Problem 1

Current beta = 3.60 Value weight

Current debt = $1,600 Mining 60%
Current equity = $400 Steel 40%
Tax rate = 25%
Sell the steel business for fair value, and use proceeds to pay down debt.

Unlevered beta for firm 0.90 ! 3.60/(1+(1-.25)(800/200))

Value of business $2,000

Value of business sold $800

Unlevered beta of remaining business 0.70 ! (0.90-.4*1.2)/0.6

New debt $800
New equity $400
New D/E 200%
New levered beta= 1.75

Problem 2 Aldo
German Company Turkish project
Business Entertainment Publishing
Currency Euro Lira
Riskfree rate 2.00% 12.00%
Unlevered beta 1.10 0.75
ERP 6.00% 11.00%
Marginal tax rate 30.00% 20.00%
Debt to capital ratio 40.00%
Default Spread 3.00%

Riskfree Rate 2.00%

Levered Beta 1.15 ! 0.75 (1+(1-.20)(40/60))
ERP 11.00%
Cost of equity 14.6500%

Cost of debt 5.00%

After-tax cost of debt 4.00% Use Turkish marginal tax rate (see grading template)

Cost of capital 10.3900%

Problem 3
Restaurant business, planning to start a frozen food entrée (to sell in grocery stores)
Now yrs 1-5
Investment needed $5,000
After-tax operating income $160.00

Incremental cash flow at restaurant $100.00

Resstaurant Food Processing
Cost of capital 12% 8%

NPV of food business

Investment ($5,000)
After-tax Operating income $160.00
+ Depreciation $1,000.00
After-tax Cash Flow $1,160.00

NPV at food ($368.46) ! Discounted back at 8%

NPV of restaurant incremental CF $ 360.48 ! Discounted back at 12%
Overall NPV ($7.98)
Problem 4
License offer License offer 2
Number of years 5.00 8.00
Initial investment -$80.00 -$60.00
License revenues $35.00 $20.00
Cost of capital 9.0% 3%
Tax rate 25%
License offer License offer 2
License revenues $35.00 $20.00
Depreciation $ 16.00 $ 7.50
Operating incomce $19.00 $12.50
- Taxes $ 4.75 $ 3.13
After-tax Operating Income $14.25 $9.38
+ Depreciation $16.00 $7.50
FCFF $30.25 $16.88
NPV $37.66 $58.46
Annuity $9.68 $8.33

Problem 5
Current
Debt to capital 20%
Cost of equity 8.5200%
Cost of debt 4.0%
After-tax cost of debt 2.4%
Current cost of capital = 7.60%
Riskfree Rate 3%
ERP 6%
Plans to double its debt to capital ratio, which will also triple its default spread

Marginal tax rate 40.0%

Levered Beta = 0.92
Unlevered Beta = 0.8
New Debt to capital ratio = 40%
New Debt to equity ratio = 66.67%
New beta = 1.12
New cost of equity = 9.720%
New cost of debt = 6.000%
New after-tax cost of debt 3.600%
New cost of capital 7.27%
Cost of capital will decrease by 0.03%

Problem 6
Current equity 1800 !100 million shares at $18/share
Current debt 900
Borrowed $900 million and bought back stock @21/share, rational price (assuming savings in perpetuity, with no growth)

Current firm value 2700

Change in value 300 ! Rational, so you can use all shares outstanding
Change in value = (Old Cost of capital - New cost of capital)/ New cost of capital
300 = (Old Cost of capital -.0750)/ .0750
New cost of capital 7.50%
Old cost of capital 8.33%

Problem 7
Stock price (cum dividend) $25.00
Annual Dividend $2.00
Stock price (ex dividend) $23.19
Tax rate 30% (Dividends and ST Capital gains)
LT capital gains is untaxed
What portion of capital gains is long term?

Price Change as % of dividend 0.90322580645161

Tax rate on capital gains 22.50%
% of capital gains that are taxed 75%
% of capital gains not taxed 25%

Problem 8
Most recent year 1 2
Revenues (in $ millions) $500.00 $1,000.00 $1,200.00
Net margin -5% 2%
Depreciation (in $ millions) 150 Grows at 10% a year
Cap Ex (in $ million) 200 Grows at 5% a year
Non-cash Working capital 10.00% 10.00% 8.00%
Payout ratio Wants to start paying dividends in year 3
Current cash balance 200 Desired =

1 2 3
Revenues $1,000.00 $1,200.00 $1,500.00
Net Income -$50.00 $24.00 $150.00
Depreciation (in $ millions) $165.00 $181.50 $199.65
Cap Ex (in $ million) $210.00 $220.50 $231.53
Change in non-cash WC $50.00 -$4.00 -$6.00
FCFE -$145.00 -$11.00 $124.13
Cash balance $55.00 $44.00 $168.13
Desired cash balance 125
Dividends in year 3 $43.13
Payout ratio in year 3 28.75%

Problem 9
Most recent year 1 2
EBIT (1-t) $120.00 12% 8%
Book value of equity $750.00
Book value of debt $400.00
Cash $150.00
Maintain current return on invested capital in perpetuity, cost of capital is 10% for next 3 years and 8% thereafter
# Shares 80
Return on invested capital = 12.00%
1 2 3
EBIT (1-t) $ 134.40 $ 145.15 $ 150.96
Reinveatment Rate 100.00% 66.67% 33.33%
Reinvestment $ 134.40 $ 96.77 $ 50.32
FCFF $ - $ 48.38 $ 100.64
Terminal Value $ 2,138.57
PV at 10% $ - $ 39.99 $ 1,682.35
Value of firm $1,722.34
+ Cash $150.00
- Debt $400.00
Value of equity $1,472.34
Number of shares 80
Value per share $ 18.40
 Grading Template
Unlev beta 1. Did not unlever beta for original company: -1 point
2. Did not compute unlevered beta for remaining business: -1 point
1.20 3. Error on recomputing D/E: -1 point
4. Math errors: -1/2 point each

1. Used lira risk free rate: -1 point

2. Used wrong beta (1.10 instead of 0.75): -1 point
3. Did not relever beta: -1 point
4. Computed a lira cost of debt: -1 point
(I gave full credit for the use of either marginal tax
rate, though the interest expenses are in Turkey and
Should benefit from the 20% tax rate.

ate (see grading template)

1. Error in computing cash flows: -1 point

2. Used 8% cost of capital on synergies: -1 point
3. Did not compute depreciation: -1 point
(I did give full credit if you tried to compute a
weighted average cost of capital across the two
businesses and used that on the aggregate
cash flow.
 1. NPV wrong for revenue sharing: -1 point
2. NPV wrong for government contract
3. Did not convert into annuities: -1 point

1. Did not unlever & relever betas: -1 point

2. Used wrong tax rate: -1 point
3. Wrong cost of debt: -1 point
4. Math errors: -1/2 point each

1. Did not compute change in firm value: -1.5 points

2. Did not set up to solve for old cost of capital: -1 point
ngs in perpetuity, with no growth) 3. Math errors: -1/2 point each

all shares outstanding

1. Did not have a clue of where to begin: -2 points

2. Left problem unfinished (solving for tax rate on CG): -1 point
3. Math errors: -1/2 point each
 3
$1,500.00 1. Errors on each item: -1/2 to -1 point
10% 2. Did not adjust cash balance for FCFE change: -1 point
0% a year 3. Math errors: -1/2 point each
5% a year
6.00% End of each year

125

3 4 & forever
4% 2% 1. Starting ROIC wrong: -1 point
2. Treated operating income as FCFF: -2 points
3. Error on terminal value: -1 point
4. Ignored cash and debt: -1 point
3 years and 8% thereafter

Terminal year
$ 153.98
16.67%
$ 25.66
$ 128.31
ness: -1 point
Problem 1
Steel $ 1,500 Equity $ 1,200
Mining $ 500 Debt $ 800
Total $ 2,000 Total $ 2,000
Current D/E ratio = 0.66666666667
Current levered beta = 1.26
Current unlevered beta = 0.84

After selling mining business, which has an unlevered beta of 0.60

Mining business beta * (Weight of mining) + Steel business beta *Weight of steel = 0.84
0.60 (.25) + X (.75) = 0.84
Steel 1500 Equity 1000
Debt 500

New unlevered beta = 0.92

New debt to equity ratio = 0.5
New levered beta = 1.265

Problem 2
Market Value of Equity = $ 750.00
Market Value of Debt = $ 914.50
Cost of equity = 12%
Pre-tax cost of debt = 8%
Adjusted marginal tax rate = 18% ! Interest expense of $50 million > EBIT of $30 million
Cost of capital = 9.01%

Problem 3
Initial Invesrtment $ 100.00

Annual Cash flow (yrs 1 -5)

Cost savings = $ 25.00
- Depreciation $ 20.00 ! I also gave full credit, if you considered operating
Taxable income $ 5.00 expenses as being after depreciation, in which case
Taxes $ 1.00 your cash flows will be $46 million and your NPV will
After-tax income $ 4.00 be $84 million.
+ Depreciation $ 20.00
+ Annual decrease in WC $ 6.00
Free Cash Flow $ 30.00

NPV = $ 19.78

Problem 4
Vendor 1 Vendor 2 Vendor 3
Initial set up cost $10,000 $5,000 $10
Contract period 5 3 0
Annual cost $3,000 $4,000 $0

NPV of costs at 8% $21,978.13 $15,308.39 $10

Equivalent Annuity $ 5,504.56 $ 5,940.17 #DIV/0!

Problem 5
Current Market Cap = $ 1,200.00
+ Net Debt $ 800.00
Enterprise Value $ 2,000.00
- Tax Benefit of Debt $ 200.00
+ Expected Bankruptcy Cost $ 120.00
Unlevered firm Value $ 1,920.00
To calculate PV of debt
Interest expense on debt = $ 40.00
Tax savings = $ 10.00
PV at pre-tax cost of debt = $ 200.00 ! Short cut = tax rate * Dollar Debt

Problem 6
CAGR in Earnings (next five years) = 14.87%
To get ROE,
BV of Equity = 50 ! Market cap = 100, Price to Book = 2
ROE = 20.00%

Market D/E ratio = 40.00%

Levered beta = 1.04

Payout Ratio = 0.40 - 8.00 (.1487) + 15.00 (.20) -.05 (1.04) = 0.2019
The expected payout ratio is 20.19%.

Problem 7
Last year 1 2 3
Revenues (millions) $1,000 1200 1350 1500
Net Margin 3% 5% 10%
Payout Ratio 10% 25% 40%
Depreciation/Revenues 2% 2% 2%
Cap Ex/Depreciation 150% 125% 125%
Total Non-cash Working Capital as % of
Revenues 10% 10% 8% 8.00%

Revenues $1,000 $ 1,200.00 $ 1,350.00 $ 1,500.00

Net Income $ 36.00 $ 67.50 $ 150.00
+ Depreciation $ 24.00 $ 27.00 $ 30.00
- Cap Ex $ 36.00 $ 33.75 $ 37.50
- Change in Working Capital $20.00 ($12.00) $12.00
FCFE $ 4.00 $ 72.75 $ 130.50
Dividends paid $ 3.60 $ 16.88 $ 60.00
Cash balance $ 50.00 $ 50.40 $ 106.28 $ 176.78
Non-cash Working Capital $100.00 $120.00 $108.00 $120.00

Problem 8
Current ROIC = 16.00%
Current EBIT (1-t) $ 80.00
Cap Ex $ 60.00
= Depreciation $ 30.00
+ Change in non-cash WC $ 20.00
Reinvestment = $ 50.00
Reinvestment Rate (next 3 years) 62.50%
Expected growth rate (next 3 years) = 10.00%
Expected growth rate (after year 3) = 2.50%
Reinvesrtment Rate (after year 3) 15.625%
Base 1 2 3
Growth Rate 10.00% 10.00% 10.00%
EBIT (1-t) $ 88.00 $ 96.80 $ 106.48
- Reinvesrment $ 55.00 $ 60.50 $ 66.55
FCFF $ 33.00 $ 36.30 $ 39.93
Terminal Value (using 7.5% cost of capital) $ 1,841.77
PV at 9% cost of capital $ 30.28 $ 30.55 $ 1,453.02
Value of operating assets today = $ 1,513.85
 1. Did not unlever current beta: -1 point
2. New unlevered beta incorrect: -1 point
3. New D/E ratio incorrect: -1 point
4. Other errors; -1/2 to -1 point

1. Market value of debt incorrect: -1/2 to -1 poitn

2. Did not adjust tax rate for EBIT limit: -1 point
3. Debt ratios incorrect: -1/2 to -1 point

on > EBIT of $30 million

1. Error on cash flow: -1 to -2 points

considered operating 2. NPV incorrectly computed; -1/2 to -1 point
ciation, in which case
llion and your NPV will

1. Did not compute NPVs right: -1 point

2. Did not convert into annuities: -2 points

1. Tax benefit from debt incorrect: -1 point

2. Bankruptcy cost incorrect: -1 point
3. Did not start with enterprise value: -1 point
 1. CAGR incorrect: -1 point
2. ROE incorrect: -1 point
3. Regression not computed correctly: -1 point

1. Net Income incorrect: -1/2 point

2. Cap ex/Depreciation incorrect: -1 point
3. Chg in WC incorrect: -1/ point
4. Dividends incorrect/ignored: -1 point
5. Cash balance incorrect: -1 point

1. ROiC incorrect: -1/2 point

2. Reinvestment Rate incorrect: -1/2 to -1 point
3. Growth rate not computed: -1 point
4. Terminal value inputs incorrect: -1 to -2 points
5. PV not computed correctly: -1/2 to -1 point

4 (TY)
2.50%
$ 109.14
$ 17.05
$ 92.09
Problem 1 Grading Template
Estimated ValUnlevered Beta
Hotels $500.00 0.90 1, Wrong risk free rate : -1 point
Travel Services $1,000.00 1.20 2. ERP incorrect: -1 point
Company $1,500.00 1.10 3. Unlevered Beta incorrect: -1/2 to -1 point
4. Wrong D/E ratio: -1/2 to -1 point
Borrowing = $1,500.00 5. Math error: -1/2 point
New D/E 100%
Marginal tax rate = 25%

Estimated ValUnlevered Beta

Hotels $2,000.00 0.90
Travel Services $1,000.00 1.20
Unlevered beta $3,000.00 1.00

New levered beta = 1.75

Value ERP
US $1,500.00 5%
Mexico 1500 7.50%
Company ERP $3,000.00 0.0625

Cost of equity = 13.94%

Problem 2
Pre-tax cost of debt 10% 1. Did not adjust tax rate: -1 point
Market value of equity $ 600.00 2. Market value of debt incorrect: -1/2 to -1 poin
Market value of bank loan $ 772.55 ! PV of $40 million for 5 yea3. Did not lever beta: -1 point
$1000 at end of year 5 @ 1 4. Levered beta incorrect: -1/2 to -1 point
Interest expense $ 40.00 5. Math errors: -1/2 point
Operating Income $ 32.00
Adjusted tax rate 20% (32/40) * 25%
After-tax cost of debt 8.00%

Unlevered beta= 1.2

D/E ratio 1.29
Levered beta 2.44
Cost of equity 15.18%

Debt to Capital Ratio 56.29%

Cost of capital 11.14%

Problem 3
Initial investment $ 2,000.00

Revenues from subscribers $2,500.00 1. Did not net out lost revenues: -1 point
- Foregone revenues from Netflix $500.00 2. Missed depreciation: -1 point
Incremental revenues $2,000.00 3. Error on NPV: -1 point
- Operating costs $1,500.00 4. Any other CF related error: -1 point
- Depreciation $400.00
Operating income $100.00
- Taxes $25.00
After-tax Operating Income $75.00
+ Depreciation $400.00
Free cash flow to firm $475.00

NPV $ (103.46)

Problem 4
After-tax cost Pre-tax cost oCost of equityCost of capital
Biogen 3.75% 5.00% 12.00% 10.00%
Merck 3.00% 4.00% 9.00% 7.50%

NPV of Biogen offer $316.47 1. Used wrong discount rate on Biogen offer; -1/
Equivalent Annuity $73.10 License fee is guaranteed. On
2. Used wrong discount rate on Merck Offer: -1/2
Biogen is going to default 3. Did not convert into annuities: -1 point
NPV of Merck offer $ 435.06 4
Equivalent Annuity $67.79 % of net income, which is equity income.
Cost of equity applies
Problem 5
Current firm value = 300 1. Did not compute change in firm value: -1 poin
New cost of capital = 7.50% 2. Did not solve for pre-borrowing cost of capital
3. Did not solve for unlevered beta: -1 point
Increae in firm value = $ 18.00 ! Rational - Use total share 4. Did not relever beta; -1 point
Change in the cost of capital 0.45% 18 = (Cost of capital -.075)/ .075
Cost of capital before 7.950%
Unlevered Beta = 0.99
New D/E ratio 25.00%
Levered Beta = 1.18

Problem 6
1 2 3
Revenues $1,200.00 $1,400.00 $1,600.00
Net Income $30.00 $70.00 $160.00
Non-cash WC as % of revenues 12.00% 9.00% 6.00%
Dividend Payout 0.00% 0.00% 20.00%
Depreciation $75.00
Cash balance $50.00
Cap ex $125.00
1 2 3
Net Income $30.00 $70.00 $160.00 1. Change in WC wrong: -1 point
+ Depreciation $82.50 $90.75 $99.83 2. Depreciation incorrect: -1/2 point
- Cap Ex $135.00 $145.80 $157.46 3. Cap ex incorrect: -1/2 point
- Change in WC -$6.00 -$18.00 -$30.00 4. Dividends incorrect: -1 point
FCFE -$16.50 $32.95 $132.36 5. Change in cash balance incorrect: -1 point
Dividends $0.00 $7.00 $32.00 6. Did not net out desired cash balance in year 3
FCFE - Dividends -$16.50 $25.95 $100.36
Cash balance $33.50 $59.45 $159.81
- Desired cash balance $100.00
Cash available for buybacks $59.81

0 1 2 3
Total WC 150 144 126 96

Problem 7
Income Statement (2018) Balance Sheet (end of 2017)
Revenues $500.00 Fixed Assets 500 Debt
EBITDA $150.00 Non-cash Wor 125 Equity
DA $50.00 Cash 125
EBIT $100.00 Total 950 Total
Interest Expense $20.00 Statement of cash flows (2018)
EBT $80.00 Capital Expen $90.00
Taxes $20.00 Change in no $10.00
Net Income $60.00
EBIT (1-t) $75.00 1. ROIC incorrect: -1/2 to -1 point
Invested Capital 625 2. Reinvestment Rate incorrect; -1/2 to -1 point
ROIC 12.00% 3. Did not recompute reinvestment in terminal y
4. Error on terminal value calculation: -1/2 to -1
Net Cap Ex $40.00 5. Did not discount back terminal value to today
Change in WC $10.00 6. Did not add cash or subtract debt: -1/2 point e
Reinvestment $50.00
Reinvestment Rate 66.67%

Expected growth rate 8.00%

1 2 3 Terminal Year
EBIT (1-t) $ 81.00 $ 87.48 $ 94.48 $ 97.31
- Reinvestment $ 54.00 $ 58.32 $ 62.99 $ 24.33
FCFF $ 27.00 $ 29.16 $ 31.49 $ 72.98
Terminal value $ 1,216.41
PV $ 24.77 $ 24.54 $ 963.61
Value of Operating Assets $ 1,012.92
+ Cash 125
- Debt 200
Value of equity $ 937.92
ee rate : -1 point

ta incorrect: -1/2 to -1 point

tio: -1/2 to -1 point

t tax rate: -1 point

of debt incorrect: -1/2 to -1 point
beta: -1 point
incorrect: -1/2 to -1 point

ut lost revenues: -1 point

ciation: -1 point

related error: -1 point

 iscount rate on Biogen offer; -1/2 point
iscount rate on Merck Offer: -1/2 point
ert into annuities: -1 point

ute change in firm value: -1 point

for pre-borrowing cost of capital: -1 point
for unlevered beta: -1 point
er beta; -1 point

C wrong: -1 point
incorrect: -1/2 point
ect: -1/2 point
orrect: -1 point
sh balance incorrect: -1 point
ut desired cash balance in year 3: -1/2 point

nd of 2017)
200
550

950
 t: -1/2 to -1 point
t Rate incorrect; -1/2 to -1 point
mpute reinvestment in terminal year: -1 point
inal value calculation: -1/2 to -1 point
unt back terminal value to today: -1/2 point
ash or subtract debt: -1/2 point each
Problem 1
Country Steel Chemicals Total ERP
US $800 $200 $1,000 5.00%
Thailand $400 $100 $500 7.25%
Sum $1,200 $300 $1,500

