Final Exam Practice Questions

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Final Exam Practice Questions MCQ Questions 1. In the adjusted present value approach (APV), you value the firm without debt (unlevered firm value) and then bring in the effects of debt by considering the value of the tax benefits of debt and the expected bankruptcy costs. In practice, faced with difficulties when estimating expected bankruptcy cost, analysts choose to ignore it and consider only the tax benefit component of debt. If you consider only the tax benefits in your APV assessment, which of the following will you find to be your optimal debt ratio? a. 0% Equity, 100% debt b. 100% Equity, 0% Debt c. Equity > 0%, Debt < 100% d. Equity < 100%, Debt > 0% e. Debt will have no effect on value 2. You notice that an analyst has valued a firm (business) using the expected growth rate in earnings per share as the growth rate in operating income. What effect will this have on value? a. The analyst will over estimate the value b. The analyst will under estimate the value c. The analyst will get the value correct since the numerator and denominator will cancel each other out d. The analyst will get the value wrong, though it is difficult to figure out in which direction e. None of the above 3. You are an activist investor looking to put pressure on companies that have accumulated too much cash to return cash to stockholders. Which of the following companies would you put the most pressure on to return cash? (You can assume that they all have a cost of capital of 10% and an optimal debt ratio of 40%) a. Company A: ROC = 25%, Actual debt ratio = 40% b. Company B: ROC =25%, Actual debt ratio = 60% c. Company C: ROC = 25%, Actual debt ratio = 10% d. Company D: ROC = 5%, Actual debt ratio = 10% e. Company E: ROC =5%, Actual debt ratio = 60% 4. ES is an all-equity funded firm with 100 million shares outstanding, trading at $10/share. The company is planning on borrowing $400 million and buying back shares. The marginal tax rate for the firm is 40% and the cost of bankruptcy as a percent of unlevered firm value is 30%. If the new market capitalization for the firm will be $700 million, after the buyback, what is the probability of bankruptcy after the buyback? (Use the standard APV assumption about the tax benefits of debt) a. 0% b. 10% c. 18.18% d. 20% e. 28.57%

5. In the cost of capital approach, you estimate the cost of equity and the cost of debt at each debt ratio and the resulting cost of capital. As you increase the debt ratio, which of the following is most likely to happen? a. Cost of equity and cost of debt will both decrease b. Cost of equity and cost of debt will both increase c. Cost of equity will go down but the cost of debt will go up d. Cost of equity will go up and the cost of debt will remain unchanged e. Cost of equity will go up but the cost of debt will go down 6. Assume that you run a phone company, and that you have historically paid large dividends. You are now planning to enter the telecommunications and media markets. Which of the following paths are you most likely to follow? a. Courageously announce to your stockholders that you plan to cut dividends and invest in the new markets. b. Continue to pay the dividends that you used to, and defer investment in the new markets. c. Continue to pay the dividends that you used to, make the investments in the new markets, and issue new stock to cover the shortfall d. Other 7. Assume that you are comparing the dividend payout ratios of computer software companies and have run a regression of payout ratios on expected growth in earnings per share: Dividend Payout ratio = 0.60 – 1.5(Expected growth rate) (Thus, with an expected growth rate of 20%, your expected payout ratio would be 30% = .6+1.5(.2) = .3) If a company pays no dividends, how high would its growth rate need to be to justify this policy? a. 0% b. 20% c. 40% d. 80% e. None of the above 8. The objective in corporate finance is to maximize the value of the business. In the standard cost of capital approach to financing, we argue that the optimal debt ratio is the one that minimizes the cost of capital. For this approach to yield the optimal, which of the following assumptions do you need to make? a. The bond rating of the firm will not change as the debt ratio changes b. The operating income of the firm will not change as the debt ratio changes c. The net income for the firm will not change as the debt ratio changes d. The beta will not change as the debt ratio changes e. None of the above

