You are suggested to finish the mock exam in 75 minutes.

There are more questions in the real final exam (120 minutes).
A formula sheet (same as the one below) is provided in the real final exam.

Q1. Capital Budgeting: Project’s Cash Flow

Cochran, Inc., is considering a new three-year expansion project that requires an initial fixed asset
investment of €1.8 million. The fixed asset will be depreciated straight-line to zero over its three-year
tax life, after which time it will be worthless. The project is estimated to generate €2 million in annual
sales, with annual variable costs of €1 million and annual fixed costs of €0.2 million. The project also
requires €0.3 million as initial net working capital (at year 0), which keeps at that level through the
project’s life and is recoverable when the project ends. The tax rate is 25%.
a) What is the cash flow for year 0?
CF0 = - (1,800,000 + 300,000) = - $2,100,000
b) What is the cash flow for year 1?
Tax Shield approach: CF = (Sales – Costs) (1 – Tc) + D x Tc
CF1 = (2,000,000 – 1,000,000 – 200,000) (1 – 0.25) + [(1,800,000/3) x 0.25] = $750,000

Q2. Bond Valuation

AB Builders has 10-year bonds outstanding with a face value of €1,000. The bonds pay interest
annually with a coupon rate of 5%. Investors require a yield to maturity of 6%.
What is the current price of the bond? (keep two digits, i.e., €XXX.XX)
n=10; F = $1,000; c = 5%; YTM=6% (This is the required return by bondholders).

Bond value (annual payment) =

Coupon
YTM
× 1−
[ 1
( 1+YTM ) n
+
]
Face value F x c
=
( 1+YTM ) YTM
n
× 1−
1
( 1+ YTM )[n
+
F
( 1+ YTM )n]
Bond value =
$ 1,000 x 5 %
6% [
× 1−
1
( 1+6 % ) 10
+
] $ 1,000
( 1+6 % )10
=$ 926.40

Q3. Stock Valuation

Burkhardt Corp. expects to pay a dividend of €1.4 per share next year. The required return is 13%
and the dividend is expected to grow at a constant rate of 6% forever.
D1=$1.40; R =13%; g=6%. The dividend is a growing perpetuity.
a) What is the current price?

PMT 1
Growing perpetuity present value: PV =
r−g
P0= D1/(R-g) = $1.40/ (13% - 6%) =$20

b) What is the expected value of this stock five years from now? (keep two digits)
We need to find the stock price at year 5.
2 methods:
Method 1: Remember, the stock price usually grow at the same rate as the dividends (g=6%).
This said, we can apply the future value equation to get the price at year 5.

n
Future value equation: FV =PV ×(1+ r) with r representing the annual growth rate!
P5 = P0 x (1+6%)5= $20(1.06)5=$26.76

Method 2 (requires more calculation):

P5 = D6/(R-g) = D1 (1+g)5 /(R-g) = $1.40 (1+6%)5/(13%-6%) = $26.76

Q4. Cost of Capital

Sixth Fourth Bank has issued both stocks and bonds. The current market value of the stocks and
bonds are €200 million and €100 million, respectively. The bank’s equity beta is 1.5. The risk-free rate
is 4%, and the market risk premium is 6%. The bank’s before-tax debt cost of capital is 5%. Corporate
tax is 40%. (Keep two digits (XX.XX%) if the answer is not an integer).
E = $200,000,000; D=$100,000,000; V = E+D = $300,000,000
Beta = 1.5; Rf = 4%; [E(RM) – Rf] = 6%
RD,BT = 5%; Tc=40%
a) What is the bank’s cost of equity?

