UNIVERSITY OF MARYLAND Smith School of Business BMGT 440 - ADVANCED FINANCIAL MANAGEMENT Sample Midterm Exam Prof.

Dalida Kadyrzhanova

Spring 2012

Part I: Multiple Choice Questions

1. Specic Motors (SM) has two divisions of equal sizes: a car division, and a truck division. The expected rate of return on its car assets is 19%, and that on its truck assets is 13%. The company debt/equity ratio is 2/3, and the beta of its debt is 0.2. s Assuming that the expected rate of return on the market is 15%, and that the riskfree rate is 5%, calculate the beta of SM equity. Assume that there are no taxes. s A) 1.10 B) 1.70 C) 2.17 D) 2.45 E) 2.90

2. According to Modigliani and Miller, which of the following statements are true? I. Companies with high equity-to-value (E/V ) ratios will have larger dierences between the return on equity and the return on (unlevered) assets. II. According to the stand-alone principle, a company should use dierent discount rates for dierent divisions if these divisions have dierent levels of unique risk. III. The asset beta of a company is expected to decrease after the company issues more debt. A) I B) II C) III D) No statements are true. E) Two or more statements are true. 3. According to Modigliani and Miller, which of the following statements are true? I. In a world without taxes, the required return on equity is xed. II. In a world with corporate taxes, the weighted average cost of capital decreases as the debt/value ratio increases. III. In a world without taxes, the weighted average cost of capital decreases as the equity/value ratio increases. A) I and II B) I and III C) II and III D) I, II and III E) less than two statements are true. 4. Corporate managers can maximize shareholder wealth by choosing positive NPV projects because A) all investors have the same preferences. B) the unhappy shareholders can sell their shares. 1

C) given the existence of nancial markets, investors will be satised with the same real investment decisions regardless of personal preferences. D) managers are wiser than shareholders regarding investments. E) none of the above. 5. If a rm borrows $50 million for one year (i.e., the rm is levered for one year only) at an interest rate of 9%, what is the present value of the interest tax shield? Assume that the corporate tax rate is 35%. A) $50.000 million D) $1.575 million B) $17.500 million E) $1.445 million C) $4.128 million

Part II: Essay Questions

1 Philip Morris is reexamining the costs of capital it uses to decide on investments in its two primary businesses food and tobacco. The two divisions have about the same market value. Philip Morris has an equity beta of 0.95 and a debt/equity ratio of 25%. The company s debt is priced to yield an expected return of 8%. The average equity beta of publicly traded rms in the tobacco business is 1.2, the average debt beta is 0.3, and the average debt/equity ratio of such rms is 20%. The average equity beta of publicly traded rms in the food business is 0.9, the average debt beta is close to zero, and the debt/equity ratio of such rms is 80%. The current interest rate is 7.1%. Assume that there are no taxes. Estimate the cost of capital for each of the two businesses. 2 Suburban Enterprises is a corporation that generates a random free cash stream ow (before interest, after tax) which market analysts expect to be $50 million next year. Assume that the company current debt consists of $100 million face value of perpes tuities with a xed annual coupon of 9%. The company equity consists of 10 million s shares with a current market price of $20 per share. The book value of its equity is $150 million. The corporate tax rate is 45%. The company can currently borrow at a spread of 50 basis points (0.5%) over Treasuries. The equity beta of the levered rm is 1.3, and this beta was estimated over a recent period during which the company s average debt-to-equity ratio was close to 25/75. The rate on Treasury notes and bonds is 11.5%, and the risk premium on the market portfolio is 8%. You agree with the $50 million cash forecast for next year. You expect cash ow ows to grow by 3% per year for the indenite future, and all free cash ows (after interest) to be paid out as dividends. You also expect Suburban Enterprises to achieve a target debt-to-equity ratio (based on market values) of 20/80 on average in the future. If you need to unlever and/or relever betas/returns, do not assume that the debt beta is zero. (a) How close is Suburban Enterprises to what you regard as its target debt-to-equity ratio? Hint: Need to compute the market values of both debt and equity. (b) Calculate the value of Suburban corresponding to your expectations. Assuming corporate debt is correctly priced, is the equity of Suburban overvalued or undervalued? (c) Suppose Suburban temporarily deviates from its long-run debt policy by buying back $100 million worth of its own equity today, nancing the repurchase with long maturity bonds. Suppose the company plans to pay down the entire debt within ve years from today, with 5 equal principal payments (nanced by eliminating dividends until a pot of cash su ciently large to pay o the debt is created). By how much does this change your valuation of the rm?