Business Unlevered beta

Steel 1.2
Chemicals 0.9

US government bond rate = 2.50%

Thai $ govt bond rate = 4.00%

Risk free rate = 2.50%

ERP = 5.75%
Beta = 1.14
Cost of equity = 9.05500%

Problem 2
Market Value (% of Capital Cost of component
Debt $ 100.00 10.00% 3.00%
Equity $ 900.00 90.00% 9.00%
Capital $ 1,000.00 100.00% 8.400%

Debt $100
Equity $900
Debt ratio = 10%
Pre-tax cost of debt 5%
Marginal tax rate 40%
Lease commitment per year for 10 years = $ 120.00
Risk free rate = 3%
ERP = 5%

Cost of equity = 9.00%

Levered beta used = 1.2
Unlevered beta = 1.125

PV of leases = $ 926.61 ! 120 million discounted back at 5%

New Debt = $1,027 You cannot discount back at the after-tax cost of debt
New D/E = 1.140675768
New beta = 1.89
Cost of equity = 12.47%
Cost of debt = 3.00%
New Debt/Capital = 53.29%
New Cost of capital = 7.43%

Problem 3
Initial Investment = 1000
Salvage Value 100
WC as percent of revenue 15%
Cost of capital 9%
0 1 2 3
Revenues $ 1,000.00 $ 1,200.00 $ 1,500.00
EBITDA $ 300.00 $ 400.00 $ 600.00
- DA 300 300 300
EBIT $ - $ 100.00 $ 300.00
- Taxes $ - $ 30.00 $ 90.00
EBIT (1-t) $ - $ 70.00 $ 210.00
+ Depreciation 300 300 300
- Cap Ex 1000 -100
- Chg in WC $ 150.00 $ 30.00 $ 45.00 $ (225.00)
FCFF $ (1,150.00) $ 270.00 $ 325.00 $ 835.00
PV of CF -1150 247.706422 273.5459978 644.7732059
NPV - $ 16.03
If you moved working capital to the end of the year, your NPV is mildly more positive (about $36 million)

Problem 4
Number of hours driven per year = 800
Annual income (net of fuel and maintenance $ 9,600
Discount Rate = 8.00%

Additional car cost (see below) = $ (2,764)

Annual income net of car cost = $ 6,836
Income earned per hour $ 8.54

Without UbeWith Uber

Cost of car 15000 25000
Years of life 5 3
Salvage value $5,000 $4,000
Depreciation None Straight line

NPV of car (without Uber) = -$11,597.08 -$14,608.80 ! Car with Uber, has depreciation tax benefit
Annual cost $ (2,905) $ (5,669) ! Converted to an annuity

I know that this was a tough problem and I cut a lot of slack for possible alternative answers, with generous partial credit giv
Here was my test for whether you were even on the right track. If the answer you got in after-tax earnings was higher than $
your answer does not hold up. If it was less than $9600, as it should be, your earnings if computed comprehensively should
1. The additional cost of buying a more expensive car (if you drive for Uber)
2. The shorter life that your car will have if you drive for Uber
3. The depreciation tax benefits that will accrue to you if you are an Uber driver
My estimate of that incremental cost is $2,764. If you considered all three factors in a different way and were within shoutin
the credit on the question.

Problem 5
Current Operating Income = $ 48.00
Current Debt = $ 400.00 2.40%
Current Equity = $ 600.00 9.300%

Current cost of debt (pre-tax) 4%

Current beta = 1.2600
Current cost of equity = 9.300%
Current cost of capital = 6.54%

New Debt = 800

New Interest rate = 0.08
New Interest expense = 64
Tax rate (for use on cost of debt) = 30.00%
New Equity= 200

Unlevered beta = 0.9

New beta = 3.42
New cost of equity = 20.100%
New cost of debt = 5.60%
Cost of capital = 8.50%

Problem 6
Current Share Price 8
Number of shares outstanding 125
Current cost of equity = 9.00%
New cost of equity = 8.00%
Borrowing 400
Buyback price 10

After buyback
Old firm value = 1000
Change in firm value = 125
New firm value = 1125
New Debt = 400
New Equity = 725
Shares outstanding after buyback 85
Value per share after buyback $ 8.53

Problem 7
Existing working capital = 35
Existing cash balance = 25
Working capital as % of revenues in year 1 & 4.00%
Dividend payout ratio in years 3-5 40%
Most recent y 1 2 3
Revenues 250 $ 750.00 $ 1,000.00 $ 1,200.00
Net Margin 0% 2% 3% 4%
Net Income $ 15.00 $ 30.00 $ 48.00
Change in NC working capital $ 20.00 $ 10.00 $ 8.00
FCFE $ (5.00) $ 20.00 $ 40.00
Dividends $ 19.20
Cash Balance 25 $ 20.00 $ 40.00 $ 60.80

Total NC Working Capital 10 $ 30.00 $ 40.00 $ 48.00

Problem 8
Last year 1 2 3
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%
Growth rate in first three years = 0.075
Reinvestment Rate in first three years = 0.6
Return on capital = 12.50%

Expected growth rate in perpetuity 2.50%

Expected reinvestment rate in perpetuity = 20%
EBIT(1-t) in year 4 127.3354297
FCFF in year 4 = 101.8683437
Terminal Value $ 1,852.15
 Grading Template
1. Beta incorrect: -1 point
2. ERP incorrect: -1 point
3. Riskfree rate incorrect: -1 point

1. PV of leases incorrect: -1 point

2. Did not relever beta: -1 point
3. Ignored prior debt: -1/2 point

he after-tax cost of debt

1. Starting after-tax income wrong: -1 point

2. Did not add back depreciation: -1 point
3. WC in wrong year: -1/2 point
4. Ignored WC: -1 point
5. Forgot salvage of investment: -1/2 point
6. Forgot salvage of WC: -1/2 point
out $36 million)

1. Did not compute annualized cost of car: -1 point

2. Forgot depreciation tax benefits: -1 point
3. Did not annualize cost: -1 point
4. Forgot salvage value: -1 point

er, has depreciation tax benefits

o an annuity

ers, with generous partial credit given along the way.

after-tax earnings was higher than $9600 after considering the car-related costs
computed comprehensively should cover the following:

fferent way and were within shouting distance of my answer, I gave you most

1. Wrong pre-tax cost of debt: -1/2 point

2. Did not factor in tax rate change: -1/2 point
3. Did not relever beta correctly: -1/2 point
4. Used old cost of equity: -1 point
5. Weights wrong: -1 point
 1. Change in firm value incorrect: -1 point
2. Forgot to subtract out debt: -1 point
3. Did not adjust shares outstanding: -1 point

1. Mangled net income: -1 point

2. Change in non-cash working capital wrong: -1 point
3. Dividends incorrect: -1 point
4 5 4. Did not cumulate change in cash balance: -1 point
$ 1,350.00 $ 1,500.00 5. Forgot starting working capital: -1/2 point
5% 6%
$ 67.50 $ 90.00
$ 6.00 $ 6.00
$ 61.50 $ 84.00
$ 27.00 $ 36.00
$ 95.30 $ 143.30

$ 54.00 $ 60.00

4
2.5% 1. Just used last year's cash flow: -2 points
2. Did not recompute reinvestment at all: -1.5 points
3. Estimated ROC/reinvestment incorrectly: -1 point
4. Wrong discount rate for terminal value: -1 point

8%
Problem 1

Revenues Govt Bond Govt Bond Equity Risk

Marginal
(in $ rate (in US rate (in Premium
tax rate
millions) $) Pesos) (Total)

US $800 2.00% NA 40% 6.00%

Mexico $200 3.50% 6.00% 30% 8.00%

Part a
Regression beta = 0.944
D/E ratio during regrssion = 30%
Marginal tax rate = 40%
Unlevered beta = 0.8

Risk free Rate = 2.00%

ERP = 6.40%

Cost of Equity = 7.1200%

Part b
Value of the business = 1500
Divested business = 600
Unlevered beta of divested business 0.65
Unlevered beta of remaining operat 0.9
Unlevered beta of company = 0.54
Cost of equity = 5.45600%

Part c
Unlevered Beta of acquired busines 1.2
Unlevered beta of the company = 1.02

Revenues in Mexico after acquisitio $520.0

Weight for Mexico after acquisiton = 52.00%
ERP after acquisition = 7.0400%

Cost of equity after acquisiton = 9.18%

Problem 2
Part a
Current cost of equity = 6.50%
Unlevered Beta = 0.75
Debt/Equity Ratio for project = 0.25
Levered Beta = 0.8625
ERP = 9%
Cost of equity for China Project = 9.76%
Cost of debt (after tax) 3.00%
Cost of capital = 8.41%

Part b
Initial Investment 1500

Expected Cash flow next year

Revenues $1,000.00
EBITDA $ 400.00
DA $ 150.00
EBIT $ 250.00
Taxes $ 100.00
EBIT (1-t) $ 150.00
+ DA $ 150.00
- Cap Maintenance $ 165.00
FCFF $ 135.00

NPV of project = $ 606.08

Part c
Debt for investment 300
Equity in investment 1200

EBIT 250
- Interest Expenses 15
Taxable income 235
- Taxes 94
Net Income 141

ROE = 11.75%
Cost of equity = 9.76%
It is a good project, on a ROE basis.

Problem 3
Debt to Capital Cost of equityPre-tax cost oTax rate Cost of debt Cost of capital
0% 6.80% 3.00% 40% 1.80% 6.800%
10% 7.12% 3.25% 40.00% 1.95% 6.603%
20% 7.52% 3.60% 40.00% 2.16% 6.448%
30% 8.03% 4.00% 40.00% 2.40% 6.344%
40% 8.72% 4.50% 40.00% 2.70% 6.312%
50% 9.68% 5.00% 40.00% 3.00% 6.340%
60% 11.12% 6.00% 40.00% 3.60% 6.608%
70% 14.72% 7.80% 29.30% 5.51% 8.275%
80% 21.73% 9.00% 22.22% 7.00% 9.947%
90% 43.60% 12.00% 14.81% 10.22% 13.560%

Part a
Debt to cap ratio after recapitalizati 40%
Unlevered beta = 0.8 1. Did not relever beta: -1 point
D/E ratio after recap = 66.67% 2. Gave remaining shareholders
Levered beta = 1.12 3. Wrong cost of capital: -1 point
Cost of equity = 8.72%
After-tax cost of debt = 2.70%
Cost of capital - 6.31200%

Change in firm value = $ 19.33

New Debt = $ 100.00

Price per share in buyback = $ 12.50
Number of shares bought back = 8
Remaining shares 17
You can also do the following
Value of firm after buyback = $ 269.33 Value to selling shareholders =
- Debt outstanding $ 100.00 Value to remaining shareholders =
Value of equity after buyback $ 169.33 Change in value per share =
Value per share after buyback $ 9.96 Value per share =

Part b
Debt in LBO = 175 1. Wrong D/E ratio: -1 point
Equity in LBO = 75 2. Did not compute new tax rate
Interest expense on debt = 13.65 3. Did not subtract out debt: -1 p
Operating Income 10
Effective tax rate = 29.30% ! Not enough income to cover interest expenses
D/E ratio after LBO = 2.333333333
Levered beta after LBO = 2.11965812
Cost of equity after LBO = 14.72%
Pre-tax cost of debt = 7.80%
After-tax cost of debt = 5.51%
Cost of capital = 8.275%

Change in firm value - $ (44.57)

New firm value = $ 205.43

- Debt $ 175.00
Value of equity $ 30.43

Problem 4
Part a
Last year 1 2 3 4
Risk-adjusted Assets $ 2,000 $ 2,100 $ 2,205 $ 2,315 $ 2,431
Regulatory Capital Ratio 10.00% 10.50% 11.00% 11.50% 12.00%
Regulatory Capital (Book Equity) $ 200 $ 221 $ 243 $ 266 $ 292
ROE 10.0% 11.0% 12.0% 13.0% 14.0%
Net Income $ 20.00 $ 24.26 $ 29.11 $ 34.61 $ 40.84
- Change in Regulatory Capital $ 20.50 $ 22.05 $ 23.70 $ 25.47
FCFE $ 3.75 $ 7.06 $ 10.91 $ 15.37

Part b
Net Income $ 24.26 $ 29.11 $ 34.61 $ 40.84
Dividends $ 9.70 $ 11.64 $ 13.85 $ 16.34
Regulatory Capital $ 200 $ 215 $ 232 $ 253 $ 277
Risk-adjusted Assets $ 2,000 $ 2,100 $ 2,205 $ 2,315 $ 2,431
Regulatory Capital Ratio 10.00% 10.22% 10.52% 10.92% 11.41%
Part c
Increasing ROE & Stable regulatory capital ratio ! Decreasing ROE is obviously not good. You clearly don't want to have an
regulatory capital ratio but I can see an argument for either st
Problem 5
Part a
After-tax Operating Income = $ 120.00
Invested Capital = $ 600.00
Return on Invested Capital = 20.00%
Reinvestment Rate = 40.0%
Last year 1 2 3 4
Expected Growth rate 8.00% 8.00% 8.00% 8.00%
Revenues $1,000.00 $1,080.00 $1,166.40 $1,259.71 $1,360.49
EBIT (1-t) $120.00 $129.60 $139.97 $151.17 $163.26
Reinvestment $51.84 $55.99 $60.47 $65.30
FCFF $77.76 $83.98 $90.70 $97.96

Part b
Return on invested capital in stab 10.00%
Expected growth rate = 2%
Reinvestment Rate = 20.0%
EBIT (1-t) in year 6 = $ 179.85
Reinvestment = $ 35.97
FCFF in year 6 = $ 143.88
Terminal value (at the end of year $2,397.94

Part c
Year 1 2 3 4
FCFF $77.76 $83.98 $90.70 $97.96
Terminal Value
PV @12% $ 69.43 $ 66.95 $ 64.56 $ 62.25
Value of operating assets = $ 1,683.87
- Debt 400
+ Cash 300
Value of equity $ 1,583.87
Value per share = $ 10.56
Grading Template
1. Used regression beta: -1 point
2. Wrong ERP: -1 point
3. Math errors: -1/2 point each

1. Did not adjust beta for cash: -1 point

2. Did not solve for beta of remaining operations: -1 point

1. Did not compute new weighted beta: -1 point

2. Did not compute new ERP: -1 point

1. Used weighted ERP instead of China ERP: -1/2 point

2. Used unlevered beta: -1/2 point
3. Wrong Debt ratio: -1 point
4. Forgot to after-tax cost of debt: -1/2 point
 1. Wrong cash flow: -1 point
2. Did not compute NPV for perpetuity: -1 point
3. Forgot initial investment: -1/2 point

1. Computed ROC instead: -1 point

2. Used EBIT(1-t) as net income: -1 point
3. Wrong comparison to WACC: -1/2 point

Debt Interest expense

0 0 0.80
25 0.8125 0.85
50 1.8 0.92
75 3 1.01
100 4.5 1.12
125 6.25 1.28
150 9 1.52
175 13.65 2.12
200 18 3.29
225 27 6.93

Did not relever beta: -1 point

Gave remaining shareholders entire value change: -1 point
Wrong cost of capital: -1 point
 $ 20.00
$ (0.67)
$ (0.04)
$ 9.96

Wrong D/E ratio: -1 point

Did not compute new tax rate
Did not subtract out debt: -1 point

5
$ 2,553
12.50% 1. Wrong net income: -1 point
$ 319 2. No reinvestment: -1.5 points
15.0% 3. Wrong reinvestment: -1 point
$ 47.86
$ 27.35
$ 20.51

$ 47.86 left income unchanged

$ 19.14 1. Did not compute dividends: -1 point
$ 306 2. Did not update book equity: -1 point
$ 2,553 3. Did not compute ratio correctly: -1/2 point
11.99%

u clearly don't want to have an increasing

ument for either st
 5
8.00% 1. Wrong ROC: -1 point
$1,469.33 2. Error on reinvestment: -1 point
$176.32 3. Used EBIT (1-t) as CF: -2 points
$70.53
$105.79

1. Did not recompute reinvestment: -1 point

2. Terminal value equation incorrect: -1/2 point

5
$105.79 1. Discounted terminal value at 8%:-1/2 point
2397.943421 2. Did not discount CF for first 5 years: -1/2 point
$1,420.69 3. Forgot cash: -1/2 point
4. Forgot debt: -1/2 point
 Problem 1
Comparable Companies
Levered Beta D/E ratio
Software 1.38 25%
Entertainment 1.17 50%

Part a
Estimated ValUnlevered BetWeights
Software 60.00% 1.2
Entertainment 40.00% 0.9
Company 1.08

Interest beari $200.00

Lease commit $50.00
PV of lease c $222.59
Total Debt = $422.59
Market value o 800
D/E ratio = 52.82%
Levered beta 1.422298804

Part b
Division sell of $400
New debt $100
Investment in $300
Stock Buybac $200
Current New % Value Unlevered Beta
Software $733.55 $333.55 29.71% 1.2
Entertainment $489.04 $489.04 43.56% 0.9
Online Advertising $300.00 26.72% 1.5
1.14948211

New Debt $522.59

New Equity $600.00
D/E ratio 0.870985194
New levered b 1.75019125

Problem 2
0 Yrs 1-10 10
Initial invest -2000 500
f you assumed EBITDA margin is before G&A allocation
If you assumed EBITDA margin is after G&A allocation
Incremental revenues $1,000 Incremental revenues $1,000
Incremental EBITDA $400 Incremental EBITDA $400
Incremental DA $150 Incremental DA $150
Incremental G&A $25 Incremental EBIT $250
Incremental EBIT $225 EBIT (1-t) $150
EBIT (1-t) $135 + Depreciation $150
+ Depreciati $150 + Fixed G&A (1-t) $45
- Maintenance Cap Ex $30 - Maintenance Cap ex $30
FCFF $255 FCFF $315

Part b.
Current cost o 7.70%
Risk free rate 2.00%
ERP (US) = 6%
Implied beta 0.95

Adjusted ERP 9%
New cost of e 10.5500%

NPV = -$ 286.09 NPV = $74.03

Part c
Annual CF ne 42.06062294 ! Used US cost of equity Annual CF needed = $10.88
EBIT needed 70.10103823 EBIT needed $18.14
EBITDA neede70.10103823 EBITDA needed $18.14
Revenues nee116.8350637 Revenues needed $45.35

Problem 3
Part a Value Proportion Cost
Equity 1800 0.9 9.20%
Debt 200 0.1 X
Cost of capital before
Part a
Unlevered bet 1.125
New debt to ca 0.2
New debt to eq 0.25
New levered b 1.29375
New cost of e 9.762500%
New cost of d 4.500%
New after-tax 0.027
New cost of ca 8.35%

Part b
Existing firm 2000
Change in val 40
Old cost of ca 8.52%
Old pre-tax co 2.37%
Old pre-tax co 3.95%

Part c
New enterpris 2040
- New Debt 400
New equity va 1640

Special divide 100

Stock Buybac 100
Shares bought 8
Remaining sh 142
Value per sha $11.5493
Your share price drops because you receive a special di $0.70
In spite of the dividend, your total return of $12.25 is less tha those who sold back made.

