FIN 442 - Midterm II - 2018 - Practice Exam - 1

UNIVERSITY OF ILLINOIS AT CHICAGO College of Business FINANCE 442 INTERNATIONAL CORPORATE FINANCIAL MANAGEMENT FALL 2018 MIDTERM II EXAM WRITE YOUR NAME BELOW Instructions There are 14 questions and 100 points . 10 questions are multiple choice questions worth 4 points each for a total of 40 points. Please use the provided scantron for your answers. 4 questions are short answers questions. Answer each of the problems below in the space provided. You will need only your pens/pencils and your calculator. All other materials must be placed beneath your seat (and remain there at all times) when you enter the room. All electronic devices must be put away and may never be used during the test. 1. SHOW YOUR WORK! You must show all your work in a well-organized fashion if you wish to be considered for any credit at all—partial or full. This applies only to the short answer questions. 2. Be neat! If I can’t read what you have written, it doesn’t exist. 3. If you run out of space please use the back page. 4. Raise your hand if you have a clarifying question. If I think you are fishing for clues or answers I’ll respond with “I can’t answer that.” 5. If you feel you need to MAKE an assumption to answer the question, please clearly state the assumption as part of your answer. 6. Practice smart test taking. Do the easy problems first. Then spend time on the harder ones. 7. If you are caught cheating OR helping a cheater you will get an F for the course at the very least.

MULTIPLE CHOICE QUESTIONS (10 questions: 40 points) Choose the one alternative that best completes the statement or answers the question. If the answer is numerical choose the answer that is closest to yours. Use the provided scantron forms (4 points each) The following information is relevant for Questions 1 and 2 Halsted Corp. has a capital structure of 35% debt and 65% equity. Its equity beta is 1.2. The market risk premium and the risk-free rate are 8% and 3% respectively. Halsted pays 9% interest on its debt, faces a marginal corporate tax rate of 40% and has an after tax cost of debt of 5.4%. Question 1 What is Halsted Corp’s cost of capital (WACC)? A) 9% B) 10.1% C) 11.2% D) 12.6% E) Not enough information Question 2 Which of the following is likely to lower Halsted’s cost of capital? A) More debt B) Less debt C) Lower tax rates D) Higher Beta E) Not enough information Question 3 Logitech Inc. is considering building a keyboard factory in Indonesia. It will cost $ 2 billion to build the factory. It has computed that the NPV is $5378. A) Logitech should accept the project as the NPV is positive. B) Logitech should conduct sensitivity analysis to see if the NPV is robustly positive before accepting the project. C) As the NPV is small relative to the cost of building the plant, Logitech should conduct sensitivity analysis to justify rejecting the project. D) Logitech should accept the project and conduct sensitivity analysis in a year. E) None of the above Question 4

Question 7 The expected growth rate is 3% and the dividend yield (excluding stock buybacks) is 1.87%. What is the implied cost of capital? D 0 = P 0 ×Dividend Yield = 1540 × 0.0187 = 28.8 D 1 = D 0 ( 1 + g ) = 28.8 ( 1.03 ) = 29.7 P 0 = D 1 k − g ⇒ k = g + D 1 P 0 = 0.03 + 29.7 1540 = 0.0492 ∨ 4.92% Question 8 General Motors has significant revenues in Euros. To reduce its exposure to the dollar-euro exchange rate General Motors wants to borrow in euros. JP Morgan Chase (a US bank) is a potential counterparty for a swap transaction. The interest rates at which these companies can borrow in the respective markets are as follows: Fixed-rate Euro Floating-rate Eurodollar JP Morgan Chase 6.50% LIBOR+0.25% General Motors (GM) 7.00% LIBOR+0.25% Is a swap mutually beneficial to both parties? Assume they have equal bargaining power (i.e., they share any profits equally). A) Yes, after the swap GM pays 6.5% fixed-rate in Euros while Chase pays LIBOR+0.25% in dollars. B) Yes, after the swap GM pays 6.75% fixed-rate in Euros while Chase pays LIBOR in dollars. C) Yes, after the swap GM pays 7% fixed-rate in Euros while Chase pays LIBOR-0.25% in dollars. D) Yes, after the swap GM pays 7.25% fixed-rate in Euros while Chase pays LIBOR in dollars. E) No, the swap is not mutually beneficial.

