Sample/practice exam 2015, questions and answers
Corporate Finance (FEB13060)
Erasmus Universiteit Rotterdam
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Problem 1
Adjusted present value (APV) and DCF-WACC are two alternative methods to value a company or a project. In the APV-method, the tax shield is computed and discounted separately.
Question: Which of the following statements is most credible?
a. Adjusted present value (APV) and DCF-WACC are equivalent when the APV’s tax shield is discounted at the cost of debt b. Adjusted present value (APV) and DCF-WACC are equivalent when the APV’s tax shield is discounted at the WACC c. Adjusted present value (APV) and DCF-WACC are equivalent when the APV’s tax shield is discounted at the unlevered cost of capital (x) d. Adjusted present value (APV) and DCF-WACC are always equivalent
Notes
Tax shield is discounted at the cost of debt, if debt is constant in absolute terms Tax shield is never discounted at the WACC APV and DCF-WACC are not equivalent when leverage changes
Problem 2
Question: Which is normally the most appropriate valuation method in the context of a leveraged buyout (LBO)? a. Discounted Cash-Flow (DCF-WACC) b. Adjusted present value (APV) (x) c. Cash-Flow to Equity d. Residual Income Method
Leveraged buyout usually goes in hand with changes in capital structure, which are not permanent APV is most capable of accounting for changes in leverage
Information on Problem 3 and Problem 4
The expected Free Cash Flows (FCFs) for project “Blue Windmill” are depicted in the following table. The WACC value used to determine the project value equals 8%. The debt capacity of the project is 25%. This means that at the beginning of each year, the amount of debt is equal to 25% of the project value at that time. Each time, the project value is equal to the present value of the expected FCFs at that time. The required investment to be paid at t=0 (the beginning of year 1) amounts to € 250.
Expected FCFs (in euro’s) for project Blue Windmill Year end 1 2 3 Expected FCF 110 140 80
Problem 3
Question: The debt capacity of this project at the start of year 1 (t=0) is closest to
a. € 55 b. € 71 (x) c. € 220 d. € 285
Discount the cash flows at the WACC to arrive at the PV = 285 Debt capacity = PV * Leverage
Problem 4
Question: The net present value of this project is closest to
a. € 35 (x) b. € 45 c. € 55 d. € 65
NPV = - Investment + PV = - 250 + 285 = -
Furthermore,
Assume that PP&E and Working Capital generate next year's Sales. Assume that the relationship between PP&E and next year’s Sales stays constant over time. Assume that the relationship between Working Capital and next year’s Sales stays constant over time.
Question: Which of the numbers below is closest to the firm’s unlevered FCF in year 1?
a. -15 (x) b. - c. 5 d. 15
EBITDA = 200
EBIT = 200 – 100 (Dep.) = 100 EBIAT = 100 – 25 (taxes) = 75 FCF = EBIAT + Dep – Capex – Inv. WC = 75 + 100 – 150 – 40 = -
Problem 7
Question: Which statement is the most credible one?
An increase in leverage ...
a. ... increases the probability of default. (x) b. ... increases the cost of debt. c. ... decreases the promised yield of the existing debt. d. ... is equivalent to reducing the relative amount of debt.
Makes firm less liquid -> default more likely Default more likely -> cost of debt impact unclear. Stays the same?
Default more likely -> promised yield goes up Leverage up -> relative amount of debt goes up
Problem 8
A company considers to invest into a project that guarantees to reduce administrative costs by 10%.
Question: Which discount rate is most appropriate to evaluate this project?
a. WACC b. Cost of equity c. Risk-free rate (x) d. The information provided is not sufficient to determine the appropriate discount rate.
If investment guarantees a return, it is risk free. Use risk-free rate.
