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Mid-Term Examination FI 500 Summer 2011 Pacific States University


Question 1. (15 points) The exercise price on one of ORNE Corporation's put options is $30 and the price of the underlying stock is $25. The option will expire in 25 days. The option is currently selling for $5.50. a. Calculate the option's exercise value?

Stock price Strike/Exercise price Market price of option

$25 $30 5.50

Exercise value of option $0.00

b. Calculate the value of the premium over and above the exercise value? Why would an investor pay more than the exercise value for the option.

Premium value


Exercise value is what the option wouth be worth if it expired immediately.

c. Is this an out-of-the money option, at-the-money, or in-the-money? Why?

out the money because strike price exceeds the current stock price

d. What will happen to the value of the option if the underlying stock price changes to $24? Why?

It will remain zero because stock price still smaller than strike price

e. Would the value of the option likely be higher, lower, or the same if the option had 60 days to expiration instead of 25? Why? For the longer expiration day, the value of the option would likely be lower. ( expectation)


is $30 and


Question 3.

(10 points) A company estimates the following free cash flows (FCFs) during the next 3 years, after which FCF is expected to grow a

Calculate the value of operations Long-term growth rate Weighted Avg. Cost of Cap. (WACC) Free Cash Flow( mil. $) Find the horizon value.

Actual 1 6% 12.00% -$5.00

Year 2 3



The horizon value is the value as of year 3 of all the free cash flows in year 4 and beyond, discounted back to year 3. The formula is:

Hvyear 3 = [FCFyear 3 * (1+g)] / [ WACC - g]

a. Horizon Value (Value at year 3) Find the PV of the horizon value and of the free cash flows. PV of Horizon Value @ WACC PV of free cash flows @ WACC b. Value of Operations $377.244 $28.847 $406.09 530.00

Find the total value of the firm. Value of operations Plus: Value of nonoperating assets Total value of firm Find the value of equity. Total value of firm Minus: Value of debt Minus: Value of preferred stock Value of equity

$406.09 $3.00 $409.09

$409.09 $50.00 $0.00 $359.09

Find the price per share. Value of equity Divided by number of shares c. Price per share $359.09 10 $35.91

d. The stock is selling for $32.50. Is it appropriately priced in the market? Explain.

Michael C. Ehrhardt

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There are 2 reasons: 1 P/S is used for long term period but stock is selling by using daily price( it can increase/decrease) 2 Company over evaluate its P/E in order to increase its value.

Michael C. Ehrhardt

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er which FCF is expected to grow at a constant 6% rate. The company's cost of capital is 12%. the company has $3 million in marketable securities, $50 million in deb

Michael C. Ehrhardt

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Michael C. Ehrhardt

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%. the company has $3 million in marketable securities, $50 million in debt, and 10 million shares of stock.

Michael C. Ehrhardt

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Mid-Term Examination FI 500 Summer 2011 Pacific States University

Question 4. (15 points) Pierre Imports has a capital budget of $20 million. It wants to maintain a capital structure of 45 percent debt and 55 percent equity. This year it expects net income of $8 million.The company has 30 million authorized shares, and 10 million are outstanding. Last year the company paid a dividend of $0.20 per share. a. How much equity does the company need to raise?

b. How much external equity does the company need to raise if it follows a residual dividend policy?

(Mil. USD) Net Income Pay out ratio Debt ratio New investment Retain Earning Total equity required New external equity needed

8 55% 45% 20 3.6 11 7.4

c. How much external equity will the company require if it pays the same dividend as last year?

d. What are the advantages of following a residual dividend policy? The primary advantage of the residual policy is that under it the firm makes maximum use of

d. What are the advantages of following a residual dividend policy? The primary advantage of the residual policy is that under it the firm makes maximum use of lower cost retained earnings, thus minimizing flotation costs and hence the cost of capital.

e. What are the disadvantages of following a residual dividend policy? negative signals are associated with stock issues would be avoided.

Question 5. (15 points) Exchange rates for several countries are shown below. The MLC Company which is based in the U.S. does business with companies in those countries. The rates are shown as direct or indirect from the standpoint of the U.S. Company.

