JRE300 FALL 2020 Final Exam - Quercus

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University of Toronto Faculty of Applied Science and Engineering and Rotman School of Management JRE 300H1F – Foundations of Accounting and Finance Final Examination, Fall 2020 Duration: 2.5 hours Please answer all questions on this exam paper. Instructions: • Handwrite your solutions on paper • Submit your solutions to Quercus by taking one picture per page • Submit your ID verification as per instructions Question Grade 1. Multiple Choice /12 2. Project Evaluation /20 3. Time Value of Money /10 4. Bonds /8 5. Cost of Capital/Project Evaluation /20 6. Capital Structure /20 7. Risk Management: Hedging /10 Total : /100

1. MULTIPLE CHOICE (12 MARKS) – SELECT THE BEST ANSWER (2 MARKS EACH) 1. Maple Ltd. has 1 million common shares outstanding. The beta on these common shares is 1.25, and they are trading at a price of $20 per share. Maple paid a dividend of $1.75 per share last year. Analysts anticipate that these dividends will grow at an average annual rate of 2% for the foreseeable future. What is the component cost of new common equity if Maple’s tax rate is 35% and flotation costs on new common equity are 6% before tax? a) 10.93% b) 11.11% c) 11.29% d) 11.49% 2. Tassone Co. recently paid a dividend of $1.25 on its common shares. Dividends are expected to grow at a constant rate of 3%. Investors require a 12% return on Tassone ’s common shares. Today, Tassone ’s CEO announced that the next dividend (to be paid next year) would be only $0.90. This announcement, along with other market conditions, caused investors to reassess Tassone ’s risk, resulting in an increase in their required return to 15% and a reduction of the expected future growth rate of dividends to 1.2%. What would likely happen to the value of Tassone ’s commo n shares following this announcement? a) A decline of $4.73 per share b) A decline of $7.37 per share c) A decline of $7.71 per share d) A decline of $7.79 per share 3. The CFO of Vincent Inc. has gathered the following information: Selling price per unit is $2,000 and variable costs per unit sold are $1,400. During the year, 10,000 units were sold. Net income for the year was $1,225,000. Income taxes for the year were $525,000 and interest expense was $750,000. By how much will operating income increase if sales increase by 10%? a) 27% b) 24% c) 21% d) 18%

4. It is currently the end of 2020, and Vovk Inc. expects to pay dividends as follows: $1.50 in 2021, $2.25 in 2022 and $3.00 in 2023. Dividends are expected to grow at 3% each year thereafter. The current required cost of equity for Vovk common shares is 12%. What is Vovk ’s current share price? a) $23.06 b) $27.09 c) $29.71 d) $39.06 5. Consider the following cash flows for the following projects: Project A: Initial investment = $3,300; Year 1 = $2,000; Year 2 = $1,500; Year 3 = $2,000 Project B: Initial investment = $5,000; Year 1 = $0; Year 2 = $4,500; Year 3 = $5,000 Which of Project A and Project B should you accept if they are mutually exclusive and the required rate of return is 25%? a) Neither project b) Project A c) Both projects d) Project B 6. Selena Corp. has 200,000 common shares outstanding with a book value of $20 per share and a current market price of $30 per share. Selena recently paid a dividend of $2.00 per share that is expected to grow at a rate of 4% for the foreseeable future. Selena also has bonds outstanding with a face value of $5,000,000. The bonds have a coupon rate of 8%, payable semi- annually, and they mature in three years. The bonds currently have a YTM of 7%. Selena’s income tax rate is 20%. Flotation costs will be 3% after tax for new debt issues and 5% before tax on common shares. What is Selena’s weighted average cost of capital ? a) 6.55% b) 8.20% c) 9.09% d) 8.71%