Problem 4
2013 2014
Revenues $1,000 $1,100
EBITDA $500 $560
EBIT $400 $440
Net Income $150 $180
Total Working $100 $120
Cash $40 $80
Total Debt $90 $120

Capital expenditures $150

Cash acquisition $50
Growth rate in revenues an 20.00%
Growth rate in cap ex and d 10%
Increase in cash balance in $20.00
Dividend payout ratio 25%
Parts a & b 2014 2015
Net Income $180 $216.0
+ Depreciati $120 132
- Capital Exp $200 $165.0
- Change in -$ 20.00 8.00
+ Net Debt I $30 $60
FCFE $150 $115
Increase in ca $40 $20.00
Buybacks 50 $41.00
Dividends pai $60 $54.00
Payout ratio 33.33%
Part c
i. Stock price will decrease by more than the dividend paid
Tax rate on ca 20%
Net tax rate o 10% ! Net of corporate tax
Problem 5
Most recent year
Revenues 2000
EBITDA 500
DA 100
Cap ex 200
Non-cash work 40
Tax rate 30%
Expected grow 8%
Cost of capita 12%
Cost of capital 8%
Part a
Most recent 1 2 3 4 5
EBIT (1-t) $280.00 $302.40 $326.59 $352.72 $380.94 $411.41
+ Depreciati $100.00
- Cap Ex $200.00
- Change in $40.00
FCFF $140.00 $151.20 $163.30 $176.36 $190.47 $205.71
Reinvestment 50.00%

Part b
Return on capi 16.00%
Expected grow 2.00%
Reinvestment 12.500%
EBIT (1-t) in 419.6400987
Cost of capita 8%
Terminal valu 6119.75144

Part c 1 2 3 4 5
FCFF $151.20 $163.30 $176.36 $190.47 $205.71
Terminal Value 6119.75144
PV 135 130.1785714 125.5293367 121.0461461 3589.234387
Value of opera $4,100.99
- Debt outsta $1,000.00
+ Cash & Cro $600.00
Value of equit $3,700.99
Number of sha $150.00
Value per sha $24.67
Grading Template

1.Did not take present value for leases correctly (wrong interest rate): -1/2 point
2. Did something to bond value (which was already in market terms): -1/2 pont

1. Did not unlever betas for comparables: -1 point

2. Wrong weights on unlevered betas: -1/2 point
3. Did not relever beta correctly: -1/2 point

1. Did not compute new weights on businesses correctly: -1 point

2. Did not compute new debt to equity ratio correctly: -1 point
3. Did not lever beta correctly: -1/2 point
4. Math errors: -1/2 point

1. Did not get after-tax EBIT correctly: -1 point

2. Did not count maintenance cap ex: -1 point
3. Wrong depreciation: -1 point
4. Forgot or miscalculated G&A: -1/2 to -1 point

1. Did not back out beta: -1 point

2. Did not adjust ERP: -1 point
3. Forgot salvage value: -1/2 point
4. Math errors: -1/2 point

1. Did not set up to solve for annuity: -1 point

2. Did not convert back into pre-tax: -1/2 point
3. Did not adjust EBITDA back to revenue: -1/2 point

1. Did not unlever and relever beta: -1 point

2. Did not after-tax cost of debt: -1/2 point
3. Debt weights wrong: -1/2 point

1. Did not solve for pre-change cost of capital correctly: -1 point

2. Did not solve for after-tax cost of debt given cost of capital: -1 point
3. Forgot to pre-tax cost of debt: -1/2 point

1. Did not adjust shares for buyback: -1 point

2. Did not adjust properly for special dividend: -1/2 to 1 point
Part a
1. Change in non-cash WC wrong: -1 point
2. Error on net debt issued: -1/2 point
3. FCFE computation wrong: -1/2 point
4. Adjustment for cash balance incorrect: -1/2 point

Part b
1. Change in non-cash WC wrong: -1 point
2. Cap ex incorrect: -1/2 point
3. Total debt incorrect: -1/2 point
4. Cash balance dealt with incorrectly: -1/2 point
5. Dividends incorrect: -1/2 point

All or nothing

Revenues Most recent year

EBITDA $2,000.00
DA $500.00
EBIT $100.00
- Interest ex $400.00
Taxable Inco $50.00
Taxes $350.00
Net Income $140.00
$210.00

1. Reinvestment incorrect: -1 point

2. Wrong tax rate: -1 point

1. Return on capital incorrect: -1 point

2. Did not compute reinvestment rate: -1 point
3. Did not use year 6 EBIT (1-t): -1/2 point
4. Math errors: -1/2 point each

1. Wrong discount rate in computing PV: -1 point

2. Debt dealt with incorrectly: -1/2 point
3. Cash dealt with incorrectly: -1/2 point
4. Math errors: -1/2 point each
Problem 1
Sector Averages
Business Revenues (in $ millions)
Enterprise Value/Sales
Computer hardware $1,000 0.80
Computer services $600 2.00

Risk free rate In local

Country currency Equity Risk Premium
United States 3.00% 5.00%
China 4.00% 7.00%

Risk free rate = 3.00%

To compute beta
Business Estimated Value Weight
Computer hardware $800.00 0.4
Computer services $1,200.00 0.6
$2,000.00
To compute ERP
Country ERP Revenues
United States 5.00% $800.00
China 7.00% $800.00
6.00% $1,600.00
Cost of equity in US $ = 9.2400%
Part b
First, estimate the divestiture value
Hardware revenues in US = $500
Estimated value = $400.00
Debt raised = $400.00
Invested in China services= $800.00
Incremental revenue $400.00 ! Invested value/ EV to Sales of sector

Business Estimated value Weight

Computer hardware $400.00 16.67%
Computer services $2,000.00 83.33%

New D/E ratio = 20.00% ! Debt raised/Old value

Levered Beta = 1.0733 ! Use US marginal tax rate, since borrowing is in U
Tax benefits are also in US.
To compute ERP
Country ERP Revenues
United States 5.00% $300.00
China 7.00% $1,200.00
6.60%
I gave full credit if you weighted the ERP by the values of the businesses in US (600) and China (1800).
Cost of equity in US $ = 10.08%

Problem 2
0 Years 1-10
Storage facility investment -2,250,000
Inventory investment -750000

Current After investment

Revenues $5,000,000.00 $7,500,000.00
EBITDA $900,000.00 $1,500,000.00
Incremental EBITDA $600,000.00
- Depreciation $200,000.00
Incremental operating income $400,000.00
- Taxes $160,000.00
Incremental after-tax operating income $240,000.00
+ Depreciation $200,000.00
After-tax cash flow $440,000.00

NPV = $89,152.82

Part b
With a perpetual life, assume that capital maintenance = depreciation & no salvage value
Initial investment = -3,000,000
NPV = -3000000 + X/.10 = 0 ! No salvage value, if you have perpetual life
Solving for X
Annual after-tax cash flow = $300,000.00
Incremental after-tax operating income $300,000.00
Incremental pre-tax operating income $500,000.00
+ Depreciation $200,000.00
Breakeven Incremental EBITDA $700,000.00
Breakeven EBITDA $1,600,000.00
Breakeven EBITDA margin = 21.33%
Note: Including depreciation while ignoring capital maintenance is not an option, since depreciation will ru

Problem 3
Current beta = 3.06
Current cost of equity = 18.300%
Current after-tax cost of debt = 6%
Debt ratio = 80%
Cost of capital = 8.4600%

New Debt/Equity ratio = 1.5

Unlevered beta = 0.9
New levered beta = 1.71
New cost of equity = 11.5500%
New after-tax cost of debt = 4.50%
New debt ratio = 0.6
New cost of capital = 7.32%

Old firm value = 1000

Increase in firm value 214.285714285714
New firm value = 1214.28571428571
- New Debt = 600 ! Don't forget to subtract debt
New equity value = 614.285714285714
No of shares 40 ! Divide by total # shares
Value per share = $15.36
(You will get the same answer, if you divide the increase in value by total number the shares and add to th

Problem 4
Three years ago Two years ago
Revenues $1,000 $1,100
Net Income $100 $110
Depreciation $40 $45
Cap Ex $50 $60
Total Working capital $10 $30
Total Debt $10 $15
Dividend Payout ratio 0% 40%
Three years ago Two years ago
Net Income $100.00 $110.00
+ Depreciation $40.00 $45.00
- Cap Ex $50.00 $60.00
- Change in Working capital $10.00 $20.00
+ Increase in debt $10.00 $5.00
FCFE $90.00 $80.00
Dividends paid $0.00 $44.00
Change in cash balance $90.00 $36.00
Cash Balance $90.00 $126.00
Next year Year +2
Revenues $1,440.00 $1,728.00
Net Income $144.00 $172.80
+ Depreciation 55 60.5
- Cap Ex 77 84.7
- Change in Working capital $84.00 $28.80
- Debt repaid $25 $25
FCFE $13.00 $94.80
Dividends paid $72.00 86.4
Change in cash balance -$59.00 $8.40
Cash balance $137.00 $145.40

Problem 5
After-tax operating income = 60
Invested capital = 500
Return on capital = 12%
High Growth Stable growth
Expected growth rate = 9.00% 3%
Reinvestment rate = 75.00% 25.00%
1 2
After-tax operating income $65.40 $71.29
- Reinvestment $49.05 $53.46
FCFF $16.35 $17.82
Terminal value
Present value $14.86 $14.73
Value of operating assets = $688.43
+ Cash $50.00
- Debt $300.00
Value of equity $438.43
Value per share = $17.54
Price per share = $16.00
Undervalued by -8.766%
 Sector Averages Grading template
Unlevered Beta
1.25
0.9

Marginal tax rate Total Revenues

40% $800.00
25% $800.00

1. Wrong risk free rate: -1/2 point

2. Used revenue weights on beta: -1/2 point
Unlevered Beta 3. Wrong ERP: -1/2 point
1.25 4. Math errors: -1/2 point
0.9
1.04

Weights
0.5
0.5

1. Wrong risk free rate: -1/2 point

2. Wrong levered beta: -1 to 1.5 points
3. ERP weighted incorrectly: -1 to 1.5 points
4. Math errors: -1/2 point each
lue/ EV to Sales of sector

Unlevered Beta
1.25
0.9
0.9583

ginal tax rate, since borrowing is in US.

are also in US.

Weghts
20%
80%

n US (600) and China (1800).

Salvage Value
250000
750000 1. Initial investment in WC incorrect: -1 point
2. After-tax cash flow incorrect: -1 point
Incremental 3. Salvage value incorrect: -1 point
$2,500,000.00 4. PV incorrect: -1/2 point
$600,000.00 5. Math error: -1/2 point
 1. Annuity not based on initial investment: -1 point
2. Included salvage value: -1 point
3. Did not consider capital maintenance: -1 point

ption, since depreciation will run out after ten years.

1. Did not after-tax cost of debt: -1/2 point

2. Wrong weights: -1/2 point
3. Math error: -1/2 point

1. Did not unlever & relever beta: -1 point

2. Did not after-tax cost of debt: -1/2 point
3. Wrong weights: -1/2 point
4. Math error: -1/2 point

1. Incorrect estimate of increase in value: -1 point

2. Did not subtract out new debt: -1 point
3. Divided change in value by old shares: -1 point
to subtract debt 4. Other math errors: -1/2 point each

tal # shares

umber the shares and add to the value per share)

Most recent year

$1,200 1. Did not compute change in non-cash WC: -1 point
$120 2. Did not compute change in debt: -1 point
$50 3. Did not compute cash balance: -1/2 point
 $70
$60
$75
50%
Most recent year
$120.00
$50.00
$70.00
$30.00
$60.00
$130.00
$60.00
$70.00
$196.00
Year +3
$2,073.60 1. Did not compute change in non-cash WC: -1 point
$207.36 2. Did not compute change in debt: -1 point
66.55 3. Did not compute cash balance: -1/2 point
93.17
34.56
$25
$121.18
103.68
$17.50
$162.90

1. ROC incorrect: -1 point

2. Did not compute reinvestment in years 1-3: -1 point
3. Did not recompute reinvestment in year 4: -1 point
4. Discounted at wrong discount rate: -1/2 point
5. Math error: -1/2 point
3 Terminal year
$77.70 $80.03
$58.28 $20.01
$19.43 $60.02
$857.49
$658.84

1. Did not add cash: -1/2 point

2. Did not subtract debt: -1 point
3. Did not compare to current market value: -1/2 point
4. Math error: -1/2 point
Problem 1 Grading template
US Brazil Total
Steel $800.00 $400.00 $1,200.00
Technology $600.00 $300.00 $900.00
Total $1,400.00 $700.00

Part a
For beta
Value Weight Unlevered beta
Steel $1,800.00 57.14% 0.9 1. Betas weighted incorrectly: -1 point
Technology $1,350.00 42.86% 1.2 2. ERP weighted incorrectly: -1 point
$3,150.00 1.02857 3. Math errors: -1/2 point
For ERP 4. Used Brazilian rate as risk free rate: -1/2 point
Value Weight ERP NOTES: You cannot use the Brazilian $ gov
US $2,100.00 66.67% 6% because it is not a risk free rate in US$.
Brazil $1,050.00 33.33% 9%
$3,150.00 7.00%

Cost of equity 10.200% ! 3% + 1.02857 (7.00%)

Part b
US Brazil Total
Steel $1,200.00 $600.00 $1,800.00 1. New D/E ratio wrong: -1 point
Technology $900.00 $1,200.00 $2,100.00 2. Betas not reweighted for business: -1 point
Total $2,100.00 $1,800.00 3. Betas not reweighted for country: -1 point
4. Did not relever beta: -1 point
Cost of capital for company 5. Math errors: -1/2 point
Debt = 1200 NOTES: Both the business and the country
Equity = 2700 company restructures. So, both numbers h
D/E ratio = 44.44%

New unlevered beta

For beta
Value Weight Unlevered beta
Steel $1,800.00 46.15% 0.9
Technology $2,100.00 53.85% 1.2
$3,900.00 1.06154
New levered b1.344615385

For ERP
Value Weight ERP
US $2,100.00 53.85% 6%
Brazil $1,800.00 46.15% 9%
$3,900.00 7.38%

Cost of equity 12.93%

After-tax cost 3.00%
Debt ratio = 30.77%
Cost of capita 9.87%

Problem 2
Part a
Initial invest -$5,000.00
Annual cash flow
Revenue $4,000.00 1. Did not treat depreciation correctly: -1 point
EBITDA $800.00 2. Forgot to take taxes: -1 point
- DA $500.00 3. Wrong discount rate: -1 point
EBIT $300.00 4. Math errors: -1/2 point each
- Taxes $120.00
Aftertax EBIT $180.00
+ DA $500.00
After-tax Cash $680.00

NPV = -$635.99

Part b
Annual after-t $107.99 1. Did not compute annuity: -1 point
Revenues= $539.96 ! Divide by after-tax margin 2. Error in getting back to revenues from annuity: -1/2
3. Wrong discount rate: -1/2 point
Part c Existing New
Expensed p $0.00 $2,000.00 1. Did not compute tax benefit from depreciaton: -1 po
Tax saving $0.00 $800.00 2. Did not compute tax benefit from expensing: -1 poin
Depreciation $500.00 $600.00 3. Math errors: -1/2 point each
Depreciation $200.00 $240.00 NOTE: You don't have to redo all of the cas
Number of yea 10.00 5.00 only the depreciation changes. In fact, doin
PV of tax savi $1,283.53 $933.52 cash flows will leave you with such a mess
Change in NP $449.98 unlikely that you will get the right answer.

Problem 3
Part a
Expected FCFF $250.00 1. All or nothing
Value of the f $5,000.00
Cost of equity 8.40%
Value = 5000 = 250/(.084-g)
Solving for g
Expected grow 3.400%
Part b
New Debt $2,000.00 1. Did not compute savings per year: -1 point
New Equity $3,000.00 2. Used wrong debt ratio in computation: -1 point
New D/E ratio 66.67% 3. Did not lever beta: -1 point
New D/C ratio 40.00% 4. Other errors: -1/2 point
New levered b 1.26
Cost of equity 10.5600%
Cost of debt 7.0000%
Cost of capital 8.02%
Change in fir $415.94
Part c
If the cash is paid out a as a special dividend, the number of shares remains unchanged at 80 million
New firm valu $5,415.94
- Debt $2,000.00 All or nothing
New Equity va $3,415.94 NOTE: When a dividend is paid, the stock p
New value per $34.16 by roughly the amount of the dividend (abo
Part c
New firm valu $5,415.94 1. Did not set up for shares correctly: -1 point
- Debt $2,000.00 Check your answer 2. Did not adjust number of shares: -1 point
Value of equit $3,415.94 If buyback price = $60.57 3. Other errors: -1/2 point each
Let the stock buyback priceNumber of share bought 33.02069528 NOTE: Many of you treated the given price
Number of sha2000/X Remaining shares 66.97930472 It is not. It is the price of the remaining shar
Remaining sh 100-2000/X Price per share = 51
Value to buyb (X-50)*(2000/X)
(100 -2000/X)*51= 3415.94Value of equity= $3,415.94
Solving for X
X= $60.57

Problem 4
1 2 3 1. Net income wrong: -1/2 point
Net Margin 12% 14% 16% 2. Change in non-cash WC wrong: -1 point
Total non-cas 30% 25% 15% 3. Other errors: -1/2 point
Part a 4. Error in getting to cash balance: -1 point
Base 1 2 3
Revenues $100.00 $140.00 $196.00 $274.40
Net Income $10.00 $16.80 $27.44 $43.90
Capital expen $40.00 $46.00 $52.90 $60.83
Depreciation $12.00 $15.00 $18.75 $23.44
Non-cash Work $36.00 $42.00 $49.00 $41.16
Chg in noncash WC $6.00 $7.00 -$7.84
FCFE -$20.20 -$13.71 $14.35
Cash balance $45.00 $24.80 $11.09 $25.44

Part b
Revenues $100.00 $140.00 $196.00 $274.40 1. Error on treating dividends: -1 point
Net Income $10.00 $16.80 $27.44 $43.90 2. Error on new debt: -1 point
Capital expen $40.00 $46.00 $52.90 $60.83 3. Error on cash balance: -1 point
Depreciation $12.00 $15.00 $18.75 $23.44
Non-cash Work $36.00 $42.00 $49.00 $41.16
Chg in noncash WC $6.00 $7.00 -$7.84
New Debt $4.00 $4.00 $4.00
FCFE -$16.20 -$9.71 $18.35
- Dividends paid $3.36 $5.49 $8.78
Cash balance $45.00 $25.44 $10.24 $19.81
Desired cash balance at end of year 3 $10.00
Cash available for buybacks $9.81

Problem 5
After-tax ope 10 Cost of capital (high growth) = 12.00%
Book value of 45 Cost of capital (stable growth) = 10%
Book value of 15
Cash 10 1. Did not compute expected growth: -1 point
Invested capit 50 2. Error on ROC: -1/2 point
Return on capi 20% 3. Error on reinvestment rate: -1 point

Net Cap ex $2.00 Terminal value

Change in non $1.00 1. Did not recompute reinvestment rate: -1/2 point
Normalized acq $3.00 2. Used wrong discount rate: -1/2 point
Reinvestment 60% 3. Math errors: -1/2 point each
Expected grow 12.00%
Expecedd grow 3.0% Value today
Reinvestment 15.00% 1. Used wrong discount rate: -1/2 point
2. Used wrong discount rate just on terminal value: -1/
1 2 3 Term year 3. Cash not added: -1/2 point
After-tax ope $11.20 $12.54 $14.05 $14.47 4. Debt not subtracted out: -1/2 point
Reinvestment $6.72 $7.53 $8.43 $2.17
FCFF $4.48 $5.02 $5.62 $12.30
Terminal value $175.72 ! New reinvestment rate = 3%/20% = 15%
PV @ 12.5% $4.00 $4.00 $129.07
Value of opera $137.07
+ Cash $10.00 Note: Since you have FCFF, you have to dis
- Debt $15.00 You then have to add cash (since you have
Value of equit $132.07 debt.
Value per sha $26.41
free rate: -1/2 point
e the Brazilian $ government bond rate,
free rate in US$.

usiness: -1 point
ountry: -1 point

ess and the country weights changes as the

So, both numbers have to be resestimated.
correctly: -1 point

venues from annuity: -1/2 point

fit from depreciaton: -1 point

fit from expensing: -1 point

to redo all of the cash flows, since

hanges. In fact, doing all of the
ou with such a mess that it is very
et the right answer.

er year: -1 point
omputation: -1 point
d is paid, the stock price will drop
of the dividend (about $20/share)

orrectly: -1 point
hares: -1 point

ated the given price as the buyback price.

of the remaining shares.

ong: -1 point

ance: -1 point

NOTE: The acquisitons are a wild card. The problem states that
there is one acquisition every five years and gives you the amount
The simplest solution is to average the amount and add it to your
reinvestment. That pushes up the reinvestment rate and growth
growth: -1 point rate.
 Here is why you cannot ignore it. This is clearly part of the company's
strategy to grow. If you ignore it, you will understate reinvestment
and growth for this firm.
tment rate: -1/2 point

ust on terminal value: -1/2 point

%/20% = 15%

CFF, you have to discount at the cost of capital.

ash (since you have not counted it yet) and subtract out
Problem 1
Part a.
Business Estimated ValWeight Unlevered beta
Storage Devic 400 0.2 0.9 !
Electronics 600 0.4 1.2
Social Media 800 0.8 1.8
Firm 1800 1.4
Equity 1200
Debt 600
D/E ratio = 0.5
Levered beta = 1.82

Part b
Business Estimated ValWeight Unlevered Beta
Electronics 600 0.375 1.2
Social Media 1000 0.625 1.8
Firm 1600 1.575
Equity 1200
Debt 400
D/E ratio 0.333333333
Levered beta = 1.89

