FOSTER SCHOOL OF BUSINESS

FINANCE 350 Business Finance PROF. RAN DUCHIN

Practice Final Exam

Before you do anything else, write your name at the top of every page of the exam.

This exam is worth 35% of your final grade. The work on this exam must be entirely your own. The
exam is closed book and closed notes. You may use your own formula sheet. Calculators, financial or
otherwise, are allowed during the exam.

In problems which ask you to calculate something, first write out the appropriate formula and then fill in the
relevant information which you use to calculate the answer to the question. Provided that you have used the
correct formula and filled-in the correct information, you will receive most of the credit for the question.
Answers that do not show how you arrived at the answer will receive little or no credit.

If a question asks "why?" or instructs you to "explain," you should give a complete and meaningful
explanation that would convince a skeptic.

Please try to write only in the space provided for each question. If you really need more space, continue on
the back of the page. Be clear and concise in your answers (remember: if I can’t read it, I can’t give you
credit!). There are 100 points on this exam and each question's point value is marked.

If you do not know how to do something, try breaking-it down into doable pieces. If you still don't know
what to do, move on to another question. There are a variety of questions on the exam and they are not in
order of difficulty. Remember to stay calm—you know more than you think. More often than not, your
mind’s first unfettered response to a question will lead you in the right direction.

Name:___________________________________

Good luck!
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Part 1: Concepts (24 points total)

1. Define portfolio diversification and explain how it benefits from imperfectly correlated assets. [8]

Portfolio Diversification – investment strategy designed to combine imperfectly correlated

assets to reduce the risk of a portfolio
Diversification benefits from imperfectly correlated assets:
Portfolio return is a weighted average of returns on constituent assets: r portfolio = wArA + wBrB
Portfolio standard deviation is always less than the weighted average of standard deviations of
constituent assets: σAB < wAσA + wBσB
As a result, combining imperfectly correlated assets improves the risk-return tradeoff: the
same returns can be achieved with a lower level of risk

2. What is the difference between systematic and non-systematic risk? Which risk is priced? Why? [8]

 
Non-systematic risk – asset-specific risk, which can be eliminated via diversification.
Systematic risk – portion of asset’s volatility that is common to the market and cannot be
eliminated via diversification.
Investors can eliminate non-systematic risk simply by holding a diversified portfolio (e.g. a
tracking stock for a broad market index). Since non-systematic risk can be eliminated nearly
costlessly, investors are not compensated for bearing this risk. However, systematic risk cannot
be diversified away, and investors require a compensation for their exposure to this risk

3. How does capital structure affect firm value? Compare your answer to capital structure in a perfect
world (Modigliani and Miller). [8]

Capital structure affects firm value through: (1) Tax shields - Higher leverage and interest
payments generate tax savings for the firm, thereby increasing firm value; (2) Bankruptcy
costs - Higher leverage increases the risk of incurring costs of financial distress, thereby
reducing firm value. The optimal capital structure minimizes the WACC and maximizes firm
value.

In a perfect world, with no taxes, no transaction costs, no information asymmetry, and where
individuals and companies have the same interest rate, capital structure does not affect firm
value. The reason is that if there are no transaction costs and tax shields, investors can create
home-made leverage and replicate any leverage of the firm. Therefore, managers cannot create
value by changing capital structure

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Part 2: Problems (76 points total)

Please show all your work.

If you need extra space, please use the back of each page.

Problem 1 [12 points]

Your company’s target capital structure consists of 45% debt and 55% equity. The firm’s unlevered beta is
1.2. The risk-free rate is 5%, the expected market return is 10%, and the tax rate is 40%. If the firm’s WACC
is 10.1%, what is the firm’s pre-tax cost of debt?

β lev = β unlev* (1 + (1 – t)*D/E)  β lev = 1.2*(1+(1-0.4)*(.45/.55)) = 1.79

RE = 5% + 1.79*(10%-5%) = 13.95%
WACC = were + wdrd(1 – t) = 10.1% = .55*13.95% + .45*rd*(1-.4)  rd = 8.99%

Problem 2 [12 points]

Assume that the CAPM holds, the risk-free rate is 3%, and the market risk premium is 7%. Stock A has an
expected return of 10%. Stock B has a beta of 1.2 and a standard deviation of 0.4. Stock C has twice as
much exposure to systematic risk as stock B. If you put 30% of your money in A, 40% in B and 30% in C,
what will the beta of your portfolio be?

We can back-out the beta for stock A: 0.1=0.03+beta(0.07), so beta=1.

Since C has twice the exposure to systematic risk as C, it has twice the beta: 2.4
Now, we can compute the portfolio beta: . ∙ . ∙ . . ∙ . .

Problem 3 [12 points]

You have a portfolio of two stocks. CDG has an expected return of 8% and a standard deviation of 20%.
NCE has an expected return of 15% and a standard deviation of 30%. The stocks have a correlation of 0.35.
If you put 40% of your money in CDG and 60% in NCE, what is the expected return and standard deviation
of your portfolio?

. . . . . . %
. . . . . . . . . .
.

