A

Name______________________________________

Mid-term Examination
FINC 5880
Session 5

2
3
4

5
6
Question 1. (10 points) The exercise price on one of ORNE Corporation's call options is $35 and the price of the underlying
7
stock is $34. The option will expire in 55 days. The option is currently selling for $0.25.
8
9
a. Calculate the option's exercise value? 0.
10 Call option's Exercise Value = Current stock price - Exercise Price. In this case the current stock price is lower than the
11 Exercise price i.e. the option is Out-of-the-money currently. Hence, Exercise Value is 0.
12
13
14
15
16
17
18
19
20
21
b. Calculate the value of the premium over and above the exercise value? What does this value represent?
22
23
24
25
26 Value of premium = $0.25
27 The option premium represents the price that the buyer of the option would be willing to pay to have the right to buy the stock
28 $34, anytime before contract expiration.
29
30
31
32
33
34
c. Is this an out-of-the money option, at-the-money, or in-the-money? Why?
35
36 This is an Out-of-the-money option. Its a call option where the Exercise price is higher than the underlying stock price.
37
38
39
40
41
42 d. What will happen to the time and exercise value of the option if the underlying stock price changes to $34.50? Why?
43
44
The Value of option will now become $0.5 i.e. (Stock price - Exercise price). It will become valuable now and the call option
45
would
be In-the-Money now, as Stock price has increased above Exercise price.
46
47
48
49
50
e. If Orne Corporation had issued a put option (instead of the call), would it have a greater or lesser value than the call
option? Why?

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If instead of Put option, Orne Corporation were to issue the Call option, its value would have been higher. This is because
as the Underlying stock price is lower than the Exercise price, the option is In-the-Money and hence the option would be

would be In-the-Money now, as Stock price has increased above Exercise price.

51
52
53
54
55
56
57
58
59
60
61
62

A
B
C
D
E
F
e. If Orne Corporation had issued a put option (instead of the call), would it have a greater or lesser value than the call
option? Why?
If instead of Put option, Orne Corporation were to issue the Call option, its value would have been higher. This is because
as the Underlying stock price is lower than the Exercise price, the option is In-the-Money and hence the option would be
valuable.

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2
3
4

5
6
ons is $35 and the
7 price of the underlying
0.25.
8
9
10
current stock price is lower than the
11
is 0.
12
13
14
15
16
17
18
19
20
21
oes this value represent?
22
23
24
25
26
27 the right to buy the stock at
ng to pay to have
28
29
30
31
32
33
34
35
36
her than the underlying
stock price.
37
38
39
40
41
42 to $34.50? Why?
tock price changes
43
44
become valuable
45 now and the call option
46
47
48
49
50
a greater or lesser value than the call

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ould have been higher. This is because

Money and hence the option would be

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G
H
a greater or lesser
value
than
the
call
51
52
53
ould have been higher. This is because
54
Money and hence the option would be
55
56
57
58
59
60
61
62

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A
1

Name______________________________________

Mid-term Examination
FINC 5880

Session 5

5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50

Question 2. (15 points) Pierre Imports is evaluating the proposed acquisition of new equipment at a cost of $90,000. In addi
cost of $10,000 plus shipping costs of $2,000. The equipment falls into the MACRS 3-year class, and will be sold after 3 yea
increased inventory of 6,000. The equipment is expected to save the company $35,000 per year in before-tax operating cos
and its cost of capital is 11 percent.
a. What is the cash outflow at Time 0?
Cost of new equipment = $90,000
Modifications = $10,000
Shipping Costs = $2,000
Inventory cost = $6,000
Total cash outflow at Time 0 = $108,000

b. What are the net operating cash flows in years 1, 2, and 3?

Depreciable Value
Cost of new equipment
add: Modifications
Shipping costs
Total Cost

90,000
10,000
2,000
102,000

Depreciation per annum - 3 years MACRS

Beginning Book Value
Depreciation Rate
Depreciation
Ending Book-Value

$
$
$

1
102,000 $
33.33%
33,997 $
68,003 $

2
68,003
44.45%
30,228
37,776

1
35,000
68,003
(33,003)
(9,901)
(23,102)
68,003
44,901 $

2
###
37,776
(2,776)
(833)
(1,943)
37,776
35,833

Calculation of Operating Cash Flows

Savings in annual operating costs before tax
less: depreciation
Profit before tax
less: Tax 30%
Profit after tax
add: Depreciation
Net Operating Cash Flows

c. Calculate the non-operating terminal year cash flow.

