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MGTF 495: Corporate Finance

Final Examination

Spring 2019

Question 1 (20 points): True  or  False.  Indicate  whether  the  following statements are true or false and explain why. Full credit will only be given for answers that include the correct explanation.

Part A (5 points): Consider a world without any frictions (so no taxes,

financial distress costs, agency costs, etc.). In such a world firms should maximize the use of

debt, because this minimizes the weighted average cost of capital of the firm. The reason for this is that the expected return on debt is generally lower than the expected return on equity, and        therefore financing with equity is expensive and financing with debt is cheap.

True

Part B (5 points): If the CAPM holds (that is, if the underlying assumptions of the CAPM discussed in class are satisfied) investors should be indifferent among which stocks to hold in their portfolio because all stocks are fairly priced and each stock will earn an appropriate        expected return to compensate for its systematic risk.

True

Part C (5 points): You are short a European put option on Microsoft stock. Suppose that the volatility of Microsoft’s stock suddenly and unexpectedly increases. Your position will decrease in value because the option is now riskier.

True

Part D (5 points): Suppose that you are evaluating two mutually exclusive projects, Project A and Project B. Project A has a higher net present value than Project B. Therefore, it is optimal to invest in Project A.

True

Question 2 (15 points): After graduating from UCSD you decide that it is time  to  upgrade  your  mode  of  transportation.  Given  your  strong  finance background you have landed a well-compensated position, and accordingly, you have  settled  on  a  top-of-the-line  Tesla  Model  S  and  are  considering  your financing options.

There are three available ways to finance the car:

o You can pay the cash price, net of federal tax incentives, of $89,750. If you decide to pay cash, the cash will come from your investment in risk-free securities, which currently yield 3% (APR, monthly compounding).

o A 3-year lease. The lease requires $7,500 down (i.e., an upfront payment of $7,500), $1,236 per month (a total of 36 monthly payments starting at the end of month 1), with a residual value of $45,000 in three years. That is, you can purchase the car outright for $45,000 at the end of three years.

o A 6-year, 4.25% (APR, monthly compounding) loan. The loan requires $7,500 down and

72 monthly payments of $1,296. At the end of the 6-year period you own the car outright.

Regardless of which financing method you choose, you want to own the car at the end of 6 years. That means that if you take the 3-year lease, you plan to pay $45,000 to purchase the car at the end of the lease contract. (For simplicity, assume that the expected market value of the car after three years is also $45,000.)

Part A (5 points): What is the cost, in present value terms, of using the lease to acquire the car?

The cost, in present value, of using the lease is: ______________________________________

Part B (5 points): What is the cost, in present value terms, of using the loan to acquire the car? The cost, in present value, of using the loan is: _______________________________________

Part C (5 points): Which method should you use to acquire the car? Why?

I would use the lease to acquire the car.

I would use the loan to acquire the car.

I would pay cash for the car.

There is not enough information to determine the best financing option.

Question 3 (10 points): Suppose that there are currently only two risky assets that exist in the economy. These two assets are the equity of Firms A and B. Both firms are all-equity          financed and have characteristics as described in the following table.

A B

Market capitalization

Equity         u

Suppose that the CAPM holds for all assets in the economy and that there are no market imperfections (i.e., no taxes, no financial distress costs, etc.).

Part A (5 points): What is the beta of Firm B’s (unlevered) equity with respect to the market portfolio?

The beta of firm Bs equity is: __________________________________________________

Part B (5 points): Suppose that Firm A undertakes a recapitalization in which they issue bonds worth $100m (market value) and use the proceeds to repurchase shares. Hence, after the transaction is completed, Firm A has $100m worth of bonds outstanding and an equity market capitalization of $100m. Suppose that after the recapitalization, Firm A’s (levered) equity beta is 2.5.

After Firm A undertakes the recapitalization, what is the beta of Firm B’s (unlevered) equity with respect to the market portfolio?

