 $ 40 m $ 30 m a. Assuming that these companies each started the most recent year with $ 10 million in cash balances, estimate the cash balances at the end of the year. ( 2 points) b. If Halifax had maintained the same debt ratio as the other two companies, how much could it have paid out in dividends in the most recent year without drawing on its starting cash balance? (2 points) c. Assume that Rutland expects its net income to double next year while net capital expenditures will increase by 50% and non-cash working capital will increase by $ 15 million. If the company wants to increase its cash balance by $ 20 million next year and maintain its existing debt to capital ratio, how much can it afford to pay in dividends next year (2 points) 5. You have been asked to value Supra Enterprises, a publicly traded firm and have collected the following information on the firm: After-tax Operating income in most recent year = $ 100 million Net Income in most recent year = $ 82.5 million Book Value of Debt at the start of the year = $ 250 million Book Value of Equity at the start of the year = $ 750 million Capital Expenditure in most recent year = $ 80 million Depreciation in most recent year = $ 30 million Increase in non-cash Working capital in most recent year = $ 10 million a. If you assume that Supra will maintain the return on capital and reinvestment rate that it had in the most recent year for the next 3 years, estimate the expected free cashflow to the firm each year for the next 3 years. ( 2 points) Spring 2005 Name: 2 - The reduction in inventory will also allow the company to sell off its existing storage facility (which has a book value of $ 5 million) today for $ 10 million and buy a new storage facility for $ 5 million. Both the old and the new storage facilities will be depreciated straight line over the next 10 years to a salvage value of zero. The firm has an income tax rate of 40%, a capital gains tax rate of 20% and a cost of capital of 10%. a. Estimate the cashflows at time 0 (today) from this investment. (2 points) b. Estimate the NPV of investing in the new inventory management system. (4 points) 3. PetSmart Inc.. is a publicly traded company involved in selling pet food and accessories. The firm has 15 million shares outstanding, trading at $ 10 a share; it has $ 50 million in 10-year bonds outstanding and interest expenses on the debt amounted to $ 2 million. The firm currently is rated A with a cost of debt of 5% and has a levered beta of 1.56. The riskfree rate is 4.5% and the market risk premium is 4%. The corporate marginal tax rate is 40%. a. Estimate the current cost of capital for PetSmart. (2 points) b. PetSmart announces that it will be borrowing $ 50 million and buying back stock at $10.75 a share. This will lower the rating to BB, with a pre-tax cost of debt of 7%. Assuming that all of the existing debt gets refinanced at this new rate, estimate the value per share after this transaction. (You can assume a growth rate of 3% in perpetuity.) 4. Girardo Mowers Inc. is a company that manufactures lawn mowers. It had net income of $ 15 million on revenues of $ 50 million last year, after depreciation charges of $ 10 million. Capital expenditures last year amounted to $ 16 million and total non-cash working capital was $ 10 million. The firm had a cash balance of $ 15 million and paid 50% of its earnings as dividends last year. There is no debt outstanding. a. Assuming that revenues, capital expenditures and depreciation grow 10% a year and that net income grows 12% a year for the next four years, and that the non-cash working capital as a percent of revenues does not change over this period, estimate the cash balance at the end of year 4, if the company maintains its current payout ratio and borrows no money. (2 points) Spring 2005 Name: 3 b. What proportion of earnings will Girardo Mowers have to pay out as dividends if the firm wants to to preserve its existing cash balance of $ 15 million at the end of 4 years? ( 2 points) c. Assuming that Girardo Mowers does not want to issue new stock and wants to maintain its existing payout ratio of 50% what debt ratio will the firm have to utilize over the next four years, to have a cash balance of $ 30 million at the end of the fourth year. (2 points) 5. You are trying to value SafeMoney Inc., a commercial bank, using the dividend discount model. SafeMoney Inc. is expected to pay $ 60 million in dividends on net income of $ 100 million next year. It is in stable growth, expecting to grow 4% a year in perpetuity. The cost of equity for banks is 8%. a. Value the equity in SafeMoney Inc. ( 1 point) b. If the expected growth rate is correct, estimate the return on equity that you are assuming for SafeMoney Inc. in perpetuity. (2 points) c. Assume now that you are told that SafeMoney can increase its return on equity to 12% in perpetuity, by lending to riskier clients. If the expected growth rate remains unchanged, what would the cost of equity have to be for the equity value to remain unchanged (from your answer in (a)? (2 points) Spring 2007 Name: 1 Corporate Finance: Final Exam Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. 1. Vaudeville Inc. is a small entertainment firm. It has 20 million shares outstanding, trading at $ 10 a share and $ 50 million in outstanding debt. The firm’s only business is making movies, but it does have $25 million as a cash balance. The firm has a regression beta based upon two years of stock returns of 1.85. The unlevered beta, cleansed of and corrected for cash holdings, for firms in the movie business is 1.20. The corporate tax rate is 40%. a. Estimate the bottom-up beta for Vaudeville. (3 points) b. The firm is considering borrowing $100 million and using the proceeds, in conjunction with the cash it has on hand, to enter the entertainment software business. The unlevered beta for firms in this business is 2.0. Estimate the beta for the company after the transaction. (3 points) 2. You are reviewing the net present value computation for a 5-year project, which requires an initial investment in fixtures and equipment of $ 10 million. The analyst has assumed straight-line depreciation down to a salvage value of zero, no working capital or capital maintenance investments over time and constant revenues and earnings over the five years, and arrived at a net present value of -$1.2 million (negative). The corporate tax rate is 40%. a. If the cost of capital used by the analyst is 10%, how much after-tax operating income is she assuming that the project will generate each year for the next 5 years. (2 points) b. Now assume that you find out that the project would be eligible for accelerated depreciation, with depreciation of $ 4 million in year 1, $ 