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A
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68

Salvage value
Tax on Salvage Value
Book-Value
Tax on Salvage Value 30%
Salvage value post-tax
Additional Working capital - Inventory
Non-operating terminal value

C
$

35,000

846
34,154
6,000
40,154

32,181

d. Calculate net present value. Should the machine be purchased?

Cost of capital
NPV
0
(108,000)

Initial Cash Flow

Net Operating cash flows
Non-operating terminal cash flow
PV Factor @ cost of capital 11%

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1
44,901

Page 6 of 28

0.9009

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xamination2
3
5880

on 5

5
6
7
ment at a cost of
8 $90,000. In addition the equipment would require modifications at a
r class, and will be sold after 3 years for $35,000. The equipment would require
9
r year in before-tax operating costs. The company's marginal tax rate is 30 percent
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
3
31
37,776
32 $
14.81%
33
$
5,595
34
32,181
35 $
36
37
3
38
35,000
39 $
32,181
40
2,819
41
846
42
1,973
43
32,181
44
$
34,154
45
46
47
48
49
50

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D
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56
57
58
59
60
61
62
63
64
65
66
67
68

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G
-

35,833

34,154
40,154
0.7312

0.8116

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A
1

Name______________________________________

Mid-term Examination
FINC 5880

Session 5

5
6
7
8
Question 3. (15 points) A company has a target capital structure that consists of 40 percent debt and 60 percent equity. The
9
company's capital budget for next year is $10 million. Axel expects net income of $8 million. The company's cost of capital i
10 percent.
11
12 a. How much will the company pay out in dividends if it follows a residual dividend policy?
13
14
15
Amount $ million
16
10
17 Capital budget
18 Percentage of capital budget
funded by debt 40%
19

Percentage of capital budget

funded by Equity 60%

20
21 Net Income
22 Less: Equity reserved for capital
budget
23

Residual Income available for

dividend distribution

6
8

(6)

24
25 b. What is the company's dividend payout ratio if it pays the dividends calculated above?
26
27 Dividend payout ratio = Dividend/Net Income
25%
28 Hence, D/P Ratio =
29
30
31
c. Is it likely the company will follow a residual dividend policy? Why or why not?
32
33
It is likely that the company will follow a residual dividend policy. This is because the Net Income is sufficient to
34
the needs of equity funding required for capital budget. The remaining amount to meet the capital budget may b
35
by debt as mandated by the target capital structure.
36
37
38
39
40

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41
d. If the company decided to pay out $4.5 million in dividends, how much would it need to raise in equity outside the compa
42
43
44
Amount $ million
45
Net
Income
8.0
46
4.5
47 Less: dividend distributed
Balance Amount to meet capital
48
budget
3.5
49 Required amount of capital
budget to be met out of equity
50
51
52
53
54
55
56
57
58
59
60
61

Shortfall to be met out of Equity

6.0
2.5

e. Should the company go ahead with a project of average risk that generates a 10 percent rate of return? Why or why not?
The company must not go ahead with accepting a project which generates a 10% rate of return. This is so because the cost o
company is 12%, which is higher than the rate of return generated by the projected. Hence, the project generates rate of ret
than the hurdle rate. It would therefore deplete capital and must not be accepted.

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1
2
3
4

5
6
7
ent debt and 608 percent equity. The
9
ion. The company's
cost of capital is 12
10
11
cy?
12
13
14
15
16
17
18

19
20
21
22

23

24
25
26
27
28
29
30
31
32
33
se the Net Income is sufficient to meet
34
to meet the capital budget may be met
35
36
37
38
39
40

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41
to raise in equity
42 outside the company?
43
44
45
46
47
48
49
50

51
52
53
54
nt rate of return?
55 Why or why not?
return. This is56
so because the cost of capital of the
nce, the project57
generates rate of return which is lower
58
59
60
61

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A
1

Name______________________________________

Mid-term Examination
FINC 5880

Session 5

5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50

Question 4. (15 points) Shown below are exchange rates for several currencies.

Spot rate
30-day forward rate
60-day forward rate

$ per 1 euro
1.33
1.31
1.29

$ per 1 franc
1.08
1.11
1.22

Peso per $1
12.8
13.1
13.9

a. Is the euro appreciating or depreciating against the U.S. dollar? Explain.

