Corporate Finance Topics (C15



Corporate Finance Topics (C15.0008)

Summer 2006

Final Exam

Instructor: Amrut Nashikkar

Name:___________________________

Instructions: The exam is for TWO HOURS and has five parts. Read all questions CAREFULLY before you answer them. Not all the parts have the same points, so allocate your time accordingly. Please show your workings, including any formulae you use. Write your answers in the space provided. I will not give any credit if you do not show your workings. You may use blue books if you need additional paper. At the end, return this paper, as well as any blue books you have used. You may only use the formula sheet that has been handed out along with the exam.

Multiple Choice Questions: (2 points each)

1. Lower dividends are good when

a. Managers have incentives to waste free cash flow

b. The firm has high future earnings

c. Dividends are taxed in the hands of the share-holders

d. The firm has been paying high dividends in the past

2. Which of the following is not an assumption behind the original Modigliani Miller propositions without taxes?

a. There are no information/announcement effects in the issuance of new debt or equity.

b. There are no distress costs.

c. Investment policies of the firms are fixed.

d. Share-holders and Bond-holders have the same preferences.

3. A targeted repurchase is

a. an arrangement to buy back short term financial instruments sold to an investment dealer at a fixed price.

b. the buying back of shares from a particular group, usually large shareholders hostile management.

c. the buying back of shares because management has few profitable investment opportunities.

d. used to buy a company in the open market.

4. The fundamental difference between the flow-to-equity method of valuation and the APV method of valuation is that:

a. In adjusted present value neither the cash-flows nor the discounting rate are adjusted for leverage. The adjustments are made separately.

b. In adjusted present value, the adjustment for leverage is done in the discounting rate

c. In adjusted present value, the adjustment for leverage is done in the cash flows

d. In Flow to Equity, the adjustment for leverage is done in the discounting rate by using the cost of unlevered equity as a discounting rate.

5. As part of its dividend policy, the firm pays a cash dividend of 10 in a given year. An investor would rather just receive a dividend of 5, and would prefer to keep the remaining invested in shares of the firm. The share price of the firm is 50. How many shares does the investor need to buy to create his preferred dividend stream?

a. 1/10

b. 1/20

c. 1/5

d. 1

6. Which of the following is not an example of a phenomenon that gives rise to an agency cost?

a. The CEO of a company buys a corporate jet

b. Shareholders of firm take risky negative NPV projects when there is debt on the balance sheet

c. Shareholders of a firm refuse to invest in positive NPV projects if they have to raise money for it through equity

d. Shareholders of a firm issue equity when they think the stock is over-valued.

7. Which of the following statements is true in the context of M&A activity?

a. Cash takeovers tend to have better long-term performance than takeovers paid for in stock

b. Friendly mergers tend to have better long-term performance than hostile takeovers

c. The acquirer’s NPV in a cash takeover is hard to determine because part of the ownership in the acquirer is transferred to the target stock-holders.

d. Conglomerate acquisitions are the most valuable kind of mergers because they bring together companies with widely different risks.

8. Which of the following trends cannot be explained by the trade-off theory of optimal capital structure?

a. Firms in industries with a higher degree of business risk tend to have lower amounts of debt

b. Firms try to achieve a capital structure that gives them the highest rating for their debt.

c. Firms in countries which have higher tax rates tend to have higher amounts of debt

d. Firms in industries with a greater amount of tangible assets tend to have higher amounts of debt

9. Which of the following statements regarding debt and equity as options on the underlying firm is false?

a. Equity is like a call option on the assets of the firm

b. Debt is like a risk free bond and a short position in a put option on the assets of a firm

c. Debt is like owning the underlying firm and having a short position in a call option on the assets of the firm

d. Equity is like short put option on the assets of the firm along with an investment in a risk-free bond.

10. In an efficient market, ignoring taxes and time value, the price of stock should

a. decrease by the amount of the dividend immediately on declaration date.

b. decrease by the amount of the dividend immediately on ex-dividend date.

c. increase by the amount of the dividend immediately on declaration date.

d. increase by the amount of the dividend immediately on ex-dividend date.

Question 1 (25 points)

You are a star equity research analyst specializing in the Widget Industry. (Widgets are fictitious devices that only find use in finance classrooms in business schools). You are asked to estimate the share price for Gudgeon Inc., the leading manufacturer of Widgets. In the year that just ended, Gudgeon had sales of 50 million dollars. Based on estimates of enrolment in Business School programs, you think that sales will grow at the rate of 5% forever. In addition, you expect Gudgeon to make capital expenditures of 4% of sales, and have a depreciation of 5% of sales. Gudgeon’s margins (EBIT/Sales) have been healthy at 10%, and you expect them to remain the same. In any year, you also expect the change in net working capital to be 0.5% of the sales for that year. Gudgeon Inc. is currently levered with a debt to equity ratio (B/S), which is expected to remain constant at 0.5.