3 million in year 2, $1.5 million in year 3, $ 1 million in year 4 and $0.5 million in year 5. If the tax rate for the firm is 40%, estimate the effect on the net present value of moving to this schedule (from the straight line depreciation) (2 points) c. Assume that the firm that is considering this project earned $ 40 million in pre-tax operating income last year; it had a book value of capital of $ 400 million and a market value of $ 1 billion. Assuming that the cost of capital of 10% applies to the entire firm, estimate the economic value added by this firm last year. (2 points) 3. Novacell Inc. is a manufacturer of solar panels that is considering moving from its existing policy of not borrowing money. The firm has 4 million shares outstanding, trading at $ 25 a share, no cash holdings and a beta of 1.20. The riskfree rate is 5%, the equity risk premium is 4% and the corporate tax rate is 40%. a. Estimate the current cost of capital for the firm. ( 1 point) b. Assume that the firm can borrow $ 25 million at a pre-tax rate of 7% and buy back shares.. Assuming that the firm is growing 3% a year in perpetuity and that investors are rational, estimate the change in value per share after the buyback. (2 points) c. Assume that instead of buying back shares, the firm had borrowed $25 million and invested the money in expanding its existing business. If the expansion has a net present value of $ 5 million, estimate the change in value per share after the transaction. (3 points) Spring 2008 Name: 2 3. Damocles Inc., a publicly traded firm, has 80 million shares trading at $ 10 a share and $ 200 million in debt (market value and book value). The firm currently has a beta of 1.20 and a pre-tax cost of debt of 5%. The riskfree rate is 4% and the market risk premium is 4.5%. The marginal tax rate is 40%. a. Estimate the current cost of capital for the firm. (1 point) b. The firm has announced that it will be borrowing $ 200 million and buying back shares. The rating for the firm will drop to BBB, causing the pre-tax cost of debt to rise to 6%. Estimate the new cost of capital for the firm. ( 2 points) c. Now assume that investors are rational and that the firm is growing 4% a year in perpetuity. How many shares can Damocles expect to buy back with $ 200 million? (2 points) 4. Cumina Stores is an all-equity-funded retailer looking for some guidance on dividend policy. Over the last 3 years, the company has seen its revenues and net income increase and has maintained a dividend payout ratio of 40% of net income: Year 3 years ago 2 years ago Most recent year Revenues $1,000 $1,200 $1,500 Net Income $ 100 $ 120 $ 150 Depreciation $ 50 $ 60 $ 75 Over the same three year period, Cumina Stores has seen its cash balance decline from $ 60 million to $ 20 million. a. Based on the information provided, estimate how much the firm reinvested in long- term assets and working capital over the 3-year period. (2 points) b. Assume now that revenues, net income and depreciation are expected to grow 10% a year for the next two years. Working capital is expected to remain 25% of total revenues over the period and capital expenditures will be 200% of depreciation each year. If the firm wants to maintain its dividend payout ratio at 40% and increase its cash balance back to $ 60 million, how much debt (as a percent of reinvestment) will the firm have to take on for this to be feasible? (4 points) 5. You are reviewing the discounted cash flow valuation of Roland Inc., a publicly traded automobile parts company. The analyst estimated the following numbers for the next 3 years (the high growth period) for the company: Year Current 1 2 3 EBIT(1-t) $80.00 $92.00 $105.80 $121.67 FCFF $20.00 $23.00 $26.45 $30.42 a. Assuming that the firm will maintain its existing return on capital for the next 3 years and that the analyst estimates of free cash flow and earnings are correct, estimate the return on capital for the firm. (2 points) b. At the end of year 3, the firm will be in stable growth, with a cost of capital of 10% and an expected growth rate of 4% forever. If the return on capital after year 3 will be 12%, estimate the value of the firm at the end of year 3. ( 2 points) c. The firm currently has a cost of capital of 12% (higher than its stable period cost of capital), a cash balance of $ 50 million and debt outstanding of $ 250 million. If there are 100 million shares outstanding, estimate the value of equity per share today. ( 2 points) Final Spring 2009 Name: 1 Corporate Finance: Final Exam Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. 1. You have been asked to assess the impact of a proposed acquisition on the beta of a firm and have been provided the following information on the two firms involved in the deal: Trident (Acquirer) Achilles (Target) Number of shares outstanding 1500 1000 Share price $8.00 $6.00 Market & Book value of debt $3000 $4000 Book value of equity $8000 $8000 Levered Beta 1.2 1.5 Tax rate 40% 40% Rating AAA BBB Default spread 0.50% 2.50% The riskfree rate is 4% and the equity risk premium is 6%. a. Estimate the unlevered beta of the combined firm. (3 points) b. Now assume that Trident plans to retire all of Achilles’ debt and that it will be able to buy Achilles’s equity at the current market price. If Trident would like to have a levered beta of 1.35 for the combined firm after the transaction, estimate how much new debt it will need to raise to finish this acquisition. (2 points) c. Finally, assume that the bond rating for the combined firm will drop to A+ after the transaction, with a default spread of 1.5%, estimate the cost of capital for the combined firm after the merger. (1 points) 2. You have been asked to examine the net present value computation for a 10-year project done by another analyst. The project will require an initial investment of $ 600 million and will be depreciated straight line over 10 years to a salvage value of zero. The project is expected to generate constant after-tax operating earnings every year for the next 10 years. The analyst estimated a net present value of $ 20 million for the project. To arrive at this value, he discounted the after-tax operating income (EBIT (1-t)) at the cost of equity and ignored working capital investments in his NPV computation. (In effect, the analyst discounted after-tax operating income at the cost of equity and subtracted out the initial investment in fixed assets to arrive at the NPV) • You estimate that the project will require an initial investment in non-cash working capital of $ 50 million, which can be fully salvaged back at the end of the 10th year. • The cost of equity is 12%, based upon the correct levered beta, but the firm has a debt to capital ratio of 40% and an