9. DASA Inc. is an apparel manufacturer with 200 million shares outstanding, trading at $15/share and $1.2 billion in debt outstanding (in market value terms). If the marginal tax rate for the firm is 40%, the cost of bankruptcy is 20% of current firm value and the probability of bankruptcy at the current debt level is 25%, what is the unlevered value of the firm? a. $2,670 million b. $3,930 million c. $4,200 million d. $4,470 million e. None of the above 10. Dividends, at least for US companies, are often describe d as “sticky”. Which of the following do we mean when we say that dividends are sticky? a. Companies are reluctant to pay dividends b. Companies are reluctant to change dividends per share c. Companies are reluctant to change dividend payout ratios d. Companies are reluctant to change dividend yield e. None of the above 11. Valley Software is a technology company and is expected to report after-tax operating income of $1 billion next year, earned on an invested capital base of $10 billion. The company is expected to grow 1% a year in perpetuity and has a cost of capital of 9%. The firm wants to double its growth rate in perpetuity, while maintaining its current return on capital. How much will the value of its operating assets change in dollar terms? a. Decrease value b. No change c. $178.57 million d. $1607.14 million e. $1785.71 million 12. When you use relative valuation, you are trying to price assets based upon what similar assets are being priced at. In comparing across these assets, which of the following do you have to do? a. Find similar or comparable assets, with trading prices b. Standardize the prices to a common variable available for all assets c. Control the standardized prices for differences across the assets d. All of the above e. None of the above

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13. Assume that Disney owns land in Rio already. This land is undeveloped and was acquired several years ago for $ 5 million for a hotel that was never built. Disney is now contemplating building a theme park in Rio. It is anticipated, if this theme park is built, this land will be used to build the offices for Disney Rio. The land currently can be sold for $ 40 million, though that would create a capital gain (which will be taxed at 20%). In assessing the theme park, which of the following would you do and why? a. Ignore the cost of the land, since Disney owns it already b. Use the book value of the land, which is $ 5 million c. Use the market value of the land, which is $ 40 million d. The cost of the land of $ 5 million or its market value of $ 40 million can be used e. Other 14. If you are valuing a business where you expect financial leverage to change over time, it is generally easier to value the business and net out debt to get to equity value than it is to value equity directly (by discounting equity cash flows at the cost of equity). Why? a. Because the cash flows to equity cannot be estimated when the debt ratio is changing b. Because the cost of capital is not affected by changing financial leverage c. Because the cost of equity is not affected by changing financial leverage d. Because the cash flows to the firm are unaffected by changing financial leverage e. None of the above 15. Boom Networks is a high growth publicly traded firm that is expected to become a stable growth firm after 5 years. You have estimated an expected after-tax operating income of $60 million in year 6 and believe that the firm will generate a return on capital of 12% in perpetuity. If the cost of capital is 10% and the expected growth rate in perpetuity after year 5 is 3% what will the terminal value be at the end of year 5? a. $857.14 million b. $666.67 million c. $642.86 million d. $450 million e. None of the above 16. A cost that has already been paid, or the liability to pay has already been incurred, is a(n): a. Salvage value expense. b. Net working capital expense. c. Opportunity cost. d. Erosion cost. e. Sunk cost.

17. Bust Inc. reported after-tax operating income of $50 million in the most recent year. At the start of the year, the company reported book value of equity of $400 million, book value of debt of $250 million and a cash balance of $150 million. The company also reported capital expenditures of $75 million, depreciation of $30 million and a decrease in non-cash working capital of $5 million. Assuming that it plans to maintain its current return on invested capital and reinvestment rate, what is the expected growth in operating income? a. 6.15% b. 8.00% c. 13.33% d. 10.00% e. None of the above 18. PK Properties purchased a warehouse for $1.6 million ten years ago. Four years ago, the company repaired the roof at a cost of $220,000. Last year, the electrical wiring and lights were upgraded at a cost of $134,000. The annual taxes on the property are $28,500 and the rental income is $170,000. The warehouse has a current book value of $800,000 and a market value of $1.95 million. The property is totally debt-free. PK is considering converting the building into a discount retailer of bulk goods. The cost of the conversion would be $95,000 and could be started next month when the existing lease on the building expires. When analyzing the bulk goods option, what value should PK assign as the initial cost of the project and why? a. $95,000 b. $895,000 c. $1,249,000 d. $2,045,000 e. $2,215,000 19. Your company currently sells oversized golf clubs. The Board of Directors wants you to look at replacing them with a line of supersized clubs. Which of the following is NOT relevant? a. A reduction in revenues of $300,000 from terminating the oversized line of clubs. b. Land you own with a market value of $750,000 that may be used for the project. c. $200,000 spent on research and development last year on oversized clubs. d. $350,000 you will pay to Fred Singles to promote your new clubs. e. $125,000 you will receive by selling the existing production equipment which must be upgraded if you produce the new supersized clubs.

