FINA 3303 SAMPLE MID-TERM EXAM SOLUTIONS

Part 1 (80 points)

We are at the beginning of 2016. Last year your well-diversified student

equity fund has acquired the full ownership in Stars & Bucks in Tai Po Tsai
village for HKD 1 million. The business is not going so well since Starbucks
has opened on campus (apparently, your former clients get mixed up and
head there, foolishly thinking that it is the same shop!)

Unexpectedly, you bump into Mr. Victor Yip, who is a member of the family
that formerly used to own Stars & Bucks and sold it to you last year. The
family has successfully invested HKD 1 million into Shenzhen Stock
Exchange and was able to generate a 75% return on the investment. Given that stock market outlook
does not look that promising, the family, represented by Mr. Victor Yip, is offering to buy back 100%
of the equity stake for HKD 1 million.

Before you take the offer, you would like to estimate the value of Stars & Bucks, based on the
information provided below. Good luck!

Past Financial Statements

Balance Sheet (HKD thousands)

Dec Dec Dec Dec
ASSETS 2014 2015 LIABILITIES & EQUITY 2014 2015
Cash 10 20 Short-Term Financial Debt 20 25
Accounts Receivable 50 55 Accounts Payable 80 75
Inventories 60 75 Long-Term Financial Debt 40 50
Net Fixed Assets 100 100 Equity 80 100
TOTAL 220 250 TOTAL 220 250

Income Statement for 2015 (HKD thousands)

Revenues 390
Cost of Goods Sold 250
Selling & Administrative Expenses 65
Depreciation 25
Interest Expenses 3.5
Tax Expenses at 15% 6.975
Net Income 39.525

Findings from Market Research and Due Diligence

1. Sales will grow at 7% in 2016 and 3% afterwards in perpetuity
2. Stars & Bucks primarily sells coffee and other hot beverages but also some light meals like
sandwiches
3. Operating margin (EBIT-to-Sales Ratio) will remain the same as in 2015
4. The corporate tax rate is not expected to change

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5. The ratio of net working capital-to-sales will remain the same as in 2015
6. Annual capital expenditures will remain equal to annual depreciation expenses
7. The cost of debt in 2015 will remain the same and can approximated by the interest
expenses paid in 2015 divided by the sum of the short-term and long-term debt shown on
the December 2014 balance sheet
8. You do not have any plans to modify Stars & Bucks’s existing capital structure
9. All cash-flows occur at the end of the calendar year
10. As of January 1, 2016, the yield of long-term government bonds is 5.8333%, while the
expected return on the market portfolio is 11%
11. You tried to find publicly listed companies in the coffee shop segment and Yahoo Finance
provides you the following information (as of January 1, 2016):

Equity Value of debt Market value of Earnings Effective

Name
beta (bn USD) equity (bn USD) (bn USD) tax rate
Dunkin’ Donuts 0.35 1.96 4.68 0.192 40%
Starbucks 0.80 2.48 65.88 2.680 40%

12. You try to understand the revenue breakdown of these companies and by searching the
web you get the following information for Starbucks:

Since Dunkin’ Donuts operates a franchise business, the exact breakdown of sales is not
known but you manage to get the following breakdown of sales from a recent newspaper
article:

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1. What is the free cash flow that Stars & Bucks has generated over the year of 2015?

𝑬𝑩𝑰𝑻 = 𝑹𝒆𝒗𝒆𝒏𝒖𝒆𝒔 − 𝑪𝑶𝑮𝑺 − 𝑺𝑮&𝑨 − 𝑫𝒆𝒑 = 𝟑𝟗𝟎 − 𝟐𝟓𝟎 − 𝟔𝟓 − 𝟐𝟓

= 𝟓𝟎

𝑵𝑾𝑪𝟐𝟎𝟏𝟒 = 𝑨⁄𝑹 + 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒊𝒆𝒔 − 𝑨⁄𝑷 = 𝟓𝟎 + 𝟔𝟎 − 𝟖𝟎 = 𝟑𝟎

𝑵𝑾𝑪𝟐𝟎𝟏𝟓 = 𝑨⁄𝑹 + 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒊𝒆𝒔 − 𝑨⁄𝑷 = 𝟓𝟓 + 𝟕𝟓 − 𝟕𝟓 = 𝟓𝟓
∆𝑵𝑾𝑪𝟐𝟎𝟏𝟓 = 𝑵𝑾𝑪𝟐𝟎𝟏𝟓 − 𝑵𝑾𝑪𝟐𝟎𝟏𝟒 = 𝟓𝟓 − 𝟑𝟎 = 𝟐𝟓

