PricewaterhouseCoopers and Tallinn University of Technology

Olympics in Corporate Finance 2006

Exercise 1 (10 p, Laivi Laidroo, TUT)
ABC a furniture manufacturer has been reported to the anti-pollution authorities on several
occasions in recent years, and fined substantial amounts for making excessive toxic discharges into
the air. Both the environmental lobby and ABCs shareholders have demanded that it clean up its
operations. If no cleanup takes place, ABC estimates that the total fines it would incur over the next
three years can be summarized by the following probability distribution (fines are presented in
present values)
Level of fine Probability
1.7 million EUR 0.3
2.2 million EUR 0.5
2.8 million EUR 0.2
A firm of environmental consultants has advised that spray-painting equipment can be installed at a
cost of 1.95 million EUR to virtually eliminate discharges. No corporate income tax has been set by
the government in this country. The equipment will have no scrap or resale value after its expected
three year working life. The equipment can be in place ready for ABCs next financial year. A EU
grant of 30% investment is available, but with payment delayed one year. The consultants charge
was 200,000 EUR and the new equipment will raise annual production costs by 2% of sales
revenue. Current sales are 12 million EUR per annum, and are expected to grow 5% per annum
compound. No change in working capital is envisaged.
ABC applies a discount rate of 10% on investment projects of this nature. All cash inflows and
outflows occur at year-ends. Advise the ABCs management on the desirability of making the
investment using the NPV criterion.

Exercise 2 (12p, Priit Sander, UT)

The WACC for currently unlevered firm is 12%. Risk-free rate of return and the return of market
portfolio are 4% and 14% respectively. The market capitalization of the firm under consideration is
currently 200 mln EEK. The firm is planning to invest in a major project, which requires an
investment of 190 million EEK. In order to aquire the funds needed to invest into the project the
firm issues new shares in the amount of 100 million EEK. The issuing costs amount 10 million
EEK. Additionally, the firm takes a 4% loan in the amount of 100 million EEK.
What is the firms WACC after acquisition of new funds? What should be the minimum acceptable
internal rate of return (IRR) for the new project?

Exercise 3 (10 p, Kaia Kask, UT)

You make plans for your retirement and you think that in addition to the state-pension you should
have additional 650 EUR a month to spend. For this puropse starting from the age 24 you start to
deposit a certain amount of money. The bank-deposit pays 6% interest once a month. Assume that
you plan to retire by the age of 65 and hope to live at least 20 years thereafter. Assume additionally
that there are no taxes and inflation.
What monthly-amount of money you have to put to the deposit in the first year assuming that:
(1) you increase the monthly-amount you put to the deposit every year by 0,5% and
(2) during retirement you take the money out in equal amounts also in the end of every month.
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Exercise 4 (15p, PWC)

A company called Fun-Trips, which is located in the Banana Islands Republic, plans to establish a
daughter company called Yacht-Trips. The necessary investment is 6 MEUR for which six luxury
yachts will be bought. The trips are expected to generate annual revenues of 15 MEUR but the
clients take 30 days to pay for the trips. The main expenses will be maintenance, fuel and salaries
altogether 12 MEUR a year. You take an average of 60 days to pay your expenses. The yachts will
be depreciated over 15 years with straight-line method and then sold with an expected salvage value
of 30 TEUR each. No other investments will be made. Yacht-Trips will receive a constant debt-toequity ratio of 1 and the total amount will be financed with a new issue of equity and risk-free debt.
The issue costs are 8% for equity and 3% for debt (of the issued amount) and can be paid from the
proceeds of the issue. It can be assumed that Yacht-Trips is in the same industry as Fun-Trips,
which is an all-equity company with assets=1,2. The risk-free rate is 5% and market risk premium
is 10%. Corporate income tax is 28% (no other market frictions are present). Please observe that the
Banana Islands Republic has different taxation system than Estonia all income (whether realised
or unrealised) is subject to corporate income tax. Calculate the NPV of the project Yacht-Trips.

Exercise 5 (6 p, Katrin Rahu, TUT)

The balance sheet for XYZ company is given in the table below.

Assume that all balance sheet items are expressed in terms of market values. The company has
decided to pay a $2000 dividend to shareholders. There are four ways to do it:
1. Pay a cash dividend
2. Issue $2000 of new debt and equity in equal proportions ($1000 each) and use the proceeds to
pay the dividend.
3. Issue $2000 of new equity and use the proceeds to pay the dividend.
4. Use the $2000 of cash to repurchase equity.
What impact will each of the four policies above have on the following?
(a) The systematic risk of the portfolio of assets held by the firm
(b) The market value of original bondholders wealth
(c) The market value ratio of debt to equity
(d) The market value of the firm in a world without taxes.

Exercise 6 (6 p, Katrin Rahu, TUT)

You currently have 50% of your wealth in risk-free asset and 50% in the four assets below:

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If you want an expected rate of return of 12%, you can obtain it by selling some of your holdings of
the risk-free asset and using the proceeds to buy the equally weighted market portfolio.
(1) If this is the way you decide to revise your portfolio, what will the set of weights in your
portfolio be?
(2) If you hold only the risk-free asset and the market-portfolio, what set of weights would give you
an expected 12% return?

Exercise 7 (4 p, Katrin Rahu, TUT)

A Mexican corporation borrowed $1 million in dollars at a 10% interest rate when the exchange rate
was 10 pesos per dollar. When the company repaid the loan plus interest one year later, the
exchange rate was 10.5 pesos to the dollar.
What was the rate of interest on the loan based on the pesos received and paid back by the Mexican
corporation?

Exercise 8 (8 p, Enn Listra, TUT)

Your firm is considering lease financing for a computer that is expected to have a five-year life and
no salvage value (it is a strict financial lease). You have the following facts:
-Your firms tax rate is 30%. There is no investment tax credit.
-If purchased, the project would require a capital outlay of $100000.
-The project will be depreciated using the straight-line method.
-Debt of equivalent risk costs 10% before taxes.
-The annual lease fee is $32000 paid at the beginning of each year for five years.
-The optimal capital structure for the project is 50% debt to total asset.
Should you use lease financing or not?

Exercise 9 (8 p, Enn Listra, TUT)

Suppose that the government passes a law that prohibits lending at more than 5% interest, but
normal market rates are much higher due inflation. You have a customer who is willing to borrow at
20% and can put up her $100000 store as collateral. Rather than refusing her request you decide to
create a five-year contract with the following terms: You hold title to the store and receive the right
to sell her store for $ X at the end of five years. If you decide to sell, she must buy. In return you
give her $80000 in cash (the amount she wants to borrow) and the right to buy the store from you
for $ X at the end of five years. How can this contract provide you with a 20% annual rate of return
on the $80000?

Exercise 10 (15 p, PwC)

If capital markets are not perfect, a companys optimal capital structure is influenced by taxes,
bankruptcy costs, agency costs, and information asymmetry. Assume now that the only market
frictions are taxes: corporate income tax, tax on equity income, and tax on bonds income (yes, there
will be double taxation at some point).
Corporate income tax is the usual income tax paid on the profit of companies
Tax on equity income is to be paid on both realised and unrealised gains from investment into a
stock either increase in stock price or dividends
Tax on bonds income is to be paid on the interest income from bonds investment
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Consider two companies on stock exchange company A is financed by both bonds and equity and
company B is financed by equity only. Both are in the same industry, have the same ROA and are
of equal size.
Which companys capital structure results in higher market value of assets? State explicitly how
your answer is influenced by the relative size of taxes. Hint: try to compose two portfolios with
exactly the same returns by using only the stocks and bond of companies A and B.

Good Luck!