Euro is depreciating against US Dollar. The reason is that less $ is required to buy 1 Euro as implied by the forward rate.

b. Is the Swiss franc appreciating or depreciating against the U.S. dollar? Why?

Swiss Franc is appreciating against the US Dollar. The reason is that more $ is required to buy 1 Swiss Franc as implied by t

c.

Is the Mexican peso appreciating or depreciating against the U.S. dollar? Why?

Mexican Peso is depreciating against the US Dollar. The reason being that more Pesos are required to buy $1 as implied by t

d. Using cross-rates, based on the spot rate, how many francs will the euro buy, how many pesos will the franc buy, and how
the peso buy?

Spot $/Eur Rate

Spot $/Franc Rate
Hence, Franc/$ Rate
Spot Franc/Eur Rate
Hence 1.23 Francs will buy 1 Euro
Spot $/Franc Rate
Spot Peso/$ Rate
Peso/Franc Rate
Hence, 13.824 Pesos will buy 1 Franc

Brigham 14e

1.33
1.08
0.93
1.23

1.080
12.8
13.824

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51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68

A
B
Spot $/Eur Rate
Spot Peso/$ Rate
Peso/Euro Rate
Hence, 17.024 Pesos would buy 1 Euro

1.33
12.8
17.024

e. A U.S. company purchases goods from several foreign companies with payment due in euros, francs, and pesos. Would th
company be better off paying now or waiting for 60 days? Why?
Payment due in Euros: US Company would be better waiting 60 days as Euro is depreciating.
Payment due in Francs: US Company would be worse-off as Franc is appreciating against US Dollar.
Payment due in Pesos: US Company would be better since Peso is depreciating against US Dollar.

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ion

1
2
3
4

5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
y 1 Euro as implied by the forward rate.
20
21
22
23
24
quired to buy 125
Swiss Franc as implied by the forward rate.
26
27
28
hy?
29
Pesos are required
30 to buy $1 as implied by the forward rate.
31
32
ow many pesos33will the franc buy, and how many euro will
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50

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51
52
53
54
55
56
t due in euros, 57
francs, and pesos. Would the
58
59
60
Euro is depreciating.
61
reciating against
62 US Dollar.
63
ciating against
64 US Dollar.
65
66
67
68

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A
1

Name______________________________________

Mid-term Examination
FINC 5880

Session 5

5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23

Question 5. (15 points) Kern Corporation entered into an agreement with its investment banker to sell 15 million shares of th
netting $300 million from the offering. The expected price to the public was $25 per share.
The out-of-pocket expenses incurred by the investment banker were $5 million.

a. What profit or loss would the investment banker incur if the issue were sold to the public at an average price of $25 per sh

Calculation of Profit/Loss incurred by Investment Banker when shares sold at average of $25 per share
Number of shares sold million
15
Average price per share
$
25
Total proceeds million
$
375
less: Proceeds passed to Kern
$
(300)
Gain million
$
75
Assumed that the out-of-pocket expenses incurred by the Investment Banker would be reimbursed by the Company.

24
25

b. What profit or loss would the investment banker realize if the issue were sold to the public at an average price of $20 per

26
27
28
29 Number of shares sold million

15

30 Average price per share

20

31 Total proceeds million

300

32 less: Proceeds passed to Kern

33 Gain million

300
$

34 Assumed that the out-of-pocket expenses incurred by the Investment Banker would be reimbursed by the Company.
35
36
37

c. Is the agreement between the company and its investment banker an example of a negotiated or a best-efforts deal? Wh
riskier to the company? Why?

The agreement between the company and its investment banker is an example of negotiated deal. This is because the procee
to the company has already been decided irrespective of the actual reults. Investment bank has undertaken to give a promis
Kern on issuance, irrespective of the final issue price and number of shares issued to the public which is $300 million.

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The riskier proposition to the company is Best-efforts deal. In Best-efforts deal, the amount to be received by the company i
certainty. Investment Bank gets commission but the fate of the issue hangs in balance and is unknown.

c. Is the agreement between the company and its investment banker an example of a negotiated or a best-efforts deal? Wh
riskier to the company? Why?
A
B
C
D
E
38
39
40
41

The agreement between the company and its investment banker is an example of negotiated deal. This is because the procee
to the company has already been decided irrespective of the actual reults. Investment bank has undertaken to give a promis
Kern on issuance, irrespective of the final issue price and number of shares issued to the public which is $300 million.