The beta of firm Bs equity is: ___________________________________________________

Question 4 (25 points): You are the CEO of Consolidated Fudge (CF), a maker of premium confections, which has 1,000,000 shares outstanding,   worth $20 each. Today, Dec. 31, 2019, the CEO of Amalgamated Caramels (AC) calls to ask if you might be interested in buying her firm. Here is some selected information from AC’s income statement and balance sheet for       2019 (reported in thousands of US dollars):

Balance Sheet:

Current Assets:

Cash

Inventory

Accounts Receivable

2019

$  60

300

220

2018

$  57 280 200

EBIT

Interest Expense

390

90

Current Liabilities:


580         537

Accounts Payable                        110          100

Accrued Expenses                         55            45

Net Income                                       195               Total Current Liabilities                 165         145

Assume that the cash on the balance sheet represents cash required in the day-to-day operations of AC’s line of retail candy stores. The firm made capital expenditures of $67 thousand during the year 2019 and is all equity financed.

Part A (10 points): Looking around for comparable companies that are publicly traded, you see that Tootsie Roll Industries (TR) has an equity beta of 0.87. TR has a debt-to-equity ratio of 11/10 and is expected to keep the same proportions of debt and equity in its capital structure for the foreseeable future. Suppose the current debt of TR is riskless, that the risk-free rate is 2.0%  (EAR), and that the market risk premium is 6%.

CF is currently financed at a debt-to-equity ratio of 1.0, which you believe to be the optimal        capital structure. You intend to keep the same proportions of debt and equity forever, both before and after the acquisition of AC. You expect that AC’s debt after the acquisition will be risk-free.

The appropriate WACC to use when valuing Amalgamated Caramels is ________________

Part B (10 points): Suppose that Amalgamated Caramels’ free cash flows will grow at 2% per year forever (i.e., the 2020 FCF will be 2% higher than the 2019 FCF, etc.). What is the most you would be willing to pay for the firm?

The most that I would be willing to pay for Amalgamated Caramels is _________________

Part C (5 points): The CEO of Amalgamated Caramels offers to sell you her firm for $15m. You agree, announce the deal publicly, and immediately issue new debt and equity to finance the acquisition (in such a way that you keep the overall debt and equity proportions constant, as described earlier). How much additional equity do you issue (in thousands $)? How many new

shares will you issue (number of shares)? How much additional debt do you issue (in thousands $)?

The amount of equity, in thousands of $, that we need to issue is: ______________________ The number of shares that need to be sold is: _______________________________________ The amount of debt, in thousands of $, that we need to issue is: ________________________

Question 5 (15 points): Jeremy Wangdu is an inventor who recently was granted a series of patents for his innovative discoveries. Mr. Wangdu exploits these patents through Wangdu Corp., a publicly traded firm that is all-equity financed. Wangdu Corp. currently has 10 million shares outstanding, and a current stock price of $30 per share.                                                                    Mr. Wangdu unexpectedly announces a plan to borrow $100 million dollars and use the proceeds of the debt issue to pay a one-time dividend. Assume that the pre-announcement stock price reflected a market expectation that the firm was to remain 100% equity financed for the foreseeable future.

Part A (5 points): If there are no frictions in the market (that is, no corporate taxes, no financial distress costs, etc.), what is the price per share of Wangdu Corp. after the announcement of the new debt issuance plan but before the dividend is paid?

The stock price after the debt issuance is announced but before the dividend is paid is

__________________________________________________________________________

Part B (5 points): Assume now that the only imperfection in the market faced by Wangdu Corp. is the presence of corporate income taxes, and that the corporate income tax rate is 35%.

What is the stock price upon the announcement of the recapitalization plan but before the debt is issued and the dividend is paid to shareholders? Assume that the debt level announced is            permanent (i.e. it will be $100 in market value forever) and that no additional changes in the      capital structure of Wangdu Corp. are expected in the future.

The stock price after the debt issuance is announced but before the dividend is paid is

__________________________________________________________________________

Part C (5 points): Assume now that issuing  debt:  (1)  allows Wangdu  Corp.to lower its corporate tax obligations, and (2) generates costs of financial distress. Suppose that corporate

income taxes and costs of financial distress are the only imperfections that are relevant for Wangdu Corp.

