ECO359: Financial Economics II Winter 2020
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ECO359: Financial Economics II
Assignment, Winter 2020
Problem 1 (15 points): XYZ is an all-equity firm with assets worth $20 billion and 10 billion shares outstanding. XYZ plans to borrow $5 billion and use these funds to repurchase shares. The firm’s corporate tax rate is 20%, and XYZ plans to keep its outstanding debt equal to $5 billion permanently. a. Without the increase in leverage, what would XYZ’s share price be? b. Suppose XYZ offers $2.05 per share to repurchase its shares. Would shareholders sell for this price? c. Suppose XYZ offers $2.50 per share, and shareholders tender/sell their shares at this price. What will XYZ’s share price be after the repurchase? d. What is the lowest price XYZ can offer and have shareholders tender their shares? What will its stock price be after the share repurchase in that case?
Problem 2 (10 points): You expect to receive $100 at the end of each year that is a multiple of 2 or 3, so, for example, the first 6 payment years would be 2,3,4,6,8,9. If the appropriate discount rate is 10% per year, what is the value of this strange perpetuity?
Problem 3 (10 points): XYZ currently has $10 billion in debt, total equity capitalization of $30 billion, and an equity beta of 1. Included in XYZ’s assets was $15 billion in cash and risk-free securities. Assume that the risk-free rate of interest is 2% and the market risk premium is 5%. a. What is the enterprise value of XYZ? b. What is the beta of XYZ’s business assets? (You need to use net debt instead of using debt.) c. What is pre-tax WACC of XYZ company?
Problem 4 (15 points): You are currently at the end of your 35th year of life and have finally decided to start saving for retirement. Your investment strategy is to invest $1,000 per month in equity investments (mutual funds) and $250 per month in an emerging market mutual fund. You estimate that the equity investments will earn an average annual rate of return of 12.68% (EAR), and that the emerging market funds will earn 26.82% (EAR). Since you dislike working and love to play golf, you plan to retire at the end of your 50th year of life. Assuming that you start your monthly investments one month from now (i.e. one month into your 36th year of life), you have a total of 180 months to invest (i.e., 15 years x 12 months). When you retire you plan to sell all your investments at place them in a money market mutual fund. Assuming the money market fund earns 6.17% (EAR), and that this money only needs to last you until you turn 65 (when you plan to live off Social Security and a company provided pension plan), and that you plan to withdraw the money in equal monthly payments, how much can you afford to spend each month in your early retirement years? (Note: The first withdrawal will be one month into your 51st year of life and the last will be at the end of the twelfth month of your 65th year of life – a total of 180 monthly withdrawals. The money market fund will have a zero balance after the last withdrawal.)
Problem 5 (15 points): Consider the following income statement and other information:
a) Luther's Operating Margin for the year ending December 31, 2005 is closest to:
A) 1.8%
B) 2.7%
C) 5.4%
D) 16.7%
b) Luther's Net Profit Margin for the year ending December 31, 2005 is closest to:
A) 1.8%
B) 2.7%
C) 5.4%
D) 16.7%
c) Luther's return on equity (ROE) for the year ending December 31, 2006 is closest to:
A) 2.0%
B) 6.5%
C) 8.4%
D) 12.7%
d) Luther's return on assets (ROA) for the year ending December 31, 2006 is closest to:
A) 2.0%
B) 6.5%
C) 8.4%
D) 12.7%
e) Luther's price - earnings ratio (P/E) for the year ending December 31, 2006 is closest to:
A) 7.9
B) 10.1
C) 15.4
D) 16.0
Problem 6 (20 points): Consider two firms, With and Without, that have identical assets
that generate identical cash flows. Without is an all-equity firm, with 1 million shares outstanding that trade for a price of $24 per share. With has 2 million shares outstanding and $12 million dollars in debt at an interest rate of 5%.
a) According to MM Proposition 1, the stock price for With is closest to:
A) $8.00
B) $24.00
C) $6.00
D) $12.00
b) Assume that MM's perfect capital markets conditions are met and that you can
borrow and lend at the same 5% rate as With. You have $5,000 of your own money to invest and you plan on buying Without stock. Using homemade leverage, how much do you need to borrow in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5,000 investment in With stock?
A) $10,000
B) $5,000
C) $2,500
D) $0
c) Assume that MM's perfect capital markets conditions are met and that you can borrow and lend at the same 5% rate as With. You have $5,000 of your own money to invest and you plan on buying Without stock. Using homemade leverage you borrow enough in your margin account so that the payoff of your margined purchase of Without stock will be the same as a $5,000 investment in With stock. The number of
shares of Without stock you purchased is closest to:
A) 425
B) 1,650
C) 2,000
D) 825
Problem 7 (15 points): Western Lumber Company expects to have a positive free cash flow in the coming year, and its free cash flow is expected to grow at a rate of g% per year thereafter. Assume that risk-free rate is 2% and market premium is 5%. Suppose Western Lumber has an equity beta of 0.8 and a debt beta of 0.2, and it pays a corporate tax rate of 30%. If Western Lumber maintains a debt-equity ratio of 1 and its value with leverage is two times its value without leverage, what is the growth rate of the company, g?
2022-02-18