Nova School of Business and Economics

2253 - Corporate Finance

Fall 2021 – Exam I

Exam Date: October 14, 2021 Exam Time: 17:30-19:00

INSTRUCTIONS

1) Please do NOT open the exam until you are told to do so.
2) Make sure that you wrote your number on each sheet.
3) Laptops and cell phones are absolutely prohibited. Textbooks and class notes
are NOT allowed. A cheat sheet is provided on page 2.
4) The exam consists of 9 pages (including the cover page) and 3 parts with a total
of 100 points. Make sure your exam has a cover page, and is composed of 9
pages and 3 parts.
5) Please write your answers ON the question sheet. ONLY the answers on the
question sheet will be graded. If you need more sheets, raise your hand.
6) In answering the questions, show all your calculations, so that you can receive
partial credit.
7) To speed up the grading process, please write your answers to the multiple
choice questions in the table that is provided below.
8) You have 90 minutes to complete the exam. Please use your time wisely.

Good luck!

Part I Your answer Your Score

1)
2)
3) Part Total Points Your Score
4) I 30
5)
II 40
6)
III 30
7)
8) Total 100
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Cheat Sheet for Exam I

1. Enterprise Value = Equity + Debt – Cash

2. Net Debt = Debt - Cash

3. Free Cash Flow = EBIT (1-tc) + Depreciation & Other Non-Cash Items – Investment
– Δ NWC, where NWC is Net Working Capital (= Current Assets – Current
Liabilities) and tc is the marginal income tax rate.

4. Liquidation or Salvage Value = Sale Price – (tc x Capital Gain),

where Capital Gain is the difference between Sale Price and Book Value.

5. Growing perpetuity formula:

where r is the discount rate, g the growth rate, and CF1 the cash flow realized one
period from now.

6. Growing annuity formula:

where N is the number of periods the annuity is paid.

7. Dividend Payout Rate = Dividend / Earnings Per Share

8. Earnings Growth Rate = (1- Payout Rate) x Return on New Investment

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Part I – Multiple Choice Questions

1) (3 points) Which of the following is the correct decision rule for accepting this project?

CF0 CF1 CF2

+100 -50 -75

A) Accept the project if IRR is greater than the discount rate.

B) Never accept the project as the NPV is always negative.
C) Accept the project if IRR is less than the discount rate.
D) The project does not have an IRR.

Answer: C

2) (3 points) Assume that the management’s decision rule is the payback period method and
that the cutoff period is 2 years. Which one of the following four projects would be accepted
despite the fact that it has a negative NPV for any positive discount rate?

CF0 CF1 CF2 CF3

A) -375 +300 0 +900
B) -2000 +1000 +1000 0
C) -400 +200 +200 +800
D) -200 +250 +1000 +300

Answer: B

3) (3 points) The following graph shows the NPV schedule of a project. Which one of the
following streams of cash flows can be associated with this NPV schedule?

CF0 CF1 CF2 CF3

A) +25 +50 0 +10
B) -100 +150 +50 0
C) +100 -20 -20 -20
D) -110 +150 +150 -200

Answer: D

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4) (3 points) A CEO is facing the decision to invest in a new product today or to postpone the
decision until next year. The project has a positive expected NPV, but if the output prices go
down, the NPV would turn negative. No competitors are likely to invest in a similar project if
the firm decides to wait and there are no additoinal costs associated with waiting. Which of
the following statements best describes the issues that the CEO faces when considering this
investment timing option?