Solutions: Multiple Choice Questions

1 The car asset beta
C

must solve 0:05)

C

0:19 = 0:05 + (0:15 Similarly, the truck asset beta

T

= 1:4:

must solve 0:05)

T

0:13 = 0:05 + (0:15 So the asset beta

A

= 0:8:

for SM is given by
A

1 1 (1:4) + (0:8) = 1:1 2 2

Since SM assets are a portfolio of its debt and its equity, we must have s 1:1 = 2=3 1 (0:2) + 2=3 + 1 2=3 + 1
E

= 1:7

2 D. (I) FALSE. A high equity-to-value (E=V ) ratio means that the company is not levered much, i.e., the debt-to-value (D=V ) is low. At the extreme, when D=V = 0, we have rE = rA . (II) FALSE. The discount rate for a project or division has nothing to do with unique risk. Since real investments are made on behalf of shareholders (who can diversify their portfolio), only the market/systemtic risk of a project or division matters. (III) FALSE. The asset beta does not change as the company changes its capital structure. Indeed, the operations of the rm remain the same. Issuing more debt simply creates extra tax shields. 3 E. (I) FALSE. It is the weighted average cost of capital that is xed in a world without taxes; the cost of equity goes up as the debt-to-equity ratio is increased. (II) TRUE. With debt, the rm benets from a tax shield that eectively reduces its (after-tax) cost of debt; this reduces the rm weighted average cost of capital. (III) FALSE. The s weighted average cost of capital is xed in a world without taxes. 4 C. See lecture notes ... 5 E. The interest payment at the end of the year is 0:09 50 = 4:5. This amount is expected to shield 0:35 4:5 = 1:575 of the rm prots from taxes. The present value s of this amount is 1:575=1:09 = 1:445.

Solutions: Essay Questions

1 Using the information for publicly traded rms in the tobacco business, the asset beta for Philip Morristobacco division should be
T A

1 5 (0:3) + (1:2) = 1:05 6 6

Similarly, using the information for publicly traded rms in the food business, the asset beta for Philip Morrisfood division should be
F A

4 5 (0) + (0:9) = 0:50 9 9

To estimate the cost of capital for the two divisions, we now need to gure out what is the expected rate of return on the market portfolio. This can be done as follows. The asset beta for Philip Morris as a whole is
A

1 2

T A

1 2

F A

1 1 (1:05) + (0:50) = 0:775 2 2

Since Philip Morris has a 25% debt/equity ratio, we must have

A

1 5

4 5

() 0:775 =

1 5

4 (0:95) () 5

= 0:075

In turn, this implies rD = rf + (rm rf )

D

() 0:08 = 0:071 + (rm

0:071) (0:075)

Solving for the expected rate of return on the market portfolio gives rm = 0:191. The cost of capital for the tobacco division is then given by
T rA = rf + (rm

rf )

T A

= 0:071 + (0:191

0:071) (1:05) = 0:197;

while the cost of capital for the food division is given by

F rA = rf + (rm

rf )

F A

= 0:071 + (0:191

0:071) (0:50) = 0:131:

2 (a) Suburban borrows at rD = 11:5% + 0:5% = 12%. The target debt/equity ratio is 20=80 = 0:25. Using market data, the company current debt/equity ratio is s 75=200 = 0:375 because D = $100 million 9% = $75 million; 12% E = $10 million $20 = $200 million: 0:25 = 0:125.

The dierence is 0:375

(b) Suburban beta of debt is calculated as follows: s rD = rf +

D (rm

rf ) () 0:12 = 0:115 +

D (0:08)

()

= 0:0625:

We unlever Suburban historical equity beta to obtain the unlevered (or asset) s beta:
A

+ 1+

D E D E

(1 tc ) (1 tc )

0:25 1:3 + 0:75 (1 0:45) (0:0625) = 1:108; 1 + 0:25 (1 0:45) 0:75

Then we relever the asset beta to obtain Suburban equity beta under the target s debt-to-equity ratio:
E

D E

(1 0:2 0:8

tc ) ( (1

D)

= 1:108 +

0:45) (1:108

0:0625) = 1:252

We can nd Suburban cost of equity under the target debt-to-equity ratio using s the CAPM: rE = rf +
E (rm

rf ) = 0:115 + 1:252(0:08) = 21:52%:

Its weighted average cost of capital is W ACC = D E (1 tc ) rD + rE V V = (0:2) (1 0:45) (0:12) + (0:8) (0:2152) = 18:53%

To compute the rm value, we use the growing perpetuity formula: V = $50 million = $321:96 million 0:1853 0:03

Notice that the eect of capital structure policy is captured in the discount rate already. Therefore, the before-interest cash (but it is after-corporate-tax) ow of $50 is the appropriate numerator to use. The value of Suburban equity, s according to the above calculation, is E=V D = $321:96 million $75 million = $246:96 million:

In your estimation, Suburban is undervalued by the stock market at $200 million. (c) Firm value increases by the extra interest tax shields: V = $100 million = $12:56 million: 0:12 0:45 1 0:80 0:60 0:40 0:20 + 2 + 3 + 4 + 1:12 (1:12) (1:12) (1:12) (1:12)2