FBE 432 - Midterm Examination

October 16, 2002

A N S W E R S
PART I - MULTIPLE CHOICE - WRITE YOUR NAME AND MARK BEST ANSWERS ON
SCANTRON. THERE ARE 17 MULTIPLE CHOICE QUESTIONS TOTAL (4 POINTS EACH).

1) A farmer growing wheat is

a) short wheat.
b) perfectly hedged.
c) long wheat.
d) in a wheat covered call position.
e) None of the above.

2) Investment bankers

a) Arrange mergers and acquisitions.

b) Underwrite issues of securities.
c) Perform evaluations and provide investment advice.
d) Arrange private sources of financing.
e) All of the above.

3) According to the Modigliani and Miller, the cost of equity

a) Does not vary with capital structure.

b) Is equal to the cost of debt after adjusting for tax effects.
c) Is equal to the risk-free rate.
d) Is the same for all firms.
e) None of the above.

4) According to Modigliani and Miller with no corporate taxation, the unlevered cost of equity is equal
to

a) The levered cost of equity.

b) The weighted-average cost of capital.
c) The cost of debt before tax.
d) The risk-free rate.
e) None of the above.

5) A term sheet for a venture capital financing deal might contain all of the following except

a) Antidilution provisions for convertible securities.

b) Liquidation preferences for preferred stock.
c) Provision for venture capital fund seats on the board of directors.
d) Venture capital fund management fees paid by investors in the venture capital fund.
e) Vesting schedules for founders’ and employees’ stock and options.

6) Buy side analysts typically work for

a) mutual funds.
b) institutional investors.
c) pension funds.
d) insurance companies.
e) all of the above.
7) Continuing value in a valuation context represents the present value of cash flows after the

a) first period.

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 b) first ten years.
c) forecast period.
d) period when assumptions concerning the future are too vague to be important.
e) period when discounting makes present values so small they can be ignored.

8) Continuing value estimates typically use estimates for all of the following except

a) the weighted-average cost of capital.

b) Investments in working capital.
c) dividend payout rates.
d) Capital expenditures.
e) All of the above are relevant to calculating continuing values.

9) If a firm has a cost of debt of 6 percent, a cost of equity of 12 percent, a tax rate of 40 percent, and a
market-value debt-equity ratio of .5 (corresponding to a debt-to-asset ratio of 1/3), its WACC would
be

a) 1.2 percent.
b) 2.0 percent.
c) 6.0 percent.
d) 9.2 percent.
e) cannot be calculated with the data provided.

10) If the debt in question 4 is valued at $100 million, the present value of the firm’s tax shield is

a) $24 million.
b) $30 million.
c) $40 million.
d) $60 million.
e) cannot be calculated with the data provided.

11) The owner of a put option has the

a) obligation to pay a certain price for an asset in the future

b) obligation to sell an asset for a certain price in the future
c) right to any gains from any price increases in an asset relative to a strike price.
d) benefit of not having had to pay any premium for future profit potential.
e) None of the above.

12) Which combination of options has the same price exposure as a long position?

a) buying a put and selling a call.

b) selling a put and buying a call.
c) Selling a call and a put.
d) buying a put and a call.
e) None of the above.

13) Debt financing has all of the following advantages except:

a) debt is cheaper than equity.

b) fixed costs of debt increase shareholders’ earnings per share if sales increase.
c) debt is tax deductible and increases total funds available to investors.

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 d) debt indenture agreements contain restrictive and other covenants.
e) All of the above are advantages of debt financing.

14) Free cash flow includes all of the following except

a) operating income
b) an allowance for taxes
c) non-cash operating expenses (like depreciation).
d) dividend payments to shareholders.
e) All of the above

15) Market comparables are used by analysts to

a) benchmark a firm’s valuation against other firms in the same industry.

b) estimate the capital structure of a firm.
c) Calculate the most accurate valuation of a firm in all cases.
d) avoid the difficulties associated with making assumptions about the future.
e) All of the above

16) Divestitures are

a) not a form of restructuring.

b) a means of downsizing or focusing on core businesses.
c) part of a hostile takeover.
d) a way of avoiding use of investment banking services.
e) always a good financial strategy.

17) Modigliana and Miller (MM) demonstrated the irrelevance of capital structure by assuming

a) the corporate tax rate was 40%.

b) corporations were not taxed.
c) markets are inefficient and homemade leverage is cheaper than the professional variety.
d) investors are indifferent to risk.
e) corporate executives never make mistakes in efficient markets.

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 FBE 432 - Midterm Examination
October 16, 2002

Name______________________________________ Student No.__________________

PART II - LONGER ANSWERS - WRITE ANSWERS IN SPACE PROVIDED. QUESTIONS ARE

EQUALLY WEIGHTED (16 POINTS EACH). SHOW ALL CALCULATIONS AND CIRCLE YOUR
ANSWERS IN NUMERICAL PARTS OF QUESTIONS.

Use the following data on a private corporation in the parts distribution business for both questions. In
answering both questions, be sure to keep the characteristics of this firm in mind and make all your
assumptions explicit. Be sure to provide any formulas and reasons you use in answering.