Assume that after Wangdu Corp. announces the recapitalization plan, but before the debt is issued and the dividend is paid to shareholders, its stock price increases from $30 to $32 per share. What are the estimated expected costs of financial distress for Wangdu Corp.?

The estimated value of the costs of financial distress for Wangdu Corp. is ______________

Question 6 (20 points) Washington Gas and Light (WGL) Holdings, Inc., is a public utility holding company serving the Washington, D.C. metropolitan region.  WGL’s  cash  flows  are  highly  dependent  on  weather  conditions. Specifically,  heating  demand  during  the  winter  months  tends  to  be  high whenever average winter temperatures are low. In contrast, heating demand and

WGL’s cash flows tend to be low whenever average winter temperatures are mild. For simplicity, assume the following:

-     EBIT next year if the winter is cold = $100M. The probability that a winter is cold is 0.5.

-     EBIT next year if the winter is mild = $0M (operating income=operating expense). The probability that a winter is mild is 0.5.

-     The expected growth in cash flows is zero for both cold and mild winters (i.e., they are expected to be equal to $100M and $0 per year, respectively, for the foreseeable future).

-     Assume the expected (i) net capital expenditures and (ii) change in net working capital are zero for each year for the foreseeable future.

-     The risk-free rate is 5% (EAR).

-    Assume that weather risk is idiosyncratic (i.e., unrelated to the market) and that WGL faces no other risks.

In Parts A and B below, suppose that all the assumptions behind the Modigliani-Miller theorems hold (e.g., no taxes, no financial distress costs, etc.).

Part A (5 points): What is the value of WGL today?

There is not enough information to determine the value.

WGL’s value today is: __________________________________________________

Part B (5 points): Assume that WGL’s management enters into a perpetual risk-management contract with an insurance company. The terms of this perpetual contract are as follows:

o In each winter going forward, WGL pays the insurance firm $50M whenever the winter is cold.

o In each winter going forward, WGL receives $50M from the insurance company whenever the winter is mild.

o The up-front fee owed to the insurance company for this perpetual contract is $4M (a one- time fee paid today).

What are WGL’s overall expected cash flows under this contract? What is the new value of WGL today? Should WGL’s management sign this risk-management contract if they seek to maximize firm value?

WGL’s expected total cash flows per year are now: _________________________________ WGLs value today is: __________________________________________________________No. WGLs management should not sign this risk-management contract.

Yes. WGL’s management should sign this risk-management contract.

In Parts C and D below assume that WGL now faces a corporate income tax rate of 50% and that interest payments  are tax deductible when  computing  corporate income taxes. There  are no personal taxes. Furthermore, due to extremely large costs of financial distress, assume that banks determine a firm’s debt capacity based on the firm’s lowest possible cash flow. Hence, banks will not lend any money to WGL if WGL’s cash flows can be $0 or below. But if WGL’s cash flows are guaranteed to be positive, then the bank would be willing to lend perpetual debt at the current risk-free rate, with a coupon payment equal to the lowest possible cash-flow realization.

Part C (5 points): What is the value today of WGL if the firm is 100% equity financed and does not hedge its weather exposure?

There is not enough information to determine the value.

WGL’s value today is: __________________________________________________

Part D (5 points): (This part is more challenging. Only attempt if you have completed the rest of the exam.) Assume that the insurance company now offers WGL two mutually exclusive risk-

management contracts:

Insurance Policy A

Insurance Policy B

- In each winter going forward,

- In each winter going forward,

WGL pays the insurance company

WGL pays the insurance company

$20M whenever the winter is cold.

$40M whenever the winter is cold.

- In each winter going forward,

- In each winter going forward,

WGL receives $20M from the

WGL receives $40M from the

insurance company whenever the

insurance company whenever the

winter is mild.

winter is mild.

- The up-front fee for this perpetual

- The up-front fee for this perpetual

contract is $0M (free)

contract is $50M (one-time fee)

Which of the two contracts, if any, should WGL’s management select if they seek to maximize firm value? What is WGL’s firm value today if management makes the optimal choice?

Management should select Insurance Policy A.

Management should select Insurance Policy B.

Neither. WGL’s management should not sign either of these two insurance contracts.

WGL’s value today is: _________________________________________________________