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2. PROJECT EVALUATION (20 MARKS) Kerry Company manufactures three different models of paper shredders including the waste container, which serves as the base. Although each model uses a different shredder head, the waste container is the same. The number of waste containers that Kerry will need during the next five years is estimated as follows: 2021 - 50,000 2022 - 50,000 2023 - 52,000 2024 - 55,000 2025 - 55,000 The equipment used to manufacture the waste container must be replaced because it has broken and cannot be repaired. The new equipment would have a purchase price of $715,000 with terms of 2/10, n/30; company policy is to take all purchase discounts. The freight on the equipment would be $11,000, and installation costs would total $22,900. The equipment would be purchased in December 2020 and be placed into service on January 1, 2021. It would have a five-year economic life. This equipment is expected to have a salvage value of $12,000 at the end of its economic life in 2025. The new equipment would be more efficient than the old equipment, resulting in a 25% reduction in both direct materials and variable overhead. The savings in direct materials would result in an additional onetime decrease in working capital requirements of $2,500 due to a reduction in direct materials inventories. This working capital reduction would be recognized at the time of equipment acquisition. The old equipment is fully depreciated and is not included in the fixed overhead. The old equipment from the plant can be sold for a salvage amount of $1,500. Kerry has no alternative use for the manufacturing space at this time, so if the waste containers are purchased, as discussed next, the old equipment would be left in place. Rather than replace the equipment, one of Kerry's production managers has suggested that the waste containers be purchased. One supplier has quoted a price of $27 per container. This price is $8 less than Kerry's current manufacturing cost, which is as follows: Direct materials $10 Direct labor 8 Variable overhead Fixed costs: 6 Supervision $2 Facilities 5 General 4 11 Total manufacturing cost per unit $35 Kerry employs a plantwide fixed overhead rate (i.e. an allocation rate) in its operations. If the waste containers are purchased outside, the salary and benefits of one supervisor, included in the fixed overhead at $45,000, would be eliminated. There would be no other changes in the other cash and noncash items included in fixed overhead, except depreciation on the new

equipment. Kerry is subject to a 40% income tax rate. Management assumes that all annual cash flows and tax payments occur at the end of the year. Assume the WACC is 12%. Required Kerry Company must decide whether to purchase the waste containers from an outside supplier or to purchase the equipment to manufacture the waste containers. Calculate the NPV of the estimated after-tax cash inflows at December 31, 2020, and determine which of these two options to pursue. Assume that the equipment is a class 8 asset - 20%.

3. TIME VALUE OF MONEY (10 Marks) Sarah is celebrating her 35th birthday today and wants to start saving for her anticipated retirement at age 65. She wants to be able to withdraw $15,000 from her savings account on each birthday for 12 years following her retirement; the first withdrawal will be on her 66th birthday. Sarah intends to invest her money in the local credit union which offers 9% interest per year. She wants to make equal, annual payments on each birthday into the account. a) If Sarah starts these deposits on her 36th birthday and continues to make deposits until she is 65 (the last deposit will be on her 65th birthday), what amount must she deposit annually to be able to make the desired withdrawals at retirement? (4 marks) b) Suppose Sarah has just inherited a large sum of money. Rather than make equal annual payments, she has decided to make one lump-sum deposit on her 36th birthday to cover her retirement needs. What amount would she have to deposit? (2 marks) c) Suppose Sarah contributes $250 per year into the account as part of the company's profit sharing plan. In addition, she expects to inherit $10,000 on her 55th birthday. What amount must she deposit annually to be able to make the desired withdrawals at retirement? (4 marks)

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4. BONDS (8 Marks) For this question, assume the current 1-year to 3-year discount rates are r1 = 7%, r2 = 7.5%, and r3 = 8%. Use these rates to compute the value of the bonds in question a) below. a) Assume there are three annual coupon bonds with maturity of 1 year, 2 years and 3 years, respectively. All three bonds are currently trading in the market at a price of $1,000, which is the same as their face value. Compute the “yield to maturity” for the 2 -year and 3-year bonds. (6 marks) b) Define what is meant by 'credit spread' for a bond? What does it represent for investors? In general, how do credit spreads affect bond prices? (2 marks)

