Prof. Pinkowitz - Finance 211

Business Financial Management

FINAL EXAMINATION SPRING 2001

Name:______KEY______

Class Time: ______All______

Please read the following instructions carefully:

(i)You have 120 minutes to complete the exam. Make sure you read the questions completely and carefully. When necessary, show all your work. I will not give partial credit for work that is not written down.

(ii)The exam totals 275 points.

(iii)Check that there are 12 pages and 3 sections in your booklet (18 questions)

(iv)You may have at your desk a pen, pencil, a pocket calculator and two sides of a formula sheet. There is to be NO sharing of calculators

(v)Allocate your time wisely. Use the number of points assigned to each question as your guide.

(vi)Make sure you write legibly, if I cannot read your work/answer, it is wrong.

(vii)In order to get partial credit, I recommend that you: (1) attempt all questions; (2) show detailed calculations, time lines, etc; (3) explicitly write out the inputs you used if you are using a financial calculator.

(viii)If something is unclear or ambiguous, state your assumptions clearly and go ahead with answering the questions.

(ix)Remember the Honor Policy

(x)GOOD LUCK

Section I: Multiple Choice - (90 points total – 15 points each question)

Clearly circle the letter of the best answer. You may also want to write the letter to the left of the question number in order to make your choice evident.

1.If you bought the stock of ATT last year for $ 15.75, received dividends totaling $1.50, and sold the stock yesterday for $ 14.25. Your holding period return was

A. 9.52%

B. -9.52%.

C. 7.02%

D. -7.02%

  1. None of the above.
  1. In comparing two projects of equal life you are given the NPV profile of both projects. You notice that the NPV profiles of the two projects cross at some point. At this point, which we call the crossover rate ______.
  1. The IRR of each project is always zero
  2. The IRR of each project is always equals to the cost of capital
  3. The NPVs of both projects are always equal
  4. The NPVs of both projects are always zero
  5. None of the above

3.Shares of ‘Sman Inc have a required rate of return of 13%. Although the firm does not currently pay dividends, it is expected that 3 years from today, the firm will begin paying dividends. The initial dividend is expected to be $0.75. Dividends are expected to grow at a constant rate of 8% from then on. What is the current market price for a share of ‘Sman stock?

  1. $10.40
  2. $11.75
  3. $12.69
  4. $15.00
  5. $19.15
  1. A decrease in the cost of capital of the project leads to ______in the NPV of the project and ______in the IRR of the project.
A.an increase, no change
B.an increase, an increase
C.an increase, a decrease
D.a decrease, no change

E. a decrease, an increase

5.In efficient markets, investments have which of the following attributes?

i.Expected return equal to zero
ii.Expected NPV of investments is zero
  1. Expected risk premium equal to zero.
  1. i only
  2. ii only
  3. iii only
  4. i, ii, and iii only
  5. None of the above
  1. The bid-ask spread of Catalina Marketing is 93.45 – 93.52. Which of the following orders executes immediately at 93.52?
  1. A limit sell order at 93.5
  2. A market buy order
  3. A market sell order
  4. A limit buy order at 93.7
  1. I only
  2. II only
  3. II and III only
  4. I and III only
  5. II and IV only

Section II: True or False, Explain: (25 points total - 25 points each question)

Determine whether the statements are true or false. If the statement is false provide an explanation as to why it is false. If the answer is true, no explanation is needed. Show work if necessary.

1. Florida Power and Light, an electric utility decides to diversify its operations and go into biotechnology. They decide to open a division that will map the human genome. The finance department calculates that this project has an internal rate of return of 13%. The project has conventional cash flows and taking it will not prevent them from taking other projects. Because Florida Power and Light has a WACC of 11.4%, they should accept this project.

False, the risk of the new division is not similar to the risk of the overall firm. We should only use the WACC as the discount rate when the risk of the project is similar to that of the firm as a whole. In this case, we should use the SML approach and the beta of the project to determine the appropriate discount rate. Thus, comparing the IRR of the project to the WACC of the firm is not useful.

Section III: Problems (160 points total) – Show all work.

Questions 1-10 (115 points total)

Esther A. Swine, president of “Santa Belito Rural Hog Farms” (SB) is facing a bit of a crisis. The company specializes in selling equipment to hog farmers and its major competitor has recently launched a mudslinging advertising campaign that has been cutting into sales. Esther has decided to get down and dirty and fight back. They are considering a new project that will revolutionize farming. SB has developed a machine that catches eggs laid by chickens and moves them along a conveyor belt to a feeding station where hogs can eat the eggs. SB wants to market the idea to farmers on the basis that they can sell their hogs as “Bacon and Eggs”. Esther A. Swine hopes that the current “Eggs and Ham” project provides them with fistfuls of green. They have dubbed the three-year project “Seuss”. You know the following:

A.The risk of Seuss is similar to that of SB as a whole.

