Final Exam

Instructions

❑ You must submit this take-home exam by the date of the actual final exam. My
preference is hardcopy, and you may bring to my office, place under my door, or give to
student workers to place in my mailbox in the Finance Suite. IF you cannot, then email is
acceptable.

❑ There are 8 pages in this exam. Please take a moment to ensure that you have all of the
pages. You may take as long as you wish BUT, I would expect 3 hours to be more than
adequate to take this exam.

❑ The exam is open book and open notes and of course open computer.

❑ The exam consists of 10 problems, some with multiple parts. Show workings to receive
partial credit. YOU ARE REQUIRED to answer 8 of the 10 questions; you must DROP 2.
You must state in the following box which TWO QUESTIONS you’ve exclude (say 2 and
5) ________________. I WILL not grade all your work and choose which two to
exclude; you must make that decision! IF YOU DON’T, I’ll grade the first 8 I find.

❑ If any question is ambiguous, use your best judgment given the other information in the
question as to what interpretation of the ambiguous information is most appropriate.

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1. The screen capture below is from Vanguard, a long-established ETF and Mutual Fund
company:

Explain BRIEFLY what ESG Investing is, and discuss why there has been a huge increase
in the number of ETFs that invest with this style? (I do not need long definitions of ESG
– instead, your answer should deal with why!)

2. As part of a year-end strategy meeting, a project has been identified as potential

investment by the head office of Hanna Barbara Inc. The information below gives
details of the project:
t=0 Y1 Y2 Y3 Y4 Y5 Y6
Cash Flow ($M) (100) 5 25 50 60 50 (50)

Cost of Capital 10%

ROIC 12%

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Prepare a report on this project, a single page should be sufficient: Should the company
invest? Why? (Hint: I expect more than a simple NPV calculation. We have studied many
methods in class; I expect a fuller explanation of your answer. It’s possible a chart may
inform the grader in a way that simple numbers cannot!)

3. As head of the Otis Division of United Technologies, you are involved with year-end
strategy meetings. Head office of United has allocated $150M for capital projects
for your division – that is a “hard” cap., in that no additional money is available at a
reasonable cost of capital.
The division is considering three capital projects. The first is an upgrade to hardware
necessary to manage the increasing amounts of data generated by elevators – part of
Otis long term goals is to use AI to improve maintenance of installed elevators. The first
project is an investment in hardware to support this development. This project requires
an initial investment of $40M – it is NOT scalable, Otis can either invest $40M or
NOTHING. The project has an IRR of 15%, and at a cost of capital of 12%, has an NPV of
$10M and a profitability index of 1.2.

The second project is a software upgrade to an existing elevator model sold by Otis. This
is needed for communications in the “wired future”. This project can be rolled out in
stages and next year (for which the $150M mentioned earlier covers) the division can
invest at three levels (four if you include DON’T INVEST as one of the choices), (the
cost of capital for all three levels is 12%):

Investment IRR PI

$0 to $50M 14% 1.3

$50M to $80M 13% 1.2

$80M to $100M 12% 1.0

Thus, as an example, if the division invests $60M next year in the second project, the
IRR will be 14% on first $50M and 13% for the remaining $10M of this investment, and
has a profitability index of 1.3 on the first $50M and 1.2 for the remaining $10M of the
$60M investment.

The third project is related to a Corp., of Engineers 1 bid request from the US military.
The project is an “all or nothing” investment, the company can choose to invest either
$60M or nothing as an initial investment. This project requires an initial investment of
1
The United States Army Corps of Engineers is a federal agency under the Department of Defense that
primarily oversees dams, canals and flood protection in the United States, as well as a wide range of public
works throughout the world.
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$60M – it is NOT scalable, Otis can either invest $60M or NOTHING. The project has
an IRR of 13%, and at a cost of capital of 12%, has an NPV of $6M and a profitability
index of 1.1.

If all projects have conventional cash flows, how should Otis invest next year and why?
(Any uninvested capital from the allocation of $150M will be returned to shareholders or
invested in other divisions at the company’s cost of capital of 12%.)

