Question 1: 10 marks.

XYZ Corporation is considering an investment which costs $100 today and produces free cash
flows of $72 at the end of each of the next two years. The firm faces a corporate tax rate of 40%.
Its cost of levered equity is 26%, and it can borrow at an interest rate of 10%. XYZ has a target
debt-equity ratio of 1.

(a) (3 marks) Use the weighted average cost of capital method to determine the net present value
of this investment.

Since the debt-equity ratio is 1, the debt-value ratio is 0.5 and the equity-value ratio is 0.5. The
weighted average cost of capital is:
rwacc = .50(.26) + .50(.10)(.6) = .16. (2 marks)
The net present value of the investment is:
$72 $72
NPV = −$100 + + = $15.58. (1 mark)
1.16 1.162

The NPV of the investment is $15.58 .

(b) (5 marks) Determine the net present value of this investment using the adjusted present value
(APV) method.

To use the APV approach, start by determining the unlevered cost of capital rU . Since the firm
maintains a target debt-equity ratio, rU is the “pretax WACC”:
rU = .50(.26) + .50(.10) = .18.
The unlevered NPV is
NPV U = −$100 + $72 × A2.18 = $12.73. (2 marks)
Next, determine the debt capacity of the project (using rwacc as the discount rate):
d2 = 0,
$72
V1L = = $62.07 ⇒ d1 = .50 × $62.07 = $31.03, (0.5 marks)
1.16
$62.07 + $72
V0L = = $115.58 ⇒ d0 = .50 × $115.58 = $57.79. (0.5 marks)
1.16
To calculate the present value of the interest tax shields, discount at rU = 18%:
$57.79(.10)(.4) $31.03(.10)(.4)
PV (interest tax shields) = + = $2.85. (1 mark)
1.18 1.182
This gives a levered NPV of $12.73 + $2.85 = $15.58, as in part (a). (1 mark)

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(c) (2 marks) Assume that instead of maintaining a target debt-equity ratio, the firm opts for a
target interest coverage ratio of 15%. Without actually calculating the NPV, can we determine if
the NPV would be higher or lower than with the fixed debt-equity ratio? If so, discuss whether it
would go up or down. If not, discuss why we cannot determine it without actually calculating the
NPV. Don’t let the full page of available space fool you, it’s only like that because there is no part
(d).

A target interest coverage ratio of 15% would imply a debt level of .15×72
0.1 = 108 which far exceeds
the amount of debt with a fixed debt/value ratio. This implies more tax shields and thus the NPV
will be higher.

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Question 2: 10 marks.

Rancho Relaxo Corp currently has an enterprise value of $400 million and $100 million in excess
cash. The firm has 10 million shares outstanding and no debt. Suppose Rancho Relaxo will pay
out its excess cash in a one time special dividend. After the dividend, news will come out that will
change Rancho’s enterprise value to either $600 million (good news) or $200 million (bad news).
Assume there is no corporate or individual taxes.

(a) (4 marks) What is Rancho Relaxo’s share price before the dividend? What will be the share
price after the dividend if the news is good?
Before:
$400 + $100
= $50 (2 marks)
10
After with good news:

$600
= $60 (2 marks)
10

The share price before the dividend is $50 .

The share price after the dividend if the news is good is: $60 .

(b) (2 marks) Suppose that the management of Rancho Relaxo knows that the news will be good
(but that markets are otherwise perfect). Could shareholders benefit if management waited to pay
the dividend until after the news is released? Why or why not?

No. The amount paid to shareholders through a dividend does not depend on the stock price like
a share repurchase. Given that an individual can replicate any dividend policy they want in an
otherwise perfect market, it makes no difference when the dividend is paid.

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(c) (2 marks) Suppose that the management of Rancho Relaxo knows that the news will be good
(but that markets are otherwise perfect). If management will pay out the cash before the news is
released, would they prefer to do a share repurchase instead of a dividend? Explain why or why
not. You can assume that management owns shares in Rancho Relaxo.

The manager knows the firm is undervalued, thus if s/he bought back shares now, he would be
creating value for shareholders (at least the ones who don’t sell!). A dividend on the other hand
will not create any value.

(d) (2 marks) Suppose that the management of Rancho Relaxo knows that the news will be good
(but that markets are otherwise perfect). If management will pay out the cash after the news is re-
leased, should they do a share repurchase instead of a dividend? Explain why or why not. Assume
managers act in the best interest of shareholders.

After the news is released, the manager no longer has any insider info and the stock is valued as
it should. Given that markets are completely perfect at this point, investors will not care whether
cash is paid through a dividend or share repo.

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Question 3: 10 marks.

