FIN 4414 In-Class Exam #2

Sample Exam
Professor Tao Li

Exam Time: 90 minutes

First Name: __________ Last Name: ____________

I agree to be bound by the honor code of the University of Florida. Do not open or
begin the exam until instructed.
____________________________
(Signature)
Answer Sheet of Section A

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Section A: Multiple choice questions (45 points, 15 questions x 3 points each)

1. SPOT.com aims to sell 171 million shares of stock in an auction IPO. At the end of the bidding period,
SPOT’s investment bank has received the following bids.

Price ($) Number of shares bid (million)

180 30
165 58
132 89
120 95.5
110 171

What will be the offer price?

a. 180
b. 165
c. 132
d. 120
e. 110

2. Caterpillar Inc. (Caterpillar) is a manufacturer of construction and mining equipment, diesel and
natural gas engines, industrial gas turbines and diesel-electric locomotives. The Company also is a
service provider through Caterpillar Financial Services, Caterpillar Remanufacturing Services,
Caterpillar Logistics Services and Progress Rail Services. Caterpillar is considering two mutually
exclusive projects, Project A and Project B. The cash flows from the projects are summarized below:

Project X Project Y
Year Cash Flow Cash Flow
0 -$3,700 million -$3,200 million
1 1,400 million 900 million
2 1,070 million 1,000 million
3 1,125 million 1,135 million
4 700 million 720 million

The two projects have the same risk. At what cost of capital would the two projects have the same net
present value (NPV)?

a. 8.07%
b. 45.80%
c. 70.39%
d. 6.90%
e. Cannot be determined.
3. Assume the risk-free rate increases. This change will ____ the value of call options and _____ the
value of put options on shares of stock.

a. Increase; decrease
b. Increase; increase
c. Decrease; decrease
d. Decrease; increase
e. Not affect; not affect

4. Chipotle Mexican Grill, Inc. and its subsidiaries (Chipotle) operate restaurants throughout the United
States, as well as two restaurants in Toronto, Canada and one in London, England. Chipotle categorizes
its restaurants as either end-caps (at the end of a line of retail outlets), in-lines (in a line of retail
outlets), free-standing or other. The company has a capital budget of $400,000 this year. Three
independent projects with lives of one-year each are currently being considered for investment. What
is the best project or a combination of project(s) to accept in order to maximize shareholder wealth?

Project Initial Cash Inflow Cost of NPV IRR

Investment (t=1) Capital
(t=0)

A -$400,000 $500,000 12% 25%

B -$300,000 $380,000 12% $39,286

C -$100,000 10% 20%

a. Only Project A
b. Only Project B
c. Only Project C
d. Project A and C
e. Project B and C

5. All of the following are supporting arguments in favor of IPO underpricing except which one?

a. Helps prevent the “winner’s curse.”

b. A low offering price raises the price on the secondary market, and enhances firms’ ability to raise
further capital.
c. Reduces potential lawsuits against underwriters.
d. Diminishes underwriting risk.
e. Provides better returns to issuing firms.
6. Nelson Paints recently went public by offering 65,000 shares of common stock to the public. The
underwriters provided their services in a best efforts underwriting. The offering price was set at $16
a share and the gross spread was $2. After completing their sales efforts, the underwriters determined
that they sold a total of 57,500 shares. How much cash did Nelson Paints receive from its IPO?

a. $805,000
b. $910,000
c. $920,000
d. $1,035,000
e. $1,040,000

7. What is a blockchain?

a. A distributed ledger on a peer to peer network

b. A type of cryptocurrency
c. A stock exchange
d. A cryptocurrency exchange
e. A centralized ledger

8. Which of the following is incorrect?

a. Ethereum Gas is paid by issuing new ethers.

b. The Bitcoin and Ethereum blockchains have different block sizes.
c. If a block is mined by two miners simultaneously one of them will be rejected.
d. In the Ethereum system, a rejected block can still be referenced in later blocks if it is mined
successfully.
e. Bitcoin generation halves every four years before 2041.

9. Alpha Inc.'s equity has a current market value of $100 million and a beta of 1.3. Alpha Inc. currently
has default free debt as well. The firm decides to change its capital structure by issuing $15 million
additional risk–free debt, and then using this $15 million plus another $10 million in cash to
repurchase stock. With perfect capital market, what will the beta of Alpha's stock (rounded to the
nearest decimal place) be after this transaction?

a. 1.1
b. 1.3
c. 1.5
d. 1.7
e. 1.9
10. Consider the following three statements:

In a world of Modigliani and Miller with corporate taxes …

(1) A firm’s weighted average cost of capital (WACC) does not depend on leverage and is equal to
the cost of unlevered equity.
(2) Absent costs of financial distress, a firm can increase its market value by increasing its leverage
(while keeping its operations unchanged).
(3) The riskiness of the cash flows to the firm’s total assets increases with leverage.

Which of the following is true?

a. Statements (2) and (3) are true, while statement (1) is false.
b. Statements (1) and (2) are true, while statement (3) is false.
c. Only statement (2) is true.
d. Only statement (3) is true.
e. None of the three statements (1), (2), or (3) is true.

11. Which of the following statements is false for the CAPM?

a. The risk premium of a security is equal to the market risk premium (the amount by which
the market’s expected return exceeds the risk-free rate), divided by the amount of market
risk present in the securityʹs returns measured by its beta with the market.
b. We refer to the beta of a security with the market portfolio simply as the securities beta.
c. There is a linear relationship between a stockʹs beta and its expected return.
d. A security with a negative beta has a negative correlation with the market, which means
that this security tend to perform well when the rest of the market is doing poorly.
e. The beta of a portfolio is the weighted average beta of the securities in the portfolio.

