(2) Please State If the Following Questions Are True Or False

Corporate Finance Final Exam 2 – Spring 2010/2011

2 hours

This exam consists of 4 problems. This is a closed book exam. You are allowed one double- sided page of notes. Calculators are permitted. Good luck!

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1 Problem 1 Zé Tolo is a well known businessman and is planning a new investment project. The project will last forever and requires an acquisition of fixed assets with a value of €100,000 and that will be depreciated in 10 years. He would need to invest in Working Capital as well. He would start the project with €5,000 invested in Working Capital and he must sustain that level to support operations. For the first 4 years of the project the values for EBIT are as follows:

1 2 3 4 EBIT €6,000 €8,000 €10,000 €10,500

EBIT, net fixed assets and working capital will grow at a rate of 3% after year 4. In this industry the average debt-to-equity ratio is 2, cost of debt is 5% and levered beta is 1.25. The expected return on the market is 7%, the risk-free rate is 3% and corporate tax rate is 25%. a) What is the NPV if the initial investment is entirely financed by Tolo’s equity? b) What is the NPV if the target debt-to-equity is 1/2 and the cost of debt is equal to the cost of debt in the industry? c) What is the NPV if the project is entirely financed with a government subsidy that is 75% refundable at the end of year 4 and 25% non-refundable?

Problem 2 In the CAPM world every investor holds a mix of the world market portfolio and the risk-free asset. The world market portfolio has an expected return of 12% and a standard deviation of 25%. The risk-free asset return is 7%. a) Simone moved to the CAPM world to go to college. Her wealth is €1,000,000 and is investing €1,250,000 Euros in the world market portfolio. What is the expected return and standard deviation of Simone’s portfolio? b) Jessica, Simone’s best friend, has a quadratic utility function and risk aversion coefficient of 2. What is the optimal portfolio expected return and standard deviation for her? c) Warner Co. common stock has a correlation coefficient of 0.5 with the world market portfolio and a standard deviation of 40%. What is the beta and expected return of Warner Co? d) What is the stock price of Warner if the company is paying a dividend per share of €2 tomorrow and dividends will grow forever at 3%?

Problem 3 Consider the following term structure of interest rates (effective annual rates):

Spot rate 1 month 2.0% Spot rate 7 months 2.4%

2 A coupon bond with a coupon rate of 6% (semi-annual frequency), face value of 100, and that matures in 13 months has a quoted price of 103.52. A zero coupon bond with 18 months to maturity is being traded at 95.4% of its face value. a) What is the spot rate for 18-month maturity? b) What is the forward rate from month 1 to months 7? c) What is the spot rate for 13-month maturity?

Problem 4 Pingu Ltd. is a very successful company in the mortar industry. The company has 2,500,000 shares outstanding and has on its balance sheet 75,000 perpetual bonds with a €1,000 face value and 9.5% annual coupon rate. The company’s cost of debt and cost of equity are 7% and 15%, respectively. The corporate tax rate is 25%. The company’s CFO expects that the company is able to generate the following unlevered free cash flows in perpetuity:

Recession (40%) Expansion (60%) Free Cash Flow €15 million €60 million a) What is the market value of company, value of the equity and value of debt? b) What is the weighted average cost of capital?

Pingu Ltd. has now the opportunity to invest in a new major project. To finance the project the company will issue shares in the market (only available to new shareholders). The discount rate for the project is 15%. The project has an initial investment of €120 million and will generate incremental unlevered free cash flows in perpetuity as follows:

Recession (40%) Expansion (60%) Free Cash Flow €12 million €30 million c) How many shares will be sold to new shareholders? d) Are the old shareholders better off with the project? Why?