DO NOT TURN THIS PAGE UNTIL I ANNOUNCE THE START OF THE EXAM

Name __________________________
Final Exam Student ID: __________________________
December 17, 3-5:30 p.m.

250 points

Instructions

This exam is worth 250 points (25% of your total grade). Please show your work in details to get partial
or full credit credit – no credit will be given for answers without supporting work. By taking this exam,
you agree to comply fully with TCU’s policy on academic honesty.

Good luck!
1. (90 points) Automated Tellers Inc, a major manufacturer of ATM machines reported the following
information about its financial structure:

Debt: 6,000 bonds outstanding, 8% coupon rate paid annually, 10 years left to maturity, $1,000 par value,
6% yield-to-maturity

Equity: 200,000 shares outstanding trading for $60 per share; book value per share $27; beta is 0.75

Also, the expected market return is 10%, and the risk-free rate is 5%. The company faces a 35% tax rate.

The company is considering investing in a new lucrative business – manufacturing electronic voting
machines in time for the 2012 presidential elections. The company has no experience in this line of
business.

The company estimates sales for the product of $600,000 in each of years 1 and 2, $2,300,000 in each of
years 3,4, and 5, and $2,100,000 in year 6. Cost of goods sold (not including depreciation) will be 50% of
sales, and the selling and administrative expenses will be 10% of sales. The project will require an
investment in fixed assets in year 0 of $3,000,000, which will be depreciated to 0 using the straight-line
method over 6 years. The firm can build the manufacturing facility on a property that it already owns, or
buy a similar property. The property can be sold for a market value of $500,000. The firm already spent
$1,000,000 on research and development expenditures related to the project.

Electoral Solutions, a single-segment firm and the only existing manufacturer of electronic voting
machines has a beta of 1.65, and a debt-to-equity ratio of 1, and also faces a 35% tax rate.

The firm will finance the new projects, if undertaken, using its existing capital structure.

a) (20 points) Calculate the appropriate discount rate to use when evaluating an average project for the
company.
b) (20 points) What is the appropriate discount rate to use when evaluating the new project?

c) (40 points) Should Automated Tellers undertake the new project?

d) (10 points) The firm expects that if the project is continued after year 6, the operating cash flows will
grow at a rate of 4% forever, but the project will require an additional investment of $4,000,000 made at
the end of year 6.

Find the NPV of the project (as of year 0) with the option to extend the project beyond year 6.
4. (60 points) Short-site.Com earned after-tax cash flows of $10,000,000 last year, and expects the cash
flows to grow at a 4% rate per year to infinity. The company has no debt, and its cost of equity is 12%.
The corporate tax rate is 40%.

Suppose the firm decides to change its capital structure by borrowing at 8% interest. The new debt-to-
equity ratio will be 1. Assume that we live in an MM world with taxes, and that the new level of debt will
not increase the probability of default significantly.

a) (15 points) What is the cost of equity after the restructuring?

b) (15 points) What is WACC after the restructuring?

c) (15 points) What is the value of the firm before and after the restructuring? Are they the same or
different, and why?

d) (15 points) What other factors that are not considered under the current MM assumption would you
recommend that the firm consider before they do the restructuring?
3. (20 points) A firm has a WACC of 12%. It is financed with 40% debt and 60% equity. The
firm’s cost of debt is 10% and its tax rate is 40%. If the firm’s dividend growth rate is 8% and its
current stock price is $40, what is the value of the next dividend the firm is expected to pay?

4. (20 points) Kaui Surf Boards is seeking to raise capital from a large group of investors to expand its
operations. Those investors currently hold the S&P 500 index, which has a standard deviation of 18% and
expected return of 10%. Kaui Surf Boards is expected to have a standard deviation of 36%, and a 15%
correlation with the S&P 500 index.

a) (10 points) If the risk-free rate is 4%, what is the appropriate cost of equity capital for Kaui Surf
Boards?

b) (10 points) Suppose you hold a portfolio consisting of 5% Kaui Surf Boards and 95% S&P 500 index.
Calculate the beta and the expected return of the portfolio.
5. (20 points) Comment on the following quotation from Brick Coleman, a leading investment analyst
with Golden, Schmucks and Co.:

“Stocks that move perfectly with the market have a beta of 1. Betas are higher as
volatility goes up, and lower as it goes down. Thus, Southern Co., a utility, whose shares
have traded between $13 and $17 for most of the past three years, must have a low beta.
At the other extreme will be Texas Instruments, whose share price has been as high as
$150 and as low as $75 during the same period.”

6. (20 points) Overheard at Buffalo Bros: “Mihov should make up his mind. One day he says that
variance is the right measure of risk. The next day he says that beta is the right measure of risk.” Can you
help your fellow students with an intelligent bar conversation? When is variance relevant and when is
beta relevant?
7 (20 points) ”Neither a borrower, nor a lender be.”- William Shakespeare, Hamlet.
If you take Shakespeare’s advice literally and apply it to your investment strategy, where would your
portfolio lie on the capital market line? Briefly explain why.