Mock exam

Print Last Name: Print First Name: ID Number:

COURSE NUMBER SECTION

FINANCE COMM 308/2 All sections

EXAMINATION DATE TIME # OF PAGES 17

Mock Final Exam DECEMBER 6, 2006 3 hours including cover, formula
VERSION BLUE sheets separate
INSTRUCTOR: DIVISION
John Molson School of Business
Concordia University

SPECIAL INSTRUCTIONS

- You are writing Version BLUE of the test. Please ensure that you have a BLUE computer
answer sheet. Your exam consists of two types of questions: Multiple Choice
Questions and Problems.

- Multiple Choice Questions:

- All your answers must be recorded IN PENCIL on the BLUE computer answer sheet
by darkening the appropriate letter corresponding to your choice. Only letters A, B, C, D
and E should be used. DARKENING ANY OTHER LETTER WILL RESULT IN AN INCORRECT
RESPONSE BEING RECORDED FOR THAT QUESTION.

- Problems:
- All your answers must be recorded on the exam sheets. Part marks will be awarded.
Write clearly and only in the space provided.

- Cell phones must be turned off, programmable calculators and PDAs are not allowed
during the final exam

- This exam contains 17 pages including cover. Formula sheets (4) are separate. Please ensure that
there are no pages missing.

- Fill in your name and other required information IN PENCIL on the Computer Answer sheet as
well as on this cover sheet.

- There is no negative marking on the multiple choice questions. Mark only one answer on the
computer answer sheet. Blank questions or those with multiple answers will not receive credit.

- Small differences may exist due to rounding. To minimize this problem, try to round only at
the end of multiple-step calculations.

- A minimum of 40% on this exam is required to pass this course.

- Allocate your time efficiently.

Blue exam Page 1 of 20

 Mock exam

For use by instructor

Maximum Grade

Multiple choice
60
questions

Problem 1
Part a 4
Part b 4
Part c 4
Part d 4
Part e 4
Problem 2 5
Problem 3 5
Problem 4
Part a 3
Part b(i) 3
Part b(ii) 4
Total 100

Blue exam Page 2 of 20

Multiple Choice Questions: Answer on Computer Answer Sheet Mock exam

Multiple Choice Questions (2 marks each):

- Only answers on the computer answer sheet will be graded.
- Select only one answer per question, blank or multiple answers will not
receive credit.
- You are encouraged to also circle your answer on the exam sheet as a back up.

Question 1) Sole proprietorships are characterized by:

a) Can be traded on a public stock exchange
b) The proprietorship life is limited to the business owner’s life
c) All business taxes are paid as individual tax
d) (a) and (c) are true
e) (b) and (c) are true

Question 2) You discover that the engine-oil additive your scientists developed three
years ago makes a great men's after shave when diluted properly using certain
chemicals. How should you treat the original $125,000 of R&D expenditures that
went into developing the engine-oil additive in your present capital budgeting
decision of whether or not to begin production of the after shave?
a) Treat it as a cash outflow three years ago for the current project, that is, find the
future value today of the $125,000 spent three years ago
b) The full $125,000 should be treated as an initial investment today
c) As a cash inflow since the formula has obviously increased in value over the years
d) As an opportunity cost if the formula cannot presently be sold to another
manufacturer
e) As a sunk cost since the R&D expenditure has no bearing on today's decision

Question 3) When evaluating a capital budgeting project, if we ignore other cash

flows of the firm that will not be changed by the project, we are focusing on
________.
a) capital expenditures
b) operating cash flows
c) incremental cash flows
d) taxes and depreciation
e) opportunity costs

Blue exam Page 3 of 20

Multiple Choice Questions: Answer on Computer Answer Sheet Mock exam

Question 4) You own shares in an income trust which benefits from tax free status.
Yesterday the government announced that it was removing the tax free status from
all income trusts. No new information has arrived today. You have analyzed your
investment and feel that the value of the trust will fall from $15 to $5 as a result of the
loss of tax free status. You decide to trade. The price of your trust will be:
a) Close to $15 because the market is semi-strong form efficient.
b) Close to $5 because the market is semi-strong form efficient.
c) Close to $5 because the market is semi-strong form inefficient.
d) Close to zero because the market is semi-strong form efficient

