INTRODUCTION TO THEORETICAL FINANCE EXAM 11 June 2015 1. This is an individual, closed-book exam; any attempt to cheat will be penalized by the immediate cancellation of the exam. 2. The exam is closed-book, however every student is allowed to use during the exam one page (two-sided) containing personal notes (photocopies will not be accepted). 3. You may answer in British English, American English, or French. An English dictionary is allowed during the exam. 4. The exam duration is 3 hours sharp. 5. The exam will be graded on 20 points. Each question (market by a number) is worth one point. 6. One error is penalized only once. In case you estimate that a piece of data is missing or ambiguous, state clearly your hypothesis in your answer and go ahead with solving the question. 7. Your answers to the qualitative questions (where no calculation is required) should not be long, but precise. 8. All types of classical calculators (including graphic / financial calculators) are authorized. The use of a computer, smartphone and/or computer-like calculator is not authorized. Students are requested to use their own calculator and may not borrow from or share a calculator with another candidate during the exam. 9. Answer all questions in a thorough, clear and readable manner. Any ambiguous or unreadable answer plays against you. 10. You are allowed to use draft paper, however ONLY your final copy will be corrected. 11. Upon completion of the exam, you are requested to hand over to the supervisor ALL exam material, including the exam questionnaire. 12. Write your name on ALL the pages. 13. Check that your questionnaire contains 8 pages. 14. Good luck! 1/8
Part 1. Financial Analysis Cool & Co is a Belgian industrial company that was incorporated on 1st January 2013. This company manufactures industrial cooling systems used for cooling Data Processing Centers (which generate a lot of heat as they basically combine a large number of electricity-powered computer units). The company is originally financed by 100M (Million ) in Equity (represented by 1000 shares with equal voting rights) and 200M in bank debt. The bank loan has been granted for 5 years and the full amount of principal will be repaid after 5 years (bullet debt). The facial interest rate on the bank loan is 5%. Fixed assets consist mainly of manufacturing equipment and are depreciated over a period of 5 years according to the Linear Method (= equal charge every year over 5 years). The initial balance sheet of the company is as follows (all figures in Million ): Balance Sheet 1/01/2013 1/01/2013 Fixed Assets 250 Capital 100 Inventories 0 Retained earnings 0 Clients 0 Bank Debt 200 Cash 50 Suppliers 0 Total Assets 300 Total Equity & Liabilities 300 After one year of activity, the company releases its first complete set of financial statements, which show a sizeable profit. Because the company is in a start-up phase, the General Assembly of Shareholders decides that no dividend will be distributed, so that the balance sheet of the company can be summarized as follows: Balance Sheet 31/12/2013 31/12/2013 Fixed Assets 200 Capital 100 Inventories 110 Retained Earnings 100 Clients 190 Bank Debt 200 Cash 0 Suppliers 100 Total Assets 500 Total Equity & Liabilities 500 2/8
1) How much was the Return on Equity (RoE) in 2013? How much was the Return on Average Equity in 2013 (in %)? 2) Did the leverage ratio as shown by the balance sheet increase or decrease after one year of activity? Please compute and explain. In 2014, Cool & Co is facing a poor economic environment and activity slows down. The Profit and Loss Account of Cool & Co in 2014, and the Balance Sheet at the end of 2014, can be summarized as follows: Profit and Loss Account 2014 Sales 500 - COGS -340 - Depreciation charges -50 - Interest charges -10 Profit before tax 100 - Tax (50%) -50 Net profit after tax 50 Balance Sheet 31/12/2014 31/12/2014 Fixed Assets 150 Capital 100 Inventories 110 Retained Earnings 150 Clients 240 Bank Debt 200 Cash 50 Suppliers 100 Total Assets 550 Total Equity & Liabilities 550 Assume that the company makes again the decision that no dividend will distributed, so that all of the net profit made in 2014 is added to retained earnings. 3) How much is Return on Equity (RoE) and Return on Assets (RoA) in 2014 (in %)? What explains the difference between the two? (hint: use a well-known decomposition) 4) Compute the Free Cash Flow in 2014 (show the details of your calculations). 3/8
