F409 Midterm Exam 2

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					                                                        Name: _____________________

                                 F409 Midterm Exam 2
                                     April 4, 2001

This is a closed book, closed note exam. Please put your final answer in the designated
space (i.e. the boxes or numbered space provided). You are allowed to use a financial
calculator and the formula sheets provided. You should show all work if you want to
receive any partial credit. Partial credit will be given as deserved on short answer and
calculation problems. However, no partial credit will be given on multiple choice or true
and false questions. You have an hour and fifteen minutes to complete the exam. Good
Luck!

1. ABC Inc. has a debt to equity ratio of 0.6. The firm recently issued a large amount of
   stock and used the proceeds to pay off some of its debt. This resulted in the debt to
   equity ratio decreasing to 0.4. For each of the following scenarios, state the impact of
   this change in leverage by circling either increase, decrease, or unchanged. (12
   points)

       a. If we consider a world with no taxes, no default risk, no agency problems and
          homogeneous information, state what will happen to the firm’s

               i. Cost of Equity – increase decrease unchanged

               ii. Weighted Average Cost of Capital – increase decrease unchanged

              iii. Value – increase decrease unchanged

              iv. Free Cash Flow – increase decrease unchanged

       b. If we consider a world with taxes but no other market imperfections, state
          what will happen to the firm’s

               i. Cost of Equity – increase decrease unchanged

               ii. Weighted Average Cost of Capital – increase decrease unchanged

              iii. Value – increase decrease unchanged

              iv. Free Cash Flow – increase decrease unchanged
       c. If we consider a world with taxes and default risk but no other market
          imperfections and we know that the firms optimal leverage ratio is 0.3, state
          what will happen to the firm’s

               i. Cost of Equity – increase decrease unchanged

              ii. Weighted Average Cost of Capital – increase decrease unchanged

             iii. Value – increase decrease unchanged

              iv. Free Cash Flow – increase decrease unchanged


2. Answer the following questions by circling true or false. (12 points)
      a. The sustainable growth rate tells you the maximum the firm can grow if it
         issues no debt or equity, assuming that the net income and pay out ratio stay
         the same.

              TRUE            or        FALSE

       b. If you run a regression of real growth in firm sales on real growth in GDP and
          find that the p-value on the x-variable coefficient (the m in y=mx+b) is .02,
          then you would conclude that this firms sales growth is related to the
          economy.

              TRUE            or        FALSE

       c. If the retail athletic shoe industry is expected to grow 10% next year and ABC
          athletic shoe retailer (that operates exclusively in this industry) is expected to
          grow 8%, then you would conclude that this firm is will have an increase in
          their sales market share.

              TRUE            or        FALSE




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3. Brook Fields Inc is a private company that manufactures hiking and camping
   equipment. The firm is considering going public. If the firm goes public, it will have
   a debt to equity ratio (based on market values) of 0.10. You are asked to evaluate the
   risk of the firm and you determine that there are 5 competitors with very similar
   business risk. Assume that the tax rate for Brook Fields and all competitors is 40%.
   Using the information below and the CAPM, calculate each of the following: (14
   points)

   Competitor                 Sales          E(growth)      Beta    Debt/Equity     Rd
   Outdoorsman Inc.           1 MM           12%            1.2       0.25          11%
   Camping Eqmt Inc.          1.5 MM         15%            1.3       0.10          10%
   Fresh Air Corp.            0.75 MM        20%            1.1       0.15          10%
   Rugmans.                   2.5 MM         7%             0.9       0.15          9%
   Orka Corp.                 0.25 MM        10%            1.5       0.35          15%


       a. The Beta for Brook Fields once the firm goes public




       b. The portion of Beta that is due to the business risk for Brook Fields.




       c. The portion of Beta that is due to the financial risk for Brook Fields.




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4. The following describes possible ways that you could model the plug in a pro-forma
   statement. For each, state if the modeling assumption implies that the firm being
   modeled is expected to retain cash, use cash reserves, issue debt, repay debt, issue
   stock or repurchase stock by circling as many of these that apply. (12 points)

       a. Debt will increase and decrease to balance the balance sheet.
             retain cash
             use cash reserves
             issue debt
             repay debt
             issue stock
             repurchase stock

       b. Equity and cash will increase to balance the balance sheet.
             retain cash
             use cash reserves
             issue debt
             repay debt
             issue stock
             repurchase stock


5. Obical Corp. has Income before interest, taxes and depreciation of $500, depreciation
   expense of $400, and interest expense of $200. The firm has $2000 of debt with an
   interest rate of 10%. The value of the firm if it has no debt (value of the unlevered
   firm) is $10,000. The firm’s income, depreciation, debt and interest are not expected
   to change (thus they will be the same forever). Assuming that the tax law is such that
   a firm cannot use its tax loss carry-forwards or carry-backs, so that a firm pays taxes
   on positive income but can not benefit from negative income, and the tax rate is 30%,
   calculate the value of the levered firm incorporating the tax benefit from debt (but
   not any other cost or benefit from debt). (10 points)




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6. In the diagram below or in your own words, explain why a circular reference results
   when cash is the plug. To use the diagram, you may draw an arrow if one variable
   listed impacts another. (10 points)

              Sales
              COGS
              Interest Expense
              Interest Income
              Income before Taxes
              Taxes
              Net Income
              Dividends
              Retained Earnings

              Cash
              Other Current Assets
              Fixed Assets
              Total Assets

              Current Liabilities
              Long-term Debt
              Common Stock
              Accumulated Retained Earnings
              Total Liabilities and Equity




7. Assuming everything else about firm A and firm B are the same except the items
   listed below, state which firm you think would have a higher optimal leverage ratio
   by circling the firm with the higher optimal. (8 points)
        a. Firm A has much higher growth potential than firm B.

              Firm A         Firm B         No Obvious Difference

       b. The managers of Firm B have very high ownership in the firm but the
          managers in firm A have very low ownership.

              Firm A         Firm B         No Obvious Difference




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8. In Project 1, you had to analyze the historical growth of SCP Pool in order to project
   future growth. State what type of corporate event complicated this analysis and
   briefly explain how your group overcame this complication (4 points)




9. You are the analyst on ABC Inc, which has just done a major debt restructuring. You
   need to calculate the WACC in order to value the firm. Based on historical
   information and the CAPM, you estimate the firm’s expected cost of equity to be
   14%. Before the restructuring, the firm had debt with a market value of 500 and a
   market value of equity of 500. Based on the current capital structure, the firm has
   debt with a market value of 300 and a market value of equity of 700. This change
   results in a decline in the firms cost of debt from 12% to 10%. Assuming that the tax
   rate is 30% and considering all of the costs and benefits of debt, (18 points)
       a. Calculate the firm’s WACC before the restructuring




       b. Calculate the firm’s current WACC (after the restructuring)




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