Part A: Your answers should be brief and to the point. Show your calculations, do not just give an answer.
Question 1
The free cashflows of an all-equity project are set out below. Year Cashflows
0 -15,000
1 -15,000
2 +1,000
3 +1,500
4 +2,000
5 +2,500
6 +3,300
Thereafter the free cashflows grow indefinitely at 2.5% per annum.
If the project has a cost of capital of 10%, what is its net present value? Show your workings.
The IRR of this project is 11%. If we tripled all the cashflows in the project but kept the other assumptions the same, what would happen to its IRR? What would happen to the NPV?
Question 2
The following table shows the expected return and standard deviation of returns for two stocks, the market, and a risk free bond. The correlation of returns between stock A and the market is 0.816.
Company A: Expected Return Not given, Standard Deviation 14%
Company B: Expected Return 12%, Standard Deviation Not given
Market: Expected Return 12%, Standard Deviation 16%
Risk free bond: Expected Return 4%, Standard Deviation 0
What is the beta of stock B?
What is the beta of stock A? What is the return of stock A?
What is the expected return of a portfolio that consists of 50% of stock A and 50% of the market?
What is the standard deviation of a portfolio that consists of 50% of stock A and 50% of the market?
Question 3
Company XYZ is entirely equity financed and has 1 million shares outstanding. The cost of capital for Company XYZ is 9.5%. The corporate tax rate is 30%. Assume that the CAPM holds.
Financial projections for XYZ suggest that it will generate an EBIT of $1.0 million next year. Depreciation next year will be $200,000, the net working capital balance will be zero, and there will be no capital expenditure. Assuming that the FCF will grow at a constant rate of 2% per annum forever after next year, compute the value of the company today and its current share price.
XYZ is contemplating a $3 million perpetual bond issue to fund a share repurchase. The bond yield will be 6% on an annually compounded basis. What will be the effect of the bond issue on the value of the firm’s equity before the share repurchase?
What will XYZ’s cost of equity be after the bond issue and before the share repurchase has taken place?
At what share price are equity holders indifferent between tendering and not tendering the shares?
How many shares will XYZ buy back if it uses all the proceeds of the bond issue to do so?
What will be the fair price of the shares after the buy-back has taken place?
Question 4
You are long a call with an exercise price of 8 and short a call with an exercise price of 12. Both options are on the same share of stock with the same exercise date. Plot the value of this combination as a function of the stock price on the exercise date (a payoff diagram). Briefly describe why you would take this position.
b) Beyond Tofu’s current stock price is 40 and in one period it may go up 50% or down 50%. The risk free rate for 1 period is 3%. What would the present value of a European put with a strike price of 35 be in the current period (its expiration date is in one period)?
Suppose the market price of a European put option on Beyond Tofu from part (b) is 3. How could you make arbitrage profits?
Part B
The response to any individual part (a, b, c, d, or e) should be fewer than 200 words (excluding calculations).
Choose two established companies in the same industry that are publicly listed in the U.S. Provide an economic explanation why the betas found on Yahoo might differ (and if they don’t differ, explain why it is possible for them to differ).
Choose one of the two companies. Without any research into what the firm’s capital structure is, do expect them to have a lot of leverage or a little? Explain why – what factors might determine why it would have so much (or so little) debt in its capital structure?
Consider the same company you chose in part (b). Suppose it has 2 new projects to evaluate. The first is to expand is to produce and sell candy. The second is to produce and sell toothpaste. Estimate the cost of capital for both of these projects (you can use the equity cost of capital). Discuss briefly any assumptions you needed to make to estimate these.
Discuss why the equity cost of capital may be inappropriate for part (c). Discuss what data you would need to estimate the appropriate cost of capital.
Consider again the same company you chose in part (b). Assume it were a private company which was thinking about doing an IPO. What method should it use to IPO and why? What are the tradeoffs with this method?