12. Which of the following statements is false?

a. On average, hedge fund activism is associated with positive short-term stock performance.
b. Activist hedge funds often demand stock buybacks, board and management shakeups, M&As, or
spin-offs.
c. Activist hedge funds typically purchase majority stakes in companies, and agitate for changes.
d. On average, there is a sizable stock price run-up in a two-week window before an activist hedge
fund discloses its position in a stock.
e. To qualify for the appraisal process for an M&A deal in the Delaware Court of Chancery, hedge
funds and other activist investors need to vote against the deal.
13. Franktown Motors is expected to have an EBIT of $2.2 million next year. Depreciation, the increase in
net working capital, and capital spending are expected to be $158,000, $92,000, and $114,000,
respectively. All are expected to grow at 15 percent per year for four years (until year 5). The firm
currently has $12 million in debt and 750,000 shares outstanding. After year 5, the adjusted cash flow
from assets (or free cash flow) is expected to grow at 2.5 percent indefinitely. The company’s WACC
is 8.7 percent and the tax rate is 34 percent. What is the price per share of the company’s stock?
a. $27.82
b. $29.34
c. $22.07
d. $26.12
e. $16.47

14. The common stock of XYZ is selling at $50 per share. A 13-week call option written on XYZ’s stock is
selling for $4. The call’s exercise price is $60. The risk free rate is 5% per year. What should a 13-
week put with an exercise price of $60 sell for?

a. 3.4
b. 8.8
c. 11.1
d. 13.3
e. 15.5
Section B: Short Answer Questions

Question 1 [17 points]: You are trying to value a financial option on the General Electric stock. You want
to value it using two separate techniques: (1) replicating portfolio and (2) probability based techniques.
GE is currently trading at $28.18. The option you want to value expires next year, on April 14th. It is a
European call option, with strike price of $30. Remember, this means that the option gives you the right
(but not the obligation) to buy GE for $30 on April 14th, 2018.
1) [6 points] Replicating portfolio technique (Binomial option pricing): You believe GE will go up to
$35 or down to $25 over the next year, ending at one of those prices. The risk free rate (at which
you can both borrow and lend money) is 2% for the next year. Use the replicating portfolio
technique to value the GE $30 call, expiring April 14th, 2018.
2) [6 points] Probability based technique: You believe GE will go to $35 or down to $25 over the
next year, ending at one of those prices. You believe there is an equal chance that it will go up or
down (i.e. 50% chance to go up, 50% chance to go down). You believe the appropriate discount
rate for any cash flows from the call option (i.e. the payouts on April 14th) is 10%. Value the call
option using probability based techniques.
3) [5 points] Which value is higher? You are sure the replicating portfolio valuation you have come
up with is correct. In the probability based valuation, you are also sure that the up and down
world and associated probabilities are correct. However, you are unsure about the discount rate
you used (10%). Would the discount rate have to increase or decrease to bring the probability
based valuation in line with the replicating portfolio technique valuation?

Question 2 [16 points]: The following questions are based on to the second case of the Modigliani and
Miller (MM) theory, which assumes corporate taxes but no bankruptcy costs. Suppose an unlevered firm
has a constant stream of earnings before interests and taxes (EBIT) at $10,000 a year. The tax rate is 30%
and the cost of capital of the unlevered firm is 7%. The firm currently has 10,000 shares of stocks
outstanding.
Please answer the following questions:
1) What is the value of the unlevered firm? What is the stock price per share of the unlevered firm?
(8 points)
2) The firm announces that it will issue a bond of $50,000 and the bond will sell at par value. What is
the firm value after the bond issuance? (8 points)
Question 3 [22 points] We are going to value a project with both a timing option and an abandonment
option. We will do both using probability based techniques. This is a restaurant that costs 500k to start. If
you start it immediately, expected cash flows are 300k per year for 2 years. However, while expected cash
flows are 300k, the actual cash flows will be either -100k or 700k per year with equal probability. The
realized cash flows in year 1 will persist in year 2 and the restaurant may be abandoned costlessly after
year one is over.

Alternatively, you can wait for a year to start the project, in which case, expected cash flows are either
200k per year for 2 years, or 400k per year for 2 years (equal probability). In each of those cases, the actual
cash flows will be 400k higher or lower than the expected cash flows, and the option to abandon the
project is there in the 2nd year of cash flows.

You may assume your discount rate is 0% for all cash flows and options.

All of these cash flows are graphically shown below.

Figure 1. Cash flows if we build immediately

Figure 2. Cash flows if we wait

Questions:
IF WE BUILD IMMEDIATELY [6 points]
(a) What is the NPV of doing the project, without factoring in the abandonment option?
(b) What is the NPV of doing the project, factoring in the abandonment option?

IF WE WAIT AND THINGS GO WELL [6 points]

(c) What is the NPV of doing the project, without factoring in the abandonment option?
(d) What is the NPV of doing the project, factoring in the abandonment option?

IF WE WAIT AND THINGS GO BADLY [6 points]

(e) What is the NPV of doing the project, without factoring in the abandonment option?
(f) What is the NPV of doing the project, factoring in the abandonment option?

Given answers to (d) and (f),

(g) What is the NPV of doing the project, factoring in the abandonment option? [2 points]

Given answers to (b) and (g)

(h) Should we wait, or build immediately? [2 points]