PRACTICE FINAL EXAMS

Practice Final 1: Corporate Finance

1. Nadir, Inc., an unlevered firm, has expected earnings before interest and taxes of \$2 million per year. Nadir's tax rate is 40%, and the market value is V=E=\$12 million. The stock has a beta of 1, and the risk free rate is 9%. (Assume that E(Rm)-Rf=6%). Management is considering the use of debt. (Debt would be issued and used to buy back stock, and the size of the firm would remain constant.) The default free interest rate on debt is 12%. Since interest expense is tax deductible the value of the firm would tend to increase as debt is added to the capital structure, but there would be an offset in the form of the rising cost of bankruptcy. The firm's analysts have estimated , as an approximation, that the present value of any bankruptcy cost is \$8 million and that the probability of bankruptcy would increase with leverage according to the following schedule:
 Value of debt Probability of failure \$ 2,500,000 0.00% \$ 5,000,000 8.00% \$ 7,500,000 20.5% \$ 8,000,000 30.0% \$ 9,000,000 45.0% \$10,000,000 52.5% \$12,500,000 70.0%

a. What is the cost of equity and WACC at this time? (2 points)

b. What is the optimal capital structure when bankruptcy costs are considered? ( 4 points)

c. What will the value of the firm be at this optimal capital structure? ( 2 points)

2. If a stock is priced at \$50.00 with dividend, and its price falls to \$46.50 when a dividend of \$5.00 is paid, what is the implied marginal rate of personal taxes for its stockholders? Assume that the tax on capital gains is 40% of the personal income tax. (3 points)

3. On January 1, 1985, you are considering buying stock in Genetic Biology Systems (GBS), which has just announced a new type of corn which will provide nitrogen to the soil and thus eliminate the need to apply fertilizer. EPS in 1984 were \$1.20. The company's expected growth rate is 50% for 1985 and 1986, 25% for the following two years, and 10% thereafter. Its payout ratio is expected to be zero in 1985 and 1986, to rise to 20% in the following two years and then stabilize at 50%. The risk free rate is 10%, the expected return on the market is 15% and the beta is 1.2. What is true value of GBS stock? (5 points)

4. AD Inc. has assets of \$ 100 million and these are expected to remain unchanged. Assume that the interest rate is 5 percent, the corporate tax rate is 46 percent and debt interest is paid at the end of each year. If debt is a constant 30 percent of the value of the assets, what is the present value of the tax shield?

5. Valuation ( 15 points)

You are trying to value Godzilla Inc. You are provided with the following data on the company:

(a) The earnings per share currently is \$2.50.

(b) The after-tax return on assets for the firm is expected to be 15%.

(c) The firm currently pays out 40% of its earnings in dividends and is expected to maintain that payout ratio for the next five years, which comprises a period when it expects high growth.

(d) The firm has a debt-equity ratio of 0.5

(e) The firm pays an interest rate of 10% on its debt. The firm faces a tax rate is 40%.

(f) The firm is expected to reach its stable phase after the fifth year and grow at 8% beyond that. The return on assets will remain unchanged at 15%.

(g) The firm has a beta of 0.8. The riskfree rate is 7% and the expected return on the market is 15%.

Answer the following questions:

(1) Value the firm (5 points)

(ii) Mr. Boone Pickens is attempting to take over Godzilla Inc.. He claims that the managers are not managing the firm optimally. In particular he feels that

(a) The firm should borrow more money. He feels that a debt-equity ratio of 1.5 is appropriate for the firm.

(b) The firm should prune some of its losing projects. This will increase the after-tax return on assets to 20%.

(c) He agrees with the growth rate estimates for the stable phase.

(d) The interest rate on debt will increase to 12%.

Assuming that Mr. Pickens is right, how much will he be willing to pay for the firm. ( 5 points)

PRACTICE FINAL 2: FINANCIAL MANAGEMENT

I. As CEO of a major corporation, you have to make a decision on how much you can afford to borrow. You currently have 10 million shares outstanding and the market price per share is \$50. You also currently have about \$200 million in debt outstanding (market value). You are rated as a BBB corporation now.

(a). Your stock has a beta of 1.5 and the six-month T.Bill rate is 8%.

(b). Your marginal tax rate is 46%.

(c). You estimate that your rating will change to a B if you borrow \$100 million. The BBB rate now is 11%. The B rate is 12.5%.

(1) What is your best estimate of the Weighted Average Cost of Capital with and without the \$100 million in borrowing? (2 points)

WACCwithout=

WACCwith=

(ii) If you do borrow the \$100 million, what will the price per share be after the borrowing?

(2 points)

(iii) Assume that you have a project that requires an investment of \$100 million. It has expected before-tax revenues of \$50 million and costs of \$30 million a year in perpetuity. Is this a desirable project by your criteria? Why or Why not? ( 1 point)

(iv) Does it make a difference in your decision if you were told that the cash flows from the project in (iii) are certain? (1 point)

II. Calculate the beta for a company if its divisions have the following characteristics:
 Division Division Beta Book Value of Assets PV of cash flows A 1.1 3.4 5.9 B 1.3 5.0 9.0 C 0.8 9.5 12.3 D 1.4 4.1 7.8

(2 points)

IIb. Answer the following questions. (Each carries 1/2 point)

(1) What important assumption must be made to estimate the current market premium as the average of historical market premiums?

a. Market premiums have remained constant from year to year.

b. There has been no clear trend in market premiums, i.e. premiums have not been consistently increasing or decreasing.

c. We are using the same stocks in the market portfolio over the estimation period.

d. There has been litte or no inflation during the period used to estimate.

(2) The required rate of return shareholders expect (Rf+b(E(Rm-Rf)) includes dividend distribution as well as price appreciation.

TRUE FALSE

(3) Zero Rocks Corporation is considering the acquisition of Ibim which has a different level of risk. Which of the following should be used as the discount rate to properly value the acquisition?

a. The required rate of return for Zero Rocks

b. The required rate of return for Ibim

c. A weighted average of the two rates with relative market values used as weights.

d. The higher of the two rates.

IIIa. A company is making a decision on how much it should pay out to its stockholders. It has \$100 million in investible funds. The following information is provided on the firm:

(a) It has 100 million shares outstanding. Each share sells for \$15. the beta of the stock is 1.25 and the riskfree rate is 8%. The expected return on the market is 16%.

(b) The tax rate for the average stockholder on ordinary income is 40% and 16% on capital gains.

(c) The firm has \$ 500 million of debt outstanding. The marginal interest rate on the debt is 12%.

(d) The corporation's tax rate is 50%.

(e) The firm has the following investment projects:
 Project Investment Requirement After-Tax Return on capital A 15 million 27% B 10 million 20% C 25 million 16% D 20 million 14% E 30 million 12%

The firm plans to finance all its investment needs entirely with equity.