after-tax cost of debt of 4%. (The tax rate is 40%) a. a. Estimate the “correct discount rate” that the analyst should have used to discount the cash flows. (1 point) Final Spring 2009 Name: 2 b. Assuming that the analyst’s estimate of after-tax operating income is correct, and taking into consideration his mistakes in computing the NPV, estimate the annual after- tax operating income on this investment. (2 points) c. Estimate the correct net present value on this investment, with all of the cash flows considered and using the correct discount rate. [You will need part b to do part c. If you have trouble with part b, use $ 100 million as your after-tax operating income and specify that you did so] (2 points) d. How would your answer to part c change if you were told that the initial investment could be depreciated over five years instead of ten. (The project will still last 10 years) [Hint: You do not have to do the whole analysis over. There is a short cut] ( 1 point) 3. You have been asked by Med Parts Inc, a medical device maker, for advice on whether they are using the right mix of debt and equity to fund their operations. The firm has 120 million shares trading at $ 10 a share and $ 300 million in outstanding debt. The current levered beta for the firm is 1.10 and the pre-tax cost of borrowing is 6%. The marginal tax rate is 40%, the riskfree rate is 5% and the equity risk premium is 4%. a. Estimate the current cost of capital for the firm. ( 1 point) b. If the market is valuing the firm correctly today and the expected free cash flow to the firm next year is $ 80 million, estimate the implied growth rate in this cash flow in perpetuity (given the cost of capital that you estimated in part a). ( 2 points) c. You estimate the optimal debt ratio for the firm to be 40% and believe that the cost of capital will drop to 8%, if you move to the optimal by borrowing money and buying back shares. If you buy back the shares at $10.25/share, estimate the increase in value per share for the remaining shares. [You will need part b to do part c. If you have trouble with part b, use 5% as your growth rate forever and specify that you did so] (2 points) d. Med Parts is considering whether it should be reinvesting the funds from new debt back into the business, rather than buying back stock. Under which of the following circumstances does it make sense for Med Parts to make this switch? (1 point) i. Never. Buying back stock will always increase the stock price more than taking new investments. ii. Only if the new investments generate returns that exceed the after-tax cost of debt. iii. Only if the new investments generate returns that exceed the cost of capital at the existing debt ratio. iv. Only if the new investments generate returns that exceed the cost of capital at the new debt ratio. v. Always, because the new investments will increase future growth. 4. You are trying to get a sense of how much Woods Inc, a sports supplies firm, should pay in dividends looking forward. You do know the following facts about the firm: • The firm generated $ 25 million in net income on revenues of $ 100 million in the most recent year and reported depreciation of $ 10 million for the same time period. • Capital expenditures in the most recent time period amounted to $ 15 million and total non-cash working capital currently is $ 12 million. Final Spring 2010 Name: 2 b. What annual licensing fee would Pfizer have to offer Life Products for the licensing deal to create more value for Life Products than Health Products producing the drug itself? (3 points) 3. CIQ Inc. is a company that provides information services to financial service companies. The company currently has 150 million shares, trading at $ 10 a share, and $ 500 million in debt (book and market). The firm currently has a beta (levered) of 1.20 and a pre-tax cost of debt of 6%; the marginal tax rate is 40%; the risk free rate is 4% and the equity risk premium is 5%. The firm is considering borrowing $ 500 million and buying back stock; it believes that doing so will lower its cost of capital to 8%. (You can assume no growth in the savings in perpetuity) a. Assuming that the firm can buy back stock at $10.25/share, estimate the increase in value per share for the remaining shares. (3 points) b. Now assume that you do not know what the price per share will be on the stock buyback. How much would the price per share on the buyback have to be for the value per share on the remaining shares to remain unchanged at $10/share? (3 points) 4. You are reviewing the earnings and cash flows statements of Texeira Ltd, a sports goods manufacturer that is all equity funded and have uncovered the following information on the firm over the last 3 years. Year -3 Year -2 Last year Revenues $1,000 $1,200 $1,500 Net Income $100 $120 $150 Depreciation $25 $40 $50 Non-cash Working capital $100 $90 $75 Texeira had a cash balance of $ 100 million two years ago (at the end of year -3) and has seen that cash balance increase to $ 120 million today. (You can assume that year -1 has just ended…) a. Assuming that the firm bought back no equity over the last two years and paid out 40% of its earnings as dividends, estimate how much the firm spent on capital expenditures (cumulated) over the last two years (i.e., years -1 and -2). (2 points) Final Spring 2010 Name: 3 b. You are now looking at making a forecast for next year and believe that the following assumptions hold: i. Revenues, net income and depreciation are expected to grow 15% next year. ii. Non-cash working capital as a percent of revenues will remain unchanged next year iii. Capital expenditures are expected to be 50% higher than depreciation next year iv. The company will finance 25% of its reinvestment needs (net cap ex and change in working capital) with debt. If the company wants to maintain its current payout ratio and reduce its cash balance from $120 million to $ 100 million, how much stock can it buy back next year? (3 points) 5. You are trying to value Hypo Bank, a European bank that has gone through a tumultuous adjustment to the crisis of 2008. The bank suspended dividends last year and currently has a book value of equity of $ 400 million and generated net income of $ 100 million on loans of $ 5 billion in the most recent year. The bank expects both loans and net income will grow at 10% a year for the next 5 years. The cost of equity is expected to be 12% for the next 5 years and 10% thereafter. a. Assuming that the bank would like to increase its regulatory capital ratio (defined as book equity/ loans) to 9% in year 5 in equal annual increments from the current level over the next 5 years, estimate the FCFE each year for the next 5 years. (3 points) b. At the end of year 5, the bank expects to be in stable growth and grow at 4% a year in perpetuity. It also expects to generate a return on equity of 12% in perpetuity. Estimate the terminal value of equity (at the end of year 5) for the bank. (2 points) c. If the bank has 50 million shares outstanding currently, estimate the value per share today. (1 point) Final Spring 2011 Name: 1 Corporate Finance: Final Exam Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. 