In January 2015, following a report from the company s Chief Financial Officer, the Board of Directors of Cool & Co recognizes that the company holds 50 M too much cash in comparison with its actual needs and decides to pay-back early 50 M of the outstanding bank debt balance with this cash. 5) What will be the impact (if any) of this early repayment of the bank debt on Cool & Co s on: a) The Net Working Capital? b) The Free Cash Flow? Please thoroughly explain how you arrive to your answer and comment it. Part 2. Project Decision Making You are Mr Cambron, a well-known alumn of the AMISM. You are now the CEO of Para Disco, a theme park with dancing animals, which you created yourself as an entrepreneur. You have asked your team to analyze an investment proposal. You organize a meeting on 31/12/2014 to make a decision (in spite of the weird date, you called your team to make sure that they remind you the good principles and concepts you saw in your finance course when you were a student at AMISM). The project consists in trying to convince the Chinese authorities to offer two pandas Dalai to the park. The analysts estimated that the simple presence of the pandas in Para Disco would boost the number of visitors to the park by 20%, from a current level of 100,000 tickets per year. The unit ticket price is fixed for next year at 25 EUR. Most of the costs are fixed cost. Those currently amount to 1,500,000 EUR yearly and mainly consist of costs of personnel, animal food (the latter two are mutually exclusive categories), and heating. Usual variable costs are 20% of revenues. You hold no inventories and all your clients pay cash. Accounts payable amount to 10% of all costs. One of your best friends is a consultant and a fan of pandas. He proposed you his help for a feasibility study. He has already conducted the feasibility and come up with the precious following information: Although the Chinese government would offer the pandas at no cost to you, you would have to entertain influential people, which would represent a cost (one-shot) of 900,000 EUR, which you would modestly classify as admin costs in your books. Chinese officials require a proper infrastructure for the pandas. The cost of this infrastructure amounts to 500,000 EUR, which you would depreciate over the expected life of the pandas. You anticipate to be able to resell, in 5 years, some specific parts of the pandas infrastructure (such as rare tree essences), for a price of 100,000 EUR. Unfortunately, this type of pandas have a life expectancy of 5 years only. 4/8
Because he is your friend, although he has already completed the work for the feasibility study, the consultant tells you he accepts to be paid only if the project succeeds, at a rate of 1 EUR per additional ticket sold due to the pandas, during the whole life of the project (the amount will be indexed over time, 1 EUR is the nominal amount for next year 1 ). You expect an inflation of 2% yearly going forward. You estimate the appropriate discount rate for such projects to be 10%. You have obtained a full tax exemption on special grounds from the new Belgian government (the agreement has been validated by the Finance Minister Le Tisserand). 6) Compute the relevant FCFs over the life of the project. 7) Compute the project NPV. Would you go ahead with the project? Explain. 8) Minister Le Tisserand likes your activity (and pandas) a lot. He allows Para Disco to depreciate its fixed assets over 3 years rather than 5 years. What will be the impact of this allowance on your project NPV? Please explain. A representative of Tibet has heard about your idea to negotiate about the Dalai pandas with the Chinese government. In agreement with the highest Tibetan authorities, this representative insists that you consider the possibility to welcome 2 Lama pandas which are very famous in Tibet. The main advantages of that project is that the both the admin and infrastructure costs would be lower. The Tibetan pandas would have the same effect on ticket sales as the Chinese pandas. Unfortunately, the Lama pandas are very fragile and would live only 3 years. For obvious political reasons, if you receive Chinese pandas, you will not be able to receive Tibetan pandas. On top of this, you do not believe that having a second couple of pandas in your park would add any contribution to your sales. 9) Assume that you have computed an NPV of 100,000 EUR for the Chinese pandas and 70,000 EUR for the Tibetan pandas over the life of the respective projects. a) What would you decide, assuming that the project is a one-shot investment? Why? b) One of your analyst objects that, once you have started with one project, thanks to the good relationships you will entertain with your foreign partners, you may expect to receive another couple of pandas when the former couple dies. What would you decision be in this case? Base you decision on an appropriate decision-making criterion, make your calculations and explain your decision. 10) Assume that the IRR from the Chinese project is 15% and the IRR from the Tibetan project is 25%. Which project would you choose and why? Please explain your decision. 1 An equivalent way to express the remuneration of the consultant is: 4% of the extra sales yearly. 5/8
