FNCE 203

PRACTICE FINAL EXAM #1 – ANSWER KEY

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Instructions:

1. This is a closed book, closed notes exam, and you have one hour and
twenty minutes to complete it.

2. There are 50 total points; points per question are indicated below.

3. Verify that your exam book consists of 14 pages and 12 questions.

N o t e : You may tear off the last sheet of the exam booklet. And, please do not
[N
write any answers on this sheet as I will discard them after the exam is over].

4. For math based questions,

a. Please round percentages and values up to 2 decimal points.

b. Show your work! You will not get full credit for most of your
answers unless you do so, and I can’t give you partial credit if you
don’t show your work!

5. Allocate your time carefully and good luck!

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1. (2 points) Cash Cow, Inc. is a stable firm with few growth prospects. Its current
assets in place generate a high amount of before-tax profits and cash flows. Why
might this firm benefit from using more debt?

I. It will benefit from the interest tax shield

II. It will reduce shareholders incentive to engage in risk shifting
III. It will reduce managers’ ability to waste excess funds

a. I only
b. I and II
c. III only
d. I and III
e. I, II, and III

2. (2 points) Suppose you have a project with a negative $10 NPV. If you do the
project, there will be the possibility of doing a follow-on project in 60 months that
has an estimated NPV of positive $5. Moreover, because the second project’s NPV
in 60 months is uncertain, the option value of potentially being able to do the project
in 60 months is positive $20. Which of the below statements is true?

a. Under no circumstances should you do the first project

b. If you need to commit to doing both projects today, you don’t do either
c. Because of the positive option value, you should always do both projects
d. None of the above

3. (2 points) Suppose that you have s o l d a call option on 100 Google stocks, and that
you have also b o u g h t a put option on 100 Yahoo stocks. You do not hold any other
assets. What are you hoping will happen to the price of each stock?

a. You want Google’s stock price to rise, and Yahoo’s stock price to fall
b. You want both stock prices to fall
c. You want Google’s stock price to fall, and Yahoo’s stock price to rise
d. You want both stock prices to rise
e. It is not possible to answer this question without more information

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4. (2 points) Assume perfect capital markets (the assumptions of Modigliani & Miller
without taxes are satisfied). Suppose that a firm issues equity and uses the proceeds
to reduce its level of debt outstanding. The firms re will…

a. Increase, because the firm is losing valuable tax shields

b. Decrease, because the firm now faces lower bankruptcy costs
c. Decrease, because the financial risk of the equity falls
d. None of the above

5. (2 points) Assume the following is true about India’s tax structure:

I. The corporate tax rate is greater than the personal tax rates on interest
earnings, dividends, and capital gains.
II. The personal dividend tax rate is greater than the personal capital gains tax
rate.

Which of the below statements is true?

a. Because of (I), Indian companies should pay out more dividends, but
because of (II), Indian companies should pay out less dividends
b. Because of (I) and (II), Indian companies should pay out less dividends
c. Because of (I), Indian companies should pay out less dividends, but because
of (II), Indian companies should pay out more dividends
d. Because of (I) and (II), Indian companies should pay out more dividends

6. (2 points) Using our discussion from the Marriott case, if you think the interest rate
spread between long-term U.S. Treasury bonds and short-term U.S. Treasury rates
only reflects a risk premium, then which of the below statements about using CAPM
is true?

a. You should use the long-term U.S Treasury rates for both risk-free rates that
are used in the CAPM model
b. You should use the short-term U.S. Treasury rates for both, the risk-
free rate that captures your opportunity cost of time, and the risk-free
rate used to calculate the market risk premium.
c. You should use the long-term U.S. Treasury rate for the risk-free rate that
captures your opportunity cost, and the short-term U.S. Treasury rate for the
risk-free rate used to calculate the market risk premium.
d. None of the above

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7. (5 points) Suppose you are trying to find a firm’s effective tax rate that accounts for
the personal taxes of its marginal investors. The firm’s current stock price is $50 and
it is expected to pay $10 of dividends next year, and its dividends are expected to
grow by 5% a year thereafter. Furthermore, assume the firm’s WACC is 15%, equity
beta = 2.4, and the company’s debt has a YTM = 8% with a default probability of
0%. Using a technique we saw in the AHP case, what would be an estimate of the
firm’s effective tax rate, T*? To answer this question you should assume the market
risk premium is equal to 7.5%, and the corporate tax rate is 40%.

