Business Midterm Practice Questions

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Eugene Whitehead
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1 Business 3019 Midterm Practice Questions Here are some questions that you may find useful to review before the exam. You should also try the questions at the end of each chapter in the textbook. Answers to the following questions are available somewhere on the course website. 1. (5 points) Weighted Average Cost of Capital Gobain Latouche, the analyst with a spin, is now trying to calculate Bed Rock s weighted average cost of capital using the values in Table 1 as well as the following information: Bed Rock s average yield on long-term debt is 8%, the interest rate it pays on its line of credit is 12% and its tax rate is 30%. Bed Rock has 250 shares outstanding, its stock trades at $45, its dividend per share in 2003 was $0.60 and is expected to grow at the rate of 5% forever. Gobain calculated Bed Rock s WACC as follows: Cost of Debt: The pre-tax cost of debt was obtained by averaging the cost of shortterm and long-term debt. That is, the current interest rate paid on short term debt being 12% and the actual long-term debt yield being 8%, Gobain calculated a pre-tax cost of debt of (STD stands for short-term debt and LTD stands for long-term debt) k D = = STD STD + LTD 12% + LTD STD + LTD 8% 4, 000 2, % + 8% = 10.67%. 6, 000 6, 000 1

2 Weights on Debt and Equity: On average, Bed Rock s bonds trade at par value and thus Gobain used book values for debt. He obtained W D = 5, , 000 5, , = 38.36% and W E = 1 W D = % = 61.64%. Cost of Equity: Gobain computed the average cost of equity provided by the CAPM and the dividend discount model (DDM). For the CAPM, Gobain used the average yield on 10-year government bonds, 4.64%, as the risk-free rate, a risk premium of 5.5% and Bed Rock s average beta over the last three years, i.e The cost of equity provided by the CAPM was then k CAPM E = r f + βk rp = ( ) = 5.57%. The DDM, on the other hand, gave him k DDM E = = 6.40%. Gobain then used k E = as Bed Rock s cost of equity = 5.98%, WACC: Using the above values, Bed Rock s WACC is WACC = 38.36% (1 30%) 10.67% % 5.98% = 6.55%. (a) (5 points) Is there any problem with Gobain s calculation of the pre-tax cost of debt? If so, explain what it is and how it affects the firm s WACC. (b) (5 points) Is there any problem with Gobain s calculation of the weights on debt and equity? If so, explain what it is and how it affects the firm s WACC. 2

3 (c) (5 points) Is there any problem with Gobain s calculation of the cost of equity? If so, explain what it is and how it affects the firm s WACC. (Don t worry about the tax rate and the risk-free rate here.) (d) (5 points) Considering Bed Rock s dividend payment and the size of its net income in 2003, is it reasonable to assume that the firm will be using debt and equity in fixed proportions over, say, ten years? Bed Rock, Inc Balance Sheet Assets Current assets 5,000 Net fixed assets 8,000 Total assets 13,000 Liabilities and Owners Equity Accounts payable 1,000 Line of credit 2,000 Current portion of long-term debt 2,000 Current liabilities 5,000 Long-term debt 2,000 Common stock 2,500 Retained earnings 3,500 Total liabilities and equity 13,000 Bed Rock, Inc Income Statement Sales 7,500 Cost of goods sold 3,500 Depreciation 300 EBIT 3,700 Interest 560 Taxable income 3,140 Taxes (30%) 942 Net income 2,198 Bed Rock s Betas Table 1: Data for Problem Consider a firm with initial value V = 400. Possible values in five years are V5 u = 800 with probability p = 0.7, V 5 = and the risk-free rate is r f = 5%. V d 5 = 300 with probability 1 p = 0.3 (a) (10 points) Compute the current values of debt (D) and equity (E) if all of the firm s debt is a pure-discount issue that promises to pay X = 250 in five years. 3

4 (b) (10 points) Compute the current values of debt (D) and equity (E) if all of the firm s debt is a pure-discount issue that promises to pay X = 400 in five years. (c) (10 points) Compute the current values of debt (D) and equity (E) if all of the firm s debt is a pure-discount issue that promises to pay X = 600 in five years. (d) (5 points) How is the firm s expected return on equity affected by leverage? 3. Consider a firm with an initial value V = 400, an original pure-discount debt paying X = 400 in three years, and whose value in three years will be V3 u = 650 with probability p = 0.7, V 3 = The risk-free rate is r f V d 3 = 250 with probability 1 p = 0.3. = 5%. For each of the following project, find (i) the payoff to shareholders and (ii) the payoff to the original bondholders. Which project would shareholders prefer? Which project would the original bondholders prefer? (a) (4 points) Use 150 of the firm s idle cash to retire debt. (b) (4 points) Use 150 of the firm s idle cash to pay a dividend to shareholders. (c) (4 points) Use 150 of the firm s idle cash to invest in a project paying 200 with certainty in three years. (d) (4 points) Use 150 of the firm s idle cash to invest in a project paying, in three years, 350 in the up state and 0 in the down state. (e) (4 points) Raise pure-discount debt with a sufficiently high promised payment in three years to be able to triple the firm s assets with the proceeds of the issue (i.e. V = 1, 200, V u 3 = 1, 950 and V d 3 = 750). Assume that the new debt issue has 4

5 the same priority as the old one over the firm s assets. What must the promised payment on the new debt be in order to do so? 5

Business 3019 Corporate Finance Lakehead University

Business 3019 Corporate Finance Lakehead University Midterm Exam Suggested Answers Philippe Grégoire Winter 2006 1. (50 points) Weighted Average Cost of Capital Use the information in Table 1 to answer