FINE 7640 Midterm Exam 2017 A Possible Score Multiple Choice 28 Question 1 40 Question 2 32 Total 100 Name: ID Number: Section: Instructions: 1. Begin by printing your name above. 2. You are allowed 75 minutes for this exam. There are a total of 100 points. The exam contains 11 pages, not including this cover page. Please pace yourself accordingly. 3. This is a closed book exam. No notes or books are allowed. You can use a one page cheat sheet and your calculator. 4. The exam contains two parts: - Part I is multiple choices, choose the best answer for each question and fill in the answer in the answer box. - Parts II contains 2 questions. To receive full credit, you must show your work and carefully justify your answers. Please report your answers to two decimal places. 5. Please write neatly. Illegible answers will be assumed to be incorrect. 6. Raise your hand if you have a question. 7. Good luck! 1 Part I Multiple Choices (4 points each) 1. When going from operating asset value to equity value, which of the following operations (if applicable) should you make? A. Subtract the value of the firm’s holdings of cash and marketable securities B. Add the estimated value of unfunded pension obligations C. Subtract the value of idle or unutilized assets D. All of the above E. None of the above 2. Which of the following is not an assumption of the Capital Asset Pricing Model (CAPM)? A. All investors have the same expectations about the future B. All investors are invested in the same portfolio of assets C. All investors can borrow limited amounts at the risk-free rate of interest D. All of the above E. None of the above 3. Which of the following statements are always true for a firm with debt? A. The cost of equity is greater than the pre-tax cost of debt B. The weighted average cost of capital (WACC) is greater than the after-tax cost of debt C. The cost of equity is greater than the weighted average cost of capital D. A and C E. All of the above 4. If you capitalize operating leases and treat them as debt, which of the following will always occur? A. The cost of equity will increase because of the higher debt ratio B. The operating income will increase because you will be adding back operating lease expenses C. The debt ratio will increase D. The return on capital will go up E. All of the above 2 5. Freeman Development is a mature company that has seen its R&D expenses decrease steadily from $200 million five years ago to $100 million in the most recent year. The company reported operating income of $250 million in the most recent year. If you capitalize R&D expenses, with straight line amortization, which of the following would you expect to see happen to your adjusted numbers? A. Operating income will increase, FCFF will decrease B. Operating income will decrease, FCFF will decrease C. Operating income will increase, no change in FCFF D. Operating income will decrease, no change in FCFF E. Operating income will increase, FCFF will increase F. Operating income will decrease, FCFF will increase 6. Alphamax has earnings per share of $ 0.50 and a stock price of $ 25. The stock is expected to grow at 40% a year for the next 5 years, and has a beta of 2.0. Betamax has earnings per share of $1.50 and a stock price of $ 30. The stock is expected to grow 10% a year for the next 5 years, and has a beta of 1.0. You have run a regression of PE/g ratios against betas, using all the companies in the market: PE/g = 2.75 - 0.50 (Beta) Note: PE/g has divided by 100 in the regression. Based upon this regression, which of the following statements about these companies would you agree with? A. Alphamax is overvalued, while Betamax is undervalued B. Betamax is overvalued, while Alphamax is undervalued C. Both companies are undervalued D. Both companies are undervalued relative to the market E. Both companies are overvalued F. Both companies are overvalued relative to the market. 7. You are a potential buyer of a company with a very low Value to EBITDA multiple. Which of the following combinations of fundamentals would make it most likely that you were getting an under-valued company? A. High tax rate, high return on capital and low reinvestment rate B. Low tax rate, low return on capital and low reinvestment rate C. Low tax rate, high return on capital and low reinvestment rate D. Low tax rate, low return on capital and high reinvestment rate 3 Answer Box for Multiple Choice 1 2 3 4 5 6 7 8 9 10 4 Part II Short Calculation Questions Question 1. WACC and FCFF Model (40 points) You are valuing Target, Inc. using an FCFF Model. The following are from the 2016 financial