P = D/(re – g)
50 = 10/(re – 0.05)
re = 0.25

re = rEf + beta*(market premium)

0.25 = rEf + 2.4*(0.075)
rEf = 0.07

(1 − TC ) rDf (1 − 0.4 ) 0.08

T * = 1− = 1− = 0.314
rEf 0.07

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8. (4 points) – Find the weighted average cost of capital (WACC) for Cupcakes, Inc.
Cupcakes has 2 million outstanding common shares that sell at price $25. The
common shares are expected to have a dividend next year of $3, and the dividends
will then grow at a rate of 3 percent a year thereafter. The company has $40 million
par value of debt that is priced 95 percent of par and has a yield to maturity of 15
percent with a default probability 33%. The return on debt in the event of a default is
0%. The company also has 1 million outstanding shares of preferred stock with a
price of $10 and constant dividend of $1.20. The corporate tax rate is 35%.

E = 2 million * $25 = $50 million

P = 1 million * $10 = $10 million
D = $40 million * 0.95 = $38 million
re = D1/P0 + g = 3/25 + 0.03 = 0.15
rp = D / P0 = $1.20 / 10 = 0.12
rd = 0.15 * (1-0.33) = 0.10

⎛ 50 ⎞ ⎛ 10 ⎞ ⎛ 38 ⎞
WACC = ⎜ ⎟ 0.15 + ⎜ ⎟ 0.12 + ⎜ ⎟ 0.10 ( 0.65 ) = 11.4%
⎝ 38 + 50 + 10 ⎠ ⎝ 38 + 50 + 10 ⎠ ⎝ 38 + 50 + 10 ⎠

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9. Capital Structure – Five Brothers, Inc. (FB) currently pays an 8% interest rate on its
existing debt, which is $40 million of consol bonds (consol bonds pay interest each
year as a perpetuity, and the firm never pays off a face value). After some analysis,
FB’s managers decide that an increase in leverage would benefit shareholders. The
firm issues another $40 million of junior consol bonds, but with a 10% interest rate.
The firm pays the proceeds of the bond issuance out as a one-time dividend, and the
first interest payment will be next year. Prior to issuing the new bonds, the firm had
an AA credit rating, which corresponds to an annual default probability of 2%. But
with the new bond issuance, FB estimates it will have a BB credit rating, which
implies a 6% chance of default per year. You should assume a 40% corporate tax
rate. Further, assume that the cost of financial distress DC (the cost in the event that
distress occurs) are unaffected by the new debt issuance. The firm only incurs distress
cost when it runs into financial distress for the first time, implying that fDC=1. The
appropriate discount rate for distress cost is 2%, independent of the choice of
leverage. Please express all your answers in millions.

a. (1.5 points) What will be the present value of incremental tax benefits of
leverage, PVTB(L), as a result of this change in the firm’s capital structure.

Increased value of tax shield due to perpetuity = D*T = 40*0.40

∆PVTB(L) = $16 million

b. (2 points) For what levels of distress cost DC, would this increase in leverage
improve firm value?

PVDC = DC * Pr / (Pr * fDC+ rDC) where fDC = 1.

