FINA 395, Section BB Final Exam, Winter 2017
Concept Questions (20 marks)
Q1. A company is contemplating a long-term bond issue. It is debating whether to include a call provision. What is a call provision and what are the benefits to the company from including a call provision? What are the costs? How do these answers change for a put provision?
Q2. What are sources of possible synergy in mergers & acquisitions?
Q3. What factors determine the beta of a stock? Briefly define and describe each.
Q4. Can the cost of debt be higher than the cost of equity? If yes, when might this happen? If not, does it follow that the cost of capital will always decrease as a
Q5. Diversification is good for shareholders. So why shouldn’t managers acquire firms in different industries to diversify a company?
Q6. The value of synergy is estimated by the equation:
- a) VA + VB – D
- b) VAB – VA – VB.
- c) VAB – VB – Taxes.
- d) VA – VB – D
Q7. Under financial leases, which of the following ratio is higher compared with that for an operating lease:
- a) current ratio
- b) leverage ratio
- c) NI margin
- d) ROE
Q8. Which of the following is not a defensive tactic in a hostile takeover?
- a) A poison pill
- b) Selling the crown jewels
- c) Finding a white knight
- d) Cooperating with the acquirer
Q9. Which of the following firms below is the most likely to raise debt in the capital market?
- a) A profitable firm that has a risky underlying business.
- b) A large and profitable firm with stable earnings and cash from operations.
- c) A less profitable firm that has a non-risky business and cyclical cash flows.
- d) A small firm that has seen its share price decrease in the past.
Q10. Which of the following firms is a growth firm?
- a) ROE > Ke
- b) ROE < Ke
- c) ROE = Ke
- d) Net Income = Ke
where, Ke=required rate of return by common shareholders
Problem solving (40 marks)
|Cash 100||Debt 900|
|PP&E 1500||Equity 700|
|Total Assets 1600||Total D&E 1600|
Q1. Maritime Cruise Line currently has the following balance sheet (in millions of dollars):
Maritime is about to add a new fleet of cruise ships. The price of the fleet is 400 million. What will Maritime’s balance sheet and debt-equity ratio look like if (a) it purchases the fleet by borrowing the $400 million, (b) it acquires the fleet through a $400 capital lease, or (c) it acquires the fleet through an operating lease?
Q2. Dorval Inc., is a firm with a debt-to-equity ratio of 1 to 3. The beta of common stock is 1.15, the market-risk premium (MRP) is 10 percent and the risk-free rate is 5 percent. The corporate tax rate is 35% and the company expects to pay 9% on its debt.
If a new project of the company has the same risk as the overall firm, what is the weighted average cost of capital (WACC) on the project?
Q3. One of Alcan’s plants sells a custom product at $1,650, with a per unit cost of $1,400. The plant manager has two suggestions to increase production by 500 units per year.
In the first option, the engineering team has submitted a proposal to install new machinery for an additional $500,000. The second choice is to use the plant’s existing equipment but hire an additional person at $30,000 per year. The cost of capital is 11%. Assume a tax rate of 33 %.
Which option has the higher EVA?
Q4. Delta Communication Corporation has a $100 million, 12 percent, annual coupon bond outstanding with 10 years remaining to maturity. The bond has a call provision that permits the company to retire the issue by calling in the bonds at an 8 percent call premium. Investment bankers have assured Delta Corp. that it could issue an additional $100 million of new 10 percent coupon, 10-year bonds that pay interest annually. Flotation costs on the new refunding issue will amount to $4 million. Predictions that are that long-term interest rate are unlikely to fall below 10 percent. Delta’s marginal tax rate is 40 percent.
Should the company refund the $100 million of 12 percent annual coupon bonds? (Hint: call premium is not a tax-deductible expense).
Q5. An all- equity firm is considering the following projects:
The T-bill rate is 5%, and the expected return on the market portfolio is 11%. The firm’s overall cost of capital (WACC) is 11%.
- Which projects should be accepted according to CAPM?
- Which projects would be incorrectly accepted or rejected if the firm’s overall cost of capital used as a hurdle rate?
Q6. Super Computers, Ltd., has been approached to supply a three-year lease on a $3,000,000 piece of equipment. The equipment is in class 8, the CCA rate is 20%, and the equipment has a useful economic life of three years, Super Computers’ marginal tax rate is 30%, its before-tax required return on debt-type investments is 12.857%, and no salvage value is assumed. What lease rate (L) will Super Computers quote if the yearly payments are made in advance?
