Finance 2 for IBA (30J201)

F.Feriozzi
Mid-term exam
October 15, 2010
Part One: Multiple-Choice Questions (40 points)
Question 1
A consequence of Modigliani-Miller Proposition 1 is that in a perfect capital market
A.
B.
C.
D.
E.

the risk of bankruptcy does not rise with more leverage.

managers cannot change the value of the firm by using more or less debt.
managers cannot change the cost of equity by using more or less debt.
a leveraged recapitalization has no effects on the earnings-per-share ratio.
investment and capital structure decisions are interdependent.

Question 2
If the only relevant frictions in financial markets are due to corporate taxation, an increase in
leverage
A.
B.
C.
D.
E.

leaves the Weighted Average Cost of Capital unaffected but increases the value
of the firm.
is beneficial to investors but leave the value of the firm unaffected.
harms equity holders because it decreases the Weighted Average Cost of Capital.
is completely irrelevant as far as debt is riskless.
decreases the Weighted Average Cost of Capital and increases the value of the
firm.

Question 3
Masters Incorporated (MI) in ready to start a new project which is of comparable risk as its
other ongoing activities. Depending upon the success of this project, next year MI will have a
value of $100 million, $150 million, or $191 million, with each outcome being equally likely.
The cash flows are unrelated to the state of the economy (i.e. risk is diversifiable) so that MI
has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%.
Assume that the capital markets are perfect and that MI has a debt obligation maturing next
year, with due payment of $125 million. The initial value of MIs equity is closest to:
A.
B.
C.
D.
E.

$30 million
$13 million
$29 million
$24 million
$15 million

Question 4
A(n) ________ may occur if a major shareholder desires to sell a large number of shares but
the market for the shares is not sufficiently liquid to sustain such a large sale without severely
affecting the price.
A.
B.

open market share repurchase.

Dutch auction share repurchase.
1

C.
D.
E.

tender offer.
leveraged recapitalization.
targeted repurchase.

Question 5
Assume that a firm is owned by individual investors and does not pay dividends to its
shareholders. According to the tradeoff theory of the capital structure, which of the following
events would lead to an increase in the optimal level of leverage?
A.
B.
C.
D.
E.

A decline in the agency benefits of debt.

A decline in the corporate tax rate.
An increase in indirect bankruptcy costs.
An increase in the personal tax rate on capital gains.
None of the above.

Question 6
Omicron Technologies has $50 million in excess cash and no debt. The firm expects to
generate additional free cash flows of $40 million per year in subsequent years and will pay
out these future free cash flows as regular dividends. Omicrons unlevered cost of capital is
10% and there are 10 million shares outstanding. Assume that Omicron uses the entire $50
million in excess cash to repurchase shares. The amount of the regular yearly dividend per
share in the future is closest to:
A.
B.
C.
D.
E.

$9.00
$5.00
$4.50
$4.00
$3.50

Question 7
Which of the following statements regarding capital budgeting with leverage is false?
A.

B.
C.
D.
E.

A firm'
s unlevered cost of capital is equal to its pretax weighted average cost of
capital that is, it uses the pretax cost of debt, rD, rather than its after-tax cost of
debt, rD (1 - C ).
The WACC method incorporates the benefit of the interest tax shield by using the
firm'
s before-tax cost of capital for debt.
When the firm maintains a target leverage ratio, its future interest tax shields have
similar risk to the project'
s cash flows, so they should be discounted at the
project'
s unlevered cost of capital.
The first step in the APV method is to calculate the present value of free cash
flows using the project'
s cost of capital if it were financed without leverage.
A project'
s cost of capital depends on its risk.

Question 8
Harris Industries is considering a project that will generate the following free cash flows:
Year
0
1
2
3
Free Cash Flows
($200)
$100
$80
$60
You are also provided with the following market value balance sheet and information
regarding its cost of capital:
2