1. Clarix Inc. is a publicly traded company that operates in two businesses – it generates 60% of its value from entertainment and 40% from electronics. The company has 100 million shares trading at $ 8/share, has $ 400 million (market and book value) in interest bearing debt and lease commitments of $ 80 million each year for the next 6 years. The current levered beta for the firm is 1.15 and the current bond rating for the firm is BBB, which corresponds to a default spread of 1.5%. The ten-year US treasury bond rate is 3.5%, the equity risk premium is 5% and the marginal tax rate is 40%. a. Estimate the current cost of capital for the firm. (2 points) b. Now assume that the firm plans to sell its electronics business at fair value and use 75% the proceeds to pay a special dividend to equity investors and 25% of the proceeds to retire interest bearing debt. If the unlevered beta of the electronics business is 0.90 and this transaction will lower the rating to BB (with a default spread of 3%), estimate the cost of capital after the transaction. (4 points) 2. Fatburger Inc. is a company that operates fast food restaurants and it is considering producing packaged food for sale at grocery stores. The initial investment in production facilities to start this venture will be $ 60 million, depreciable straight line over 10 years to a salvage value of $10 million. The packaged food business is expected to generate revenues of $ 100 million each year for the next 10 years and the EBITDA margin (EBITDA/revenues) is expected be 15% on these revenues. The working capital is expected to be 10% of revenues, with the investment occurring at the start of each period, where needed. The cost of capital for Fatburger is 12% but the cost of capital for other firms in the packaged food business is 9%. The marginal tax rate is 40%. a. Estimate the NPV of the investment. (3 points) b. Now assume that you expect this business to continue in perpetuity, after year 10. Estimate the NPV of the investment today. (2 points) c. Now assume that the packaged food business will increase the after-tax cashflows at the fast food restaurants by $ 5 million a year for the next 10 years. What value would you attach to this synergy? (1 point) 3. Prolox Inc. is a pharmaceutical company with 100 million shares trading at $10/share and debt outstanding of $ 250 million. The firm has a levered beta of 1.00 and a pre-tax cost of debt of 4.5%. The riskfree rate is 3.5%, the marginal tax rate is 40% and the equity risk premium is 5%. a. Estimate the current cost of capital for the firm. ( 1 point) Final Spring 2012 Name: 1 Corporate Finance: Final Exam Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. 1. Novellus Inc. is a publicly traded company that operates in three businesses with the following characteristics: Revenues (in millions) Estimated Enterprise Value (in millions) Unlevered Beta Storage Device $600.00 $400.00 0.9 Electronics $500.00 $600.00 1.2 Social Media $400.00 $800.00 1.8 The firm has 100 million shares trading at $ 12/share, has no cash balance and raises the rest of its funding from debt. The marginal tax rate is 40%. a. Estimate the current levered beta for the firm. (2 points) b. Assume that Novellus is planning to sell its storage device business for the estimated value and invest half the proceeds in its social media business and use the other half to retire debt. Estimate the new beta for the firm. (2 points) c. How would you answer to (b) change, if you used the proceeds entirely to buy back shares in the company? (2 points) 2. You own a retail business and generated $ 40 million in EBITDA on revenues of $ 200 million in the most recent year. You are considering spending $ 20 million in a new computerized inventory system; the investment is depreciable straight line over 5 years to a salvage value of zero. If you install the system, you expect to see two primary benefits: • Your revenues which had been expected to be flat ($200 million each year) for the next 5 years will grow 5% each year for the next 5 years with the new system in place ($210 million next year, $ $220.5 million in year 2 etc…) • Your EBITDA margin (as a percent of revenues) will remain unchanged at current levels for the next 5 years but you do expect your non-cash working capital which is currently 10% of revenues to drop to 5% of revenues immediately and remain at that percent level each year for the next 5 years. At the end of year 5, you expect to scrap the new inventory system and get no salvage value for the system. The working capital is expected to revert back to 10% of revenues at the point in time. Your marginal tax rate is 40% and your cost of capital is 10%. a. Estimate the NPV of the investment. (3 points) b. If you can expense the computerized inventory system rather than depreciate it, estimate the NPV of the investment. (1 point) c. Now assume that you are offered the alternative of using a service to manage your inventory. Assuming that the benefits that the service delivers are equivalent to those stated in part (a), i.e., higher growth in revenues and lower working capital requirements, how much would you be willing to pay as an annual fee for this service for the next 5 years? (2 points) Final Spring 2012 Name: 2 3. You are looking at Lizma Steel, a mature steel company that generated $ 120 million in operating income (EBIT) last year on revenues of $ 5 billion. The firm has 40 million shares trading at $ 20/share and $ 200 million (book & market) in debt. The current beta (levered) is 1.15 and the pre-tax cost of debt is 4%. The marginal tax rate is 40%, the riskfree rate is 3% and the equity risk premium is 6%. a. Estimate the current cost of capital for Lizma Steel. (1 point) b. Now assume that you are considering doing an LBO (leveraged buyout) of Lizma Steel and are looking to move to a mix of 90% debt and 10% equity. If the pre-tax cost of the debt in the LBO will be 7.5%, estimate the cost of capital at a 90% debt ratio. (2 points) c. How much would you need to borrow (in dollar terms) to get to a 90% debt ratio of the new firm value? (If necessary, you can assume that any savings you get from a change in cost of capital will be perpetual and have no growth) (2 points) d. How (if at all) would your answer to part (b) change if you were told that Lizma Steel has only $ 60 million in operating income? (1 point) 4. You have been provided with forecasts of operating items for Zune Inc. for the next 5 years (in millions): Most recent year (just ended) 1 2 3 4 5 Revenues $1,000 $1,100 $1,200 $1,300 $1,400 $1,500 EBITDA $250 $275 $300 $325 $350 $375 Depreciation $60 $66 $72 $78 $84 $90 Net Income $80 $88 $96 $104 $112 $120 Non-cash Working Capital $75 $70 $65 $60 $50 $40 Total Debt outstanding 150 145 140 135 130 125 a. The firm currently has a cash balance of $ 150 million and expects this cash balance to drop to $50 million by the end of year 5. If the company plans to pay out 60% of its earnings as dividends for the next 5 years, how much capital expenditure does it have planned cumulatively for the five-year period? (3 years) b. If the company would like to keep its cash balance unchanged over the next 5 years, i.e., it wants its cash balance to be $ 150 million at the end of year 5, and pay off all of its debt over the 5 years, what dividend payout ratio should the firm maintain, on average, over the next 5 years? (2 points) c. Which of the following would you consider the most defensible reason for a company that has never paid dividends before, to initiate dividends? (1 point) i. The company wants to attract pension fund investors who are restricted from buying stocks that don’t pay dividends ii. The company had a windfall gain from a lawsuit that increases income and cash flows this year. iii. The company expects earnings growth and reinvestment needs to be much higher in the future iv. The company expects its earnings growth and reinvestment needs to decrease in the future Final Spring 2012 Name: 3 v. All the other companies in the sector pay dividends 5. You are trying to value Kappa Inc., a small, publicly traded entertainment company. The firm generated $ 10 million in after-tax operating income in the most recent year on revenues of $ 80 million; the invested capital (book value) at the start of the year was $ 100 million. The firm is expected to maintain its existing return on capital in perpetuity. Capital expenditures in the most recent year amounted to $ 12 million, depreciation was $ 5 million and non-cash working capital increased from $ 6 million to $ 8 million during the course of the year. The firm is expected to have a 12% cost of capital for the next 5 years and 8% thereafter. a. Assuming that Kappa maintains the reinvestment rate that it posted in its most recent year for the next 5 years, estimate the expected free cash flows to the firm each year for the next 5 years. (3 points) b. At the end of year 5, Kappa Inc. is expected to be a stable growth firm, growing 3% a year in perpetuity. Estimate the terminal value (the value at the end of year 5). (2 points) c. Finally, assume that Kappa Inc. has a cash balance of $ 15 million, debt outstanding (in book and market terms) of 40 million and 8 million shares outstanding, estimate the value per share. (1 point) Final Spring 2013 Name: 3 a. The company currently has a cash balance of $45 million. How much cash will be left after year 3, if it pays no dividends and does not borrow money? (3 points) b. Assume that the company decides to institute a dividend payout ratio of 20% and also to borrow $4 million every year for the next three years. How much stock can the company buy back over the three years, if it wants to have a cash balance of $10 million at the end of year 3? (3 points) 5. Loma Vista Inc. is a small, publicly traded company that manufactures beachwear and casual apparel. The company generated $ 10 million in after-tax operating income on revenues of $100 million in the most recent year. It reported book value (and market value) of debt of $15 million, book value of equity of $45 million and a cash balance of $10 million; the company’s return on capital is expected to remain stable in perpetuity. The company has a cost of equity of 15% and a cost of capital of 12% today. a. Loma Vista had capital expenditures of $7 million and depreciation of $ 5 million in the most recent year. Its working capital increased from $9 million to $10 million during the year. Finally, while the company did not do an acquisition last year, it does one acquisition every 5 years at a cost of approximately $15 million. Assuming that it continues its existing reinvestment policy, estimate the expected free cash flow to the firm each year for the next 3 years. (3 points) b. At the end of year 3, the company expects growth to drop to 3% a year in perpetuity and its cost of equity will drop to 12% and its cost of capital to 10% after year 3. Estimate the terminal value (end of year 3). (1.5 points) c. Estimate the value of equity per share today, if there are 5 million shares outstanding. (Please be explicit about the discount rate that you are using to compute your value today.) (1.5 points) Final Spring 2014 Name: 1 Corporate Finance: Final Exam Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. For partial credit, when discounting, please show the discount rate that you are using (not just the PV). 1. Alliant Technology is a publicly traded company that sells both computer hardware and services. It has no debt outstanding or cash. In the most recent year, the company reported the following information about its two businesses: Sector Averages Business Revenues (in $ millions) Enterprise Value/Sales Unlevered Beta Computer hardware $1,000 0.80 1.25 Computer services $600 2.00 0.9 The company also provides the breakdown of revenues geographically: Country Risk free rate In local currency Equity Risk Premium Marginal tax rate Total Revenues (in $ millions) United States 3.00% (US $) 5.00% 40% $800.00 China 4.00% (Yuan) 7.00% 25% $800.00 Both countries have the same mix of hardware & service businesses. a. Estimate the cost of equity in US dollars for Alliant Technology (2 points) b. Now assume that Alliant wants to sell just its hardware business in the United States at fair value (based on the EV/Sales ratio for the sector) in the United States, borrow an additional $400 million in the US and invest the total amount in computer services in China. Estimate the cost of equity in US $ for Alliant after the transaction. (3 points) 2. Hillsdale Media is a specialty kitchen cabinet maker that produces cabinets to order. It is a mature business that earned EBITDA of $900,000 on revenues of $ 5 million in the most recent year and is expected to continue to generate these figures in perpetuity. The company is considering carrying some of its most popular models in inventory, with an eye on increasing sales and operating profits. It has collected the following information: • To carry inventory, the company will