Q7. You are analysing a valuation done on stable firm by a well-known analyst. Based on the expected free cash flow to the firm (FCFF), next year, of $30 million, and an expected growth rate of 5%, the analyst has estimated a value of $750 million. However, he has made the mistake of using the book values of debt and equity in his calculation. Although you do not know the book value weights he used, you know that the firm has a cost of equity of 12% and an after-tax cost of debt of 6%. You also know that the market value of equity is three times the book value of equity, while the market value of debt is equal to the book value of debt. Estimate the correct value of the firm.
Q8. You have been hired as a capital budgeting analyst by a sporting goods firm that manufactures athletic shoes and has captured 10% of the overall market. (The total market is worth $100 million a year). The fixed cost associated with manufacturing these shoes is $2 million a year, and variable costs are 40% of revenues. The company’s tax rate is 40%. The firm believes that it can increase its market share to 20% by investing $10 million in a new distribution system (which can be depreciated over the system’s life of 10 years to a salvage value of zero) and spending $1 million a year in additional advertising. The company proposes to continue to maintain working capital at 10% of annual revenues. The discount rate to be used for this project is 8%.
What is the NPV of this project?
Q9. Marvellous Mining Company expects an EBIT of $19,750 every year. Marvellous Mining currently has no debt and its cost of equity is 15%. The firm can borrow at 10%. If the corporate tax is 35%:
- what is the value of the firm?
- What will the value be if Marvellous Mining converts to 50% debt?
Q10.Atlantic Transportation Co. has a payout ratio of 60%, debt-equity ratio of 50%, return on equity (ROE) of 16%, and capital intensity ratio (or asset-sales ratio) of 175%. What must its profit margin be in order to achieve its sustainable growth rate (SGR)?
Mini Cases (40 marks)
Case #1: Mergers & Acquisitions (20 marks)
Apple Juice Inc. is considering making an offer to purchase Jungle Juice Corp. Apple Juice‘s Vice President of finance has collected the following information:
|Apple Juice||Jungle Juice|
Apple Juice also knows that securities analysts expect the earnings and dividends of Jungle Juice t grow at a constant rate of 4% each year. Apple Juice management believes that the acquisition of Jungle Juice will provide the firm with some economies of scale that will increase this growth rate to 6% per year.
- What is the value of Jungle Juice to Apple Juice?
- What would Apple Juice’s gain be from this acquisition?
- If Apple Juice were to offer $20 in cash for each share of Jungle Juice, what would the NPV of the acquisition be?
- What is the most Apple Juice should be willing to pay in cash per share for the stock of Jungle Juice?
- If Apple Juice were to offer 225,000 of its shares in exchange for the outstanding stock of Jungle Juice, what would the NPV be?
- Should the acquisition be completed? If so, should it be as in (c) or as in (e)?
- Apple Juice’s outside financial consultants think that 6% growth rate is too optimistic and a 5% rate is more realistic. How does this change your previous answers?
Case #2: Leasing (10 marks)
Suppose Procter and Gamble (P&G) is considering purchasing $15 million in new manufacturing equipment. If it purchases the equipment, it will depreciate it on a straight-line basis over the five years, after which the equipment will be worthless. It will also be responsible for maintenance expenses of $1 million per year. Alternatively, it can lease the equipment for $4.2 million per year for the five years, in which case the lessor will provide necessary maintenance. Assume P&G’s tax rate is 35% and its borrowing cost is 7%.
- What is the NPV associated with leasing the equipment versus financing it with the lease equivalent loan?
- What is the break-even lease rate—that is, what lease amount could P&G pay each year and be indifferent between leasing and financing a purchase?
Case #3: Sensitivity & Break-even Analysis (10 marks)
You are evaluating a project that costs $724,000, has an eight-year life, and has no salvage value. Assume that depreciation is straight-line to zero over the life of the project. Sales are projected at 75,000 units per year. Price per unit is $39, variable cost per unit is $23, and fixed costs are $850,000 per year. The tax rate is 35%, and you required a 15% return on this project.
- Calculate the accounting break-even point.
- Calculate the base-case cash flow and NPV. What is the sensitivity of NPV to changes in the sales figure? Explain what your answer tells you about a 500-unit decrease in projected sales.
- What is the sensitivity of OCF to changes in the variable cost figure? Explain what your answer tells you about a $1 decrease in estimated variable costs.