Final Exam 2011/1
MGT3004 Financial Management
Prof. Ahn
Name:
Student ID:
- There are 10 questions: 4 points each and total score is 10*4=40 points
- Please show your calculation procedure with answers in the space below the question.
1. An investment offers a 10.5 percent total return (nominal return) over the coming year.
Sam Bernanke thinks the real return on this investment will be only 4.5 percent. What does
Sam believe the inflation rate will be for the next year?
(1 + 0.105) = (1 + 0.045)  (1 + h); h = 5.74 percent
2. Southern Utilities just issued some new preferred stock. The issue will pay a $19 annual
dividend in perpetuity beginning 9 years from now. What is one share of this stock worth
today if the market requires a 7 percent return on this investment?
A. $157.97
B. $164.16
C. $189.08
D. $241.41
E. $271.43
A.
3. Consider the following two mutually exclusive projects:
Evaluate the above projects with NPV, IRR, and PI techniques and make investment decision.
If there is conflict among decision criteria, explain why you have to use one technique over
other techniques.
NPV provides then most clear valuation impact of the project selection. Thereby, if there is
conflict with other decision criteria, you should rely on NPV.
4. You are considering a new product launch. The project will cost $630,000, have a 5-year
life, and have no salvage value; depreciation is straight-line to zero. Sales are projected at 160
units per year, price per unit will be $24,000, variable cost per unit will be $12,000, and fixed
costs will be $283,000 per year. The required return is 11 percent and the relevant tax rate is
34 percent. Based on your experience, you think the unit sales, variable cost, and fixed cost
projections given here are probably accurate to within 9 percent. What is the worst case
NPV?
A. $3,417,907
B. $2,654,241
C. $888,618
D. $3,102,134
E. $3,458,020
Unit salesWorst = 160 (1 - 0.09) = 145.6 units
Variable cost per unitWorst = $12,000 (1 + 0.09) = $13,080
Fixed costsWorst = $283,000 (1 + 0.09) = $308,470
OCFWorst = [($24,000 - $13,080)(145.6) - $308,470][1 - 0.34] + 0.34($630,000/5) =
$888,618.12
5. Suppose you observe the following situation:
Assume these securities are correctly priced. Based on the CAPM, what is the return on the
market (market expected return or expected return on the market portfolio)?
Rf : (0.12 - Rf)/0.8 = (0.16 - Rf)/1.1; Rf = 1.33 percent
RM: 0.12 = 0.0133 + 0.8(RM - 0.0133); RM = 14.67 percent
6. Jake’s Sound Systems has 210,000 shares of common stock outstanding at a market price
of $36 a share. Last month, Jake’s paid an annual dividend in the amount of $1.593 per share.
The dividend growth rate is 4%. Jake’s also has 6,000 bonds outstanding with a face value of
$1,000 per bond. The bonds carry a 7 % coupon, pay interest annually, and mature in 4.89
years. The bonds are selling at 99% of face value. The company’s tax rate is 34%. What is
Jake’s weighted average cost of capital?
Debt: 6,000  $1,000  .99 = $5.94m
Common:
210,000  $36 = $7.56m
Total = $5.94m + $7.56m = $13.50m
Re = [($1.593  1.04)  $36] + .04 = .08602
990
70
1000
I/Y
PV
PMT
FV
Solve for
7.250
$
7
.
56
m

  $5.94m

WACC  
 .08602   
 .07250  (1  .34)   .04817  .02105  .06922 =
 $13.50m
  $13.50m

6.9%
Enter
4.89
N
7. Explain “homemade leverage” and why unlevered firm value shall be the same as levered firm
value under perfect capital market (e.g. when there is no tax, no bankruptcy costs, and the
borrowing rate is the same for corporation and individual investors). You can use an example
comparing cash flows to investors in two companies otherwise identical except for the capital
structure.
Homemade leverage is the ability of investors to alter their own financial leverage to achieve a
desired capital structure no matter what a firm’s capital structure might be. If investors can use
homemade leverage to create additional leverage or to undo existing leverage of the firm at their
discretion then the actual capital structure decision of the firm itself becomes irrelevant.
And, students can explain this with example in our lecture notes.
8. New Schools, Inc. expects an EBIT of $7,000 every year forever. The firm currently has
no debt, and its cost of equity is 17 percent. The firm can borrow at 8 percent and the
corporate tax rate is 34 percent. What will the value of the firm be if it converts to 50 percent
debt?
A. $29,871.17
B. $31,796.47
C. $32,407.16
D. $34,552.08
E. $37,119.30
VU = $7,000 (1 - 0.34)/0.17 = $27,176.47
VL = $27,176.47 + 0.34 (0.50) ($27,176.47) = $31,796.47
Note: When levered, the value of debt is equal to one-half of the unlevered value of the firm.
9. Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at
11 percent. Bruce currently has no debt, and its cost of equity is 18 percent. The tax rate is 31
percent. Bruce will borrow $61,000 and use the proceeds to repurchase shares. This
recapitalization, however, will increase the possibility of bankruptcy. The present value of
expected bankruptcy costs is estimated to be 10% of unlevered firm value.
(1) What is the net effect of debt financing?
(2) What will be the value of the firm if you consider both tax and bankruptcy cost.
(3) What will be your recommendation regarding current capital structure of the firm?
VU = $100,000(1 - 0.31)/0.18 = $383,333.33
Net effect of the firm = 0.31($61,000) -0.1*383,333.33 = -$19,423.3
VL = $383,333.33 + 0.31($61,000) -0.1*383,333.33 = $363,910
Therefore, you recommend to reduce debt.
It gets to the essence of capital structure theory: the firm trades off higher equity costs for
lower debt costs. The shareholders benefit, to a point, because their investment in the firm is
leveraged, enhancing the return on their investment. Thus, even though the cost of equity
rises, the overall cost of capital declines to a point (due to tax benefit) and firm value rises.
Beyond the point, the financial distress costs increase cost of debt and cost of equity, thus
WACC and firm value declines.
10. Atlas Corp. wants to raise $4 million via a rights offering. The company currently has
450,000 shares of common stock outstanding that sell for $40 per share. Its underwriter has
set a subscription price of $26 per share and will charge the company a 7 percent spread.
Assume that you currently own 7,200 shares of stock in the company and decide not to
participate in the rights offering. How much can you get for selling all of your rights?
A. $24,911.21
B. $25,362.84
C. $25,792.19
D. $26,414.14
E. $27,094.95
Net proceeds to firm = $26 (1 - 0.07) = $24.18
New shares offered = $4m/$24.18 = 165,425.97
Number of rights needed per share = 450,000/165,425.97 = 2.72025
PEx = [$26 + 2.72025($40)]/(1 + 2.72025) = $36.24
Right value = $40 - $36.24 = $3.76
Sale proceeds = $3.76 (7,200) = $27,094.95