Student number:
Nova School of Business and Economics
2253 - Corporate Finance
Fall 2021 – Exam II
Exam Date: December 20, 2021
Exam Time: 16:00-17:30
INSTRUCTIONS
1) Please do NOT open the exam until you are told to do so.
2) Make sure that you wrote your number on each sheet.
3) Laptops and cell phones are absolutely prohibited. Textbooks and class notes
are NOT allowed. A cheat sheet is provided on page 2.
4) The exam consists of 9 pages (including the cover page) and 3 parts with a total
of 100 points. Make sure your exam has a cover page, and is composed of 9
pages and 3 parts.
5) Please write your answers ON the question sheet (unless you are solving the
exam online). ONLY the answers on the question sheet will be graded. If you
need more sheets, raise your hand.
6) In answering the questions, show all your calculations, so that you can receive
partial credit.
7) You have 90 minutes to complete the exam. Please use your time wisely.
Good luck!
1
Part
Total Points
I
30
II
40
III
40
Total
100
Your Score
Student number:
Nova School of Business and Economics
Corporate Finance – Cheat Sheet for Exam II
1. Growing perpetuity formula:
𝑃𝑉 =
𝐶𝐹1
𝑟−𝑔
where r is the discount rate, g the growth rate, and CF1 the cash flow realized one
period from now.
2. CAPM: 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 × 𝑀𝑅𝑃, where rf is the risk-free rate, 𝛽𝑖 the beta of the asset and
MRP the market risk premium.
3. After-tax company cost of capital:
𝐸
𝐷
𝑟𝑤𝑎𝑐𝑐 = 𝐸+𝐷 𝑟𝐸 + 𝐸+𝐷 𝑟𝐷 (1 − 𝜏𝑐 )
where E and D refer to Equity and (net) Debt, respectively.
4. Assuming that the risk of tax shields is equal to the risk of unlevered assets:
𝐷
𝑟𝐸 = 𝑟𝑢 + 𝐸 (𝑟𝑢 − 𝑟𝐷 )
and
𝐷
𝛽𝐸 = 𝛽𝑢 + 𝐸 (𝛽𝑢 − 𝛽𝐷 )
5. Assuming that the risk of tax shields corresponds to the risk of debt:
𝐷
𝑟𝐸 = 𝑟𝑢 + 𝐸 (𝑟𝑢 − 𝑟𝐷 )(1 − 𝜏𝑐 )
and
𝐷
𝛽𝐸 = 𝛽𝑢 + 𝐸 (𝛽𝑢 − 𝛽𝐷 )(1 − 𝜏𝑐 )
where 𝑟𝑢 is the unlevered cost of capital and 𝛽𝑢 is the unlevered asset beta.
6. Firm Free Cash Flow (FFCF) = EBIT x (1 - tc) – CAPEX – Δ Working Capital +
Depreciation
7. Equity Free Cash Flow (EFCF) = (EBIT – Interest) x (1 - tc) – CAPEX – Δ Working
Capital + Depreciation + Δ Debt
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Part I: Multiple Choice Questions (30 points)
PLEASE FILL YOUR ANSWERS IN THE TABLE BELOW
Part I
Total Points
1)
3
2)
3
3)
3
4)
3
5)
4
6)
4
7)
5
8)
5
Your Answer
1) (3 pts) In M&M’s perfect capital markets which of the following statements is
FALSE?
A) With perfect capital markets, leverage merely changes the allocation of cash flows
between debt and equity, without altering the total cash flows of the firm.
B) Leverage does not increase the risk of equity if there is no risk that the firm will
default.
C) It is inappropriate to discount the cash flows of levered equity at the same
discount rate that we use for unlevered equity.
D) In the absence of taxes or other transaction costs, the total cash flow paid out to
all of a firm's security holders is equal to the total cash flow generated by the firm's
assets.
Answer: B
2) (3 pts) Which one of these statements about costs of financial distress is
CORRECT?
A) Expenses for lawyers, accountants, restructuring advisors, etc. are indirect costs
associated with legal bankruptcy.
B) Fire sales refer to companies in distress selling their assets at prices equal to or
above their fair values.
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C) Time that the management spends dealing with creditors cannot be counted as
cost of financial distress.
D) Indirect costs of financial distress are realized before the firm files for bankruptcy.
Answer: D
3) (3 pts) According to the tradeoff theory, the optimal capital structure tends to
include MORE debt for firms with:
A) the highest depreciation deductions.
B) the lowest marginal tax rate.
