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Instructions to Students
This paper consists of (5) questions and printed on a total of (10) pages and includes (5) pages of
formulae.
There is a hurdle requirement in this unit. Students must attain a mark of at least 50% to pass the
unit.
Page 1 of 9
Question 1: Cost of Capital
Siemens SA currently has $300 million of market value debt outstanding. The firm just issued five-
year zero coupon bonds with a face value of $1,000, which are currently priced at $789.52 per bond.
The firm also has an issue of 2 million preference shares outstanding with a market price of $12.00
per share. The preference shares have a par value of $100 and a fixed dividend rate of 1.2%. Siemens
SA also has 14 million ordinary shares outstanding with a price of $20.00 per share. The firm has just
paid a dividend of $2.09 per ordinary share, and that dividend is expected to increase by 5.0% per
year forever.
Required:
a) If Siemens SA is subject to a 40% marginal tax rate, what is the firm’s weighted average cost of
capital (WACC)?
b) After completing the computation for Siemens SA’s weighted average cost of capital (WACC),
the manager is relieved because he says that he can now use that WACC to evaluate all projects
that the firm is considering for the next four years. Evaluate the manager’s statement.
(7 + 3 = 10 marks)
Innovation Company is getting ready to start a new project that will incur some clean-up and
shutdown costs when it is completed. The project costs $5.40 million up front and is expected to
generate $1.10 million per year for 10 years and then have $700,000 shutdown costs at the end of
year 11. Assume all profits and expenses occur at the end of the year.
Required:
a) What is the NPV of this investment if Innovation Company ‘s cost of capital is 15%. Should the
firm undertake the project?
b) What are the maximum shutdown costs the firm can incur so that there is a positive NPV for the
project? Assume that the cost of capital is still 15% for this project.
c) What is the payback period of the project? Should the firm undertake the project when the firm’s
payback cut-off period is 3 years?
Page 2 of 9
Question 3: Capital Structure
a) Absent tax effects, why can’t managers change the cost of capital of the firm by using more debt
financing and less equity financing?
c) Acort Industries owns assets that will have a 60% probability of having a market value of $50
million in one year. There is a 40% chance that the assets will be worth only $20 million in one
year. The current Acort’s cost of debt is 5%, and Acort's assets have a cost of capital of 10%.
Required:
ii. Suppose instead that Acort has debt with a face value of $13 million due in one year.
According to MM, what is the value of Acort's equity in this case?
iii. What is the expected return of Acort's equity without leverage? What is the expected return
of Acort's equity with leverage?
(3 + 3 + [1+1+2] = 10 marks)
b) Why would stock price drop by the same amount as dividend on the ex-dividend date?
c) Without taxes or any other imperfections, why doesn’t it matter how the firm distributes cash?
d) Oranges Corporation currently has an enterprise value (EV) of $360 million and $100 million in
excess cash. The firm has 15 million shares outstanding and no debt. Suppose Oranges uses its
excess cash to repurchase shares. After the share repurchase, news will come out that will
change Oranges 's enterprise value to either $560 million or $160 million.
Required:
Page 3 of 9
Question 5: Capital Budgeting
ACME manufacturing is considering replacing an existing production line with a new line that has a
greater output capacity and operates with less labour than the existing line. The existing line, which
was purchased several years ago, originally cost $500,000 and currently has a book value of $250,000.
The new line would cost $750,000 and would be depreciated on a straight-line basis over a useful life
of 5 years. At the end of five years, the new line could be sold as scrap for $75,000. The existing unit
is being depreciated at $50,000 per year and will be fully depreciated at the end of year 5. ACME can
sell the existing unit today for $275,000. Assume ACME’s tax rate is 30%.
Because the new line is more automated, it would require fewer operators, operating costs (exclusive
of depreciation) are expected to decrease by $20,000 per annum, and revenues are expected to
increase by $100,000 per annum (due to increased additional sales). ACME estimates that in addition
it will require an initial increase in net working capital of $40,000. At the end of year 5, this amount
will be fully recovered.
ACME’s equity beta is 1.8 and its pre‐tax cost of debt is 7.14% per annum. The risk free rate is 6%
per annum and the market return is 11% per annum. ACME’s debt to equity ratio is 1.
Required:
b) What is the NPV of the new production line? Advise whether the company should replace the
existing line or not?