4. The Maxim Group’s manufacturing division is preparing an operational budget for

next year. The manufacturing division operates one large factory manufacturing
‘argnots’. Each argnot is expected to sell for $1,000; for context last year, the
division manufactured and sold 85,000 argnots. Each argnot requires 5 ozs of a
specialized rare-earth metal “unobtanium” costing $55 per oz. Other variable costs
include labor of $85 per argnot, and other material costs of $35 per argnot. The
division has annual fixed costs of $35M forecast for next year which INCUDES
$3M of depreciation. The company is expected to pay taxes at a rate of 20% in
the future.
a. What is the number of argnots the division needs to sell next year, to
breakeven measured on a profit basis?
b. What is the number of argnots the division needs to sell next year, to
breakeven measured on a cash flow basis? (You may ignore any effects from
net working capital or capital expenditure.)
5. The Oak Island Group is considering an investment in a new project for next year.
The management team estimates that the project must generate after-tax cash
flows of $12M next year to be a success. The biggest unknown in the project
forecasts are revenues: Based on past experience, the revenues are expected to
be $80M next year BUT the actual revenues can be modeled as a normal (Gaussian)
random variable with a mean of $80M and standard deviation of $20M. Variable
costs are projected to be 40% of revenues. Fixed costs are expected to be $30M
(excluding depreciation of $5M). The company pays taxes at 20% of pre-tax
income. GIVEN only the above facts (ignoring NWC and capex), what is the
probability the company will achieve or exceed its goal of after-tax cash flows of
$12M?
6. A venture capital firm is considering a series C investment in a new venture; the new
venture has already completed one informal fundraising round (FFF) 2, and two formal
rounds (series A and B). An analyst for the VC has created the following qualitative
model of the potential investment:
 The investment today by the VC firm is $5M if the firm decides to invest.
2
Somewhat unfairly, the first investors in a startup are grouped together as Friends, Family and Fools.
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  In one year, the new venture will require additional funding:
o IF the new venture is considered a “success” at the one-year anniversary,
the VC firm will invest an additional $6M.
o IF the new venture is considered a “failure” at the one-year anniversary, no
additional investment will be made and the new venture will be closed, paying
nothing to its investors (including the VC firm, and yes, they lose the $5M
initially invested).
o The probability of success at the one-year anniversary is 40%, failure 60%.
 IF the new venture survives the first year (“success” in above bullet), the new
venture will require additional funding at the end of year 2, the second
anniversary:
o IF the new venture is considered a “success” at the two-year anniversary,
the VC firm will invest an additional $12M.
o IF the new venture is considered a “failure” at the two-year anniversary, no
additional investment will be made and the new venture will be closed, paying
nothing to its investors (including the VC firm, and yes, they lose the $5M
initially invested, and the $6M invested at the one-year anniversary).
o At the two-year anniversary a third outcome exists labeled “Sale”. In this
outcome, the new venture will never become a Unicorn 3, BUT the intellectual
property can be sold. In the Sale outcome, the VC firm will make an
additional investment of $2M at the end of the second year (paying for legal
work on the intellectual property, etc.), and a year later (the three-year
anniversary), the VC firm will receive a payout of $125M. At which point, the
new venture will be shut down.
o The probability of success at the two-year anniversary is 20%, Sale 10%,
and failure 70%.
 IF the new venture survives the second year (“success” in above bullet NOT
“Sale”), the new venture will require NO more additional funding instead the new
venture will be harvested4 at t = 3.

3
Unicorn definition from Merriam-Webster: business: a start-up that is valued at one billion dollars or
more. Examples in use: “… a tech unicorn in Michigan is even more of a rarity, far from Silicon Valley's
investor echo chamber.” — Scott Martin; “The blockbuster initial public offering is expected to kick off a
revitalized market this year, encouraging IPO debuts by other unicorns, the privately held start-ups whose
hefty venture capital funds have allowed them to avoid Wall Street and the legal requirements of a public
offering.” — Jon Swartz
4
In Entrepreneurial Finance, harvest refers to the exit event where investors plan on exiting the new
venture. A successful harvest is usually achieved through an IPO. Although of lessor value, new ventures
can be sold to a larger established company (example, a VC-backed software company purchased by
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 o The best outcome at Harvest is an IPO, this will happen with probability
20%, and will pay the VC firm $500M at t = 3.
o Second best is a sale of the new venture to another competitior; this
outcome has a probability of 15%, and will pay the VC firm $300M at t = 3.
o If failure occurs at this stage, with probability 65%, the VC firm will receive
nothing at t = 3. (Yes, new ventures can be funded a year before an expected
IPO and still fail!)
If the cost of capital for this type of investment is 25%, should the VC firm make the
initial investment of $5M? [Hint: the successful answer will likely include a diagram (The
Event Tree in the Real Option slide deck) as workings.]

