Unformatted text preview: First Letter of LAST NAME ECO359H1S, Financial Economics II, Section L5101 University of Toronto Midterm Test, February 15th, 2011 Duration: 110 minutes
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Question (Marks Possible) 1 (20) 2 (25) 3 (20) 4 (30) Bonus (5) Total Marks (out of a possible 100) Marks Earned Page 1 of 7 Q1. (20 marks total) True/False/Uncertain. Read the statement carefully. Decide whether the statement is true, false or uncertain and explain the arguments for your answer. Answers without an explanation will not receive credit. If the answer you give is based on any assumptions, be sure to state them clearly. Otherwise, you may not receive full marks for your answer. Answers without an explanation will not receive credit, even if the answer is correct. a) (5 marks) Mutually exclusive projects that are accepted when using the NPV rule maybe rejected when applying the Internal Rate of Return criterion. True. IRR rule does not consider timing issue and investment scales. The projects with higher NPV might be rejected using IRR rule when projects are mutually exclusive. b) (5 marks) Suppose a firm decreases its fixed costs and increases its variable costs, leaving the EBIT unchanged. At the same time, it also raises debt to buy back shares. Then the firm's required rate of return on equity remains constant. False. The required rate of return on equity can go up or down. 1 mark The operating leverage of the firm declines when the fixed costs decrease and the variable costs increase. As a result, the firm’s beta decreases, so does the required rate of return on equity. 2 marks However, rising debt to equity ratio increases the risk of equity, which increases the required rate of return on equity. 2 marks c) (5 marks) The Fama-French multi-factor model implies, in particular, that on average, firms with higher book-to-market factors have higher required rates of return. False. The book-to-market factors are not asset specific, ‐ these are macro‐variables! They have nothing to do (directly) with a firm’s market capitalization or its book‐to‐market ratio. d) (5 marks) If a firm uses a simple uniform hurdle rate for all investment project returns, then over time on average, the firm's non-diversifiable risk will increase. True. A firm should use different discount rates to evaluate different investment projects according to the risk characteristics of projects. Using a simple uniform hurdle rate might overestimate or underestimate the required rate of return of different projects and hence increase the firm's non-diversifiable risk. Page 2 of 7 Q2. (25 marks total) NPV and Other Investment Rules. The Galaxy Inc. is facing two investment projects. The estimated cash flows of the projects are listed below: Year 0 1 2 Project A -$30,000 $20,000 $20,000 Project B -$15,000 $12,000 $10,000 a) (5 marks) Suppose the two projects are mutually exclusive. If the required return is 10% and the firm applies Profitability Index rule, which project should the firm accept? (Hint: PI = Total PV of future cash flows / initial investment.) 20,000/1.1 20,000/1.1 30,000 12,000/1.1 10,000/1.1 15,000 By PI rule, the firm should choose project B. 1 mark 1.15 2 marks 1.27 2 marks b) (5 marks) To make sure the decision is correct, the financial manager of the firm conducts incremental analysis by calculating the PI index of incremental investment. Which project should be accepted based on incremental analysis? 2 marks for calculating the correct cash lows of incremental invesments 8,000/1.1 10,000/1.1 1.04 1 2 marks 15,000 Based on incremental investment analysis, bigger project, i.e., project A should be accepted. 1 mark c) (5 marks) If the firm applies NPV decision rule, which project should it take? 30,000 20,000 20,000 4710.74 2 marks 1.1 1.1 12,000 10,000 15,000 4173.55 2 marks 1.1 1.1 , project A should be chosen. 1 mark d) (5 marks) Explain why your answer in a) is different from b) and c). Using the profitability index to compare mutually exclusive projects can be ambiguous when the magnitudes of the cash flows for the two projects are of different scale. In this problem, Page 3 of 7 project A is 2 times as large as project B and produces a larger NPV, yet the profitability index criterion implies that project B is more acceptable. e) (5 marks) Now suppose the firm has a third project, as well as the first two. Project C has the following cash flows: Year Project C 0 -$15,000 1 $8,000 2 $13,000 Further, imagine project A, B and C are independent, but the firm has only $30,000 to invest. Which project(s) the firm should choose? Explain the reason verbally. Individually, project B and C have lower NPVs than project A has. However, when NPVs of projects B and C are added together, they are higher than the NPV of project A. Thus project B and C shall be accepted. 2 marks In the case of limited funds, we cannot rank projects according to their NPVs. Instead we should rank them according to the ratio of PV to initial investment, i.e., the PI rule. Both project B and project C have higher PI ratios than does project A. Thus they should be ranked ahead of project A when capital is rationed. 3 marks Q3 (20 marks total) Real Options. Suppose that the investment bank, Hedge & Hogs, is considering using a large portion of its capital to enter the pig-raising industry. To enter the industry, the firm must invest $6 billion. If the investment is a success, its present value is $10 billion. If, however, the investment fails, its present value is zero (the unsold pigs eat any revenue). The firm knows that success in the industry occurs with a 60% probability. Assume the investment bank is risk neutral and cares about expected profit only. a) (5 marks) What is the expected NPV of the project? Is the project worth investing? 