RUC

Corporate Finance
Exam Fall 2016

4 hours written exam

Open Book

Remarks:

1) It is not allowed to connect the internet during the exam.

2) The exam consists of 4 questions. A percentage is given to each question, which is a guidance
concerning their weights on the total points.
3) Students are entitled to assistance concerning the interpretation of the exam questions during 30
minutes of the exam.
4) If you need to supply further assumptions, please make clear what you assume.

Good Luck!
Problem 1 - NPV x IRR (25%) - As newly hired financial analyst, your first task is to analyze 2 mutually exclusive
projects of investment for your company and choose 1 of them to be implemented. Suppose your company’s
cost of debt “Rd” equals 5%, the risk-free rate of the economy “Rf” equals 1%, the expected return on the
market portfolio “Rm” equals 10%, the beta of your company against the market return equals 1.5 and your
company uses a target long-term relation between debt and equity of 25% to finance its assets. The table
below summarizes the project’s net cash flows. Please answer the following questions:

Year Project A Project B

0 -150,000 -150,000

1 1,000 170,000

2 1,000 1,000

3 220,000 1,000

In order to facilitate calculations, assume that the corporate tax rate “t” equals zero.

a) Calculate the Weighted Average Cost of Capital “WACC” for your company?
Re = Rf + beta (Rm-Rf)  Re = 1% + 1.5 (10%-1%) =14.5%
D/E = 25%  D/(D+E) = 25/125 =1/5  E/(D+E)= 4/5
WACC = E/(D+E) * Re + D/(D+E) * Rd
WACC = 0.8 * 14.5% + 0.2 * 5% =12.6%

b) Using the WACC calculated in “a” as discount rate, calculate the net present value (NPV) of each of the
2 different projects? Which is the best project according to this criterion?

Definitely, project A is the best according to the NPV criterion.

c) Calculate the Internal Rate of Return “IRR” of the 2 different projects? Which project would you choose
according to this criterion?
 Definitely, project B is the best according to the IRR criterion.

d) Do you see any paradox in the answers of items “b” and “c”. If yes, explain with your own words this
problem. What criterion would you finally choose for your analysis and why?

Ranking problem of the IRR happens when the NPV indicates the choice of one project and the IRR of
the other. This problem happens usually because of liquidity reasons of the cash flows. For example, project
concentrates cash flows in the beginning and project b in the end. If the IRR is very different than my cost of
capital, results can be biased. Always choose the NPV approach, because assumptions are more reliable. By
choosing the NPV you assume the discount rate is similar to your real cost of capital, while the IRR assumes a
completely different discount rate. This choice of discount rate of the NPV is also more realistic considering the
reinvestment assumption of these techniques.

e) Do you believe that the overall corporate WACC is the best discount rate you can use to analyze your
projects? Reflect with your own words upon the consequences of using an overall corporate WACC for
this purpose.

It is not the best rate to use. The discount rate should be adjusted according to the risk of each project. Using
the Enterprise’s WACC to discount projects that have a higher average risk than Enterprise’s one would bias the
project to be accepted (WACC is lower than the rate that should be used to discount the project). Analogously,
using the Enterprise’s WACC to discount projects that have a lower average risk than the Enterprise’s one
would bias the project to be rejected (WACC is higher than the rate that should be used to discount the
project).

Hint: You can answer question e without having answered the prior ones.
Problem 2 - Bonds and Equity Pricing (30%) - You started working at Company X this year. You decide to invest
part of your salary in bonds and equity of this company. Market information for Company X is offered by the
table below:

Stocks of Company X:

Last dividend paid 100 DKK

Expected dividend growth 0.5% yearly

Beta 1.5

Bonds of Company X

Face Value 50,000 DKK

Yield to Maturity 3%

Maturity 15 years

Coupon Rate (paid annually) 4%

Other Important Information

Risk-Free rate of the economy (Rf) 1%

Expected market return (Rm) 5%

a) Calculate the market price of one bond of Company X.

b) If a shock happens in the economy and moves the yield to maturity of this bond immediately from
3% to 5%, what would be the new bond price for Company X? Explain with your own words the
relation between the bond price and the bond’s yield to maturity.

If interest rates increase sharply, this will affect the bond prices in the opposite direction. Thus, prices
of the bond will decrease. Because the bond has a long duration, its price will decrease a lot (very
sensible). Basically this strong effect has to do with the fact that the owners of the bond are bind to the
investment longer.

c) Calculate the stock price of Company X using the Dividend Growth Model. Use the Rm rate, the
market expected return, as required return of the investor.

d) Now, calculate the stock price of Company X using the Dividend Growth Model, but using the
CAPM to calculate the required return of the investor.
 e) Why are there differences in the prices you calculated in “c” and “d”? Which of the answers is
more precise? Explain.