Question 5) Tuscany Wines Inc has just declared a dividend of $1. The date of record
is December 10, 2006 and the ex-dividend date is December 7, 2006. Fred will
receive the dividend if he:
I. Buys after December 7 and sells December 9
II. Buys after December 7 and sells December 11
III. Buys before December 7 and sells December 9
IV. Buys before December 7 and sells December 11
a) I or II
b) III or IV
c) I or III
d) II or IV

Question 6) A well-diversified portfolio has negligible:

a) Expected return
b) Systematic risk
c) Unsystematic risk
d) Variance
e) Both c and d

Question 7) Finance determines the value of the firm based on:

a) The cash flows of the firm
b) The timing and risk of the cash flows
c) The profits earned under Generally Accepted Accounting Principles
d) A and C
e) A and B

Question 8) “Homemade leverage” refers to:

a) Illegal counterfeiting of bond certificates
b) Use of unconventional sources of debt by small businesses
c) Borrowing from domestic banks as opposed to foreign banks.
d) The use of borrowing on the personal account by investors to offset borrowing by
corporations.

Blue exam Page 4 of 20

Multiple Choice Questions: Answer on Computer Answer Sheet Mock exam

Question 9) The market price of ________ maturity bonds fluctuate _______

compared with ________ maturity bonds as interest rates change.
a) Shorter, less, longer
b) Longer, less, shorter
c) Shorter, more, longer
d) Both (b) and (c)
e) The prices of bonds do not change as interest rates change.

Question 10) You are the CFO for the Sask Soy Bean Company. Your company will
be producing 1 million tons of Soy Beans in 3 months and you would like to hedge
against possible price declines. Which of the following transactions will help you
hedge against the risk of price declines?
I. Buy a call
II. Buy a put
III. Enter into a forward contract to sell
a) I only
b) II only
c) III only
d) I and II only
e) II and III only

Question 11) Consider a project with an initial investment and positive future cash
flows. As the discount rate is increased the
a) IRR remains constant while NPV increases
b) IRR decreases while NPV remains constant
c) IRR remains constant while NPV decreases
d) IRR increases while NPV remains constant
e) IRR decreases while NPV decreases

Question 12) Suppose the Quebec government “bails out” a business in financial
distress by guaranteeing any new debt issued by the company. If the firm issues new
debt, who gains:
a) Shareholders
b) Original bond holders
c) New bond holders
d) A and B
e) B and C

Blue exam Page 5 of 20

Multiple Choice Questions: Answer on Computer Answer Sheet Mock exam

Question 13) Assume there are no corporate or personal taxes. According to M&M
Proposition
a) I, the total value of the firm depends on how cash flows are divided up between
stockholders and bondholders
b) I, a firm's capital structure is relevant
c) II, the cost of equity rises as the firm increases its use of debt financing
d) II, the cost of equity depends on the firm's business risk but not its financial risk
e) I and II, as debt increases, the increase in the cost of equity is more than offset by
the lower cost of debt and the WACC falls

Question 14) A key assumption of M&M I (no taxes) is:

a) Corporations can borrow more cheaply than individuals
b) Individuals can borrow more cheaply than corporations
c) Individuals must be able to borrow and lend at the same rate as corporations
d) Managers are compensated using stock options

Question 15) _____________ suggests that value-maximizing financial managers will

employ capital structures composed almost entirely of debt.
a) M&M Proposition I with taxes
b) M&M Proposition I without taxes
c) The static theory of capital structure
d) M&M Proposition II without taxes
e) M&M Proposition II with taxes

Question 16) Topstone Industries' preferred stock pays an annual dividend of $4.00
per share. When issued, the shares sold for their par value of $100 per share. What is
the cost of preferred stock if the current price is $125 per share?
a) 3.2%
b) 3.7%
c) 4.0%
d) 4.7%
e) 31.3%
Cost of preferred shares = $4.00 / $125 = 3.2%