(i) Should the company return money to its stockholders? If so, how much should be returned to stockholders? ( 2 points)

(ii) If the company decides to pay the excess funds (from (i)) in the form of a dividend, what will

- the dividend per share be? ( 1 point)

- the price after the ex-dividend date ( 3 points)

(Assume that \$15 is the price before the ex-dividend date)

4. You are in the process of valuing a firm. You have been given the following information on it.

Current EPS = \$ 2.00

Fundamental data for growth rate:

ROA= 15%

Payout ratio=25%

D/E ratio =.5

Interest rate on debt=10%

Tax Rate = 40%

Growth rate beyond the fifth year = 4%

Required rate of return on stock = 15%

a. Value the firm ( 4 points)

b. It has been estimated that by quadrupling the debt you have, you will increase your firm's required rate of return to 17%. Would it make sense to quadruple debt? (Assume that other fundamental data does not change) ( 4 points)

CORPORATE FINANCE: PRACTICE FINAL 3

SPRING 1988

1. You have been hired as a management consultant by AD Corporation to evaluate whether they have an appropriate amount of debt. (They are worried about a leveraged buyout.) You have collected the following information on AD's current position:

(a) There are 100,000 shares outstanding at \$20/share. The stock has a beta of 1.15.

(b) They have \$500,000 in long-term debt outstanding and are currently rated as a 'BBB' company. The current market interest rate is 10% on "BBB" bonds and 6% on T.Bills.

(c) The company's marginal tax rate is 40%.

You proceed to collect the data on what increasing debt will do to the company's ratings:
 Additional debt* New Rating Interest Rate \$500,000 BB 10.5 \$1,000,000 B 11.5 \$1,500,000 B- 13.5 \$2,000,000 C 15

* In addition to the existing debt of \$500,000

a. How much additional debt should the company take on?

b. What will the price per share be after the company takes on new debt?

c. What is the weighted average cost of capital before and after the additional debt?

d. Assume that you are considering a project which has the following earnings in perpetuity, and is of comparable risk to existing projects.
 Revenues/year \$1,000,000 Cost of goods sold \$ 400,000 (Includes depreciation of \$100,000) EBIT \$ 600,000 Debt payments \$ 100,000 (All Interest payments) Taxable Income \$ 500,000 Tax \$200,000 After-tax profit \$ 300,000

If this project requires an investment of \$ 3,000,000, what is its' NPV?

2a. You are comparing the dividend policies of three firms. You have collected the following information on the ex-dividend behavior of the three firms: (The data is from 1986, before the new tax law)
 A B C Price before 50 70 100 Price after 48 67 95 Dividends/share 4 4 5

If you were a tax-exempt investor, which company would you use to make 'dividend arbitrage' profits? How would you go about doing it?

2b. XYZ company is currently paying out 60% of its earnings as dividends. Its current earnings per share is \$ 2.50 and its beta is 1.0 (The current six-month T.Bill rate is 6%). It has several promising projects in the pipeline (with an average return on Assets of 12%) and has a debt/equity ratio of 1.0. (It does not want to change this ratio and would like to keep its borrowing rates at the current level of 10%.) The firm faces a 40% tax rate. Assuming that all these measures hold in perpetuity, would you advise XYZ to cut its payout ratio to 40%?

3. You have just been hired by KKR and asked to do an evaluation of a potential leveraged buyout of LMN Corporation. Shares of the company are currently selling for \$40/share and there are 1,000,000 shares outstanding. LMN currently has no debt and its stock has a beta of 1. The leveraged buyout would involve buying out all shares outstanding at \$65/share and would be financed as follows:

New Equity= \$ 15 million New Debt: \$ 50 million

The interest rate on new debt is 20%, and the principal will be paid off in equal annual installments of \$10 million a year over five years. The current six-month T.Bill rate is 6% and the company's marginal tax rate is 50%.

You also have access to the projections made by KKR's analysts for future earnings from operations:

PROJECTIONS (in '000s)
 Year 1 Year 2 Year 3 Year 4 Year 5 Revenues 25,000 27500 30250 33275 36602 COGS 10,000 11000 12100 13310 14641 Depreciation 5,000 5000 5000 5000 5000 EBIT 10,000 11500 13150 14965 16961

The revenues are expected to grow at 8% beyond year 5.

(a) What are the projected cashflows to equity investors from this deal?

(b) What are the required rates of return to equity holders who invest in this deal?

(c) Should equity investors go through with the deal?

(d) How much of the value of this deal comes from the leverage?

FINAL EXAM: SPRING 1989

1. The managers of DB corporation have just been informed by a raider that he has been accumulating stock and that he intends to take over the company. The managers have called in Kohlberg, Kravis and Roberts as advisors in fighting the takeover. KKR recommends that they do a leveraged buyout of DB company. The following are some of the relevant details:

(a) DB currently has 1 million shares outstanding and each share is selling for \$25. It also has debt worth \$ 5 million. The beta of the stock currently is 1.08. The current six-month T.Bill rate is 9%. The firm's tax rate is 40%.

(b) KKR estimates that the firm can be acquired for \$50 million. The makeup of this financing will be as follows:

Bank Borrowing: \$ 10 million @ 20%

LBO participants:

(1) Senior debt: \$ 30 million @ 16%

(2) Subordinated debt: \$ 5 million @ 18%

(2) Equity: \$ 5 million

(c) The principal on the bank borrowing and the senior debt will be paid off in equal amounts over a period of five years. ( \$ 2 million a year for bank borrowing; \$ 6 million a year for senior debt). The principal on the subordinated debt will not be paid off but will become part of the long-term capitial structure of the firm (It will remain on the books beyond the fifth year.)

(d) The firm has net operating income (Revenues - Operating expenses-Depreciation) before interest and taxes of \$ 8 million currently. This income is expected to grow 20% each year for the next five years, and at 8% after the fifth year.

(e) The firm has depreciation of \$ 5 million a year currently. This is expected to remain unchanged for the future.

Attempt to answer the following questions:

(a) How much would equity investors require as a return on their investment in the LBO in each of the five years?

(b) Does the deal make sense from the viewpoint of the equity investors?

(c) Does the deal make sense from the viewpoint of all capital?

(d) Does the deal make sense from the viewpoint of the LBO participants?

2. UB Inc. is examining its capital structure with the intent of arriving at an optimal debt ratio. It currently has no debt and has a beta of 1.5. The riskless interest rate is 9%. Your research indicates that the debt rating will as follows at different debt levels:
 D/(D+E) Rating Interest rate 0% AAA 10% 10% AA 10.5% 20% A 11% 30% BBB 12% 40% BB 13% 50% B 14% 60% CCC 16%
70%CC18%

The firm currently has 1 million shares outstanding at \$ 20 per share. (Tax rate = 40%)

a. What is the firm's optimal debt ratio?