The riskier proposition to the company is Best-efforts deal. In Best-efforts deal, the amount to be received by the company i
certainty. Investment Bank gets commission but the fate of the issue hangs in balance and is unknown.

42

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ation

1
2
3
4

5
6
ker to sell 15 million
shares of the company's stock with Kern
7
8
9
10
t an average price of $25 per share?
11
12
13
14
15
16
17
18
19
20
21
22
23
rsed by the Company.
24

25
c at an average price of $20 per share?
26
27
28
29
30
31
32
33

34
rsed by the Company.
35

36
ated or a best-efforts deal? Why? Which is
37

deal. This is because the proceeds to be passed on

has undertaken to give a promised amount to
lic which is $300 million.

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to be received by the company is not known with

unknown.

Page 19 of 28

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ated or a best-efforts deal? Why? Which is

F

deal. This is because

the proceeds to be passed on
38
has undertaken to give a promised amount to
39 million.
lic which is $300

40 the company is not known with

to be received by
unknown.
41
42

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A
1

Name______________________________________

Mid-term Examination
FINC 5880

Session 5

5
6
7
8
9
10
11
12

Question 6. (15 points) Epoty Corporation is evaluating whether to lease or purchase needed equipment at a cost of $100,00
the equipment is leased, the lease would not have to be capitalized. The company's balance sheet prior to the acquisition of t
equipment is shown below.
a. Calculate the company's current debt ratio?
b.
a. Is
Calculate
How
the
bank
company's
financing
debt
isthe
needed
ratio,
current
to eliminate
the
andpast-due
quick ratio.
accounts payable?
c.
themuch
bank
likely
to make
loan?
Whyratio,
or why
not?

No, the company appears to be carrying excess inventory and financing extensively with debt. Bank

13 Equipment
$100,000
high, andcost
the liquidity situation is
poor. On the basis of these observations, the loan should be denie
14
should be advised to seek permanent capital, especially equity capital.
15

Current Balance Sheet

16 Current assets
17 Net Fixed assets

300,000 Debt

400,000

600,000 Equity

500,000

18 Total assets
19

900,000 Total claims

900,000

20 a. Current debt ratio

21

Debt/Total Assets
0.44

22
23
24
25 b. Calculate the company's debt ratio if it purchases the equipment with debt.
26 New Debt Amount = Existing debt + Borrowing
27 Total Assets = Existing assets + Equipment
28
29 Debt Ratio
30

500,000
1,000,000

0.50

31
32
33
34
35 c. Calculate the company's debt ratio if it leases the equipment?
36 When the company leases the equipment, both debt and assets will not increase.
37 Debt Ratio
38

0.44

39
40
41

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42
43
44
45
46
47
48
49
50
51
52
53

d. Will the company's ROA and ROE ratios be affected by its decision to lease or purchase? Why or why not?

If a decision to lease the asset is taken instead of purchase, there is no increase in either the debt or the asset
would be pushed higher. However, there are other concerns too. Typically lease payments are higher than inte
bring down the Net Income. Hence, the numerator in calculation would be lower with leasing decision. Hence,
ROA and ROE will be affected differently when lease or purchase decision is taken. Whether it is higher or low
is dependent on the facts of the case.

54
55
56

e. What factors should the company consider in coming to its decision other than net advantage to leasing? Why?

57

There are several factors to be considered than just the net advantages to leasing:

58
59

1. Modification/Customisation to suit the needs: In case of leased assets, it is difficult to modify/customise the assets to suit t
loss-making proposition in the long run.

60

2. Early termination/replacement: In case of lease, early termination of lease contract may attract penalties, law suits

61

3. Asset ownership: Having well capitalised balance-sheet is suggestive of strong financials. These also serve as guarantee fo
advantage is not present in Lease.

