Mid Term Exam FINC 5880 Version A – Answer Key
Shanghai, Winter 2014
Contents:
Dividend Policy; Capital Structure; Bottom Up Beta’s; Investment Banking and Leasing
Question 1) Bottom Up Beta’s
You have estimated the returns on XYZ corporation and on the overall market for five years:
Year
1982
1983
1984
1985
1986
Rxyz
20%
-10%
30%
10%
0%
Rm
15%
-5%
25%
15%
-10%
A) Estimate the beta for this stock XYZ. B) What is the expected return on XYZ corporation if you use the CAPM? (The risk free rate is 9%)
(5 points)
C) If XYZ corporation has a current debt/equity ratio of 50%, what would its beta be if it increased
its debt/equity ratio to 200% ? (The tax rate is 40%)
D) Do you think this Beta is accurate enough? If you would proceed to calculate a more accurate
Beta what steps would you take and what calculation would you make to find it?
ANSWER
A)
XYZ
M
20
15
-10 5
30
25
10
15
0
-10
10
8
(XYZ-XYZ)SQ (M-M)SQ
100
49
400
169
400
289
0
49
100
324
1000
Var Rm 880
(XYZ-XYZ)(M-M)
70
260
340
0
180
Covar Rxyz/Rm 850
BETA = 850/880 = 0.96590909
(ALPHA = 10-8*0.97= 2.27272727 ! IT DID BETTER THAN EXPECTED)
B)
EXPECTED RETURN = 9 +0.97 *8.3 (OR 8.5) = 17.0170455 %
NOTE the spread is the historical spread up to 1987 (Damodaran) the average market return over only 5 years would be too
inaccuarate! (Hope you did not use that for your homework)
C) Hamada: 0.966*(1+200/50*(1-40%))= 3.3
D) No! Bottom Up Beta….
Find companies in same industry
Take their leveraged beta
Average them
Unlever them with D/E (Hamada)
Crrect them for Cash
Divide over several divisions/ Industries if necessary
Bring cash back into Beta and Lever up per Industry
Question 2) Dividend Policy
Dragon Inc. started it’s Business 5 years ago with $ 150M cash and no (non cash) working capital.
From the Accounting data we can see:
(in M USD)
first year
Net Income
Capital Expenditure
Depreciation
Non Cash Work.Cap.
Total Debt
4 years ago
-20
120
20
-10
10
3 Years
Ago
0
50
40
20
20
2 Years
Ago
100
90
60
-20
0
Last Year
130
120
70
0
40
175
150
70
10
20
If the company has $ 120M in cash today what must have been the average Pay Out ratio over the past
5 years if the company did not use it’s cash for any other purposes? (show your calculations)
ANSWER
(in M USD)
first year
Net Income
Capital Expenditure
Depreciation
Non Cash Work.Cap.
Total Debt
cash flow
cash left
Pay Out:
-20
120
20
-10
10
-100
50
40.1%
Thus 155 M paid out / NI summed 385M
4 years ago
0
50
40
20
20
-30
20
3 Years
Ago
2 Years
Ago
100
90
60
-20
0
90
110
Last Year
130
120
70
0
40
100
210
175
150
70
10
20
65
275
385
120
Question 3) Cost of Capital Leveraged and Unleveraged Beta’s
You have been asked to analyze GenCorp, a corporation with food and tobacco
subsidiaries.
The tobacco subsidiary is estimated to be worth $ 15 billion and the food
subsidiary is estimated to have a value of $ 10 billion.
The firm has a debt to equity ratio of
1.00.
You are provided with the following information on comparable firms:
Business
Average Beta
Average D/E Ratio
Food
0.92
25%
Tobacco
1.17
50%
All firms are assumed to have a tax rate of 40%. If the current long-term bond rate is 6%,
estimate the current cost of equity of GenCorp.
ANSWER
Unlevered Beta for Food Business = 0.92/(1+(1-.4)(.25)) =
0.8
Unlevered Beta for Tobacco Business = 1.17/(1+(1 - .4)(.5)) =
0.9
Unlevered Beta for the Company = 0.8 (10/25) + 0.9 (15/25) =
0.86
Levered Beta for the Company = 0.86 (1 + (1-.4)(1.00)) =
Cost of Equity for the Company = 6% + 1.376 (5.5%) =
0.86
Weighted by values of each division
1.376
13.57%
Question 4) Capital Structure (Minimizing WACC%)
You have been provided the information on the after-tax cost of debt and cost of capital
that a company will have at a 10% debt ratio, and asked to estimate the after-tax cost of debt
and cost of capital at 20%. The long term treasury bond rate is 7%.
ANSWER
Bond Rating =
Interest Rate =
After-tax Cost of Debt =
BBB
9.00
%
5.40
%
0.9937562
11
1.1428196
43
Unlevered Beta = 1.06/(1+(1-0.4)(.1111)) =
Beta at 25% D/E Ratio = 0.99(1+0.6(.25)) =
Cost of Equity = 7% + 1.14 (5.5%)
=
13.27
%
Cost of Capital = 5.40% (.2) + 13.27% (.8) =
11.70%
Question
5)
Cost of
Capital
changes
with
change in
Capital
Structure
You are helping the CFO of a steel company assess whether the firm should embark
on a plan to reduce its financial leverage. The firm currently has equity with a market
value of $ 400 million and debt outstanding (in market value terms) of $ 600 million.
The cost of equity currently is 13% and the pre-tax cost of borrowing is 9%. (The
Risk free rate is 5% , the tax rate is 40% and the equity risk premium is 4%)
a. Estimate the current cost of capital for the firm.
b. The firm plans to issue new stock and retire half of its existing debt. If the pretax
cost of borrowing will drop to 6% as a consequence, estimate the cost of
capital after the recapitalization.
ANSWER
a. Cost of capital at existing debt
ratio =
b.
Beta at current cost of equity =
Unlevered beta =
New Debt to Equity Ratio =
8.44%
2
1.0526
Levered Beta =
New cost of equity
42.86%
1.32330827
1
10.29%
New cost of capital
8.29%
END MID EXAM
! 13%(.4)+9%(1.4)(.6)
! (13-5)/4
! (600300)/(400+300)