20. Which of the following describe(s) relevant cash flows for the purpose of performing capital budgeting analysis? I. Cash flows must be incremental II. Cash flows must be after-tax III. NI + D IV. Additions to net working capital a. I and III only b. I, II, and III only c. I and IV only d. II, III, and IV only e. I, II, III, and IV

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Short Answer Type Question (Please note that short answer questions will be converted to multiple choice questions) S1 : List five underlying assumptions being made when relative valuation is being used? Problems (Please note that problems will be converted to multiple choice questions) P1 : You are trying to value Ask Inc., a small, publicly traded manufacturing company. The firm generated $10 million in after-tax operating income in the most recent year on revenues of $ 80 million; the invested capital (book value) at the start of the year was $100 million. The firm is expected to maintain its existing return on capital in perpetuity. Capital expenditures in the most recent year amounted to $12 million, depreciation was $5 million and non-cash working capital increased from $6 million to $8 million during the course of the year. The firm is expected to have a 12% cost of capital for the next 5 years and 8% thereafter. a. Assuming that Ask maintains the reinvestment rate that it posted in its most recent year for the next 5 years, estimate the expected free cash flows to the firm each year for the next 5 years. b. At the end of year 5, Ask Inc. is expected to be a stable growth firm, growing 3% a year in perpetuity. Estimate the terminal value (the value at the end of year 5). c. Finally, assume that Ask Inc. has a cash balance of $15 million, debt outstanding (in book and market terms) of $40 million and 8 million shares outstanding, estimate the value per share. P2 : Lev Inc. has approached you for advice on its capital structure. Lev Inc. has debt outstanding of $12.14 billion (trading at par) and equity outstanding of $20.55 billion. The firm has EBIT of $1.7 billion and faced a corporate tax rate of 36%. The beta for the stock is 0.84, and the bonds are rated A – (with a market interest rate of 7.5%). The probability of default for A – rated bonds is 1.41%, and the bankruptcy cost is estimated to be 30% of firm value. a. Estimate the unlevered value of the firm. b. Value the firm, if it increases its leverage to 50%. At that debt ratio, its bond rating would be BBB and the probability of default would be 2.30%. c. If Lev Inc. has investment needs of 0.50 billion and is expected to finance these needs at the current capital structure, what is the maximum amount it can distribute back to its shareholders? d. Assume now that Lev Inc. is considering a move into entertainment, which is likely to be both more profitable and riskier than the phone business. What changes would you expect in the optimal leverage?