have to invest $2.25 million in a storage facility, which will be depreciated straight line over ten years down to a salvage value of $250,000. • With the inventory, the company expects its annual revenues to increase to $7.5 million and its overall EBITDA margin (EBITDA as % of sales) to increase to 20%. • For the next decade, the inventory will be maintained at 10% of total revenues, with the investment made at the start of each year. The inventory will be sold for book value at the end of ten years. • The cost of capital for the company is 10% and it faces a 40% tax rate. Final Spring 2014 Name: 2 a. Estimate the NPV of the project (carrying inventory) assuming at ten-year life for the investment. (4 points) b. Estimate the breakeven EBITDA margin for the company, for the investment to have a zero NPV, if you now assume that the project lasts forever. (2 points) 3. Voltaire Steel is a highly levered company with 20 million shares, trading at $10/share and $800 million in debt (in market and book value terms) outstanding. The pre-tax cost of debt for the company is 10%, the marginal tax rate is 40% and the levered beta for the company is 3.06. The risk free rate is 3% and the equity risk premium is 5%. a. Estimate the cost of capital for the company. (1 point) b. A bondholder in the firm is willing to accept 20 million newly issued shares in the company in exchange for $200 million in debt (which will be retired). This transaction will raise the company’s bond rating to BBB and lower their pre-tax cost of debt to 7.5%. Estimate the new cost of capital, if you go through with the swap. (2 points) c. Assuming that you go through with the swap of equity for debt (from part b), estimate the value per share after the transaction. (You can assume that the firm is in perpetual growth, growing 2% a year forever) ( 3 points) 4. You have been asked to assess the dividend policy of Gallows Inc., a funeral home company that was started as a business on January 1, 2011. You have been provided with the information from its operating history: 2011 2012 2013 Revenues $1,000 $1,100 $1,200 Net Income $100 $110 $120 Depreciation $40 $45 $50 Cap Ex $50 $60 $70 Non---cash Working capital (End of year) $10 $30 $60 Total Debt (End of year) $10 $15 $75 Dividend payout ratio 0% 40% 50% a. Assuming that the company started operations on January 1, 2011, with no cash and no debt, how much cash did the company have at the end of each year from 2011 to 2013. (3 points) b. Now assume that the company plans to double its non-cash working capital as a percent of revenues and believes that doing so will allow it to grow revenues 20% a year for the next three years, while maintaining the net margin and payout ratio it had in the most recent year. If capital expenditures and depreciation are expected to grow 10% a year and the company intends to repay its existing debt in three equal annual installments, estimate the cash balance three years from now. (You can assume that you are at the start of 2014) (3 points) 5 Final Spring 2015 Name: 3. Madeira Inc. is a publicly traded company that is considering a restructuring plan. The company currently has 150 million shares trading at $12/share and total debt outstanding of $200 million. The firm currently has a (levered) beta of 1.20, the risk free rate is 2%, the equity risk premium is 6% and the marginal tax rate is 40%. a. The firm is planning to double its dollar debt and use the proceeds from the new debt to pay dividends & buy back stock. If it’s bond rating will drop to BBB with a default spread of 2.5% over the risk free rate, estimate the cost of capital after the recapitalization. (2 points) b. You estimate that if the firm doubles its debt, its value as a business will increase by 2%. Estimate the pre-tax cost of debt that currently faces (before recapitalization), if the firm is mature with no growth expected in perpetuity. (2 points) c. Now assume that the firm plans to use half of the proceeds to buy back stock at $12.50/share and the other half to pay a special dividend to the remaining shareholders. Estimate the value per share of the remaining shares after the recapitalization. (2 points) 4. You have been asked to assess the dividend policy of Spring Tide Inc., a consumer product company and have been given the last two years of data on the company. 2013 2014 Revenues $1,000 $1,100 EBITDA $500 $560 EBIT $400 $440 Net Income $150 $180 Total Working Capital (including cash) $100 $120 Cash (invested in T.Bills) $40 $80 Total Debt $90 $120 The company also had capital expenditures of $150 million in 2014 and made a cash acquisition of $50 million in 2014. a. If Spring Tide bought back $50 million of its own stock in 2014, estimate the dividend payout ratio for Spring Tide in 2014. (Dividend payout = Dividends as a percent of net income). (2 points) b. Now assume that you are told that net income and revenues are expected to grow 20% in 2015, while capital expenditures and depreciation will grow 10%. In addition, the company plans to make no cash acquisitions in 2015, to maintain non-cash working capital at the same percent of revenues as it did in 2014 and to pay out 25% of its net income as dividends. Estimate how much the company can spend on stock buybacks in 2015, if it also wants to increase its cash balance by $20 million during the year and retire half of its total debt. (3 points) c. Assuming that you operate in a market where capital gains are taxed at 20%, and dividends are taxed at 40% for all investors. However, investors are allowed to claim a tax credit for taxes paid by company on the income used to pay dividends. If the average effective corporate tax rate is 30%, which of the following would you expect to observe, on average, happening to stock prices on the ex-dividend day? i. Stock price will decrease by more than the dividend paid ii. Stock price will decrease by less than the dividend paid iii. Stock price will increase by more than the dividend paid iv. Stock price will increase by less than the dividend paid v. Stock price will not change 5. Carbon Springs is a beverage company that reported the following numbers for the most recent fiscal year: Most recent year Revenues $2,000.00 EBITDA $500.00 DA $100.00 6 Final Spring 2015 Name: EBIT $400.00 - Interest expenses $50.00 Taxable Income $350.00 Taxes $105.00 Net Income $245.00 During the year, the company reported capital expenditures (including acquisitions) of $200 million and an increase in non-cash working capital of $40 million. You can assume that the company will continue to generate its current return on invested capital in perpetuity and that its effective tax rate is the marginal tax rate. a. Assuming that operating income will grow at 8% a year for the next five years, estimate the free cash flows to the firm for the next five years. (2 points) b. At the end of year 5, the company is expected to become a mature business, growing at 2% a year in perpetuity with a cost of capital of 8% (mature company levels). Estimate the value of the business at the end of year 5. (2 points) c. Assume that the company’s current cost of capital is 12% and is expected to stay at that level for the next 5 years, estimate the value of equity per share today. (The total debt outstanding is $1 billion, the company’s cash balance is $600 million and there are 150 million shares outstanding.) 