Part c
Business Estimated ValWeights Unlevered beta
Electronics 600 0.428571429 1.2
Social Media 800 0.571428571 1.8
Firm 1400 1.542857143
Equity 800
Debt 600
D/E 0.75
Levered Beta = 2.24

Problem 2
0 1 2 3 4 5
Investment -20 0

Incremental Revenue $10.00 $20.50 $31.53 $43.10 $55.26

Incremental EBITDA $2.00 $4.10 $6.31 $8.62 $11.05
Incremental Depreciation 4 4 4 4 4
Incremental EBIT -$2.00 $0.10 $2.31 $4.62 $7.05
Incremental Tax -$0.80 $0.04 $0.92 $1.85 $2.82
Incremental EBIT (1-t) -$1.20 $0.06 $1.38 $2.77 $4.23
+ Incremental Depreciaton 4 4 4 4 4
- Incremental -10 $0.50 $0.53 $0.55 $0.58 $13.37
FCFF -10 $2.30 $3.54 $4.83 $6.19 -$5.14
NPV = -$0.32

Revenue befo 200 200 200 200 200 200

Revenue after $210.00 $220.50 $231.53 $243.10 $255.26
Incremental revenue $10.00 $20.50 $31.53 $43.10 $55.26

Working capita 20
Working capita 10 $10.50 $11.03 $11.58 $12.16 $25.53 ! If you revert back to old r
Incremental 10 $0.50 $0.53 $0.55 $0.58 $13.37 ! Your NPV will be higher a

b. Effect of expensing
Tax benefit of $8.00
Tax benefit of $6.07 ! Tax savings each year = 4 (0.4) = 1.6
Effect on NPV $1.93 ! Initial investment * tax rate
New NPV = $1.62

c.
NPV with sys -$0.32
Cost of syste -$13.93
NPV of increm $13.62
Annual after-t $3.59 ! Annuity given NPV
Pre-tax expen $5.99 ! Pre-tax amount

Long way to do 0 1 2 3 4 5
Incremental EBITDA $2.00 $4.10 $6.31 $8.62 $11.05
Incremental EBIT $2.00 $4.10 $6.31 $8.62 $11.05
Incremental taxes $0.80 $1.64 $2.52 $3.45 $4.42
Incremental EBIT (1-t) $1.20 $2.46 $3.78 $5.17 $6.63
- Incremental -$10.00 $0.50 $0.53 $0.55 $0.58 $13.37
FCFF $10.00 $0.70 $1.93 $3.23 $4.59 -$6.74
PV $13.62

Problem 3
Part a
Current lever 1.15
Cost of equity 9.900%
After-tax cost 2.40%
Market value o 800
Debt 200
Debt ratio = 0.2
Cost of capita 8.40%

Unlevered bet 1
New D/E ratio 9
Levered beta 6.4
Cost of equity 41.400%
After-tax cost 4.50%
Debt ratio = 90%
Cost of capita 8.1900%

Change in cost 0.2100%

Savings each 2.1
Increase in fi $25.64
New firm valu $1,025.64
New debt (to $923.08
Old debt $200.00
Increase in d $723.08

If the operating income is only 60 million

Interest expe $69.23 ! Two things can affect your cost of capital. The first is that your
Operating in $60.00 ! Interest coverage ratio will decrease increasing your default spread.
Tax rate for c 34.67% ! That may be difficult to compute and I did not look for it.
Levered beta 6.88 ! However, you can compute your interest expense and it gives you an
After-tax cost 4.90% ! Interest expense> EBIT, which affects your cost of capital
Cost of equity 44.28%
Cost of capita 8.84%
You did not have to work your way through. If you showed the tax rate effect, you got full credit
Problem 4

Last 12 months 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 Worki $75 $70 $65 $60 $50 $40
Total Debt outs 150 145 140 135 130 125

Part a
FCFE wihtout c 1 2 3 4 5 Cumulative
Net Income $88 $96 $104 $112 $120 $520
+ Depreciati $66 $72 $78 $84 $90 $390
- Change in n ($5) ($5) ($5) ($10) ($10) ($35)
+ (New Debt - -5 -5 -5 -5 -5 ($25)
FCFE (before c $154 $168 $182 $201 $215 $920
Dividends $52.80 $57.60 $62.40 $67.20 $72.00 $312
Change in cash balance -100
Capital expenditures $708

Part b,
To keep the cash balance constant & pay down debt
Exisitng divide $312 ! You don't need cap ex to solve this part of the problem
- Cash to pay 125 ! So, not credit for carry through of part a mistakes
- Cashflow to 100
Remaining divi $87
Cumularive net $520
Payout ratio 16.73%

Part c
The company expects its earnings growth and reinvestment needs to decrease in the future

Problem 5
Current After year 5
EBIT (1-t) 10
Invested Capit 100
Net Cap Ex 7
Change in wor 2
Return on capi 10% 10%
Reinvestment 90% 30%
Expected grow 9% 3%
Cost of capital 12% 8%
Year 1 2 3 4 5 Terminal year
EBIT (1-t) $10.90 $11.88 $12.95 $14.12 $15.39 $15.85
- Reinvestme $9.81 $10.69 $11.66 $12.70 $13.85 $4.75
FCFF $1.09 $1.19 $1.30 $1.41 $1.54 $11.09
Terminal value $221.87
Present value $0.97 $0.95 $0.92 $0.90 $126.77
Value of opera $130.51
+ Cash $15.00
 - Debt $40.00
Value of equit $105.51
/ Number of s $8.00
Value per sha $13.19
 ! Used revenue weights: -1 point
! Wrong D/E ratio: -1 point

! Wrong weights on businesses: -1 point

! Wrong D/E ratio: -1 point

! Wrong weights on businesses: -1 point

! Wrong D/E ratio: -1 point

! Used total revenue instead of incremental: -1 point

! Change in working capital not computed each year: -1 point
! Forgot to reverse working capital at end of period (when it reverts): -0.5 point
! Other mistakes: -0.5 points each

If you revert back to old revenue, WC in year 5 = 20

Your NPV will be higher and you should get full credit
! Did not compute savings from expensing: -0.5 points
! Did not compute lost PV from depreciation tax savings correctly: - 0.5 points
(If you did the entire problem the long way - with the cash flows - you should
get the same effect where your NPV increases by this amount)

! Used NPV from part 1 without correcting for investment & depreciation: -1 point
! Did not annualize: -1 point

! Cost of equity incorrect: -0.5 point

! After-tax cost of debt incorrect: -0.5 point

! Did not unlever & relever beta: -1 point

! Did not after-tax cost of debt: -0.5 point
! Math errror: 0.5 point

! Change in firm value not computed: -1 point

! Did not use firm value change to get to debt: -1 point

! Mostly all or nothing

! I did give half a point, if you explicitly computed an interest coverage ratio
! Working capital change shown as a cash outflow (instead of inflow): -1 point
! Paying down debt shown as cash inflow instead of outflow: -1 point
! Forgot depreciation add back: -1 point

! Payout ratio incorrect for any reason: -1 point

! All of the other reasons may sound plausible, but they are not defensible. You don't want
to pay dividends just because everyone else is or to attract dividend-liking investors just
for the sake of expanding your investor base. You certainly don't want to pay dividends
if you expect your reinvestment needs to be high in the future.

! Wrong growth rate: -1 point

! FCFF not consistent with growth: -1 point

! Did not compute reinvestment rate in year 6: -1 point

! Wrong discount rate on termnal value: -0.5 point

! Discounted terminal value at wrong discount rate: -0.5 point

! Subtracted cash (instead of adding it): -0.5 point
Problem 1
a.
Market value of equity = 800 1. Did not capitalize leases: -1 point
Market value of interest bearing d 400 2. Used after-tax cost of debt to capitalize lease
PV of lease commitments = 406.0553654 ! PV of $ 80 million @5% 3. Unlevered and relevered beta for leases (why
Firm value = 1606.055365 4. Did not after-tax cost of debt: - 0.5 point
Debt ratio = 50.19%
Beta = 1.15
Cost of equity = 9.25%
Cost of debt (after-tax) 3.00%
Cost of capital = 6.11%

b.
Value of entertainment = 963.6332192
Value of electronics = 642.4221462 1. Did not compute unlevered beta: -1 point
Current unlevered beta = 0.716715637 ! 1.15/(1+(1-.4)(806/800)) 2. Did not back out unelvered beta of entertainm
Unlevered beta = 0.7167 = 0.90 (.4) + X (.6) 3. Did not estimate new D/E ratio correctly: -1 p
Solving for new unlevered beta 4. Did not adjust cost of debt: -0.5 point
Unlevered beta after divestiture = 0.594526061 5. Did not after-tax cost of debt: -0.5 point
Debt after transaction = 645.4498288 ! 806 - 0.25*642.42
Equity after transaction = 318.1833904 ! 800 - 0.75*642.42
D/E ratio after transaction = 2.028546581
Levered beta after transaction = 1.318140347
Cost of equity = 10.09%
After-tax cost of debt = 3.90%
Cost of capital = 5.94%

Problem 2
Initial investment = 60 1. Ignored working capital initial investment: -0
Initial investment in WC = 10 2. Errors on computing annual after-tax cash flo
3. Did not salvage working capital or show tax b
0 Yrs 1-10 Year 10 4. Did not salvage initial investment: -0.5 point
Initial investment -70 5. Used company's cost of capital : -1 point
Salvage 20
Revenues 100
EBITDA 15 ! If you choose not to salvage working capital, y
- Depreciation 5 you will get in year 10 because you will be writi
EBIT 10 tax benefit will be 0.4(10) = 4
EBIT (1-t) 6
+ Depreciaton 5
Cash flow 11

NPV = 9.042450851

b. If project continues in perpetuity

Initial investment -70 Forever ! Note that if the project is to continue forever,
Terminal value will deplete your assets' earning power and not
Revenues 100
EBITDA 15 ! Used cash flow from part a in perpetuity: -1 po
- Depreciation 5 There will be nothing to depreciate after year 1
EBIT 10 ! Adjusted cash flow just for perpetuity in year 1
EBIT (1-t) 6 is not mathematically impossible, but it is econ
+ Depreciaton 5 ! Other errors: -0.5 point each
- Cap maintainence exp 5 ! Salvaged working capital and initial investmen
Cash flow 6
NPV = -3.33333333 ! -70 + 6/.09

c.
PV of synergy = 28.25111514 ! 5 million @12% ! Used wrong discount rate: -0.5 point
! Error in PV = -0.5 point
Problem 3
a.
Current cost of equity = 0.085 1. Did not after-tax cost of debt: -0.5 point
After-tax cost of debt = 0.027 2. Error on weights: 0.5 point
Debt ratio 0.2
Cost of capital 0.0734

b.
New debt ratio = 0.6 1. Did not adjust beta: -1 point
Unlevered beta = 0.869565217 ! 1/(1+(1-.4)(0.25)) 2. Errors in unlevering and relevering beta: - 0.5
New levered beta = 1.652173913 ! 0.8686(1+(1-.4)(1.50)) 3. Errors in pre-tax cost of debt: -0.5 point
Cost of equity = 0.117608696 4. Did not after-tax cost of debt: -0.5 point
After-tax cost of debt = 0.039
Cost of capital = 0.070443478

c.
Increase in firm value = 52.46265893 ! (.0734-.0704)(1250)/.0704 ! Did not compute change in firm
! Error in computing change in firm
Price per share in buyback = 11 ! Did not net out portion of value
Number of shares bought back = 45.45454545 ! 500/11 ! Did not adjust number of shares
Portion of value to bought back sh 45.45454545 ! 45.45 (11-10)

Remaining value increase= 7.008113476 ! 52.46-45.45)

Remaining shares = 54.54545455 ! 100-45.45
Value increase per remaining shar 0.12848208 !7.008/54.54
Price per share = 10.12848208

d. The value per share will be higher than computed in part c, because stockholders
will get a bonus from being able to keep existing debt at lower rates on the books.

Problem 4
Most recent y Next year
Revenues 60 90 Part a
Net income 10 15 1. Error on dealing with change in working capi
+ Depreciation 5 7.5 2. Error on dealing with change in debt: -0.5 po
- Cap Ex 8 10 3. Other errors in computing FCFE: -0.5 point
- Change in WC -1 3 4. Change in cash balance incorrect: -0.5 point
- (Debt repaid + Debt issued) -1 2.75
FCFE 9 12.25 Part b
Dividends 2 10.25 1. Did not compute change in working capital c
Change in cash balance 7 2 2. Did not compute change in debt correctly: -1
Cash balance at start of year 3 10 3. Other errors: -0.5 point each
Cash balance at end of year 10 12 4. Divided dividend by revenues or some other

Total reinvestment = 2
Debt used = 1
Debt ratio = 0.5

Payout ratio = 0.2 0.683333333 ! 10.25/15

c.
 iii. Negative Jensen’s alpha, negative EVA
I would not trust the managers of the company and want my cash back.

Problem 5
High growth Stable growth
Return on capital = 25.00% 15% Return on capital = EBIT (1-t)/ (BV of debt + BV of eq
Expected growth = 10% 3%
Reinvestment rate = 0.4 0.2 ! g/ ROC
Cost of capital 12% 10%
Year Current 1 2 3 4
EBIT (1-t) $20.00 $22.00 $24.20 $26.62 $29.28
Reinvestment $8.80 $9.68 $10.65 $11.71
FCFF $13.20 $14.52 $15.97 $17.57
Terminal value
Present value (at 12%) $11.79 $11.58 $11.37 $11.17
Value of operating assets = 272.0068328
+ Cash 20
- Debt 50
Value of equity 242.0068328
Value per share $12.10
 alize leases: -1 point
ax cost of debt to capitalize leases: - 0.5 point
nd relevered beta for leases (why?): 0.5 point
-tax cost of debt: - 0.5 point

pute unlevered beta: -1 point

out unelvered beta of entertainment business: -1 point
mate new D/E ratio correctly: -1 point
st cost of debt: -0.5 point
-tax cost of debt: -0.5 point

king capital initial investment: -0.5 point

mputing annual after-tax cash flow: -1 point
age working capital or show tax benefit from not salvaging: -0.5 point
age initial investment: -0.5 point
ny's cost of capital : -1 point

not to salvage working capital, you have to show the tax benefit
year 10 because you will be writing off the investment. That
be 0.4(10) = 4

e project is to continue forever, the cap ex = depreciaation. Otherwise, you

ur assets' earning power and not be able to go on forever.

w from part a in perpetuity: -1 point (This is mathematically impossible.

othing to depreciate after year 10)
flow just for perpetuity in year 10: -0.5 point (This is a lesser sin. It
atically impossible, but it is economically infeasible. Think Apple iTV)
-0.5 point each
king capital and initial investment: -0.5 point
iscount rate: -0.5 point

-tax cost of debt: -0.5 point

ghts: 0.5 point

st beta: -1 point
evering and relevering beta: - 0.5 point
-tax cost of debt: -0.5 point
-tax cost of debt: -0.5 point

Did not compute change in firm value: -1 point

Error in computing change in firm value: -0.5 point
Did not net out portion of value to buyback shares: -1 point
Did not adjust number of shares: -1 point

! All or nothing: -1 point

ing with change in working capital: -1 point

ing with change in debt: -0.5 point
in computing FCFE: -0.5 point
sh balance incorrect: -0.5 point

pute change in working capital correctly: -1 point

pute change in debt correctly: -1 point
-0.5 point each
end by revenues or some other variable: -0.5 point
(1-t)/ (BV of debt + BV of equity - Part a
a. Did not compute reinvestment: -1 point
b. Computed ROC incorrectly: -0.5 point

5 Terminal yearPart b
$32.21 $33.18 a. Did not compute reinvestment: -1 point
$12.88 $6.64 b. Did not use new cost of capital;: -0.5 point
$19.33 $26.54 c. Other errors in computation: -0.5 point
$379.16
$226.11
Part c
a. Used wrong discount rate for term value: -0.5
b. Did not compute PV of FCFF: -0.5 point
c. Forgot to add cash: -0.5 point
d. Forgot to subtract debt: -0.5 point
Problem 1
Book Value Market Value Unlevered beta of business
Cement $500 $900 0.90
Steel $500 $600 1.20
Total $1,000 $1,500

a,
Market value of equity = $1,000 ! Used book value weights for unlevered beta: -0.5 point
Market value of debt = $500 ! Debt to equity ratio set to zero or ignored: -1 point
Debt/equity ratio = 50.00% ! Did not use after-tax cost of debt: -0.5 point
! Math errors: -0.5 point
Unlevered beta for firm = 1.02
Levered beta for firm = 1.33 Computational notes
Cost of equity = 10.63% The unlevered betas should always be weighted based upon the market values of
After-tax cost of debt = 3.60% Since balance sheets have to balance, the market value of assets (businesses) =
Debt Ratio = 33.33% Thus even though the debt is not given, it can be backed out of the market value
Cost of capital = 8.29%

b After-tax operating income

Book value ROC Levered Beta Cost of equityCost of capital
Cement $75 $500 15.00% 1.17 9.8500% 7.77%
Steel 25 $500 5.00% 1.56 11.8000% 9.07%

Problem 2
Pre-tax cost of
After-tax
debt cost of debt
Cost of equityCost of capital
Life Products 8.00% 4.80% 14.00% 12.50%
Pfizer 5.00% 3.00% 9.00% 7.50%
Computational notes
a. Invest and produce The key aspect of the licen
Initial investment = $750.00 ! Did not comptue after-tax cash flow right: -1 point and that the only risk you
! Used wrong discount rate: -1 point not a function of operating
After-tax Cash flow ! Forgot to subtract out initial ivnestment: -1 point for Pfizer. It is not the cost
After-tax Operating inc 90.00 If the licensing fee had bee
+ Depreciation = $50.00 been appropriate to use Pfi
Cash flow to firm= $140.00

Discount rate = 12.50%! Pre-debt cash flows

PV of cash flows = $928.61
NPV = $178.61

b. PV of licensing fees has to be greater than the NPV of investing an ! Used wrong discount rate: -1 point
PV of cash flows = $178.61 ! PV formula not set up: -1 pont
Annual after-tax cash flow $17.21 ! Use pre-tax cost of debt fo(I gave full credit for both 15-year annuity and perpetu
Annual licensing fee = $28.68 ! Tax rate implicit in pre-tax and after-tax cost of debt. No points off for not doing

Problem 3
Current cost of equity = 10.00% Compuatational notes
Current after-tax cost of 3.60% The key part of this problem is recognizing that when investors are
Current firm value = $2,000.00 and those who do not will be a function of the buyback price. While
Debt Ratio = 25.00% a buyback price is provides is an indication that they are not. After a
Current cost of capital = 8.40% Thus, you need to go through the following steps:
New cost of capital= 8.00% 1. Estimate the change in firm value from the change in the cost of
Savings in cost of capital 0.40% 2. Estimate how many shares you will buy back at the buyback price
PV of savings = $100.00 3. Estimate how much buyback stockholders get of the value chang
4. Estimate how much remaining value change there is for those wh
Part a: Buy back stock at $10.25 5. Divide by the remaining shares outstanding to get the value chan
# of shares bought back 48.78
Premium paid = $0.25 ! Did not compute pre-change cost of capital correctly: -0.5 to -1 point
Value paid to buyback sh $12.20 ! Firm value change computed incorrectly: -1 point
Remaining value increas $87.80 ! Did not allocate a portion of firm value change to buyback shares: -1 point
Remaining shares = 101.22
increase in value for rem $0.87
Value per share = $10.87

Part b: Buyback price to make value change zero

Let the price paid back be X
Number of shares bought 500/X ! Kept number of shares bought back fixed: 1.5 points
Premium paid = X-10 ! Equation set up incorrectly for soluation: -1 point
Value paid to buyback sh(500/X) (X-10)
For the value per share on remaining shares to be unchanged
Value paid to buyback sh $100.00
(500/X) (X-10) = 100
X= $12.50

Problem 4
-3 -2 Last year ! Used 3 years instead of 2 years to get
Revenues $1,000 $1,200 $1,500 ! Working capital change not dalt with co
Net Income $100 $120 $150 1 Forgot dividends: -1 point
Depreciation $25 $40 $50 ! Did not deal with change in cash corre
Non-cash Working capital $100 $90 $75

FCFE without cap ex

Net Income $120 $150
+ Depreciation $40 $50
- Change in non-cash WC -$10 -$15
FCFE (without cap ex $170 $215

Dividends paid $48.0 $60.0

Change in cash balance = FCFE - Dividends - Stock buybacks

(120-100) = FCFE - 108 -0
FCFE = 128

FCFE without cap ex = $385

FCFE with cap ex = 128
Cap ex over two years = $257.00

Next year
Revenues $1,725.0 ! Debt change computed incorrectly or ignored: -1 point
Net Income $172.5 ! Change in working capital incorrect or ignored: -0.5 to -1 point
Cap Ex $86.25 ! Forgot to net out dividends: -0.5 to -1 point
Depreciation $57.5 ! Math errors: -0.5 point
Chg Non cash Working Capit 11.25
New Debt issued 10.00
FCFE $142.50
Dividends $69.0

Change in cash balance = FCFE - Dividends - Stock buybacks

(100-120) = 142.5 - 69 -X
Stock Buybacks = $93.50

Problem 5 Current 1 2 3 4 5
Loans $5,000.00 $5,500.00 $6,050.00 $6,655.00 $7,320.50 $8,052.55
Book value of equity $400.00 $451.00 $508.20 $572.33 $644.20 $724.73
Capital Ratio 8.00% 8.20% 8.40% 8.60% 8.80% 9.00%
Capital invested $51.00 $57.20 $64.13 $71.87 $80.53

Net income $100.00 $110.00 $121.00 $133.10 $146.41 $161.05

- Capital invested $51.00 $57.20 $64.13 $71.87 $80.53
FCFE $59.00 $63.80 $68.97 $74.54 $80.53

b. Stable growth
ROE = 12.00%
Expected growth rate = 4.00% ! Did not compute FCFE in year 6 correctly: -1 point
Equity Reinvestment Rate = 33.33% ! Used wrong discount rate: -0.5 point
! Used wrong growth rate: -0.5 point
Net income in year 6 = $167.49 ! 161.05*1.04
FCFE in year 6= $111.66
Cost og equity ;in year 6 = 10.00%
Terminal value of equity in $1,861.03

c. Value today
Year 1 2 3 4 5
FCFE $59.00 $63.80 $68.97 $74.54 $80.53
Terminal value of equity $1,861.03
PV $52.68 $50.86 $49.09 $47.37 $1,101.69
Value of Equity $1,301.69
/ number of shares 50
Value per share $26.03
pon the market values of the businesses, not book values
of assets (businesses) = market value of equity + debt
out of the market value of the assets

EVA ! Computed return on capital using market value: -1 point

$36.17 ! Did not compute costs of capital for businesses (used company cost of capital): -2 points
-$20.33 ! Multiplied return spread by market value: -0.5 point

omputational notes
he key aspect of the licensing fee is that it is a fixed amount
nd that the only risk you face is the default risk in Pfizer. Since it is a fixed amount (anld
ot a function of operating income or risk), the discount rate is the pre-tax cost of debt
or Pfizer. It is not the cost of capital.
the licensing fee had been a percentage of operating income on the product, it would have
een appropriate to use Pfizer's cost of capital to discount the cash flows.

