EXAM 2 SOLUTIONS

Finance 40610 Security Analysis

Mendoza College of Business

Professor Shane A. Corwin
Fall Semester 2008

Wednesday, November 5, 2008

INSTRUCTIONS:

1. You have 75 minutes to complete the exam.

2. The exam is worth a total of 100 points.
3. Allocate your time wisely. Use the number of points assigned to each problem as your guide.
4. In order to get full credit on the problems, you must show ALL your work!
5. You may use a calculator and a formula sheet. Please put your name on your formula sheet and hand
it in with your exam.
Multiple Choice (28 points)
Choose the best answer for each of the following questions. The questions are worth 4 points each.

1. You are valuing a firm that has $370 million in tax loss carryforwards. If the firm has earnings this
year of $760 million and pays a marginal tax rate of 40%, what will be the firms effective tax rate?

a) 0.0%
b) 16.3%
c) 20.5% (taxable income of 760-370=390 gives tax of 156 or 20.5%)
d) 40.0%

2. Which of the following sections from the Statement of Cash Flows would describe funds used to
purchase property, plant, and equipment?

a) Cash flow from operations

b) Cash flow from investing activities
c) Cash flow from financing activities
d) PP&E purchases would not be listed on the Statement of Cash Flows

3. You are calculating the weighted average cost of capital (WACC) for a firm that has a single
convertible bond and no other debt. The bond is a zero coupon bond with 10 years to maturity and a
face value of $120 million. The firms cost of debt equals 6% and the convertible bond is currently
trading for a market value of $92 million. What debt value should be used to calculate the weight in
the debt component of the WACC formula?

a) $92 million
b) $120 million
c) $67 million 120
DebtValue $67.01million
d) $25 million (1.06) 6

4. The financial statements for McDonalds are provided at the end of the exam. Based on this
information, what is the accounts receivable turnover ratio for McDonalds? (To avoid confusion,
assume that all amounts listed under "accounts and notes receivable" are accounts receivable.)

a) 28.24
b) 12.92 Sales t 22786 .6
28.24
c) 21.62 ARt 1 806 .9
d) 16.88

Finance 40610 Exam 2 1 November 5, 2008

5. The balance sheet for McDonalds is provided at the end of the exam. Based on this data, what is the
value of non-cash working capital for McDonalds as of year-end 2007? (To avoid confusion, note
that there are no deferred tax items listed under current assets or current liabilities.)

a) -$906.8 million (non-cash current assets minus non-debt current liabilities)

b) -$916.6 million
c) $1600.6 million
d) -$2033.4 million

6. Your firm has just completed an acquisition for a total price of $2 billion. The net value of the
tangible and intangible assets of the acquired firm equals 1.65 billion. Which of the following
statements correctly describes the treatment of this acquisition on the firms reported financial
statements under current GAAP accounting rules?

a) Your firm will record no goodwill on its balance sheet

b) Your firm will record 350 million in goodwill and amortize it over 40 years
c) Your firm will record 2 billion in goodwill and amortize it over 15 years
d) Your firm will record 350 million in goodwill and test it annually for impairment

7. Which of the following should NOT be excluded from past cash flow estimates when developing
forecasts of future cash flows?

a) Income from cash and marketable securities

b) Income from holdings in other firms
c) Non-recurring and one-time expenses
d) Expenses associated with executive compensation
e) All of the above items should be excluded

Finance 40610 Exam 2 2 November 5, 2008

Problems (72 points)
Answer each of the questions below completely. You must show ALL your work to get full credit.

8. Operating Lease Debt (20 points)

Future operating lease commitments for McDonalds are shown below. In 2007, the firm had
operating income of $3,879 million and operating lease expenses of $1,437 million. The firms cost
of debt is 7%.

Year Operating Lease

Commitments
($ millions)
2008 990
2009 918
2010 854
2011 787
2012 730
>2012 5,870
Total 10,149

a) (14 points) Calculate the total value of operating lease debt for McDonalds assuming a cost of
debt equal to 7%.

