Finance 2 for IBA (30J201) F.Feriozzi Regular exam December 15 th, Part One: MultipleChoice Questions (45 points)


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1 Finance 2 for IBA (30J201) F.Feriozzi Regular exam December 15 th, 2010 Question 1 Part One: Multiplehoice Questions (45 points) Which of the following statements regarding the capital structure decision in perfect capital markets is false? A. Because investors can borrow or lend at the same interest rate as the firm, homemade leverage is a perfect substitute for the use of leverage by the firm. B. When investors use leverage in their own portfolios to adjust the leverage choice made by the firm, we say that they are using homemade leverage.. The value of the firm is determined by the present value of the cash flows from its current and future investments. D. The investor can recreate the payoffs of unlevered equity by borrowing and using the proceeds to purchase the equity of the firm. E. The future repayments that the firm must make on its debt are equal in value to the amount of the loan it receives up front. Question 2 Kroger Inc. has a corporate tax rate of 35% and currently has some leverage. onsider the following income statements for Kroger (figures are in $ Millions): Year Total Sales 60,553 56,434 53,791 ost of goods sold 45,565 42,140 39,637 Selling, general & admin expenses 11,688 12,191 11,575 Depreciation 1,265 1,256 1,209 Operating Income 2, ,370 Other Income EBIT 2, ,370 Interest expense Earnings before tax 1, Taxes (35%) Net Income The income that would be available to equity holders in 2006 if Kroger was not levered is closest to A. $1,525 million. B. $2,035 million.. $1,500 million. D. $1,325 million. E. $1,850 million. 1
2 Question 3 Assume that the only friction in capital markets is represented by corporate taxation. Keeping constant the leverage of a company, a reduction in its marginal tax rate would A. not affect its aftertax WA. B. result in a lower aftertax WA.. result in a higher aftertax WA. D. result in a lower cost of equity capital. E. result in a higher cost of equity capital. Question 4 Big Bang orp. (BBA) is a clothing retailer with a current share price of $10.00 and with 25 million shares outstanding. Suppose that BBA currently has no leverage and announces plans to lower the amount of corporate taxes it pays, by borrowing $100 million and using the proceeds to repurchase shares. Suppose that BBA pays corporate taxes of 35% and that shareholders expects the change in leverage to be permanent. Assume that capital markets are perfect except for the existence of corporate taxes and financial distress costs. If the price of BBA's stock rises to $10.85 per share following the announcement, then with $100 million of debt the present value of BBA's financial distress costs is closest to A. $21.25 million. B. $35.00 million.. $11.40 million. D. $24.50 million. E. $13.75 million. Question 5 onsider the following personaltax rates: apital Ordinary Dividend Year Gains Rate Income Rate Rate % 40% 40% % 39% 39% % 35% 15% The effective dividend tax rate for a oneyear individual investor in 2006 is closest to A. 20%. B. 0%.. 15%. D. 35%. E. 20%. Question 6 Which of the following statements regarding the alternative methods of capital budgeting with leverage is false? A. The APV method explicitly values the market imperfections and measures their contribution to value. B. We need to know the debt level to compute the APV, but with a constant debtequity ratio we need to know the project's value to compute the debt level. 2
3 . With the WA method we must compute the value of the interest tax shield and the unlevered value of the project with two separate valuations. D. Implementing the APV method with a constant debttoequity ratio requires solving for the project's debt and value simultaneously. E. The first step in the APV method is to calculate the value of free cash flows using the project's cost of capital if it were financed without leverage. Question 7 An option strategy in which you hold a long position in both a put and a call option on the same underlying stock and with the same strike price is called A. a strangle. B. portfolio insurance.. a butterfly spread. D. a straddle. E. a protective put. Question 8 Which of the following represents an arbitrage upper bound for the value of a put option? A. Its strike price. B. Its intrinsic value.. The value of the underlying stock. D. Its time value. E. None of the above. Question 9 The current price of KD Industries stock is $20. In each of the following 5 years, the stock price will either go up by 20% or go down by 20%. KD pays no dividends. The riskfree rate for all maturities is 5% and will remain constant. The riskneutral probability that in two years KD stock will be below $19 is closest to A B D E Question 10 onsider a European option on an underlying stock. The delta of an option measures the change in the value of the option given a $1 change in the price of the underlying stock. Which of the following statements is true? A. The option delta is positive for both a call and a put option. B. The option delta is negative for both a call and a put option.. The option delta cannot be positive for a put option. D. The option delta cannot be positive for a call option. E. None of the above is true. 3
