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AMERICAN UNIVERSITY IN BULGARIA BUS 330: CORPORATE FINANCE I FALL 2012, AUBG

MIDTERM EXAM 1 Name: ___________________________________ ID _________ Version 2 Solution Guide

INSTRUCTIONS: 1. You have 75 minutes to complete the exam. 2. The exam is worth a total of 100 points. 3. You may use a calculator and scratch paper sheets. You must hand in the sheets with your exam (put your name on it). 4. Allocate your time wisely. Use the number of points assigned to each problem as your guide. 5. In order to get full credit on the problems, you must show ALL your work! 6. You can get partial credits if you show your calculations or provide arguments to support your answer. 7. No credits will be warded if you fail to state your assumptions or conclusions explicitly.

Part A: Multiple choice questions (16 points in total): 1. Which of the following statements is CORRECT? a. It is generally more expensive to form a proprietorship than a corporation because, with a proprietorship, extensive legal documents are required. b. Corporations face fewer regulations than sole proprietorships. c. One disadvantage of operating a business as a sole proprietorship is that the firm is subject to double taxation, at both the firm level and the owner level. d. One advantage of forming a corporation is that equity investors are usually exposed to less liability than in a regular partnership. e. If a regular partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business. Answer: D 2. Which of the following statements is CORRECT? a. The statement of cash flows reflects cash flows from operations, but it does not reflect the effects of buying or selling fixed assets. b. The statement of cash flows shows where the firms cash is located; indeed, it provides a listing of all banks and brokerage houses where cash is on deposit. c. The statement of cash flows reflects cash flows from continuing operations, but it does not reflect the effects of changes in working capital. d. The statement of cash flows reflects cash flows from operations and from borrowings, but it does not reflect cash obtained by selling new common stock. e. The statement of cash flows shows how much the firms cash - the total of currency, bank deposits, and short-term liquid securities (or cash equivalents) - increased or decreased during a given year. Answer: E 3. Which of the following statements is CORRECT? a. The more depreciation a firm reports, the higher its tax bill, other things held constant. b. People sometimes talk about the firms net cash flow, which is shown as the lowest entry on the income statement, hence it is often called "the bottom line. c. Depreciation reduces a firms cash balance, so an increase in depreciation would normally lead to a reduction in the firms net cash flow. d. Net cash flow (NCF) is often defined as follows: Net Cash Flow = Net Income + Depreciation and Amortization Charges. a. Depreciation and amortization are not cash charges, so neither of them has an effect on a firms reported profits. Answer: D 4. Which of the following statements is CORRECT? a. Since accounts payable and accrued liabilities must eventually be paid off, as these accounts increase, AFN as calculated by the AFN equation must also increase. b. Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess current assets. Based on the AFN equation, its AFN will be larger than if it had been operating with excess capacity in both fixed and current assets.

c. If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth. d. Additional funds needed (AFN) are typically raised using a combination of notes payable, long-term debt, and common stock. Such funds are non-spontaneous in the sense that they require explicit financing decisions to obtain them. e. If a firm has a positive free cash flow, then it must have either a zero or a negative AFN. Answer: D 5. Which of the following statements is CORRECT? a. The primary difference between EVA and accounting net income is that when net income is calculated, a deduction is made to account for the cost of common equity, whereas EVA represents net income before deducting the cost of the equity capital the firm uses. b. EVA stands for economic value added, and it is defined as follows: EVA = EBIT(1-T) (Investor-supplied operating capital) x (A-T cost of capital). c. MVA gives us an idea about how much book value a firms management has added during the last two years. d. MVA stands for market value added, and it is defined as follows: MVA = (Shares outstanding)(Stock price) + Book value of common equity. e. EVA gives us an idea about how much value a firms management has added over the firms overall life. Answer: B 6. 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT? 1. If the yield to maturity remains constant, the bonds price one year from now will be higher than its current price. 2. The bond is selling below its par value. 3. The bond is selling at a discount. 4. If the yield to maturity remains constant, the bonds price one year from now will be lower than its current price. 5. The bonds current yield is greater than 9%. Answer: D 7. Inflation, recession, and high interest rates are economic events that are best characterized as being: a. Systematic risk factors that can be diversified away. b. Company-specific risk factors that can be diversified away. c. Among the factors that are responsible for market (non-diversifiable) risk. d. Risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers. e. Irrelevant except to governmental authorities like the Federal Reserve. Answer: C 8. Which of the following statements is CORRECT?