Problem 9
Question: Which statement is the least credible one?
a. Share repurchases reduce the number of shares outstanding b. Ex-dividend, the stock trades at a lower price than cum-dividend c. A share repurchase does not affect the fundamental value of the stock and thus has no effect on the stock price d. Share repurchases increase shareholder value (x)
In a share repurchases, firms buy back stock in the open market. Thus firms buy back stock that is outstanding. The bought back stock is afterwards cancelled or put into treasury. Either way, share repurchases reduce the number of shares outstanding. Ex-dividend = cum-dividend – dividend
Problem 12
On the day of the announcement of an SEO, the stock price of a firm increases from 10 Euro to 11 Euro. On the same day, the market increases by 5%, A market model estimation predicts the following relationship between the stock return and the market return: Rit = 0 + 1 x Rmt
According to the market model, which of the numbers below is closest to the abnormal return of the stock on the announcement day?
a. 0% b. 1% (x) c. 3% d. 5%
AR = R(it) – E(Rit) = 10% - 8% = 1%
Problem 13
Consider an IPO where 50 shares are offered to the public. Those 50 shares are composed of 20 primary shares and 30 secondary shares. Existing shareholders hold another 100 shares after the offer and the offer price is 220 Euro. On the first trading day, the stock price closes at 250 Euro.
Question: Which of the numbers below is closest to the net proceeds going to the issuing firm? a. 4400 Euro (x) b. 6600 Euro c. 11000 Euro d. 33000 Euro
Primary shares: Proceeds go to the company (additional capital): 20 x 220 = 4400 Secondary shares: Proceeds go to selling shareholders All shares outstanding x market price = market capitalization
Problem 14
According to the IPO Prospectus of Go Public Inc., the company intends to sell 1,000,000 shares at 50 Euro. The Underwriter furthermore has the right to sell additional shares via the “Greenshoe” procedure. On the first trading day, the stock trades between 52 Euro and 58 Euro.
Question: How many additional shares will the investment bank have sold using the greenshoe option? a. 0 b. 50, c. 100, d. 150,000 (x)
An issue is usually sold short by 15%. If the investment bank cannot buy the stock back at the offer price, it will close its short position by exercising the greenshoe option.
Problem 15
Question: Which of the following statements on debt covenants is true?
a. The more restrictive the debt covenants, the lower, on average, the interest costs of the loan (ceteris paribus). (x) b. The more restrictive the debt covenants, the higher, on average, the interest costs of the loan (ceteris paribus). c. The interest costs of a loan can be both higher and lower as the debt covenant becomes more restrictive (ceteris paribus). d. The interest costs of a loan are independent of debt covenants.
Debt covenants are designed as such that they protect the debtholders from measures taken by the firm that increase the default risk of the firm. Default risk up -> Bond depreciates.
c. Increases in the same order of magnitude as the acquirer’s stock price d. Increases by less than the acquirer’s share price
Problem 19
Assume a perfect capital market. The following is known about company Large and Small:
Large Small Expected profits for the coming year (€ mln) 4 1. Eternal yearly profit growth 5% 10% Number of shares outstanding (mln) 2 2. Cost of capital 15% 15%
Both companies have no debt and pay out all profits to shareholders every year. The next dividend is expected in exactly one year from now.
Large ́s management decides to bid on all Small shares outstanding. The Small shareholders agree to the bid, meaning the takeover will happen. The bid is paid in Large stocks. For every share owned by a Small shareholder, they will receive a share in Large. The net present value of the expected synergy gains as a result of the takeover is estimated to be € 10 mln.
Question: Because of this takeover, the return for the shareholders of Small is closest to
a. 25% b. 54% (x), Plarge = 4 / (15%-5%) = 40. Psmall = 1 / (15%-10%) = 24. Plarge + Psmall + Synergies = 74. 50% go to Small-Shaerholders = 37. Return: 37-24 / 24 = 54% c. 66% d. 108%
Problem 20
Assume that Coca Cola announces to takeover Pepsi.
Question: Which of the following statements is the least credible one regarding this merger?
a. Coca Cola is a strategic buyer b. The transaction is a vertical merger (x) c. The transaction is motivated by realizing synergies d. The transaction will most likely not increase Coca Cola’s growth
Sample/practice exam 2015, questions and answers
Vak: Corporate Finance (FEB13060)
Universiteit: Erasmus Universiteit Rotterdam
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