Com

year annuity and perpetuity answers)

o points off for not doing this.

that when investors are not rational, the value allocation between those who sell back shares
the buyback price. While the problem does not specify that investors are not rational, the very fact that
that they are not. After all, when investors are rational, the buyback price = price for the remainign shares.

he change in the cost of capital (as you always do)

back at the buyback price (Dollar debt taken/ Buyback price)
rs get of the value change (Buyback price - Original price) (No of shares bought back)
ange there is for those who do not sell back their shares
ing to get the value change for remaining stockholders
0.5 to -1 point

ack shares: -1 point

instead of 2 years to get to cash flows: - 0.5 point

al change not dalt with correctluy: - 0.5 point
nds: -1 point
with change in cash correctly: -1 point

ored: -1 point
ored: -0.5 to -1 point

Compuational notes
 For a bank, investment in regulatory capital becomes the equivalent of net cap ex and working
capital change. Thus, the amount you have to invest in regulatory capital has to be taken out
of net income each year to get to FCFE. I gave full credit, if you estimated the investment in
regulatory capital to be an absolute number ($64.95 million a year)…

! Did not compute change in regulatory capital: -1 point

! Did not treat it as reinvestment for FCFE: -1 point
! Subtracted out other items (like loans) to get to FCFE: -1 point

! Forgot to add PV of FCFE in years 1-5: -0.5 point

! Forgot to PV terminal value: -0.5 point
! Subtracted out debt from PV: 0.5 point
of capital): -2 points
Problem 1
Achilles
Trident (acquirer) (Target)
Levered Beta 1.2 1.5
Tax rate 40% 40%
Market value of equity 12000 6000
Book value of equity 8000 8000
Market & Book value of debt 3000 4000

a. Unlevered beta 1.043478261 1.071428571

Value of the firm = 15000 10000
Weights of the firms = 60.00% 40.00%
Unlevered beta for the firm = 1.05

b.
Levered beta after transaction = 1.35
To compute D/E ratio
1.05 ( 1+ (1-.4)* D/E) = 1.35
Solving for the D/E ratio
Debt to equity = 46.67% ! You cannot keep equity value fixed while you solve f
Value of combined firm = $25,000.00 Instead, you have to estimate th value of the combine
Debt in combined firm = $7,955.23 and take the proportion that is debt.
Debt in existing firms = $3,000.00
New debt for deal = $4,955.23

c.
Cost of equity = 12.100%
Cost of debt = 3.300%
Debt ratio = 31.821%
Cost of capital = 9.30%

Problem 2
a. Correct discount rate is cost of capital (since operating cashflows are being discounted)
Cost of capital = 8.80%

b. Computed NPV = 20
Discount rate used = 12%
Initail investment = 600
PV of 10 years of earnings = 620
Annual after-tax OI = $109.73 ! Annuity given r=12% and 10 years

c. Initail invest Salvage

Assets 600 0
Non-cash WC 50 50

EBIT (1-t) $109.73

+ Depreciation 60
- Change in WC 0
FCFF $169.73

NPV = $470.44 ! -650+169.73(PV of annuity, 8.8%,10) + 50/1.088^10

PV of tax benefits from 5-yr depr $187.68 ! Deprcn=120; Tax savings=48; n=5 year
PV of tax benefits from 10-yr depr $155.39 ! Deprecn=60; Tax savings=24; n=10
Change in NPV from shift $32.29
New NPV = $502.72
Problem 3
a. Current debt ratio = 0.2
Cost of equity = 0.094
Cost of capital = 8.24%

b. Implied growth rate

Current value of firm = 1500
Expected cash flow next year= 80
Value of firm = 1500 = 80/ (Cost of capital -g) ! Already next year's cashflow. No growth needed in numerator.
Solve for g,
Implied growth rate = 2.91%

c. New cost of capital = 8.00%

Annual savings = 3.6
PV of savings with implied growth = $70.68
Debt at the optimal debt ratio $600.00 ! 40% of firm value
Existing debt = $300.00
New Debt issued = $300.00
# Shares bought back = 29.27
Preimium to shares bought back = $7.32
Remaining premijm = $63.36
Remaining number of shares = 90.73
Increase in value per share = $0.70

d. Only if new investments earn more than the new cost of capital. After you borrow the money,
the new cost of capital is the only one you care about.

Problem 4
Revenues = 100
Net Income = 25
Depreciation = 10
Cap Ex = 15
Non-cash Working capital = 12
Expected growth rate = 20%
Debt ratio for funding new investments 25%
Year 1 2 3
Revenues 120 144 172.8
Non-cash Working capital 14.4 17.28 20.736
Net Income 30 36 43.2
+ Depreciation 12 14.4 17.28
- Cap ex 18 21.6 25.92
- Change in WC 2.4 2.88 3.456
+ New debt issued 2.1 2.52 3.024
FCFE 23.7 28.44 34.128
Total FCFE = 86.268
Dividends to be paid = 76.268
Total Net income = 109.2
Payout ratio -= 69.84%

b. Effect of using 40% debt ratio for reinvestment

Net Income 30 36 43.2
+ Depreciation 12 14.4 17.28
- Cap ex 18 21.6 25.92
- Change in WC 2.4 2.88 3.456
- Debt repaid 10 10 10
FCFE 11.6 15.92 21.104
Total FCFE= 48.624
Change in cash balance 0
Dividends paid 48.624
Payout ratio 44.53%

c. Firms are less certain about future earnings (buybacks are flexible)
The other answers either do not make sense (more certain about earnings would increase dividen
or would have applied even more strongly prior to the last decade (dividends taxed at a higher ra
(I know we talked about mgmt compensation containing options, but more as a contributing facto
than the main factor. If you did circle other, and mentioned this, you did get 0.5 point)

Problem 5
EBIT (1-t) 4000
- Net Cap Ex 1000
- Chg in non-cash WC 200
FCFF 2800
Book Capital invested = 12000
Reinvestment rate = 30.00%
Return on capital = 33.33%
Expected growth rate = 10.00%
a. FCFF for next 3 years
Year 1 2 3
EBIT (1-t) $4,400.00 $4,840.00 $5,324.00
- Net Cap Ex $1,100.00 $1,210.00 $1,331.00
- Chg in WC $220.00 $242.00 $266.20
FCFF $3,080.00 $3,388.00 $3,726.80
PV (at 12%) $2,750.00 $2,700.89 $2,652.66
b. Terminal value
Growth rate = 3%
Return on capital = 33.33%
Reinvestment rate = 9.00%
EBIT (1-t) in year 4 = $5,483.72
- Reinvestment in year 4 = $493.53
FCFF in year 4 $4,990.19
Terminal value = $71,288.36 ! Use stable period cost of capital

c. Value of equity per share today

PV of FCFF for next 3 years = $8,103.56
PV of terminal value = $50,741.65 ! Discount at 12% for 3 years
Value of operating assets = $58,845.20
- Debt $4,000.00
Value of equity $54,845.20
Per share value = $10.97
 ! Used book value instead of market: -1 point
Wrong weights on companies: -1 point
Math errors: -0.5 point

! Kept equity value fixed; -1 point

Math errors: -0.5 point each

eep equity value fixed while you solve for debt.

ve to estimate th value of the combined firm
oportion that is debt.

! Math error: -0.5 point

! Did not set up annuity: -1 point

! Used 8.8% rate: -1 point
! I gave full credit, if you misread the problem and subtracted
depreciation from this number

! Forgot WC initial investment: -0.5 point

! Forgot salvage value: -0.5 point
Did not add back depreciation: -1 point
Math errors: -0.5 point

8.8%,10) + 50/1.088^10
! Forgot the tax effect: -0.5
! Multipled by (1-t) instead of t: -0.5 point
 ! Math error: -0.

! Used equity value: -0.5 to -1 point

Did not set up equation: -2 points

w. No growth needed in numerator.

! Bought back shares at today's price: -1 point

Used wrrong WACC in discounting: -0.5 point
! Did not estimate surplus paid to buyback shares: -0.5 point
Did not adjust number of shares for biuyback:-0.5 point

! Counted all of WC: -0.5 point

! Did not adjust for debt : -0.5 point
! No changei n non-cash WC: -0.5 point
! Computed payout ratio incorrectly: -0.5 point

Did not count cash flow from debt properly: -1 point

! When you are replaying debt, you cannot also multiply
your reinvestment by (1-Debt ratioj since that works only
if the debt raito is constant.
Consequently, you have to subtract out the debt repayment
to get to FCFE
! Counted the debt ratio adjustment: -1 point
Problem 1 Grading Guidelines
a. Unlevered Beta = 1.04 1. Error on weighting or used levered beta
b. Debt = 500 1. Used book value of equity: -1
Equitty = 2000 ! Value of the firm - Debt 2. Used effective tax rate: -.5
D/ E Ratio = 0.25 3. Math error: -0.5
Levered Beta = 1.196
c. New unlevered beta = 1 1. Did not recompute unlevered beta: -1.5
New Debt = 1500 2. Error on new business weights: -0.5 to
New Equity = 1500 3. Error on new debt to equity ratio: -0.5 p
D/E Ratio = 1 4. Used book equity in D/E ratio: -1 poiint
New levered beta = 1.6 twice but there were clues in the second

Problem 2
Investment in upgrade = 10 1. Computed PV of future cash flows : -0.5
- Salvage of old plant 2.5 ! Depreciation of $500,000 for next 5 year2. I have no clue what you were doing: -0
Initial investment 7.5

b. Annual incremental cashflow - Yrs 1-5

Existing Upgraded Incremental 1. Reported total annual cash flow: -1 poi
EBIT 1 2.5 1.5 2. Used total depreciatioin instead of incr
EBIT (1-t) 0.6 1.5 0.9 3. Other errors: -0.5 point to -1 point
+ Depreciation 0.5 1 0.5 (I gave full credit if you treated EBIT as EB
After-tax Cashflow 1.1 2.5 1.4 in incremental cash flows from years 1-5
In yrs 6-10, the entire upgrade cash flow of $2.5 million is incremental

c. NPV = $3.69 ! -7.5 + PV of 1.4 million from yrs 1-5 1. Did not estimate higher cashflows from
+PV of 2.5 million from yrs 6-10 2. Ignored years 6-10 completely: -1.5 po
Problem 3 3. Ignored initial investment: -1 point
a. Cost of equity today = 9.400%
Cost of debt today = 3.00% 1. Weights on debt and equity wrong: -0.5
Debt Ratio = 0.2 2. Wrong cost of equity: -0.5 point
Cost of capital today -= 8.12% 3. Forgot after-tax cost of debt: -0.5 point
b. Unlevered beta = 1.043478261
New levered beta = 1.460869565 1. Did not recompute beta: -1 point
New cost of equity = 10.57% 2. Errors on weights: -0.5 to -1 point
New cost of debt = 0.036 3. Forgot to after-tax cost of debt: -0.5 po
New debt ratio = 0.4
Cost of capital = 7.78%
c. Annual savings = 3.356521739 ! (.0812-.0778) (1000) 1. Used equity value instead of firm value
PV of savings = 88.69485294 ! 3.36/(.0778-.04) 2. Did not compute PV of savings with gro
Increase in value/share 1.108685662 ! Divide by 80 million 3. Did not divide by the total number of s
New share price = 11.10868566 4. Other math errors: -0.5 point
Amount of buyback = 200
# of shares bought back 18.00393009

Problem 4
Year -3 -2 -1 Total 1
Revenues 1000 1200 1500 3700 I gave full credit for both net and gross re
Net Income 100 120 150 370 1. Forgot cash balance change: -1 point
Deprecistion 50 60 75 185 2. Subtracted change in cash baqlance: -1
Dividends paid 40 48 60 148 Any mistake in this problem cost you a po
simply because tracing out math errors w
Decrease in cash balance 40
FCFE over 3-year period = 108
Net Reinvestment 262 ! Net Income - Dividends + Chg in Cash
Gross Reinvestiment 447 ! Add depreciation
 1 2 Total
Revenues 1650 1815 3465 1 Used total working capital instead of ch
Net Income 165 181.5 346.5 2. Error on FCFE computation: -1 point
Depreciation 82.5 90.75 173.25 3. Misplayed the change in cash balance:
Capital Expenditures 165 181.5 346.5 4. Other errors: -0.5 point each
Change in working capital 37.5 41.25 78.75
Dvidends 66 72.6 138.6

Total dividends = 138.6 If you got the dollar debt used (84.1) corr
Increase in cash balance = 40 full credit even if your ratio did not match
Required FCFE = 178.6
Net Reinvestment 167.9
Total Reinvestment 252
Debt used = 84.1
As % of Reinvestment = 33.37%

Problem 5
Year Current 1 2 3 1. Did not compute Reinvestment rate rig
EBIT(1-t) $80.00 $92.00 $105.80 $121.67 2. Did not compute growth rate right: -1 p
FCFF $20.00 $23.00 $26.45 $30.42 3. Error on ROC formula = -0.5 to -1 point
Reinvestment Rate = 75.00%
Expected growth rate= 15.00%
Return on capittal = 20.0%

Stable growth rate = 4% 1. Did not recompute reinvestment rate: -

Stable reinvestment rate= 0.333333333 2. Used wrong cost of capital (12% instea
EBIT (1-t) in year 4 $126.54 3. Grew operating income twice: -0.5 poin
FCFF in year 4 = 84.35786667
Termnal value = 1405.964444
1 2 3
FCFF $23.00 $26.45 $30.42 1. Forgot cashflows from years 1-3: -0.5 p
Terminal Value 1405.964444 2. Forgot to discount terminal value: -0.5
PV @ 12% $20.54 $21.09 $1,022.39 3. Used wrong discount rate (10% instead
Value of operating assets $1,064.01 4. Subtracted cash instead of adding: -0.5
+ Cash 50 5. Added debt instead of subtracting: -0.5
- Debt 250
Value of equity $864.01
/ Number of shares 100
Value of equity per share $8.64
ghting or used levered betas: -0.5 each
alue of equity: -1
e tax rate: -.5

mpute unlevered beta: -1.5

business weights: -0.5 to -1 point
debt to equity ratio: -0.5 point
quity in D/E ratio: -1 poiint (Feels like you are being punished
were clues in the second part that should have led to fixing the error)

V of future cash flows : -0.5 point

e what you were doing: -0.5 point to -1 point

al annual cash flow: -1 point

epreciatioin instead of incremental: -1 point
-0.5 point to -1 point
dit if you treated EBIT as EBITF+DA. That would have given you $1.1 million
cash flows from years 1-5 and $1.9 million from years 6-10.

mate higher cashflows from years 6-10: -1 to 1.5 points

s 6-10 completely: -1.5 point
al investment: -1 point

debt and equity wrong: -0.5 point

of equity: -0.5 point
tax cost of debt: -0.5 point

mpute beta: -1 point

ights: -0.5 to -1 point
er-tax cost of debt: -0.5 point

value instead of firm value in computing savings

pute PV of savings with growth: -1 point
e by the total number of shares: -0.5 point
errors: -0.5 point

t for both net and gross reinvestment

balance change: -1 point
hange in cash baqlance: -1 point
this problem cost you a point, even if it were a math error
tracing out math errors was very messy.
rking capital instead of change: -1 point
E computation: -1 point
e change in cash balance: -1 point
-0.5 point each

ollar debt used (84.1) correct, you got

if your ratio did not match up.

pute Reinvestment rate right: -0.5 to -1 point

pute growth rate right: -1 point
C formula = -0.5 to -1 point

mpute reinvestment rate: -1 point

cost of capital (12% instead of 10%) -0.5 point
ng income twice: -0.5 point

ows from years 1-3: -0.5 point

count terminal value: -0.5 point
discount rate (10% instead of 12%) -0.5 point
ash instead of adding: -0.5 point
nstead of subtracting: -0.5 point
Problem 1
a. Market value of equity = 200 Firm value = 250
Debt value = 50 Cash = 25
Debt to equity ratio = 0.25 Operating ass 225

Unlevered beta corrected for cash = 1.2

Unlevered beta for Vaudeville = 1.08 ! 1.2(225/250)+ 0 (25/250)

Levered beta for Vaudeville = 1.242 ! 1.08(1+(1-.4)(.25))

b. New debt = 150 ! Old debt + New debt issue

Equity = 200 ! Stays unchanged
New Debt/Equity ratio = 0.75
Firm value = 350
New unlevered beta = 1.486 Movie = 225
New levered beta = 2.154 Software = 125

Problem 2
a. NPV of project = -1.2
PV of cashflows over next 5 years = 8.8 ! Initial investment + NPV
Annual after-tax cashflow = $2.32 ! Five year annuity with r=10%
Annual after-tax operating income = $0.32 ! Subtract out depreciation of $ 2 million

b. PV of tax benefits
From straight line depreciation = $3.03 ! Annual tax benefit = $0.8 million: PV over 5 years
From accelerated depreciation =
Year Tax benefit PV
1 $1.60 $1.45
2 $1.20 $0.99
3 $0.60 $0.45
4 $0.40 $0.27
5 $0.20 $0.12
$3.29
NPV will increase by $0.26 ! Difference in present values

c. After tax return on capital = 6.00% ! After-tax operating income/ BV of capital