(b) Assuming that the firm restructures by repurchasing stock with debt, what will the value of the stock be after the restructuring?

3. A top executive of ABC Corporation is being offered an unusual salary package. One year from now he will be paid \$150000 plus an extra \$200 for every cent that ABC's stock price exceeds its price today (which is \$40). If ABC is below \$40 at year end he gets only the \$150000. If for example it is \$60 he gets \$150000 + \$200 X 2000 = \$550000. You are also given the following data.

(i) The riskfree rate is 10%

(ii) The standard deviation of ABC's stock prices (logs) is 30% and no dividends are paid on this stock.

Calculate the value of this package.

4. Based upon the empirical evidence that you have been presented with in class, state whether the following statements are true or false

1. Firms are reluctant to change dividends. TRUE FALSE

2. Stock prices generally go up on the ex-dividend date by less than the amount of the dividend TRUE FALSE

3. Increasing dividend payments to stockholders generally makes bondholders in the firm better off. TRUE FALSE

4. The cancellation of a takeover bid will cause the target firm's stock price to drop back to pre-merger levels. TRUE FALSE

5. A firm with a variance of 30% in its returns takes over another firm with a variance of 25% in returns. The beta of this firm will decrease after the takeover. TRUE FALSE

CORPORATE FINANCE: FINAL EXAM

Spring 1990

1. XYZ Corp. currently has \$25 million in outstanding debt and has 10 million shares outstanding. The book value per share is \$10 while the market value is \$ 25.00. The company is currently rated A and its bonds have a yield to maturity of 10% and the current beta of the stock is 1.06. The six-month T.Bill rate is 8% now and the company's tax is 40%.

a. What is the company's current Weighted average cost of capital? ( 2 points)

b. The company is considering a repurchase of 4 million shares @\$25 per share with new debt. It is estimated that this will push the company's rating down to a B (with a yield to maturity of 13%). What will the company's weighted average cost of capital be after the stock repurchase? ( 4 points)

2. Company A has just declared a dividend of \$ 1. The average investor in A faces an ordinary tax rate of 50%. While the capital gains rate is also 50%, it is believed that the investor gets the advantage of deferring this tax until future years (The effective capital gains rate will therefore be 50% discounted back to the present). If the price of the stock before the ex-dividend day is \$10 and it drops to \$9.20 by the end of the ex-dividend day, how many years is the average investor deferring capital gains taxes? (Assume that the opportunity cost (discount rate) used by the investor in evaluating future cashflows is 10%.) ( 6 points)

3. You have been asked to value a firm which has the following characteristics:

Current Earnings per share = \$ 2.00

Current Depreciation per share = \$ 3.00

Number of shares outstanding = 100,000

Current capital spending = \$250,000

Current working capital = \$ 200,000

You have also collected the following data on fundamental variables:

Return on Assets = 15%

Payout ratio = 40%

Debt/Equity ratio = 1.00

Interest rate on debt = 10%

Beta of the stock = 1.00

T. Bond rate = 9%

Tax Rate = 40%

Assume that both capital expenditures, depreciation and working capital grow at the same rate as earnings. You estimate that the growth rate in all four variables after year 5 will be 8%.

a. What is the expected growth rate in earnings over the next five years (using fundamentals)?

b. What is the projected payout ratio after year 5? (assuming fundamentals other than payout do not change) ( 1 point)

c. What is the value per share of stock using the dividend discount model? ( 2 points)

d. What is the value per share of stock using the free cashflows per share approach? ( 2 points)

4. You have been asked to evaluate an LBO which has the following projected cashflows:
 1 2 3 4 5 Term Yr. CF to Equity -100 -50 +50 +150 +250 300 Interest (1-t) 60 48 36 24 12 0 Princ. Repaid 100 100 100 100 100 0 CF to Firm 20 58 146 234 322 300

At the beginning of each time period, the debt and equity numbers were as follows:
 Debt 500 400 300 200 100 0 Equity 100 125 175 300 400 500

The unlevered beta is 1.00, the firm's tax rate is 40% and the six-month T.Bill rate is 8%.

a. What is the weighted average cost of capital in the first year? ( 2 points)

b. What is the terminal value of the firm? ( 1 points)

c. What is the present value of interest tax savings in year 1? ( 2 points)

5. You have been asked to value a 10-year convertible bond with the following features:

Current rating of company issuing bond = BBB
Current interest rate on 10-year BBB straight bonds = 12%

Interest rate on 10-year convertible bond = 8%

The convertible bond can be converted into 40 shares of stock at \$25. The current stock price is \$20 and the company pays an annual dividend of \$1.00 per share. The standard deviation of the stock is 10% and the ten-year T.Bond rate is 10%.

a. What is the conversion option worth? ( 3 points)

b. What is the value of the straight bond portion of the convertible bond? ( 3 points)

CORPORATE FINANCE: FINAL EXAM

Fall 1990

1. You have been called in as a consultant for CF Inc. that is examining its debt policy. The firm currently has a balance sheet that looks as follows:
 Liability Assets LT Bonds \$100 Fixed Assets 300 Equity \$300 Current Assets 100 Total \$400 Total 400

The firm's income statement looks as follows:
 Revenues 250 COGS 175 Depreciation 25 EBIT 50 LT Interest 10 EBT 40 Taxes 16 Net Income 24

The firm currently has 100 shares outstanding selling at a market price of \$5 per share and the bonds are selling at par. The firm's current beta is 1.12 and the six-month T.Bill rate is 7%.

a. What is the firm's current cost of equity? (1 point)

b. What is the firm's current cost of debt? (1 point)

c. What is the firm's current weighted average cost of capital? (1 point)

Assume that management of CF Inc. is considering doing a debt-equity swap, i.e. borrow enough money to buy back 70 shares of stock at \$5 per share. It is believed that this swap will lower the firm's rating to C and raise the interest rate on the company's debt to 15%.

d. What is the firm's new cost of equity? (1 point)

e. What is the effective tax rate (for calculating the after-tax cost of debt) after the swap? (1 point)

f. What is the firm's new cost of capital? ( 1 point)

2. A firm which has never paid dividends before is considering whether it should start paying dividends. This firm has a cost of equity of 22% and a cost of debt of 10%. (The tax rate is 40%). The firm has \$100 million in debt outstanding and 50 million shares outstanding selling for \$10 per share. The firm currently has net income of \$90 million and has depreciation charges of \$10 million. It also has the following projects available:
 Project Initial Investment EBIT (Annual) Depreciation Lifetime Salvage 1 \$10 million \$ 1 mil \$500,000 5 years \$2.5 mil 2 \$40 million \$ 5 mil \$ 1 million 10 years \$10 mil 3 \$50 million \$ 5 mil \$ 1 million 10 years \$10 mil