4 Question 11 onsider the following two statements regarding the real option to wait, which is available for many capital budgeting decisions. I. If there is a lot of uncertainty, the benefit of waiting is diminished. II. The smaller the cost of waiting, the less attractive the option to wait becomes. A. Statement I is correct, statement II is false. B. Statement I is false, statement II is correct.. Statement I is false, statement II is false. D. Statement I is correct, statement II is correct. Question 12 Which of the following characteristics of IPOs does not represent a puzzle to financial economists? A. The price at the end of the first trading day is often substantially higher than the IPO price. B. In many IPO deals, the underwriter has the option to issue more shares of stock, amounting to 15% of the original offer size, at the IPO offer price.. The costs of the IPO are very high. D. The longrun performance of a newly public company (three to five years from the date of issue) is poor. E. The number of issues is extremely cyclical. Question 13 Which of the following statements regarding sinking fund provisions is false? A. With a sinking fund, if a bond is trading at below its face value, because the bonds are repurchased at par the decision as to which bonds to repurchase is made by lottery. B. With a sinking fund, instead of repaying the entire principal balance on the maturity date, the company makes regular payments into a sinking fund administered by a trustee over the life of the bond.. Sinking fund provisions usually specify a minimum rate at which the issuer must contribute to the fund. D. Because the sinking fund allows the issuer to repurchase the bonds at par, the option to accelerate the payments is another form of call provision. E. In some cases, the sinking fund payments are not sufficient to retire the entire issue and the company must make a large payment on the maturity date. Question 14 The leaseequivalent loan is A. the loan that is required on the purchase of the asset that leaves the purchaser with the same obligations as the lessor would have. B. the loan on the purchase of the asset that makes the lessor indifferent between purchasing and leasing the asset.. the loan that is required on the purchase of the asset that leaves the purchaser with the same obligations as the lessee would have. 4
5 D. the loan on the purchase of the asset that makes the lessee indifferent between purchasing and leasing the asset. E. None of the above. Question 15 Sigma Manufacturing has earnings per share (EPS) of $3.00, a share price of $32, and 5 million shares outstanding. Sigma is considering buying Delta Industries, which has earnings per share of $2.50, a share price of $20, and 2 million shares outstanding. Sigma will pay for Delta by issuing new shares. There are no expected synergies from the transaction. Assume that Sigma pays no premium to acquire Delta. Sigma's priceearnings (P/E) ratio after the acquisition of Delta is closest to A. 8. B D. 11. E. 12 Question 1 Part Two: Open Questions (55 points) onsider a firm that is currently allequity financed, and has assets in place worth $5 billion. Its current market share price is $25. The firm plans to borrow $1.5 billion and use these funds to repurchase shares. The firm s corporate tax rate is 40%, and it plans to keep its outstanding debt equal to $1.5 billion permanently. (a) What is the lowest share price that the firm can offer to existing shareholders and have them tender their shares? (5 points) (b) Assume now that for each tendered share the firm will offer a premium of $2.00 on top of the minimum acceptable share price computed in the previous point (a). What will the stock price be after the share repurchase in this case? (5 points) Question 2 A firm will be liquidated in one year and today its managers can choose one of two business strategies that both require no additional capital expenditures. The first strategy is risky and its cash flow in one year is forecasted to be $100 million with probability 0.8, $150 million with probability 0.1, and only $10 million with probability 0.1. The second strategy is instead riskless and will produce in one year a sure cash flow of $100 million. The risk of the first strategy is diversifiable and the yearly riskfree interest rate is 5%. Managers act in the interest of existing equity holders. (a) Assume that the firm has a required debt payment of $60 million maturing in one year. What strategy will managers choose? What is the strategy that maximizes the total value of the firm? (5 points) (b) How would your answers to point (a) change if the required debt payment were $40 million? (5 points) (c) Assume now that the required debt payment, due in one year, is $40 million. However, before choosing the business strategy, managers are considering the issue of a zero coupon bond maturing in one year which is junior with respect to existing debt (but of course senior with respect to equity). The proceeds would be used to immediately pay a special dividend to shareholders. ompute the dividend that could be paid to shareholders if the face value of the zero coupon bond were $20 million. Is 5