Spot 30-day forward 90-day forward 180-day forward

U.S. Dollar / Japanese yen (indirect) 115 112 110 108

British Pound / U.S. Dollar / U.S. Dollar Mexican Peso (direct) (indirect) 1.81 11.1 1.82 11.3 1.84 11.4 1.845 11.5

a. Is the U.S. dollar appreciating or depreciating against the Japanese yen? Explain.

US dollar is depreciating vs Japanese yen because 1 US dollar is buying fewer Japanese Yen

Is the U.S. dollar appreciating or depreciating against the British pound? Why?

Us Dollar is depreciating vs British Pound because 1 pound is buying more Us dollars

c. Is the U.S. dollar appreciating or depreciating against the Mexican peso? Why?

Appreciating because 1 us dollar is buyng more mexican peso.

d. The U.S. company orders merchandise from companies in Japan, Britain, and Mexico, and pays in the foreign curren

In Japan Britain Mexico

: wait 3month Pay now Pay now

because because because

forward rate<spot rate spot rate<forward rate spot rate<forward rate

e. Who bears the foreign exchange risk, the U.S. company or the foreign suppliers? Explain.

Exchange risk is simple in concept: a potential gain or loss that occurs as a result of an exc
It will depend on the exchange rate change.

ys in the foreign currency of each country at the end of 3 months.

From a foreign exchange standpoint, would it be to the advan

as a result of an exchange rate change

dpoint, would it be to the advantage of the U.S. company to pay now instead of waiting 3 months? Why or why not?

Why or why not?

Question 6. (15 points) Thomas Corporation is evaluating whether to lease or purchase equipment. Its tax rate is 30 percent. The company expects to use the equipment for 5 years, with no expected salvage value. The purchase price is $1 million and MACRS depreciation, 3-year class, will apply. If the company enters into a 5-year lease, the lease payment is $230,000 per year, payable at the beginning of each year. If the company purchases the equipment it will borrow from its bank at an interest rate of 11 percent. a. Calculate the cost of purchasing the equipment.


New Equipment cost New Equipment life Equip. Salvage Value Tax Rate Loan interest rate Annual rental charge Depreciation After-tax cost of debt

$1,000,000 5 $0 30% 11% $230,000 MACRS 7.70%

NPV LEASE ANALYSIS Year = Cost of Owning Equipment cost Loan amount Interest expense Tax savings from interest Principal repayment Depreciation (based on 3 years MACRS table) Tax savings from depreciation Net cash flow PV ownership cost @ 7.7% Cost of Purchasing Cost of Leasing Lease payment (beginning of the year) Tax savings from lease Net cash flow PV of leasing @ 7.7% Cost of Leasing Cost Comparison PV ownership cost @ 7.7% PV of leasing @7.7% Net Advantage to Leasing 0 ($1,000,000) $1,000,000 ($110,000) ($110,000) ($110,000) 33,000 33,000 33,000 330,000 $99,000 $22,000 450,000 $135,000 $58,000 150,000 $45,000 ($32,000) 1 2 3

$0 ($740,061.43) $740,061

($230,000) ($230,000) ($230,000) ($230,000) $69,000 $69,000 $69,000 $69,000 ($161,000) ($161,000) ($161,000) ($161,000) ($697,832.79) $697,833

($740,061.43) ($697,832.79) $42,228.64


because Cost of leasing< Cos

pment. Its tax salvage value. ompany enters year. If the

($110,000) 33,000 70,000 $21,000 ($56,000)

($110,000) 33,000 ($1,000,000)


($230,000) $69,000 ($161,000)

because Cost of leasing< Cost of purchase

Par value = Conversion price = Stock price = Conversion ratio = Conversion value =

$1,000.00 $25.00 $20.00 40 $800.00


If stock price Bond price

$23 $920.00

Stock price increase will lead to bond price increase. c. Total mkt value 1400

d. Does the company's balance sheet change at the point the bondholders convert their bonds to common stock? Ex


because Total equit& Liability same

ds to common stock? Explain?