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BUSFIN 1030 Introduction to Finance Tuesdays 5:45 – 8:10 p Corporate Finance EXAM 3&4 Complete and submit Exam 34 by 11:00 PM on Sunday, May 3. No late submissions will be considered for a grade! Students are not allowed to discuss the exam with their classmates, colleagues, friends, internet buddies, etc. prior to the submission!! The submitted answers must be your own work. Show all your work!! A correct result without relevant (and correct!) explanation will be awarded with zero points. Important: As future financial economists, analysts, captains of industries, etc., you must be able to present your results in a concise and understandable manner. Therefore, it is your responsibility to make sure that I understand the way you interpret your work, logic, etc. Unclear work will be awarded with zero points. The exams must be electronically submitted IN THE WORD FORMAT (extension *.doc) on Blackboard. When submitting files, you must include your name and the name of the assignment in the file name. If Jane Doe was submitting an assignment, the filename would be: doej_exam34.doc Also, make sure to include your name, course name, and page number in the header or footer of the document. Good luck! Question 1 (6 points) Assume that the volatility of United Airlines Holdings Inc (ticker: UAL) stock is σ = 110% per year. (i) Based on formulas/techniques you learned in this course ONLY, compute *today’s* value of the following option on UAL stock: · EUROPEAN CALL option on UAL stock issued today with exercise price X=$35 and maturity of *exactly* 6 months from today (Don’t forget to list ALL the input values: S,X,T,r,σ; as well as mention the today’s date.) (ii) Based on formulas/techniques you learned in this course ONLY, compute *today’s* value of the following option on UAL stock: · EUROPEAN PUT option on UAL stock issued today with exercise price X=$25 and maturity of *exactly* 6 months from today (Don’t forget to list ALL the input values: S,X,T,r,σ; as well as mention the today’s date.) A) You DO NOT believe the current stock price of UAL is correct. Instead, you feel that within the next 6 months, due to the uncertain recovery from coronavirus crisis, the UAL price will either be significantly below OR significantly above the price you see today. Create the simplest investment strategy based on the above belief. You are allowed to do only the following: a) buy or sell ONE European call option on UAL with maturity of 6 months, issued today with the exercise price X=$35 b) buy or sell ONE European put option on UAL with maturity of 6 months, issued today with the exercise price X=$25 c) buy or sell ONE share of UAL at today’s price I ABSOLUTELY DO NOT CLAIM YOU NEED TO DO ALL THREE ABOVE ACTIONS (a,b,c)! ONE OR TWO MAY BE PERFECTLY SUFFICIENT! (i) Explain what exactly will you do in order to profit from your belief TODAY and why this is the right strategy (1-2 sentences) (ii) Assume there are three possible scenarios of UAL price in exactly 6 months: 1. UAL price exactly 6 months from today = $3 2. UAL price exactly 6 months from today = $34 3. UAL price exactly 6 months from today = $85 For each of the three above scenarios, provide the following information: Possible UAL price in 6 months: $3 $34 $85 How much money will you receive (+) or pay (-) from your strategy today? How much money will you receive (+) or pay (-) from your strategy 6 months from today (i.e. when you may or may not exercise options, liquidate the stock position IF it was a part of your strategy, etc.)? Ultimate profit/loss of your trading strategy (after you consider ALL cash inflows/outflows both today and 6 months from today)* * Disregard time value of money – that is, do not discount. Disregard various transaction fees (such as commissions), and assume that you will indeed be able to buy/sell precisely one option. In order to increase the chance for partial credit, you may want to describe your Ultimate profit/loss calculations in detail, and/or provide a simple graph (not necessary). Question 2 (8 points): A) Pick one protective covenant that can be written into a debt contract (ANY, as long it is a covenant we discusses in our class). Describe WHY debtholders may like to have such a covenant written into a debt contract. (1-2 sentences) B) Relying STRICTLY on our classroom discussion: It appears that firms requesting monetary assistance from the US government during the time of the current coronavirus crisis will have to firmly commit NOT to buy back their own stocks for a very long time. While there may be benefits associated with requiring such a commitment (after all, the firms will be bailed out by our own – public – money), I want you to discuss TWO reasons (1-2 sentences per reason) why inability to initiate stock buybacks for a long time may be detrimental and value reducing for the affected firms. C) Describe one of the indirect costs of debt (1-2 sentences) D) Relying STRICTLY on our classroom discussion: what types of firms would benefit from providing significant dividend payments to their shareholders (1-2 sentences) E) The need for financial flexibility is sometimes used as explanation for the tendency of US firms to utilize LOWER D/V ratios compared to the (optimal) target ratios based on