6 it in the interest of existing equity holders to issue this junior zero coupon bond? (5 points). Hint: Investors anticipate the business strategy that will be chosen by managers. Question 3 You are the FO of a chain of gourmet food stores. Your company is considering opening a new store in a recently renovated building in New York. If you don t sign the lease on the store today, someone else will, so you will not have the opportunity to open a store later. There is a clause in the lease that allows you to break the lease at no cost in two years. Including the lease payments, the new store will cost $15,000 per month to operate. Because the building has just reopened, you do not know what the pedestrain traffic will be. If your customers are mainly limited to morning and evening commuters, you expect to generate $10,000 per month in revenue in perpetuity (as far as the store is operated). If, however, the building becomes a tourist attraction, you believe that your revenues will be $25,000 per month in perpetuity (as far as the store is operated). You estimate there is a 50% probability that the building will become a tourist attraction. Immediately after the store is open, it will be obvious whether the building is a tourist attraction or not. The costs to set up the store will be $600,000. Assume that the riskfree rate is 6% per year and will remain constant over time. You also estimate that the risks involved in the project are perfectly diversifiable. (a) ompute the NPV of the project. (5 points) (b) What is the value of the option to break the lease at no cost in two years? (5 points) Hint: Remember that you are not forced to start the project if it has a negative NPV. (c) Assume now that you can negotiate an additional clause in the lease contract that gives you the opportunity to break the lease in one year by paying an earlycancellation fee. Notice that the fee would be paid in one year only in case of an early cancellation. In any case you retain the right to break the lease contract after two years at no cost. What is the maximum earlycancellation fee that you are willing to negotiate today for the option of walking away from the project in one year? (5 points) Question 4 The current market value of equity of Miller Stores, Inc., is $5 billion, and its debt value is $2.4 billion. Moreover, Miller s levered cost of equity is 9.5% and its debt cost of capital is 6%. Miller is investigating an investment project that would require a $125 million outlay today, and would produce annual EBIT of $16 million in perpetuity, starting one year from now. Assume that the project will not generate any taxdeductible depreciation, nor it will require any change in net working capital. Miller faces a 30% corporate tax rate. It intends to maintain its current debttoequity ratio over time with the new project. (a) alculate the NPV of the investment project using the WA method. (5 points) (b) Assume that Miller starts the project immediately. What is the value of the additional debt that Miller must issue today to keep its debttoequity ratio constant? (5 points) (c) Recalculate the NPV of the investment project using first the APV method and then the FTE method. (5 points) 6
7 Solutions Part 1: Multiplehoice Questions 1 2 D D Year EBIT Total available to equity holders if no leverage = EBIT(10.35) , , E B D A A B A VU = $ million shares = $250 million Without financial distress costs we would have VL = VU + cb = $ ($100) = $285 million, and the share price would therefore be $285 / 25 million shares = $ Hence, financial distress cost are given by PV of financial distress costs = ($ $10.85) 25 million shares = $13.75 million d = 15%, g = 15% (one year) τ d τ d τ g = 1 τ g = Each year, the riskneutral probability of a 20% increase can be obtained by solving 0.05 = (1 )( 0.20) that yields = For the stock price to be below $19 after two years, it must go down by 20% both in year one and in year two. The riskneutral probability of this event is (1 )(1 ) = The number of shares that Sigma must issue is given by So the total number of shares in the new merged firm equals 5 million (existing Sigma shares) million new shares = 6.25 million shares. Total earnings for the merged firm = earnings from Sigma + earnings from Delta. Earnings from Sigma = EPS shares outstanding = $ million = $15 m Earnings from Delta = EPS shares outstanding = $ million = $5 m Total earnings = $15 + $5 = $20 million $20 million earnings $32 EPS merged firm = = $3.20, Post merger P/E = 6.25 million shares = 10 $3.20 7