a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock. b. Two firms with the same expected dividend and growth rates must also have the same stock price. c. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. d. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stocks dividend yield is also 5%. e. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate Answer: A

Part B: Problem solving (84 points in total) Problem 1 (5 points) Mr. Smart has been working on an advanced technology in laser eye surgery. His technology will be available in near term. He anticipates his first annual cash flow from the new technology to be $250,000 received two years from today. Subsequent annual cash flows will grow a 6 percent in perpetuity. What is the present value of the technology if the appropriate discount rate is 10 percent? (Note: this is a growing perpetuity) Solution: This is a growing perpetuity. The present value of a growing perpetuity is: PV = C / (r g) PV = $250,000 / (.10 .06) PV = $6,250,000 It is important to recognize that when dealing with annuities or perpetuities, the present value equation calculates the present value one period before the first payment. In this case, since the first payment is in two years, we have calculated the present value one year from now. PV = FV / (1 + r)^t PV = $6,250,000 / (1 + .10)^1 PV = $5,681,818.18

Problem 2 (12 points) Based on the following information calculate the expected return and the standard deviation for the two stocks. State of Economy Recession Normal Boom Probability of State of Economy 0.10 0.60 0.30 Rate of Return on stock A 6% 7% 11% Rate of Return on stock B -20% 13% 33%

a. What is the expected return on stock A and stock B? b. What is the variance and standard deviation for stock A and stock B? c. What is of the standard deviation of an equally weighted portfolio of these two stocks if the correlation is 0.2? Solution: 1. The expected return of an asset is the sum of the probability of each return occurring times the probability of that return occurring. So, the expected return of each stock asset is: E(RA) = .10(.06) + .60(.07) + .30(.11) = .0810 or 8.10% E(RB) = .10(-.2) + .60(.13) + .30(.33) = .1570 or 15.70% 2. To calculate the standard deviation, we first need to calculate the variance. To find the variance, we find the squared deviations from the expected return. We then multiply each possible squared deviation by its probability, and then add all of these up. The result is the variance. So, the variance and standard deviation of each stock are: 2A = .10(.06 - .0810)^2 + .60(.07 - .0810)^2 + .30(.11 - .0810)^2 = .000369 A = (.00037)^(1/2) = .01921 or 1.921% 2B = .10(.-2 - .1570)^2 + .60(.13 - .1570)^2 + .30(.33 - .1570)^2 = .022161 B = (.02216)1/2 = .14886 or 14.89% 3. To calculate the portfolio standard deviation, we first need to calculate the variance. To find the variance we use the formula based on the individual stocks variances and the covariance between the two stocks. So, the portfolio variance is: p2 = wA2A2 + wB2B2 + 2wAwB ABAB p2 = (0.5^2)(0.01923^2) + (0.5^2)(0.1489^2) + 2(0.5)(0.5)(0.2)( 0.0192)( 0.1489) p2 = 0.0059183 P = (0.0059183)^(1/2) = 0.076930, or 7.6930%

Problem 3 (12 points) Assume your professor is now 45 years old, that he plans to retire in 12 years, and he expects to live for 20 years after he retires, that is, until he is 77. He wants fixed retirement income (withdrawals) that has the same purchasing power at the time he retires as $60,000 has today. He retirement income will begin the day he retires (that is, immediately), 12 years from today, and he will receive 20 annual payments. Inflation is expected to be 5 percent per year over the next 12 years. He expects to earn a rate of return of 9 percent per year on similar investments. To the nearest dollars, how much must he save during each of the next 12 years (with deposits being made at the end of each year) to meet his retirement goals? (Note: this is 3-step problem where you have to find the FV of the inflated amount of today dollars, the PV of an annuity due and finally, the PMT of an ordinary annuity) Solution: This is a three-step problem. 1. The first step is to solve for the future value of the $60,000 in today dollars inflated over the next 12 years at 6%. PV = $60,000; PMT = 0; I/Y = 5%; N = 12; CPT FV = $107,751.38

