Question 1

Which of the following statements is FALSE?

a) When a firm adjusts its leverage to maintain a target debt-equity ratio, we can compute its
value with leverage by discounting its free cash flow using the weighted average cost of
capital.
b) The theoretically optimal level of leverage from a tax saving perspective is the level such that
interest paid by a company exceeds its EBIT.
c) Under a classical system, interest expense effectively reduces the amount of taxes the
investors of the company pay.
d) Increasing the level of debt in capital structure increase the probability of bankruptcy.
e) None of the above is false.

Question 2
Assume that you are planning to buy the shares of SLM, Corp. in the coming weeks and SLM
has recently announced a dividend of $2.5 per share.
To receive the dividend, you need to make sure that you buy the shares of SLM before the:
a) Declaration date.
b) Ex-dividend date.
c) Record date.
d) Distribution date.
e) None of the above

Question 3
BCA Corp is planning an acquisition that will contribute $4.5 million in free cash flows in the first
year that will grow at 4% per year thereafter. BCA is planning to offer $120 million for the target
and the acquisition will be financed with $80 million in new debt initially at a cost of 4%. Assume
that BCA’s unlevered cost of capital is 6% and its corporate tax rate is 30%. The value of the
acquisition to BCA is closest to:
a) $100 million
b) $175 million
c) $212 million
d) $273 million
e) None of the above

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Question 4
Indicate whether the following statement is true or false:

If a firm reduces its working capital requirements, that is positive news as the firm will be freeing
up some free cash flows that can immediately be distributed to its shareholders.

a) True
b) False

Question 5

Coles Ltd. has just issued a commercial paper with a face value of $40 million and a maturity of
four months. Coles received $39.210 million when it sold the paper. The effective annual rate for
this financing is closest to:

a) 2.67%
b) 4.97%
c) 6.17%
d) 12.96%
e) None of the above

Question 6
According to chief financial officers, the most common reason for acquiring a company is to:
a) use excess free cash.
b) reduce tax on the combined company due to tax losses of the target company.
c) diversify.
d) take advantage of synergies.
e) realize gains from breakup value of the target firm.

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Question 7

Ansell, Inc. has just announced plans to acquire AGL Corporation. Ansell is trading for $35 per
share and AGL is trading for $20 per share, implying a premerger value for AGL of approximately
$9.2 billion. If the projected synergies are $3.25 billion, what is the maximum exchange ratio
Ansell could offer in a stock swap deal and still generate a non-negative NPV?
a) 0.40
b) 0.62
c) 0.77
d) 1.15
e) None of the above

Question 8
Which of the following statements is FALSE?
a) Stock option grants give managers a direct incentive to increase the stock price which ties
managerial wealth to the wealth of shareholders.
b) One of the main objectives of SOX is to get companies to validate their internal financial
control processes.
c) Following the passage of SOX in the early 2000s, the UK government formed a
committee to develop a code of best practices in corporate governance. The problems
identified by this committee echoed the ones that SOX was trying to address.
d) In many other countries, the central conflict is between what are called “controlling
shareholders” and “minority shareholders.”
e) None of the above is false.

Question 9
Suppose Geelong Ltd. stock is currently trading at $45 per share. A call option, which still has
one-year to expiration, with an exercise price of $35 is currently trading at $12.5 and a put option
with the same exercise price and expiration date on the same stock sells for $2.5. Assume that the
risk-free rate is 4%. Geelong’s expected dividend per share is closest to:
a) $1.40
b) $4.58
c) $8.08
d) $12.40
e) None of the above

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Question 10

Of the inputs required in the Black-Scholes formula, which one is not directly observable?

a) The current stock price

b) The exercise price of the option
c) The volatility of the stock price
d) The number of days to the expiration of the option
e) The risk-free interest rate

Question 11
Zetatron is an all-equity firm with 100 million shares outstanding, which are currently trading for
$7.50 per share. A month ago, Zetatron announced it will change its capital structure by borrowing
$100 million in short-term debt, borrowing $100 million in long-term debt, and issuing $100
million of preferred stock. The $300 million raised by these issues, plus another $50 million in
cash that Zetatron already has, will be used to repurchase existing shares of stock. The transaction
is scheduled to occur today. Assume perfect capital markets.
a. What is the market value balance sheet for Zetatron
i. Before this transaction?
ii. After the new securities are issued but before the share repurchase?
iii. After the share repurchase?
b. At the conclusion of this transaction, how many shares outstanding will Zetatron have, and
what will the value of those shares be?