statement: Revenue $ 69,495 million Operating Income (EBIT) $ 4,969 million Interest Expense $ 1,004 million Net Income $ 2,737 million In fiscal year 2016, the company had capital expenditure of $1,547 million, total depreciation of $2,298 million, a change in non-cash working capital of $1,929 million, and a net debt reduction of $11 million. In addition, the firm also reported book value of debt and book value of equity of $12,749 million and $11,591 million, respectively. The firm has cash on hand of $2,512 million and the interest income from cash can be ignored. The marginal tax rate is 40%. A. Estimate the firm’s cost of equity. a.1). Estimate the cost of equity using fundamental beta. The following are the betas of the equity of four retail companies, and their debt/equity ratios. Company Beta Debt/Equity Ratio Walmart 1.05 60.72% Macy 1.20 144.12% Costco 1.03 60.1% (All the firms face a corporate tax rate of 40%) Assume Target’s unlevered beta equals to the average unlevered beta of the provided comparable firms. Calculate the target unlevered beta and levered beta. (8 points) Hint: Please use book value to calculate the D/E ratio 5 a.2). Given a risk-free rate of 2.6% and a market risk premium of 5%, calculate the cost of equity. (5 points) B. Estimate the cost of debt using a synthetic bond rating. The following are the estimated synthetic bond ratings based on interest coverage ratio. Interest Coverage Ratio Synthetic Bond Rating Default Spread > 8.50 AAA 0.35% 6.50 - 8.50 AA 0.50% 5.50 - 6.50 A+ 0.70% 4.25 - 5.50 A 0.85% 3.00 - 4.25 A– 1.00% 2.50 - 3.00 BBB 1.50% 2.25- 2.50 BB+ 2.00% 2.00 - 2.25 BB 2.50% 1.75 - 2.00 B+ 3.25% 1.50 - 1.75 B 4.00% 1.25 - 1.50 B – 6.00% 0.80 - 1.25 CCC 8.00% 0.65 - 0.80 CC 10.00% 0.20 - 0.65 C 12.00% < 0.20 D 20.00% Calculate the cost of debt of Target, Inc. (5 points) 6 C. Assume the firm has a market debt/equity ratio of 1/2. Calculate the WACC. (5 points) D. Estimate the expected growth rate on after-tax operating income (EBIT). d.1) Calculate the return on non-cash capital. (3 points) d.2) Calculate the capital reinvestment rate. (3 points) d.3) Calculate the expected growth rate on after-tax operating income. (3 points) 7 E. Assume the firm will maintain this extraordinary growth rate for 5 years. After this extraordinary growth period, the firm will have a stable, constant growth rate. We assume the return on capital in the stable period will be equal to WACC and the payout ratio will be 60%. Please calculate the firm value using FCFF model. e.1) calculate the FCFF in year 2016. (5 points) e.2) find the terminal value in year 2021 (the end of the high growth period). (3 points) 8 Question 2. FCFE Model (32 points) Pacific Track Inc. just reported net income of $1250 million in 2016. The net income contains $5 million in interest income from cash holdings of $50 million. The beta of the stock is 1.05. There are 200 million shares outstanding, trading at $40 per share. The firm reports book value of equity of $8 billion. The firm also had $4 billion in debt outstanding on the books, rated AA with a yield to maturity of 8%. The bond is trading at par. The firm remains fixed level of debt over recent years. Assume the 10-year Treasury bond rate is 7%, the arithmetic mean of historical risk premium is 5%, and the geometric mean is 4%. The corporate tax rate is 40%. A. You have also decided to capitalize the leasing commitment. The leasing expense in year 2016 and future years are listed below. Year Operating Lease Expense 0 50 million 1 50 million 2 50 million 3 50 million 4 50 million 5 50 million Thereafter 300 million a.1) Given the yield to maturity of 8%, calculate the debt value of operating leases. (5 points) 9 a.2) Please calculate the adjusted net income from non-cash assets. (3 points) a.3) Assuming the firm has the net capital expenditure of $400 million and change in non-cash working capital of $300 million, please calculate the FCFE in year 2016. (3 points) 10 B. We assume the 10 year extraordinary growth period, during which the growth rate will linearly drop to a stable growth rate of 4%. The firm will maintain a constant payout rate and constant cost of equity. Please calculate the equity value using FCFE model. b.1) Calculate the cost of equity. (5 points) b.2) Calculate the expected growth rate on net income in 2016. (5 points) b.3) Calculate the equity value using FCFE model (6 points) 11 C. Based on the answer you have in part B, calculate the intrinsic value of Pacific Track stock per share. Would you buy or sell the share? (5 points)
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