𝑪𝑨𝑷𝑬𝑿 = ∆𝑵𝒆𝒕 𝑷𝑷&𝑬 + 𝑫𝒆𝒑 = 𝟏𝟎𝟎 − 𝟏𝟎𝟎 + 𝟐𝟓 = 𝟐𝟓

𝑭𝑪𝑭𝟐𝟎𝟏𝟓 = (𝟏 − 𝒕)𝑬𝑩𝑰𝑻 + 𝑫𝒆𝒑 − ∆𝑵𝑾𝑪 − 𝑪𝑨𝑷𝑬𝑿

= (𝟏 − 𝟎. 𝟏𝟓)𝟓𝟎 + 𝟐𝟓 − 𝟐𝟓 − 𝟐𝟓
= 𝟏𝟕. 𝟓

2. What is the unlevered beta (i.e. beta on assets) in the coffee shop segment (provide your
answer with 2 decimal points)?

𝑫𝒖𝒏𝒌𝒊𝒏′ 𝒔 𝑫𝒐𝒏𝒖𝒕𝒔
𝑫
𝜷𝑬 = (𝟏 + (𝟏 − 𝒕) ) 𝜷𝑨
𝑬
𝟏. 𝟗𝟔
𝟎. 𝟑𝟓 = (𝟏 + (𝟏 − 𝟎. 𝟒) )𝜷
𝟒. 𝟔𝟖 𝑨
𝜷𝑨 = 𝟎. 𝟐8

𝑺𝒕𝒂𝒓𝒃𝒖𝒄𝒌𝒔
𝑫
𝜷𝑬 = (𝟏 + (𝟏 − 𝒕) ) 𝜷𝑨
𝑬
𝟐. 𝟒𝟖
𝟎. 𝟖𝟎 = (𝟏 + (𝟏 − 𝟎. 𝟒) )𝜷
𝟔𝟓. 𝟖𝟖 𝑨
𝜷𝑨 = 𝟎. 𝟕𝟖

𝟎. 𝟐8 + 𝟎. 𝟕𝟖
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 = = 𝟎. 𝟓𝟑
𝟐

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3. What is the estimated cost of equity capital of Stars & Bucks according to the CAPM (provide
your answer with 2 decimal points)?

𝟐𝟎𝟏𝟒

𝑫𝒆𝒃𝒕 = 𝑺𝑻 𝑫𝒆𝒃𝒕 + 𝑳𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝑫𝒆𝒃𝒕 = 𝟐𝟎 + 𝟒𝟎 = 𝟔𝟎

𝑬𝒒𝒖𝒊𝒕𝒚 = 𝟖𝟎
𝑫 𝟔𝟎
= = 𝟎. 𝟕𝟓
𝑬 𝟐𝟎𝟏𝟒 𝟖𝟎

𝟐𝟎𝟏𝟓

𝑫𝒆𝒃𝒕 = 𝑺𝑻 𝑫𝒆𝒃𝒕 + 𝑳𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝑫𝒆𝒃𝒕 = 𝟐𝟓 + 𝟓𝟎 = 𝟕𝟓

𝑬𝒒𝒖𝒊𝒕𝒚 = 𝟏𝟎𝟎
𝑫 𝟕𝟓
= = 𝟎. 𝟕𝟓
𝑬 𝟐𝟎𝟏𝟓 𝟏𝟎𝟎

𝑫
𝜷𝑬 = (𝟏 + (𝟏 − 𝒕) ) 𝜷𝑨
𝑬
= (𝟏 + (𝟏 − 𝟎. 𝟏𝟓) 𝑿 𝟎. 𝟕𝟓) 𝟎. 𝟓𝟑
= 𝟎. 𝟖7

𝒓𝑬 = 𝟎. 𝟎𝟓𝟖𝟑 + 𝟎. 𝟖7 × (𝟎. 𝟏𝟏 − 𝟎. 𝟎𝟓𝟖𝟑) = 𝟎. 𝟏𝟎

4. What is Stars & Bucks’s estimated weighted average cost of capital (provide your answer
with 2 decimal points)?

𝑫
= 𝟎. 𝟕𝟓
𝑬

𝑬 𝟏𝟎𝟎
= = 𝟎. 𝟓𝟕
𝑽 𝟏𝟕𝟓

𝑫 𝟕𝟓
= = 𝟎. 𝟒3
𝑽 𝟏𝟕𝟓

𝟑. 𝟓
𝒓𝑫 = = 𝟎. 𝟎6
𝟔𝟎

𝑫 𝑬
𝑾𝑨𝑪𝑪 = 𝒓𝑫 (𝟏 − 𝒕) + 𝒓𝑬
𝑽 𝑽
= 𝟎. 𝟒3 × 𝟎. 𝟎6 × (𝟏 − 𝟎. 𝟏𝟓) + 𝟎. 𝟓𝟕 × 𝟎. 𝟏𝟎

= 0.02 + 0.06
= 𝟎. 𝟎𝟖

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5. What is Stars & Bucks’s estimated free cash flow for year 2016 (provide your answer with 2
decimal points)?