Question 12
Kohwe Corporation plans to issue equity to raise $50 million to finance a new investment. After
making the investment, Kohwe expects to earn free cash flows of $10 million each year. Kohwe
currently has 5 million shares outstanding, and it has no other assets or opportunities. Suppose the
appropriate discount rate for Kohwe’s future free cash flows is 8%, and the only capital market
imperfections are corporate taxes and financial distress costs.
a. What is the NPV of Kohwe’s investment?
b. Given these plans, what is Kohwe’s value per share today?
Suppose Kohwe borrows the $50 million instead. The firm will pay interest only on this loan each
year, and it will maintain an outstanding balance of $50 million on the loan. Suppose that Kohwe’s
corporate tax rate is 20%, and expected free cash flows are still $10 million each year.
c. What is Kohwe’s share price today if the investment is financed with debt?

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Now suppose that with leverage, Kohwe’s expected free cash flows will decline to $9 million per
year due to reduced sales and other financial distress costs. Assume that the appropriate discount
rate for Kohwe’s future free cash flows is still 8%.
d. What is Kohwe’s share price today given the financial distress costs of leverage?

Question 13
You work for a large car manufacturer that is currently financially healthy. Your manager feels
that the firm should take on more debt because it can thereby reduce the expense of car warranties.
To quote your manager, “If we go bankrupt, we don’t have to service the warranties. We therefore
have lower bankruptcy costs than most corporations, so we should use more debt.” Is he right?

Question 14
The Needy Corporation borrowed $10,000 from Bank Ease. According to the terms of the loan,
Needy must pay the bank $400 in interest every three months for the three-year life of the loan,
with the principal to be repaid at the maturity of the loan. What effective annual rate is Needy
paying?

Question 15
You work for a leveraged buyout firm and are evaluating a potential buyout of UnderWater
Company. UnderWater’s stock price is $20, and it has 2 million shares outstanding. You believe
that if you buy the company and replace its management, its value will increase by 40%. You are
planning on doing a leveraged buyout of UnderWater, and will offer $25 per share for control of
the company.
a. Assuming you get 50% control, what will happen to the price of non-tendered shares?
b. Given the answer in part (a), will shareholders tender their shares, not tender their shares, or
be indifferent?
c. What will your gain from the transaction be?

Question 16
The shareholders of Flannery Company have voted in favour of a buyout offer from Stultz
Corporation. Information about each firm is given here:
Flannery Stultz
Price-earnings ratio 6.35 12.70
Shares outstanding 73000 146000
Earnings $230000 $690000

Flannery's shareholders will receive one share of Stultz stock for every three shares they hold in
Flannery.

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a) What will the EPS of Stultz be after the merger? What will the PIE ratio be if the NPV of the
acquisition is zero?
b) What must Stultz feel is the value of the synergy between these two firms? Explain how your
answer can be reconciled with the decision to go ahead with the takeover.

Question 17
Consider two loans with a 1-year maturity and identical face values: an 8% loan with a 1% loan
origination fee and an 8% loan with a 5% (no-interest) compensating balance requirement. Which
loan would have the higher effective annual rate? Why?

Question 18
Consider an American put option on XAL stock with a strike price of $55 and one year to
expiration. Assume XAL pays no dividends, XAL is currently trading for $10 per share, and the
one-year interest rate is 10%. If it is optimal to exercise this option early:
a. What is the price of a one-year American put option on XAL stock with a strike price of $60
per share?
b. What is the maximum price of a one-year American call option on XAL stock with a strike
price of $55 per share?

Question 19
Roslin Robotics stock has a volatility of 30% and a current stock price of $60 per share. Roslin
pays no dividends. The risk-free interest is 5%. Determine the value of a one-year, at-the-money
call option on Roslin stock.

Question 20
Consider the at-the-money call option on Roslin Robotics evaluated in the previous question.
Suppose the call option is not available for trade in the market. You would like to replicate a long
position in 1000 call options.
a. What portfolio should you hold today?
b. Suppose you purchase the portfolio in part a. If Roslin stock goes up in value to $62 per share
today, what is the value of this portfolio now? If the call option were available for trade, what
would be the difference in value between the call option and the portfolio (expressed as percent
of the value of the call)?
c. After the stock price change in part b, how should you adjust your portfolio to continue to
replicate the options?

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 Answers

Question 1 – B

Question 2 – B

Question 3 – D
Value unlevered = 4.5/(0.06-0.04) = 225. Interest expense = 80*0.04 = 3.2. Interest tax shield =
3.2*0.3 = 0.96. PV(ITS) = 0.96/(0.06-0.04) = 48. Value = 225 + 48 = 273.

Question 4 – A

Question 5 – C
40-39.210 = 0.790, 0.790/39.210 = 0.02015, there are 3 four-month periods in a year,
(1+0.02015)^3 -1 = 6.17%

Question 6 – D

Question 7 – C
(20/35)(1+ (3.25/9.2)) = 0.77

Question 8 – C

Question 9 – A
Use put call parity with dividends. PV(DIV) = 2.5 – 12.5 + 45 – (35/1.04), PV(DIV) = 1.37 
DIV = 1.40.

