Questions & Solutions
(for REVIEW before Final Exam FINC 5880)
Mid Exam FINC 5880
Winter 2015
Note: Even with the answers provided some students could
still not understand how we got to the solution.
For these students (B questions) attached a detailed
explanation! For Q4 a separate spreadsheet is also provided!
Question 1B: Beta’s (a) 10 points; b) 15 points)
Answer & detailed Explenation!
a) The weights of how much is invested in each business are calculated with the EV/Sales multiple given in the question. Thus
the Cap Bars are valued at $50 times multiple 1 and the Coffee Mach business with multiple 3. This adds up to 50+150=200
Since there is no mention of cash here and the beta’s are unlevered 25% of the business has beta 1.20 and 75% has a beta of
0.80 (these beta’s are given in the question) The weighted average of this is 0.90 You now use HAMADA to lever up to a
levered Beta but NOTE the D/E ratio is 50 (debt given in question) and the rest 150 (equity)thus D/E=50/150 or 0.3333333
and HAMADA leads to a levered beta of 1.08 (if you are still confused about the weights MAKE A BALANCE SHEET)
b) Your problem here maybe your interpretation of the question (language) The CEO borrows extra 100 after which debt is thus
150 and uses this money to pay back shareholders/buy out public stock thus reducing Equity to 50. On top of this the Bar
business is sold of at fair value (no profit no loss) i.e. 50 which money is used to pay back debt (debt 100 after that) This brings
D/E ratio to 100/50 or 2; the rest is simple … only the Machine Business is left and there is no cash; so the unlevered beta is 0.80
levered up with the newly found D/E (HAMADA again) leads to 1.76
Q2B: Capital structure (a) 10 points ; b) 15 points)
Answer Q2BA & Explenation
For this question you are in a) required to calculate the WACC (cost of capital); no problem as long as you remember the
formula; actually all the numbers you need are given and this is a “give away points question”; 40% equity times 13% cost of
equity and 60% debt times an after tax cost of debt of 9%*(1-40%); WACC=8.44%
b) If leverage changes the cost of debt and equity will change! (session 1) your task is to find out with how much. Since Rf=5%
and (Rm-Rf)=4% are given AND you know Ce=13% you can easily find that in a) Beta =2 but the company will retire half of its
debt so beta will go down! (lower leverage). Use HAMADA to find the new Beta if 600 debt will now be 300 debt and there will
be 700 equity (see above) the D/E=42.86% You can now find the new beta in 2 ways; you can adjust the D/E you had in a) from
600/400 (1.5) to 0.4286 OR you can first UNLEVER the beta of 2 (to D=0) and then lever up to 300/700 D/E both methods will of
course lead you to the new beta of 1.3233. After this you can calculate the new Ce with Rf+New beta *(Rm-Rf) and find
Ce=10.29% Since the new Cost of debt is already calculated for you at 6% (pre tax) you can find the new WACC 8.29% Note that
it must go down due to a much lower Ce than in a)
Q3B: Dividend Policy (a) 10 points; b) 15 points)
Q3B Answer = EXPLENATION!
A) asks for the reinvestment rate; if you forget what this was you could have checked your notes of session 2 about
Dividend policy where we did a class assignment and examples in class in calculating FCE (free cash flow to equity)
Net reinvestment= Net Income + Change in Cash balance –Dividends=Change in non cash WC+Capex-Depreciation
To remind you of this I WROTE the equation on the white board DURING THE EXAM again!
The rest is calculation (see below)
In B) we start to PLAY with the numbers and make some additional assumptions about growth the rest is calculation.
A) USE THE
FORMULAlook
backwards
B) READ
carefully
and
forecast
what will
happen
from last
year going
FORWARD
Q4A: Option Valuation (25 points)
On 16 November 2015 the SBUX Call with X=$60 maturing 16 January 2016 costs $ 2.37
1) Assuming that the stock up to maturity will stay between Sd=$55 and Su=$65 and
Rf=2% per year, calculate the Theoretical value of the Call with the Binomial model
(the spot price of SBUX on 16 November was $60) SHOW YOUR CALCULATION (10
points)
2)
Calculate the value of the Call according to the Black Scholes (BS) model; list the
inputs in the yellow cells on your answer sheet. The variance on SBUX stock returns is
10.24%. (2 points)
3)
Now calculate the value of the Put with X=$60 and the same maturity (i.e. 2 months)
both based on the Binomial model and the BS model. SHOW YOUR CALCULATION (3
points)
4)
If your calculated value in 1) is correct, given the market price of $ 2.37, what could
you do with ARBITRAGE to risk free gain the price difference? SHOW YOUR
CALCULATION AND STRATEGY (10 points)
ANSWER similar for 4B (separate
spread sheet provided)
ANSWER similar for 4B (separate spread sheet provided)