Question 9 In class we discussed Cemex’s plan to build a cement plant in Indonesia. It is important for Cemex to consider the following factor(s) in computing the project’s NPV, A) Foreign Exchange Movements B) Financing C) Political Risk D) Cement Prices E) All of the above Question 10 Home bias is ________ among US investors, but _______ among investors in other countries. A) prevalent, rare B) rare, prevalent C) rare, also rare D) prevalent, also prevalent E) progressive, regressive

Question 12 - (20 points) – This question continues onto the next page. WRX Manufacturing is considering opening a sales outlet in Wisconsin. Startup costs are $50,000. The sales outlet is expected to generate an extra $25,000 in sales net of costs for each of the next three years. The startup costs depreciate straight-line over three years. WRX will finance the project with 50% debt with the remainder being financed by equity. The interest rate on WRX’s loans is expected to be 7%. WRX has an equity beta of 0.8. WRX expects to sell the sales outlet for $3000 at the end of year 3. Other potentially relevant information is given below, K u = return on assets = 10% K l = return on equity = 15% τ = Tax rate = 34% Risk-free rate = 2% (a) (5 points) To attract WRX Wisconsin agreed to not tax WRX for the life of the project. Should WRX accept the project? Why or why not? Use the WACC methodology. To find the cash flows use the following equation, C F t = OC F t ( 1 − τ ) + τ D t Since there is no tax it reduces to, C F t = OC F t So, C F 0 =− 50,000 C F 1 − 2 = 25,000 C F 3 = 25,000 + 3,000 Note, there is no tax on the sale as the tax rate is zero for the life of the project. k WACC = 0.5 ( 0.15 ) + 0.5 ( 1 − 0 ) ( 0.07 ) = 0.11 You can either solve these on your calculator or solve, NPV = 25,000 1.11 + 25,000 ( 1.11 ) 2 + 28,000 ( 1.11 ) 3 − 50,000 = 13,286 Accept as NPV>0

(b) (5 points) Does your decision to accept or reject the project change if Wisconsin instead applies a 34% tax rate? Explain. Again use the WACC methodology.

(d) (4 points) Explain the main differences between the WACC and APV methodologies. The two methods are similar. APV is the net present value of a project if financed solely by equity plus the present value of financing benefits (i.e., APV takes a value additive approach to capital budgeting). Each cash flow is discounted by a discount rate that reflects the risk of the cash flows (e.g., operating cash flows are discounted by the return on assets while depreciation and interest tax shields are discounted by the cost of debt). In contrast, the WACC methodology discounts cash flows by the weighted average cost of capital (WACC). Question 13 – (16 points) Briefly answer the following, (a) (4 points) When is it appropriate to use the global CAPM versus the domestic CAPM to estimate the cost of equity? (b) (4 points) Mention at least one advantage and one disadvantage of using options contracts relative to futures or forward contracts to hedge foreign exchange exposure. (c) (4 points) Briefly, how can swap contracts be used to hedge foreign exchange risk? (d) (4 points) Your firm is going to pay a supplier in Britain in 3 months. You can hedge this exposure by buying (going long) a put option on the British pound. True or false? Discuss.

Question 14 - (15 points) – This question continues onto the next page The APV for a foreign project is given by: APV = ∑ t = 1 T S t OCF t ( 1 − τ ) ( 1 + K ud ) t + ∑ t = 1 T S t τD t ( 1 + i d ) t + ∑ t = 1 T S t τI t ( 1 + i d ) t + S T TV T ( 1 + K ud ) T − S 0 C 0 + S 0 RF 0 + S 0 CL 0 − ∑ t = 1 T S t LP t ( 1 + i d ) t (a) (5 points) Briefly explain each term. In your answer refer to each term as 1 through 8. Focus on the intuition of how each one contributes to the APV. (b) (5 points) Yuppy Yup (YY) is a US based firm. YY is considering a two-year foreign project to build a plant in Germany. The cost of the plant is 10,000 Euros. There is no incremental depreciation. The current spot rate is 1.1 USD/EUR. The euro is expected to depreciate against the US dollar by 5% per year. The project is all equity financed. There are no restricted funds. Given the business risks associated with the project, YY’s unlevered cost of equity is 10% and its cost of debt is 8%. The applicable tax rate is 30%. The plant is worthless after two years. Incremental cash flows in year 1 and 2 are 6000 and 7000 Euros respectively. Using the APV methodology should YY accept or reject the project. Why?

Extra Page if you need it

Formula Sheet Percentage change in the exchange rate: ΔS = S ( t + 1 ) − S ( t ) S ( t ) Mean change in the exchange rate: m ( ΔS )= ¿ Standard Deviation of the change in the exchange rate: σ ( Δ S )= √ ¿¿ Net Present Value (NPV) NPV = ∑ t = 1 n C F t ( 1 + r ) t − C F 0 NPV = ∑ t = 1 T CF t ( 1 + K ) t + TV T ( 1 + K ) T − C 0 C F t = OC F t ( 1 − τ ) + τ D t C F t = NO I t ( 1 − t ) + D t Adjusted Present Value (APV) APV = ∑ t = 1 n ( OC F t ( 1 − τ ) ( 1 + K u ) t + τ D t ( 1 + i ) t + τ I t ( 1 + i ) t ) + T V T ( 1 + K u ) T − C 0 APV = ∑ t = 1 T S t OCF t ( 1 − τ ) ( 1 + K ud ) t + ∑ t = 1 T S t τD t ( 1 + i d ) t + ∑ t = 1 T S t τI t ( 1 + i d ) t + S T TV T ( 1 + K ud ) T − S 0 C 0 + S 0 RF 0 + S 0 CL 0 − ∑ t = 1 T S t LP t ( 1 + i d ) t Weighted Average Cost of Capital (WACC)