B.The equipment needed for Seuss costs $4,000,000 and is 5-year MACRs. The firm estimates that the market value of the machinery will be $2,000,000 at the end of the third year. The depreciation schedule for 5 years MACRS is as follows: year 1 – 20.00%, year 2 – 32.00%, year 3 – 19.20%, year 4 – 11.52%, year 5 – 11.52%, and year 6 – 5.76%.

C.The firm estimates that it will sell 500 machines in the first year, 700 in the second, and 400 in the third. Each machine will be priced at $12,000. Each machine will cost the firm $6,000 to produce. In addition, SB will have overhead costs of $200,000 per year.

D.SB has no room in their current factory to place the new equipment so they are planning on renting a 15,000 square foot warehouse from a local real estate development family, the Sneeches. The cost for the warehouse is currently $300,000 per year and will increase by 10% per year. This cost is not included in the overhead costs in part C.

E.Project Seuss will require that the firm increase net working capital by $400,000 immediately and then maintain a balance equal to 10% of sales. At the end of the project, SB will recover all NWC (with no loss or gain).

F.Lorax and Co conducted a 16 month marketing research study to determine whether consumers would purchase “Bacon and Eggs” in a single meat product. The cost to SB for the study was $100,000. To date, SB has only paid Lorax and Co. $70,000 and the remaining $30,000 is due at the end of the next year.

G.You know that the firm is currently at its target capital structure.

In addition, you have the following selected information about SB from their most recent balance sheet.

(numbers in millions) / 2000
Total Assets / 365
Liabilities:
Current Portion of Long Term Debt / 0
Long – Term Debt / 200
Equity:
Paid in Capital / 90
Common Equity / 10

H.The company has one bond issue outstanding. Eight years ago, they issued 30-year bonds with a face value of $1,000. The firm originally issued 300,000 of these bonds but repurchased 100,000 of them in the last three years. The bonds sell at 112.5% of face value. The current yield on these bonds is 8% and the bond pays semi-annual coupons of $45.

I.The firm has 4,000,000 shares outstanding. The beta of the stock is 0.45 and it currently sells for $100 per share. The risk free rate is 6%. You also know the following forecast (on which all investors agree) of the returns on the market portfolio. The forecast is expected to remain unchanged each year for the next 3 years.

Probability / Return on the market
0.4 / 16%
0.5 / 13%
0.1 / -9%

J.The firm has a tax rate of 34%.

1. What is SB’s cost of equity? (10 points)

The cost of equity for the firm can be found using the CAPM. The formula for the CAPM is E(Ri)=rf+i (E(Rm) – rf). Here we know that the risk-free rate is 6%. We also know that the beta of the firm is 0.45. To find the expected return on the stock (which is also the cost of equity), we need the expected return on the market portfolio. While that is not directly given, we can calculate it from the possible states.

Recall that expected return is the sum of the products of the probability of a state and the return in that state.

Thus, E(Rm)= (0.4)*(0.16) + (0.5)*(0.13) + (0.1)*(-0.09) = 0.12 = 12%

Plugging this into the CAPM we have that

E(Ri)= 0.06 + 0.45*(0.12 – 0.06) = 0.087 = 8.7%

The cost of equity for SB is 8.7%.

2. What is SB’s cost of debt? (10 points)

The cost of debt for the firm is given by the YTMs of its debt. Since there is only one bond issue outstanding, its YTM is the cost of debt. Recall that the bond pricing formula is given by

In this case, we know that the price of the bond is 112.5% of par value and that par value is $1,000. Thus, FV=1,000 and price is (1,000 *112.5%) = $1,125. Further the bond pays semi-annual coupons of $45 so that is c. Finally, the bond had 30 years to maturity eight years ago. Thus, there are 22 years left. With two periods per year, t=44. We can now solve for YTM

Using the financial calculator, we can get that YTM = 7.80236%

Note, the current yield of a bond is given by its annual coupons divided by its price. Thus, the current yield equals 90/1125 = 8%. However, we do not need the current yield to solve for YTM because we have both the price and the coupons

  1. What are SB’s capital structure weights? (10 points)

The capital structure weights are given by the market values of the securities relative to the total value of the firm. Since there is no preferred stock, we only need to worry about D, the value of debt and E, the value of common equity.