the trade-off between tax benefits and distress- or agency-related drawbacks associated with debt financing. Which types of companies would you expect to have the greatest need for financial flexibility? (1-2 sentences) F) Describe one of the agency costs of debt (1-2 sentences) Question 3 (6 points): A large US city wants a major manufacturing company to build a big factory in that city. The manufacturing company estimates the initial cost to be $360 million (to be paid at T=0). The project benefits are expected to be $40 million EVERY year starting in year 3, for the following 50 years (assume the cash flows will be generated at the end of year 3, year 4,…, year 52). The WACC for the project should be 10%. A) What is the NPV of such a project? Would you accept it? Why or why not? (1 sentence) B) Assume, in addition, that the city really wants the factory to be built even in the current uncertain environment. Consequently, the city offers the manufacturing company the following deal: If the manufacturing company indeed invests $360 million at T=0, it will have the opportunity to walk away from the project EXACTLY 2 YEARS FROM NOW. The manufacturing company will give up all the future benefits of the project, but it will get a one-time payment of $280 mil guaranteed by the city. The manufacturing company understands that the project benefits are uncertain, and they can change in the future. In fact, the annualized volatility of changes in the present value of project benefits is 50% per year. What is the dollar value of the above guarantee? How will the guarantee change the decision of the manufacturing company to accept the project? C) If a project with the same characteristics (Costs = 360 mil, PV of benefits = whatever you estimated in part A; the opportunity to abandon it after 2 years for $280 mil) were to be considered by a water utility company, the value of the city guarantee would likely be higher / lower / equal to the value you computed in part B. (Pick the correct choice and explain why in one sentence) (NO CALCULATION needed for part C. The answer should be centered strictly on finance intuition based on the expected difference between manufacturing and water utilities.) Question 4 (10 points) Compute the most recent Book and Market Value Economic Value Added (EVA) for Costco (ticker COST): Assume that in terms of financial statements, February 2020 (i.e. Q1/2020) data is the most recent you can get. A) Assume that the most recent pre-tax RD = 1.5%. These are the most recent Operating Leases for COST (values in $mil): Compute the most recent value of Operating Leases Debt (i.e. the PV of all future operating leases obligations). Hint: (a) Year 2020 is your “Year 1”. B) Here is the most recent Balance Sheet (make sure you look at February 2020): https://www.nasdaq.com/market-activity/stocks/cost/financials Compute the most recent (Book Value of) Invested Capital. Hints: i. Please, DO NOT consider “Cash” and “Short Term Investments” to be a part of “Operating Current Assets” ii. “Accounts Payable” should be THE ONLY considered part of “Operating Current Liabilities” iii. Note that Invested Capital should be computed as Net Working Capital + (all possible sources of) Long Term Assets + ADJUSTMENTS C) Compute the most recent Market Value of Invested Capital. Hints: i. Remember that V = E+D, where E = Market Value of Equity (by now you have to remember what needs to be factored into this value) and D = value of Debt (and, after Week 10, you need to remember that Debt may be listed not only on the Balance Sheet, but also off the Balance Sheet). D) Use the same Yahoo Finance Link (https://www.nasdaq.com/market-activity/stocks/cost/financials ) to get the most recent annual value of EBIT (note that EBIT is often referred under its synonym “Operating Profit”). Hint: Naturally, the latest ANNUAL profit should be the sum of the last four QUARTERLY profits. Assume tax rate TC = 21%. Compute the most recent NOPLAT. Hint: Don’t forget that there may be adjustments due to operating leases! E) Assume that the most recent WACC = 5.4% Compute Book Value based EVA for COST. INTERPRET THE RESULT! Compute Market Value based EVA for COST. INTERPRET THE RESULT! (Hint: Interpret the values STRICTLY based on the signs of the EVA and the meanings of positive/negative EVA as discussed in our course.) F) Briefly (1-2 sentences) explain why EVA gives arguably the best estimate of firm’s true profitability. Question 5 (2 points) You moved to Prague to work for a large investment bank. Your task is to figure BOTH pre-tax and after-tax cost of debt (Rd) for a small Czech producer of auto parts. This is the company’s income statement (in CZK million): Sales 950 Cost of Goods Sold -600 Selling, General, and Administrative Costs -100 Depreciation -50 Earnings Before Income and Taxes 200 Interest Expenses -34 Taxable Income 166 Taxes -32 Net Income 134 Question 6 (8 points): You moved to Lisbon to work for a large investment bank. Your first job is to compute the (US Dollar-based) WACC of Energias de Portugal (EDP; the largest electric utility in Portugal): https://www.edp.com/en https://en.wikipedia.org/wiki/Energias_de_Portugal Assume the company wants to use the WACC to value a FIVE-YEAR project: *** Assume that despite operating in multiple countries,