AFM 372 Fall 2006 Midterm Examination Friday, October 27

Student name: ______

Student number: ______

Instructor: Alan Huang

Duration: 2 hours

Total Marks: 100

This exam has 11 pages including this page. A separate formula sheet will be provided.

Materials Allowed: Calculator

Important Information:

1. You must answer all questions except (1) the bonus question and (2) one true/false question. The bonus question is optional. Answers must be legible. If I cannot read it, I cannot mark it. 2. If you make any assumptions, state them clearly in your answer. 3. Show all working in questions other than multiple-choice. Answers that do not show how the answer was arrived at will receive little or no credit. 4. In cases where returns/rates are to be calculated, if you are using percentage points round off to two decimal places (12.24%), and if you are not using percentage points, round off to four decimal places (0.1224). In all other cases, round off your answers to two decimal places. 5. Use back of the page if there is not enough space. 6. To have your exam considered for re-grading, the exam must be written in ink.

Good Luck!

MARKING SCHEME:

Section Question Score I. Multiple Choice (25 points) II. Short answer 1 (5 point) 2 (5 point) III. True/False 1 (4 points) (only 1 counts) 2 (4 points) IV. Calculation 1 (15 points) 2 (14 points) 3 (17 points) 4 (15 points) Bonus 1 (5 points)

1 I. Multiple choice questions: Circle one answer that is the best. (2.5 points each)

1. A bond issued by Owers Divestiture Corporation on July 1, 2005 has the following features: face value $1,000, annual interest rate of 8%, maturity date July 1, 2010, semi-annual interest payments on July 1 and January 1 each year. How much is the accrued interest if an investor buys the bond on Sept. 1, 2006?

A) $13.33 B) $26.67 C) $40.00 D) $80.00 E) $120.00

Use the information below to answer questions 2 and 3:

The shareholders of the Unicorn Company need to elect five new directors. There are one million shares outstanding.

2. At least how many shares should you own to be certain that you can elect two directors if the company has straight voting?

A) 500,001 B) 500,000 C) 1 million D) 333,334 E) 166,667

3. At least how many shares should you own to be certain that you can elect one director if the company has cumulative voting?

A) 500,001 B) 500,000 C) 1 million D) 333,334 E) 166,667

4. Consider two corporations, G and H, that have exactly the same risk. They both have a current stock price of $60. Corporation G pays no dividend and will have a price of $66 one year from now. Corporation H pays dividends and will have a price of $63 one year from now after payment of a dividend. Corporations pay no income taxes. Investors pay no taxes on capital gains, but they pay a 30% income tax on dividends. What is the value of the dividend that investors expect Corporation B to pay?

A) $4.29 B) $3.00 C) $3.15 D) $3.30 E) It is impossible to calculate expected dividend without the discount rate.

5. Preferred stock may exist because:

A) losses before income taxes prevent a company from enjoying the tax advantages of debt interest while none exist for preferred dividends. B) an advantage exists for the firm; preferred shareholders can not force the company into bankruptcy because of unpaid dividends. C) corporations get a tax exemption on preferred dividends received. D) all of the above. E) none of the above.

6.A firm has a debt-to-equity ratio of 1.20. If it had no debt, its cost of equity would be 15%. Its cost of debt is 10%. What is its cost of equity if there are no taxes or other imperfections?

A) 21%. B) 18%. C) 15%. D) 10%. E) None of the above.

2 7. The pecking-order theory of capital structure is at odds with the tradeoff theory of capital structure in that pecking-order theory says

A) There should be no target book/equity ratio. B) Profitable firms should use less debt. C) One should take advantage of tax shield of debt. D) Both A) and B). E) Both B) and C).

8. Your aunt is in a high tax bracket and would like to minimize the tax burden of her investment portfolio which is subject to high taxes. She is willing to buy and sell in order to maximize her after-tax returns and she has asked for your advice. There are several choices for her: i). Buy high dividend yield stocks because high dividend stocks are safer with cash in hand. ii) Buy low dividend yield stocks to avoid paying high taxes on dividends. iii) Sell low dividend yield stocks because those stocks tend to be overpriced. iv) Move high dividend yield stocks that are currently in her portfolio to a tax-deferred account such as retirement account.

