Practice Final Exam (2) Solutions

Finance 325

Name:

Exam Instructions:

• This exam should have 7 pages (including this one) and 11 questions. The point
value is given for each problem. The entire exam is worth 100 points.

• There is a page at the back of the exam that has information that you will need to
solve problems on the test. You may remove this page if it makes it easier for you
to reference it during the test.

• You may use a calculator and the provided formula sheet on this exam.

• You must show your work in order to receive credit for your answers. Partial
credit will be given for partially correct answers.

• If a question asks “Why/Explain”, you should give an explanation that would

convince a skeptic.

• You may use the back of a page if you need additional space to write an answer.

Suggestions:

• Use your time wisely. Move on to another problem if you feel like you’re stuck.

• You may ask me questions if you are unclear about a problem. I may be able to
clarify the problem for you.

GOOD LUCK!!

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1. Explain the investment decision rule when using IRR. Under what conditions is it
inappropriate to use IRR in investment decision making?

The IRR decision rule say to invest in any project with an IRR greater than a
benchmark return.

The IRR method will give the same answer as the NPV method under most
circumstances, and is an appropriate method in those cases. However, it can give a
different decision than NPV (and is thus inappropriate) under the following
conditions:
- there is more than one sign change in the stream of CFs
- the investment decision for one project does not affect the decision to accept
or reject another investment project (ie… you’re not choosing between
different projects)

2. You are at a party during spring break, and you overhear someone talking about investing
in the stock market. As you eavesdrop, you hear this guy saying: “It’s easy to make
money in the stock market. All you have to do is read the Wall Street Journal in the
morning and look for companies that announced good news about future earnings. Then
you go to your stock broker and buy those stocks. Because these companies have
announced good news, their stock price will go up, and you can make a quick profit on
your stock purchase.” Is he right about his strategy, and why?

No… he is incorrect. Because the financial markets are semi-strong efficient, they
incorporate all available public information into the stock price. In other words,
you can’t make abnormal returns on public information. Evidence has shown that
public information gets incorporated into the stock price in less than 15 minutes. In
this case, the Wall Street Journal is reporting stories that happened the previous
day… the information will have already worked itself into the stock price. Thus, on
average, one cannot make excess returns with this strategy.

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3. Earl and Randy Hickey are brothers who won the lottery and have decided to go into
business together. They are interested in oil prospecting, which is the business of looking
for oil and drilling oil wells. Most oil prospectors find oil in only 1 out of every 5 wells
that they drill, but Earl and Randy feel that their good karma will enable them to find oil
in 1 out of every 2 wells that they drill. Regardless of their karma, they would sign
contracts to sell any oil that they find to Exxon oil refineries at set prices. Thus, the only
risk of their potential venture is whether they find oil and how much oil they find.

They hire you to evaluate whether this venture is a good investment for them to make.
Do you have enough information to calculate a discount rate for them? If so, explain
why and calculate the discount rate. If not, explain why not. (8 pts)

Yes, there is enough information to calculate a discount rate.

When determining a discount rate, we are concerned with the riskiness of the cash flows
that result from the project. But we are not concerned with total risk… only systematic
risk. Thus, to determine a discount rate, we need to know the amount of systematic risk, or
beta, of the CFs from the investment. Once we have beta for the investment, we can plug
the beta into the CAPM and get a discount rate.

Now let’s look at this investment. It is risky… there is a chance that no oil will be found,
and who knows how much oil they would find if they are successful. However, because
they have locked in a price for any oil that they find, the ONLY risk of the investment is
whether they find oil and how much they find. Both of these risks are company or project-
specific… market-wide economic shocks will not affect Earl’s ability to find the oil or the
amount that they eventually find. Therefore, there is no systematic risk in this
investment… and beta is zero. Therefore, the correct discount rate for Earl and Randy to
use is the risk-free rate, or 6%.

