Instructions:

1. Answer all questions in the space provided.

2. Show all of your calculations. Put your final answer in the space provided (if one is provided).

3. The examination has 12 pages (including this cover page). Verify that your copy is complete.

4. Materials allowed: calculator.

5. You may use a one page 8.5 X 11 single sided cheat-sheet, with anything on it. You may take it
home with you after the exam.

6. Unless specifically instructed otherwise, provide final answers relating to percentage rates to
four decimal places (e.g. 6.27% or .0627) and provide final answers involving dollar amounts to
two decimal places (e.g. $98.27).

7. To have your exam considered for re-grading, the exam must be written in *ink*. For re-
grading you must: submit within 7 days of the exam being returned, wait 24 hours from the
time the exam was returned, write a note explaining why you would like the exam re-graded.

Mark Distribution
1. /10
2. /8
3. /9
4. /9
5. /4
Total: /40
Question 1: 10 marks.

BidPal Inc. is evaluating an investment which costs $500,000 today and produces EBIT of $400,000
at the end of each of the next two years. The firm faces a corporate tax rate of 35%. If BidPal Inc.
makes the investment, it would be financed using the firm’s existing debt-equity ratio of 23 . BidPal
has estimated that the (levered) beta of the firm’s equity is 1.5, and that this value is appropriate
for the new project. The risk-free interest rate is 4% and the market risk premium is 6%. The firm
can borrow at an interest rate of 6%.

(a) (4 marks) Use the WACC approach to determine the NPV of this investment.

Suggested Solution

Given the debt-equity ratio of 23 , the debt-value ratio is 0.40 and the equity-value ratio is 0.60. The
cost of equity is rE = .04 + 1.5(.06) = 13% (1 mark). This implies
rwacc = .6(.13) + .4(.06)(1 − .35) = 9.36%. (1 mark)
**Marking Note: half mark for correct debt, half mark for correct debt-value and equity-value.**
Therefore
NPV = −$500,000 + $400,000(1 − .35)A2.0936 = −$44,854.71. (2 marks)
**Marking Note: one mark for PV of future cash flows correct, 1 mark for overall answer.**

The NPV of this investment is .

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(b) (5 marks) Use the FTE approach to calculate the present value of the free cash flows to equity.

Suggested Solution

From part (a), the NPV of −$44,854.71 and the initial cost of $500,000 imply that V L = $455,145.29.
This in turn gives an initial debt capacity of D0 = $182,058.12 (1 mark). The debt capacity after
one year is D1 = .4 × $400,000(1 − .35) ÷ 1.0936 = $95,098.76 (1 mark). Then:

FCFE0 = −$500,000 + $182,058.12 = −$317,941.88

FCFE1 = $400,000(1 − .35) − .06(1 − .35)($182,058.12) + ($95,098.76 − $182,058.12) = $165,940.37
(1 mark)
FCFE2 = $400,000(1 − .35) − .06(1 − .35)($95,098.76) − $95,098.76 = $161,192.39 (1 mark).

The NPV equals the present value of the free cash flows to equity:

$165,940.37 $161,192.39
PV (FCFE) = −$317,941.88 + + = −$44,854.71 (1 mark),
1.13 1.132
as in part (a).

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(c) (1 marks) Without doing any calculations, would the APV approach yield the same solution as
in part (b)? Briefly discuss why or why not. Note that you are given a full page for this, but that
doesn’t mean you will need all that space.

NO, the APV approach will give a value which represents both debt and equity, whereas part (b)
is just equity. (1 mark)**Marking note: this is all or nothing, just saying no is nothing**

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Question 2: 8 marks.

RTC Corp currently has an enterprise value of $100 million and $50 million in excess cash. The
firm has 10 million shares outstanding and no debt. Suppose RTC will pay out its excess cash
in a one time special dividend. After the dividend, news will come out that will change RTC’s
enterprise value to either $400 million (good news) or $75 million (bad news). Assume there is no
corporate or individual taxes.

(a) (2 marks) What is RTC’s share price before the dividend? What will be the share price after the
dividend if the news is good?
Before:
$100 + $50
= $15 (1 mark)
10
After with good news:

$400
= $40 (1 mark)
10

The share price before the dividend is $15 .

The share price after the dividend if the news is good is: $40 .

(b) (2 marks) Suppose that the management of RTC knows that the news will be good (but that
markets are otherwise perfect). Could shareholders benefit if management waited to pay the divi-
dend until after the news is released? Why or why not?

No. The amount paid to shareholders through a dividend does not depend on the stock price like
a share repurchase. Given that an individual can replicate any dividend policy they want in an
otherwise perfect market, it makes no difference when the dividend is paid. (2 marks)

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(c) (2 marks) Suppose that the management of RTC knows that the news will be good (but that
markets are otherwise perfect). If management will pay out the cash before the news is released,
would they prefer to do a share repurchase instead of a dividend? Explain why or why not. You
can assume that management owns shares in RTC.

The manager knows the firm is undervalued, thus if s/he bought back shares now, he would be
creating value for shareholders (at least the ones who don’t sell!). A dividend on the other hand
will not create any value. (2 marks)

(d) (2 marks) Suppose that the management of RTC knows that the news will be good (but that
markets are otherwise perfect). If management will pay out the cash after the news is released,
should they do a share repurchase instead of a dividend? Explain why or why not. Assume man-
agers act in the best interest of shareholders. (2 marks)

After the news is released, the manager no longer has any insider info and the stock is valued as
it should. Given that markets are completely perfect at this point, investors will not care whether
cash is paid through a dividend or share repo.

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Question 3: 9 marks.