𝟓𝟎
𝑬𝑩𝑰𝑻 𝒕𝒐 𝑺𝒂𝒍𝒆𝒔 = = 𝟎. 𝟏3
𝟑𝟗𝟎
𝑺𝒂𝒍𝒆𝒔𝟐𝟎𝟏𝟔 = 𝟑𝟗𝟎 × 𝟏. 𝟎𝟕 = 𝟒𝟏𝟕. 𝟑
𝑬𝑩𝑰𝑻𝟐𝟎𝟏𝟔 = 𝟒𝟏𝟕. 𝟑 × 𝟎. 𝟏3 = 𝟓4. 25

𝟓𝟓
𝑵𝑾𝑪 𝒕𝒐 𝑺𝒂𝒍𝒆𝒔 = = 𝟎. 𝟏𝟒
𝟑𝟗𝟎
𝑺𝒂𝒍𝒆𝒔𝟐𝟎𝟏𝟔 = 𝟑𝟗𝟎 × 𝟏. 𝟎𝟕 = 𝟒𝟏𝟕. 𝟑
𝑵𝑾𝑪𝟐𝟎𝟏𝟔 = 𝟒𝟏𝟕. 𝟑 × 𝟎. 𝟏𝟒 = 𝟓𝟖. 42
∆𝑵𝑾𝑪𝟐𝟎𝟏𝟔 = 𝑵𝑾𝑪𝟐𝟎𝟏𝟔 − 𝑵𝑾𝑪𝟐𝟎𝟏𝟓 = 𝟓𝟖. 42 − 𝟓𝟓 = 𝟑. 42

𝑭𝑪𝑭𝟐𝟎𝟏𝟔 = (𝟏 − 𝒕)𝑬𝑩𝑰𝑻 + 𝑫𝒆𝒑 − ∆𝑵𝑾𝑪 − 𝑪𝑨𝑷𝑬𝑿

= (𝟏 − 𝟎. 𝟏𝟓)𝟓4.25 + 𝑫𝒆𝒑 − 𝟑. 42 − 𝑪𝑨𝑷𝑬𝑿
= 46.11 + Dep - 3.42 - CAPEX
= 𝟒2.69

6. What is Stars & Bucks’s estimated free cash flow for year 2017 (provide your answer with 2
decimal points)?

𝟓𝟎
𝑬𝑩𝑰𝑻 𝒕𝒐 𝑺𝒂𝒍𝒆𝒔 = = 𝟎. 𝟏3
𝟑𝟗𝟎
𝑺𝒂𝒍𝒆𝒔𝟐𝟎𝟏𝟕 = 𝟒𝟏𝟕. 𝟑 × 𝟏. 𝟎𝟑 = 𝟒𝟐𝟗. 𝟖2
𝑬𝑩𝑰𝑻𝟐𝟎𝟏𝟕 = 𝟒𝟐𝟗. 𝟖2 × 𝟎. 𝟏3 = 𝟓𝟓. 88

𝟓𝟓
𝑵𝑾𝑪 𝒕𝒐 𝑺𝒂𝒍𝒆𝒔 = = 𝟎. 𝟏𝟒
𝟑𝟗𝟎
𝑺𝒂𝒍𝒆𝒔𝟐𝟎𝟏𝟕 = 𝟒𝟏𝟕. 𝟑 × 𝟏. 𝟎𝟑 = 𝟒𝟐𝟗. 𝟖2
𝑵𝑾𝑪𝟐𝟎𝟏𝟕 = 𝟒𝟐𝟗. 𝟖2 × 𝟎. 𝟏𝟒 = 𝟔𝟎. 17
∆𝑵𝑾𝑪𝟐𝟎𝟏𝟕 = 𝑵𝑾𝑪𝟐𝟎𝟏𝟕 − 𝑵𝑾𝑪𝟐𝟎𝟏𝟔 = 𝟔𝟎. 17 − 𝟓𝟖. 42
= 𝟏. 𝟕5

𝑭𝑪𝑭𝟐𝟎𝟏𝟕 = (𝟏 − 𝒕)𝑬𝑩𝑰𝑻 + 𝑫𝒆𝒑 − ∆𝑵𝑾𝑪 − 𝑪𝑨𝑷𝑬𝑿

= (𝟏 − 𝟎. 𝟏𝟓)𝟓𝟓. 88 + 𝑫𝒆𝒑 − 𝟏. 𝟕5 − 𝑪𝑨𝑷𝑬𝑿
= 47.50 + Dep - 1.75 - CAPEX
= 𝟒𝟓. 75

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7. What is Stars & Bucks’s estimated enterprise value at the beginning of 2016 (provide your
answer with 2 decimal points)?