4. Why do we use beta in the CAPM instead of standard deviation?

The CAPM determines the amount of return given a unit of systematic risk.
Standard deviation measures total risk, while beta measures systematic risk. That is
why we use beta instead of standard deviation.

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5. Pepsi is deciding whether or not to launch a new soft drink and want your help in the
analysis. They would need to spend $1 billion immediately in order to produce and
distribute “Dr. Salt”. They think there is a 35% chance that it will be a hit, and generate a
perpetual cash flow of $100 million starting in 1 year. They also acknowledge that there
is a 40% chance that public reaction will be average, and generate a perpetual CF of $75
million starting next year. And there is a 25% chance of the drink being a flop, and
generating only $20 million each year in perpetual CFs. All CFs are after-tax cash flows.

Pepsi can also test market Dr. Salt before production, which will cost $90 million. It will
tell Pepsi for sure whether the new drink will be a hit, average, or a flop.

What should Pepsi do?

We need a discount rate: Pepsi has an equity beta of 0.50… to find the asset beta:
. . .
Next we find the discount rate for Pepsi given the asset beta:
. . . . . %

First, let’s look at the NPV without test-marketing:

Year 0 Year 1
100 into perpetuity (prob = 35%) Æ PV0 = 100/.08 = 1250

-1000 75 into perpetuity (prob = 40%) Æ PV0 = 75/.08 = 937.5

20 into perpetuity (prob = 25%) Æ PV0 = 20/.08 = 250

The expected CF in year 0 is: (0.35)(1250)+(0.40)(937.5)+(0.25)(250) = 875

The NPV of the drink with no test marketing is:

NPV = -1000 + 875 = - $125 million

Now, with test marketing:

Years
0 1
-1000 + 100 into perpetuity (prob = 35%) Æ PV0 = 100/.08 - 1000 = 250

-90 -1000 + 75 into perpetuity (prob = 40%) Æ PV0 = 75/.08 -1000 = -62.5

-1000 + 20 into perpetuity (prob = 25%) Æ PV0 = 20/.08 - 1000 = -750

Since Pepsi wouldn’t purposely take a negative NPV project:

PV0 = 250 (prob = 35%)

-90 PV0 = 0 (prob = 40%)

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 PV0 = 0 (prob = 25%)

Thus, the expected NPV is: -90 + (0.35 * 250) = - $2.5 million
Because both NPVs are negative, Pepsi should not even attempt to make this new drink.
They would expect to lose money regardless of whether they test market or not.

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6. Find the risk and return of Cisco Systems and Sun Hydraulics. Can you use the
mean/standard deviation rule to determine which company is the better individual
investment?

0.10 − 0.13 + 0.15 + 0.19

E[ RCS ] = = 0.0775 = 7.75%
4

σ CS
2
=
(0.10 − 0.0775) + (− 0.13 − 0.0775) + (0.15 − 0.0775) + (0.19 − 0.0775)
2 2 2 2
0.02049
3
σ CS = 0.02049 = 0.1431 = 14.31%

0.03 + 0.43 + 0.09 + 0.05

E[ RSH ] = = 0.15 = 15%
4

σ SH
2
=
(0.03 − 0.15)2 + (0.43 − 0.15)2 + (0.09 − 0.15)2 + (0.05 − 0.15)2 0.035467
3
σ SH = 0.035467 = 0.1883 = 18.83%

We cannot use the mean/standard deviation rule in this case. Sun Hydraulics has a
higher return AND higher standard deviation than Cisco Systems.

7. You decide to make a portfolio of 75% Sun Hydraulics and 25% Cisco Systems. Find
the risk and standard deviation of the portfolio.

E[ RP ] = (0.75)(0.15) + (0.25)(0.0775) = 0.1319 = 13.19%

σ P2 = (0.75)2 (0.1883)2 + (0.25)2 (0.1431)2 + (0.75)(0.25)(0.1883)(0.1431)(0.23) = 0.02355
σ P = 0.02355 = .1535 = 15.35%

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8. MAK, a construction company, has decided to double the amount of debt in their capital
structure. They will replace existing equity with new debt. It will cost MAK $4.2
million to make this change in its capital structure. MAK considers all debt in the capital
structure to be perpetual. What will be the new value of the firm after they increase their
debt? What is the new value of the equity in the firm?

