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MGTF 495: Corporate Finance

Final Examination

Winter 2020

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): If two firms are in the same industry, engage in similar types of projects, and have roughly the same size, then their equity betas should be similar.

True

False

Part B (5 points): Suppose that the assumptions behind the CAPM hold. If two stocks have the same correlation with the market portfolio, then they must have the same beta.

True

False

Part C (5 points): Suppose that the assumptions behind the Black-Scholes model hold.          (trading takes place continuously, stock prices are log-normally distributed, etc.). Suppose that    we are attempting to price options on an underlying asset does not pay any dividends. Then an     American call on this asset can be valued using the appropriate version of the Black-Scholes call formula, but it is not possible to value any American put on this asset using the Black-Scholes    put formula.

True

False

Part D (5 points): In a perfect capital market, the risk of a firm (i.e., of its free cash flows) increases as the proportion of debt in its capital structure increases.

   True

Question 2 (20 points): You are the CFO of SignCo, a leading                   manufacturer of street signs. Your firm is evaluating the opportunity to expand into a lucrative market: light-up signs for businesses. It will cost $3M to           purchase the necessary equipment, and you forecast that the project will           produce $1M in free-cash-flow at the end of the first year, which will then

grow by 2% in perpetuity. To complete your analysis, you need to determine an appropriate cost of capital to use for evaluating the opportunity.

Due to the fact that most of your street sign revenues are derived from long-term contracts with  local governments, you are concerned that their risk profile may differ from the risk profile of    the cash flows from the expansion. As such, you have gathered data on a number of publicly-      traded firms who produce similar lighted signs. The data on your own firm, as well as the others, is included in the following table. For the purpose of your analysis, you are comfortable treating the debt of all of the firms, including SignCo, as risk-free.

Marquee,              Consolidated

($ amounts in millions)

Market value of equity

Book value of equity

Leverage ratio (D / D+E), current  Leverage ratio (D / D+E), 5-yr avg. Equity beta (estimated on 5-yrs    of monthly data)

Industry

100

25

0.2

0.1

 

1

Street signs

50

10

0

0

 

1.3

Light-up signs

125

75

0.33

0.2

 

1.5

Light-up signs

650

175

0.1

0.3

 

1.1

Diversified

conglomerate

Suppose that corporate taxes are the only capital market imperfection and that the assumptions behind the CAPM hold. The corporate tax rate is 35%, the Treasury yield curve is flat at 2%    (EAR) at all maturities, and the expected excess return on the market portfolio is 5% (EAR).

Part A (10 points): Which of the firms will you use to determine the appropriate asset beta   for the lighted-sign project? Supposing that you take an equal-weighted average of the estimated asset betas from whichever firms you deem comparable, what is the asset beta of the lighted-sign project?

I will use the following firms to determine the asset beta (choose up to four):

口  SignCo

  In-A-Flash

 Marquee, Inc.

The asset beta of the lighted-sign expansion is: ____________________________________

Part B (5 points): Suppose that SignCo will maintain its current leverage ratio for the lighted- sign division. What is appropriate weighted-average cost of capital (WACC) to use when valuing the lighted-sign project?

The appropriate WACC for the lighted-sign project is: _____________________________

Part C (5 points): What is the NPV of the lighted-sign project? Should SignCo undertake the expansion into the new market? Why or why not?

The NPV of the expansion is: ___________________________________________________ SignCo should / should not (circle one) expand into the lighted-sign market because:

Question 3 (20 points): You are the CEO of a firm with a market value of $500m. This value is derived from a single project (Project A) with expected after-tax free cash flows of $110m next year, which are expected to grow at 3% per year forever. The firm is financed with a mix of debt and equity that is maintained at a constant target debt-to-equity (D/E) ratio of 2/3. The firm’s debt is risk-free. The risk-free rate is 5% (EAR) at all maturities, and the firm faces a corporate income tax rate of 30%. Assume that the only friction is corporate taxes. There are no bankruptcy costs, agency costs, information asymmetries, etc.                                                                                      You have just been offered a new project (Project Z) that requires a $200m upfront investment. Project Z is expected to pay off $50m of after-tax free cash flow in exactly one year, and after that its annual cash flow is expected to grow at 2% per year forever. Project Z is of similar risk to Project A.

Part A (5 points): Assuming that Project Z is all-equity financed, determine the appropriate discount rate to evaluate its cash flows. (Hint: Using what we know about the expected cashflows and market value of Project A, it is possible to back out what the after-tax WACCfor Project A must be. We are also given the debt cost of capitalfor Project A, which can be used along with the after-tax WACC to back out the pre-tax WACC, i.e., the unlevered cost of capital.)

The appropriate discount rate for Project Z is: ___________________________________

Part B (5 points): If Project Z is all-equity financed, what is its NPV?

