Part 1
Question 1. (Total marks: 30)
Comfort Shoe Company has decided to spin off its Samba Dance
Shoe Division as a separate entity in the United Kingdom. The
assets of the Samba Dance Shoe Division have the same operating
risk characteristics as those of Comfort. The capital structure of
Comfort has been 40% debt and 60% equity in terms of market
values, and is considered by management to be optimal. The
required return on Comfort’s assets (if unlevered) is 16% per year,
and the interest rate that the firm (and the division) must currently
pay on their debt is 10% per year. Sales revenue for the Samba
Shoe Division is expected to remain indefinitely at last year’s level
of ￡ 10 million. Variable costs are 55% of sales. Annual
depreciation is ￡1 million, which is exactly matched each year by
new investments. The corporate tax rate is 40%.
a) ow much is the Samba Shoe Division worth in unlevered form?
(10 marks)
b) If the Samba Shoe Division is spun off with ￡5 million in debt,
how much would it be worth?
(10 marks)
c) What rate of return will the shareholders of the Samba Shoe
Division require?
(10 marks)
Question 2. (Total marks: 30) a)
State of the economy
Return on stock
A
Return
stock B
Bear
Normal
Bull
-4%
5%
20%
1%
4%
7%
on
Calculate the expected return and standard deviation of
each of the following stocks. Assume each state of the
economy is equally likely to happen.
(15 marks)
b)
After graduating from King’s Business School, Lewis received
two job offers: one from JPMorgan and one from McKinsey &
Co. The starting salary at JPMorgan is £35,000 per year and
it will grow 5% every year. In contrast, the starting salary at
McKinsey & Co. is £70,000 per year but it will stay constant
for the rest of his career. The discount rate is 7%. Lewis is
expected to work for 40 years. What is the present value of
JPMorgan’s salary? How about McKinsey & Co’s? Which job
offer Lewis should take if salary is the only factor to
consider?
(15 marks)
Question 3: (Total marks: 10)
What is the primary goal of multinational companies? Why is
stockholder wealth maximization more important than profit
maximization?
(10 marks)
Part 2
(ANSWER EITHER QUESTION 4 OR QUESTION 5)
Question 4. (Total marks: 30)
Wendy’s is an American fast food restaurant, famous for its
hamburgers. Wendy’s considers opening stores in the United
Kingdom (UK). The projected revenues and costs associated with
opening stores in the UK are as follows:
1) Wendy’s will be selling 1.2 million burgers at £8 per burger in
each of the first three years. It will then drop to 1 million
burgers each year at £7 per burger in years 4, 5 and 6. Wendy’s
will be closing down stores in the UK at the end of the 6th year.
2) The material cost is £4 per burger. This cost is fixed over 6
years.
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3) Wendy’s runs 5 restaurants in the UK. Each restaurant employs
5 staffs, each will work 12 hours a day, 360 days a year. Wages
are at £10 per hour.
4) Wendy’s needs to make an initial investment of £12 million in
hamburger-making machines. These machines can be sold for a
total of £0.5 million at the end of the 6th year.
5) Changes in working capital requirements: Cash increases by 4%
of the change in sales; inventory increases by 5% of the change
in sales; trade payables increase by 3% of the change in material
costs; and trade receivables increase by 5% of the change in
sales. (Hint: Working capital will be required at the end of year
1 and will be released later).
6) All revenues and expenses are paid in cash in the year they
incur.
7) For simplicity, assume there is no corporate tax.
Requitements:
(a)Calculate the Internal Rate of Return (IRR) of this investment
using the trial-and-error method. Suppose the cost of capital for
Wendy’s is 10%. Should Wendy’s open stores in the UK? Justify
your answers.
(20 marks)
(b) What are the potential problems associated with using the
IRR approach to evaluate projects?
(5 marks)
(c) IRR is the most popular capital budgeting technique. 78% of
public companies use the IRR approach to evaluate their
investment projects (Graham and Harvey, 2001). What explains
the popularity of the IRR rule?
(5 marks)
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Question 5. (Total marks: 30)
Clarus Corp is a company that operates in two businesses, steel and
technology, and in two countries, the US and the UK. The table
below summarises the revenues by business and by country (in
millions):
Steel
US
$800
UK
$300
Total
$1,100
Technology
Total
$600
$1,400
$400
$700
$1,000
$2,100
You have estimated unlevered betas of 0.90 for steel and 1.20 for
technology and equity risk premiums of 6% for the US and 7% for
the UK. The US Treasury bond rate is 3% and the UK-denominated
bond rate is 4%. Clarus Corp has 315 million shares, trading at $10
per share, no debt outstanding and no cash balance. The corporate
marginal tax rate is 40%. Assume that Clarus Corp can hedge
against foreign exchange risk.
a. Based on the information provided, estimate the cost of
capital for Clarus.
(15 marks)
b. Now assume that Clarus plans to borrow $1.2 billion at 5%
(pre-tax) to invest in its technology business in the UK.
Estimate the cost of capital for the company after the debt
issue and expansion.
(15 marks)
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