University of Toronto

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1 University of Toronto Faculty of Applied Science and Engineering and Rotman School of Management JRE 300H IS - Foundations of Accounting and Finance Final Examination, April 2017 Duration: 2.5 hours Aids allowed: non-programmable calculator and 2-sided, 8.5' x 11" crib sheet. Please answer all questions on this exam paper. Please circle your instructor: Scott Douglas Maureen Stapleton The exam consists of 12 pages. Answers are to be written on the exam paper. Last Name: First Name: Student #: Question Grade Project EvaluationfNPV /25 Cost of Capital/Capital Structure /20 Capital Budgeting Decisions /15 Equity Valuation /10 Derivatives/Hedging /20 Bonds /10 Total : /100

2 1. Project Evaluation/NPV - Total 25 marks McGill Golf Inc. has decided to sell a new line of golf clubs. The new clubs will sell for $600 a set and the variable costs will be $240 per set. The company spent $150,000 for a marketing study that determined that they will sell 50,000 sets of the new clubs per year for 7 years. The marketing study also determined that introducing this new line of clubs will cause the company to lose sales of 12,000 sets per year of its higher priced clubs and increase annual sales of its cheaper clubs by 10,000 sets. The higher priced clubs sell for $1,000 and have variable costs of $550 per set. The cheaper clubs sell for $300 and have variable costs of $100 per set. Annual fixed costs will be $7,000,000. The plant and equipment required to manufacture the new clubs will cost $15,400,000, have a CCA rate of 30% and an expected salvage value of $2 million. Manufacturing the new clubs will require a $900,000 increase in working capital which will be released at the end of the project. The tax rate is 40% and McGill's cost of capital in 14%. a) What is the payback period for this project? (10 marks) 2

3 b) What is its NPV? How would you answer change if the UCC balance in the class was $1,500,000 at the time of the disposal? (13 marks) c) Should McGill launch this new line of golf clubs? Briefly, why or why not? What is the implication for McGill's shareholders, assuming that there are 1 million shares outstanding and the company has no debt. (2 marks)

4 2. Cost of Capital/Capital Structure -Total 20 marks You have been given the following information on the capital structure of Dunhill Power Inc: Debt: 3,000 bonds outstanding; 8% coupon rate, semiannual coupon payments, $1000 par value, 20 years remaining term to maturity. The current market price of the bonds is $103 or 103% of par value. Common Shares: 90,000 shares outstanding, current market price = $45/share; CAPM beta is 1.2 Preferred Shares: 13,000 shares of 7% preferred stock outstanding; current market price = $108/share Other information: The equity market risk premium is 8% and the risk free rate is 6%. a) What is Dunhill's existing capital structure, based on market values? (5 marks) b) What is Dunhill's weighted average cost of capital (WACC)? (5 marks) 4

5 c) Dunhill must raise $lmillion in new capital to fund an expansion. The company will maintain its existing capital structure. Assuming floatation costs of 5% for bonds and preferred shares, and 10% for common shares, what is Dunhill's marginal cost of capital? (5 marks) d) Next, assume that Dunhill choses to finance its additional capital requirements by issuing only debt. List, and explain briefly 3 implications of increasing debt or leverage in the capital structure (point form answers are acceptable). (5 marks)

6 3. Capital Budgeting Decisions -Total 15 marks a) The Calgary Country Club is evaluating two different irrigation systems for its golf course. An underground automatic system will cost $9.5 million to install and is expected to last for 20 years. Annual pretax operating costs are $55,000. Alternatively, an above ground system will cost $4.5 million to install, last for 9 years and cost $165,000 pretax per year to operate. The Country Club leases its land from the city so both irrigation systems would be considered leasehold improvements, subject to straight-line capital cost allowance. There is no salvage value. The Club's tax rate is 36%. Which system should the Club acquire if its discount rate is 12%? 11

7 4. Equity Valuation -Total 10 marks Alpha Company has a net profit margin of 10%, asset turnover of 1.8 and a leverage ratio of 0.3. This year the company reported net income of $2.5 million and it had 1 million common shares outstanding. The dividend payout ratio is 35%. The required return for Alpha stock is 5%. a) What is Alpha's sustainable growth rate (ie how fast can this company grow without external financing)? (5 marks) b) How much would you be willing to pay for a share of Alpha? (5 marks) Show all calculations. 7

8 S. Derivatives and Hedging- Total 20 marks a) Barrick Gold is a Canadian company that reports in $Canadian. It borrowed 100 million Euros at an annual interest rate of 3.5%. Principal and interest on the loan are due in 1 year, with payment to be made in Euros. Barrick used these funds to purchase machinery in Euros for use in its mine in Chili. In one year, the mine is expected to produce 1 million ounces of gold which will be sold on world markets in $US. Barrick would like to hedge its currency and commodity risks. Management has received the following quotes on forward contracts: One year C$/Euro forward exchange rate: 1.60 One year US$ forward exchange rate: 1.05 One year US$/Euro forward exchange rate: 1.10 One year gold forward contract: US$250/ounce List Barrick's long and short exposures, and briefly explain their implications. (4 Marks) II. Design the optimal hedging strategy for Barrick. Hint: are there any arbitrage opportunities? (5 Marks)

9 b) You believe that the price of oil will soon increase significantly. You also believe that rising oil prices will significantly reduce the profitability of transportation companies like Westjet, and cause their stock prices to decline. You own 500 shares of Westjet which have a current market price of $22 per share. Use this information to answer the following questions: List and briefly explain two general strategies you could use to avoid or reduce the expected loss on your Westjet shares? (2 marks) II. You bought a put option to sell Westjet at a strike price of $25. You paid $4 for this option will expire in September, What is the intrinsic value of the option? What is its time value? (4 marks) Ill. List 3 factors that would cause the price of this put option to change. (3 marks)

10 IV. Assume that it is now September, 2017 and your option is approaching its expiry date. The market price of your Westjet shares is now $26. What is the intrinsic value of your put option? Will you exercise your option? Why or why not?(2 marks) 10

11 6. Bonds - Total 10 marks Today, April 25, 2017, Bombardier raised capital by issuing $10 million of new bonds which trade in the Canadian bond market. These bonds pay a fixed 6% coupon rate and they will mature exactly 5 years from today. Their quoted price is $100 (ie $100 per $100 face value of bonds). Bombardier's bonds are rated B by Moody's and B(low) by S&P. A Government of Canada bond which pays a fixed 2% coupon rate and has the same 5 year term to maturity is also priced at $100. What is yield to maturity of the Bombardier bond? Of the Government of Canada bond? What is the credit spread on the Bombardier bond and why does it exist?? (2 marks) On what date will you receive the first interest payment on the Bombardier bond? How much will you receive? (2 marks) Ill. Now, assume that exactly one year has passed and the yield to maturity of your Bombardier bond is now 5%. What return did you earn on your bond investment? (3 marks) IV. You just learned that Moody's, a bond credit rating agency, changed the rating of Bombardier bonds from B to BBB. How do you expect this event to impact the market price of the bonds? List and briefly explain two financial ratios that may be used to determine a credit rating. (3 marks) 11

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