Thus, the change in PVDC is given by

∆PVDC(L)
= DC * PrBB / (PrBB + rDC) - DC * PrAA / (PrAA + rDC)
= DC * (0.06 / 0.08 - 0.02 / 0.04 )
= DC * 0.25

Firm value will increase if ∆PVTB(L) > ∆PVDC(L)

16million > DC * 0.25
DC < $64 million

c. (2.5 points) Now suppose that the firm had distress cost, DC, of $16 million.
Accounting for both distress costs and tax benefits, what will be equity
holders’ gain or loss from this capital structure change, assuming that the
market value of the original consol bonds is unaffected by the new debt
issuance?

Equity holders gain due to change in PV(financial side effects):

∆PVTB(L) – ∆PVDC(L) = 16 – 0.25*16 = 12 million

[Note: The market value of the firm’s equity will also be affected by
the dividend payout. The total change in the market value of equity
after this payout is: 12-40=-28, but equity holders get this dividend]

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10. Options – Bank of America (BofA) has just announced that it is providing 2 billion
stock options with an exercise price of $25 to its employees. The options are
European options and expire in 2 years. Immediately prior to this announcement,
BofA’s stock price was $17.75 with 8 billion shares outstanding. Assume that this
stock price of $17.75 did not reflect any anticipation of the stock option program
announcement, i.e. the stock price of $17.75 reflects the market’s beliefs that BofA
would not provide stock options to its employees. BofA’s announcement includes no
other news. Further, you should assume that the new options will not imply any
change in the firm’s operations (that is, the value of all assets in place is unaffected).
The firm also has $30 billion of excess cash on hand and $50 billion in long-term
debt. The firm’s WACC is 12%, and its required return on equity is 18%. To keep
your below analysis simple, you should assume that BofA has not previously granted
any stock options to its employees, and that BofA is not paying any dividends for the
next 2 years.

a. (2 points) If you were going value all 2 billion options, what would be the
exercise price, X, that you would plug into the Black-Scholes model?

n=2 billion
XW = 25
alpha = 2/(2 + 8) = 0.20
X=(1-alpha)*n*XW
X=(1-0.20)*2*25 = $40 billion

b. (1.5 points) What would be the price, P, that you use in the Black-Scholes
model?

Y = 17.75*8 = $142 billion

P = alpha*Y = 0.20*142 = $28.4 billion

It is incorrect to add the proceeds of exercise (50) to Y. This is

incorrect as it is already accounted for in the exercise price -- see part
(a).

c. (2.5 points) Now suppose you’ve successfully valued the granted options and
discovered that they have a value of $5.8 billion. Assume that the value of the
existing debt is unaffected by the new options. How should BofA’s stock
price adjust in response to the surprise announcement?

Prior to the announcement, E = 17.75*8 = $142 billion

Now, E = 142 – 5.8 = $136.2 billion
Price = 136.2/8 = $17.025

The price falls by 17.75-17.025 = $0.73

Or, just using 5.8/8 = $0.73.

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11. Mergers & Acquisitions – Suppose that Fox Entertainment Group has just made
an offer to acquire CKX. Prior to the offer, CKX had 30 million shares outstanding
that traded at a price of $25, and Fox had 50 million shares outstanding that traded at
$40. Assume that prior to the offer the stock market did not anticipate an acquisition
of CKX by FOX. As a result of the merger, Fox estimates that CKX’s operations will
generate an additional $60 million FCF a year via synergies (starting one year from
today). The business risk of CKX’s operations will remain the same as before the
merger. You should assume that the ra for Fox is 10% and the ra for CKS is 15%.
The proposed merger will not affect the riskiness of either company’s existing debt.
Use this information to answer the below questions, and when possible, please express
all answers in millions of dollars.

a. (1.5 points) If Fox is correct in its estimates, what will be the combined equity
value of the merged firm if it uses equity to finance the deal? [ i.e. what is
PVAB?]

PVA = 50*40 = $2,000 million

PVB = 30*25 = $750 million
PV(synergies) = 60/0.15 = $400 million

PVAB = 2,000 + 750 + 400 = $3,150 million

b. (2 points) Suppose that Fox offers to pay 5/6 a share of Fox for each share of
CKS. What is the value gained by CKS shareholders from the deal?