5870
Annuity Length 8.04 yrs
730

1 1.07 8.04
730

990 918 854 787 730 .07 6665.0
PV 1
2
3
4
5

(1.07) (1.07) (1.07) (1.07) (1.07) (1.07) 5

b) (6 points) Using the balance sheet provided at the end of the exam and your answer to part (a),
calculate the adjusted book value of debt for McDonalds as of year-end 2007.
Debt 1126.6 864.5 7310 9301.10

AdjustedDebt 9301.10 6665.0 15,996.10

Finance 40610 Exam 2 3 November 5, 2008

9. Financial Ratio Analysis (10 points)
The financial statements for McDonalds are provided at the end of this exam. Using this
information, calculate the Return on Equity for McDonalds in 2007. Demonstrate (by calculating
each of the individual ratios) that the ROE is a function of profit margin, asset turnover, and financial
leverage.

NetIncome NetIncome Sales Assets t 1

ROE
Equity t 1 Sales Assets t 1 Equity t 1

2395 .1 2395 .1 22786 .6 28974 .5

10.51% 0.7864 1.8744 15.49%
15458 .3 22786 .6 28974 .5 15458 .3

Note: You could also use average equity and asset values from the beginning and ending balance sheets. Using
these values would give an ROE of 15.58%.

10. Free Cash Flow to Equity (10 points)

In 2007, McDonalds had capital expenditures of 1,946.6 million, depreciation of 1,214.1 million, and
an increase in non-cash working capital of $428.6 million. The firm raised $572.6 million from new
debt issues and maintains a debt ratio of 40%. The firms tax rate was 35%. Using this information
and the earnings information provided in the attached Income Statement, calculate free cash flow to
equity (FCFE) for McDonalds in 2007.

FCFE = Net Income 2395.1

- (Capex - Depr) - (1946.6 - 1214.1)
- (change in WC) - 428.6
+ net debt issues + 572.6
1806.6

OR

FCFE = Net Income 2395.1

- (Capex - Depr)(1-) - (1946.6 - 1214.1)(.6)
- (change in WC)(1-) - 428.6(.6)
1698.4

Finance 40610 Exam 2 4 November 5, 2008

11. R&D Capitalization and FCFF (32 points)
The table below describes research and development expenditures at Boeing for each of the past six
years. Use this information to answer the questions below.

R&D 2007 2007 2007 2007

Year ($ millions) Amortization Amortization Unamortized Unamortized
Rate ($) R&D (%) R&D ($)
2002 1,639 20.0% 327.8 0.0% 0.0
2003 1,651 20.0% 330.2 20.0% 330.2
2004 1,879 20.0% 375.8 40.0% 751.6
2005 2,200 20.0% 440.0 60.0% 1320.0
2006 3,315 20.0% 663.0 80.0% 2652.0
2007 3,900 0.0% 0.0 100.0% 3900.0
Total 2136.8 8953.8

a) (14 points) You are performing a valuation of Boeing based on free cash flow to the firm
(FCFF). You have decided to capitalize R&D using a five-year life. Using this information,
calculate both the R&D amortization that should be applied to income in the most recent year
and the unamortized value of the R&D asset remaining on the balance sheet at year end.

R&D Amortization (2007) = $2136.8 million

Unamortized R&D (2007) = $8953.8 million

b) (10 points) For 2007, Boeing reported net income of $4,074 million, operating income of
$5,830 million, capital expenditures of $1,672 million, and depreciation of $1,334 million.
The firm also increased their non-cash working capital by $1,200 million and paid off debt
totaling $1,360 million. The firm made acquisitions totaling $75 million and paid a tax rate of
30%. Using this information, calculate the FCFF for Boeing in 2007 before adjusting for the
capitalization of R&D.

FCFF = EBIT(1-T) 5830(1-.3)

- (Capex - Depr) - (1672 - 1334)
- (change in WC) - 1200
- (acquisition costs) - 75
$2468

c) (8 points) Recalculate the FCFF for Boeing in 2007 after adjusting for the capitalization of
R&D.

The adjustment to both after-tax operating income and capex is the same, so FCFF is unaffected by
the R&D adjustment and quals $2468.

FCFF = EBIT(1-T) 5830(1-.3) + (3900 - 2136.8)

- (Capex - Depr) - (1672 - 1334)
- (R&D Expense - R&DAmort) - (3900 - 2136.8)
- (change in WC) - 1200
- (acquisition costs) - 75
$2468

Finance 40610 Exam 2 5 November 5, 2008

Financial Statements for McDonalds Corp.

Finance 40610 Exam 2 6 November 5, 2008

Financial Statements for McDonalds Corp.

Finance 40610 Exam 2 7 November 5, 2008