final fall 20

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University of Pennsylvania The Wharton School Fall 2020 Howard Kaufold FNCE 611 Final Exam December 17, 2020 Quiz Instructions This is an open book and open notes exam. You may use a calculator, laptop (EXCEL), summary sheets, textbook, internet content, but not use any notes from students that have taken this class previously. You may use past exams for preparation and during the exam. You are to take this exam on your own with no help from any other person. You may not talk to others about the exam from 7am to 9pm. The exam time is 120 minutes. The clock will begin to run the moment you click "Take the Quiz", and you are not able to pause it. If you want to use the entire 120 minutes then the latest you should start is 9am or 7pm, respectively. If possible, please select a quiet, private location with a steady internet connection. Good luck!

FNCE 611 Final, Fall ‘20 : 2 Part I Please use this information as the basis for answering Questions 1 through 5. In answering Questions 1-5, please assume that there are no personal taxes or costs of financial distress. Also, assume that markets are semi-strong efficient. Clothing retailer, Carter Inc., has revenue of $180 million, and cash costs (excluding depreciation) of $100 million per year. Depreciation expense for the company is $30 million annually, and the company matches this amount with new investment spending. Carter pays a 20% corporate tax rate, and plans to maintain its current all-equity capital structure. Investors expect the company to continue to provide these financial results every year indefinitely into the future, as long as the current management team is in place. Another firm in the same industry, Rex & Co., has achieved higher profit margins and maintains a debt- to-value ratio of 50%. Rex borrows at a 5% interest rate, its shareholders require a 14% return, and it too is in the 20% corporate tax bracket. Rex’s management is considering an acquisition of Carter. They believe they can maintain Carter’s sales at the current level while reducing the target’s costs in Year 1 by 10%, and in Year 2 by another 10%. They project they can then maintain costs at the Year 2 level (19% below where they are today) indefinitely into the future. These efficiencies could be realized without affecting depreciation or investment. Question 1 5 pts What is Carter’s required return on assets? [Format: Suppose you want to answer 8.50%, please enter 8.50.] Question 2 7 pts Assuming Carter’s management team continues to run the company using 100% equity financing, what should the company be worth today? Please show the relevant cash flows and steps in the valuation process. Question 3 9 pts Value Carter today assuming Rex acquires it and successfully implements its cost-cutting plan, but maintains Carter’s all-equity capital structure. Please show the relevant cash flows and steps in the valuation process. Question 4 5 pts What would Carter’s enterprise value be with the cost-cutting if it is also financed using Rex’s capital structure? Please show the relevant cash flows and steps in the valuation process. Question 5 4 pts With Rex’s cost-cutting and leveraged financing plans in place, how much of Carter’s overall enterprise value would come from the present value of its interest tax shields? Please describe the process you used to arrive at your answer.

FNCE 611 Final, Fall ‘20 : 3 Part II Please use this information as the basis for answering Questions 6 through 14 on Options. You believe that it is very likely that the price of Tesla stock is going to fall from its current level of $585 over the next few months. To profit from this price movement, you consider two separate option strategies: i) buy a Tesla put expiring in February 2021 with an exercise price of 590 (premium of $91.76), or ii) write a Tesla call with the same exercise price and expiration (premium of $88.50). (The exercise price and the respective option premiums are quoted on a per share basis.) You do not currently own the company’s shares. For the following questions, give your answers to the penny (hundredth of a dollar). That is $600 should be written as 600.00. Question 6 2 pts Excluding the premium you would pay today to buy the put, what would the value of the put position be at expiration if the stock price is $570? Question 7 2 pts Excluding the premium you would pay today to buy the put, what would the value of the put position be at expiration if the stock price is $610? Question 8 4 pts Including the cost of buying the put option, what would the share price have to be at expiration in order for you to break even on the put purchase? Question 9 2 pts Excluding the premium you would receive today from selling the call, what would the value of the call position be at expiration if the stock price is $570? Question 10 2 pts Excluding the premium you would receive today from selling the call, what would the value of the call position be at expiration if the stock price is $610? Question 11 4 pts Including the proceeds from selling the call option, what would the share price have to be at expiration in order for you to break even on the call sale? Question 12 3 pts Including the put and call premiums, there would be two different share prices – at expiration - at which you would be indifferent between these two option strategies. In the answer box for this question, indicate ONE of those share prices. In the answer box to the NEXT question (Question 13), provide the OTHER share price. Question 13 3 pts Including the put and call premiums, there would be two different share prices – at expiration - at which you would be indifferent between these two option strategies. In the answer box for the prior question (Question 12), you indicated ONE of those share prices. In the answer box to THIS question, provide the OTHER share price. Question 14 3 pts Including the put and call premiums, indicate ONE share price at which you would prefer the call sale to the put purchase. Question 15 Briefly explain your approach/thinking while solving the questions about options above, allowing us to give partial credit. If you are confident in your numerical answers, feel free to skip this.

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FNCE 611 Final, Fall ‘20 : 4 Part III Please use this information as the basis for answering Questions 16 and 17. In answering this question, please assume that there are no personal taxes or costs of financial distress, and that markets are semi-strong efficient. Moon, a company which owns a number of restaurant chains, is interesting in launching a new restaurant concept in several cities across the US this year. The total upfront cost for kitchen equipment for all the restaurants is $12 million, which will be depreciated using the straight-line method over 10 years to its estimated salvage value of $2 million. However, Moon plans to run the restaurants for only 3 years, at which time it expects to be able to sell the equipment at its book value. Over the 3 years of operations, the new restaurants are expected to generate annual pre-tax cash revenue less expenses of $4 million. Moon’s corporate tax rate is 30%, and it estimates its unlevered equity return to be 10%. Question 16 22 pts Moon’s bankers are willing to lend it the full $12 million of equipment cost at an interest rate of 6%, assuming Moon agrees to pay back $4 million of principal at the end of each of its 3 years of operation. With these financing arrangements, what value would Moon create for its shareholders if it moved forward with the new dining concept? Question 17 8 pts The bankers propose an alternative borrowing plan to Moon’s CFO. If Moon borrows a lower principal amount (to be determined), the bankers will allow Moon to forego principal payments until the end of Year 3 (and borrow at the same 6% pre-tax interest rate). That is, the loan will be unamortized. How much would Moon have to be able to borrow on these terms for the company to be indifferent between these two loan offers? Part IV For Questions 18, 19, and 20, indicate whether or not the evidence described suggests that the market is inefficient. If so, indicate whether the inefficiency is at the level of weak form, semi-strong form or strong form. Question 18 5 pts Stocks of companies with unexpectedly high earnings appear to offer high excess returns for several months after the earnings announcement. Question 19 5 pts Corporate managers make excess returns when they buy stock in their own companies. (Subject to certain constraints, it is legal for them to do so.) Question 20 5 pts There is a positive correlation between the return on the S&P 500 stock index in one quarter (3-month period) and the change in the aggregate corporate profits for these companies in the next.