Blue exam Page 6 of 20

Multiple Choice Questions: Answer on Computer Answer Sheet Mock exam

Question 17) A firm needs to raise $165 million for a project. If external financing is
used, the firm faces flotation costs of 8% for equity and 2.5% for debt. If the project
is to be financed 60% with equity and the rest with debt, how much cash must the
firm raise in order to finance the project?
a) $128.6 million
b) $142.2 million
c) $161.7 million
d) $171.6 million
e) $175.2 million
Weighted average flotation costs: .6*8% + .4* 2.5% = 5.8% . Need to raise $165
million / (1- 5.8%) = $175.2 million

Question 18) You have been asked to evaluate 2 pollution control devices. The wet
scrub costs $100 to set up and $50 per year to operate. It must be completely replaced
every 3 years, and it has no salvage value. The dry scrub device costs $200 to set up
and $30 to operate. It lasts for 5 years and has no salvage value. Assuming that
pollution control equipment is replaced as it wears out, which method do you
recommend if the cost of capital is 10%? Assume the tax rate is zero.
a) Dry scrub, the EAC is $11.00
b) Wet scrub, the EAC is $90.21
c) Dry scrub, the EAC is $82.76
d) Wet scrub, the EAC is $9.79
e) Dry scrub, the EAC is $124.34
Wet scrub: Present value (including the initial set-up costs) = -$224.3426. The life of
the Wet scrub is 3 years, so the annuity factor is 2.4869. EAC = $90.21

Dry scrub: Present value (including the initial set-up costs) = -$313.7261. The life of
the Dry scrub is 5 years, so the annuity factor is 3.7908. EAC = $82.76

Question 19) You bought 100 shares of stock at $20 each. At the end of the year, you
received a total of $400 in dividends, and your stock was worth $2,500 total. What
was your percentage rate of return?
a) 20%
b) 25%
c) 45%
d) 125%
e) 145%
Value of the shares at the end = $2500+400 = $2,900. Initial investment = $2,000. So
total return over the 1 year = 2900/2000 -1 = 45%

Blue exam Page 7 of 20

Multiple Choice Questions: Answer on Computer Answer Sheet Mock exam

Question 20) A portfolio has 50% of its funds invested in Potter Brooms Inc. and 50%
of its funds invested in Hagrit Hightops Corp. Potter Brooms has an expected return
of 8% and a standard deviation of 6%. Hagrit Hightrops has an expected return of
14% and a standard deviation of 12%. The securities have a coefficient of correlation
of -0.50. Which of the following values is closest to the portfolio variance?
a) 0.0027
b) 0.0490
c) 0.0063
d) 0.0794
e) 0.1100
Note: the actual value of the portfolio variance is 0.0036. If this happens on the exam,
answer the question and note the question number on your formula sheet (which you
can bring home). After the exam, email me with the question number and indicate the
nature of the problem with the question (ie. Answer not there etc) and I will double
check the question.

Question 21) Suppose the JumpStart Corporation’s common stock has a beta of 0.80.
If the risk-free rate is 4% and the expected market return is 9%, the expected return
for JumpStart’s common stock is:
a) 3.2%
b) 4.0%
c) 7.2%
d) 8.0%
e) 9.0%
Using the CAPM we find that the expected return is 4% + .8*(9%-4%) = 8%

Question 22) A corporate bond with a face value of $1,000 matures in 4 years and has
an 8% coupon paid semi-annually. The current price of the bond is $932. What is the
yield to maturity for this bond?
a) 5.05%
b) 8.00%
c) 8.58%
d) 10.15%
e) 11.92%
Input the cash flows and solve for the IRR Æ we get 5.5442%. However, this is the semi-
annual. Convert to annual by multiplying by 2 to get 10.1088%. The closest answer is
10.15%.