1. Fighting Boys Corporation 1996 1997 1998 1999 2000 2001

Sales 10,000 11,000 10,500 9,500 10,000 10,500
Costs 8,000 8,800 8,400 7,600 8,000 8,400
Depr. 250 250 250 250 250 250
Op. Inc. 1,750 1,950 1,850 1,650 1,750 1,850
Taxes 700 780 740 660 700 740
Net Income 1,050 1,170 1,110 990 1,050 1,110

Assets
Cash 2,050 3,370 4,780 6,120 7,370 8,680
Short-Term Assets 5,000 5,500 5,250 4,750 5,000 5,250
Plant and Equipment 10,000 10,000 10,000 10,000 10,000 10,000
- Accumulated Depr. 400 650 900 1,150 1,400 1,650
Net Plant 9,600 9,350 9,100 8,850 8,600 8,350
Total Assets 16,650 18,220 19,130 19,720 20,970 22,280

Liabilities and Equity

Trade Payables 4,000 4,400 4,200 3,800 4,000 4,200
Equity 12,650 13,820 14,930 15,920 16,970 18,080
Total Liabilities + Equity 16,650 18,220 19,130 19,720 20,970 22,280
The asset-beta for this business is .8 and the risk-free rate is currently 1.2%, while the market-risk
premium is estimated at 8.5%. The average publicly traded firm in this industry has a P-E of 15 and a
market-to-book ratio of 1.0

a. What methods are available to value this closely held corporation? What are the advantages and
disadvantages of the different approaches?
Three methods are used: market comparables, discounted cash flow (DCF), and liquidation value.
Comparables use traded-company valuations and associated accounting numbers (like income or
book value of equity) to value firms in the same industry and have the advantage of being easy to use
and widely used by equity analysts. Disadvantages are that comparables do not account for
differences in firm’s product lines, capital structure, growth prospects, and management quality, and
rely on accounting numbers. DCF methods allow for firm-specific analysis of sales, costs,
investments, and financial structure to be incorporated into valuations and are the most thorough
valuation technique, but have the disadvantage of requiring many operating and valuation
assumptions, estimates of terminal values, and the possibility of widely varying results between
analysts or different sets of reasonable assumptions. Liquidation approach requires adjustment of
the book value of assets and assumes no franchise or going-concern values. They are relatively easy
to implement and interpret given good asset valuations, but these are not provided for this firm.
b. Estimate the value of the firm using several methods and provide an opinion on the likely range of
values for the firm.

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Note: The following calculations assume no growth in sales revenues or income as the firm’s sales
seem stable (varying between $9,500 to $11,000 with no trend). Alternative assumptions that are
explicitly presented and explained were equally acceptable in answers
.
Using market comparables provided by the problem:
Average P-E times net income = 15 x $1,110 = $16,650
Average Market-to-Book = 1.0 x $18,080
(Note: book value of equity, not assets, is appropriate for this calculation.)
DCF method (again assuming no growth)
Estimated FCF :
Net income $ 1,110
+ Depreciation 250
- Change W/C - 0 - (Note: low growth in working capital over 6
years)
- Cap. Exp. - 0 - (Note: no new investment in last 6 years)
Free Cash Flow $ 1,360

Estimated WACC = 1.2% + .8x(8.5%) = 8% (Note: Risk premium is in excess of risk-free

rate.)

DCF Value = $ 1,360/.08 = $17, 000

(Note: Alternative assumptions explicitly stated and defended are acceptable.)

Range of estimates (using my assumptions) between $16,650 to $18,080. The DCF estimate of $17,
000 is reasonable middle-range estimate.)

2. Two partners each own 50% of the stock in this privately held corporation. One partner wants to cash
out of the firm (sell his share of the equity) and start a non-competing business.

The objective of this problem is to apply concepts developed in Eskimo Pie (valuation), Continental
Carriers (debt capacity), and the John Case Case (financing options).

a. What options are available to the remaining partner to finance the buyout of the selling partner?

Note: Any reasonable list of three or so options is acceptable.

The buying partner can consider finding a new partner (and sharing control), going public or
finding a venture capital investor or LBO fund partner, or borrowing funds, or any combination.
The best option depends on the effect of the financing on the firm’s balance sheet and the remaining
partner’s risks, the cost of funds, and future control over the business. The discussion below assumes
that the selling partner needs an all cash purchase to finance the new business so cannot take back
debt.

b. If the firm could borrow 50% of the buyout price at 8%, what advantages and disadvantages would this
have for the remaining partner?

Note: Any set of reasonable assumptions used consistently and supporting your position is acceptable
in your answer. The following assumptions and analysis are provided for illustrative purposes only.

First, how much borrowing is needed. Assume a purchase price: I assume the DCF estimate of
$17,000. Second, note that the firm has been accumulating cash which has a zero net present value
(as an asset). Assuming that no new capital expenditures or changes growth are anticipated in the
near future, it would seemm that up to $ 6,000 (growth in cash in the last six years) is available.
Thus if the selling partner is paid $8,500 for his half of the value of the firm, up to $6,000 is available
from excess cash. (Note: The cash belongs equally to both partners and is reflected in the valuation,
so the selling partner is getting his part of the value in cash and the selling partner’s excess cash.)
The remaining $2,500 could easily be borrowed if it is not too risky given that the firm has no debt
and stable earnings and cash flows. The cost of debt before tax is equal to the cost of equity (8%),

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but after-tax is only 4.8% (assuming a 40% tax rate typical in the past). The use of debt would tend
to increase the remaining partner’s net income. Analysis of the firm’s last six years operations shows
little variation, with revenues fluctuating about 5% from year to year. The firm would seem to have
a great deal of unexploited debt capacity.

c. What is your recommendation to the remaining partner concerning buying the firm?

Note: Again, any reasonable defended and consistent position is acceptable.

This is a stable firm in a low-risk industry as shown in low variation in revenues, costs, and profits.
This is further evident in the low systematic risk represented in the industry’s asset beta (.8). The
firm has been generating excess cash in the past. Using excess cash and debt to purchase the firm
would add value (the tax savings from $2,500 debt is $1,000 or about a 6% increase in value), allow
the remaining partner to keep control, and exploit the firm’s apparent unused debt capacity
stemming from its current no-debt balance sheet and steady operating history. The remaining
partner might consider even greater use of debt if cash conserved could be redeployed in positive
net-present value projects in the firm.