We look and see that MAK currently has 18% debt in the capital structure, with a
firm value of $220 million. Thus, they have $39.6 million in debt. They want to add
another $39.6 million in debt to replace $39.6 million in equity. The change in the
tax shield benefits is:

PVtax shields = τD = (0.34)(39.6) = $13.46 million

The value of the firm is:

Vnew = Vold + PVΔtax shields – tx costs

= 220 + 13.46 – 4.2
= 229.26

Thus, the new value of the firm is $229.26. The value of the debt of the firm is $79.2
million, thus the value of the equity is 229.26 – 79.2 = $150.06 million.

9. After the above transaction, what will be the change in compensation demanded by
shareholders of the firm?

Use the CAPM to find the return to equity before the change in capital structure:
E[ Re ] = rf + β e (rm − rf )
E[ Re ] = 0.06 + 1.5(0.14 − 0.06)
E[ Re ] = 0.18
The equity holders were receiving an expected return of 18% before the change.
Now we need to calculate the change in return after the transaction. First, we need
to convert the equity beta to an asset beta:
⎛ E ⎞
βa = βe ⎜ ⎟ = 1.5(0.82) = 1.23
⎝D+E⎠
Then, we convert this to a new equity beta, given the new capital structure:
⎛D⎞
βe = βa + βa ⎜ ⎟
⎝E⎠
⎛ 79.2 ⎞
β e = 1.23 + 1.23⎜ ⎟ = 1.879
⎝ 150.06 ⎠
This is then converted into a return on equity using the CAPM:
E[ Re ] = 0.06 + 1.879(0.14 − 0.06)
E[ Re ] = 0.210
The equity holders demand 3% more return due to the transaction.

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10. You hold common stock in the company PBR, which is in the Pharmaceutical business.
Later today, you will receive your annual dividend payment from PBR. You expect
dividends to be paid every year, and that they will grow at a rate of 3% every year. What
is the current price of the stock?

The formula for the value of a firm with growing dividends into perpetuity is:

DIV1 DIV0 (1 + g )
PV = DIV0 + = DIV0 +
re − g re − g

We use the CAPM to determine the return on equity:

E[re ] = rf + β e (rm − rf )
E[re ] = 0.06 + 1.9(0.14 − 0.06)
E[re ] = 0.212

The price of the stock today is:

DIV1 2(1 + 0.03)

PV = DIV0 + = 2+ = $13.32
re − g 0.212 − 0.03

11. MM theory tells us that capital structure has no effect on firm value… assuming that
certain conditions are satisfied. List and explain these conditions.

The three conditions for the MM theory are:

- No taxes… if taxes are present, then firm value can be affected because of tax
shields.
- No transactions costs… if transaction costs are present, then it costs equity
holders to switch between debt and equity.
- Fixed investment policy… the choice of debt or equity must have no affect on
whether a project is taken or not. If so, then the value of the assets will
change.

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 Equity Standard Firm Stock Dividend
Company Business Debt P/E P/CF
Beta Deviation Value Price this year
Pepsi Soft Drinks 0.50 .30 50% 83 Bil 21 17
MAK Construction 1.5 .40 18% 220 Mil $62 $0 31 26
PBR Pharmaceuticals 1.9 .60 55% 7.5 Bil $2 13 15

Return on the market: 14%

Risk-free rate: 6%
Corporate tax rate: 34%

Assume the beta of debt is zero.

Assume that changes of capital structure have no effect on investment policy.

Equity returns for Cisco Systems and Sun Hydraulics

1 2 3 4
Cisco Systems 10% -13% 15% 19%
Sun Hydraulics 3% 43% 9% 5%

Correlation of Sun Hydraulics and Cisco Systems: 0.23