Part 3. Interest Rates and Bonds Cool & Co would like to issue debt to finance a growth in its activities. It has the choices between the following financial products: Bond 1 (bank loan): Face value = 1000 EUR Maturity = 5 years Coupon rate = 0 Bond 2 (corporate bond): Face value = 1000 EUR Maturity = 5 years Coupon rate = 2% Bond 3 (corporate bond): Face value = 2000 EUR Maturity = 5 years Coupon rate = 2% Bond 4 (corporate bond): Face value = 1000 EUR Maturity = 5 years Coupon rate = 10% 11) What is the duration of the bank loan? What will be the duration of bonds 2 to 4, compared to the duration of the bank loan. Please explain (without calculation) 12) All members of the Executive Committee fear that, in the current deflationary environment, interest rates might further decrease going forward. Which bond should they choose for their current financing need, and why? 13) You go on the ECB website and notice that, without any surprise, the yield curve today has its standard shape. Please define the yield curve and illustrate your answer with a graph. What is the standard shape of the yield curve? 14) Assume that the risk-free rate is 2% and the risk premium for corporate bonds is 4%. For each bond, indicate whether they will trade above / at / below par. Shortly explain. 15) Assume that capital markets are perfect, the risk-free rate is 2% and the risk premium for corporate bonds is 4%. Compute the yield-to-maturity of: a) Bond 1, expressed as an Annual Effective Rate b) Bond 4, expressed as a Stated Annual Rate with semi-annual compounding (hint: remember that capital markets are perfect!) 6/8
Part 4. Portfolio Management Mr Harry Cover has recently retired from its professional activity. During his career, he has accumulated his savings in an equity trust fund investing exclusively in 2 listed company shares with the following characteristics: Expected Return Standard deviation Weight (%) Share A 20% 30% 60% Share B 10% 40% 40% 16) Assume that shares A & B are perfectly correlated (correlation = +1). What are the riskreturn characteristics of this portfolio of shares? (calculate the expected return and standard deviation) 17) Would a rational investor ever buy share B? If yes, in which case and why? If no, why not? Now that he does not longer work, Harry Cover feels that he needs to be more risk averse when investing. So he decides to sell his entire position in Share B and replace it with an equivalent amount in risk-free Belgian government bonds. Expected Return Standard deviation Weight (%) Share A 20% 30% 60% T-Bills 2% 0% 40% 18) What are the risk-return characteristics of this new portfolio? a) Does Harry Cover really achieve lower total risk with this change? Why? Shortly explain and show the risk-return features of the portfolios on a little graph. b) Does Harry Cover achieve lower systematic risk with his new portfolio? Please explain (hint: use the CAPM relationship) Thinking again about his situation, Harry Cover is disappointed that the expected return by his new portfolio of investments level of expected return. 7/8
19) a) What should the allocation (in %) between Share A and T-Bills be in order for this new portfolio with Share A and T-Bills to show the same expected return as the old portfolio (with 60% share A and 40% share B)? Based on your result, tell him what he should do in practice. b) Did Harry Cover apply a risk diversification strategy when he replaced Share B by T- Bills in his new portfolio of investments? Explain why / why not? Part 5. A discussion with Finance Professionals We are in the real world and markets are not perfect. 20) Please shortly explain three ways for private equity investors to create value (valuecreation drivers). Part 6. Bonus 21) Use data from the general statement of part 3. The Executive Committee altogether agrees that bond 2 is preferable to bond 3. Give one potential argument which justifies their position. 8/8