The firm plans to finances its future capital investment needs using 20% debt.

a. Which of these projects should the firm accept? ( 4 points)

b. How much (if any) should the firm pay out as dividends? (1 point)

3. You are faced with the task of valuing XYZ Corporation. You are provided with the following information:

Current Earnings per share= \$4.00 Current payout ratio = 40%

Return on Assets = 20 % Beta = 1.2

Debt/Equity ratio = 0.75 Interest rate on debt = 12 %

Treasury Bond Rate= 8% Number of shares outstanding= 100,000

You expect the firm to grow at 8% beyond the first five years, with the return on assets declining to 16%. You also know that XYZ Corporation has substantial real estate holdings which are currently unutilized and can be sold for \$1,000,000. What is your estimate of XYZ's intrinsic value?

a. What is your best estimate of the growth rate for the first five years? ( 1 point)

b. What is your best estimate of the payout ratio after year 5? ( 2 points)

c. What is your best estimate of the intrinsic value of this firm? (3 point)

4. You are analyzing the merger of two firms. ABC Inc. has a infinite growth rate of 8%, current earnings of \$500 and a beta of 1.20. DEF Inc. has an infinite growth rate of 6%, a current earnings of \$400 and a beta of 1.00. (The T.Bond rate is 8% and both firms have a payout of 50%.) The merger is expected to increase the infinite growth rate of the combined firm by 1%.

a. How much is ABC Inc. worth? ( 1 point)

b. How much is DEF Inc. worth? (1 point)

c. What will the growth rate of the combined firm be after the merger? (1 point)

d. What will the beta of the combined firm be after the merger? (1 point)

e. What is your best estimate of how much you would be willing to pay for synergy in this takeover? (2 points)

5a. Assume that a company has both convertible and straight bonds outstanding. The company's straight bond,which has a twenty-year maturity and a coupon rate of 12%, is selling for 950. The company's convertible bond, which also has a twenty-year maturity and a coupon rate of 8%, is selling for \$1035. What is the value of the conversion option in the convertible bond? ( 4 points)

5b.A company is considered delaying a project which annual after-tax cashflows of \$25 million but costs \$300 million to take (The life of the project is 20 years and the cost of capital is 16%). A simulation of the cashflows leads you to conclude that the standard deviation in the PV of cash inflows is 20%. If you can acquire the rights to the project for the next ten years, what are the inputs for the Black-Scholes model? (The six-month T.Bill rate is 8% , the ten year bond-rate is 12% and the twenty year bond rate is 14%.)

S = r =

K = s2 =

t = ( 2 points)

CORPORATE FINANCE: FINAL EXAM

Spring 1991

1. AD Inc. currently has a balance sheet that looks as follows:
 Liability Assets LT Bonds \$1000 Fixed Assets 1700 Equity \$1000 Current Assets 300 Total \$1000 Total 1000

The firm's income statement looks as follows:
 Revenues 1000 COGS 400 Depreciation 100 EBIT 500 LT Interest 100 EBT 400 Taxes 200 Net Income 200

The firm's bonds are all twenty-year bonds with a coupon rate of 10% which are selling at 90% of face value (The yield to maturity on these bonds is 11%). The stocks are selling at a PE ratio of 9 and have a beta of 1.25. The six-month T.Bill rate is 6%.

a. What is the firm's current cost of equity? (1 point)

b. What is the firm's current after-tax cost of debt? (1 point)

c. What is the firm's current weighted average cost of capital? (2 points)

Assume that management of CF Inc., which is very conservative, is considering doing a equity for debt swap, i.e. issuing \$200 more of equity to retire \$200 of debt. This action is expected to lower the firm's interest rate by 1%.

d. What is the firm's new cost of equity? (1 point)

e. What is the new WACC? (1 point)

f. What will the value of the firm be after the swap? ( 1 point)

2. LMN Corp. is faced with the decision of how much to pay out as dividends to its stockholders. It expects to have a net income of \$ 1000 (after depreciation of \$500) and it has the following projects:
 Project Initial Investment Beta IRR (to equity investors) A \$ 500 2.0 21% B \$600 1.5 20% C \$ 500 1.0 12%

The firm's beta is 1.5 and the current riskfree rate is 6%. The firm plans to finance net capital expenditures (cap ex -depreciation) and working capital with 20% debt. The firm also has current revenues of \$5000, which it expects to grow at 8 %. Working capital will be maintained at 25% of revenues.

a. How much should the firm return to its stockholders as a dividend? ( 2 points)

b. Most of the investors in LMN corporation are other corporations, which pay 40% of their ordinary income and 28% of their capital gains as taxes. However, they are allowed to exempt 85% of the dividends they receive from taxes. If there are 1000 shares outstanding, selling at \$10 per share, how much would you expect the stock price to drop on the ex-dividend day? (Use the dividend amount you calculated in part a for this part) ( 2 points)

3. You are faced with the task of valuing NYU Corporation. You are provided with the following information:

(1) NYU corporate has a beta of 1 and the tax rate is 40%. The current T.Bond rate is 8.5%.

(2) NYU expects to have return on assets on its projects of 20% for the first three years and 16% thereafter. It has no debt.

(3) NYU expects the following growth rates in earnings per share. (The current earnings per share is \$4.00)
 Year g 1 20% 2 15% 3 10% 4 - _ 8%

a. What is your best estimate of value using the dividend discount model? (3 points)

b. If the debt-equity ratio is increased to 1 and the interest rate on debt is 10%, how much would the value of this firm change? (The tax rate is 40%.) (4 points)

4. You are valuing the compensation package of an executive for your company. He has been guaranteed \$500,000 next year and he will also receive \$10,000 for every dollar that the stock price rises above \$ 50 over the next year. The bonus package will be capped off at \$250,000, i.e. he will receive no additional bonuses if the stock price exceeds \$75. The current stock price is \$45. This company has only put options traded on it on the Options exchange. The prices of the traded put options are provided below:

Strike price 3-month 6-month 1 year

45 1.00 2.25 3.00

50 7.00 9.00 12.00

75 30.25 30.50 31.00

The riskless interest rate is 10%. Value this package. ( 6 points)

CORPORATE FINANCE

FINAL EXAM: FALL 1992

1. You have been asked to analyze the capital structure of DASA Inc, and make recommendations on a future course of action. DASA Inc. has 40 million shares outstanding, selling at \$20 per share and a debt-equity ratio (in market value terms) of 0.25. The beta of the stock is 1.15, and the firm currently has a AA rating, with a corresponding market interest rate of 10%. The firm's income statement is as follows:
 EBIT \$150 million Interest Exp. \$ 20 million Taxable Inc. \$130 million Taxes \$ 52 million Net Income \$ 78 million

The current T.Bill rate is 8%.