A) The more uncertain the future cash flows are, the more logical it is for the firm to go ahead
with this project today.
B) Since the project has a positive expected NPV today, this means that it should be accepted
in order to lock in that NPV.
C) The payoff to waiting is likely to be zero if the new product price turns out to be low.
D) Since the project has a positive expected NPV today, and there are no costs associated with
waiting, this means that its NPV will be the same or higher if the CEO chooses to wait a year.
Answer: D

5) (6 points) As of On October 9, 2002, the four auto manufacturers publicly traded were as
follows (figures in billions):
Equity
Manufacturer Mkt.Cap EBITDA Debt
Volvo $5.70 -$0.18 $2.85
DaimlerChrysler $32.30 $4.63 $29.07
Ford $14.10 -$5.30 $8.46
GM $18.80 $1.83 $18.80

On the same day, Yahoo! Germany reported that Volkswagen AG had EBITDA of 3.8 billion
euros. In terms of sales, Volkswagen was most similar to GM and DaimlerChrysler. If none of
these companies had cash at that time, and Volkswagen did not have any debt in its capital
structure, what would be your estimate of Volkswagen’s market capitalization?

A) $64.2 billion
B) $16.9 billion
C) $25.56 billion
D) $32.30 billion
Answer: A

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6) (3 points) Which of the following statements is FALSE?

A) Successful young firms often have high initial earnings growth rates.
B) If a firm wants to increase its share price, it must cut its dividend and invest more.
C) A firm can increase its dividend by decreasing its shares outstanding, by increasing its
earnings and/or by increasing its dividend payout rate.
D) According to the constant dividend growth model, the value of the firm depends on the
current dividend level, the equity cost of capital and the growth rate.
Answer: B
Explanation: This will only increase the share price if the reinvested money is invested in
positive NPV projects.

7) (6 points) You expect that KT Industries (KTI) will have earnings per share of $3 at the end of
this year and they will pay out 50% of these earnings to shareholders in the form of a dividend.
KTI's return on new investments is 15% and their equity cost of capital is 12%. The value of a
share of KTI's stock is closest to:
A) $39.25
B) $33.33
C) $20.00
D) $12.50
Answer: B
Explanation: g = retention rate × return on new investment = 50% × .15 = .075 or 7.5%
P0 = Div1/(rE - g) = 1.50/(.12 - .075) = 33.33

8) (3 points) Based on the information in question 7, how would the stock price change if KTI
increased the payout ratio from 50% to 60%?
A) It would not change because the payout ratio does not affect the stock price.
B) It would increase because the dollar amount of dividends is higher with the new payout
policy.
C) It would decrease because the equity cost of capital is less than the return on investment.
D) It would increase because the equity cost of capital is less than the return on investment.
Answer: C

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Part II - Capital budgeting

ABC Inc. has just terminated one of its product lines at a cost of $10 million. This resulted in
one of its factories being unused. To find out about possible opportunities, a manager of ABC
Inc. has spent $1 million on extensive market research. She is considering whether to
(1) sell the unused factory immediately, or
(2) launch a new product line, sell the products for two years and then resell the factory in
year 3.

Analyzing the real estate market, the manager sees that the selling price of the factory should
be stable over the next five years. The expected post-tax income from selling the factory is $20
million.

To launch the new product line, the company would need to invest $15million in up-front
R&D expenses, and to acquire some new machinery immediately. The necessary machinery
would cost $5 million and would last 5 years. At the end of the 2nd year (year 2), ABC Inc. can
sell its machinery at $3.3 million. It expects to produce 100,000 units a year (in year 1 and in
year 2). The price and cost per unit are $250 and $75, respectively. Account payables and
account receivables are expected to be 8% and 5% of sales, respectively. Assume that the cost
of capital is 10% and that the corporate tax is 30%.

What is the NPV of launching the new product? Should ABC Inc. launch the product or sell
the factory immediately?