Assets
Cash
Other Assets

0
1000

Liabilities
Debt
400
Equity
600

Cost of Capital
Debt
Equity
c

7%
12%
35%

Suppose that to fund this new project, Harris borrows $120 with the principal to be paid in
three equal installments at the end of each year. The present value of Harris interest tax
shield is closest to:
A.
$5.25
B.
$5.00
C.
$6.25
D.
$5.90
E.
$4.90
Part Two: Open Questions (60 points)
Question 1
Flagstaff Enterprises expects to have a free cash flow in the coming year of $8 million, and
this free cash flow is expected to grow at a rate of 3% per year thereafter. Flagstaff has an
equity cost of capital of 13%, a debt cost of capital of 7%, and it is in the 35% corporate tax
bracket. Assume that Flagstaff maintains a debt-to-equity ratio of 1.
(a) Compute both the pre-tax and the after-tax WACC of Flagstaff Enterprises. (10 points)
(b) Compute the levered value of Flagstaff Enterprises. (10 points)
(c) Compute the present value of Flagstaffs interest tax shields. (10 points)
Question 2
Wynton PLC has 12 million shares outstanding and a current share price of $35 per share. It
also has debt outstanding. This debt is risk free and imposes a yearly payment of $50 million
for 5 years. Each installment includes both an interest and a principal component, and the
first payment is due in exactly one year, while the last payment is due in exactly 5 years. The
riskless interest rates for all maturities are constant at 2.50%. Wynton has EBIT of $155
million, which is expected to remain constant each year in perpetuity. New capital
expenditures are expected to equal depreciation and equal $20 million per year, while no
changes to net working capital are expected in the future. The corporate tax rate is 35% and
Wynton is expected to keep its debt-to-equity ratio constant in the future (by either issuing
additional new debt or buying back some debt as time goes on).
(a) Based on this information, estimate Wyntons current WACC. (10 points)
(b) What is Wyntons current equity cost of capital? (10 points)
(c) Explain what difficulties would you have in answering points (a) and (b) if Wynton were
not expected to keep its debt-to-equity ratio constant. (10 pionts)

Solutions
Part 1: Multiple-Choice Questions

1
2
3
4
5
6

B
E
C
The value of equity is E

$28.89 million

E
D
C
$40
= $400 million.
.10

Enterprise value = PV(Future FCF) =

Market value = Enterprise Value + cash = $400 + $50 = $450 million.

Market value
$450M
Share price =
=
= $45.00.
shares outstanding
10M
Number of shares repurchased =

7
8

$50M
= 1,111,111 shares.
$45

Shares outstanding = 10 million - 1,111,111 = 8,888,889 shares.

$40 million free cash flow
Dividend =
= $4.50 per share.
8,888,889 shares
B
A
Dr
Dr
Dr
PV(interest tax shield) = 0 D c1 + 1 D c2 + 2 D c3
(1 + rD )

PV(interest tax shield) =

(1 + rD )

120(.07)(.35)
1

(1.07)

(1 + rD )

80(.07)(.35)
(1.07)

40(.07)(.35)
(1.07)3

= $5.2596.

Part 2: Open Questions

Question 1

(a)

The pre-tax WACC is given by

equity ratio of 1, we have

E
D
r +
r . Hence, if Flagstaff mantains a debt-toE+D E
E+D D

pre-tax WACC =
The after-tax WACC is given by
debt-to-equity ratio of 1, we have

1
1
.13 +
.07 = .10
1+1
1+1

E
D
rE +
r (1 c). Hence, if Flagstaff mantains a
E+D
E+D D

after-tax WACC =

1
1
.13 +
.07 (1 - .35) = .087750
1+1
1+1

(b)
the value of Flagstaff as a levered firm is
VL = FCF/(after-tax WACC g) =
4

$8
= $138.53 million
.087750 .03

(c)
To compute the present value of the interest tax shield we can notice that
PV(Interest tax shield) = VL VU
Furthermore, the value of Flagstaff as a unlevered firm is
VU = FCF/(pre-tax WACC g) =

$8
= $114.29 million.
.10 .03

Finally we get
PV(Interest tax shield) = VL VU = 138.53 114.29 = 24.24.
Question 2

(a)

We dont know Wyntons equity cost of capital, so we cannot calculate the WACC directly.
However, we can compute it indirectly by estimating the discount rate that is consistent with
Wyntons market value.
E = 12 35 = $420 million
D = 50

= $232.29 million (rounded to the second decimal position)

Hence the levered value of Wynton is:

VL = 420 + 232.29 = $652.29 million.
The free cash flow is obtained as
FCF = EBIT EBIT(1 C ) + Dep Capex Inc in NWC = 155(1 0.35) = $100.75 million
Because Wynton is not expected to grow,
VL =

, that is 652.29 =

, leading to

(rounded to the second decimal position).

From

"

! !

(b)
we get

$%
& $ $'

"

$($ $'
$
& $ $'

%(

Solving we finally obtain

)

*
*

%( ,+

+$ %

$( %' .

(c)
If Wynton does not keep its debt-to-equity ratio constant its WACC will change over time and
the expression VL =
is no longer valid. In this case the estimation of the current WACC
is not possible with the available information.
5