7 Final Spring 2016 Name: Final Exam: Corporate Finance (Spring 2016) Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. 1. Thexos Inc. is a company that has operated in two businesses, housewares and food processing, across the US and Mexico, for the last five years. You have a regression of the returns of the stock against the market index (on top) and a breakdown of revenues by country, below. Regression: ReturnsThexos = 0.20% + 0.944 ReturnsMarket Index Regional Breakdown Revenues (in $ millions) Govt Bond rate (in US $) Govt Bond rate (in Pesos) Marginal tax rate Equity Risk Premium (Total) US $800 2.00% NA 40% 6.00% Mexico $200 3.50% 6.00% 30% 8.00% The company had an average (market) debt to equity ratio of 30% during the last five years, with all of the debt in the US, but it currently has 150 million shares trading at $10 per share and no debt outstanding. The marginal tax rate is 40%. a. Assuming that the regression beta is the right beta for the equity for the five-year period, estimate the cost of equity for the company in US dollar terms today. (2 points) b. Now assume that the company plans to sell off its housewares business, which accounts for 40% of the current value of the company, for fair value, and hold the cash. If the unlevered beta for housewares is 0.65, estimate the US dollar cost of equity for the company after this transaction. (You can assume that the geographical mix is unaffected). (2 points) c. Now assume that the company plans to sell off its housewares business, which accounts for 40% of the current value of the company, for fair value, and uses the cash from the divestiture to invest in the luxury retail business in Mexico, estimate the cost of equity after this investment. (You can assume that the EV/Sales ratio for the retail business is 1.5 and that the unlevered beta of this business is 1.20) (2 points) 2. Collier Inc. is a firm that currently generates an EBITDA of $200 million on revenues of $ 1 billion (all in the US) and is a mature business, with stable margins and growth of 2% a year in perpetuity. The company is considering an expansion opportunity (in the same business) in China, where investing $1.5 billion will allow the company to double its sales immediately (with the additional sales coming from China), while generating an EBITDA margin of 40% (in perpetuity) on the additional sales. The marginal tax rate is 40%. a. Assume that the company currently is all equity funded and uses a (correct) US $ cost of capital of 6.5% on its US investments. What cost of capital would you use for the China expansion, if the company plans to borrow 20% of the capital needed for the investment at a 5% US $ interest rate? (The risk free rate in US $ is 2% and the US ERP is 6%; the ERP in China is 9%) (2 points) b. Assume that 10% of the initial investment will be depreciated each year, but also that capital maintenance will be 110% of depreciation. Estimate the NPV of this investment. (2 points) c. What is the return on equity on the expansion investment and what does it tell you about whether the investment is a good or bad one? (Show the comparison you would make to arrive at your conclusion? (2 points) 3. Xterra Inc. is an all-equity funded technology company that is profitable but is seeing growth slacken, as it matures. The company has 25 million shares trading at $10/share currently and generated $10 million in operating income in the most recent year. The company’s current cost of equity is 6.8%, the risk free rate is 2%, the marginal tax rate is 40% and the equity risk 10 Final Spring 2017 Name: Corporate Finance: Final Exam Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. 1. Sumi Inc. is an all-equity funded company that is incorporated in Thailand but gets a large portion of its revenue in the US, while operating in two businesses: steel and chemicals. You have been provided the geographic and business breakdown for the value of the company in the table below (in millions of US$): Country Steel Chemicals ERP for Country US $800 $200 5.00% Thailand $400 $100 7.25% Unlevered beta for business 1.20 0.90 The US treasury bond rate is 2.5% and the Thai US$ Government bond rate is 4.5%. Estimate the cost of equity for the company in US dollar terms. (4 points) 2. Collins Inc. is a publicly traded company with a market capitalization (market value of equity) of $900 million and $100 million in interest-bearing debt. You have computed a cost of capital for the company based on this mix: Market Value (in millions US$) % of Capital Cost of component Debt $100.00 10.00% 3.00% (after tax) Equity $900.00 90.00% 9.00% Capital $1,000.00 100.00% 8.400% Reviewing your calculations, you realize that while the unlevered beta (used to estimate a levered beta and a cost of equity) and cost of debt estimates are right, you forgot to capitalize lease commitments, which amount to $120 million a year, each year for the next ten years. If you capitalize leases (and treat them as debt), estimate the correct cost of capital for the company. (The riskfree rate is 3%, the equity risk premium is 5% and the marginal tax rate is 40%) (3 points) 3. You have been asked to estimate the NPV of an investment in a new 3-year venture for a telecomm firm. a. The initial investment is expected to be $1 billion and will be depreciated straight line over three years to a salvage value of $100 million at the end of the third year. b. During the three years, working capital is expected to be 15% of revenues and the investment has to be made at the start of each year; it can be fully salvaged at the end of the project. c. The cost of capital for the investment is 9% and the tax rate is 30%. d. The project is expected to have the following revenues and EBITDA for the next 3 years (in millions of dollars) 1 2 3 Revenues $1,000.00 $1,200.00 $1,500.00 EBITDA $300.00 $400.00 $600.00 Estimate the NPV for this project. (4 points) 4. Underpaid at your job, you are considering becoming an Uber driver. While you believe that you can make $12/hour after taxes and vehicle maintenance costs, driving 800 hours a year, you