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2
d-term Examination
3
FINC 5880

Session45
5

6
e or purchase needed equipment at a cost of $100,000. If
7
company's balance
sheet prior to the acquisition of the
8
9

10
e
atio.
accounts payable?
11
12

and financing extensively with debt. Bank borrowings are already

13
ese observations,
the loan should be denied, and the treasurer
quity capital.14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41

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42
43
44
45
46
47

48
n to lease or purchase?
Why or why not?
49
ere is no increase
50 in either the debt or the asset. Because of this the ROA
o. Typically lease payments are higher than interest payments,which may
51 with leasing decision. Hence, we can conclude that both
n would be lower
se decision is52
taken. Whether it is higher or lower with one decision vs other,
53
54
55
other than net advantage to leasing? Why?
56
to leasing: 57

s, it is difficult 58
to modify/customise the assets to suit the changing needs. This may be
59

f lease contract60
may attract penalties, law suits
61
of strong financials. These also serve as guarantee for taking further loan. This

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A
1

Name______________________________________

Mid-term Examination
FINC 5880

Session 5

5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43

Question 7. (15 points) Calhoun Resorts is interested in developing a new facility in Toronto. The company estimates that the hot
company expects that the facility will produce positive cash flows of $3,000,000 a year at the end of each of the next 5 years. The
a. Calculate the expected net present value of the project.

Expected NPV of the project = PV of cash inflows at the cost of capital - Cost of project
NPV at the cost of capital 12%
Year
0
1-5
NPV

Sum of PV Factor @ 12% Amount $

1
(10,000,000)
3.6048
3,000,000

b. A hotel tax may be imposed that would affect cash flows. In one year, the company expects to know whether the tax will
change that the tax will be imposed, in which case annual cash flows will be $2.5 million for 5 years. If the tax is not impose
It is deciding whether to proceed with the facility today or to wait 1 year to find out whether the tax will be imposed. If it wa
million, and incoming cash flows will be delayed 1 year. Cost of capital will remain at 12%.
If the company waits one year, calculate the project's NPV in Year 1 with restrictions and without restrictions. What would y

Scenario
Probability
Cash-Flows
Tax will be imposed
40%
$2.5
Tax willl not be imposed
60%
$3.2
Project NPV = $
(0.60)
Since the Estimated NPV is negative, the recommendation to the Company would be to abandon the project.

c. Apart from real options, discuss 3 qualitative factors that the company should consider when making its decision on accep
The 3 qualitative factors that a company should consider when making its decision on accepting a new project are:

1. Environmental Factors: Will the new project have far-reaching impact on environment. If it will then the company beside
Government, environmental authorities and local public.

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2. Product quality: Whether the new capital project would lead to lower quality than the exisiting standards. In that case the

c. Apart from real options, discuss 3 qualitative factors that the company should consider when making its decision on accep

44
45
46
47
48
49
50

The 3 qualitative factors that a company should consider when making its decision on accepting a new project are:
A
B
C
1. Environmental Factors: Will the new project have far-reaching impact on environment. If it will then the company beside
Government, environmental authorities and local public.

2. Product quality: Whether the new capital project would lead to lower quality than the exisiting standards. In that case the

3. Internal Culture: How would the acceptance of the new poject impact the internal culture of the organisation? If the exist
be detrimental.

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1
2
Mid-term
Examination
3 FINC 5880
4

Session 5

5
6
w facility in Toronto. The company estimates that the hotel would require an initial investment of $10 million. The
000,000 a year at7the end of each of the next 5 years. The project's cost of capital is 12%.
8
9
10
11
12
13

14
15
16
17 PV $
18
(10,000,000)
19
10,814,400
20 $
814,400
21
22
23
24
25
26expects to know whether the tax will be imposed. The company believes there is a 40%
ar, the company
27 for 5 years. If the tax is not imposed, annual cash flows will be $3.2 million for 5 years .
will be $2.5 million
r to find out whether
the tax will be imposed. If it waits a year, the initial investment will remain at $10
28
l will remain at 12%.
ith restrictions29
and without restrictions. What would you recommend to the company?
30
31
32
33
34
35
Year
PV Factor @12%
PV $
Cost $
36
2-6
3.2186
8.05
37
2-6
3.2186
10.30
38
any would be to39abandon the project.
40
41 when making its decision on accepting the new project.
any should consider
42
g its decision on accepting a new project are:
43
act on environment. If it will then the company besides being wrong ethically would also be inviting the ire of

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er quality than the exisiting standards. In that case the brand and reputation would suffer.

-10
-10

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any should consider when making its decision on accepting the new project.

g its decision on accepting a new project are:

D
E
F
G
act on environment.
If it will then the company besides being wrong ethically would also be inviting the ire of
44

45
er quality than46
the exisiting standards. In that case the brand and reputation would suffer.
47
ct the internal culture of the organisation? If the existing managers are not comfortable, the new project may
48
49
50

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