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# F409 Midterm Exam 2

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F409 Midterm Exam 2
April 4, 2001

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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