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(2 points) What does D

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1. (2 points) What does D.C.F. typically stand for in finance?
2. (2 points) Which is a better capital budgeting tool: NPV or Payback period?  Why?
3. (2 points) Should more volatile stocks have a higher return?
4. (2 points) Does the interest tax shield subsidize debt?
5. (2 points) Can a firm with no debt lower its WACC by issuing debt?
6. (4 points) Is the price of oil a systematic risk factor, and what is your reasoning?
7. (4 points) If two assets have zero covariance, can they still be used to diversify each other even if the CAPM holds?
8. (4 points) Can you earn excess returns trading on rumors about a merger?  Why or why not?
9. (4 points) In a Modigliani-Miller world with no taxes, do de-leveraging recapitalizations (issuing equity and using the proceeds solely to retire debt) increase the stock price?
10. (4 points) A put and a call on the same underlying security have the same maturity and exercise price. If they also sell for the same price, prove which one is in the money.
11. (10 points) Consider two ways of getting a mortgage on a house worth $750,000.  You plan to make a down payment of $300,000 at closing.  You need to borrow the rest of the $450,000.  The first option is a 15 year fixed-rate mortgage at a 5.25% effective annual interest rate (assume monthly compounding with 12 payments per year to get a monthly interest rate).  In the second option, you can “buy” a lower effective annual interest rate of 4.5% by paying the bank an additional $25,000 cash at closing (also assume 12 monthly payments over the year with monthly compounding).  You are still borrowing $450,000, but now you are paying an additional $25,000 in cash up front at origination (this is commonly called paying “points” on a mortgage).  All other costs are the same under both options.
12. 1. (3 points) Using the monthly interest rate over 180 payments, what would your monthly payment be under the first scenario?
    2. (3 points) Using the monthly interest rate over 180 payments, what would be your monthly payment under the second scenario?
    3. (4 points) Show which option is better.

 

12. (10 points) The Weston Enchilada Company has a levered equity beta of 0.8.  The company is thinking about getting into the Whataburger business.  Currently, Weston Enchilada is financed with 50% long-term debt.  The debt is risk free and pays 4% interest before taxes.  A little research suggests that the Whataburger business is expected to yield 16% on after-tax total operating cash flows.  For comparison, another Whataburger in town has an equity beta of 2.5 but has 20% debt in its capital structure.  You can assume that the market return is 12%, marginal tax rates on everything are 35% and the new project would be financed with 50% debt.  Find the WACC for the new Whataburger venture and decide what Weston Enchilada should do?

 

13.  (10 points) Drayton McLane sold the Astros a few years back for about $645 Million.  (You can assume he sold it at the end of 2011).  He originally purchased the team at the end of 1992 for $117 million.  Back in 1992 the S&P 500 stock market index was at about $30 and it was about $120 at the end of 2011 (adjusted for splits and dividends).  You can assume the yield on treasuries was about 4% over the period and the expected market risk premium was 5.5%.  Also, forget about any other cash flows from ownership rights, franchise fees, subsidies for the stadium etc.  Assume the whole deal was 100% equity.  Based on the purchase and sale price, was it a good deal?

 

14. (10 points) A protective collar involves buying an out-of-the-money put and writing an out-of-the-money call on an underlying asset that you own.  Let’s say you own an S&P 500 index security that is currently trading at $30/share.  You bought the index at $10 per share so you currently have a big capital gain.  You don’t want to sell your shares, but you want to lock in your profits with a protective collar for the next year.  You want to make sure you can sell your shares for at least $29/share.  The standard deviation of returns on the S&P 500 is 20% and the assume risk free rate is 2%.
15. 1. (3 points) How much would it cost to buy the put?
16. 2. (3 points) What strike price should you set on the call so that you make the same premium that you paid for the put (zero net cost)?
17. 3. (4 points) Draw the net profit diagram for the entire protective collar position (long stock, long put, short call) at maturity (including the premiums).  Carefully label in detail all axis, strike prices, payoffs, etc.

 

15.  (10 points) Consider a firm that is financed THREE ways: common equity, preferred equity, and long term debt.  The firm is considering replacing all of the machinery in its Cleveland plant.  They have more than enough cash on hand to pay for the project without raising external capital.  Some relevant information about the firm is given below.  Based on all THREE sources of funding, what cost of capital should the firm use to evaluate the project?

 

Stock Price (common shares)	$15
Number of common shares outstanding	5M
Equity beta (for common stock)	2.5
Stock Price (preferred shares)	$8
Number of preferred shares outstanding	10M
Dividends per share on preferred stock	$1.00
Market value of Total Debt outstanding	50M
Yield to maturity on the firm’s long term debt	6.5%
Coupon rate on the firms long term debt	2.0%
Corporate tax rate	35%
Risk-free rate	4.5%
Market Risk Premium	5.5%

           

16.  (10 points total) Your firm is considering a new three-year project.  You know that the unlevered cost of equity for firms with a similar risk as your target is 8%.  At the end of the project, all available funds are distributed to equity and debt holders.  Use the following financial statements to answer the questions on the next page:

Year	0	1	2	3
Income statement
Sales		$175,000	$175,000	$175,000
COGS		$26,250	$26,250	$26,250
Depreciation		$100,000	$100,000	$100,000
EBIT		$48,750	$48,750	$48,750
Interest payment on debt		$9,000	$9,000	$9,000
Profit Before tax		$39,750	$39,750	$39,750
Taxes		$21,863	$21,863	$21,863
Profit after tax		$17,888	$17,888	$17,888
Dividends		$17,888	$17,888	$17,888
Retained earnings		$0	$0	$0
Balance Sheet
Cash and Mark. Sec.	$0	$100,000	$200,000	$300,000
Current Assets	$0	$0	$0	$0
Fixed Assets
At cost	$300,000	$300,000	$300,000	$300,000
Acc. Depreciation	$0	$100,000	$200,000	$300,000
Net Fixed Assets	$300,000	$200,000	$100,000	$0
Total Assets	$300,000	$300,000	$300,000	$300,000
Current liabilities	$0	$0	$0	$0
Debt	$150,000	$150,000	$150,000	$150,000
Stock	$150,000	$150,000	$150,000	$150,000
Acc. Ret. Earn.	$0	$0	$0	$0
Total liab.and equity	$300,000	$300,000	$300,000	$300,000

1. 1. (1 point) How large an equity investment does the project require upfront? 
2. 2. (1 point) How much equity is recovered at the end of the project?
3. 3. (2 points) Show the cash to and from equity holders for the entire project.  Don’t forget about dividends, initial, and terminal equity flows.  Actual cash, not free cash flow!

Year	0	1	2	3
Total cash flows to equity

1. 4. (2 points) Based on the cash flows in part c, what is the IRR for the equity holders?
2. 5. (2 points) What is the present value of the tax shield for this three-year project?  Remember, this is not a perpetuity, it’s a three-year project.
3. 6. (2 points) Is this a good project for shareholders?

	Extreme Recession	Moderate Recession	Normal	Moderate Growth	Extreme Growth
Pr[economic condition]	15%	20%	30%	20%	15%
Return on the market	-12%	0%	12%	24%	36%
Return on project A	-35%	2%	10%	20%	20%
Return on project B	-9%	0%	12%	22%	28%