2. The second step is to compute the amount he will need in order to be able to withdraw payments of $107,751.38 per year for 20 years. This is an annuity due. PMT = $107,751.38; N = 20; I/Y = 9; FV = 0; CPT PV = $1,072,138.60

3. The third step is to find how much your professor will have to save during the next 12 years. This is an ordinary annuity. FV = $1,072,138.60; N = 12; I/Y = 9; PV = 0; CPT PMT = $53,232.39

Problem 4 (10 points) Bannister Legal Services generated $2,000,000 in sales during 2010, and its year-end total assets were $1,500,000. Also, at year-end 2010, current liabilities were $500,000, consisting of $200,000 of notes payable, $200,000 of accounts payable, and $100,000 of accruals. Looking ahead to 2011, the company estimates that its assets must increase at the same rate as sales, its spontaneous liabilities will increase at the same rate as sales, its profit margin will be 5%, and its payout ratio will be 60%. How large a sales increase (in $US) can the company achieve without having to raise funds externally? (Note: solve AFN equation to find S1) Solution: S0 = $2,000,000; A0* = $1,500,000; CL = $500,000; NP = $200,000; AP = $200,000; Accruals = $100,000; M = 5%; Payout ratio = 60%; A0*/S0 = 0.75; L0*/S0 = (AP + Accruals)/S0 = ($200,000 + $100,000)/$2,000,000 = 0.15. AFN = (A0*/S0)S (L0*/S0)S (M)(S1)(1 payout rate) = (0.75)S (0.15) S (0.05)(S1)(1 0.6) = (0.75)S (0.15)S (0.02)S1 = (0.6)S (0.02)S1 = 0.6(S1 S0) (0.02)S1 = 0.6(S1 $2,000,000) (0.02)S1 = 0.6S1 $1,200,000 0.02S1 $1,200,000= 0.58S1 $2,068,965.52 = S1 = S0 + S. Sales can increase by $2,068,965.52 $2,000,000 = $68,965.52 (or 3.448%) without additional funds being needed.

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Problem 5 (10 points) Suppose Allen Inc., sold an issue of bond with a 10-year maturity, a $1000 par value, a 9precent coupon rate, and semiannual interest payments. The bond earns a market interest rate (YTM) of 8 percent. Two years after the bonds were issue, the going rate of interest on bonds such as these fell to 6 percent. At what price would the bonds sell in two years (that is, n = 8)? At what price would the bonds sell when they were issued (that is, n = 10)? (Note: be aware that market interest rates for the two periods are different) Solution: To find the price the bond would sell in two year we need to compute PV of the bond if it matures in 8 years: PMT = $90/2 = 45; FV = $1000; N = 8 x 2 = 16; I/Y = 3.0%; CPT PV = $1,188.42 To find the price the bond would sell when it was issued we need to implement the following two steps: 1. The present value (the bond price) we computed above is the future value of a 2-year ordinary cash flow at 8% discount rate. FV = $1,188.42; PMT = 0; N = 2 x 2 = 4; I/Y = 4.0%; CPT PV = $1,015.866

2. Find the PV of interest payments over the first 2 years and add them to PV of cash flows computed at step 1. FV = 0; PMT = 45; N = 2 x 2 = 4; I/Y = 4.0%; CPT So, PV bond = $1,015.866 + $163.345 = $1,179.211 The bond sells at premium! PV = $163.345

