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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 2 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. 3 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) 4 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 5 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) 6