8 Question 1 Part 2: Open Questions Outstanding shares are $5b/$25 = 200 million. After borrowing $1.5 billion and before repurchasing, the value of the firm is (a) 5(assets in place) + 1.5(cash) + (0.40)1.5(tax shield) = $7.1 billion. The value of equity is now = $5.6 billion, so that the fair value of a share before the repurchase is $5.6 billion / 200 million shares = $28. If the repurchase is realized at this price, the firm can buy back $1.5 billion / $28 per share = 53,571,428 shares, and there would be 200,000,000 53,571,428 = 146,428,572 share outstanding thereafter. The value of equity after the repurchase would be = = $4.1 billion, so that remaining shares would be worth $4.1 b / 146,428,572 = $28. Hence, $28.00 is the minimum acceptable price to realize the buyback. Assume the repurchase price is set to $30. The firm can bay back (b) $1.5 billion / $30 per share = 50 millionshares, and there are = 150 million share outstanding thereafter. The value of equity after the repurchase is = = $4.1 billion, so that remaining shares are worth $4.1 b / 150 m = $ Question 2 (a) With a due debt payment of $60 million, the cash flows in one year will be!!! learly, managers prefer the risky strategy as it makes equity worth more than the riskless strategy. However, the riskless strategy maximizes the total value of the firm. 8
9 With a due debt payment of $40 million, the cash flows in one year will be (b)!! "#! learly, managers prefer now the riskyless strategy, which also maximizes the total value of the firm. (c) With a due payment of $40 million and a zero coupon bond with face value of $20 million, the total due payment is as in point (a) and managers will choose the risky strategy. In this case the face value of $20 millions can only be paid with probability 0.9, i.e., if the total cash flow is either $100 million or $150 million. When instead the cash flow is $10 million it is used to partially repay senior debt holders. The amount of money that can be raised with the issue of the junior zero coupon bond is therefore /1.05 = $17.14 million. This is the special dividend that can be paid. The issue of the zero coupon bond is not in the interest of shareholders. In fact if the junior bond is not issued, with a due debt payment of $40 million the management will choose the riskless business strategy and the value of equity is $60 million in this case. If instead the zero coupon bond is issued, total debt payments amount to $60 million and the management will choose the risky strategy. The value of equity is $41 million in this case and they also receive a dividend of $17.14 million. The total value of shareholders portfolio (shares of stock plus cash) is therefore = $58.14 million which is smaller than the value of equity in the absence of the zero coupon bond. Question 3 (a) The monthly interest rate is 0.06/12 = The information about the project is as follows: Setup cost 600,000 Monthly operating costs 15,000 Monthly revenues 10,000 with probability ,000 with probability 0.5 With 50% probability monthly revenues are $25,000. In this case the option to walk away from the lease is not exercised. ash flows are then perpetual and the present value of the project is With 50% probability monthly revenues are $10,000. In this case the option to walk away from the lease is exercised. ash flows then only last for two years (i.e., 24 months) and the present value of the project is 9
10 We therefore have that. Without the option to walk away, cash flows are in any case perpetual (whether revenues turn out to be high or low). In this case we have (b) Hence, the project is not started if the contract does not include the option to break the lease after two years. This means that all the value comes from this right, that is, the value of the option to break the lease is $343,593. (c) Early cancellation is valuable when revenues are low. In this case the early cancellation option allows saving $5,000 of monthly losses for 12 months. The value of such savings is And this is the maximum earlycancellation fee that you are (should be) willing to pay. Question 4 (a) First, we need to obtain the aftertax WA as follows Using the WA method we then obtain! "##"$% (b) The amount of additional debt to raise today, say & ', equals the target debttovalue ratio (2.4/7.4) times the present value of future FF. Hence we have & ' = (2.4/7.4)* = $46.68 million. To apply the APV method we need the pretax WA, that is given by (c) 10
11 ( Notice that the debt obtained in (b) is expected to be maintained in perpetuity as the project FFs are also a perpetuity. Hence, using the APV method we obtain )*! "##"$% Notice in particular that the yearly tax shields are discounted at the rate ( because with a constant debttoequity ratio the tax shields have the same risk as the FFs. Finally, to apply the FTE method we need to obtain the free cash flows to equity holders (FFE), which is obtained as follows: FFE = FF + Net Borrowing (1 τ c ) Interest Payments. Notice that Net borrowing is $46.68 million today and it is expected to be zero in the future. Yearly interest payments are clearly zero today and are expected to be 46.68(0.06) in the future. Hence we obtain Today: Future: FFE 0 = = $78.32 million FFE t = 16(1 0.30) (1 0.30)46.68(0.06) = $9.24 million. Finally, using the FTE method we obtain +,.! "##"$% This confirms that the three methods are indeed equivalent. 11
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