In addition, you have the following information:

1. The beta for Gudgeon’s equity is 1.5.

2. The spread of its debt over the risk free rate (Rb-Rf) is 2%.

3. The risk free rate (Rf) is 5%.

4. The market risk premium (Rm-Rf) is 6%.

5. The company has 1 million shares outstanding.

6. The corporate tax rate is 35%.

Because you took C15.0008, you know exactly (well, hopefully) how to find the share price of Gudgeon Inc.

1. The first step is to find next year’s sales, EBIT, Cap-ex, Depreciation and the change in net working capital. Find each of these values.

2. The next step is to find unlevered cash flows. Based on your answers in 1, find the unlevered cash flow for next year.

3. Now that you have the numerator for the value equation, you try to estimate the WACC for the firm. But first, what is the cost of equity for the firm, using the CAPM?

4. What is the cost of debt for the firm?

5. What are the weights for debt and weight for equity (B/(B+S), and S/(B+S))? What is the WACC?

6. The firm is clearly a growing perpetuity of cash flows. What is the value of the firm?

7. What is the value of equity of the firm?

8. What is the share price?

Question 2 (15 points)

As a loan-portfolio manager for Town-Bank, your bonus is usually equal to about 0.1% of the value of the loans you manage. Your bank has made a loan to a friend of AL. AL was a classmate of yours in a course you took at a Well-Known School of Business in NYC. AL’s friend made an impressive presentation to your bank and succeeded in getting a loan with a promised payment of 10 million to be made 1 year from today. In his pitch to the bank, he presented the fact that his business of supplying candles to big home-products chains in the US was practically risk free, and the assets of his firm were surely to be worth 20 million 1 year from today, and thus the bank would not lose any money on the loan. The risk free rate is 5%. The loan was going to be the only form of debt. One day, AL calls you up to tip you off about the friend’s plans. Specifically, it turns out that his assets are insured for more than they are worth, and he plans to burn a plant that is worth 1 million dollars today (Present Value of the plant is 1 million). If his plan succeeds and his insurance claims go through, his business will be worth 40 million in 1 year. On the other hand, if the plan fails, the friend will go to jail and lose all his reputation, causing his business to be worth only 1 million in 1 year.

1. What is the current value of the business?

2. What is the value of the business after he burns the plant that is worth 1 million?

3. What will be the pay-off from the underlying firm if AL’s tip is true? (Draw Binomial Tree)

4. What will be the pay-off from equity if AL’s tip is true? Ignore taxes and distress costs (Draw Binomial Tree)

5. What will be the value of equity if AL’s tip is true? (Use replication)

6. What is the value of the loan if AL’s tip is true?

7. What reduction in bonus do you expect if the tip is true?

Question 3 (25 points)

Doofus graduated from the Duh School of Business and joined Blah Blah Inc., a maker of hot air. Blah Blah had a debt to value ratio (B/(B+S)) of 0.5. It’s expected unlevered cash flows are 5 million in perpetuity starting next year, and its current WACC was 10%. Blah Blah had 1 million shares outstanding. Doofus believed that the firm should reduce the debt from its balance sheet TO a value of 10 million (perpetual debt) by issuing new equity. Thinking that Doofus was smart, the company announced that it would issue new equity to reduce its debt level. The company’s tax rate is 30%.

1. What is the value of the firm? (The company has zero growth, and its UCF and WACC are given)

2. Currently, what is the value (amount) of debt in the firm? What is the value of equity (amount)?

3. By what amount is the debt proposed to be reduced?

4. What will be the reduction in the tax shield from debt?

5. What is the new value of the firm after the announcement of the recapitalization? Shareholders value the firm as if the debt tax shield is lost, but the current amount of debt is still there on the balance sheet. What is the new value of equity after announcement of recapitalization?

6. What will be the share price after announcement of recapitalization?

7. What will be the number of shares required to be issued?

8. What will be the number of shares outstanding when the recapitalization is completed?

Question 4 (15 points)

You are asked to estimate the value of financial distress costs for a firm. The firm is liquidated at the end of 1 year. If things go well (probability 0.5), the total after tax cash-flow from the firm is 50 million. If things go poorly (probability 0.5), the total after-tax cash-flow from the firm will be 10 million and the firm will be have to file for bankruptcy. The discounting rate for the firm is 10%. The distress costs have been estimated as follows: 500,000 to be paid as direct costs (such as lawyer’s fees) for bankruptcy and an estimated value of 1.5 million to be lost in reputation. Risk-free rate is 5%.

1. Draw the binomial tree for the underlying firm.

2. What is the present value of the underlying firm?

3. What is the total value of distress costs if things go poorly? What is the value if things go well?

4. Draw the binomial tree for distress costs.

5. What is the value of distress costs? Find H, B and HS-B.

6. What is the value of the firm after accounting for the value of distress costs?

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