Auckland Travel Inc. has traditionally served customers in the travel planning industry. It is
evaluating whether to establish a new division that will sell insurance to travelers. Auckland has
identified two comparable firms which exclusively operate in the travel insurance industry. Auck-
land has obtained the following estimates for these comparable firms (each of which maintains a
target debt-equity ratio):

Comparable Firm #1 Comparable Firm #2

Equity beta 1.25 1.65
Debt cost of capital 3.4% 3.6%
Debt-equity ratio 1 1.5

Auckland believes that the cost to start this new division will be $100 million and will generate free
cash flow of $20 million dollars every year forever (with the first payment in exactly one year).
It intends to maintain a fixed debt-equity ratio of 0.5. Auckland’s cost of debt capital is 2.5%
and it faces a corporate tax rate of 40%. Assume that the current risk-free interest rate is 3%, the
historical expected return on the market was 10% and the corresponding historical risk-free bond
rate was 6%. Using averages of the information from the two comparable firms, determine the
NPV of this investment.
Note that there is room provided on this page and the next for you to show your work. Please put
your final NPV amount in the space provided on the next page.

start by calculating the cost of equity and the cost of debt for each of the comparable firms. For
Comparable Firm #1:

rE = .03 + 1.25(.04) = .08 (1 mark)

rD = .034,

and for Comparable Firm # 2:

rE = .03 + 1.65(.04) = .096 (1 mark)

rD = .036.

Next, calculate the unlevered cost of capital for each firm. Since they each maintain a target debt-
equity ratio, this is just the pretax WACC:

#1 : rU = .5(.08) + .5(.034) = .057, (1 mark)

#2 : rU = .4(.096) + .6(.034) = .06. (1 mark)

Averaging these values gives an unlevered cost of capital of 5.85% for Auckland’s new division.
(0.5 marks)

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Now that we know rU we can calculate rE .

rE = .0585 + .5(.0585 − .025) = .07525 (2 marks)

Now we can calculate WACC: 13 (.025)(1 − .4) + 32 (.07525O) = .0551666. (2 marks)

**Marking note, you can calculate WACC directly using the formula ru − VD τc rD in which case that
is worth 4 points.**
20
from here we can calculate the NPV: −100 + .0551666 = 262.5421 (0.5 marks)

The NPV of Auckland’s new division is: $262.54 million .

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Question 4: 9 marks.

Multiple Choice: Choose only the MOST correct answer and write it below the choices. There are
6 multiple choice problems spanning two pages (3 on the first and 3 on the second).

(a) (1.5 marks) An equity issue offered to the existing stockholders is called:

A. A cash offering.
B. A private placement.
C. A rights offering.
D. An investment banker’s issue.
E. An underpriced issue.

Enter your above selection here (use the capital letter): C

(b) (1.5 marks) Under the method, the underwriter buys the securities for less than the
offering price and accepts the risk of not selling the issue, while under the method, the
underwriter does not purchase the shares but merely acts as an agent to find buyers for the shares.

A. best efforts; cash offer.

B. cash offer; best efforts.
C. best efforts; firm commitment.
D. firm commitment; best efforts.
E. none of the above.

Enter your above selection here (use the capital letter): D

(c) (1.5 marks) Which of the following statements is false?

A. After deciding to go public, managers of the company work with an underwriter, an investment
banking firm that manages the offering and designs its structure.
B. The shares that are sold in the IPO may either be new shares that raise new capital, known as
a secondary offering, or existing shares that are sold by current shareholders (as part of their exit
strategy), known as a primary offering.
C. Many IPOs, especially the larger offerings, are managed by a group of underwriters.
D. At an IPO, a firm offers a large block of shares for sale to the public for the first time.

Enter your above selection here (use the capital letter): B

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(d) (1.5 marks) Which of the following statements is false?

A. In the event of default, the assets not pledged as collateral for outstanding bonds cannot be used
to pay off the holders of subordinated (junior) debt until all more senior debt has been paid off.
B. Because more than one debt contract might be outstanding, the bondholder’s priority in claim-
ing assets in the event of default, known as the bond’s seniority, is important.
C. When a firm takes a revolving line of credit from a bank, the amount of the loan that the firm
takes and the payment schedule that the firm must adhere to is not fixed.
D. Most debt issues contain clauses restricting the company from issuing new debt with equal or
lower priority than existing debt.

Enter your above selection here (use the capital letter): D

(e) (1.5 marks) Suppose that ABC inc has a stock currently selling for $60 per share. They issue
convertible debt now with par value $1000 that can be converted into 15 shares of the stock. What
is the conversion premium closest to?

A. 66.67
B. 6.67
C. 4.00
D. 44.00
E. -66.67
F. -6.67

Enter your above selection here (use the capital letter): B

(f) (1.5 marks) PK inc. wants to raise $50 million in an IPO. The offer price in the IPO is $24 per
share, and the underwriting fee is 6%. The number of shares that the firm must issue is closest to?

A. 2,208,333
B. 2,083,333
C. 2,216,312
D. 1,456,555
E. 1,888,123
F. 4,222,112

Enter your above selection here (use the capital letter): C

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Question 5: 4 marks.

Please assess the following statement. To do so, you need to state whether it is true, false, or un-
certain and justify your answer. All marks are based on the quality of your argument supporting
your answer.

“There will never be an arbitrage opportunity if the convertible bond sells for more than its con-
version value.”
False. There are two lower bounds on the price of a convertible bond. One is the conversion
value, and the other is its straight bond value. It is possible that a convertible could sell for a price
above its conversion value but below its straight bond value. This would represent an arbitrage
opportunity, because an equivalent straight bond could be issued at a higher price and the risk
exposure covered by purchasing the convertible.

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