Faculteit Bedrijf, Bestuur en Technologie
Afdeling Financieel Management en Bedrijfseconomie
Kenmerk: FMBE 03.003/br
Datum: 28 januari 2003
Exam
Vermogensmarkten en Ondernemingsfinanciering
(Corporate Finance)
186010
Date:
Januari 28, 2003
Time:
13:30 – 17:00
Place:
BB 4
Teacher:
B. Roorda
Questions may be answered in Dutch or English
The exam consists of 5 questions
The points are distributed is as follows:
Question 1
Question 2
Question 3
Question 4
Question 5
15 points
15 points
20 points
20 points
30 points
NB: The final grade for the course also depends on your grade for the
compulsary group assignments
Question 1 [15 points]
a. The expected dividend for asset X with price $200 is at a constant level of $10 each year.
Determine its opportunity cost of capital.
b. A growth stock sells for $100. Earnings per share are estimated at $10 over next year. Its expected
return is 20%. What fraction of the market value is due to growth opportunities?
c. A 100% equity financed company with market capitalization rate of 15% applies a payout ratio of
40%. Next year expected dividend is $10, and expected yearly dividend growth is 5%. Determine
the dividend yield. Also determine the growth rate of dividends if the payout ratio would be 8%.
Question 2 [15 points]
A company considers to undertake a 3-year project that requires an initial investment (at t=0) of $1.4
million. Expected (after-tax) revenues are $0.2 million in year one (at t=1), and $1.0 million in year two
as well as in year three (at t=2 and t=3). The project’s hurdle rate is 25%. The company’s cost of capital is
12%, and its cost of debt is 8%. The risk free rate is 6%.
a. Determine the Net Present Value (NPV) and the profitability of the project. What is the maximal
initial investment for which the project is acceptable according to the NPV rule?
In analogy to ‘certainty equivalents’, we define the ‘company equivalents’ as the cash flows with the
same present value as the project’s cash flows at the company’s average cost of capital.
b. Determine the ‘company equivalents’ for the project in year 1, 2 and 3. Are these above or below
the project’s certainty equivalents?
So far we ignored tax deductions. Suppose the effective tax rate is 25%, and that the project is financed by
equity and a 3 years loan of $0.9 million at 8% interest rate.
c. Determine the present value of the tax shield, and the corresponding adjusted present value (APV)
of the project. Is it acceptable according to the APV rule?
Question 3 [20 points]
The following table shows estimates of the risk of stock A, stock B and the AEX. The listed volatility is
the standard deviation of the asset return over next year. The R2 relates to the usual regression involved in
estimating the beta of equity, with AEX taken as the market portfolio.
stock A
stock B
AEX
volatility
40%
40%
30%
R2
0.20
not given
not given
Beta of Equity
not given
0.8
not given
a. Complete the table, i.e, reconstruct the 4 figures that are not given in the table.
Suppose that the AEX has expected return 20%, and stock A has expected return 14%.
b. What is the expected return of stock B according to CAPM with the AEX taken as market
portfolio?
c. What return would you expect from stock A and B if the AEX return over next year would be –
15%?
Question 4 [20 points]
Are the following statements correct? Motivate your answers.
a. A firm U is unleveraged; a firm L is for 60% financed by risk-free debt, but apart from that
identical to firm U. According to the Modigliani-Miller (MM) theory, and assuming risk free
borrowing, $2.50 invested in firm U with borrowed money, and, alternatively, borrowing $1 and
investing it in equity of firm L, will produce identical cashflows.
b. Actual average asset returns are much better in line with standard CAPM during 1931-1965 than
during 1966-1991.
c. The internal rate of return of the series of cash flows (in $ millions) given by –1, 2, -1.1 in
respectively year 0, year 1 and year 2, has internal rate of return below 10%
d. According to Lintner’s model for dividend payments, the payout ratio after an unexpectedly
succesful period for the company, is not below its target ratio.
Question 5 [30 points]
Company ABC has the following (stylized) balance sheet, in million $.
Current Assets
Plant and Equipment
Total Assets
40
85
125
Debt: short term
long term
Equity
Firm Value
25
50
50
125
Cost of equity is given by rE = 15%, cost of short term debt by rDS = 6%, and cost of long term debt by
rDL = 8%. Assume that the corporate tax rate (TC) is equal to 35%.
a. Compute the opportunity cost of capital (commonly denoted as r) and the (‘after tax’) weighted
average cost of capital (WACC) of the firm. Explain the difference in one or two sentences.
b. Also compute the WACC after ‘netting out’ short term debt.
The company considers replacing $25 million of equity by long term debt. Because of increased leverage,
the cost of long term debt is set to 9%; short term debt remains 6%.
c. Compute the WACC under this new capital structure.
d. Make a sketch of WACC as function of leverage (D/E) that is in line with the given information.
e. Indicate roughly how to modify your sketch in part d for costs of financial distress, and relate this
to the trade-off theory on optimal capital structure.
[end of the exam]
Short Answers Exam Corporate Finance January 28 2003 (version Nov 25)
Question 1
a. r = 5%
b. 50%
c. y=10%; new growth rate is 13%
Question 2
a. NPV = -0.088 (mln $); profitability = -6.3%; max init investment: $1.312.000
b. Company equivalents 0.1792, 0.8028, 0.7193 in resp. year 1, 2 and 3.
c. PV(tax shield) = 0.04639; APV = -0.0416.
Question 3
a. for AEX: R2=1, beta =1; R2 for stock B: 0.36; Beta for stock A: 0.596
b. 17.03%
c. –6.87% for stock A and –10.97% for stock B
Question 4
a. Yes; b. Yes; c. No; d. No
Question 5 (a,b,c treated in lecture)
a. r = 10.4%; WACC = 8.86%.
b. 10.1%
c. 8.09%
d. e. -[end of answers]