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TCH321 CORPORATE FINANCE MOCK EXAM Time: 1 hour 30 minutes The exam lasts 1 hour and 30 minutes and

d consists of 5 questions. Approved calculators are permitted. You are not allowed to use Excel. This is a closed book exam. You are NOT permitted to access any other material in either written or electronic form. All numerical answers should be reported to TWO decimal places. To ensure the accuracy of your answer, you should perform all intermediate calculations to at least THREE decimal places. Choose FIVE questions. DO show your working. Question 1. (20 marks) Suppose that you have the following information about a company Credit rating Beta Tax expense Pre-tax income Preferred dividend rate Preferred stock par value Preferred stock price Preferred stock outstanding Common stock price Common stock par value Common stock outstanding Expected next common stock dividend Long term bond yield-to-maturity Enterprise value Market risk premium 30 year Treasury bond yield-to-maturity AA 0.95 14,325,000 113,895,000 5.25% $100.00 $101.25 13,000,000 $53.29 $25.00 50,000,000 $1.95 7.55% 4,945,795,000 6.00% 4.75%

a. What is the estimated cost of common equity for the company? [4 marks]

b. What is the estimated after-tax cost of debt for the company? [4 marks]

c. What is the estimated cost of preferred equity for the company? [4 marks]

d. What is the estimated WACC of the company? [4 marks]

e. What is the implied long run growth rate of the companys dividends? [4 marks]

Question 2. (20 marks) Your company is considering buying a new factory. The initial cost of the factory is $500,000, but there is an annual maintenance charge of $15,000. The factory will be depreciated over 25 years on a straight line basis (i.e. the depreciation rate each year). Your company plans to sell the factory in 3 years for $400,000. Use of the factory requires an increase in net working capital of $40,000. The

factory would increase net operating revenues by $200,000. The companys marginal tax rate is 40 percent. Assume that all cash flows occur at the end of the respective year. a. What is the total year 0 cash flow? [4 marks]

b. What are the net operating cash flows in years 1, 2 and 3? [4 marks]

c. What is the terminal year cash flow? [4 marks]

d. If the projects cost of capital is 10 percent, what is the NPV of the project? [4 marks]

e. What is the payback period of the project? [4 marks]

Question 3. (20 marks) Consider two stocks, A and B, with the following expected returns and betas E(R) A B 9.55% 10.98% Beta 0.80 1.10

The risk free rate is 5.75% a. Assuming that Stock A is priced according to the CAPM, What is the market risk premium? [4 marks]

b. What is the equilibrium expected return of Stock B? [4 marks]

c. Consider Stock C, which has a beta of 0.90. Suppose that you have forecast a return of 8.00% for Stock C. Is Stock C is overpriced, underpriced or fairly priced? [4 marks]

d. Suppose that you construct an arbitrage portfolio to exploit any mispricing that you might have found in Stocks A, B and C. What would the weights of this portfolio be? [4 marks]

e. Suppose that the risk free rate rises by 1%. What is the equilibrium expected return of Stock A? [4 marks]

Question 4. (20 marks) Consider two stocks, A and B, with the following expected returns and standard deviations. E(R) A B 8.00% 12.00% Std. Dev. 20.00% 30.00%

The correlation coefficient between the returns of A and B is 0.3. Short selling is allowed. a. Consider a portfolio, P, that comprises 45% invested in stock A and 55% invested in stock B. What is the expected return, standard deviation and coefficient of variation of P? [4 marks]

b. Plot A and B in expected return-standard deviation space and draw (approximately) the feasible set for P. On this diagram, mark the minimum variance portfolio and the efficient set. [4 marks]

c. Draw (approximately) the feasible set, minimum-variance portfolio and efficient set when the correlation coefficient between A and B is (a) -1 and (b) +1. [4 marks]

d. Suppose that the correlation coefficient between A and B was -1. What are the weights of the minimum variance portfolio? [4 marks]

e. What would the risk free rate be if the correlation coefficient between A and B is -1? [4 marks]

Question 5. (20 marks) Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $30 per set, and this years sales are expected to be 450,000 units. Variable production costs for the expected sales under present production methods are estimated at $11,250,000, and fixed production (operating) costs at present are $1,600,000. WCC has $4,800,000 of debt outstanding at an interest rate of 8%. There are 240,000 shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is 70%, and WCC is in the 40% federal-plus-state tax bracket. The company is considering investing $7,200,000 in new equipment. Sales would not increase, but variable costs per unit would decline by 20%. Also, fixed operating costs would increase from $1,600,000 to $1,800,000. WCC could raise the required capital by borrowing $7,200,000 at 10% or by selling 240,000 additional shares at $30 per share. a. What would be WCCs EPS (1) under the old production process, (2) under the new process if it uses debt, and (3) under the new process if it uses common stock? [4 marks]


At what unit sales level would WCC have the same EPS assuming it undertakes the investment and finances it with debt or with stock? [4 marks]


At what unit sales level would EPS = 0 under the three production/financing setups that is, under the old plan, the new plan with debt financing, and the new plan with stock financing? [4 marks]


Assume that there is a fairly high probability of sales falling as low as 250,000 units and determine EPSDebt and EPSStock at that sales level. [4 marks]


On the basis of the analysis in Parts a through d and given that operating leverage is LOWER under the new setup, which of the three plans is the riskiest, which has the highest expected EPS, and which would you recommend? [4 marks]

Question 6. (20 marks) Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. Its treasury staff has consulted with investment bankers. On the basis of those discussions, the staff has created the following table showing the firms debt cost at different levels:

Debt-to-Assets Equity-to-Assets Debt-to-Equity Bond Rating Before-Tax Cost Ratio Ratio Ratio (D/E) of Debt 0.0 1.0 0.00 A 7.0% 0.2 0.8 0.25 BBB 8.0 0.4 0.6 0.67 BB 10.0 0.6 0.4 1.50 C 12.0 Elliott uses the CAPM to estimate its cost of common equity, rs, and estimates that the risk free rate is 5%, the market risk premium is 6%, and its tax rate is 40%. Elliott estimates that if it had no debt, its unlevered beta, bU, would be 1.2. a. Fill in the following tables. [12 marks] Equity-toAssets Ratio 0.8 0.6 0.4 Before-Tax Cost of Debt 8.0 10.0 12.0 After tax cost of debt [3 marks] Levered beta [3 marks] Cost of equity [3 marks] WACC [3 marks]

Debt-toAssets Ratio 0.2 0.4 0.6 b.

What is the firms optimal capital structure, and what would be its WACC at the optimal capital structure? [2 marks]


If Elliotts managers anticipate that the companys business risk will increase in the future, what effect would this likely have on the firms target capital structure? [3 marks]


c. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on Elliotts target capital structure? [3 marks]