(Questions 1a through 1d all relate to DASA Inc.)

a. What is the firm's current Weighted average cost of capital? (1 point)

b. The firm is proposing borrowing an additional \$200 million in debt and repurchasing stock. If it does so its rating will decline to A, with a market interest rate of 11%. What will the Weighted average cost of capital be if they make this move? (1 point)

c. What will the new stock price be if they borrow \$200 million and repurchase stock (assuming rational investors)? (1 point)

d. Now assume that the firm has another option to raise its debt/equity ratio (instead of borrowing money and repurchasing stock). It has considerable capital expenditures planned for the next year (\$150 million). The company also pays \$1 in dividends per share currently (Current Stock Price=\$20). If the company finances all its capital expenditures with debt and doubles its dividend yield from the current level for the next year, what would you expect the debt/equity ratio to be at the end of the next year. (3 points)

2a. RYBR Inc., an all-equity firm, has net income of \$100 million currently and expects this number to grow at 10% a year for the next three years. The firm's working capital increased by \$10 million this year and is expected to increase by the same dollar amount each of the next three years. The depreciation is \$50 million and is expected to grow 8% a year for the next three years. Finally, the firm plans to invest \$60 million in capital expenditure for each of the next three years. The firm pays 60% of its earnings as dividends each year. RYBR has a cash balance currently of \$50. Assuming that the cash does not earn any interest, how much would you expect to have as a cash balance at the end of the third year? (3 points)

2b. Now assume that stockholders in RYBR are primarily corporations. They are exempt from ordinary taxes on 85% of the dividends that they receive (Ordinary tax rate=30%), and pay capital gains on price appreciation at a 20% rate. If RYBR pays a dividend of \$2 per share, how much would you expect the stock price change to be on the ex-dividend date? (3 points)

3. LOB Inc. is a firm with the following characteristics:
 Year 1 2 3 After year 3 Growth rate in Earnings 20% 16% 12% 8% ROA 20% 20% 16% 12% D/E 0% 10% 25% 50% i NA 8% 8% 8%

The firm has EPS currently of \$2.00 and the beta now is 1.00. The tax rate is 40%. The current riskfree rate is 6.5%. The tax rate is 40%.

a. What would you project the EPS and DPS to be for the next three years? (2 points)

b. What is the terminal price (at the end of the third year)? (2 points)

c. What is your best estimate for the DDM Value per share? (2 points)

4. You have been approached by a real estate conglomerate with a deal. You can buy 100,000 square feet of space in a mall at \$50/square foot. Over the next ten years, you expect to make an after-tax cash inflow of \$500,000 a year. At the end of ten years, you expect to be able to sell the space back at \$5,000,000 to other investors.

a. From a standard capital budgeting analysis, would you take this project if your discount rate is 15%? (2 points)

b. Assume that the promoters, as an inducement, offer to give you the option to buy another 100,000 square feet at today's price anytime over the next five years. The five year bond rate is 6%, and the prices per square foot for the last six years have been as follows:
 Year Price/Square Foot -6 \$20 -5 \$30 -4 \$55 -3 \$70 -2 \$55 -1 \$50

What is the value of this option? (4 points)

[Just set up the inputs for the Black-Scholes. You do not have to solve for the value]

CORPORATE FINANCE

FINAL EXAM: FALL 1993

1. You are a corporate finance analyst at a management consulting firm, which has been approached by a company for advice on its capital structure decisions. The company, Boston Turkey Inc., has been in existence for only two years, and its stock is currently trading at \$20 per share (There are 100,000 shares outstanding.) The following are the most recent financial statements of the company:
 Income Statement Revenues \$ 1,000,000 - Expenses \$ 400,000 - Depreciation \$ 100,000 EBIT \$ 500,000 - Interest Expense \$ 100,000 Taxable Income \$ 400,000 - Tax \$ 160,000 Net Income \$ 240,000

Balance Sheet

Assets Liabilities
 Property, Plant & Equipment \$ 1,500,000 Accounts Payable \$ 500,000 Land & Buildings \$ 500,000 Long Term Debt \$ 1,000,000 Current Assets \$ 1,000,000 Equity \$ 1,500,000 Total \$ 3,000,000 Total \$ 3,000,000

The debt is not traded, but its estimated market value is 125% of face (book) value.

Due to its limited history, the beta of the stock cannot be estimated from past prices. You do have information about comparable listed firms and their betas --
 Firm Beta Debt/Equity Ratio Kentucky Fried Chicken 1.05 20% Hardee's 1.20 50% Popeye's Fried Chicken 0.90 10% Roy Rogers 1.35 70%

(The comparable firms all have the same tax rate as Boston Turkey)

As general information, you have also collected data on interest coverage ratios, ratings and interest rate spreads, and they are summarized below:
 Rating Interest Cov. Ratio gt. and Cov. Ratio lt. Spread over T-bond AAA 9.65 _ 0.30% AA 6.85 9.35 0.70% A+ 5.65 6.849999 1.00% A 4.49 5.649999 1.25% A- 3.29 4.4899999 1.50% BBB 2.76 3.2899999 2.00% BB 2.17 2.7599999 2.50% B+ 1.87 2.1699999 3.00% B 1.57 1.8699999 4.00% B- 1.27 1.5699999 5.00% CCC 0.87 1.2699999 6.00%

CC

0.67

0.8699999

The treasury bill rate is 3.00% and the treasury bond rate is 6.25%.

a. What is the current cost of equity?

b. What is your best estimate of the current after-tax cost of debt? (The company is not rated currently)

c. What is the current cost of capital?

As part of your analysis, you are examining whether Boston Turkey should borrow \$500,000 and buy back stock. If it does so, its rating will drop to A-.

d. If it does so, what will the new cost of equity be?

e. How much will the stock price change if it borrows \$500,000 and buys back stock?

2. Boston Turkey was so impressed with your grasp of capital structure basics that they have come back to you for some advice on dividend policy. To save you the trouble of having to refer back to page 1, the latest financial statements are reproduced on this page.

Income Statement

 Revenues \$ 1,000,000 - Expenses \$ 400,000 - Depreciation \$ 100,000 EBIT \$ 500,000 - Interest Expense \$ 100,000 Taxable Income \$ 400,000 - Tax \$ 160,000 Net Income \$ 240,000

Balance Sheet

Assets Liabilities
 Property, Plant & Equipment \$ 1,500,000 Accounts Payable \$ 500,000 Land & Buildings \$ 500,000 Long Term Debt \$ 1,000,000 Current Assets \$ 1,000,000 Equity \$ 1,500,000 Total \$ 3,000,000 Total \$ 3,000,000

Boston Turkey expects its revenues to grow 10% next year, and its expenses to remain at 40% of revenues. The depreciation and interest expenses will remain unchanged at \$100,000 next year. The working capital, as a percentage of revenue, will remain unchanged next year.