P3 : You are helping a bookstore decide whether it should open a coffee shop on the premises. The details of the investment are as follows: • The coffee shop will cost $5,000,000 to open; it will have a five-year life and be depreciated straight line over the period to a salvage value of $1,000,000. • The sales at the shop are expected to be $1,500,000 in the first year and grow 10% a year for the following four years. • The operating expenses will be 50% of revenues. • Net working capital amounting to 5 % of revenues has to be maintained; investments in working capital are made at the beginning of each year. • The tax rate is 40%. • Cost of Capital is 12%. The coffee shop is expected to generate additional sales of $2,000,000 next year for the book shop, and the pretax operating margin on book sales is 40%. These sales will grow 20% a year for the following four years. a. Estimate the NPV of the coffee shop without the additional book sales. b. Estimate the present value of the cash flows accruing from the additional book sales. Would you open the coffee shop? P4 : Wiley Inc. reported EBITDA of $ 1,290 million in a recent financial year, prior to interest expenses of $ 215 million and depreciation charges of $ 400 million. Capital expenditures amounted to $ 450 million during the year, and working capital was 7% of revenue (of $ 13,500 million). The firm had debt outstanding of $ 3.068 billion (with a market capitalization of 3.2 billion) and yielding a pre-tax interest rate of 8%. There were 62 million shares outstanding, trading at $ 64/share, and the most recent Beta is 1.10. The tax rate for the firm is 40%, and the treasury bond rate is 7%. The firm expects revenues, earnings, capital expenditures and depreciation to grow at 9.5%/year for the next 5 years, after which the growth rate will drop to 4%. The company plans to lower its debt/equity ratio to 50% for the steady state, which will result in the pre-tax interest rate dropping to 7.5%. The market risk premium is 5.5%. a. Estimate the value of the firm. b. Estimate the value of the equity in the firm and value/share. Other Information 1. Review textbook and lectures slides. EVA is not part of the final exam. 2. Review all practice questions (including final and quizzes practice questions)

3. Review suggested problems for the relevant chapters Answer Key 1. a. Since you are counting in the benefits of debt and are assuming no costs, debt can only increase value (The only exception is if you have a zero tax rate, in which case it will have no effect on value). 2. a. The growth in earnings per share will generally be higher than the growth in operating income, because it will be augmented both by financial leverage and reduction in share count (from buybacks). 3. d. An under levered company that takes bad projects has no business holding on to cash. It cannot claim that it needs the cash for great projects or as a buffer against a downturn (default). 4. d. Set up the equation for the value of the levered firm Value of levered firm = Value of unlevered firm + Debt * Tax Rate – Probability of bankruptcy * Cost of bankruptcy 700 + 400 = 100*10 + 400*.4 – Probability of bankruptcy(.3)(1000) Probability of bankruptcy = 60/300 = 20% 5. b, The latter will go up because you are borrowing more money and increasing your default risk. The cost of equity will increase because borrowing more money will create interest expenses, which, in turn, will make equity earnings more volatile. 6. d, Because the phone company has attracted a dividend clientele, they may not be swayed by the arguments that you need to cut dividends for your investment needs. It would be best to try to spin off the media division and allow it to set a different dividend policy. Investors who would prefer the capital gains will hold on to the media division shares and those who want the dividends will continue to hold the phone company shares. 7. c.

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To get an expected payout ratio of 0% 0 = .60 -1.5(X) X = .40 8. b. For a lower cost of capital to result in higher firm value, the operating cash flow of the firm will have to remain fixed (or unchanged) as the debt ratio changes. For operating cash flow to not change, operating income has to be fixed as the debt ratio changes. 9. b. The unlevered firm value can be obtained from the firm value by subtracting out the tax benefits of debt and adding back the expected bankruptcy costs (you will lose both when you have no debt) Value of levered firm = 3000 + 1200 Tax benefit = 1200*.4 Expected cost of bankruptcy = .25*.20*4200 = $210 Value of unlevered firm = 4200 – 480 + 210 = $3,930 million 10. b. Companies try to maintain their dividends per share over time. They change dividends infrequently, and when they do, it is more likely to be an increase than a decrease. 11. c. First, value the firm with an expected growth rate of 1%. Return on capital = 1000/10000= 10% g = Reinvestment rate * ROC ➔ Reinvestment rate = g / ROC = 1%/10% = 10% Value = FCFF/(r-g) = EBIT(1-T)*(1-Reinvestment Rate)/(r-g) Value = 1000(1-.10)/(.09-.01) = $11,250 million With a 2% growth rate Reinvestment rate = g / ROC = 2%/10% = 20% Value = 1000(1-.20)/(.09-.02)= $11,428.57 Change in value = $11,428.57 - $11,250 = $178.57 12. d. You have to find traded, similar companies, standardize prices to a common variable and adjust for differences across companies. 13. e.