Auckland Travel Inc. has traditionally served customers in the travel planning industry. It is
evaluating whether to establish a new division that will sell insurance to travelers. Auckland has
identified two comparable firms which exclusively operate in the travel insurance industry. Auck-
land has obtained the following estimates for these comparable firms (each of which maintains a
target debt-equity ratio):

Comparable Firm #1 Comparable Firm #2

Equity beta 1.25 1.65
Debt beta 0.10 0.15
Debt-equity ratio 1 1.5

Auckland believes that the cost to start this new division will be $100 million and will generate
free cash flow of $20 million dollars every year forever (with the first payment in exactly one year).
It intends to finance the initial cost with $50 million in debt, and expects to maintain debt at that
level forever (i.e., it will issue perpetual debt). It believes that the debt will have a beta of zero
and interest on the debt will reflect the fact that it is risk-free. It faces a corporate tax rate of 40%.
Assume that the risk-free interest rate is 3% and the market risk premium is 4%. Using averages of
the information from the two comparable firms, determine the NPV of this investment. Hint: first
you will need to get rU as an average of the rU ’s from the two comparable firms.
Note that there is room provided on this page and the next for you to show your work. Please put
your final NPV amount in the space provided on the next page.

start by calculating the cost of equity and the cost of debt for each of the comparable firms. For
Comparable Firm #1:

rE = .03 + 1.25(.04) = .08

rD = .03 + 0.1(.04) = .034,

and for Comparable Firm # 2:

rE = .03 + 1.65(.04) = .096

rD = .03 + 0.15(.04) = .036.

Next, calculate the unlevered cost of capital for each firm. Since they each maintain a target debt-
equity ratio, this is just the pretax WACC:

#1 : rU = .5(.08) + .5(.034) = .057,

#2 : rU = .4(.096) + .6(.034) = .06.

Averaging these values gives an unlevered cost of capital of 5.85% for Spacely’s new division.

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Now that we know rU we can use APV to find V L .

20
VL = .0585 + 50×.03×.4
.03 = 361.88

The NPV is then: −100 + 361.88 = 261.88.

The NPV of Auckland’s new division is: $261.88 million .

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Question 4: 8 marks.

Multiple Choice: Choose only the MOST correct answer and write it below the choices. There are
4 multiple choice problems spanning two pages (3 on the first and 1 on the second).

(a) (2 marks) Anyone who purchases the stock on or after the date will not receive the div-
idend but will receive the dividend if they purchase it before this date.

a. distribution
b. record
c. ex-dividend
d. declaration

Enter your above selection here: c

(b) (2 marks) Which of the following is NOT one of the four characteristics of IPOs that puzzle
financial economists?

a. On average, IPOs appear to be underpriced.

b. The long-run performance of a newly public company (three to five years from the date of issue)
is superior to the overall market return.
c. The number of issues is highly cyclical.
d. The costs of the IPO are very high, and it is unclear why firms willingly incur such high costs.

Enter your above selection here: b

(c) (2 marks) Luther Industries currently has 100 million shares of stock outstanding at a price of
$25 per share. The company would like to raise money and has announced a rights issue. Every
existing shareholder will be sent one right per share of stock that he or she owns. The company
plans to require twenty rights to purchase one share at a price of $20 per share. The amount of
money that Luther will raise through its rights offering is closest to:

a. $500 million
b. $125 million
c. $100 million
d. $400 million

Enter your above selection here: c

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(d) (2 marks) Suppose that Rose Industries is considering the acquisition of another firm in its
industry for $100 million. The acquisition is expected to increase Rose’s free cash flow by $5
million the first year, and this contribution is expected to grow at a rate of 3% every year thereafter
(forever). Rose intends to finance the initial cost of the acquisition with debt and equity in equal
proportion. Rose Industries will maintain a constant debt-equity ratio for the acquisition and the
appropriate WACC is 6.85%. The Free Cash Flow to Equity (FCFE) for the acquisition in year 0
is closest to:

a. $5 million
b. $100 million
c. -$100 million
d. -$50 million
e. -$150 million

Enter your above selection here: d

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Question 5: 5 marks.

Please assess the following statement. To do so, you need to state whether it is true, false, or un-
certain and justify your answer. All marks are based on the quality of your argument supporting
your answer.

“In the past few years Elise Corp has grown rapidly, undertaking many new profitable (on average)
projects, although its cashflows have been very variable. Elise Corp has never before declared a
dividend, yet announces that it will begin to pay dividends next quarter. Shareholders will interpret
this announcement as positive news about the firm’s future prospects.”

Uncertain. Shareholders may interpret the announcement in this way, but there is another possi-
bility: shareholders may interpret the announcement as a signal that management thinks they are
out of ideas (i.e., they aren’t many more positive NPV projects ont he horizon). In this case, the
shareholders would actually interpret this announcement as negative news. If you really wanted to
stretch it, maybe it could be a negative signal if investors think that management is cashing out (and
is a shareholder). Of course, shareholders would like them to cash-out since it is the bondholders
that would get hurt, but if shareholders had no idea that things were that dire, then who knows,
maybe it’s not completely out of the realm of possibilities.

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