C) low probabilities of financial distress.
D) less taxable income.
Answer: C
4) (3 pts) Which of the following statements regarding recapitalizations is FALSE?
A) With a recapitalization, even though leverage reduces the total value of equity,
shareholders capture the benefits of the interest tax shield up front.
B) The share price always rises after the completion of the recapitalization.
C) Recapitalization changes cost of equity.
D) In the presence of corporate taxes, we include the interest tax shield as one of the
firm's assets on its market value balance sheet.
Answer: B
5) (4 pts) IMT Inc. is considering issuing one year debt, and has come up with the
following estimates of the value of the interest tax shield and the probability of distress
for different levels of debt:
If in the event of distress, the present value of distress costs is equal to $25 million,
then the optimal level of debt for IMT is:
A) $25 million
B) $50 million
C) $60 million
D) $70 million
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Answer: B
Explanation: A) Select $50 million since it has the highest net benefit.
6) (4 pts) Galt Industries has no debt with total equity capitalization of $600 million,
and an equity beta of 1.2. Included in Galt's assets is $90 million in cash. Assume the
risk-free rate is 4% and the market risk premium is 6%. Galt's beta of operating assets
is closest to:
A) 1.1
B) 1.2
C) 1.3
D) 1.4
Answer: D
Explanation: D) βU =
=
× 1.2 -
βE +
βD -
βC
× 0 = 1.411765
7) (5 pts) Nielson Motors is currently an all-equity financed firm. It expects to generate
EBIT of $20 million over the next year. Currently Nielson has 8 million shares
outstanding and its stock is trading at $20.00 per share. Nielson is considering
changing its capital structure by borrowing $50 million at an interest rate of 8% and
using the proceeds to repurchase shares. Assume perfect capital markets. Nielson's
EPS if they change their capital structure is closest to:
A) $2.9
B) $2.5
C) $2.3
D) $2
Answer: A
Explanation: A) Nielson will repurchase $50 million/$20 share = 2.5 million shares
This leaves 8 million - 2.5 million = 5.5 million shares outstanding
NI = EBIT - Interest expense (no taxes) = $20 million - $50 million × 8% = $16 million
available to shareholders. EPS =NI/shares outstanding = $16 million/5.5 million =
$2.91
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8) (5 pts) Flagstaff Enterprises expects to have free cash flow in the coming year of $8
million, and this free cash flow is expected to grow at a rate of 3% per year thereafter.
Flagstaff is a private firm with a debt cost of capital of 7%. The firm is in the 35%
corporate tax bracket. The following publicly traded firm maintains its debt-toequity ratio indefinitely and is comparable to Flagstaff:
Firm Name
Lincoln
Cost of
Equity
15%
Debt-to-Equity
Ratio
0.25
Cost of Debt
5%
If Flagstaff maintains a 0.5 debt-to-equity ratio, then Flagstaff's after-tax WACC is
closest to:
A) 16.4%
B) 12.2%
C) 18.1%
D) 13.8%
Answer: B
Explanation:
4
1
𝑟𝑢 = 15% × 5 + 5% × 5 =13%
1
𝑟𝑒 = 13% × (13% − 7%) = 16%
2
2
1
𝑤𝑎𝑐𝑐 = 16% × 3 + 7% × 3 (1 − 35%) = 12.18%
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Part II: Debtholder-Equityholder Conflicts
ABC Inc. is about to launch a new product. Depending on the success of the new
product, the company may have one of three values next year: $250 million, $160
million, or $130 million. These outcomes are all equally likely, and this risk is
diversifiable. The risk-free rate is 5%.
a) Suppose that ABC Inc. has zero-coupon debt with a $150 million face value due
next year. What is the initial value of the firm’s debt and equity?
From now on, consider that in the event of default, 20% of the value of the firm’s
assets will be lost to bankruptcy costs.
b) Debt holders agree to issue debt with the same market value as in part a). What
will be the face value of the debt? What is the initial value of the firm’s debt and
equity?
Hint: the face value of the debt is bigger than 160
Now ABC Inc. has an investment opportunity that will increase firm’s cash flows in all
states of the world by $42 million which costs $20 million. (The company will still face
bankruptcy costs in case of default)
c) Will equity shareholders agree to finance this project by raising $20 million by
issuing new equity?
Hint: the company will face bankruptcy costs only in case of default
d) Consider a restructuring plan where the existing creditors reduce the face value of
debt to $X million (provided that the firm raises new equity to fund the project).