E = price per share x number of shares outstanding.

E= $100 x 4,000,000 = $400,000,000

D = price per bond x number of bonds outstanding.

D = $1,125 x 200,000 = $225,000,000

With no preferred stock, the value of the firm is the sum of the values of debt and equity.

V = D + EV= $225,000,000 + $400,000,000 = $625,000,000

Thus, the capital structure weights are

D/E = $225,000,000 / $625,000,000 = 0.36 and

E/V = $400,000,000/ $625,000,000 = 0.64

D/E = 36% and E/V = 64%

  1. What is the depreciation schedule for the equipment SB needs to buy? (10 points)

The firm needs to depreciate the $4,000,000 of equipment they are buying. The MACRS schedule is given below and the depreciation expense in each year is just the MACRs % multiplied by the $4,000,000. The book value of the asset is the prior year’s book value minus the current year’s depreciation expense.

Year / MACRS % / Depreciation / Book Value
1 / 20.00 / $800,000 / $3,200,000
2 / 32.00 / $1,280,000 / $1,920,000
3 / 19.20 / $768,000 / $1,152,000
4 / 11.52 / $460,800 / $691,200
5 / 11.52 / $460,800 / $230,400
6 / 5.76 / $230,400 / $0

5.Complete the pro forma financial statement for SB? Use the template below (note: there may be more rows than you need) (20 points)

Year 1 / Year 2 / Year 3
Sales Revenue / 6,000,000 / 8,400,000 / 4,800,000
Cost of Goods Sold (aka Variable cost) / 3,000,000 / 4,200,000 / 2,400,000
Fixed Costs (Overhead) / 200,000 / 200,000 / 200,000
Depreciation Expense / 800,000 / 1,280,000 / 768,000
Rent for Warehouse / 300,000 / 330,000 / 363,000
EBIT / 1,700,000 / 2,390,000 / 1,069,000
Taxes (34%) / 578,000 / 812,600 / 363,460
Net Income / 1,122,000 / 1,577400 / 705,540

The depreciation expense comes from question 4. The rent for warehouse is given in the problem. Th e first year cost is $300,000 and then the costs go up by 10% each year. EBIT is Sales Revenue – COGS – Fixed costs – Dep. Exp – Rent.

Taxes are given as 34% and thus the amount SB pays in taxes is 34% of EBIT.

Net Income is EBIT - Taxes

6.What is the operating cash flow for SB? (note: there may be more rows than you need) (10 points)

OCF is EBIT + Depreciation - Taxes

Year 1 / Year 2 / Year 3
EBIT / $1,700,000 / $2,390,000 / $1,069,000
+ Depreciation / $800,000 / $1,280,000 / $768,000
- Taxes / $578,000 / $812,600 / $363,460
Operating Cash Flow / $1,922,000 / $2,857,400 / $1,473,540

7. What are the additions to Net Working Capital? (10 points)

Year / Net Working Capital / Additions to NWC
0 / $400,000 / $400,000
1 / $600,000 / $200,000
2 / $840,000 / $240,000
3 / $0
(or $480,000 which is the amount during the year) / ($840,000)

Net working capital requirements are $400,000 to start. After that the requirements for NWC is 10% of sales. Taking 10% of the sales revenue from the pro-forma income statement gives us the Net working capital amounts. The additions to NWC are the changes from year to year. Since we recover all the NWC at the end of the project, the year 3 NWC is 0 at the end of the year (during the year it would be $480,000 which is 10% of year 3 sales). Thus, there is an $840,000 inflow from NWC in year 3.

8. Calculate the cash flows for Project Seuss. (10 points)

Year / Operating Cash Flow / Additions to NWC / Net Capital Spending / Total Project Cash Flow
0 / 0 / $400,000 / $4,000,000 / ($4,400,000)
1 / $1,922,000 / $200,000 / 0 / $1,722,000
2 / $2,857,400 / $240,000 / 0 / $2,617,400
3 / $1,473,540 / ($840,000) / *($1,711,680) / $4,025,220

Net capital spending in year 0 comes from buying the equipment for $4,000,000

* The year 3 net capital spending comes from the sale of the equipment for $2,000,000. We know from the depreciation table that the book value of the equipment at the end of year 3 is $1,152,000. Thus, we have a gain of

($2,000,000 - $1,152,000) = $848,000. We will need to pay taxes on that gain at the 34% tax rate, so we will pay ($848,000*0.34)=$288,320 in taxes.