Cost of capital = 10.00%
Economic Value Added= -16

Problem 3
a. Current cost of equity = 9.80%
Cost of capital = 9.80%
b. New Debt to Equity = 33.33% ! Debt increases by $25 million; Equity decreases
New beta = 1.44 ! Unlevered beta (1+(1-t)(D/E))
New cost of equity = 10.76%
New cost of capital = 9.12% ! Cost of debt =7% (1-.4)
Change in firm value = $11.11 ! (Change in cost of capital * 100)/(.0912-.03)
Change in value per share = $2.78
c.
Debt to Equity = 0.25 ! Debt increases by $25 million; Equity does not change
New beta = 1.38 (This is an approximation. The NPV will add to equity va
New cost of equity = 10.52000% making the debt ratio even lower)
New cost of capital = 9.26% ! Uses new weights for debt and equity
Change in firm value = 8.695652174 ! (Change in cost of capital * 100)/(.0926-.03); note that even though fi
NPV from project = $5.00
Total increase in firm value = $13.70
Increase in value per share = $3.42
Problem 4
Year 3 years ago 2 years agoMost recent year
Next year
Net Income $100.00 $120.00 $150.00 $180.00
- Net Cap ex $30.00 $50.00 $55.00 $66.00
- Change in non-cash WC -$10.00 $20.00 $10.00 $4.00 ! The non-cash WC =30
+ Change in debt $0.00 $40.00 -$10.00 $0.00 Increase of 20% =6
FCFE $80.00 $90.00 $75.00 $110.00

Change in cash balance over 3 years

= 30
Total FCFE over 3 years = $245.00

Total dividends paid over 3 years = $215.00 ! FCFE - Change in cash balance
Dividend payout ratio = 58.11%

b. Expected FCFE next year $110.00

Cash available for stockholders = $110.00

Problem 5
Current 1 2 3
EBIT (1-t) $20.00 $23.00 $26.45 $30.42
- Net Cap Ex $10.00 $11.50 $13.23 $15.21
- Change in non-cash WC $5.00 $5.75 $6.61 $7.60
FCFF $5.00 $5.75 $6.61 $7.60
PV (at current cost of capital of 12%) $5.13 $5.27 $5.41

b. Reinvestment rate in first 3 years = 75% ! (Net cap ex + Chg in WC)/ EBIT (1-t)
Growth rate during firt 3 years = 15%
Return on capital first 3 years = 20.0% ! Growth rate in high growth period/ Reinvestment Rate
Growth rate after year 3 = 0.04
Reinvestment rate = 0.2 ! Growth rate/ ROC
EBIT (1-t) in year 4 = $31.63 ! EBIT (1-t) in year 3 (1.04)
FCFF in year 4 = $25.31 ! Net of reinvestment
Terminal value of firm = $421.79 ! FCFF in year 4 / (New cost of capital -g)

c. Value of firm today = $316.04 ! PV of cash flows in first 3 years + Terminal value/1.12^3
+ Cash $25.00 (Terminal value gets discounted back at today's cost of
- Debt $80.00
Value of equity today = $261.04
Value per share today = $26.10
 a. Weights on cash incorrect: -0.5 points
b. Did not consider cash: -1 point
c. Debt to Equity ratio wrong; -0.5 point

a. Wrong weights on new beusinesses: -0.5 point

b. Wrong debt to equity ratio: -0.5 point

a. Computed break-even cashflow incorrectly: -1 point

b. Did not consider depreciation: -1 point
c. Added back depreciation: -0.5 point

a. Tried to adjust cashflows for new depreciation: -1 point

(Very difficult to do. You have to subtract out old depreciation_
b. Computed tax benefit incorrectly: -0.5 point
c. Other errors: -0.5 point each

a. Computed ROC incorrectly: -0.5 points

b. Used market value instead of book value: -1 point

a. Used old cost of equity in computation: -1 point

b. New cost of capital incorrect: -0.5 point
c. Adjusted number of shares for buyback: -1 point
(If investors are rational, this is not necessary)

a. Did not compute new debt ratio and cost of capital: -1 point
b. Did not add back NPV of new invstment: -1 point

03); note that even though firm value increases to 125, you save only on the old firm value which was invested at the old cost of capital.
 a. Computed FCFE incorrectly: -1 point
b. Dividends computed incorrectly: -1 point
c. Mechanical errors: -0.5 point each
The non-cash WC =30
Increase of 20% =6

a. Reduced FCFE by cash balance (this will double the cash balance): -0.5 to 1 point

b. change in WC incorrect: -1 point

c. Other error: -0.5 to -1 point

a. FCFF computed incorrectly: -0.5 to -1 point

a. Did not compute new reinvestment rate: -1 point

b. Mechanical errors; -0.5 point each
estment Rate

a. Discounted terminal value at wrong rate or for 4 years: -0.5 points

al value/1.12^3
b. Did not subtract debt and add back cash: -0.5 each
at the old cost of capital.
Problem 1
Part a
Market value of equity = 700
Market value of debt = 300

Unlevered beta = 0.96

Levered beta = 1.206857143
Cost of equity = 0.093274286
Cost of capital = 7.43%

Part b
New business mix after acquisition
Hotels 1000
Transportation 400

New value for Equity = 800

New value for debt = 600
Unlevered beta= 0.914285714
New debt to equity ratio = 0.75
Levered beta = 1.325714286
New cost of equity = 0.098028571
Cost of capital = 7.02%

Problem 2
Iniital investment = -15
Reduction in Inventory = 4
Savings from storage facility 4 ! Investment in new facility - Capital Gains tax - Investment in old facility
Net Initial Investment = -7

Annual Cash flow Yr 1 yrs 2-10

Increased Revenue 15 15
Increase in EBIT 1.8 1.8
- Depreciation 1.5 1.5 ( No incremental depreciation from storage facility, since both
Increase in EBIT 0.3 0.3 the old and the new system have same book value)
Increase in EBIT (1-t) 0.18 0.18
+ Depreciation 1.5 1.5
- Change in WC 1.2
Annual Incr CF 0.48 1.68

NPV = $2.23

Problem 3
Cost of equity - 0.1074
Cost of debt (after-tax) 0.03
Market value of equity = 150
Market value of debt 46.13913254 ! You have to compute market value based upon interest expenses and cost
Cost of capital = 8.92%

Part b
Unlevered beta = 1.316948546
New market value of equity = 100
New market value of debt = 96.13913254 ! I did give full credit if you assumed that refinancing would alter market val
New levered beta = 2.076610291
New cost of equity = 0.128064412
New cost of debt = 0.042
Cost of capital = 8.59%
Change in firm value = $11.63
Shares bought back = $4.65
Share of those sold back = $3.49 ! Don’'t forget to net out the share of the surplus given to those who sell the
Remaining firm value = $8.14
Remaining shares = $10.35
Increase in value/share $0.79
Value per share = $10.79

Problem 4
Year 1 2 3 4
Revenues $50.00 $55.00 $60.50 $66.55 $73.21
Non-cash WC $10.00 $11.00 $12.10 $13.31 $14.64

Net Income $15.00 $16.80 $18.82 $21.07 $23.60

+ Depreciation $10.00 $11.00 $12.10 $13.31 $14.64
- Cap ex $16.00 $17.60 $19.36 $21.30 $23.43
- Change in non-cash WC $1.00 $1.10 $1.21 $1.33
FCFE $9.20 $10.46 $11.88 $13.49
Dividends paid $8.40 $9.41 $10.54 $11.80
Cash balance $15.00 $15.80 $16.85 $18.19 $19.87

b. To maintain its cash balance at $ 15 million, the firm can afford to pay out $ 4.87 million more in dividends over the entir
Total dividends paid = $45.02 ! No need for elaborate mathematical equaltions…. Just compu
Total net income = $80.29 ! I did give full credit to those who used only year 4 numbers..
Payout Ratio = 56.07%

c. To get to a cash balance of $ 30 million, you would have to issue $ 10.13 million in debt

Total reinvestment 1 2 3 4
$7.60 8.36 9.196 10.1156
Debt Ratio = 28.72%
Problem 5
Expected dividends next year = 60
Cost of equity = 8% ! Since you are given next year's income, you do
Growth rate = 4% who did use it…..
Value of Equity = 1500

b. Growth Rate = 4%
Retention Ratio = 40%
Return on equity = 10.0%

c. New Return on equity = 12%

New retention ratio = 33.333%
Value of equity = 1500 = 100 (1-.3333)/(r - .04) ! Don't forget to recompute the new payout ratio
Solve for r
Cost of equity = 8.44%

d. When the return on equity is less than the cost of equity. As the payout ratio is increased, the expected growth rate (whi
 ! I did give you full credit if you showed the inventory reduction in year 1.

tax - Investment in old facility

! Only incremental revenues and operating income matter

! Depreciation on storage facility is not incremental since it is the same for
n from storage facility, since both both old and new facility
have same book value)

! I was very, very generous on this problem. I did take off 1 point for using non-incremental revenue (operating income)
and 0.5 points for using non-incremental depreciation….

upon interest expenses and cost of borrowing

efinancing would alter market value of existing debt.

urplus given to those who sell their share back at 10.75/share

n more in dividends over the entire period.

ematical equaltions…. Just compute the total FCFE/Total net income
e who used only year 4 numbers..

Total
! Divide additional debt by total reinvestment…

$35.27

given next year's income, you don't need (1+g), though I did not take off credit for those

o recompute the new payout ratio (you cannot keep dividends fixed while raising ROE and holding g constant)

ed, the expected growth rate (which is = (1- payout ratio) ROE) will decrease. If the ROE < COE, the second effect will dominate.
ue (operating income)
ect will dominate.
Problem 1
a. Unlevered beta prior to restructuring
Levered beta from regression = 1.2
Average debt to equity ratio = 25%
Tax rate = 40%
Unlevered beta from regression= 1.0435

b.
.30 (.80) + .70 (X) = 1.0435
Solving for X,
Unlevered beta of remaining business = 1.147826087

Cash of 30% of firm value is used to retire debt (10%) and buy back stock (20%)
Debt to Equity after = 0.1666666667 ! The easiest way to do this is to set up a balance sheet.
D =20 and E =80 before the restructuring; D=10 and E = 60 after)
Levered beta after = 1.2626086957

Problem 2
As set up by the analyst,
NPV = 1.5 = -10 + Annual Cashflow (PV of annuity, 10 years, 12%)
Solving for the annual cashflow
Annual Cashflow estimated by analyst $2.04

b. Corrections for errors

The cashflows are pre-debt cashflows. The analyst should have used the cost of capital
a. One solution is to discount the pre-debt cashflows at the cost of capital
Cost of capital =` 0.096
Depreciation correction
Depreciation used = 1
Correct depreciation = 0.8
Reduciton in depreciation = 0.2
Reduction in tax savings (CF) - 0.08

Salvage value = 2 (in year 10)

Working capital (initial investment)= 1.5 ! Negative cashflow in year 0

Working capital salvage = 1.5 ! Salvage value in year 10

Correct Cashflows Year 0 Years 1-10 Year 10

Cashflow to fir- -11.5 $1.96 3.5

Net present value = $2.12

b. The other and more complicated solution is to estimate cashflows to equity and discount at the cost
of equity
0 1-9 10
Investment -$11.50 Debt = 30% of investment
Salvage 3.5
Debt $3.45 -$3.45 (Debt creates cash inflow
when borrowed, and has
After-tax interest expenses $0.14 to be repaid at end)
Cashflow to Equity -$8.05 $1.82 $0.05
Net present value at 12% = $2.23

Problem 3
a.
Market value of debt = $471.27
Market value of equity = $300.00
Debt to capital ratio = 61.10%
Cost of equity = 14.84500%
Cost of debt = 4.80%
Cost of capital = 8.71%

b.
If the value of the firm does not change, the cost of capital after the change should be the same as before.
Cost of capital after = 8.71%
Unlevered Beta = 1.1582811169
New Debt ot capital ratio = 0.3055147726
New levered beta = 1.4640085634
New cost of equity= 11.06%
After-tax Cost of debt after = 3.37%
Pre-tax Cost of debt = 5.61%

Problem 4
Halifax Donnelly Rutland
Net Income $100 $80 $50
Capital Expenditures $150 $60 $30
Depreciation $60 $30 $15
Increase in Non-cash Working $10 $10 $5
Debt to Capital Ratio 0% 20% 20%
Dividends $0 $40 $30
FCFE $0 $48 $34

a.
Cash balance at beginning $10.00 $10.00 $10.00
+ FCFE $0 $48 $34
- Dividends $0 $40 $30
Ending Cash Balance $10 $18 $14

b.
Net Income $100
- (Cap Ex - Depreciation) (1- 72
- Chg in WC (1- DR) 8
FCFE $20
Dividends that could have been $20

c. Expected net income next ye $100

- (Cap Ex - Deprecn)*(1-DR) 18
- Chg in WC (1-DR) 12
FCFE $70
Increase in cash balance = 20
Amount available for dividend $50
Increase over current year $20
Problem 5
a. Net Cap Ex = 50
Change in Working capital = 10
Total Reinvestment = 60
Reinvestment Rate = 60.00%
Retun on capital = 10.00%
Expected growth rate = 6.00%

current 1 2 3
EBIT (1-t) $100.00 106 112.36 119.1016
- Reinvestment 60.00 63.6 67.416 71.46096
FCFF $40.00 42.4 44.944 47.64064

b. Retun on capital in perpetuit 9%

Expected growth in perpetuity 3%
Reinvestment rate in perpetuity 33.33%
FCFF in year 4 = 81.783098667
Terminal value at end of year 31635.6619733

c.
Value of the firm today 1 2 3
FCFF $42.40 $44.94 $47.64
Terminal Value $1,635.66
Present Value $38.55 $37.14 $1,264.69
Value of the firm today = $1,340.38
- Value of Debt = $400.00
Value of Equity $940.38
Value per share $9.40
D=10 and E = 60 after)

unt at the cost

Problem 1
a.
Business Unlevered beta Sales Value/Sales Estimated Value of Business
House Furnishings 1.3 400 1.6 640
Construction Services 0.9 600 0.6 360
Unlevered beta = 1.3(640/1000) + 0.9 (360/1000) = 1.156

Debt/ Equity ratio = 0.666666667

Levered Beta = 1.6184

b.
Cost of equity = 11.473600%
Cost of capital = 11.4736 (.6) + 6.8 (1-.4) (.4) = 8.52%

c. After expansion plan

New value of construction business = 560
Value of house furnishings = 640
Unlevered beta = 1.11333333
Debt to Equity ratio = 1
New levered beta = 1.7813

Problem 2
Yrs 1-10 Check
Revenues $8,400,000 7903703.15 ! Any errors in the cashfl
- Printing & production $2,400,000 2258200.9
- Payroll costs $2,000,000 2000000
- Depreciation $1,500,000 1500000
EBIT $2,500,000 2145502.25
- Taxes $1,000,000 858200.899
EBIT (1-t) $1,500,000 1287301.35
+ Depreciation $1,500,000 1500000
CF to firm $3,000,000 2787301.35

NPV = -20,000,000+ 3,000,000 (Pv of annuity for 10 years at 9%) + PV of 5,000,000 at end fo year 10 =
$1,365,027.14 ! Forget salvage value: -

To get a NPV of zero,

Annual cash flow has to be = $2,787,301 ! - 20,000 + 5,000/1.09^10 + X(PVA,
Difference in after-tax cash flow = $212,699
Difference in pre-tax cashflow = $354,498
Difference in number of papers/year = $141,799 ! Divide by $ 2.50 (difference between
Difference in number of papers/month = $11,817
Breakeven number of papers = 188183.41

Problem 3
Market value of debt = $22.30 1. Use wrong cost of debt
PV of Operating leases = $19.45 ! Other math errors: -0.
Total Debt= $41.75

Market value of equity = $20.00

Cost of equity = 0.162
Cost of capital = 8.90%
Cost of capital at optimal
Cost of equity at optimal debt ratio ! If you use the old cost o
Debt/Equity Ratio = 1
Unlevered beta = 1.243111822
New levered beta = 1.988978915
Cost of equity = 12.96%
Cost of capital = 8.25% = 12.96% (.5) + Pre-tax cost of debt (1-.4) (.5)
Pre-tax cost of debt = 5.91%

Problem 4
Year Base 1 2 3
Revenues 500 550 605 665.5
EBIT 150 165 181.5 199.65
- Interest expenses 10 10 10 0! Did you remember to tak
Taxable income 140 155 171.5 199.65
- Taxes 42 62 68.6 79.86 ! Did you switch to a 40%
Net Income 98 93 102.9 119.79
+ Depreciation 40 44 48.4 53.24
- Cap Ex 50 50 50 50
- Chg in WC 10 11 12.1 ! Did you compute the cha
- Debt repayment 100 ! Did you show repayment
- Acquisition 50
FCFE 27 -9.7 110.93

Cash Balance 80 107 97.3 208.23

Target cash balance 50
Cash that can be paid out over next 3 years = 158.23 ! Did you consider the st
Total net income over next 3 years = 315.69
Maximum dividend payout ratio over next 3 years= 50.12% ! I did give you full cred

Problem 5
Return on capital for the firm = 0.15 ! 60/400: : I also gave full credit if
Reinvestment rate for first 3 years = 0.66666667
1 2 3
EBIT (1-t) $66.00 $72.60 $79.86
- Reinvestment $44.00 $48.40 $53.24 ! Forget reinvestment (-1.
FCFF $22.00 $24.20 $26.62
Terminal value $940.07 ! 79.86 (1.03) ( 1 - 0.20)
PV of cashflows $19.64 $19.29 $688.07
Reinvestment rate in stable growth = 0.2
Terminal value = $940.07

Value of firm today = $727.00

+ Cash 100 ! Since you began with o
- Debt 150 ! You have to add back ca
Value of Equity = $677.00
Value per share = $67.70
ue of Business
If you use revenue weights: -1

Any errors in the cashfl

0 at end fo year 10 =
Forget salvage value: -

,000/1.09^10 + X(PVA,

2.50 (difference between

. Use wrong cost of debt

Other math errors: -0.
If you use the old cost o

Did you remember to tak

Did you switch to a 40%

Did you compute the cha

Did you show repayment

Did you consider the st

I did give you full cred

lso gave full credit if

Forget reinvestment (-1.