Blue exam Page 8 of 20

Multiple Choice Questions: Answer on Computer Answer Sheet Mock exam

Question 23) Your credit card company quotes an annual rate of 5%, compounded
weekly. What is the actual annual cost of carrying a balance on this card? (effective
annual rate)
a) 5%
b) 260%
c) 12.64%
d) 5.12%
e) 1.051%
52
⎛ .05 ⎞
EAR = ⎜1 + ⎟ −1
⎝ 52 ⎠
= 5.12%

Question 24) What would your payment be on a 10-year, $150,000 loan at 10%
compounded semi-annually assuming payments are made annually?
a) $19,716.67
b) $20,743.77
c) $24,411.81
d) $24,674.60
e) $25,366.63
Step 1: convert APR to EAR. EAR = 10.25%. Then using the annual rate, solve for the
annuity payments. Answer: $24,674.59556

Question 25) A project costs $475 and has cash flows of $100 for the first three years
and $75 in each of the project's last five years. The discount rate is 8%. What is the
payback period of the project?
a) 4.75 years
b) 5 years
c) 5.33 years
d) 7.50 years
Payback: 100+100+100+75+75 = $450 in 5 years. Need another $25, earn $75 per year
so it will take an additional 1/3 of a year.

Blue exam Page 9 of 20

Multiple Choice Questions: Answer on Computer Answer Sheet Mock exam

Question 26) Suppose XYS Company has an expected return of 18%. Assume the risk
free rate is 5% and the market risk premium is 6%. If the CAPM holds, what is
XYS’s beta?
a) 1.00
b) 7.00
c) 2.40
d) 2.17
e) 1.00
18% = 5% + Beta * 6% Æ 13% / 6% = Beta

Question 27) Cash Corp. will pay (per share) a dividend of $3 in 1 year, no dividends
in year 2 and a dividend of $5 at the end of year 3. Thereafter, the dividend will grow
at a constant rate of 3%. If the appropriate discount rate is 8%, what is the price of the
stock today?
a) $83.22
b) $85.03
c) $86.87
d) $88.51

3 0 5 1 ⎛ 5(1 + .03) ⎞
P0 = + + + ⎜ ⎟
1.08 1.08 1.08 1.083 ⎝ .08 − .03 ⎠
2 3

= 2.7777 + 0 + 3.96916 + (.7938)(103)

= $88.51

Question 28) You bought 100 shares of stock at $25 each. At the end of the year 1
your received $200 in dividends and at the end of year 2, you received $400 in
dividends. At the end of year 2, your stock was worth $2,700 total. What annual rate
of return did you earn on your investment?
a) 11.36%
b) 14.89%
c) 15.43%
d) 16.00%
Solve for the IRR of the investment: CF0 = -2500, Cf1 = $200, Cf2=$400+2700.

Blue exam Page 10 of 20

Multiple Choice Questions: Answer on Computer Answer Sheet Mock exam

Question 29) Suppose that an investor with a five-year investment horizon is

considering purchasing a 25-year, 10% coupon bond (paying interest semi-annually)
for $888.80. The investor expects that she can reinvest the coupon interest payments
at an annual interest rate of approximately 11% (5.5% every 6 months) and that at the
end of the investment horizon period, the bond will be selling to offer a YTM of 9%.
What effective annual rate of return has the investor realized?
a) 5.38%
b) 10.76%
c) 13.84%
d) 14.32%
e) 9.00%
The cash flows are:
- Semi-annual coupons: $50 for 5 years
- sale price = present value of remaining 20 years of coupons at YTM = 9%
o $1,092.0079 (remember the YTM is an annual rate)
- Initial investment = $888.80
- Determine the value of the investment at the end of 5 years:
o FV of the 10 coupons reinvested at 5.5% every 6 months + sale of
bond. = $643.767689+1092.0079 = $1,735.775589

The investor invested $888.80 which grew in value to $1,735.775589 in 5 years.

