Exam 2

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Western New England University *

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350

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Finance

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Jan 9, 2024

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Finance 350 Exam 2 Exam time: 50 mins Name___________________________________ This is a closed-book exam. You are allowed to bring one 8 ½ x 11 HANDWRITTEN sheet of information of your choosing. Scientific calculators and financial calculators are permitted for exams, however, no other electronic devices are allowed. Answer all questions and show necessary work. MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question (Question 1 – 7 you are worth 5 points each. ) 1. Which of the following would you do if you were valuing the entire business? a. Discount cash flows before debt payments (FCFF) at the cost of equity b. Discount cash flows after debt payments (FCFE) at the cost of equity c. Discount cash flows before debt payments (FCFF) at the cost of capital (WACC) d. Discount cash flows after debt payments (FCFE) at the cost of capital (WACC) e. None of the above 2. In real world, most analysts and appraisers get their equity risk premium by looking at the past: the historical risk premium is the difference between what you would have earned invested in stocks over a past period over what you would have earned on a risk free investment. Which of the following are problems with this approach? a. The estimate can be biased and “subjective”, since it depends upon the time period and averaging approach used. b. The estimate is backward looking c. The estimate moves counter intuitively: down after crisis and up after prosperity d. All of the above e. None of the above 3. Discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. Based on DCF, which of the followings is not related to the value of an asset? a. Cash flows in year 1. b. Risk(s) of cash flow c. Terminal value of an asset d. Investor perception e. All of the above are related to the value of an asset

4. The financial crisis of 2007–2008, also known as the Global Financial Crisis and 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s. Stock markets dropped significantly worldwide. This in turn led to investor panic and a bank run. If you use the historical analysis, the event of 2007-2008 would be expected to _______ ; The actual equity risk premium during financial crisis should be _____ than normal. a. Bias the historical equity risk premium estimate upwards; higher b. Bias the historical equity risk premium estimate downwards; lower c. Bias the historical equity risk premium estimate upwards; lower d. Bias the historical equity risk premium estimate downwards; higher e. None of the above 5. A key input into your terminal value is the expected growth in perpetuity. Assuming that you are valuing a company in a country with a GDP growth of 3%. Which of the following growth rate is not feasible? a. 3% b. 2.5% c. 6% d. 2% e. None of the above 6. Which of the following is the best description of the free cash flow to the firm? A. It is the cash that investors take out of the firm. B. It is the dividend that is paid to stockholders. C. It is the cash that investors can take out of the firm after financing investment needed to sustain future growth. D. It is the cash left over after meeting debt payments and paying taxes. E. None of the above. 7. Which one of the following statements relating to the calculation and use of FCFE is correct? a. The free cash flow to equity can never be negative. b. The free cash flow to equity will always be higher than the dividends. c. The free cash flow to equity will always be higher than net income. d. All of the above (a.,b.,c.) are incorrect e. All of the above (a.,b.,c) are incorrect.

Problems. Write your answer in the space provided. Please show your work. 8. As of last week, the forecasted dividend yield on the S&P 500 was 1.87%. The consensus analyst view was that earnings growth estimates was close to 7.9% for the next 5 years. The 10-year government bond rate was about 2.00%. a. What was the equity risk premium based on Constant Growth Model estimates? (5) b. If you were conducting a research of the value General Motors (Beta=1.08), what is the appropriate required return for GM’s stock? (5)

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9. Joey just bought a share of stock for $42.50. He believes that the stock will pay three quarterly dividend of $0.15 each and followed by another quarterly dividend of $0.20 during the next year. He also believes that he will be able to sell the stock one year later for $51.72. The required return of the stock is 15%. a. What was Joey's holding period return? (5) b. Is your estimate realized return or expected return? (2.5) c. What is a target price that is most consistent with the stock being fairly valued, assuming dividend is correctly forecasted. (5) d. Based on your answer, if analyst is correct, should you buy or sell the stock? (2.5)

10. TryTips Inc., a food processing company, has come to you for some help in estimating a discount rate for the firm. The regression beta is 0.45. But the firm has been publicly traded for only two weeks and the regression beta is not very reliable. The firm is in two businesses, and you have collected the following information on them: Comparable firms Business TryTip’s revenues Unlevered Beta Average D/E (debt to equity) ratio Food processing $500 millions 0.60 100% Restaurants $500 millions 1.20 15% TryTips has 100 million shares outstanding, trading at $6 a share, $ 100 million in debt (market value). The risk-free rate is 3.5%, the equity risk premium is 4.5% and the firm has a rating of BBB. The marginal tax rate for all firms is 40% and cost of debt is 6%. a. What is the discount rate you will use if you are using FCFE model? Please answer the question with proper calculation. (10) b. What is the discount rate you will use if you are using FCFE model? Please answer the question with proper calculation. (5)

11. Use the following information Computron Industries Balance Sheet 2012 2013 Assets Cash 9,000 7,282 Accounts receivable 399,800 652,160 Inventories 715,200 1,287,360 Total current assets 1,124,000 1,946,802 Gross fixed assets 491,000 1,202,950 Less: Accumulated depreciation 146,200 263,160 Net fixed assets 344,800 939,790 Total assets 1,468,800 2,886,592 Liabilities and Equity Accounts payable 145,600 324,000 Notes payable 200,000 720,000 Accruals 136,000 284,960 Total current liabilities 481,600 1,328,960 Long-term debt 323,432 1,000,000 Common stock 460,000 460,000 Retained earnings 203,768 97,632 Total equity 663,768 557,632 Total liabilities and equity 1,468,800 2,886,592 Computron Industries Income Statement 2012 2013 Revenue 3,432,000 5,834,400 Cost of goods sold 2,864,000 4,980,000 Other expenses 340,000 720,000 Depreciation 18,900 116,960 Total operating costs 3,222,900 5,816,960 EBIT 209,100 17,440 Interest expense 62,500 176,000 EBT 146,600 -158,560 Taxes 58,640 -63,424 Net Income 87,960 -95,136 Other Data

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Total Dividend 22,000 11,000 Stock price 8.5 6 Shares outstanding 100,000 100,000 EPS 0.8796 -0.9514 DPS 0.22 0.11 Tax rate 40% 40% a. Find: FCFE in year 2013. (10 pts) b. Assume today is Dec 31, 2013. Use the FCFE in “a” as current FCFE. Computron’s FCFE is expected to grow 10% a year over the next two years before it stabilizing at an annual growth rate of 3%. Computron’s cost of equity is 10%, cost of debt is 5%, tax rate is 30%. Computron has 200 million shares outstanding, trading at $20 a share, $ 1 billion in debt (market value).Calculate the value of one share of Computron’s common stock. (15 pts)

12. Here is a favorite question among corporate finance interviewers: "Can betas be negative? And if so, what exactly do they tell us?" The reason negative betas pose a conundrum to many finance students is that they seem to go against intuition. After all, if a beta of one is average risk and a beta of zero is riskless, how can an investment have negative risk? Here is the answer. Yes, betas can be negative. a. Give one example of negative beta investment. Discuss why this investment will have negative beta. (extra credit 7) b. If one stock has a negative beta, what will be the consequence on required return of equity? (extra credit 3)