𝟒𝟓. 75
𝟒2.69 +
𝑬𝑽 = 𝟎. 𝟎𝟖 − 𝟎. 𝟎𝟑
𝟏. 𝟎𝟖

= 𝟖86.75

8. What is Stars & Bucks’s estimated equity value at the beginning of 2016 (provide your
answer with 2 decimal points)?

𝑬𝒒𝒖𝒊𝒕𝒚 = 𝑬𝑽 + 𝑪𝒂𝒔𝒉 − 𝑫𝒆𝒃𝒕 = 𝟖86.75 + 𝟐𝟎 − 𝟐𝟓 − 𝟓𝟎 = 𝟖𝟑1.75

9. Should your fund sell the shares at the offered price?

𝒀𝑬𝑺

10. What equity value would you get if you used PE multiple (relative valuation) (provide your
answer with 2 decimal points)?

𝑫𝒖𝒏𝒌𝒊𝒏′ 𝒔 𝑫𝒐𝒏𝒖𝒕

𝑷 𝟒. 𝟔𝟖
= = 𝟐𝟒. 𝟑8
𝑬 𝟎. 𝟏𝟗𝟐

𝑷 = 𝟐𝟒. 𝟑8 × 𝟑𝟗. 𝟓𝟐𝟓 = 𝟗𝟔𝟑. 62

𝑺𝒕𝒂𝒓𝒃𝒖𝒄𝒌

𝑷 𝟔𝟓. 𝟖𝟖
= = 𝟐𝟒. 𝟓𝟖
𝑬 𝟐. 𝟔𝟖

𝑷 = 𝟐𝟒. 𝟓𝟖 × 𝟑𝟗. 𝟓𝟐𝟓 = 𝟗𝟕𝟏. 52

𝟗𝟔𝟑. 62 + 𝟗𝟕𝟏. 52
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 = = 𝟗𝟔𝟕. 𝟓7
𝟐

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Part 2 (20 points)

Company ABC is expected to have EBIT of $1 million per year forever and the market value of the
shares of the company currently is $8 million. At present the company has no debt. ABC plans to
raise $3 million of perpetual debt at 8%, which will be risk-free, and use that to buy back shares. The
tax rate of ABC is 20%.

1. What will be the value of equity after the change in capital structure of ABC?

𝐵𝑦 𝑀𝑀𝐼, 𝑉𝐿 = 𝑉𝑈 = 𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦 = 0 + 8 (𝑚) = 8 (𝑚)

𝐸𝐵𝐼𝑇 (1 − 𝑡) 1 (1 − 0.2)
= = 8 (𝑚) => 𝑟𝑎 = 0.1
𝑟𝑎 𝑟𝑎

𝐸𝐵𝐼𝑇 (1 − 𝑡) 1(1 − 0.2)

𝑉𝐿 = 𝑉𝑈 + 𝑇𝐶 𝐷 = + 𝑇𝐶 𝐷 = + (0.2)(3) = 8.6 (𝑚)
𝑟𝑎 0.1

𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑉𝐿 − 𝐷𝑒𝑏𝑡 = 8.6 (𝑚) − 3(𝑚) = 5.6 (𝑚)

2. After the change in capital structure, suppose that due to a tax rate hike by the government,
the tax rate for ABC goes up from 20% to 30%. What will be the value of equity of (the
levered company) ABC after the change in the tax rate?

𝐼𝑓 𝑇𝑐 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑓𝑟𝑜𝑚 20% 𝑡𝑜 30%, 𝑡ℎ𝑒𝑛

𝐸𝐵𝐼𝑇 (1 − 𝑡) 1(1 − 0.3)

𝑉𝐿 = 𝑉𝑈 + 𝑇𝐶 𝐷 = + 𝑇𝐶 𝐷 = + (0.3)(3) = 7.9 (𝑚)
𝑟𝑎 0.1

𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑉𝐿 − 𝐷𝑒𝑏𝑡 = 7.9 (𝑚) − 3(𝑚) = 4.9 (𝑚)