15
⎛ 1735.775589 ⎞
EAR = ⎜ ⎟ − 1 = 14.3241%
⎝ 888.80 ⎠

Blue exam Page 11 of 20

Multiple Choice Questions: Answer on Computer Answer Sheet Mock exam

Question 30) Gauss Industries has just purchased an executive jet from Bombardier
for $15 million. The jet is eligible for a 25% CCA rate. The expected economic life of
the jet is 10 years. At the end of year 10, the jet will be sold for $1.15 million and the
pool will be closed. If the tax rate is 36%, what are the after-tax proceeds from the
sale? Assume that the half-year rule applies.
a) $1,150,000
b) $1,209,225
c) $1,090,775
d) $985,487
e) $1,314,514

Year UCC (begin) CCA UCC(end of year)

1 .5*15mil 1.875mil 5.625mil
2 5.625+.5*15 3.28125 9.84375 million
3 (1-.25)*9.84375=7.3828125
…. ….
10 (1 − .25) 9.84375 = 0.98548651
8

Sale value = $1.15 million, UCC value $.98548651 million (note: pool is closed).
Taxable gain = 1.15 -.9855 = $0.16451349 million. Tax = .36*0.410885 = $0.05922486
million.

After tax proceeds = 1.15 million – 0.05922486 million = $1.090775 million

Blue exam Page 12 of 20

Problems: Answer in the space provided on this exam Mock exam

Problems:
- Answer on this document, in the space provided.
- Write clearly! Part marks will be awarded (when deserved!). Write your final
numerical answer in the box provided.

Problem 1. (20 marks) The Valley Electricity Utility Company operates in only one
line of business – producing electricity in Northern Canada using hydro-electric dams.
They are considering investing in a project to produce electricity in Afghanistan using a
nuclear reactor. The project will require an initial investment of $441 million, is
expected to generate cash flows of $15 million a year for 25 years and then cost $50
million to clean up the site at the end of the project. The following information about
the Valley Power Co. is provided by the CFO.

• Debt: 2,500 9.85 percent coupon bonds outstanding. $1,000 par value, 8 years
to maturity, selling for 105% of par; the bonds make annual payments.

• Common stock: 75,000 shares outstanding, selling for $50 per share with a
dividend yield is 2%; the beta is .85.

• Preferred stock: 10,000 shares of 5% preferred stock outstanding, currently

selling for $80 per share. Par value $100.

• Market: 5% market risk premium, and 6% risk free rate, Tax rate = 35%

Charlie, the person who had the job before you, began to compute the WACC
(weighted average cost of capital) for Valley before he was promoted. The CFO has
given you Charlie’s preliminary calculations. Charlie’s notes for the debt and
common stock part of the calculation are:

• Cost of debt = 9.85%, Cost of equity = 2%

• Value of debt = 2500*1,000 = $2.5 million; value of common stock =

75,000*$50 = $3.75 million.

2%*3.75 + 9.85% *(1 − .35) * 2.5

• WACC = = 3.76%
3.75 + 2.5

Blue exam Page 13 of 20

Problems: Answer in the space provided on this exam Mock exam

a. Identify 4 significant errors in Charlie’s calculation of the WACC. Briefly explain (no
calculations necessary). (4 marks)

- Cost of capital components are incorrectly determined:

o Cost of debt should be determined as the current yield to maturity of the bonds
not the coupon rate. Need to use the rate of return required by the market for the
firm’s bonds
o Cost of equity is not the dividend yield – need to use either the CAPM or the
dividend discount model to determine the rate of return required by the common
stock holders
- Weights are incorrectly determined:
o Value of the debt must be current market value not the value of the bonds when
issued
- WACC is incorrectly calculated
o Omitted the cost of preferred stock in the calculation

b. Compute the WACC for the Valley Electricity Utility Company (4 marks)

- Costs of components:
o Before tax cost of debt: annual coupon = $98.50 per year for 8 years, current price
= $1050. YTM = 8.94836%
o cost of equity using CAPM = 6% + .85* 5% = 10.25%
o cost of preferred stock = $5/$80 = 6.25%
- Weights:
o Debt: 2500*1000*105% = $2,625,000
o Equity: 75000*50 = $3,750,000
o Preferred: 10000*80 = $$800,000