A total of (5/6)*30M = 25 million shares are given.

Thus, the merged firm will have 50 + 25 = 75 million shares.
Per share value = 3,150/75 = $42

CKS gets 42*25 = $1,050

Thus, the gain is 1,050 – 750 = $300 million

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Now suppose that another motivation for Fox’s offer was to avoid letting One
Equity Partners acquire CKS. If this happened, Fox suspected its own free cash
flows would drop by about $20 million a year. You should assume that One Equity
Partners made its competing offer last week, and this expected loss for Fox is already
priced by the market into Fox’s pre-offer share price of $40.

c. (2 points) Given this, what is the most that Fox should now be willing to pay
to complete its acquisition of CKS?

PV(avoided losses) = 20/.10 = $200 million

PV(increased CKS cash flows) = 60/.15 = $400 million
PVB = 30*25 = $750 million

The most Fox should be willing to pay now is:

200 + 400 + 750 = $1,350 million

d. (2 points) Suppose that instead of exchanging shares, Fox issues $1.2 billion
in senior notes and uses the proceeds to pay $40 cash per share of CKS.
Assume that the value of the existing debt of both firms is unaffected by the
new issuance. What will be the stock price of Fox after the deal is complete?

Issuing senior notes by itself does not change Fox’s equity

value PVA since both firm and debt value go up by $1.2 billion.
Yet the acquisition of CKS changes Fox’s equity value:

PVAB = (2,000 – 1,200) + 750 + 400 + 200 = $2,150 million

Thus, per share value = 2,150/50 = $43.

e. (1.5 points) Now assume that the new debt issue has reduced the market
value of Fox’s existing debt by $50 million, because it is now riskier as a result
of the large debt issuance used to fund the acquisition. Assume that relative to
part (d) projected FCFs and their riskiness are not changed. In addition,
assume that the present value of financial side effects remains unchanged.
Using your answer from part (d), what is the total gain to Fox’s shareholders?

From part (d), the gain was (43 – 40) * 50 = $150 million.

Since total firm value is the same as in part (d) but the debt
value drops by $50 million, Fox’s shareholders gain an
additional $50 million. Thus, their total gain is $200 million.

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12. (6 points) – Honda is considering producing a new line of compact cars called the H-
Mini. The new line will require an initial investment in equipment of $400 million
and is expected to generate $600 million in revenues for each of the next 3 years (i.e.,
t=1, t=2, and t=3). The equipment will be depreciated straight-line to $100 million
over 3 years. Variable costs are estimated to be 70% of the H-Mini sales. Fixed costs
will be $30 million a year. For marketing of the new car, Honda plans to use its
existing provider, GSD&M. GSD&M has been under contract to provide all of
Honda’s marketing services for the past 3 years at $50 million a year, and Honda &
GSD&M agreed last month to another three year contract at the same price,
independent of Honda’s decision regarding the new product line. The project will
require an investment in inventory. At the beginning of the project (i.e., t=0), $50
million of inventory is required. Thereafter, inventory is projected to remain at $50
million each year (i.e. they make no further additions to inventory) and is recovered
fully at the end of the project. At the end of the project (i.e. t=3), the firm estimates
the initial equipment can be sold for $150 million. The sale of this new line of cars,
however, will reduce sales of the Honda Civic by $10 million a year. The cost of
capital is 10%. The corporate tax rate is 30%. What is the NPV of the project, and
should Honda do this project? Show your work! N o t e : for this problem, express all
answers in millions of dollars.

1 point is subtracted if the erosion of sales to Honda’s existing cars is

not taken into account. 1 point is deducted if marketing costs are
included. 1 point is deducted if depreciation is wrong.