What is the minimum value of X, for which both debtholders and equity
shareholders agree on this plan?
Solution:
a)
Face value debt
150
Expected
value
Total Assets
250
160
130
171.43
Debt
150
150
130
136.51
Equity
100
10
0
34.92
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b)
Total Assets
Debt
𝐷=
250
160
104
153.02
X
X
104
136.51
0.33(𝑋 + 𝑋 + 104)
= 136.51
1.05
X=163. Now we need to check that 𝑋 ≤ 250 (which is true) and 𝑋 ≤ 160 (which is
false).
𝑋 > 160 means that the firm will not be able to repay the debt of $163 and will face
the financial distress in the second scenario. This implies that the firm will bear
bankruptcy. So, we need to adjust for this and recalculate the face value of the debt:
Total Assets
250
128
104
153.02
Debt
X
128
104
136.51
Equity
52
0
0
16.51
𝐷=
0.33(𝑋 + 128 + 104)
= 136.51
1.05
X=198. We still need to check that 𝑋 ≤ 250 (which is true). So, the face value of the
debt is $198.
c)
Total Assets
292
202
137.6
200.51
Debt
198
198
137.6
169.40
Equity
94
4
0
11.11
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d) To calculate the minimum face value of the debt, we need to make sure that
debtholders will receive the market value of the debt of $136.51. This means that
the face value of the debt is $143.3 if the company doesn’t default. We see that
the company’s value exceeds in every scenario ($292, $202, and $172).
Total Assets
292
202
172
211.43
Debt
143.33
143.33
143.33
136.51
Equity
148.67
58.67
28.67
74.92
Part III: Capital Restructuring
CoolVans, a manufacturer of camper vans, just identified an investment opportunity
for the segment of outdoor extreme sports adventurers. It plans to launch a new
vehicle catering to this segment’s specific needs. The new van will be called
CampChamp, requires an upfront investment of $1,500M, and has an NPV of $200M.
You also have the following information:
• The company is publicly traded and, before any announcement regarding
CampChamp, the stock price is $15. The company has 20M shares outstanding.
• Currently CoolVans has permanent debt of $500M.
• The corporate tax rate is 30% and the present value costs of financial distress
are estimated at $20M. These costs are not expected to change with the launch
of CampChamp.
• The new project needs to be funded by new equity (CoolVans plans to maintain
its current debt level).
a) (15 pts) Draw the market value balance sheet of CoolVans just before the
announcement, verifying that total asset value is $800M.
b) (15 pts) Assuming the equity offering is fairly priced, what is the stock return upon
announcement? How many new shares will be issued?
c) (10 pts) Now assume there is asymmetric information regarding CampChamp (and
nothing else). Specifically, the average investor participating in the offering applies
an adverse selection discount to the project, and expects an NPV of just $100M.
1. How many new shares need to be issued?
2. From the perspective of a long-run initial shareholder (locked in, does not
trade strategically), what is the percent “hit” on the value of her CoolVans
equity holdings due to the discounted offering price? (hint: assume that after
the offering the true project value becomes public)
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a) The market value balance sheet (MVBS) just before the announcement is as
follows:
Assets
PVTS = 0.3 * $500M = $150M
-PVCF = - $20M
Initial Vu = $800M-$150M+$20M = $670M
Total = $800M
Claims
Equity = 20M * $15 = $300M
Debt = $500M
Total = $800M
b) Upon announcement, the new project’s NPV is incorporated into the firm. The
new MVBS looks as follows:
Assets
Claims
Equity = $1,000M-$500M = $500M
Debt = $500M
PVTS = $150M
-PVCF = - $20M
Initial Vu = $670M
NPV = $200M
Total = $1,000M
Total = $1,000M
Therefore the new share price is $500 M / 20M = $25, which is an increase of
66.7% relative to the pre-announcement level. The number of shares to be issued
is $1,500M / $25 = 60M.
c)
1. From the perspective of new (uninformed) investors, total asset value is just
$900M. Therefore, total equity value is just $400M (vs $500M). From their
perspective, the break-even share price is then $400M / 20M = $20 (instead of
$25). Therefore the number of new shares to be issued is $1,500M / $20 = 75M.
2. After asymmetric information disappears, then the market value of equity is
$2,000M (total asset value is $2,500M; debt is $500M). Therefore, the stock
price becomes $2,000M / (75M+20M) = $21.05. The adverse selection discount
caused a “hit” of 15.8% (21.05/25-1) to long-run initial shareholders.
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