(2 + 8 = 10 marks)
END OF EXAMINATION
Page 4 of 9
Formula Sheet
1 𝐶 2 𝐶 𝑁 𝐶
𝑃𝑉 (𝑚𝑢𝑡𝑖𝑝𝑙𝑒 𝐶𝐹𝑠) = 𝐶0 + (1+𝑟) + (1+𝑟)2 + ⋯ + (1+𝑟)𝑁
𝐶
𝑃𝑉( 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦) = 𝑟
𝐶
𝑃𝑉( 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝐷𝑢𝑒) = 𝐶 + 𝑟
𝐶 1
𝑃𝑉 (𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦) = 𝑟 (1 − (1+𝑟)𝑁 )
𝐶 1
𝑃𝑉 (𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐷𝑢𝑒) = 𝑟 (1 − (1+𝑟)𝑁 ) (1 + 𝑟)
𝐶
𝐹𝑉 (𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦) = 𝑟 ((1 + 𝑟)𝑁 − 1)
𝐶
𝐹𝑉 (𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐷𝑢𝑒) = 𝑟 ((1 + 𝑟)𝑁 − 1)(1 + 𝑟)
𝐶 1+𝑔 𝑁
𝑃𝑉 (𝐺𝑟𝑜𝑤𝑖𝑛𝑔 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦) = 𝑟−𝑔 (1 − ( 1+𝑟 ) )
𝑃𝑉
𝐶 (𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦) =
1 1
(1−( ) )
𝑟 (1+𝑟)𝑁
𝐴𝑃𝑅 𝑚
1 + 𝐸𝐴𝑅 = (1 + ) = (1 + 𝐸𝑃𝑅)𝑚
𝑚
𝐴𝑃𝑅
𝐸𝑃𝑅 = 𝑚
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑅𝑎𝑡𝑒−𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒
𝑅𝑒𝑎𝑙 𝑟𝑎𝑡𝑒 = ≈ 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 − 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒
1+𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒
Page 5 of 9
Week 4: Bond and Stock Valuation
𝐶𝑜𝑢𝑝𝑜𝑛 𝑅𝑎𝑡𝑒×𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒
𝐶𝑃𝑁 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐶𝑜𝑢𝑝𝑜𝑛 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑌𝑒𝑎𝑟
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒𝑖𝑛𝑓𝑙𝑜𝑤𝑠
𝑃𝑉𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 = (1+𝑀𝐼𝑅𝑅)𝑁
𝑃𝑉
𝐸𝐴𝐴 = 1 1 𝑁
(1−( ) )
𝑟 1+𝑟
Page 6 of 9
Week 6 – Fundamentals of Capital Budgeting and Working Capital Management
𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = (𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 −
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) × (1 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒)
𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝐴𝑠𝑠𝑒𝑡 𝑆𝑎𝑙𝑒 = 𝑆𝑎𝑙𝑒 𝑃𝑟𝑖𝑐𝑒 − (𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 × 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛)
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑑𝑎𝑦𝑠 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 (𝑜𝑟 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑖𝑓 𝑔𝑖𝑣𝑒𝑛)
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑎𝑦𝑠 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐷𝑎𝑦𝑠 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑆𝑎𝑙𝑒𝑠
Page 7 of 9
Week 8 – Risk and Return
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖
𝜔𝑖 = 𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝐷𝑖𝑣1
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = +𝑔
𝑃𝐸
Page 8 of 9
Week 10 – Capital Structure
𝑉 𝐿 = 𝑉 𝑈 + 𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑)
𝑉𝐿 = 𝐷 + 𝐸
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 = 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 × 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑) = 𝑃𝑉(𝑇𝐶 × 𝐹𝑢𝑡𝑢𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠)
𝑃𝑉(𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑇𝑎𝑥 𝑆ℎ𝑖𝑒𝑙𝑑 𝑜𝑓 𝑃𝑒𝑟𝑚𝑒𝑛𝑎𝑛𝑡 𝐷𝑒𝑏𝑡 ) = 𝑇𝐶 × 𝐷
𝐷
𝑟𝐸 = 𝑟𝑈 + 𝐸 (𝑟𝑈 − 𝑟𝐷 )
𝐷
𝑟𝐸 = 𝑟𝑈 + 𝐸 (𝑟𝑈 − 𝑟𝐷 )(1 − 𝑇𝐶 )
𝐸 𝐷
𝑟𝑤𝑎𝑐𝑐 = 𝑟𝐸 𝐸+𝐷 + 𝑟𝐷 (1 − 𝑇𝐶 ) 𝐸+𝐷
Page 9 of 9