8.94836%(1 − .35)2625 + 10.25% *3750 + 6.25% *800

WACC =
2625 + 3750 + 800
152.6813925 + 384.3750 + 50
=
7175
587.0564
=
7175
= 8.1820%

WACC = 8.1820%

Blue exam Page 14 of 20

Problems: Answer in the space provided on this exam Mock exam

c. Is the WACC the appropriate discount rate for this project? Why or why not? If not,
what adjustments would you recommend? (4 marks)

The WACC is only appropriate for this project if the risk of the project is similar to the
risk of the firm – this is not true. The current activities of the firm are hydro-electric dams
in Northern Canada. The project is nuclear reactors (different risk than hydro-electric) in
Afghanistan (very different risk than Northern Canada). Therefore, the project risk is very
different from the current assets and the WACC is not appropriate.

I would adjust the WACC to reflect the greater risk of the project by:
- finding another company already in the nuclear reactors in Afghanistan business
and determine their cost of capital
- alternatively I could add two risk premiums: one to reflect the difference
between hydro-electric and nuclear (using North American utility companies?) and the
second to reflect the risk associated with doing business in Afghanistan (perhaps compare
the cost of capital of two firms in the same line of business, one in Canada and one in
Afghanistan, to get an idea of how large the premium should be.

d. The CFO has indicated that he would like you to calculate the IRR of the project. Is
the IRR an appropriate method of evaluating this project? Discuss (4 marks)

The IRR is not an appropriate method of evaluating this project because the pattern of the
cash flows changes sign more than once (we have to pay $441 million to start the project
and an additional $50 million to end the project; expect positive cash flows during life of
project). We know that the IRR can have multiple values if the cash flows change sign
more than once.

Blue exam Page 15 of 20

Problems: Answer in the space provided on this exam Mock exam

e. The CFO has always used a payback period of 4 years as the decision rule for
investments (accept all projects with a payback period of 4 years or less), but, he has
heard about this thing called NPV. Define NPV and explain to your boss the
advantages and disadvantages of using payback and NPV for investment analysis. (4
marks)

The Net Present Value (NPV) is the value added to the firm after satisfying all the
requirements of the suppliers of capital – it is calculated by comparing the present value
of all future cash flows with the investment today. The present value is determined using
a risk adjusted discount rate reflecting the returns required in the market for projects of
this type of risk.

The payback period ignores the time value of money and determines the number of years
it will take until the total cash flows received equals the cash spent to start the project.

The NPV is the preferred method of determining the “value” of a project, however, the
payback period does have its place especially when:
- liquidity is of great concern (payback favours projects that return capital quicker)
- future cash flows are very uncertain (the quality of the NPV calculation depends on
the quality of the cash flow forecasts – easier to forecast cash flows in the early years
rather than in the later years).
- Very quick and easy to calculate
A major problem with the payback method is that it ignores anything that happens after
the payback period has been achieved. For example: consider two projects each costing
$1000, each has cash flows of $250 for the first 4 years. Project 1 has a cash flow of
$1,000 in year 5 while project 2 has a cash flow of $100 in year 5. According to the
payback method, we are indifferent – both projects have a payback period of 4 years.
However, assuming the risk is the same, NPV indicates that project 1 is preferred.
Payback missed the large year 5 cash flows.

Blue exam Page 16 of 20

Problems: Answer in the space provided on this exam Mock exam

Problem 2. (5 marks) Your boss is very puzzled by the finance courses in his MBA.
He has learned that “Cash Flow is King”, but, notices that all the capital budgeting
problems spend a lot of time and effort dealing with depreciation and but not interest
expenses. He knows that depreciation is a non-cash expense and he knows that
interest is definitely a cash expense. He would like an explanation of why he needs to
bother with depreciation and not with interest expense.

Depreciation:
- The fact that depreciation, a non-cash expense, is tax deductible means that it will
reduce our tax bill – thereby increasing our after tax cash flows. So we need to
consider depreciation as long as it is tax deductible.
o In fact, what we really care about is the depreciation tax shield (the tax reduction
because of the depreciation not the depreciation itself)
- Note – the depreciation we consider for capital budgeting is the depreciation that is
tax deductible. This is not necessarily the same as the depreciation reported on the
financial statements.