The managers of Boston Turkey claim to have several projects available to choose from next year, where they plan to invest the funds from operations, and suggest that the firm really should not be paying dividends. The projects have the following characteristics --

Project Equity Investment Expected Annual CF to Equity Beta

A \$ 100,000 12,500 1.00

B \$ 100,000 14,000 1.50

C \$ 50,000 8,000 1.80

D \$ 50,000 12,000 2.00

The treasury bill rate is 3% and the treasury bond rate is 6.25%. The firm plans to finance 40% of its future net capital expenditures (Cap Ex - Depreciation) and working capital needs with debt.

a. How much can the company afford to pay in dividends next year?

b. Now asssume that the firm actually pays out \$1.00 per share in dividends next year. The current cash balance of the firm is \$150,000. How much will the cash balance of the firm be at the end of next year, after the payment of the dividend?

c. The average investor in Boston Turkey is a wealthy individual, who pays 40% in taxes on ordinary income and only 28% on capital gains. How much would you expect the price to drop on the ex-dividend day, if the company pays out \$1 per share as dividend?

3. You are now trying to value Boston Turkey. For purposes of simplicity, the relevant information about the company is reproduced here --

Current Numbers:

Earnings per share = \$ 2.40 Net Income = \$240,000

Dividends per share = \$ 1.00 Interest Expenses = \$100,000

Market price per share = \$ 20 Book Value of Debt = \$1,000,000

Number of shares = 100,000 Book Value of Equity = \$1,500,000

Market Value of Debt = 1,250,000 Tax Rate = 40%

Due to its limited history, the beta of the stock cannot be estimated from past prices. You do have information about comparable listed firms and their betas --

Firm Beta Debt/Equity Ratio

Kentucky Fried Chicken 1.05 20%

Hardee's 1.20 50%

Popeye's Fried Chicken 0.90 10%

Roy Rogers 1.35 70%

(The comparable firms all have a tax rate of 40%)

[ This is the same information you were given in problem 1. You can use the beta estimated from that section in this problem.]

a. Assuming that these numbers are sustainable for the next three years, what is the expected growth rate in earnings per share for this period?

b. The growth rate after year 3 is expected to be 6% forever. What will the price per share be at the end of year 3?

c. What is the value per share using the dividend discount model?

4. I am attempting to do a leveraged buyout of Boston Turkey, but have run into some roadblocks and come to you for advice. I have some partially completed projected cashflow statements, and I need your help to complete them.
 Year 1 2 3 4 5 Term. Year Revenues \$1,100,000 \$1,210,000 \$1,331,000 \$1,464,100 \$1,610,510 \$1,707,141 - Expenses \$440,000 \$484,000 \$532,400 \$585,640 \$644,204 \$682,856 - Depreciation \$100,000 \$110,000 \$121,000 \$133,100 \$146,410 \$155,195 EBIT \$560,000 \$616,000 \$677,600 \$745,360 \$819,896 \$869,090 - Interest Exp. \$360,000 \$324,000 \$288,000 \$252,000 \$216,000 \$180,000 Taxable Income \$200,000 \$292,000 \$389,600 \$493,360 \$603,896 \$689,090 - Tax \$80,000 \$116,800 \$155,840 \$197,344 \$241,558 \$275,636 Net Income \$120,000 \$175,200 \$233,760 \$296,016 \$362,338 \$413,454

The capital expenditures are expected to be \$120,000 next year and grow at the same rate as revenues for the rest of the period. Working capital will be kept at 20% of revenues. (Revenues this year were \$1,000,000.)

The leveraged buyout will be financed with a mix of \$ 1,000,000 of equity and \$3,000,000 of debt (at an interest rate of 12%). Part of the debt will be repaid by the end of year 5, and the debt remaining at the end of year 5 will remain on the books premanently.

a. Estimate the cashflows to equity and the firm for the next two years.

b. I have computed the cost of equity in year 1. Compute the cost of equity each year for the rest of the period.
 1 2 3 4 5 Term. Year Equity 1,000,000 Debt 3,000,000 Debt/Equity Ratio 3.00 Beta 2.58 Cost of Equity 24.90%

c. Compute the terminal value of the firm.

Corporate Finance: Fall 1994

General Information

The current treasury bond rate is 8.00%. All the questions in this exam relate to the company described in problem 1. You can use information across problems.

1. Jackson-Presley Inc. is a small company in the business of producing and selling musical CDs and cassettes and it is also involved in promoting concerts. The company last two reported income statements indicate that the company has done very well in the last two years ñ
 Last Year Current Year Revenues \$ 100 million \$150 million - Cost of Goods Sold \$ 40 million \$ 60 million - Depreciation & Amortization \$ 10 million \$ 13 million Earnings before interest and taxes \$ 50 million \$ 85 million Interest Expenses \$ 0 \$ 5 million Taxable Income \$ 50 million \$ 80 million Taxes \$ 20 million \$ 32 million Net Income \$ 30 million \$ 48 million

The company's current balance sheet also provides an indication of the company's health ñ

Assets Liabilities
 Property, Plant & Equipment \$ 100 million Current Liabilties \$ 20 million Land and Buildings \$ 50 million Debt \$ 60 million Current Assets \$ 50 million Equity \$120 million Total \$ 200 million Total \$ 200 million

Jackson-Presley's stock has been listed on the NASDAQ for the last two years and is trading at twice the book value (of equity). There are 12 million shares outstanding. Jackson-Presley derives 75% of its total market value from its record/CD business and 25% from the concert business. While the price data on the company is insufficient to estimate a beta, the betas of comparable firms in these businesses is as follows ñ

Comparable Firms
 Business Average Beta Average D/E Ratio Record/CD Business 1.15 50.00% Concert Business 1.20 10.00%

(You can assume that these companies have 40% tax rates)

The debt is composed of ten-year bonds, and is rated A (Typical A rated bonds are yielding 10% currently in the market).

a. Estimate the market value of the debt. (2 points)

b. Estimate the current cost of equity. ( 3 points)

c. Estimate the current weighted average cost of capital. ( 1 point)

d. If the treasury bond rate were to rise to 9%, make your best estimate of the new cost of capital. (2 points)

2. Jackson-Presley, in the latest year, had a dividend payout ratio of 25%. The firm has asked you for some advice on whether it should maintain this payout ratio. The income statements for the current year and the current balance sheet are reproduced below ñ

Current Year
 Revenues \$150 million - Cost of Goods Sold \$ 60 million - Depreciation & Amortization \$ 13 million Earnings before interest and taxes \$ 85 million Interest Expenses \$ 5 million Taxable Income \$ 80 million Taxes \$ 32 million Net Income \$ 48 million

The company's last balance sheet also provides an indication of the company's health ñ

Assets Liabilities
 Property, Plant & Equipment \$ 100 million Current Liabilties \$ 20 million Land and Buildings \$ 50 million Debt \$ 60 million Current Assets \$ 50 million Equity \$120 million Total \$ 200 million Total \$ 200 million

ï The equity is trading in the market at two times the book value. The debt is composed of ten-year bonds, and is rated A (Typical A rated bonds are yielding 10% currently in the market).