The NPV of Project Z is: ______________________________________________________

Part C (5 points): Assume instead that Project Z is financed by issuing $100m worth of risk- free perpetual debt that will be kept at a constant level (in dollars) and financing the remaining $100m with equity. What is the NPV of Project Z now?

The NPV of Project Z is: ______________________________________________________

Part D (5 points): Shortly before taking Project Z, you decide to stick with your old policy in which you maintain a 2/3 debt-to-equity ratio for the entire firm. What is the NPV of Project Z now? Is this NPV different from the NPV computed in Part C above? Explain.

The NPV of Project Z is: ______________________________________________________

The NPV of Project Z  is /  is not (choose one) different from the NPV computed in Part C above. The reason(s) why are:

__________________________________________________________________________

Question 4 (15 points): XYZ Corp. is an equipment rental company that serves the construction industry. The projected market values for the firm’s assets in each of the two possible states of the economy at the end of year 1, along with their probabilities are:

High                        Low             State      (prob = 75%)        (prob = 25%)    

Asset value          $150M                   $90M          

The company is considering changing their strategy to also begin targeting individual homeowners who are undertaking do-it-yourself construction projects. Changing strategies does not involve any upfront costs; however, because  an individual homeowner’s construction  activities  are more sensitive to the overall state of the economy than those of construction firms, the resulting values of XYZ’s assets at the end of the year under the new strategy are:

High                        Low             State      (prob = 75%)        (prob = 25%)    

Asset value          $170M                   $40M          

Suppose that XYZ Industries has zero-coupon debt outstanding with total face value $75M, which is due at the end of year 1. Assume that the year-end asset values in each table above include the year 1 FCFs.

Additional Assumptions:

-     There are no corporate taxes.

-     Any relevant bankruptcy costs are included in the asset values above.

-     All of the firms managers and investors have the same information.

-     All securities are correctly priced in the financial market.

-    Under the existing strategy and existing capital structure, XYZ’s WACC is 10% and the debt cost of capital is 2%. Under the new strategy and existing capital structure, XYZ’s WACC is 15% and the debt cost of capital is 5%.

Part A (5 points): Under the existing strategy, what is the enterprise value of XYZ? What are the market values of XYZ’s debt and equity?

The enterprise value of XYZ is: _______________________________________________  The market value of XYZs debt is: ____________________________________________ The market value of XYZs equity is: ___________________________________________

Part B (5 points): Suppose that XYZ announces immediately that they are undertaking the new strategy. What is their enterprise value? What are the new market values of XYZ’s debt and equity?

The enterprise value of XYZ is: _______________________________________________  The market value of XYZs debt is: ____________________________________________ The market value of XYZs equity is: ___________________________________________

Part C (5 points): Suppose that all investment/strategy decisions are made by the existing equity-holders. Does undertaking the new strategy increase the enterprise value of the firm? Will the equity-holders choose to undertake the new strategy? Explain.

The new strategy  will /  will not (choose one) increase the enterprise value of the firm. The equity holders  will /  will not (choose one) undertake the new strategy.                   The reason for this is:

Question 5 (20 points): LeapSpace, Inc. is an all-equity financed firm. It currently has 20 million shares outstanding and a share price of $20 per share. LeapSpace does not pay dividends, and the movement of its stock price is consistent with the assumptions of the Black-Scholes model. Call and put options on LeapSpace Inc. ’s stock are traded on the Chicago Board Options Exchange, and the implied volatility of its stock price calculated from the market prices of these options is 40%.

Suppose that LeapSpace announces that it will issue zero-coupon bonds with a face value of $200m and a 4-year maturity. LeapSpace will use the proceeds from the debt issue to repurchase shares. Suppose that the debt issue was unanticipated by the market.

Assume that there are no market imperfections (so, no corporate taxes, no bankruptcy costs, securities are correctly priced, etc.). Finally, assume that the yield of Treasury STRIPs maturing in 4 years is 5% (EAR).

Part A (15 points): How much money will LeapSpace raise from the bond issuance? Calculate what the initial yield-to-maturity (EAR) of the bond will be at the time of issuance. What is LeapSpace’s stock price per share after the announcement of the debt issue and share repurchase?

The dollar amount LeapSpace will raise from investors is: __________________________  The initial yield-to-maturity of the bond is: ________________________________________ LeapSpaces stock price per share after the announcement is: ________________________ Justify your answer. Show all of your work:

Part B (5 points): LeapSpace’s equity beta before the debt issue was 0.8. What is its equity beta after the debt issue and share repurchase? What is its debt beta?

The equity beta (after the debt issue and share repurchase) is:

______________________________________________________________________________

The debt beta (after the debt issue and share repurchase) is:

______________________________________________________________________________