Interest expense:
- Interest expense is a payment to the debt holders.
- When we calculate the present value of the future cash flows, we discount at the cost
of capital thereby taking into account the interest expense.

Example:
- Consider a project which will earn $75 forever.
- Project is 100% debt financed
- Firm borrows $1,000 of debt, annual coupon = $50 forever (ie. Cost of debt = 5%),
zero taxes. In other words, the investment = $1,000
- PV of cash flows: 75/.05 = $1,500 > value of loan so project is good (each year, it
generates more cash than that required to repay the loan)

- If we deduct the interest from the cash flows, we get an annual cash flow of $25.
- Present value of the cash flows = 25/0.05 = $500 < $1,000
o Project looks bad (NPV < 0) just because we double counted the interest.

Blue exam Page 17 of 20

Problems: Answer in the space provided on this exam Mock exam

Problem 3. (5 marks) You have a portfolio of two options – a call and a put – on
ABC corp. You purchased the call option for $4.50 and sold the put option for $1.50.
The call has an exercise price of $15 and the put has an exercise price of $35. Both
options expire on the same day. Fill in the missing data in the table below and graph,
on the next page, the value (payoff) of the two positions on the expiration date.
Clearly label the graph on the next page.

Value of ABC on the expiration date

10 15 20 35 50
Value of call
0 0 5 20 35
position
Value of put
-25 -20 -15 0 0
position

Call position: bought call Æ right to buy (if I choose) at $15 on the expiration date.
Therefore value at expiration will equal (ABC - $15) as long as ABC>15, zero otherwise.

Put position: sold put Æ buyer (not me) has the right to sell ABC to me for $35 if he
wants to Æ buyer will exercise put if price of ABC is less than $35. Value of put to me
will be ($35 – ABC) as long as ABC < $35. Hint: if you are the seller of the option, put
or call, the value of the option to you at the expiration cannot be greater than zero.

Note: the value of the two positions is not the same as the profit on the two positions.
Profits take into account how much you spent to buy (or received if you sold the option).

Blue exam Page 18 of 20

Problems: Answer in the space provided on this exam Mock exam

Graph of payoff to the two option positions at expiration date.

$20

Buying a call

Value
of
options
at expir.
$15 $35

Selling a put

-$25

Value of ABC at expiration

Blue exam Page 19 of 20

Problems: Answer in the space provided on this exam Mock exam

Problem 4. (10 marks) The Albacore Tuna Company expects to have EBIT = $20,000
per year forever. The corporate tax rate is 38%. Albacore’s capital structures consists
of 1,000 shares (market value per share = $62) and zero debt.
a. What is Albacore’s WACC? (3 marks)

Albacore is an all-equity company therefore its WACC equals its cost of equity.

Cost of equity:
Æ value of equity = $62,000
Æ perpetual cash flows to equity = EBIT *(1-T) = 20,000 * (1-.38) = $12,400
Æ cost of equity = $12,400/62,000 = 20%
WACC = 20%

b. Albacore is considering issuing $20,000 of debt (perpetual, yield = 10%) and using
the proceeds to buy back stock.
i. What is the value of the Albacore after the repurchase? (3 marks)

Using M&M, we know that the relationship between the value of the levered and
unlevered firm is given by:

Vl = Vu + tD
= $62,000 + .38*$20,000
= $69,600
Value after repurchase:
$69,600

ii. After the repurchase, how many shares are outstanding and what is the market
price? (4 marks)

Price of stock prior to repurchase = $62.

Borrow $20,000 and repurchase 20,000/62 = 322.58 shares

Shares outstanding after repurchase = 677.42

Total value of equity after repurchase = value of firm – value of debt

= $ 49,600

Price per share after repurchase = $49,600/677.42 = $73.22

Shares outstanding: 677.42
Price per shares = $73.22

Blue exam Page 20 of 20