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Multiple Choice: Select the best response (2 points each).  You may add comments to explain your reasoning.

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1.       Financial risk arises from

A.      Debt use

B.      Fixed operating costs

C.      Cyclical revenues.

 

2.       A ___ gives you the right to buy stock at a set price (exercise price) for a specific period of time.

A.      Stock

B.      Bond

C.      Call

D.      Put

 

3.       Which factor(s) influence a firm’s business risk (and therefore, its asset beta)?

A.      Cyclical revenues

B.      Operating leverage

C.      Both A and B influence business risk.

 

4.       In a world with only corporate taxes, firm value is maximized by

A.      All equity financing

B.      All debt financing

C.      A weighted average of debt and equity financing

D.      Capital structure is irrelevant in this case

 

Short Answer Questions: You should be able to answer these in a sentence or two (Limit explanations to half page maximum). Questions are worth 5 points each.

 

1.       Safety Stores has a company cost of capital of 8%.  The risk-free rate is 4% and the return on the market is 12%.  A new project has a beta of 2 and is expected to generate the following cash flows (all in millions):

Time

0

1

2

3

IRR

Cash Flow

-12

8

5

3

 

Should Safety accept the project? Explain.

 

2.       An investor is attempting to select one of 4 investment opportunities selected below. Given the information supplied, can you eliminate any of the choices?  If so, which ones and why?

Opportunity

Expected Return

Standard Deviation

A

10%

.10

B

10%

.20

C

25%

.25

D

30%

.25

 

PROBLEMS:

For all problems, show you work and highlight your answer. Numbers in ( ) indicate how many points each item is worth. No credit will be given on problems without supporting work, even if the final answer is correct.  Unless stated otherwise, interest is compounded annually and payments occur at the end of the period.  Face value for bonds is $1000. 

 

1.        (15) Over the past 5 months, Cloak, Dagger and the Market had the following monthly returns:

MONTH

Cloak

Dagger

Market

January

-.04

.08

-.02

February

.15

.25

.10

March

.21

.16

.05

April

.00

-.05

-.01

May

.18

.14

.10

a.       Calculate the return and standard deviation for Cloak and Dagger. Assume the observations are the population rather than a sample. 

b.      Calculate the correlation (coefficient) between Cloak and Dagger.

c.       Dagger has a beta of 1.53.  You invest equal amounts in Cloak and Dagger.  Find the return, beta and the variance of the portfolio. 

 

2.       (7) Use Black-Scholes to find the price for a call with 1 month to maturity.  The exercise price is 47.  The annual risk-free interest rate is 4%.  The stock price closed at 45.  The historic variance is .31.  The stock does not pay dividends.  NOTE: You can use the Black-Scholes option worksheet to answer this problem.

  

3.       (10) Cook Wares is an all equity firm.  The tax rate is 30%.  They have the following information on their stock:

Current EPS

8

Current Dividend

6

Return on Equity

20%

Current Price

$50

        Calculate the weighted average cost of capital.

 

4.       (15) You have estimated the financial statements for next year.  You expect free cash flows to grow by 10% in Y2, 6% in Y3 and 4% on average thereafter.  The cost of capital is estimated at 10%.   Assume today is January of Y1. 

a.       Estimate the share price if there are 10M shares issued and outstanding. 

b.      You discover that Gravel is actually trading at $35 per share.  Should you buy the stock? Explain.

 

GRAVEL: INCOME STATEMENT (M$)

Fiscal Year Ending

Y0 (Actual)

Y1 (Projected)

Sales

350

450

Cost of Goods Sold

150

200

SG&A

75

75

Depreciation

25

25

Earnings Before Interest & Tax (EBIT)

100

150

Interest Expense

20

25

Earnings Before Tax

80

125

Taxes (40%)

32

50

Net Income

48

75

Dividends

8

10

Additions to Retained Earnings

40

65

 

GRAVEL: BALANCE SHEET (M$)

Fiscal Year Ending

Y0 (Actual)

Y1 (Projected)

Cash

100

150

Accounts Receivable

200

250

Inventories

300

350

Net Fixed Assets

1,000

1,050

TOTAL ASSETS

1,600

1,800

Accruals

50

90

Accounts Payable

150

195

Long Term Debt

250

300

Common Stock

350

350

Retained Earnings

800

865

Total Liability & Equity

1,600

1,800

 

 

5.       (10) Crawler is considering a new project that requires an investment of $90 million in machinery.  This is expected to produce sales of $114 million per year for 4 years.  Operating expenses are 70% of sales.  Operating expenses do not include depreciation. The machinery will be fully depreciated to a zero book value over 4 years using straight-line depreciation.  The salvage value is $10 million.  Working capital costs are negligible.  The tax rate is 40%.  The unlevered cost of capital (ru) is 11%. 

a)      Calculate the base-case NPV.

b)      Crawler plans to use $30,000,000 in bonds. The remaining funds will come from retained earnings.  The bonds have a 4-year life, a coupon rate of 6% and a yield of 6%.  Use the adjusted present value (APV) to find the value of the project. 

 

6.        (15) Crow Corporation is planning a $200 million expansion to be financed with debt, preferred stock and common stock. Their target capital structure includes 20% debt and 5% preferred stock.  The rest of the funds are from retained earnings.  The tax rate is 40%. 

a)      Using the information below, calculate the weighted average cost of capital. 

 

Bonds: Crow Corporation has bonds with 6 years to maturity and a face value of $1000.  The coupon rate is 7.8% and coupons are paid semiannually. The bonds trade at $990 per bond.    

                                                                                                                                                                          

Preferred Stock: Crow issues preferred stock with a $2.85 dividend per year.  They are sold to the market at $27 per share, but issue costs are $2 per share.

 

Retained Earnings: The firm’s equity beta is .95.  The risk-free return is 4% and the market risk premium is 10%.

 

b)      The expansion is expected to produce cash flows of $48,000,000 every year for the next 6 years. Use the WACC to find the net present value (NPV).   Should they expand? Explain.

 

7.       (10) This is a world with NO TAXES (perfect capital markets).  The firm is a no growth firm and pays out all of its earnings as dividends.  It is originally all equity financed (unlevered).  The firm decides to issue $500,000 in debt to repurchase stock.  The cost of debt is 4%.  Fill in ALL the missing values in the table.

 

Unlevered

Levered

EBIT

200,000

200,000

INTEREST

0

20,000

Earnings (Net Income)

200,000

180,000

#Shares

20,000

 

rA

8%

8%

rE

8%

 

EPS

$10.00

 

Price

 

 

 

 

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