Practice Final Exam. Before you do anything else, write your name at the top of every page of the exam.
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1 FOSTER SCHOOL OF BUSINESS FINANCE 350 Business Finance PROF. RAN DUCHIN Practice Final Exam Before you do anything else, write your name at the top of every page of the exam. This exam is worth 35% of your final grade. The work on this exam must be entirely your own. The exam is closed book and closed notes. You may use your own formula sheet. Calculators, financial or otherwise, are allowed during the exam. In problems which ask you to calculate something, first write out the appropriate formula and then fill in the relevant information which you use to calculate the answer to the question. Provided that you have used the correct formula and filled-in the correct information, you will receive most of the credit for the question. Answers that do not show how you arrived at the answer will receive little or no credit. If a question asks "why?" or instructs you to "explain," you should give a complete and meaningful explanation that would convince a skeptic. Please try to write only in the space provided for each question. If you really need more space, continue on the back of the page. Be clear and concise in your answers (remember: if I can t read it, I can t give you credit!). There are 100 points on this exam and each question's point value is marked. If you do not know how to do something, try breaking-it down into doable pieces. If you still don't know what to do, move on to another question. There are a variety of questions on the exam and they are not in order of difficulty. Remember to stay calm you know more than you think. More often than not, your mind s first unfettered response to a question will lead you in the right direction. Name: Good luck!
2 Part 1: Concepts (24 points total) 1. Define portfolio diversification and explain how it benefits from imperfectly correlated assets. [8] 2. What is the difference between systematic and non-systematic risk? Which risk is priced? Why? [8] 3. How does capital structure affect firm value? Compare your answer to capital structure in a perfect world (Modigliani and Miller). [8] 2
3 Part 2: Problems (76 points total) Please show all your work. If you need extra space, please use the back of each page. Problem 1 [12 points] Your company s target capital structure consists of 45% debt and 55% equity. The firm s unlevered beta is 1.2. The risk-free rate is 5%, the expected market return is 10%, and the tax rate is 40%. If the firm s WACC is 10.1%, what is the firm s pre-tax cost of debt? Problem 2 [12 points] Assume that the CAPM holds, the risk-free rate is 3%, and the market risk premium is 7%. Stock A has an expected return of 10%. Stock B has a beta of 1.2 and a standard deviation of 0.4. Stock C has twice as much exposure to systematic risk as stock B. If you put 30% of your money in A, 40% in B and 30% in C, what will the beta of your portfolio be? 3
4 Problem 3 [12 points] You have a portfolio of two stocks. CDG has an expected return of 8% and a standard deviation of 20%. NCE has an expected return of 15% and a standard deviation of 30%. The stocks have a correlation of If you put 40% of your money in CDG and 60% in NCE, what is the expected return and standard deviation of your portfolio? 4
5 Problem 4 [16 points] The expected return on stock X is twice the expected return on the market, and the annual standard deviation of stock X is 3 times the standard deviation of the market. The market portfolio has an expected return of 11%, and the risk-free rate is 4%. a) Compute the equity beta of stock X and the correlation between stock X and the market. [8] b) Stock X is currently trading at $100 and pays no dividends. An equity analyst has a one-year target price of $121 for this stock. If the analyst s forecast holds true, what alpha will be earned next year by a portfolio that has a beta of 0.8 and is invested in stock X and the risk-free asset? (Assume next year s market return and the risk-free rate will be 11% and 4%, respectively.) [8] 5
6 Problem 5 [24 points] You would like to value the stock of Liberty Communications, Inc., by using the discounted cash flow method. Liberty has 10 million common shares outstanding. In addition to equity financing, the company is also financed with debt. The company s debt consists of 180,000 bonds, which have a face value of $1,000 per bond, mature in 5 years, and pay an annual coupon of 6%. The yield-to-maturity on these bonds is 7%. The management s target capital structure is 25% debt and 75% equity. Assume that the company does not have non-operating assets. Other financial information, industry comparables, and the forecast of free cash flows are summarized below. The tax rate for Liberty and all peer companies is 40%, the risk-free rate is 4%, and the expected market return is 11%. To guide you through the solution, the problem is broken down into four parts a through d. a. What is the TTM free cash flow of Liberty? Please use the table below. [6] Cash flow computation for Liberty Communications, TTM Financials Value, $mil EBITDA 250 EBIT 200 Capital expenditures 80 Increase in working capital 40 6
7 b. Based on its peers, what is Liberty s equity beta? Please use the table below. [6] Atlantic Telecom American Communications Millennium Telecom Enterprise value, $mil Market value of equity, $mil Levered beta c. What is Liberty s cost of equity according to the CAPM? What is its WACC? [6] 7
8 d. What is Liberty s enterprise value, equity value, and price per share according to the DCF method? Please use the table below. [6] Free cash flow forecast for Liberty Communications, years forward Year Steady state FCF growth rate N/A 12% 7% 4% 3.5% growth forever 8
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