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Problem 4 [16 points]

The expected return on stock X is twice the expected return on the market, and the annual standard deviation
of stock X is 3 times the standard deviation of the market. The market portfolio has an expected return of
11%, and the risk-free rate is 4%.

a) Compute the equity beta of stock X and the correlation between stock X and the market. [8]

First, let’s calculate the beta of stock X from the CAPM:

E[rx] = 2*E[rm] = 2*0.11 = 0.22

E[rx] = rrisk-free + βx * (E[rm] – rrisk-free)
0.22 = 0.04 + βx* (0.11 – 0.04) => βx = 0.18 / 0.07 = 2.5714

Next, compute the correlation between stock X and the market:

β x = (ρx,m * σx) / σm
σx = 3σm
2.5714 = (ρx,m * 3σm) / σm => ρx,m = 0.8571 = 85.71%

b) Stock X is currently trading at $100 and pays no dividends. An equity analyst has a one-year target
price of $121 for this stock. If the analyst’s forecast holds true, what alpha will be earned next year by
a portfolio that has a beta of 0.8 and is invested in stock X and the risk-free asset? (Assume next year’s
market return and the risk-free rate will be 11% and 4%, respectively.) [8]

First, compute the weights of stock X and the risk-free asset in the portfolio:

β portfolio = Wx * βx + Wrisk-free * βrisk-free

0.8 = Wx * βx + (1 – Wx) * 0
Since βx = 2.5714, we can calculate Wx as Wx = 0.8/2.5714 = 31.11%
Since Wrisk-free = 1 – Wx. we get: Wrisk-free = 1 – 0.3111 = 68.89%

Now, we can calculate the return based on the analyst’s forecast:

Next year return on stock X according to the analyst: rx = (P1 – P0) / P0 = (121 – 100) / 100 = 21%
Next year return on the portfolio: r portfolio = Wx * rx + Wrisk-free * rrisk-free
r portfolio = 0.3111 * 0.21 + 0.6889 * 0.04 = 0.0929 = 9.29%

Now, we can calculate the alpha by subtracting the CAPM expected return:

α portfolio = 0.0929 – [0.04 + 0.8 * (0.11 – 0.04)] = -0.0031 = -0.31%

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Problem 5 [24 points]

You would like to value the stock of Liberty Communications, Inc., by using the discounted cash flow
method. Liberty has 10 million common shares outstanding. In addition to equity financing, the company is
also financed with debt.

The company’s debt consists of 180,000 bonds, which have a face value of $1,000 per bond, mature in 5
years, and pay an annual coupon of 6%. The yield-to-maturity on these bonds is 7%. The management’s
target capital structure is 25% debt and 75% equity.

Assume that the company does not have non-operating assets. Other financial information, industry
comparables, and the forecast of free cash flows are summarized below. The tax rate for Liberty and all peer
companies is 40%, the risk-free rate is 4%, and the expected market return is 11%.

To guide you through the solution, the problem is broken down into four parts – a through d.

a. What is the TTM free cash flow of Liberty? Please use the table below. [6]

Financials Value, $mil

EBITDA 250
EBIT 200
-taxes on EBIT @ 40% -80
+Depreciation & Amortization +50
-Capital expenditures -80
-Increase in working capital -40
FCF 50
 
Next, to discount future cash flows, we need to determine Liberty’s discount rate – the firm’s
weighted average cost of capital (WACC). The cost of debt is given in the problem, and the
cost of equity can be computed from the CAPM. To apply the CAPM, we first need to find the
unlevered beta from industry comparable firms and then lever it up based on the target capital
structure

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b. Based on its peers, what is Liberty’s equity beta? Please use the table below. [6]

Atlantic American Millennium

Telecom Communications Telecom

Enterprise value, $mil 500 400 300

Market value of equity, $mil 300 200 250

Levered beta 1.61 1.87 1.30

Unlevered beta 1.15 1.17 1.16

Average unlevered beta 1.16

To find Liberty’s beta:

βlev = (average peer βunlev)* [1 + (1 – 0.40) * (D/ELiberty)]
βlev = 1.16 * [1 + 0.6 * 0.25 / 0.75)] = 1.39

c. What is Liberty’s cost of equity according to the CAPM? What is its WACC? [6]

E[rX] = r risk-free + βlev * (E[rM] – r risk-free)

E[rLiberty] = 0.04 + 1.39 * (0.11 – 0.04) = 0.1373 = 13.73%
WACC Liberty = wE * rE + wD * rD * (1 – tax)
WACC Liberty = 0.75 * 0.1373 + 0.25 * 0.07 *(1-0.4) = 11.35%

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d. What is Liberty’s enterprise value, equity value, and price per share according to the DCF method?
Please use the table below. [6]

Now we have the discount rate and can compute PV (FCFs):

Year 0 1 2 3
FCF growth rate N/A 12% 7% 4%
Nominal FCF, $mil 50 56 59.92 62.32
Discounted FCF @ 11.35% 50 50.29 48.33 45.14
Sum of discounted FCFs - 143.76

TV3 = FCF3 * (1 + g) / (r – g) = 62.32 * 1.035 / (0.1135 – 0.035) = $821.67 mil

TV0 = TV3/ (1 + r)3 = 821.67 / 1.11353 = $595.15 mil
EV = PV (FCFs) + PV (TV) = 143.76 + 595.15 = $738.91 mil
Next, we need to calculate the market value of debt:
FV = 1,000; N=5; PMT=60; I/Y=7; CPT PV = -959.00
Thus, the market value of debt is given by: 180,000*959 = $172.62 mil
Value of equity = EV – (market value of debt) = 738.91 – 172.62 = $566.29 mil
Price per share = (market value of equity) / (shares outstanding)
Price per share = 566.29 mil / 10 mil = $56.63