You think she should do:

A) Both i) and ii). B) Both ii) and iv). C) i) only. D) Both i) and iii).

9. A firm commitment arrangement with an investment banker occurs when:

A) the syndicate is in place to handle the issue. B) The spread between the buying and selling price is less than one percent. C) The issue is solidly accepted in the market evidenced by a large price increase. D) When the investment banker buys the securities for less than the offering price and accepts the risk of not being able to sell them. E) When the investment banker sells as much of the security as the market can bear without a price decrease.

10. You estimate that Canadian Tire’s stock beta is 0.35. Its current debt has market value of $1.25 billion, and its equity value is $10 billion. From past market data, you estimate that the riskfree interest rate is 5%, and the market return is 20%. Current yield on Canadian Tire’s bonds is 8%. The corporate tax rate is 36%. Ignore personal taxes and financial distress costs. What’s Canadian Tire’s cost of equity if it were an all-equity firm?

A) 10.25% B) 10.08% C) 10.00% D) 9.86% E) Not enough information.

3 II. Short answer questions (5 points each.)

1. If Miller-Modigliani Proposition II (with corporate taxes) is correct, every firm should take (almost) 100% debt to maximize the firm value. But you do not observe that in real life. Give three reasons that why firms do not follow Miller-Modigliani Proposition II and brief explain your reasons.

2. You just read the following from The Financial Post on Thursday, October 12, 2006: “Gannett Co. Inc. the largest U.S. newspaper publisher, reported a lower third-quarter profit yesterday because of weak advertising growth and lower-than-expected revenues, sending shares down 3.4%. Revenue rose 2.7% to US$1.91-billion, but fell short of analysts’ views ranging from US$1.92-billion to US$1.99-billion, according to Reuters Estimates.” Assume nothing happens before the event. Comment whether this event is consistent with, against, or uncertain with the efficient markets hypothesis.

4 III. True or false. Choose only one true/false question to answer. If you answer both questions, you will get the average mark of the two.

Assess whether each of the following statements is true, false, or uncertain. Justify your answer. All marks are based on the quality of your arguments supporting your answer.

1. (4 points) If the efficient–market hypothesis is true, then the pension fund manager might as well select a portfolio with a pin.

2. (4 points) As the firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return. Thus by reducing the debt equity ratio we can reduce both the cost of debt and the cost of equity, making everybody better off.

5 IV. Calculations (Show your process to get partial credit).

Question 1. (15 points) Mellow-Dramas Inc. is expected to (1) earn an operating income of $2.2 million one year from now, which it pays as dividends on its 200,000 outstanding shares, and (2) dissolve and have a liquidating value of $6.05 million two years from now. The company is all equity financed with a required rate of return of 10%. At the dividend declaration board meeting, several board members claimed that given that the firm is dissolving in two years, the dividend is too meager and is probably depressing the firm’s stock price. They proposed that the firm sell enough new shares one year from now to raise the dividend by 50%. The new shares sold are entitled to the liquidating value but not the dividend. Assume that markets are perfect, there are no taxes, and issuing stock is the only financing alternative.

(a) (2 points) What is the stock price under the current dividend policy?

(b) (5 points) One year from now, at what price and how many new shares must the firm issue to finance the new dividend policy?

(c) (4 points) Jones owns 1,000 shares and prefers the current dividend policy. How can he achieve it if the firm switches to the new policy?

(d) (4 points) Comment on the claim that the low dividend is depressing the stock price and relates your comments to the relevance of dividend policy. Support your answer with calculation.