Question 10 – C

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Question 11
a. i. A = $50 cash + $700 non-cash
L = $750 equity

ii. A = $350 cash + $700 non-cash

L = $750 equity + $100 short-term debt + $100 long-term debt + $100 preferred stock

iii. A = $700 non-cash

L = $400 equity + $100 short-term debt + $100 long-term debt + $100 preferred stock

350 400
b. Repurchase = $46.67 shares ⇒ $53.33 remain. Value is = $7.50.
7.50 53.33

Question 12
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a. $75 million
− 50 =
0.08
75
b. = $15 / share
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c.

d.

Question 13
No, not necessarily. He has neglected the effect on customers. Customers will be less willing to
buy the company’s cars because the warranty is not as solid as the company’s competitors. Since
the warranty is presumably offered to entice customers to buy more cars, the overall effect could
easily be reduced value.

Question 14
In this problem, Needy must pay $400 every three months to have the use of $10,000. Thus, the
interest rate per period is $400/$10,000 = 4%. Because there are four three-month periods in a
year, the effective annual rate is (1.04)4 – 1 ≈ 17%.

Question 15
a. The value should reflect the expected improvement that you will make by replacing the
management, so the value of the company will be $40 million plus 40% = $56 million. If you
buy 50% of the shares for $25 apiece, you will buy 1 million shares, paying $25 million.
However, you will borrow this money, pledging the shares as collateral and then assign the

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 loan to the company once you have control. This means that the new value of the equity will
be $56 million – $25 million in debt = $31 million. With 2 million shares outstanding, the price
of the equity will drop to $15.50.
b. Since the price of the shares will drop from $20 to $15.50 after the tender offer, everyone will
want to tender their shares for $25.
c. Assuming that everyone tenders their shares and you buy them all at $25 apiece, you will pay
$50 million to acquire the company, and it will be worth $56 million. You will own 100% of
the equity, which will be $56 million – $50 million loan to buy the shares = $6 million.

Question 16
a) The EPS of the combined company will be the sum of the earnings of both companies divided
by the shares in the combined company. Since the stock offer is one share of the acquiring firm
for three shares of the target firm, new shares in the acquiring firm will increase by one-third
of the number of shares of the target company. So, the new EPS will be:
EPS = ($230,000 + $690,000)/[146,000 + (1/3)(73,000)] = $5.401

The market price of Stultz will remain unchanged if it is a zero NPV acquisition. Using the
P/E ratio, we find the current market price of Stultz stock, which is:
P = 12.7($690,000)/146,000 = $60.02

If the acquisition has a zero NPV, the stock price should remain unchanged. Therefore, the
new PE will be:
P/E = $60.02/$5.401 = 11.11
b) The value of Flannery to Stultz must be the market value of the company since the NPV of the
acquisition is zero. Therefore, the value is:
V* = $230,000(6.35) = $1,460,500

The cost of the acquisition is the number of shares offered times the share price, so the cost is:
Cost = (1/3)(73,000)($60.02) = $1,460,500

So, the NPV of the acquisition is:

NPV = 0 = V* + ∆V – Cost = $1,460,500 + ∆V – $1,460,500

∆V = $0

Although there is no economic value to the takeover, it is possible that Stultz is motivated to
purchase Flannery for other than financial reasons.

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Question 17
The loan with the 1% loan origination fee would cost the most because the loan origination fee is
just another form of interest, so on a $1,000 loan, the borrower is paying $90 in interest and will
have the use of only $990 for the period, making the effective annual cost of the loan over 9%
($90/$990 = 9.1%). The compensating balance requirement of 5% on a $1,000 loan reduces the
usable proceeds of the firm by 5% to $950, but the interest rate is still 8%, so the effective annual
cost of that arrangement is 8.4% (=$80/$950). The effective annual rate is not increased by a full
percentage.

Question 18
a. It is optimal to exercise early puts with higher strikes, so value = intrinsic value of $60 – $10
= $50.
b. Because the put has no time value, call value must be less than dis(55) = $55 – $55/1.10 = $5.

Question 19

PV(K) = = 57.143,

Question 20
a. Delta = N(d1) = N(0.312634) = 0.6227, so purchase 623 shares.
B = –PV(K) N(d2) = –$28.859, so borrow $28,859.
Cost = 622.27 × $60 – $28,859 = $8,477.2
b. Portfolio = 622.27 × $62 – $28,859 = $9,749
Call = 9,790
Difference = ($9,749 – $9,790)/ $9,790 = –0.42%
c. Delta = 0.663
Increase shares to 663.
Borrow additional (663 – 623) × $62 = $2,480.

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