7. Centech Inc., has an opportunity to invest $11M in a small startup company that is
developing a new technology that will enhance Centech’s main product. The
investment will come in two stages – the first of $3M is immediate, the second in
two years of $8M is OPTIONAL; in two years, if Centech does not like what it sees
with the startup’s progress it can walk away, investing nothing, but losing the $3M
invested at the beginning; alternatively, if the startup is progressing well, Centech
can make the additional $8M investment. The company has used an appraiser to value
the small startup, and using a DCF model, estimates that the value of Centech’s
investment is $9M. On the face of it, the investment should not be made – why
invest $11M ($3M + $8M) to buy something worth $9M! Here are some additional
facts:
 The risk-free rate is 3.0%.
 The uncertainty of the investment can be measured by  = 75% (this is an early
stage venture).
Should Centech make the first $3M investment?
8. Chevron stock is currently priced at $116 per share. The company has paid a
dividend of $4.69 over the last 4 quarters:

1. The last 4 dividends

total:

2. $1.12 + 3 x $1.19 =

According to Value Line, the company has seen steady

dividend growth over recent years and this expected to continue into the future. The
company expects to earn an ROE of approx., 10% in the future, and expects to payout
approximately 56% of net income as dividends:

Microsoft). Of course, even at this final stage in the life of the company, failure can still occur (WeWork).
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Answer the next four questions using the data given above (YOU DO NOT NEED to find
your own data, everything you need is given above):

a. What is the forecast retention ratio (yes a truly trivial calculation)?

b. What is the long-run growth rate for future dividends?
c. What is the forecast dividend for next year?
d. Using the Gordon model, what is Chevron’s cost of equity?
9. Chevron’s stock has a CAPM beta of 1.25. The company historically has maintained a
debt to equity ratio of 1/6 and pays taxes at a rate of 30%.
a. If the risk-free rate is 3.0% and the expected market premium is 5.0%, using
the CAPM, what is Chevron’s cost of equity?
b. What is the asset beta of Chevron (the unlevered beta)?
c. IF the company decides to restructure its capital, adjusting its debt to equity
ratio from 1/6 to 1/2, assuming the tax rate stays at 30%, what is the cost of
equity after this restructuring?
10. Untied Technologies consists of two divisions, Itos and Wratt & Pitney (Wratt). The
company has a very simple capital structure – common equity and a single zero-
coupon bond. Currently Untied has the following characteristics:
 Value of the business today, $1.5B. This is measured at the enterprise level, EV =
$1.5B = Market Value of Equity + Market value of Debt.
 The business level of risk is measured with a standard deviation of 30%.
 The zero has a face value of $2.0B and matures in 5 years.
The risk-free rate is 3.0%.

a. What is the current market value of equity?

b. What is the current market value of the debt (the zero)?
c. What is the annual yield to maturity of the debt?
An activist hedge fund is pressuring Untied to split the business into two: the hedge fund
does not believe the market truly understands Untied’s business because of the mix of
the two divisions and believes that if the two divisions were broken into two separate

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public companies, and given to the current investors instead of Untied’s stock, then this
would unlock value. The two divisions have the following characteristics:

 Value of the Itos division today, is $1.0B. The smaller Wratt division is worth
$500M. Both values are measured at the enterprise level, EV = Market Value of
Equity + Market value of Debt. The value of $1.5B mentioned earlier is the sum of
the value of these two divisions.
 The business level of risk is measured with a standard deviation of 35% for Itos,
and 40% for Wratt. (Note that because of diversification, the standard deviation
of Untied is 30%, compared to 35% for Itos and 40% for Wratt – lower than
both!)
 As Itos has the more stable cash flows, the existing zero will be split into two
separate zeros, one for each division. The zero for Itos has a face value of $1.5B
and the zero for Wratt has a face value of $500M; both mature in 5 years.
d. Should the investors of Untied agree to the restructuring? (To be clear,
investors currently own shares in Untied – your answer to a., above shows what
these are worth in total. Under the restructuring, investors’ shares in Untied
would be “destroyed”, and they would be given shares in Itos and Wratt
INSTEAD. Is this worth more?)

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