6 Question 2 (14 points)

Milano Pizza Club is a restaurant popular for its specialty pizzas. The restaurant has a debt-to- equity ratio of 30 percent and marks interest payments of $30,000 at the end of each year. The cost of the restaurant’s levered equity ( rs ) is 20%. The restaurant costs 130,000 to set up, which are financed according to the restaurant’s debt-to-equity ratio. Its estimated annual sales will be $1 million, annual cost of goods sold will be $400,000, and annual general and administrative costs will be $300,000. These cash flows are expected to remain the same forever. The corporate tax rate is 40%. Ignore personal taxes and financial distress.

a. (6 points) Determine Milano Pizza Club’s i) equity value and ii) firm value.

b. (3 points) Decide Milano Pizza Club’s weighted average cost of capital.

c. If Milano Pizza Club were an all-equity firm, what is its cost of capital? (3 points) Generally, why is it different from the cost of levered equity? (2 points)

7 Question 3: (17 points)

Brice Co., is in the process of going public. Its pre-IPO equity accounts are as follows:

Common shares (1,500 shares outstanding) 100,000 Retained earnings 50,000 Total 150,000

Brice will issue 500 new common shares, each with a face value of $1 and an issuing price of $150. Assume no issuance costs.

a. (3 points) What’s the book equity per share i) before the IPO, and ii) after the IPO? What is the market to book ratio right after IPO?

b. (3 points) Construct the post-IPO equity accounts for Brice.

c. (3 points) The lead underwriter has a greenshoe option to issue an additional 10% of shares during the month following the IPO. The lead underwriter exercises the greenshoe option when the stock price climbs to $180 twenty days after the IPO. What’s the new book to equity ratio? (Assume no issuance costs.)

8 Question 3 cont’d: d. (4 points) Back to settings in a) where Brice issues 500 new shares only and there is no greenshoe option. Brice has a strong stock performance since IPO. Two years after its IPO, the stock price reaches $250. At that moment, the management is considering a rights offering to raise an additional $50,000 for a significant expansion. The subscription price for each new share is $100. Figure out the terms for the right offering: i) How many rights are needed for a share and ii) what’s the value for a right?

e. (4 points) Show how a shareholder with 100 shares and no desire (or money) to buy additional shares is not harmed by the rights offering.

9 Question 4 (15 points): Consider two firms, U and L, both with $40,000 in assets on balance sheet, are identical in every way except their capital structure. Firm U is unlevered, and firm L has a market value of $20,000 of perpetual debt that pays 8% interest per annum. Each company expects to earn $7,500 before interest per year in perpetuity and distributes all its earnings as dividends. Firm U has 1,000 shares outstanding, while firm L has 600 shares outstanding. The required rate of return for firm U is 15%. Assume no taxes and no financial distress costs. a. (4 points) What is the share price for U and L respectively?

b. (5 points) Mike owns 20% of firm L and believes that leverage works in his favor. You tell Mike that this is an illusion, and that with the possibility of borrowing on your own account at 8% interest, your can replicate Mike's payoff from firm L using borrowing/lending and firm U. Show to Mike the replication.

c. (4 points) You find that value of the unlevered firm is 10% lower than the combined value of the equity and bond of the levered firm. Is there an arbitrage opportunity? If yes, design an arbitrage strategy to take advantage of it. Show the cashflows of your arbitrage strategy.

d. (2 points) Now assume there is bankruptcy costs (but still no taxes). S&P credit rating services assigns a credit rating of BBB+ to firm L. Altman estimates that bankruptcy costs are 20% of firm value and that the probability of default with BBB+ is 5%. What is the firm value for L now?

10 Bonus question (5 points)

There are $7,600 million of equity and $1,000 million of bond on the balance sheet of CanTire Inc. The firm has 90 million shares outstanding, and its current stock price is $100. Its bond has the following features: face value $1,000 million, maturity of 3 years from now, coupon rate 10%, annual coupon payment. The bond is callable 2 years from now (after coupon payment of that year), with a call premium of 5%. You estimate the term structure of interest rates to be the following: 1-year spot rate is 10%, and 2-year spot rate is 8%. Depending on economic expansion or recession, 3-year spot rate can either be 6% or 10% with equal probability. What’s the firm value today?

(Definition: spot rate is the yield on a zero coupon bond. That is, if we let the current price of the T-year zero-coupon bond to be P, the face value to be $1, then the T-year spot rate, r, is derived as P(1+ r)T = 1.)

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