6 60% 10 0 0 The firm is indifferent (project should be rejected is also correct) As a stroke of good luck, however, investing $6 billion into the pig-raising industry makes it ‘Too Big To Fail’ and in the event of a possible project failure, the government would rescue the firm by purchasing the pig farm for 50% of the initial investment. The risk-free rate is 3%, and the rate of return on similar livestock investments is 10%. Page 4 of 7 b) (3 marks) Draw a tree diagram that illustrates the different possible present value outcomes, and in which period they occur. Success (60%) Invest $6 Billion Star Fail (40%) Bail out No invest NPV=0 $3 billion $10 billion No Bail out $0 c) (5 marks) What is the NPV of entering the pig-raising industry given the existence of the bailout option? 3 6 60% 10 40% 1.09 0 1 10% d) (2 marks) What is the value of the ‘bailout option’? → 1.09 0 1.09 e) (5 marks) Suppose there is an identical second firm, Silverado Savings & Livestock, who is facing an identical investment opportunity, and has both an identical bailout option if the project fails, as well as an option to expand if the project succeeds. Using the above information, can we tell whether the NPV of Silverado Savings and Livestock’s investment is higher, lower or the same as the one faced by Hedge & Hogs? Explain your answer in two to three sentences. The NPV of Silverado Savings and Livestock’s investment is higher. If the project is successful, there is a possibility of expanding the project to get a larger NPV. Hence with the real option to expand has value and the NPV of the project is higher. Q4. (30 marks) Capital Structure. a) According to Reuters, Bombardier currently has market capitalization (value of its equity) of $9,062.49 million, its debt-equity ratio is 118.22%=1.1822, and its equity beta is 1.55. Its ROA is 3.79%, and you may assume that ROA is the best estimate of the company's current weighted average cost of capital. i) (5 marks) Bombardier wants to restructure. It will buy back some of its debt and issue new equity instead so as to achieve the industry average debt-equity ratio of 54%=0.54. What is Bombardier's equity beta? Page 5 of 7 → After restructuring: → 0.54 1.1822 1.55 0.7110 1.0934 ii) (5 marks) Assume further that Canada has decided to abolish its corporate tax on the TSX 60 companies (which include Bombardier). What will Bombardier's weighted average cost of capital be after the restructuring? Explain the intuition of your answer in 2 or 3 sentences. Rwacc=r0. Although the drop of debt/equity ratio increases the weight applied to equity capital in calculating the WACC of a firm (and hence increases the WAAC), it decreases the cost of equity of the firm (and hence decreases the WACC) at the same time. Without corporate taxes, the two effects exactly offset each other, so Rwacc, the overall cost of capital of the firm, keeps unchanged. b) From the New York Times, January 19, 2010. “Kraft to Acquire Cadbury in Deal Worth $19 Billion'' By MICHAEL J. de la MERCED and CHRIS V. NICHOLSON After months of fiercely resisting any deal, Cadbury agreed on Tuesday to an improved takeover offer from Kraft Foods, worth about $19 billion. [...] According to Reuters on January 27, 2010, Cadbury's equity beta is 0.95, its current market capitalization (market value of its equity) is $11.3 billion and its debt-equity ratio is 71.98%=0.7198. Cadbury's most recently issued bonds have an annual coupon of 5.375% (assume that this coincides with Cadbury's YTM (which is the required rate of return on Cadbury's debt)). Assume that, being a corporation, Kraft expects to exist forever and expects the takeover to boost its (Kraft's) annual profits by $1.9 billion (assume that the first boost comes a year from today). As you should have gathered from above, Kraft will pay $19 billion for Cadbury's equity (assume, this payment comes right now). Assume further that the market risk premium is 7% and the risk free rate is 2.85%. i) (5 marks) Should Kraft go ahead with this takeover? Why or why not? Yes, since the NPV is positive. Kraft is buying equity only, so the relevant discount rate is rs, the return on equity. 2.85% 0.95 7% 1.9 1 0 0.095 9.5% 19 Page 6 of 7 Kraft Foods Inc. has about 1.5 billion shares outstanding. Assume that pre-takeover announcement these shares were trading at approximately $26.5. In what follows, assume instead that Kraft Inc has decided to pay for Cadbury shares solely in cash (i.e. that Kraft will pay $19 billion in cash for Cadbury's equity). Kraft needs to raise this amount either by issuing debt or by issuing equity. ii) (5 marks) Assuming no taxes, would you advise Kraft to finance this purchase by debt or equity? Doesn't matter (MM theorem) In what follows, assume that Kraft has decided to finance the takeover by equity. iii) (5 marks) How many shares will they have to issue? (Hint: you may need to calculate the value of the equity capital of the firm after takeover first.) The value of the company increases upon the announcement by the NPV of the project. Hence, the new price per share is 1.5 26.5 1 27.167 1.5 and therefore the number of shares to issue is 19B/27.167 ≈ 700M. iv) (5 marks) What will be the value of Kraft upon completion of the takeover? 1.5B(26.5)+1B+19B=59.75B Page 7 of 7 ...
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