also recognize that you will need to buy a more expensive car (than 11 Final Spring 2017 Name: the one you would normally buy) and that the car will not last as long, if you drive for Uber: Without Uber With Uber Cost of car $15000 $25000 Car life (in years) 5 3 Salvage value (at end of life) $5,000 $4,000 Depreciation method None Straight line for tax purposes If your tax rate is 40% and your discount rate is 8%, estimate the annual after-tax income you will earn as an Uber driver, with the incremental car costs factored in. (You can assume that your income will stay constant over time, as will the car related costs in this table). (4 points) 5. Maxim Enterprises currently has the following capital structure (with associated costs): Market Value Cost of Component (after taxes) Debt = $400.00 2.40% Equity = $600.00 9.30% Capital $1000.00 6.54% The company is expected to generate $48 million in operating income next year and face a marginal tax rate of 40% on taxable income. If Maxim borrows $400 million and buys back stock, you believe that this will double the pre-tax cost of debt. Estimate the cost of capital for the firm after the recapitalization. (The risk free rate is 3% and the equity risk premium is 5%.) (4 points) 6. Conway Inc. has 125 million shares, trading at $8/share, no debt and a cost of equity of 9%. You believe that if the company is able to borrow $400 million and buy back shares, the cost of capital will drop to 8%. If there is no growth in the savings (from a lower cost of capital) and the shares are bought back at $10/share, estimate the value per share for the remaining shares after the buyback. (3 points) 7. Roslyn Inc. is a small, publicly traded company that had revenues of $250 million in the most recent year, while breaking even (a profit of zero). Currently, the company has total working capital of $35 million, which includes a cash balance of $25 million. The table below provides estimates of revenues and net profit margins for the company, for the next five years. Year 1 2 3 4 5 Revenue (in millions) $750.00 $1,000.00 $1,200.00 $1,350.00 $1,500.00 Net Profit Margin 2% 3% 4% 5% 6% The company plans to keep its non-cash working capital, as a percent of revenues, constant for the next five years and has no significant capital expenditures or depreciation over that period. If the company plans to return no cash in years 1 and 2, and pay out 40% of net income as dividends in years 3-5, estimate how much of a cash balance it will have at the end of year 5. (4 points) 8. You are trying to value Hollow Inc. and have estimated the following cash flows for the firm for its high growth period: Last year 1 2 3 12 Final Spring 2017 Name: Expected Growth Rate 7.5% 7.5% 7.5% EBIT (1-t) $100.00 $107.50 $115.56 $124.23 + Depreciation $20.00 $21.50 $23.22 $25.08 - Cap Ex $80.00 $86.00 $92.88 $100.31 FCFF $40.00 $43.00 $45.90 $49.00 Cost of capital 10% 10% 10% After year 3, Hollow Inc. is expected to be a mature firm, growing 2.5% a year in perpetuity with a cost of capital of 8%. If the company will earn the same return on capital (as it is expected to earn in years 1-3) in perpetuity, estimate the terminal value of the firm, i.e.., the value of the firm at the of year 3. (4 points) Spring 2019 Name: 3 EBITDA $150.00 Non-cash Working Capital 125 Equity 550 DA $50.00 Cash 125 EBIT $100.00 Total 750 Total 750 Interest Expense $20.00 EBT $80.00 Taxes $20.00 Net Income $60.00 In the most recent year, the company also reported capital expenditures of $90 million and an increase in working capital of $ 10 million. Justin will continue to reinvest at the same rate as it did in the most recent year and generate the same return on invested capital it earned in the most recent year, for the next three years. If after year 3, it becomes a mature firm, growing 3% a year in perpetuity (while maintaining its current return on capital), estimate the value of the equity today. (5 points) Spring 2019 Name: NUMBER OF YEARS IN ANNUITY 1 2 3 4 5 6 7 8 9 10 15 20 25 0% 1.0000 2.0000 3.0000 4.0000 5.0000 6.0000 7.0000 8.0000 9.0000 10.0000 15.0000 | 20.0000 | 25.0000 1% 0.9901 1.9704 2.9410 3.9020 4.8534 5.7955 6.7282 7.6517 8.5660 9.4713 13.8651 18.0456 | 22.0232 2% 0.9804 1.9416 2.8839 3.8077 4.71235 5.6014 6.4720 7.3255 8.1622 8.9826 12.8493 16.3514 19.5235 3% 0.9709 1.9135 2.8286 3.7171 4.5797 5.4172 6.2303 7.0197 7.7861 8.5302 11.9379 14.8775 17.4131 4% 0.9615 1.8861 2.7751 3.6299 4.4518 5.2421 6.0021 6.7327 7.4353 8.1109 11.1184 13.5903 15.6221 0.9524 1.8594 2.7232 3.5460 4.3295 5.0757 5.7864 6.4632 7.1078 7.7217 10.3797_| 12.4622 | 14.0939 0.9434 1.8334 2.6730 3.4651 4.2124 4.9173 5.5824 6.2098 6.8017 7.3601 9.7122 11.4699 | 12.7834 0.9346 1.8080 2.6243 3.3872 4.1002 4.7665 5.3893 5.9713 6.5152 7.0236 9.1079 10.5940 | 11.6536 0.9259 1.7833 2.5771 3.3121 3.9927 4.6229 5.2064 5.7466 6.2469 6.7101 8.5595 9.8181 10.6748 ZIZ|Z/ZlF 0.9174 1.7591 2.5313 3.2397 3.8897 4.4859 5.0330 5.5348 5.9952 6.4177 8.0607 9.1285 9.8226 10% 0.9091 1.7355 2.4869 3.1699 3.7908 4.3553 4.8684 5.3349 5.7590 6.1446 7.6061 8.5136 9.0770 11% 0.9009 1.7125 2.4437 3.1024 3.6959 4.2305 4.7122 5.1461 5.5370 5.8892 7.1909 7.9633 8.4217 0.8929 1.6901 2.4018 3.0373 3.6048 4.1114 4.5638 4.9676 5.3282 5.6502 6.8109 7.4694 7.8431 0.8850 1.6681 2.3612 2.9745 3.5172 3.9975 4.4226 4.7988 5.1317 5.4262 6.4624 7.0248 7.3300 DISCOUNT RATE BR 14% 0.8772 1.6467 2.3216 2.9137 3.4331 3.8887 4.2883 4.6389 4.9464 5.2161 6.1422 6.6231 6.8729 15% 0.8696 1.6257 2.2832 2.8550 3.3522 3.7845 4.1604 4.4873 4.7716 5.0188 5.8474 6.2593 6.4641 16% 0.8621 1.6052 2.2459 2.7982 3.2743 3.6847 4.0386, 4.3436 4.6065 4.8332 5.5755 5.9288 6.0971 17% 0.8547 1.5852 2.2096 2.7432 3.1993 3.5892 3.9224 4.2072 4.4506 4.6586 5.3242 5.6278 5.7662 18% 0.8475 1.5656 2.1743 2.6901 3.1272 3.4976 3.8115 4.0776 4.3030 4.4941 5.0916 5.3527 5.4669 19% 0.8403 1.5465 2.1399 2.6386 3.0576 3.4098 3.7057 3.9544 4.1633 4.3389 4.8759 5.1009 5.1951 20% 0.8333 1.5278 2.1065 2.5887 2.9906 3.3255 3.6046 3.8372 4.0310 4.1925 4.6755 4.8696 4.9476 21% 0.8264 1.5095 2.0739 2.5404 2.9260 3.2446 3.5079 3.7256 3.9054 4.0541 4.4890 4.6567 4.7213 22% 0.8197 1.4915 2.0422 2.4936 2.8636 3.1669 3.4155 3.6193 3.7863 3.9232 4.3152 4.4603 4.5139 23% 0.8130 1.4740 2.0114 2.4483 2.8035 3.0923 3.3270 3.5179 3.6731 3.7993 4.1530 4.2786 4.3232 24% 0.8065 1.4568 1.9813 2.4043 2.7454 3.0205 3.2423 3.4212 3.5655 3.6819 4.0013 4.1103 4.1474 25% 0.8000 1.4400 1.9520 2.3616 2.6893 2.9514 3.1611 3.3289 3.4631 3.5705 3.8593 3.9539 3.9849 HOW TO USE THIS TABLE: PV OF OF A 10-YEAR ANNUITY (OF $1) WITHA 12% DISCOUNT R 5.6502 —_(Look under 10 years on the top axis and for 12% in the vertical axis) IF YOU HAVE $50 MILLION A YEAR FOR 10 YEARS, @12% = 282.51 ! 50*6.6502