Problem 6 (10 points) Macdonald Co. is a growing quickly. Dividends are expected to grow at 25 percent rate for the next three years, with the growth rate falling off to a constant 7 percent date thereafter. If the required rate of return is 12 percent and the company just paid a $2.50 dividend (D0), what is the current market price of Macdonald stock? Solution: With supernormal dividends, we find the price of the stock when the dividends level off at a constant growth rate, and then find the PV of the future stock price, plus the PV of all dividends during the supernormal growth period. The stock begins constant growth in Year 4, so we can find the price of the stock in Year 3, one year before the constant dividend growth begins as: D0 = 2.50 D1 = 2.50(1.25) = 3.125 D2 = 3.125(1.25) = 3.9062 D3 = 3.9062(1.25) = 4.8827 D4 = 4.8827(1.07) = 5.2247 P3 = D3(1 + g) / (R g) = 5.2293/(.12 0.07) = $104.492 The price of the stock today is the PV of the first three dividends, plus the PV of the Year 3 stock price. The price of the stock today will be: P0 = 2.50(1.25) / 1.12 + $2.50(1.25)^2 / 1.12^2 + $2.50(1.25)^3 / 1.12^3 + $104.46/ 1.12^3 = $83.732 Or, using the cash flow register of your calculator we find: CF0 = 0 CF1 = 3.125 CF2 = 3.9062 CF3 = 4.8827 + 104.492 = $109.375 I = 12% P0 = $83.7552

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Mini case (25 points) Surya Pradhan, CFO of Bagmati Bhoj Sewa, has created the firms pro forma balance sheet for the next fiscal year. Sales are projected to grow by 10 percent to $440,000,000. Current assets, fixed assets, and short-term debt are 20 percent, 140 percent and 15 percent of sales, respectively. Bagmati Bhoj Sewa pays out 40 percent of its net income in dividends. The company currently has $145 million of long-term debt and $60 million in common stock par value. The net profit margin is 12 percent. a. (8 points) Construct the current balance sheet for the firm using the projected sales figure. (Note: find first the current year sales) b. (5 points) Based on Mr. Pradhans sales growth forecast how much does the company need in external funds for the upcoming fiscal year? (Note: use the AFN formula where S-T debt = spontaneous liabilities) c. (12 points) Construct the firms pro forma balance sheet for the next fiscal year and confirm that the external funds needed are same as those you calculated in part (b). (Note: keep POR and PM same) Solution: a. Construct the current balance sheet for the firm First, we need to calculate the current sales and change in sales. The current sales are next years sales divided by one plus the growth rate, so: Current sales = Next years sales / (1 + g) Current sales = $440,000,000 / (1 + .10) Current sales = $400,000,000 And the change in sales is: Change in sales = $440,000,000 400,000,000 Change in sales = $40,000,000 We can now complete the current balance sheet. The current assets, fixed assets, and short-term debt are calculated as a percentage of current sales. The long-term debt and par value of stock are given. The plug variable is the additions to retained earnings. So:

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Note: Accumulated RE are computed as difference between total assets and the sum of all liabilities and common stock account. b. How much does the company need in external funds for the upcoming fiscal year? We can use the equation from the text to answer this question. The assets/sales and debt/sales are the percentages given in the problem, so:

EFN = (.20 + 1.40) $40,000,000 (.15 $40,000,000) [(.12 $440,000,000) (1 . 40)] = $26,320,000 c. Construct the firms pro forma balance sheet for the next fiscal year and confirm that the external funds needed are same as those you calculated in part (b). The current assets, fixed assets, and short-term debt will all increase at the same percentage as sales. The long-term debt and common stock will remain constant. The accumulated retained earnings will increase by the addition to retained earnings for the year. We can calculate the addition to retained earnings for the year as: Net income = Profit margin Sales(new) Net income = .12($440,000,000) Net income = $52,800,000 Addition to retained earnings = Net income(1 d) Addition to retained earnings = $52,800,000(1 .40) Addition to retained earnings = $31,680,000 So, the new accumulated retained earnings will be: Accumulated retained earnings = $375,000,000 + 31,680,000 Accumulated retained earnings = $406,680,000 The pro forma balance sheet will be:

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So, the EFN is: EFN = Total assets Total liabilities and equity EFN = $704,000,000 677,680,000 EFN = $26,320,000

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Bonus questions (4 points total): 1. (2 points) Who was the first AUBG president? The best answer is A. a. Julia Watkins b. Ron Bloom c. Michael Easton d. Alex Aleksandrov 2. (2 points) Who will be teaching Investment and Portfolio Management classes in the Spring 2013 semester? The best answer is B. a. Prof. Fedhila Hassouna b. Prof. Miroslav Mateev c. Prof. Marla Howard d. Prof. Alf Eastergard

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