The capital market line and the CAPM approach is much more precise, since it uses a discount rate according to
the systematic risk beta of the company and not one based only on the stock market portfolio.

f) Would you invest all your money in Company X? Shortly explain with your own words the possible
gains of diversification and the concepts of Beta, systematic and non-systematic risks.

Hint: You can answer questions e and f without the results of questions a, b, c and d.

You should diversify your portfolio in order to avoid non-systematic risk. The society only pays investors for
holding risk that is not diversifiable, the so called systematic risk. This is exactly the risk measured by Beta.
Problem 3 - Modigliani and Miller with taxes (25%) - You are willing to make a valuation of a company.
Answers the following questions according to the table below:

D/E 80%

Rd 4%

T 30%

EBIT 20,000 forever

Rf 2%

Rm 8%

Beta 2

“D” is the market value of debt, “E” is the market value of equity, “Rd” is the cost of debt before taxes, “t” is
tax rate, “EBIT” is earnings before interest and taxes, “Rf” is the risk free rate, “Rm” is the market return of the
stock index and “Beta” is a measurement of systematic risk of the company. Assume that both depreciation
and net-investment (replacement) are zero, the company has no current assets and no current liabilities and
that it will add nothing to retained earnings in the future. All net income is paid out as dividends.

a) Calculate the cost of equity capital “Re” of this company.

b) Calculate the weighted average cost of capital (WACC) for the company.

c) What would the cost of equity and the WACC for this company be if it had no debt?
RE = RU + (RU – RD)(D/E)(1 – t)
14% = RU + (RU – 4%)(0.8)(0.7) 14% = RU + (RU )(0.56)- 2.24%
 16.24% = 1.56Ru  Ru = 10.4102%

If there is no debt, Ru=WACC

 WACC would be 10.4102%

d) Does the choice of capital structure of the company influence its WACC in the presence of taxes? What
about the total value of the company? What can you observe in this exercise? Explain with your own
words.

Hint: You can answer question d without having answered the prior ones.

I can observe that WACC increases when there is no debt to finance the company’s operations. Thus, since
WACC discount the FCFs in the valuation, the value of the total value of the company should decrease if the
company does not use debt to finance its operations. This is observable from topic “b” to “c”, where WACC
increases. According to MM proposition 1 and 2 without taxes the capital structure does not influence at all the
value of the company nor the WACC. Increasing leverage only increases the cost of equity Re. Because Rd is
usually lower than Re, the higher Re is compensated by a higher weight on the cheaper source of capital (debt).
This compensates the higher Re and therefore WACC continues the same.

Nevertheless, in the presence of taxes, the company can deduct the interest expenses of debt from the taxes,
what creates the so called tax shield. Because of this effect, WACC decreases and the total value of the
company increases.
Problem 4 - Options and Put-Call-Parity (20%) - You would like to trade put and call options that have the
same strike price of 100 DKK and same maturities of 1 year for a stock with market value of 80DKK today in the
Danish stock exchange. If the call option costs 30 DKK and the risk free rate equals 4%, answer the following
questions:

a) Explain the concept of call and put options with your own words. What is the maximum one can lose and
earn by buying this call option?

Buying a contract of call options is the same as purchasing the right to buy the stock for a given price (strike
price) in a given date in the future. This means that after buying a call option, the seller of the option has an
obligation with the buyer to sell the stock for the strike price in the day of the maturity if the buyer decides to
exercise his option. The maximum one can lose by buying call option is equal to the premium one pays to have
this option. If the share price is for example below the strike price in the day of the maturity, the buyer of the
option will have no incentive to exercise his right. Thus, he will end up losing the premium he paid for the
option. On the other hand, if the price of the stock increases and is above the strike price in the day of the
maturity, he will exercise the option by buying the stock for the strike price. In this case, he will always earn the
difference between the market price of the stock and the strike price of the option, subtracting also how much
he paid for the option (option premium). Maximum you can lose =100% maximum you can earn = infinite.

b) Would you say that the call option described by this problem is “in the money”? What about the put option?
Explain with your own words.

No, the call option is “out of the money”, since if the maturity were today, you would have as owner of a call
option the right to buy a stock for 100 DKK, which costs 80 in the market. Thus, you would not exercise your
option. The contrary is valid for the put option, where you would have the right to sell for 100DKK something
that costs 80DKK in the market today. So, the put option is “in the money”.

c) Calculate the price of the put option of this problem.

S0 = 80, E = 100, C = 30, maturity = 1 year

Rf = 4% year

Put option?

2 possible ways to solve the problem: Continues or Discrete solutions.

Solution continuous: Put-Call Parity (continuously compounded): P = Ee-Rt + C – S

P = 100 e-4% * 1 + 30 – 80 = 46.07 DKK

Solution discrete: monthly compunded  P = E/(1+r)^t + C – S  P = 100/(1.04)^1+30-80  P = 46.15 DKK