Thus, the after tax cash flow in year 3 is the sales price minus the taxes

($2,000,000 – $288,320) = $1,711,680. Since it is an inflow, it is negative spending.

Total project cash flow is OCF – Additions to NWC – Net capital Spending.

  1. What is the NPV of this project? If your goal is to maximize wealth of the shareholders of SB, do you take this project? WHY?(15 points)

To get the NPV of the project, we need to have the cash flows and the discount rate. In question 8, we calculated the total project cash flows. Now we need the discount rate. Since the problem stated that the risk of “Seuss” is similar to the overall firm, the appropriate discount rate to use is the WACC.

We calculated each of the needed components earlier. Recall that E/V = 0.64 and D/V = 0.36, while Re is 8.7% and Rd was 7.80236%. The tax rate is 34%.

Now that we have the WACC of 7.422%, we can discount the cash flows.

Thus, the NPV of the project is $2,718,442. SB should take this project because the NPV is positive and thus accepting the project will increase shareholder wealth.

10.Assume that the firm needs to raise money to cover the outflow in year zero. The firm has talked to an underwriter and discovered that the flotation costs of equity are 7%. They also learned that they could issue bonds at a flotation cost of 4%. Given current market conditions, the bonds would have an 8% coupon rate. The firm has decided that it wants to keep its balance sheet leverage constant and thus will raise the money with 2/3 debt and 1/3 equity. What is the initial outlay for the project when the issuances of the securities are considered? (10 points)

To determine the initial outlay, we use the fact that:

Amount raised * (1-fa) = Amount needed

We know that we need $4,400,000 because that is the outflow at time zero. What we want to determine is the amount we need to raise. In order to do this, we need the weighted average flotation costs fa.

Recall that weighted average flotation costs are given by fa=E/V*fe + D/V fd.

We know that fe is 7% and fd is 4%. We also know from part G of the question that the firm is at its optimal capital structure so we should use the capital structure weights that we calculated in question 3.

fa=(0.64)*(0.07) + (0.36)*(0.04) =0.0592 = 5.92%. The weighted average flotation costs are 5.92%. Remember that the way the firm finances the project is irrelevant so we do not use the 1/3 and 2/3 weights. Now we can calculate the initial outlay with flotation costs as: Amount raised = $4,400,000/ (1-0.0592) = $4,676,871

With flotation costs, the time zero cash flow would be -$4,676,871.

Question 11 (45 points)

You have graduated from Georgetown and have purchased a lovely starter home. You take out a 30-year mortgage at a fixed rate of 12.00% APR. Your fixed monthly payments are $2,400.00. After 2 years, you receive the following offer in the mail. Your mortgage company is going to allow you to participate in their “Bisaver” Biweekly Mortgage Cost Reduction System. The system is such that you will make a half-payment every two weeks instead of a full payment every month. Thus, you will pay $1,200 every two weeks. By taking advantage of the system, you will pay off your mortgage 9 years and 6 months earlier than the full 30 years. They claim this will save you $112,428 in interest payments. The reason this works, they say is that because there are 26 biweekly periods, you are effectively making an additional monthly payment each year. This additional payment goes to principal and thus allows you to pay off your loan earlier. The fee for this service is $379. However, with your astute understanding of finance, you realize that you can effectively mimic their system at no cost. You can simply make equal monthly payments of more than the $2,400 and have the loan paid off at exactly the same time (i.e. 9 years and 6 months early) and not pay them $379.

11. How much extra (above your $2,400 payment) do you have to pay each month to mimic the “Bisaver” Biweekly Mortgage Reduction System? (ignore the $379 cost) (45 points)

This problem is basically an application of an EAC problem. Recall that to get EAC what we did was take the present value of the costs and then turn them into an annuity with time periods equal to the life of the asset. Here, we will do the exact same thing.

The first step is to get the present value of the costs. We know that the current loan costs you $2,400 per month. Since the payment is the same each month, it is an annuity and we need to get the present value of the annuity. The formula for that is:

where C is the $2,400 payment. Since we have monthly payments, we will need a monthly rate. The annual rate is 12.00% APR so the monthly rate is .12/12 = 0.01. Finally, we need to know t, the length of the annuity. However, t is just the number of payments remaining on the loan. Since we took out a 30 year fixed mortgage, we would have to make 360 payments, but it is 2 years since we took the loan so we have made 24 payments already. Thus, there are 336 payments remaining.