5. COST OF CAPITAL/PROJECT EVALUATION (20 Marks) Part A (6 Marks) In 2020, United Inc. had A-rated, five-year bonds outstanding with a yield to maturity of 4.15%. At the time, similar maturity Treasuries had a yield of 1.5%. • If United's bonds were risk-free, what is your estimate of the expected return for these bonds? • If you believe United's bonds have a 2% chance of default per year and that the expected loss rate in the event of default is 45%, what is your estimate of the expected return of these bonds? Part B (6 Marks) You would like to estimate the WACC for a new semiconductor business. Based on its industry asset beta, you have already estimated an unlevered cost of capital for the firm of 12%. However, the new business will be 40% debt-financed, and you anticipate its debt cost of capital will be 7% before tax. If its corporate tax rate is 35%, what is your estimate of its WACC? Part C (8 Marks) Firm ABC is considering a new project with a $7.5 million initial outlay. The project will generate after‐tax (year‐end) cash flows of $2.25 million for four years. The firm has a debt ‐ to ‐equ ity ratio of 0.50. It has an equity beta of 0.85. The expected return on the market is 6% and the risk‐ free rate is 1%. The before‐tax cost of debt is 3.5%. The corporate tax rate is 35%. The project has the same risk as the overall firm. Calculate the NPV. Should ABC accept the project?

6. COST OF CAPITAL/CAPITAL STRUCTRE (20 Marks) Clarkson Commerce (CC) is considering expanding into new geographic markets. The expansion will have the same business risk as CC's existing assets. The expansion will require an initial investment of $38 million and is expected to generate perpetual EBIT of $15 million per year. After the initial investment, future capital expenditures are expected to equal depreciation (assumed equal to CCA charges), and no further additions to net working capital are anticipated. CC's existing capital structure is composed of $350 million in equity and $350 million in debt (market values), with 5 million equity shares outstanding. The unlevered cost of capital is 12%, and CC's debt is risk free with an interest rate of 3%. The corporate tax rate is 40%, and there are no personal taxes. a. CC initially proposes to fund the expansion by issuing equity. If investors were not expecting this expansion, and if they share CC's view of the expansion's profitability, what will the share price be once the firm announces the expansion plan? (4 Marks) b. Suppose investors think that the EBIT from CC's expansion will be only $5 million. What will the share price be in this case? How many shares will the firm need to issue? (4 Marks) c. Suppose CC issues equity as in part b. Shortly after the issue, new information emerges that convinces investors that management was, in fact, correct regarding the cash flows from the expansion. What will the share price be now? Why does it differ from that found in part a? (6 Marks) d. Suppose CC instead finances the expansion with a $38 million issue of permanent risk- free debt. If CC undertakes the expansion using debt, what is its new share price once the new information comes out? Comparing your answer with that in part c, what are the two advantages of debt financing in this case? (6 Marks)

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7. RISK MANAGEMENT: HEDGING (10 Marks) Part A (5 Marks) You are the CFO of a Canadian based company that reports in Canadian currency. The firm is exposed to various uncertainties. What type of financial contract (i.e. with a symmetrical payoff profile) and position will you consider in order to reduce any risk exposure for the following situations? (Hint: Draw payoff diagrams.) a. Your firm will pay significant cash (costs) (denominated in foreign currency) 1 month from now from operations in Australia. b. Silver represents one of the largest input costs for one of your business units. Your internal forecast suggests silver prices to significantly increase over the next year. You plan to purchase silver for your operations at market prices. Part B (2.5 Marks) You own a call option on ABC stock with a strike price of $10. The option will expire in exactly three months' time. a. If the stock is trading at $16 in three months, what will be the payoff of the call? b. If the stock is trading at $8 in three months, what will be the payoff of the call? c. Draw a payoff diagram showing the value of the call at expiration as a function of the stock price at expiration. Part C (2.5 Marks) You own a put option of XYZ stock with a strike price of $20. The option will expire in exactly six months' time. a. If the stock is trading at $12 in six months, what will be the payoff of the put? b. If the stock is trading at $28 in six months, what will be the payoff of the put? c. Draw a payoff diagram showing the value of the put at expiration as a function of the stock price at expiration.

JRE300 FALL 2020 Final Exam - Quercus

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