Sales 600
Erosion 10
Variable Costs 0.7*600=420
Fixed Costs 30
Depreciation (400-100)/3=100
EBIT 40

OCF = EBIT + Depreciation – tax rate * EBIT

= 40 + 100 – 0.30 * 40 = 128

1 point – There is no partial credit for this part.

Year 0 = 400
Year 1 = 0
Year 2 = 0
Year 3 = -[150 - 50 * (0.3)] = -135

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1 point – There is no partial credit for this part.

Year 0 = 50
Year 1 = 0
Year 2 = 0
Year 3 = -50

1 point – There is no partial credit for this part.

FCF = OCF – NCS – Change in NWC

Year 0 = 0 – 400 – 50 = -450

Year 1 = 128 – 0 – 0 = 128
Year 2 = 128 – 0 – 0 = 128
Year 3 = 128 + 135 + 50 = 313

1 point – There is no partial credit for this part. 1/2 point is deducted if
the NPV is not used to answer the question if Honda should do the
project.

CF1 CF2 CF3

NPV = −I + + +
1 + WACC (1 + WACC ) (1 + WACC )3
2

128 128 313

NPV = −450 + + + = $7.31 million
1.10 (1.10 ) (1.10 )3
2

Yes, Honda should do the project since the NPV > 0.

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 FORMULA SHEET

• Present Value of Annuity Future Value of Annuity

CF1 ⎡ 1 ⎤ CF1
PVA0 = × ⎢1 − FVA0 = × ⎡⎣(1 + r )n − 1⎤⎦
r ⎣ (1 + r )n ⎥⎦ r

• Present Value of Growing Annuity Future Value of Growing Annuity

n
CF1 ⎡ ⎛ 1 + g ⎞ ⎤ CF1 ⎡ n n
PVA0 = × ⎢1 − ⎜ ⎟ ⎥ FVA0 = × (1 + r ) − (1 + g ) ⎤
r − g ⎣⎢ ⎝ 1 + r ⎠ ⎦⎥ r − g ⎣ ⎦

• Present Value of Perpetuity PV of Growing Perpetuity

CF1 CF1
PVP0 = PVP0 =
r r−g

• Capital Asset Pricing Model (CAPM) Fundamental PE Ratio

b (1 + g )
ri = r f + βi (rm − r f ) PEF =
r−g

• Cost of Levered Equity & Levered Equity Beta

⎛ D ⎞ ⎛ D ⎞
re = ra + ( ra − rd ) ⎜ ⎟ , β E = β A + ( β A − β D ) ⎜ ⎟
⎝ E ⎠ ⎝ E ⎠

• Cost of Levered Equity & Levered Equity Beta – MM Version

⎛ D ⎞ D ⎞
re = ra + ( ra − rd ) ⎜ ⎟ (1 − TC ) , β E = β A + ( β A − β D ) ⎛⎜ ⎟ (1 − TC )
⎝ E ⎠ ⎝ E ⎠

• Weighted Average Cost of Capital

⎛ E ⎞ ⎛ D ⎞
WACC = ⎜ ⎟ re + ⎜ ⎟ rd (1 − TC )
⎝ D + E ⎠ ⎝ D + E ⎠

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• Risk-Adjusted Discount Rate – ME Version of WACC

⎛ D ⎞ ⎛ 1 + ra ⎞
WACC ME = ra − ⎜ ⎟ rd TC ⎜ ⎟
⎝ D + E ⎠ ⎝ 1 + rd ⎠

• Firm Valuation with Mid-Year Discounting

1/ 2 ⎡ N FCFt TVN ⎤
Firm Value = cash0 + (1 + r ) ⎢ ∑ (1 + r )t + (1 + r ) N ⎥
⎣ t =1 ⎦

• Effective tax shield of debt

T * = 1−
(1 − TC ) (1 − TE ) (1 − TC ) rDf
T * = 1−
1 − TD rEf

• Present Value of Distress Cost

!! !"
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 =
!!" !!! !!"

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