79.86 (1.03) ( 1 - 0.20)

688.068204

Since you began with o

You have to add back ca
Problem 1
a. Unlevered beta for the firm =0.9 (.6) + 1.4 (.4) = 1.1 On part a and b, the key question was w
Debt to equity ratio = 900.00% a levered beta and a cost of capital with
Levered beta = 1.1 (1 + (1-0) (9)) = 11 would be determined by the marginal ta
the problem asked for next year's beta a
b. Cost of equity for the firm = 49.00% debt. Thus, harsh though it might seem,
Cost of capital = 49% (.1) + .17 (1-0) (.9) = 20.20%

c. If 1/2 of the internet business is divested,

Unlevered beta = 0.9 *.75 + 1.4 *.25 = 1.025 I gave full credit even if you did consider
New Debt to equity ratio = 7 If you did not recompute the unlevered b
New levered beta = 8.2

Problem 2
The maximum amount of initial investment will be the amount that makes the net present value zero.
First compute the PV of the cashflows ignoring depreciation
EBIT on Dried Flowers = $2.00
EBIT on Traditional offerings = $1.80 ! I was gentle here and allowed for multiple inter
- Over time Salary $1.00 in overtime is already considered in the operatin
EBIT w/o depreciation $2.80 still got full credit.
Taxes $1.12
Incremental EBIT = $1.68
PV of EBIT for 10 years = $10.32 ! If there was no depreciation, this would be your breakeven initial in
A second best solution for those who abhor algebra
Assume you invest $10.32 million and compute depreciation on that basis
Depreciation tax benefit each year = $0.41 ! Depreciation * Tax rate
PV of depreciation tax benefits for 10 yea $2.54 0
Initial investment with depreciation tax b $12.86 ! I have added the depreciation tax benefit to the PV of EBIT. It is an
will now change to 1.286 million and you will be in iterating forever.
The correct solution
If your initial investment is $1, your depreciation each year would be $.10 and the tax benefit would be $0.04
PV of tax benefit on $ 1 iniitial investment = PV of $0.04 for 10 years 0.245782684
If your initial investment was X, your tax benefits would be $0.2458
X = 10.32 + .2458 X
Solving for the initial investment, Initial investment = $13.69

Problem 3
a. Current cost of equity = 0.086
Current cost of capital = 7.72% ! Errors here mostly math…
b. Unlevered beta = 0.782608696
New levered beta = 1.486956522 ! If you forgot to reestimate the cost of equity, you lost a point
New cost of equity = 0.109478261 ! Wrong weights for debt and equity also cost a point
New cost of capital = 7.26%
c. Increase in firm value = 75 ! With rational investors you have to multiply by the total number of
Annual Savings = 2.880434783 ! (.0772 - .0726) (625)… Don't use market value of equity alone whi
Annual savings/ (WACC - g) = 2.88/(.0726 -g) = 75
Solve for g,
Expected growth rate= 3.42% ! If you set the problem up right but got the wrong answer, you lost

Problem 4
Most recent fiPrevious year
Earnings 110 100
Dividends 44 40
Cash Balance 100 78

Increase in cash balance = 22

Dividends paid by the firm = 44
Free Cashflows to Equity = 66
Net cap ex in most recent year = 44 ! If you got net cap ex wrong, you lost a point

Estimates for the future

1 2 3
Earnings $121.00 $133.10 $146.41
- Net Cap Ex $52.80 $63.36 $76.03
FCFE $68.20 $69.74 $70.38
Dividends $0.00 $0.00 $0.00 ! Dividends are eliminated. If you continued to project
Cash balance $168.20 $237.94 $308.32 ! Add the FCFE every year to the previous year's balan

b. .85 = (1- ord tax rate)/ (1- cap gains rate)

.85 = (1- ord tax rate)/ (1-.2)
Ordinary tax rate = 32.00% ! For some reason, if you inserted a dollar dividend or

Problem 5
Reinvestment last year = 50
EBIT (1-t) last year = 60 ! If you use average return on capital, you would have
Reinvestment rate = 83.33%
Return on capital = 12.00%
Expected growth for next 3 years = 10.00%

b. Terminal value calculation

Stable period reinvestment rate = 0.333333333 ! A common error was not recomputing the reinvestem
Expected EBIT (1-t) in 4 years = 83.0544
Terminal value = 1107.392 ! A minor error is pulling this out an extra year. It wou

c. Value today
1 2 3
EBIT (1-t) $66.00 $72.60 $79.86
Reinvestment $55.00 $60.50 $66.55 ! I gave you full credit if you took your FCFF and termi
FCFF $11.00 $12.10 $13.31 a. discounted EBIT (1-t) instead of FCFF
Terminal value $1,107.39 b. discounted the terminal value back at 10% instead
Present value $10.00 $10.00 $842.00 c. discounted the terminal value back 4 years instead
Value of firm $862.00
b, the key question was whether to consider the marginal tax rate. If the problem had asked for
and a cost of capital without specifying a time period, a reasonable case can be made that the eventual beta
mined by the marginal tax rate of 40% (giving you a beta of 7.04) and the cost of debt would be 10.2%. However
ked for next year's beta and cost of capital. Next year, there is no way the firm will be getting any tax benefits of
sh though it might seem, you lost a point on each if you did consider taxes.

t even if you did consider a tax rate. I felt you had borne enough punishment
ecompute the unlevered beta or used the wrong one, you did lose a point.

nt value zero.

owed for multiple interpretations. For instance, if you assume that the $ 1 million
sidered in the operating margin, your incremental EBIT would be $2.28 million. You

e your breakeven initial investment. If you go to this point, you got 4 points

to the PV of EBIT. It is an approximate solution because the depreciation

ill be in iterating forever. If you go this far, you got 5 points.

uity, you lost a point

ply by the total number of shares outstanding. If you used remaining shares, you lost a point
value of equity alone which is 500…

e wrong answer, you lost only 1/2 point.

, you lost a point

you continued to project dividends, you lost a point

the previous year's balance to get to final cash balance. Start at 100

erted a dollar dividend or put the wrong sign on price change, you would have lost a point

n capital, you would have got a lower return on capital but still should have got full credit.

computing the reinvestement rate = g/ ROC = 4/12 = 33.33%

out an extra year. It would have cost you 1/2 point

took your FCFF and terminal value and discounted back at 10%. However, you would have lost credit if you

lue back at 10% instead of 9%

lue back 4 years instead of 3 years
Problem 1
Market value of equity = 2000
Market value of debt = 2000 ! Value of firm (4000) - Value of equity
Debt/Equity ratio 1

Bottom-up unlevered bet 0.9625

Bottom-up levered beta 1.54
Cost of equity = 12.1600%
Cost of capital = 9.08% ! Debt to capital ratio = 50%; Cost of debt = 10%

b. New unlevered beta = 1.08

New D/E ratio = 0.5 ! Debt drops to $ 1 billion
New levered beta = 1.41
New cost of equity = 11.63%
New cost of capital = 9.26%

Problem 2
Stated NPV = 100 !
- 700 + CF (PVA, 10 years, 10%) = 100 ! The analyst expensed the entire investment in computing NPV
Solve for the CF,
Annual operating cashflow (prior to depreciation) $130.20

Correct initial investment = 1000

Correct after-tax annual cashflow = $160.20 ! Add the tax benefit from depreciation to each year's cash
Correct NPV = -1000 + 160.20 (PVA, 10 years, 12%) = -$94.86

Problem 3
Cost of equity before = 9.600%
Cost of capital before = 9.0600%
Increase in firm value = (Cost of capital before - Cost of capital after) * Firm value/ (Cost of capital after - Expected growth
150 = (.0906 - X) (1000)/(X - .05)
Solving for X,
Cost of capital after = 8.53%
Unlevered beta = 0.84375
New levered beta = 1.06071428571429
New cost of equity = 10.24%
Cost of capital = 8.55% = 10.24%(.7) + After-tax cost of debt (.3)
After-tax cost of debt = 4.61%
Pre-tax cost of debt = 7.68%

Problem 4
Current year Next year
Net Income 100 110
- Reinvestment 70 77
+ Net debt issued 0 15.4
FCFE 30 48.4
Payout ratio 30.00% 44.00%

b.
Dividends paid 44
Stock buyback 50
Cash returned to stockholders 94
Effect on cash balance = FCFE - Cash returned = -45.6
Cash balance at end of year = 54.4 ! 100 - 45.6

Problem 5
Firm value = 1500
Firm value = 1500 = 100 (1- Reinvestment rate)/ (.10- .05)
Solve for the reinvestment rate
Reinvestment rate = 25%
Return on capital = g/ Reinvestment rate = 20.00%

If the ROC = Cost of capital = 10%

Reinvestment rate = 0.5
Firm value = 100 (1-.5)/ (.10 - .05) = 1000
Value of equity = 700
ent in computing NPV

preciation to each year's cashflow

pital after - Expected growth rate)

Spring 2000
Problem 1
Unlevered beta for AT&T = 0.86 ! =0.92/(1+(1-.4)(.12)) ! Use average D/E ratio duri
Unlevered beta for Media One = 1.22 ! =1.40/(1+(1-.4)(.25))
Unlevered beta for combined firm = 0.95 ! Weighted average = 0.86 (300/400) + 1.22 (100/400

Debt for AT&T after merger = 125

Equity for AT&T after merger= 275

New levered beta = 1.21

Problem 2
Net present value estimated by analyst ($750.00)
- PV of Working capital investments = $264.99 ! I also gave you full credit if you counted only the
(I counted 200 right away and 100 in five years)
- PV of Salvage = $844.82
+ PV of Terminal Value = $1,631.56 Comment: You were incredibly creative in trying to c
each year for the 10 years. Given the information in
- PV of depreciation tax benefits $513.41
+ PV of expensing tax benefit $800.00 ! It is only the difference in tax benefits that matters.

Corrected net present value $58.33

Problem 3
Current Cost of Equity = 9.96%
Current after-tax cost of debt = 3.72%
Current Cost of Capital = 9.07% ! Current cost of capital'

Unlevered Beta = 0.9

New Levered beta = 1.26
New Cost of Equity = 11.04%
New After-tax cost of debt = 0.045
Cost of Capital = 8.42% ! New cost of capital

Change in firm value = $21.62 ! In billions

Change per share = $5.40

b.
Current interest expense on debt = 2.48
Book Value of Debt outstanding = 40 ! Before you issue new debt, this debt is trading at
Market value of debt at 7.5% = $36.43 ! When you borrow more and make yourself riskier, t
Drop in value of debt = $3.57 ! This is the drop in value in debt, but it goes to stoc
Total Change in firm value = $25.19 ! I added the drop in bond value to the answer of th
Change per share = $6.30
Many of you tried to solve the problem by reestimati
the old debt and new debt. You then used the lower co
which provides you with an increase in the stock pric
While you are on the right track, doing this will lock
fact, you will be able to get this benefit for only 10

Problem 4 Check
a. Change in cash balance = 1500 1500
Dividends Paid = .2 X 950
Stock Bought back = 1000 1000
FCFE 2500 +.2 X 3450
Using the statement of cash flows,
Net Income X 4750
+ Depreciation 2000 2000
+ Capital Expenditures -3000 -3000
+ Change in non-cash working capital 500 500
+ Net Debt Issued -800 -800
= FCFE 2500 +.2X 3450

Solve for X
Net Income in 1998 = 4750

Problem 5
1 2 3 Term. year (4)
Exp. Growth 15% 15% 15% 5%
EBIT (1-t) 115 132.25 152.09 159.69
ROC 20% 20% 20% 15%
Cost of Capital 12% 11% 10% 9%

Reinvestment Rate 75.00% 75.00% 75.00% 33.33% ! Reinvestment Rate = g / ROC

EBIT(1-t) $115.00 $132.25 $152.09 $159.69

- Reinvestment $86.25 $99.19 $114.07 $53.23
FCFF $28.75 $33.06 $38.02 $106.46
Terminal Value $2,661.50 ! Terminal value in year 3= CF
Cumulated Cost of Capital 1.12 1.2432 1.36752 ! When costs of capital change
Present Value $25.67 $26.59 $1,974.03 take the cumulated cost. We h
Value of Firm = $2,026.29 the valuation we had in the lec
- Value of Debt outstanding = 800
Value of Equity = $1,226.29
Value per share = $12.26 1974.025974
Reinvestment Rate = g / ROC

Terminal value in year 3= CF in year 4/(.09-.05)

When costs of capital change each period, remember to
ake the cumulated cost. We had to do this for Disney in
he valuation we had in the lecture notes.
 Spring 1999
Problem 1
Unlevered Beta for Pepsi = 1.2 / (1 + 0.6*(0.1)) = 1.13
Current Levered Beta = 1.13 (1 + 0.6*(10/40)) = 1.30

Unlevered Beta of the firm after divestiture = (1.13 - 1.35*(10/50))/(40/50) =

New Debt = 10 + 2 = 12
New Equity = 40 - 12 = 28
Levered Beta = 1.075(1 + 0.6*(12/28)) = 1.35

Problem 2
Cost of Equity = 5% + 1.25 (6.3%) = 12.875%
PV of Cash Flows = 15/.12875 = $ 116.50 ! Net cap ex and working capital are both zero
Equity Invested in Project = 0.6*150 = 90 ! Only equity investment considered
NPV of Project = 116.5 - 90 = $ 26.5 million
If you want to do this analysis on a firm basis, you have to compute the EBIT (1-t)
EbIT (1-t) = FCFF = 15 + 60*.08*(1-..4) = 17.88
Cost of Capital = 12.875% (0.6) + 4.8% (.4) = 0.09645
NPV = 17.88/.09645 - 150 = $ 35.38

Problem 3
Current Cost of Equity = 5% + 0.9 (6.3%) = 10.67%
Current Cost of Capital = 10.67% (.9) + 6% (1-.4) (.1)= 9.963%

Unlevered Beta = 0.9/(1+0.6*(1/9)) = 0.84375

New Levered Beta = 0.84375 (1 + (1-.4)(40/60)) = 1.18125
Cost of Equity = 5% + 1.18 (6.3%) = 12.43%
Cost of Capital = 12.43% (0.6) + 7% (1-.4)(.4) = 9.138%

Change in firm value = 10000 (.09963 - .09138)/(.09138 - .05) =

Change in value per share = 1994/300 = $ 6.65

Number of shares bought back = 3000/30 = 100 ! New Debt taken = Debt at optimal - C
Shares remaining = 300 - 100 = 200
Change in value per share = 2093/200 = $ 9.97

c. If you overpay on the acquisition,

Effect of overpaying on value per share = 500/300 = $ (1.67) ! Value per share will be $ 1.67 lower th
Thus, your move to the optimal, and whether you use debt is independent of this assessment. Any answer that incorporate
stock price got full credit.

Problem 4
1996 1997 1998 1999 2000
Net Income $150 $225 $315 $394 $492

Capital Expenditures $200 $250 $300 $375 $469

Depreciation $125 $190 $250 $313 $391

Non-Cash Working Capital $300 $330 $375 $469 $586

Net Income $150 $225 $315 $393.75 $492.19

- Net Cap Ex (1- Debt ratio) 67.5 54 45 $56.25 $70.31
- Chg in WC (1-DR) 22.5 27 40.5 $84.38 $105.47
FCFE $60 $144 $230 $253 $316
Dividends $30 $45 $63 $79 $98
Cash Balance $130 $229 $396
Non-cash WC $375 468.75 585.9375
Cash available for stock buybacks = $174 $218

Problem 5
Return on Capital in 1998 = 600 (1-.4)/2000 = 18.00%
Reinvestment Rate in 1998 = (360-300+50)/360 = 0.305555556
Expected Growth Rate = 18% (.3056) = 5.50%
Cost of Equity = 5% + 1.1 (6.3%) = 0.1193
Cost of Capital = 11.93% (.7) + 7.5% (1-.4) (.3) = 9.70%
FCFF = EBIT (1-t) - (Cap Ex - Depreciation) - Chg in WC = 360 - (360-300) - 50 = 250
Firm Value = 250*1.055/(.097-.055) = $ 6,280 ! Getting the right answer is not enough
1999

1.0750

d working capital are both zero

vestment considered

$ 1,994

New Debt taken = Debt at optimal - Current debt = 4000 - 1000 = 3000

Value per share will be $ 1.67 lower than whatever your optimal value
essment. Any answer that incorporated this drop in the

! Change in 1999 computed from total WC

below

Total
 $392

Getting the right answer is not enough. You have to justify the growth rate.
 Spring 1998
Problem 1
a. Cost of Equity = 6% + 0.67 (5.5%) = 9.68%
b. Bottom-up Beta
Pharmaceutical Business = 1.15/(1+0.6*0.1) = 1.08
Specialty Chemical Business = 0.70/(1+0.6*0.35) = 0.58
Unlevered Beta for Mallinckrodt = 1.08 (255.4/306.9)+ 0.58 (51.5/306.9) = 1.00
c.
Current Debt/Equity Ratio = 556.9/(32*73) = 23.84%
Levered Beta for Mallinckrodt = 1.00 (1 + 0.6*(.2384)) = 1.14

Problem 2
a. Return on Equity = $ 190.10/1231.20 = 15.44% ! I used the beginning of the year book value of equity
b. Equity EVA = (.1544 - .0969) (1231.20) = $ 70.80
c. Divisional EVAs
Division EBIT Capital Inves ROC Levered Beta Cost of EquityCost of CapitaEVA
Pharma $ 255.40 $ 1,298.00 11.81% 1.24 $ 0.1282 11.14% $ 8.67
Spec Chem $ 51.10 $ 601.00 $ 0.05 0.66 9.64% 8.57% $ (20.83)

Problem 3
Pre-tax Cost of Debt for Mallinckrodt = 6.80% (Based upon interest coverage ratio and rating of A+)
Cost of Capital = 9.69% (32*73/(32*73+556.9)) + 6.80% (1-.4) (556.9/(556.9/(32*73+556.9)) = 8.61%
b. Optimal Cost of Capital
Pre-tax Cost of Debt at Optimal = 7.25% (Based on interest coverage ratio at optimal)
Unlevered Beta = 0.67/(1+0.6*0.2384) = 0.586156215
New Beta = 0.60 (1+0.6*(40/60)) = 0.820618701
New Cost of Equity = 6% +0.84*5.5% = 10.51%
New Cost of Capital = 10.62% (.6) + .0725*.6*.4 = 8.05%
c. Value of Firm = 32*73+556.9 = 2892.9
New Dollar Debt at 40% Debt Ratio = 0.4*2892.9 = 1157.16
Additional Debt to be taken = 1157 - 556.9 = 600.26
Weighted Duration of Debt = (12/1157)(0.5) + (545/1157)(3)+(600/1157)X = 6.5
Solve for X,
X= 9.80

Problem 4 1996 1997

Net Income 212 190
+ Depreciati 149 128
+ Cex -169 -170
+ Chg in WC -152 34
+ Net Debt i 608 -113
FCFE 648 69

Dividends $ 45.70 $ 48.20

+ Buybacks $ 131.00 $ 150.00 ! I did not net out stock issues. If you did, specify that you did so…
Cash Returne $ 176.70 $ 198.20

Cash Returne 27.27% 287.25%

c.
Return on Capital = 307(0.6)/(109+558+1232) = 9.70%
Net Cap Ex/Revenues = (170-128)/1861 = 2.26%
Predicted Dividend Yield = 0.03 - 0.053(.097) - 0.15(.0226) = 2.15%
Predicted Dividend = 0.0215 * $ 32 = $ 0.69
Problem 5
Base 1 2 3 Terminal Year
EBIT (1-t) $ 184.20 $ 202.62 $ 222.88 $ 245.17 $ 252.53
+ Deprecn $ 128.00 $ 140.80 $ 154.88 $ 170.37 $ 175.48
- Cap Ex $ 170.00 $ 187.00 $ 205.70 $ 226.27 $ 193.03 ! Used industry average cap ex/deprciat
- Chg in WC $ 50.30 $ 55.33 $ 60.86 $ 20.08
FCFF $ 106.12 $ 116.73 $ 128.41 $ 214.89

Revenues $ 1,861.00 $ 2,047.10 $ 2,251.81 $ 2,476.99 $ 2,551.30

WC $ 503.00 $ 553.30 $ 608.63 $ 669.49 $ 689.58
% of Revenue 27.03% 27.03% 27.03% 27.03% 27.03%

b. Terminal Value Calculation

Cost of Equity in stable growth = 6% + 1(5.5%) = 0.115
Cost of Capital in Stable growth = 0.115(.6)+.07*.6*.4 = 8.58%
Terminal Value = 215/(.0858-.03) = $ 3,851

c. Cost of Capital = 9.69% (32*73/(32*73+556.9)) + 6.80% (1-.4) (556.9/(556.9/(32*73+556.9)) =

Value of the Firm = 106/1.0861+117/1.0861^2+(128+3851)/1.0861^3 = $ 3,302.81
Value of Debt Outstanding = $ 556.90
Value of Equity = $ 2,745.91
Value of Equity per Share = $ 37.62
year book value of equity

0.80749421
average cap ex/deprciation in year 4.