40 – (20%*(40-5)) = $33 million. The opportunity cost of the land will be the expected proceeds from its sale less any capital gains taxes. Since there is a 20% capital gains taxes, they need to be subtracted. 14. d. 15. c. To compute the terminal value at end of year 5, you first have to estimate a reinvestment rate: • Reinvestment rate = 3%/12% = 25% • Terminal value = 60 (1-.25)/(.10-.03) = $642.86 million 16. e. 17. b. The keys are the reinvestment rate and return on invested capital: • ROIC = 50/(400+250 -150) = 10% • Reinvestment Rate = (75 -30-5)/50 = 80% (Decrease in WC reduces reinvestment) • Expected growth rate = 10%(.80) = 8% 18. d, 1,950,000+95,000 = 2,045,000. The only relevant costs to be included in the project analysis as initial cost of the project are the opportunity cost of the land (its current market value of 1.95 million) and the cost of converting the building (i.e. the $95K). 19. c. 20. e.

Short Answer Type Question S1 : a) The sector itself is, on average, fairly priced. b) The earnings of the firms in the group are being measured consistently. c) The firms in the group all have equal risk. d) The firms in the group are all at the same stage in the growth cycle. e) The firms in the group are of equivalent risk and have similar cash flow patterns. Problems P1 : Solution Current After year 5 EBIT (1-t) 10 Invested Capital 100 Net Cap Ex 7 =(12-5) Change in working capital 2 =(8 - 6) Return on capital = 10%= (10/100) 10% Reinvestment rate = 90%= ((7+2)/10) 30% (3%/10%) Expected growth rate = 9%= (90%*10%) 3% Cost of capital 12% 8% Year 1 2 3 4 5 Terminal year EBIT (1-t) $10.90 =(10*(1+9%)) $11.88 =(10.90 *(1+9%)) $12.95 = (11.88 *(1+9%)) $14.12 = (12.95 *(1+9%)) $15.39 =(14.12*(1+9%)) $15.85 =(15.39*(1+3%)) - Reinvestment $9.81 =90%*10.90 $10.69 =90%*11.88 $11.66 =90%*12.95 $12.70 =90%*14.12 $13.85 =90%*15.39 $4.75 =30%*15.85 FCFF $1.09 $1.19 $1.30 $1.41 $1.54 $11.09 Terminal value $221.87 =11.09/(8%-3%) Present value (@12%) $0.97 $0.95 $0.92 $0.90 $126.77 Value of operating assets = $130.51 + Cash $15.00 - Debt $40.00 Value of equity $105.51 / Number of shares 8.00 Value per share $13.19

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P2 : Solution a. The expected bankruptcy cost = .0141*(.30)*(12.14+20.55) = 0.1383b. The tax advantage to debt = 12.14(0.36) = 4.37b. Hence the unlevered firm value = 12.14 + 20.55 + 0.1383 - 4.37 = 28.46b. b. To estimate the firm value at a 50% debt ratio, we first compute the dollar debt at a 50% debt ratio using the current market values of debt and equity as the base. Dollar debt at 50% debt ratio = 0.5 (12.14+20.55) = $16.345 billion Tax benefits at 50% debt ratio = 16.345*.36 = $5.88 billion Expected bankruptcy cost = .023*(28.46+5.88)*30% = $0.79 billion Value of the firm = 28.46+5.88 - 0.24 = $34.58 billion c. Debt Ratio based on Current Capital Structure = 12.14 / (20.55+12.14) = 37.14% Net Income = (EBIT-Int)*(1-T) = (1.7-(12.14*7.5%))*(1-36%) = 0.51 FCFE = 0.51-(0.5*(1-37.14%)) = 0.20 billion d. Since the earnings will be more volatile, you’d expect the leverage ratio to be lower.