(in thousands)
0 1 2 3
Sales 25,000 25,000
COGS (7,500) (7,500)
Gross Profit 17,500 17,500
Up-front R&D (15,000)
Depreciation (1,000) (1,000)
EBIT (15,000) 16,500 16,500
EBIT (1-t) (10,500) 11,550 11,550
Depreciation 1,000 1,000
Factory sale (post-tax) (20,000) 20,000
After-tax cash flow from machinery sale (5,000) 3,210
NWC 750 - (750)
FCF (35,500) 13,300 15,760 19,250
PV(FCF) (35,500) 12,091 13,025 14,463
NPV 4,079
The change in net working capital:
0 1 2 3
Account receivables 1,250 1,250
Account payables (2,000) (2,000)
NWC - (750) (750)
delta NWC - (750) - 750
Calculations of after-tax cash flow from the machinery sale:
ABC Inc. must pay taxes only on capital gains when it sells the machinery.

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Capital gain=Purchase Price – Book value=3,300-3,000=300

After-tax cash flow from machinery sale=3,300-30%*300=3,210

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Part III – Real Options

Diversa Inc. is a large conglomerate always looking for investment opportunities. Recently
Diversa started a new venture in the electronic chips sector. The venture will spend the next
year developing and marketing a new chip technology, the success of which is still uncertain
today. As a next step, Diversa needs to recruit a Chief Operating Officer (COO) for the new
venture, and in particular choose between a generalist COO and a specialist COO. The
specialist COO is very knowledgeable about this new chip technology, and so if the
technology proves successful, she will amplify the financial returns of the project. If the
technology is not successful, having a generalist COO onboard is better in terms of overseeing
the phasing out of the venture. You have the following additional information:
• If Diversa chooses the specialist COO, the value of the project one year from now is
$300 if the technology is successful and -$50 if the technology fails. The -$50 represent
the present value of phasing out costs.
• The main rival of Diversa’s new venture is EvilChip Inc., a publicly traded company
which employs a tried-and-tested chip technology. EvilChip’s current stock price is
$19, which in one year will become either $22 if Diversa’s chip venture fails (EvilChip
keeps market share) or $15 otherwise (EvilChip loses market share).
• The risk-free rate is zero.

a) (15 points) Show that the NPV of the new venture if Diversa chooses a specialist COO (no
flexibility) is $100, by verifying the following: (i) that the replicating portfolio of the project
comprises short-selling 50 EvilChip stocks and lending out $1,050; (ii) that the value of
such replicating portfolio is indeed $100.

The payoff of the replicating portfolio in case Diversa’s technology succeeds is equal to
$1050 – 50 * $15 = $300,
which matches the project. For the other scenario, the year-1 payoff of the replicating portfolio
is
$1050 – 50 * $22 = -$50,
which also matches the project. Finally, the value of the portfolio is simply
$1050 – 50 * $19 = $100,
where $19 is the current stock price of EvilChip.

b) (15 points) Now assume that Diversa can choose a generalist COO initially but can later
switch to a specialist COO. The year-1 payoffs associated with the specialist COO are the
same as before, whereas the payoffs are either $250 (Diversa technology succeeds) or -$5
(Diversa technology fails) under a generalist COO. The switching costs in year 1 amount to
$11 and hiring a generalist costs more upfront (an extra $6 in present value terms). Should
Diversa go with a generalist COO to begin with, or is it better to hire a specialist
immediately? Assume that it is not possible to switch from a specialist to a generalist. The

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switch from generalist to specialist happens immediately and the value of the project
adjusts at the moment of the switch.

The year-1 payoffs of the project under a generalist COO are now
$300 – $11 = $289, in case of success (COO switch option is exercised, since $289>$250)
-$5, in case of failure (COO switch option not exercised, since -$5>-$50-$11)
To value this new version of the project, we need to set up an appropriate replicating portfolio.
Denote by x the number of EvilChip stocks and by y the cash position. Then we need to solve
the following system of equations:
15 x + y = $289
22 x + y = -$5
After some easy algebra you will find that x=-42 and y=$919. The NPV of the project under the
generalist (which also needs to include the higher upfront costs of $6) is thus given by
$919 – 42 * $19 - $6 = $115,
which is greater than $100. Therefore Diversa should choose a generalist COO.