8.61%
 Spring 1997
Problem 1
Cost of Equity for the project = 7% + 1.5 (5.5%) = 0.1525 ! Since I did not give a premium, use a reasonabl
Cost of Capital = 15.25% (.6) + 10% (1-.4) (.4) = 11.55%
NPVof project = -40 + 10 (1-.4)/.1155 = $ 11.95

Problem 2
Business Unlevered BetWeight Beta *Weight
Tech 1.51 33.33% 0.503144654
Auto Parts 1.02 26.67% 0.271186441
Financial Services 0.72 40.00% 0.2875
1.06
Levered Beta = 1.06 (1+ (1-.4) (40/60)) = 1.49 ! Use debt to equity, not debt to capital

Problem 3
Firm Value before change = 2000
Firm Value after change = 2200 ! I have assumed investors are rational and that they sold their stock back at
If you assume that the stock buyback was at $ 40, you will get a smaller num
Change in firm value = 200

Cost of Capital before the buyback = 11.40% ! The cost of equity (using the 5.5% premium) is

Since no growth is given, I have taken the simpler assumption of no growth:

(.114 - New Cost of Capital) (2000) /New Cost of Capital = 200
New cost of Capital = 228/2200 = 10.36%

Levered beta after transaction = 0.8 (1 + (1-.4) (500/1500)) = 0.96

Cost of Equity after the transaction = 12.28%
Let X be the pre-tax cost of new debt =
12.28% (.75) + X (1-.4) (.25) =10.36%
Solving for X,
Pre-tax cost of borrowing on new debt = 7.67%

Problem 4
a. FCFE during year = Dividends paid + Increase in cash balance = 500 + 250 = 750
FCFE = Net Income - Net Cap Ex (1- Debt Ratio) - Change in Working Capital (1- debt ratio)
750 = 2000 - Net Cap Ex (1-.3)
Net Cap Ex = $ 1,785.71
b. Drop in the stock price = $ 1.80
Dividend Paid = $ 2.40 ! Change in stock price = Dividends (1- ord tax rate)/ (1- capital gains rate)
Number of shares = 500/2.40 = 208.33 ! Divide total dividends paid by dividends per share

Problem 5
a. Expected growth rate in perpetuity = ROE * Retention Ratio = .15 * .4 6.00% ! Cannot just assume a growth rate
Value per share = EPS (Payout ratio) (1+g)/(r-g) = $ 19.57 ! Used 5.5% risk premium and beta of 1

b. New growth rate with higher retention ratio = 14% *.5 = 7%

Value per share = EPS (Payout ratio) (1+g)/(r-g) = $ 19.45

Problem 6
a. False
b. False. Firms may pay out more in dividends than they have available in FCFE.
c. True
d. True. It may be the same for an unlevered firm, but it cannot be lower.
t give a premium, use a reasonable number

d that they sold their stock back at $ 44

at $ 40, you will get a smaller number (2150)

quity (using the 5.5% premium) is the cost of capital

d tax rate)/ (1- capital gains rate)

Cannot just assume a growth rate

k premium and beta of 1
 Spring 1996
Problem 1
a. Unlevered Beta for Samson = 0.90/(1+(1-0.4)(.05)) = 0.873786408 ! Used the average debt/equity ratio ov
New Levered Beta = 0.87(1+(1-.4)(.25)) = 1.0005
New Cost of Equity = 8% + 1(5.5%) = 13.50%
b. Cost of Capital = 13.50%(.8) + 10%(1-.4)(.2) = 12.00%
c. The debt ratio currently is 20%. Doubling the debt ratio will increase it to 40%.
New Levered Beta = 0.87(1+(1-.4)(.40/60)) = 1.218
New Cost of Equity = 8% + 1.22(5.5%) = 14.71%
New Cost of Capital = 14.71%(0.6)+11.5%(1-.4)(0.4) = 11.59%
d. Value of Firm today = 240+60 = 300
Dollar Debt at 40% debt ratio = 0.4*300 = 120
Additional Debt needed = 120 - 60 = 60
e. Value of Equity in 3 years = 240(1.135)^3 = $ 351 ! This is probably understated. The beta will rise over
Dollar Debt in 3 years = (0.4/0.6) ($ 351) = $ 234.00
f. Return on Capital in most recent year = 40(1-.4)/100 = 24.00% ! I used the book value at the beginning.
The firm is making a return on capital that is higher than the cost of capital. If it can continue to do so, I would suggest it t

Problem 2
a. FCFE in 1995 = Net Income + Deprecn - Cap Ex - Chg in Non-cash WC -(Principal Repaid + new Debt issued)
=150+20-70-10+15 = 105
Cash Balance increased by $ 50 million
Dividends paid must have been $ 55 million
b. Capital Expenditures = Change in Fixed Assets + depreciation = 50 + 20 = 70
Cash Balance increased by $ 50 million
c.
Net Income 165
- Net Cap (1-DR) 21 ! See below for calculation of net cap ex.
- Chg in WC (1-DR) 4.5
FCFE $ 139.50

Project ROC Beta Cost of EquityCost of Capital

A 13.34% 1.2 13.60% 11.40% ! Use firm's debt ratio of 25% and firm's after tax cost
B 9.99% 1 12.50% 10.58%
C 12.51% 1.1 13.05% 10.99%
D 14.28% 2 18.00% 14.70%
Accept projects A and C; total cap ex = $ 50 million
Depreciation next year = 20*1.1 = 22
Net Cap Ex = 50-22 = 28

Problem 3
a. Return on Capital = 25%
Debt/Equity Ratio = 25%
Interest rate on debt = 8%
Expected Growth = .67(25% + .25(25%-8% (1-.4))) = 20.13%
b. Current 1 2 3 Term. Year
EPS $ 3.00 $ 3.60 $ 4.33 $ 5.20 $ 5.51 ! Use a stable growth rate; I used 6%.
DPS $ 1.00 $ 1.20 $ 1.44 $ 1.73 $ 3.63
Payout Ratio 33.33% 33.33% 33.33% 33.33% 65.81% ! Payout Ratio in stable growth=1 - .06/(
c. Terminal Value per share = 3.63/(.125-.06) = $ 55.85
d. Value per share today = 1.20/1.1415 + 1.44/1.1415^2+(1.73+55.85)/1.1415^3 = $ 40.87
Cost of Equity today = 7% + 1.3 (5.5%) = 0.1415
e. If there is no net cap ex or working capital investment, the expected growth after year 3 has to be zero
EPS $ 3.00 $ 3.60 $ 4.33 $ 5.20 $ 5.20
- Net Cap Ex( 1.2 $ 1.44 $ 1.73 $ 2.08 0
 - Chg in WC ( 0 0 0 0 0
FCFE $ 2.16 $ 2.60 $ 3.12 $ 5.20
Current debt ratio = 20% (D/E ratio of 25% translates into debt ratio of 20%)
Terminal Value per share = 5.20/.125 = $ 41.61
Value per share today = 2.16/1.1415+2.60/1.1415^2+(3.12+41.61)/1.1415^3 = $ 33.96
(If you had used a 6% growth rate forever in this case as well, the assumptions would have been inconsistent.)
rage debt/equity ratio over period)

d. The beta will rise over time.

ok value at the beginning. If you decide to use averages, specify it here…

do so, I would suggest it take projects

Debt issued)

and firm's after tax cost of debt of 4.8%

growth rate; I used 6%.

n stable growth=1 - .06/(.15+.25(.15-.048))

nconsistent.)
 Fall 1995
Problem 1
a. To estimate market interest rate,
Yield to maturity on the debt = 9.31% ! If you are short of time, you can use the short cut = Interest
Estimated market value of bank debt = $ 39.52 ! Assumed that it was balloon payment debt.
Total Market Value = 42.5+39.5 = 82
After-tax Cost of Debt = 9.31%(1-.4) = 5.59%
b. Average Beta for comparable firms = 1.04
Average D/E Ratio for comparable firms = 22%
Unlevered Beta for comparable firms = 0.918727915
Levered Beta for SDL = 0.92 (1+0.6*(82/400)) = 1.03
(See below for calculation of debt)
Cost of Equity = 6% + 1.03 (5.5%) = 11.68%
c. Cost of Capital = 11.68% (400/482) + 5.59% (82/482) = 10.76%
d. SDL's debt seems much too long term for its needs. (The debt duration is only 1.5 years)
I would convert the debt into shorter term debt. I would keep it dollar debt since it does not seem to be affected by the $/D
e. Unlevered beta after acquisition = 0.92(482/632)+1.25(150/632) = 0.998322785
New Dollar Debt = 82 + 150 = 232
New Debt/Equity ratio = 232/400 = 0.58
New Levered Beta = 1.00 (1+0.6*0.58) = 1.348
New Cost of Equity = 6% + 1.348(5.5%) = 13.41%
New Cost of Capital = 13.41% (400/632) + 9.5%(1-.4) (232/632) = 10.58%

Problem 2
a.
Net Income 150
- Net Cap Ex 75 ! No debt
- Chg in WC 20
FCFE 55

If cash balance increased by $ 25 million, the dividend must have been $ 30 million.

b.
Project ROE COE
A 13% 11.50% ! Assuming that betas given are levered betas
B 16% 17.00%
C 12% 10.40%
D 15% 12.05%
Take projects A, C and D

Net Income 165

- Net Cap Ex (1-.2) 72
- Chg in WC (1-.2) 8 ! Working capital will increase by 10%, if revenues increase 10%
FCFE 85
The firm can afford to return $ 85 million to its equity investors

Problem 3
a. Expected growth during high growth period = 0.8 (20%) = 16% ! ROE = EPS/BV ofEquity = 2/10 =
b.
1 2 3 Terminal year
EPS $ 2.32 $ 2.69 $ 3.12 $ 3.31
DPS $ 0.46 $ 0.54 $ 0.62 $ 2.10
Payout ratio 20% 20% 20% 63.53% ! Payout ratio in stable phase=.06/(.14+.25(.14-.
Cost of Equity 14.25% 14.25% 14.25% 11.06% ! Levered Stable beta = 0.8(1+0.6*.25) ); Tax ra
(I used a cost of debt of 7% after year 3. It has to be greater than 6%, which is the T.Bond rate)
Terminal Value = 2.10/(.1106-.06) = $ 41.50
c. Value per Share = 0.46/1.1425+0.54/1.1425^2+(0.62+41.50)/1.1425^3 = $ 29.06
 can use the short cut = Interest exp/ MV of debt = 70/850 = 8.24%
n payment debt.

not seem to be affected by the $/DM rate.

! Beta fpr XLNT is unlevered

ROE = EPS/BV ofEquity = 2/10 = 20%

n stable phase=.06/(.14+.25(.14-.07*.6))
e beta = 0.8(1+0.6*.25) ); Tax rate used =40%]
 Fall 1994
Problem 1
a. Market Value of debt = 5 (PVA,10%,10) + 60/1.1^10 = $ 53.86 ! I estimated the market valu
b. given the current market int
Business Beta D/E Unlev Beta
Record/CD 1.15 50% 0.88
Concert 1.2 10% 1.13
Unlevered Beta for JP = 0.88 (.75) + 1.13 (0.25) = 0.9425
Levered Beta for JP = 0.9425 (1+(1-.4)(53.86/240)) = 1.07
Cost of Equity = 8% + 1.07 (5.5%) = 13.89%
c. Cost of Capital = 13.89% (240/293.86) + 10%(1-.4)(53.86/293.86) = 12.44%
d. If the treasury bond rate rises to 9%,
New Market Value of Debt = 5 (PVA,11%,10) + 60/1.11^10 = $ 50.58 ! You can even re-estimate t
Cost of Equity = 9% + 1.07 (5.5%) = 14.89% but it won't change by much
Cost of Debt = 11%
Cost of Capital = 14.89% (240/290.58) + 11% (1-.4) (50.58/290.58) = 13.45%

Problem 2
Project IRR to Equity Cost of Equity
A 16.00% 16.80%
B 15.00% 14.88%
C 12.50% 13.50%
D 11.50% 10.75%
Accept projects B and D
a.
Net Income $ 57.60
- (Cap Ex - Depr) (1-DR) $ 28.10 ! (50 - 13(1.2))(1-(53.86/293.86)) ! I would also have given you credit if debt
- Chg in WC (1-DR) $ 4.90 ! Working capital is 20% of revenues
FCFE $ 24.60
b. Dividends next year = 0.25*(57.60) = $ 14.40
Expected increase in cash balance = (24.60-14.4) = $ 10.20

Problem 3
a. Expected growth rate = .75(.48) = 36% ! If you use current ROE = 48/100 = 48%
The expected growth rate will be slightly lower if the market value debt to equity ratio and interest rate is used to get the g
Expected growth = .75 (.3188+ 53.86/240 (.3188-.06)) = 28.26% ROC =
If book value debt/equity ratio and book interest rate is used, the answer will be 35.55%
I am going to use the 27.46% growth rate because I think it is more sustainable.
b. Expected Dividends
Current 1 2 3 4 5
EPS $ 4.00 $ 5.13 $ 6.58 $ 8.44 $ 10.83 $ 13.88
DPS $ 1.00 $ 1.28 $ 1.65 $ 2.11 $ 2.71 $ 3.47
Payout Ratio 25.00% 25.00% 25.00% 25.00% 25.00% 25.00%
c. Stable Payout Ratio = 1 - [.06/(.15+(53.86/240)(.15 - .06)] = 64.75%
d. Terminal Value
Cost of Equity in stable growth = 13.50%
Terminal Value = $ 9.53/(.135-.06) = $ 127.06
e. Value today (discounting at current cost of equity of 13.89%)
Cost of Equity during high growth = 13.89% ! See problem 1
DPS + Term Price $ 1.28 $ 1.65 $ 2.11 $ 2.71 $ 130.53
PV $ 1.13 $ 1.27 $ 1.43 $ 1.61 $ 68.12
Value per share = $ 73.55

Problem 4
a. New Fundamentals:
Return on Capital = (85-5)*(1-.4)/(160-50) = 43.64% : Book Value of capital drops $ 50 mil after
Debt/Equity Ratio after buyback = 53.86/190 = 28.35% ! Market value of equity drops $ 50 mil aft
Interest rate on debt is assumed to stay at 10.00% ! Interest rate on debt is assumed not to c
Retention Ratio = 15.00%
new Expected Growth Rate = .85 (.4364 + .2835 (.4364-.06)) = 46.16%

Proportion of the firm in record/CD business after sale = 69.87% ! It used to be 75% of $ 293.86 million.
! Now it is = .75 * 293.86 million - 50 millio
! New Proportion = (.75*293.86-50)/(293.8
New Unlevered Beta = 0.88 (.70) + 1.13 (.30) = 0.955
New Levered Beta = 0.955 (1+0.6*(.2835)) = 1.12
I estimated the market value of the debt
iven the current market interest rate of 10%

You can even re-estimate the levered beta with this new debt
ut it won't change by much.

ave given you credit if debt=60

0.0034
/100 = 48%
est rate is used to get the growth rate
31.87%
{85*0.6/(100+60)) ! I am assuming that there was no cash at the start of the year. If there
had been, I would have netted it out.

Term Year
$ 14.72
$ 9.53
64.75%
 capital drops $ 50 mil after buyback: I am adjusting the beginning of the year book capital by this.
of equity drops $ 50 mil after buyback
on debt is assumed not to change

75% of $ 293.86 million.

5 * 293.86 million - 50 million
n = (.75*293.86-50)/(293.86-50)
 Fall 1993
Problem 1

Kentucky Fried Chicken 1.05 0.2

Hardee's 1.2 50%
Popeye's Fried Chicken 0.9 10%
Roy Rogers 1.35 70%
1.125 0.375
Unlevered Beta = 0.9183673

1a. First calculate the beta based upon comparable firms:

Average Beta = 1.125
Average D/E Ratio = 0.375
Unlevered beta = 0.91836735
Beta for Boston Turkey = 1.2627551
Use this beta to calculate the cost of equity
Cost of Equity = 6.25% + 1.26*5.5% = 13.18%
(Alternatively the long bond rate could have been used as the riskfree rate, with a 5.5% premium)

1b. After-tax Cost of Debt :

First compute the interest coverage ratio = EBIT / Interest Expense = 5
This yields a bond rating of A, and a pre-tax rate of 7.50% = 6.25% + 1.25%
After-tax cost of debt = 7.5% (1-0.4) = 4.50%

1c. Market Value of Equity = 20 * 100000 = $ 2,000,000

Market Value of Debt = 1.25 * 1000000= $ 1,250,000
1c. Cost of Capital = 13.18% (2/3.25) + 4.5% (1.25/3.25) = 9.84%

1d. New Debt Equity ratio after repurchase = 1.16666666667

New beta after repurchase = 1.5612244898
New cost of equity = 6.25% + 1.56*5.5% = 14.83%

1e. New after-tax cost of debt = 7.75% (1-0.4) = 4.65%

New cost of capital = 14.83% (1.5/3.25) + 4.65% (1.75/3.25) = 9.35%
Change in Firm Value = 3,250,000(.0984-.0935)/.0935 = $ 171,419
Change in stock price per share = $ 1.71 ! Divide by the total number of

2a. First decide which projects you will accept

Project ROE Cost of Equity
A 12.50% 11.75% Accept
B 14.00% 14.50% Reject
C 16.00% 16.15% Reject
D 24.00% 17.25% Accept
Next calculate working capital as % of Revenues
Working Capital = Current Assets - Current Liabiliti $500,000
Working Capital as % of Revenues = 50%

Income Statement Next year

Revenues 1100000
- Expenses 440000
- Depreciation 100000
= EBIT 560000
- Interest Exp 100000
= Taxable Inc. 460000
- Tax 184000
= Net Income 276000
-(CapEx- Deprec)(1-∂) 30000 (150000-100000)(1-0.4)
- ∂ WC (1-∂) 30000 (50% of increase in revenues ($100000))*(1-0.4)
= FCFE 216000

2b. Cash Balance next year = Current Balance + FCFE - Dividends = 150000+216000-100000 = 266000

2c. Ordinary tax rate = 40% Capital Gains tax rate = 28%
(Price before - Price after) / Dividend = (1-0.4)/(1-0.28) = 0.833
Change in price = $0.833

3a. Retention Ratio = 1 -(1/2.4) = 58.333%

ROC = (EBIT(1-t)) / (BV of Debt + BV of Equity ) 12.00% ! You can estimate ROE directly by dividing net in
Debt/Equity Ratio = 1.25/2 = 0.625 ! If you decide to use book value debt to equity ratio, specify it h
Interest rate = Market interest rate on debt = 7.50%
Expected Growth Rate = 0.5833 ( 0.12 + 0.625 (0.12 - 0.045) = 9.73%

3b. Terminal price = Price at the end of year 3

Cost of Equity = 6.25% + 1(5.5%) = 11.75%
Payout Ratio at the end of year 3 = 1 - (0.06/(0.12+0.625(0.12-0.045))) = 0.64044944
Terminal price = ($2.40*1.0973^3*1.06*0.6404)/(0.1175-0.06) = $ 37.44

3c. Year DPS

1 $ 1.10 ! Growing at 9.73% estimated above
2 $ 1.20
3 $ 1.32 $37.44
Current Cost of Equity (based upon current beta) =- 13.18% ! See problem 1 for calculation
Present Value of Dividends and Terminal Price = $ 28.65
% premium)

Divide by the total number of shares outstanding.

-100000 = 266000

e ROE directly by dividing net income by book equity, but your answer will be different.
debt to equity ratio, specify it here…

for calculation
 Fall 1992
1a. Current Cost of Equity = 8% + 1.15 (5.5%) = 14.33%
Current after-tax Cost of Debt = 10% (1- 0.4) = 6.00%
Current Weighted Average Cost of Capital = 14.33% (0.8) + 6.00% (0.2) = 12.66%
1b. New Debt Ratio = (200+200)/1000 = 40.00%
Unlevered Beta = 1.15/(1+0.6*.25) = 1.00
New levered beta = 1.00 (1+0.6*0.67) = 1.40
New Cost of Equity = 8%+1.40 (5.5%) = 15.70%
New Cost of Capital = 15.70% (0.6) + 6.60% (0.4) = 12.06%
1c. Change in Firm Value = 1000 (.1266-.1206)/.1206 = $ 49.75 millions
Increase in Stock Price = $49.75 million/ 40 million = $ 1.24
1d. Debt next year = $ 200 + $150 = $350 million
Expected Price Appreciation in Equity = Expected Return - Dividend Yield = 14.33%-10% = 4.33%
Expected Value of Equity = 800 (1.0433) = $ 834.64
Expected Debt/Equity Ratio at end of next year = $350/$835 = 41.92%

2a. - 1 2 3
Net Income $ 100.00 $ 110.00 $ 121.00 $ 133.10
+ Deprec'n $ 50.00 $ 54.00 $ 58.32 $ 62.99
- Cap. Ex. $ 60.00 $ 60.00 $ 60.00 $ 60.00
- Chg. WC $ 10.00 $ 10.00 $ 10.00 $ 10.00
= FCFE $ 94.00 $ 109.32 $ 126.09
Dividends $ 66.00 $ 72.60 $ 79.86
(Assuming that net capital investment and working capital is financed with equity)
Cash Balance $50.00 $78.00 $114.72 $160.95

b. If the firm had financed its net capital investment and working capital with 20% debt
Net Income $ 100.00 $ 110.00 $ 121.00 $ 133.10
- (CE-Dep) (1-∂) $ 8.00 $ 4.80 $ 1.34 $ (2.39)
- (Ch WC) (1-∂) $ 8.00 $ 8.00 $ 8.00 $ 8.00
= FCFE $ 97.20 $ 111.66 $ 127.49
Dividends $ 66.00 $ 72.60 $ 79.86
Cash Balance $ 50.00 $ 81.20 $ 120.26 $ 167.88

2b. Ordinary Tax Rate = (0.3)(0.15) = 4.50%

Capital Gains Tax Rate = 20.00%
Dividends Per Share = $2.00
Price Change per share on Ex-Dividend Day = [(1-.045)/(1-.20)]($2.00) = $ 2.39

Problem 3 1 2 3 4
EPS $ 2.40 $ 2.78 $ 3.12 $ 3.31
Payout Ratio 0.00% 25.65% 36.17% 61.54% ! Payout ratio = 1 - g/ROE, where ROE = R
DPS $ - $ 0.71 $ 1.13 $ 2.03
Beta 1.4 1.25 1.1 1
Cost of Equity 0.142 0.13375 0.1255 0.12
Note: The alternative to estimating a levered beta in year 4 is to assume a beta of 1.

Terminal Price = $2.03/(.12 - .06) = $ 33.90

DDM Value = $0.71/(1.142*1.13375)+(1.13+33.90)/(1.142*1.13375*1.1255) = $ 24.59

= 1 - g/ROE, where ROE = ROC + D/E (ROC - I (1-tax rate))