ï Assume that Jackson-Presley intends to maintain its working capital at the same percentage of revenues for the next year, as it has this year.

ï Also assume that the following is the listing of the major investment opportunities that Jackson-Presley has for the next year.

Project Total Investment IRR on project Beta (Levered)

(using CF to Equity)

A \$ 15 million 16% 1.60

B \$ 30 million 15% 1.25

C \$ 25 million 12.5% 1.0

D \$ 20 million 11.5% 0.5

a. If revenues, net income and depreciation are all expected to grow 20% next year, and the firm maintains its existing debt financing mix (in market value terms), how much can the firm afford to pay out as dividends after meeting working capital and capital budgeting needs? ( 5 points)

b. The company's current cash balance is \$10 million. What will happen to this cash balance if Jackson-Presley maintains its payout ratio at 25% next year? (1 point)

3. The managers at Jackson-Presley also believe that they are significantly undervalued, and want you to estimate how much the equity in the firm is truly worth. They provide you with the following additional information ñ

ï They believe that they can maintain 'high growth' for the next five years.

ï The beta calculated, using comparable firms, in problem 1b, is a good estimate of the beta for the next five years.

ï The dividend payout ratio will be maintained at 25% for the high-growth period.

ï The current (from the current income statement and balance sheet) return on assets, debt equity ratio and interest rate will be maintained for the high growth period.

• There are 12 million shares outstanding.

ï After the high-growth period, the earnings growth rate is expected to drop to 6%, and the firm's return on assets will also drop to 15%. The debt equity ratio and interest rate are expected to remain unchanged. The beta is expected to be 1.00 in the stable growth period.

a. Estimate the expected growth rate in the high growth period. ( 2 points)

b. Estimate the expected dividends in the high growth period. (1 point)

c. Estimate the expected payout ratio in the stable growth phase. (2 points)

d. Estimate the terminal price (at the end of the high-growth period) (2 points)

e. Estimate the value today from the dividend discount model. (1 point)

4. Jackson-Presley is now planning a major restructuring involving the following actions _

• A division, producing records and cassettes, will be sold for \$ 50 million. That division is currently earning \$ 5 million before interest and taxes. As mentioned in problem 1, comparable firms in this business have an average beta of 1.15 and an average debt/equity ratio of 50%.
• The cash from the sale of the divisions will be used to buy back stock.
• The dividend payout ratio will be reduced to 15%.

a. Estimate the new growth rate in earnings, after the restructuring, using fundamentals.

(4 points)

b. Estimate the new cost of equity for Jackson-Presley after the restructuring. (4 points)

FINAL EXAM: FALL 1995

Answer all questions on the exam. If you have additional work, please attach the work.

1. SDL is a firm manufacturing perfumes and other cosmetics and it sells its products world wide. The financial statements for the most recent two years are included below.

Income Statements

(All figures in millions)

 1993 1994 Revenues \$ 150.00 \$ 200.00 - Operating Expenses \$ 115.00 \$ 140.00 - Depreciation \$ 10.00 \$ 20.00 = EBIT \$ 25.00 \$ 40.00 - Interest Expenses \$ 5.00 \$ 6.50 = Taxable Income \$ 20.00 \$ 33.50 - Taxes \$ 5.00 \$ 13.50 = Net Income \$ 15.00 \$ 20.00

Balance Sheets (in millions)

 1993 1994 1993 1994 Fixed Assets \$150 \$175 Current Liabilities \$40 \$50 Current Assets \$60 \$75 Debt \$90 \$100 Equity \$80 \$100 Total \$ 210 \$ 250 Total \$ 210 \$250

In addition, you are provided the following information ñ

• The long-term treasury bond rate is 6%.
• There are 10 million shares outstanding, trading at \$ 40 per share currently; the stock has been traded for only two years. A regression of stock returns against market returns yields a beta of 0.9, with a standard error of 0.8. There are, however, five cosmetics firms which are publicly traded, with the following estimates of betas for each.

 Company Beta D/E Ratio Alberto Culver 0.85 10% Avon Products 1.3 40% Gillette 1.25 25% Helen of Troy 0.95 15% Helene Curtis 0.85 20%

All these firms face a marginal tax rate of 40%.

• The debt on the balance sheet has two components. The first is traded bonds, with ten years to expiration and a coupon rate of 7%; there are 50,000 bonds outstanding, trading at \$ 850 apiece (the face value is \$ 1000). The second is \$50 million in bank debt, which also has a ten year maturity, and carries an interest rate of 6%.

a. Estimate the cost of equity for SDL Inc. (2 points)

b. Estimate the market value of debt and the after-tax cost of debtfor SDL Inc. (3 points)

d. Estimate the cost of capital for this firm. (1 point)

e. Assume that you have regressed SDLís firm value over the last 8 quarters against long term rates, GNP growth and the DM (SDLís overseas sales are primarily in Europe) and have arrived at the following results ñ

Change in firm value = 0.11 - 1.50 (Change in Long Term Interest Rate)

Change in firm value = 0.18 + 0.50 (GNP Growth)

Change in firm Value = 0.15 - 0.26 (US \$ /DM Currency Rate)

Does SDLís current debt mix (ten-year \$ debt) fit its needs? If so, why? If not, why not? How would you change the debt mix to fit their firm characteristics? (2 points)

f. Assume that this firm decides to do an acquisition of XLNT Inc, a specialty retailer, who sells primarily cosmetics. XLNT has an estimated market value of equity of \$ 150 million, a beta of 1.25 and no debt outstanding. The acquisition will be financed entirely with debt, which will result in the rating for SDL dropping to BBB; typical BBB rated bonds currently carry an interest rate of 9.5%. Estimate SDLís cost of capital after this acquisition. (4 points)

2. VRF Inc. is a well-established firm that manufactures automobile components, and has a long and venerable history. It has come to you for advice on dividend policy, and it provides you with the following information for 1994 (which is its most recent year of financial data)ñ

• In 1994, it had revenues of \$1,000 milion and made a net income of \$ 150 million; it had a book value of equity of \$ 1.5 billion.
• It had capital expenditures of \$ 175 million in 1994, and depreciation of \$ 100 million.
• The working capital increased from \$80 million in 1993 to \$100 million in 1994.
• The firm did not have debt outstanding at any time during the year.
• The firmís cash balance increased by \$ 25 million from 1993 to 1994, after the payment of dividends for the period.

a. How much did the company pay out as dividends during 1994? (4 points)

b. Assume now that you are trying to estimate how much it should pay out as dividends during 1995, and that you are given the following additional information ñ

• The revenues and earnings are expected to grow 10% from 1994 levels.
• The working capital is expected to remain at the same percent of revenues as in 1994.
• The depreciation is expected to grow at the same rate as earnings, but the firm has broken out its expected capital expenditures by division for 1995ñ

 Division Cap Ex Needs Return on Equity Beta A \$ 75 million 13% 1.00
 B \$ 50 million 16% 2
 C \$ 65 million 12% 0.8 D \$ 60 million 15% 1.1

The long term bond rate is 6%, and the beta of the stock is 1.05.