P3 : Solution a) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Investment (5,000,000) Revenue 1,500,000 1,650,000 1,815,000 1,996,500 2,196,150 - Operating Expenses (750,000) (825,000) (907,500) (998,250) (1,098,075) - Depreciation (800,000) (800,000) (800,000) (800,000) (800,000) EBIT (50,000) 25,000 107,500 198,250 298,075 Taxes (20,000) 10,000 43,000 79,300 119,230 EBIT(1-t) (30,000) 15,000 64,500 118,950 178,845 Depreciation 800,000 800,000 800,000 800,000 800,000 Change in WC (75,000) (7,500) (8,250) (9,075) (9,983) Working Capital Recovery 109,808 Salvage Value 1,000,000 After tax cash flows (5,075,000) 762,500 806,750 855,425 908,968 2,088,653 PVIF 1.0000 0.8929 0.7972 0.7118 0.6355 0.5674 Present Value (5,075,000) 680,804 643,136 608,875 577,665 1,185,158 NPV (1,379,363) b) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Additional Sales 2,000,000 2,400,000 2,880,000 3,456,000 4,147,200 Pretax Operating Margin 800,000 960,000 1,152,000 1,382,400 1,658,880 After tax Operating Margin 480,000 576,000 691,200 829,440 995,328 PVIF 0.8929 0.7972 0.7118 0.6355 0.5674 Present Value 428,571 459,184 491,983 527,124 564,776 NPV 2,471,638 Total NPV = -1,379,363 + 2,471,638 = 1,092,275. Since NPV is positive after considering the additional book sales, the owner shop open the coffee shop.

P4 Solution: HGP SGP Calc Value Calc Value D/E 3200/(62*64) 0.8065 Given 0.5000 Unlevered Beta 1.1/(1+((1-0.4)*.8065)) 0.7413 Same 0.7413 Levered Beta Given 1.1 .7413*(1+((1-0.4)*.5000)) 0.9637 Ke 0.07+1.1*0.055 0.1305 0.07+.9637*0.055 0.1230 Kd Given 8% Given 7.50% WACC (3968/(3968+3200))*.1305+(32 00/(3968+3200))*0.08*(1-0.4) 0.0937 (1/(1+0.5))*.1230+(0.5/(1+0.5)) *0.075*(1-0.4) 0.0970 a) Current Year 1 2 3 4 5 Terminal Year Year 5 Calc Revenues 13,500 14,782.50 16,186.84 17,724.59 19,408.42 21,252.22 22,102.31 19,408.42*(1+0.095) EBITDA 1,290 1,412.55 1,546.74 1,693.68 1,854.58 2,030.77 2,112.00 1,854.58*(1+0.095) Depreciation 400 438.00 479.61 525.17 575.06 629.70 654.88 575.06*(1+0.095) CapEx 450 492.75 539.56 590.82 646.95 708.41 736.74 646.95*(1+0.095) Working Capital 945 1,034.78 1,133.08 1,240.72 1,358.59 1,487.66 1,547.16 1,358.59*(1+0.095) EBIT 974.55 1,067.13 1,168.51 1,279.52 1,401.07 1,457.12 2,030.77-629.70 Taxes (40%) 389.82 426.85 467.40 511.81 560.43 582.85 0.4*1,401.07 EBIT(1-T) 584.73 640.28 701.11 767.71 840.64 874.27 1,401.07-560.43 Net CapEx 54.75 59.95 65.65 71.88 78.71 81.86 708.41-629.70 Change in WC 89.78 98.30 107.64 117.87 129.07 59.51 1,487.66-1,358.59 FCFF 440.21 482.02 527.82 577.96 632.87 732.90 840.64-78.71-129.07 Terminal Value 12,857.45 732.90/(.0970-.0400) Total CF 440.21 482.02 527.82 577.96 13,490.32 632.87+12,857.45 Discount Factor 0.9144 0.8360 0.7644 0.6990 0.6391 1/(1+.0937)^5 PV 402.50 402.99 403.48 403.97 8,621.67 13,490.32*.6391 b) Calculation Value of operating assets 10,234.62 402.50+402.99+403.48+403.97+8,62 1.67

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+ Cash & Cash Equiv 0 + Value of minority cross holdings 0 - MV of Debt outstanding 3,200 = Value of equity 7,034.62 10,234.62+.00+.00-3,200.00 - Value of equity options 0 - Minority interests 0 = Value of equity in common stock 7,034.62 7,034.62-.00-.00 / Number of shares 62 Value per share 113.46 7,034.62 / 62.00