Midterm – Solutions

1) Theoretical Questions:

a) What should be the objective function of a firm and how can shareholders ensure their
interest are met by management?

Maximize Firm value (stock price) through governance. Possible mechanisms for motivating
managers to act in stockholders’ best interest: Board of directors, Compensation Plans, Threat
of Firing, Shareholder Pressure, Threat of Takeovers

b) Name 3 common characteristics present among successful boards of directors

Independent boards: Are a majority of the directors outside directors?, Is the chairman of the
board independent of the company (and not the CEO of the company)?, Are the compensation
and audit committees composed entirely of outsiders?

Companies do better with less overcommitted board members (<4 boards)

Reasonable pay for board members; equity stakes

No reciprocity of board membership

2) Alphabet is trading at 43 EUR and is paying a dividend of 2.15 EUR per share. In terms of
total return, investors receive equal amounts of dividend income as capital gains on this stock.
Alphabet is involved in three activities; all three have different levels of systematic risk and
contribute differently to the overall firms sales.

Activity Sales € % Sales per activity Beta

1 520.000 1,8
2 30% 1,1
3 340.000 0,9
Knowing that a T-Bill has an expected return of 2%, what would be the market price of risk you
would back out assuming the CAPM holds.
2.15
Total Return: 2 ∗ 43
= 10%

Excess Return: 10% - 2% = 8%

520
Percentage of Activity 1: 520+340 ∗ (1 − 30%) = 42.33%

Percentage of Activity 3: 100% − 30% − 42.33% = 27.67%

Weighted Beta: 42.33% ∗ 1.8 + 30% ∗ 1.1 + 27.67% ∗ 0.9 = 1.34

8%
Market Price of Risk: = 5.97%
1.34
3) You are an Equity Research Analyst following a publicly listed Oil Company. After today’s
stock market close time, the company’s Investors Relations Department disclosed a news
release announcing a new Oil Exploration and Production project to the market.

As a junior analyst, you will have to work overnight because you want to estimate the impact
of the project on the company’s equity market value to update your equity price target before
the stock market opens tomorrow morning.

By midnight you finished forecasting the project unlevered cash flows as follows:

Year 0 1 2 3 4 5
FCFF (€m) -175 10 50 100 50 20

The company’s average unlevered cost of capital is 12% but you notice that the unlevered cost
of capital of highly comparable projects from other companies is 10%.

The company announced a specific financing agreement for this project, at a cost of debt of
4%. The company will receive €150m from debt at the end of year 0 to finance the project
initial investment. You estimate the debt outstanding at the end of each year as follows:

Year 0 1 2 3 4 5
Debt outstanding at
end of the year (€m) 150 150 100 50 0 0

The tax rate for oil projects is 50%.

a) Which method is appropriate to compute the project value? Compute the project value.

b) Now ignore the above financing agreement and assume the company will finance the
project with a Debt to Equity ratio equal to 1, constant over time. Assume the levered equity
cost of capital is 16%. Which method is appropriate to compute the project value? Compute
the project value.

c) If the IRR of the project with debt financing is 9.4%, would this be a valid measure of return?

rD = i 4%
T 50%
r0 - unlevered cost of capital 10%
D/E 1,00
equity cost of capital 16,00%
wacc 9,00%

a) - APV

Year 0 1 2 3 4 5
FCFF (€m) -175 10 50 100 50 20
Present Value FCFF -175,00 9,09 41,32 75,13 34,15 12,42
 Year 0 1 2 3 4 5
Debt outstanding at end of the
year (€m) 150 150 100 50 0 0
+ debt increase - debt
repayment 150 0 -50 -50 -50 0
Interest expense -6,0 -6,0 -4,0 -2,0 0,0
Interes Tax shield 3,0 3,0 2,0 1,0 0,0
PV TS 2,88 2,77 1,78 0,85 0,00
Cash flows from debt 150,0 -3,0 -53,0 -52,0 -51,0 0,0

NPV -2,89
PV TS 8,29
APV 5,40

2 - WACC

Year 0 1 2 3 4 5
FCFF (€m) -175 10 50 100 50 20
Present Value FCFF -175,00 9,17 42,08 77,22 35,42 13,00

DCF
(wacc) 1,90

c) The IRR can only be interpreted as return if the intermediate CFs are reinvested at that rate,
in this case the opportunity cost of capital (wacc) is 9% so slightly lower so it’s likely that the
IRR overstates it by a bit.

4) AIRmil Corporation, a producer of military aircraft, reported net income of $120 million in
2018, after paying interest expenses of $19 million. The depreciation allowance in 2018 was
$77 million, while capital expenditures amounted to $80 million in the same year. Working
capital increased by $15 million in 2018. (The tax rate is 40%.) AIRmil finances 10% of its net
capital investment and working capital needs using debt. The free cash flows to equity are
expected to grow 10% a year from 2019 to 2023, and 6% a year after that. The stock had a
beta of 0.80, and this is expected to remain unchanged. The treasury bond rate is 7% and
market risk premium is 5.5%.

If the firm has 1 bln shares outstanding which it originally sold at IPO for 0.5 bln dollars, what is
the P/E ratio?
Cost of Equity = 7% + 0.8 * 5.5% = 11.4%

FCFE2018 = Net Income + Depreciation - CAPEX (1 - debt ratio) - Working Capital Change (1-
Debt ratio)

= 120 + 77 - 80*0 .9 - 15 *0.9 = $111.5 million

PV of all future FCFE=market value of equity

FCFE2019-2023= 111.5*(1.1)*Annuity factor with n=5, g=10% and r=11.4%=536.83

FCFE 2024 onwards (terminal value)

Terminal value is FCFEt+6=(111.5*1.1^5*1.06)/(11.4%-6%)=3524.929

PV terminal value=3524.929/(1.114^5)=2054.587

FCFE=536.83+2054.587=2591.417 mln

Price Per share =2591.417/1000=$2.59

EPS= NET INCOME/#shares

EPS= 120 mln/(1000)=0.12

P/E=2.59/0.12=21.59