• The firm also plans to raise 20% of its net capital expenditure and working capital needs from debt.

Should it make all its scheduled capital expenditures? Assuming that you can reevaluate these capital expenditures, how much cash does the firm have available to return to stockholders in 1995? (5 points)

3. You are trying to value a company using the dividend discount model. You have collected the following information on the firm ñ

• The company has earnings per share currently of \$2.00, and pays 20% of its earnings as dividends. Its book value of equity per share is \$10.00, and it is trading at 2.5 times the book value.
• The firm has no leverage currently, and is expected maintain this policy for the high growth phase, which is expected to last 3 years. During the high growth phase, the beta is expected to be 1.5.
• After 3 years, the firm is expected to reach stable growth and earnings are expected to grow 6% a year. The fundamentals are expected to approach industry averages for return on assets (where the average is 14%), leverage (where the industry average debt/equity ratio is 25%) and unlevered beta (where the industry average unlevered beta is 0.8).

The long term treasury bond rate is 6%.

a. Estimate the expected growth rate during the high growth period. (2 points)

b. Estimate the terminal value per share at the end of the high growth period. (4 points)

c. Estimate the value per share using the dividend discount model. (3 points)

Corporate Finance: Final Exam - Spring 1996

Aswath Damodaran

This exam is worth 30 points. Please answer all questions.

1. You have been hired by Samson Corporation, a mid-size company which manufactures luggage to assess their capital structure. You have been provided with the most recent income statement and balance sheet for the company ñ

Income Statement

 Revenues \$ 100 million - COGS \$ 60 million (Includes deprecín of \$ 10 million) = EBIT \$ 40 million - Interest Expenses \$ 5 million = Taxable Income \$ 35 million - Taxes \$ 14 million = Net Income \$ 21 million

Balance Sheet

Assets Liabilities
 Fixed Assets \$ 100 million Current Liabilities \$ 20 million Current Assets \$ 40 million Debt \$ 60 million Equity \$ 60 million

The company had 10 million shares outstanding trading at \$24 per share. Nearly 40% of the outstanding stock is held by the founding family. You are also provided with the following additional information ñ

• A regression of returns on the stock against a market index over the last 5 years yields a beta of 0.90, but Samson had no debt for the first four out of the five years. Its debt ratio in the fifth year was similar to its current debt ratio.
• The debt is 10-year bank debt; however, based on its interest coverage ratio the firm would be rated AA and carry a market interest rate of 10%. The treasury bond rate is 8%.

a. Estimate the current cost of equity for Samson Corporation. ( 2 points)

b. Estimate the current weighted average cost of capital for Samson Corporation ( 2 points)

c. Assume now that Samson Corporation plans to double its debt ratio. The bond rating is expected to drop to BBB, with a market interest rate of 11.5%. Estimate the new cost of capital. ( 2 points)

d. If Samson does decide to double its debt capacity immediately by buying back stock, estimate the dollar debt it would need to borrow. ( 1 point)

e. If Samson decides to double its debt ratio over the next 3 years, and plans to use the new debt to finance new projects, estimate the total dollar debt that the firm will have to issue over the next 3 years. (Samson pays no dividends) ( 3 points)

f. Based upon the most recent financial data, would you suggest that Samson take projects with the debt or return cash to stockholders. Explain. (1 point)

2. You have been asked by Jupiter Corporation, a toy manufacturer, for advice on dividend policy. Jupiter Corporation had net income of \$ 150 million in 1995 and reported depreciation of \$ 20 million. Its balance sheets for 1994 and 1995 are provided below (in millions):

Assets Liabilities
 1994 1995 1995 1995 Fixed Assets \$750 \$ 800 Current Liabilities \$50 \$60 Current Assets Debt \$ 200 \$ 215 Cash \$ 50 \$ 100 Equity \$ 650 \$ 720 Non-cash Current Assets \$100 \$ 120

a. Estimate how much Jupiter paid out as dividends during 1995. ( 2 points)

b. Estimate how much capital expenditure Jupiter Corporation had in 1995. ( 1 point)

c. Now assume that you have been given the following information on next yearís projections for Jupiter Corporation.

• Net Income, depreciation and non-cash working capital are expected to increase 10% from 1995 levels.
• The firm has four projects that it is considering for next year:

 Project EBIT Investment Beta A \$ 6.67 million \$ 30 million 1.20 B \$ 3.33 million \$ 20 million 1.00 C \$4.17 million \$ 20 million 1.10 D \$ 8.33 million \$ 35 million 2.00

Assume that the firm plans to finance these projects at a debt to capital ratio of 25%, and that the cost of debt is 8% (Corporate tax rate = 40%), and that the treasury bond rate is 7%. Estimate how much Jupiter can afford to pay out next year as dividends. ( 4 points)

3. You are trying to value Wee-Growth, a firm that manufactures childrenís software using the dividend discount model. In the most recent year, Wee-Growth had earnings per share of \$ 3.00, dividends per share of \$ 1.00 and a beta of 1.30. In the same year, the firm also had a return on assets of 25%, a debt-equity ratio of 25% and paid an interest rate of 8% on its debt. (Its corporate tax rate was 40%.) Over the next 3 years, Wee-Growth expects to maintain its existing dividend payout ratio, return on assets, debt-equity ratio and pre-tax interest rate. After year 3, the firm expects its beta to drop to 1, its return on assets to move to the industry average of 15% and its leverage to remain unchanged. The treasury bond rate is 7%.

a. Estimate the expected growth over the next 3 years. ( 2 points)

b. Estimate the expected dividends per share over the next 3 years. ( 1 point)

c. Estimate the terminal price (at the end of the third year). ( 3 points)

d. Estimate the value per share today. ( 1 point)

e. Assume now that you had valued Wee-Growth also using the FCFE model. The capital expenditure per share in the most recent year was \$ 2.50, whereas the depreciation was \$ 1.00 per share. Assuming that these grow at the same rate as earnings for the next 3 years, and that they offset each other after 3, estimate the value per share. [There are no working capital requirements] ( 4 points)