Capital Asset pricing model:

r i=r f + β i [ E ( Rmkt )−r f ]

R E=R f + β E [E ( R M ) −Rf ] = 4% + (1.5 x 6%) = 13%

b) What is the bank’s WACC? (Cost of capital)

WACC = WE x RE + WD x RD, AT = WE x RE + WD x RD,BT x(1-Tc) = (2/3) x 13% + (1/3) x (5% (1-40%)

WACC = 9.67%

Q5. Capital Structure

Calvert Corporation estimates an annual free cash flow of €27 million for the coming year, and
expects this number to grow indefinitely at a 3% rate. The company currently has no debt but can
borrow at a 6% rate. The company’s current cost of equity is 15%.
The firm’s CFs are a growing perpetuity; CF1 = $27,000,000; g = 3%
D = 0 (currently: actual capital structure); R D=6%; RE=15%. Note: the firm’s cost of capital is currently
its cost of equity).
a) What is the current total value of the firm?
Current value of the firm = PV of all future CFs
Future CFs are a growing perpetuity so we can apply the growing perpetuity PV:

PMT 1
Growing perpetuity present value: PV = = $27,000,000/(15% - 3%)= $225,000,000
R−g
Note: We used RE as the discount rate since the firm is currently financed 100% by equity (no debt!)

b) Assume there is no corporate tax. What would the firm’s WACC be if it issues €100 million
worth of perpetual bonds to repurchase equity?
We are moving from an all-equity capital structure to a levered capital structure (with debt)
NOTE: NO CORPORATE TAX
We can actually rely on the M&M proposition (case number 1) about the WACC with no taxes!
The proposition says that the WACC is not affected by the capital structure if there are no taxes.
It means that WACC before (0 debt) = WACC after (with debt) = RE = 15%

c) Assume the corporate tax rate is 30%. What would the firm’s total value be if it issues €100 million
worth of perpetual bonds to repurchase equity? (D= $100,000,000)

Here we need to calculate the value of the firm after the capital restructuring. In other words, we
need the value of the levered firm!
With taxes, interest payments are tax deductible, so it means that the firm benefits from a tax shield
which increases its CFs.
 The CFs of the levered firm > The CFs of the unlevered firm!
M&M mentioned that it is possible to calculate the levered firm value:

Value of levered firm: V L=V U + D ×Tax rate

VL = $225,000,000 + (100,000,000 x 30%) = $255,000,000

Formula Sheet

Time value of money (FV: future value; PV: present value; n: period; r: discount rate; PMT: annual
payment; first payment at the end of first year)

Single cash flow

n
 Future value equation: FV =PV ×(1+ r)

1
 Present value equation: PV =FV × n
(1+r )

Multiple cash flows

PMT n
 Annuity future value: FV = ×[ ( 1+r ) −1]
r
PMT 1
 Annuity present value: PV = ×[1− ]
r (1+ r)
n

PMT
 Perpetuity present value: PV =
r
PMT 1
[ ( )]
n
1+ g
 Growing annuity present value: PV = × 1−
r−g 1+ r
PMT 1
 Growing perpetuity present value: PV =
r−g

Average accounting return = Average net income / Average book value

Net Salvage Cash Flow = Selling price − (Selling price − Remaining book value)× Tax rate

Bond Valuation

 Bond value (annual payment) =

Coupon
YTM
× 1−
[ 1
( 1+YTM ) n
]+
Face value
( 1+YTM )n
 Coupon

[ ]
2 1 Face value
 Bond value (semi-annual payment) = YTM × 1− +
( ) ( )
2n 2n
YTM YTM
1+ 1+
2 2 2
 Fisher equation: (1 + nominal rate) = (1 + real rate) * (1 + expected inflation rate)

Stock Valuation (Dividend model)

D1 D2 D3 D∞
 General form: P0= 1
+ + +…+
( 1+r ) ( 1+r )2 (1+ r )3 ( 1+r )∞
D
 Constant dividend: P 0=
r
D1
 Constant dividend growth: P 0=
r −g

The Capital Asset Pricing Model (r i : expected return of asset i ; r f : risk-free interest rate; β i: systematic
risk of asset i ; E ( Rmkt ): expected return of the market; E ( Rmkt )−r f : market risk premium)

 r i=r f + β i [ E ( Rmkt )−r f ]

Capital Structure (no tax)

D
 Cost of equity: R E=R A + ( R A −R D ) ×
E

Capital Structure (with tax)

 Value of levered firm: V L=V U + D ×Tax rate