Questions 1-13 ONLY. the file is attached below!
FIN555-1045 Final Exam Don Storm CFA, Adjunct Instructor (847) 207-3780
[email protected] Questions 1 through 17 are worth 4 points each. Questions 18 through 23 are worth 2 points each. Questions 24 through 27 are 1 point extra-credit questions. Question 28 is worth 20 points. Please do your best to answer the questions completely. Show your calculations and BE NEAT. Draw number lines! Try to understand and address the importance of each concept and explain WHY the concept is important. When calculations are necessary be sure to CIRCLE YOUR ANSWER. Remember: This exam must represent your own work. No collaboration allowed. Good luck! ______________________________________________________________________________________ 4 Point Questions: 1. Your crazy brother-in-law has discovered a map to the Lost Dutchman gold mine in the Arizona desert. He wants you to give him $10,000 today and then another $10,000 every year for the next 5 years to help fund his expedition. He’ll then give you $100,000 in Year 6 when the gold is recovered. Use a discount rate of 12%. What is the NPV and IRR of this proposal? What does the IRR tell you and do you trust it? Why or why not? What components go into your personal choice of discount rate? 2. Describe the factors that a company considers when choosing an optimal debt ratio. Which of these factors will inevitably limit the amount of debt a company issues? What are the effects of leverage on equity beta (β), WACC, and risk? What is the “Trade-Off Theory” and how does it affect the decision-making process? Generally speaking, why is debt cheaper than equity? 3. We performed various Dividend Discount Model experiments in class and they were all unmitigated disasters. Why? What could we have done to get better, more accurate results? What do you consider to be the strengths and limitations of this analytical technique? mailto:
[email protected] Nida Rasool 2 4. We are living in interesting times. Over the past 2 weeks, the S&P 500 Index has dropped over 10%. At the same time, the short-end of the U.S. Treasury yield curve is approaching zero and long-dated yields are at all-time lows. Please evaluate the dynamics of this situation. If the risk-free rate is falling, why aren’t asset prices increasing? How would you describe the flow of funds and the direction of causality? What does CAPM say about equity beta (β) in the current environment? What predictions can you make based upon the current U.S. Treasury yield curve? 5. You are trying to determine the equity beta (β) of a privately held company, Summa Corporation, that is not required to publish its financial information. The average asset beta from a group of comparable companies is 1.28. If Summa Corp has a debt/equity ratio of 30% and the tax rate is 35% what is its equity beta (β)? Why do we use asset betas for the comparable companies rather than equity betas? What is the appropriate method to determine comparable companies? What are the risks involved? 6. If the historical return over the past 30 years of the S&P 500 Index is 8% and the risk-free rate (as measured by the 30-Year Treasury Bond) is 3%, what is the equity cost of capital for Summa Corp? If Summa’s long-term debt trades at Treasuries plus 1.25% what is Summa’s WACC? What two factors are the biggest determinants of equity cost? How would you explain these factors to a non-finance person? 7. With reference to the Capital Asset Pricing Model, provide 6 characteristics of the Efficient Frontier. What does it mean to borrow or lend at the Risk-Free Rate and how does that affect equity beta (β)? Describe the tangency point where the Capital Market Line meets the Efficient Frontier. 3 8. You have an opportunity to buy a Magic Box. At the time of purchase the Box spits out $100. It will then give you $60 on the anniversary of its purchase for the next 7 years. After that it pays you $40 per year forever. What is the value of the Box? Use a discount rate of 6%. If the Box were a tradable security, what would be the NPV of the purchase? Describe how Ocean Carriers is like a Magic Box. How is it different? 9. What are the effects of diversification on both systemic and idiosyncratic risk? What part does correlation play in diversification? Generally speaking, how is one compensated for taking on idiosyncratic risk? How do we measure a security’s systemic risk? 10. You are considering buying $10,000 worth of bonds in Peridox Corporation. You have a choice of two bonds, both of which yield 8%. One bond has a 6% coupon and the other bond has a 10% coupon. Which bond do you want to buy if you want to minimize your interest rate risk? What is the PV of this bond if it pays its coupon annually? What is the NPV of this transaction? What is the difference between a bond’s coupon and its yield? What is meant by a bond’s duration and under what circumstances would a bond’s duration equal its maturity? 11. Congratulations! You have just won a $20 million Powerball Lottery. You have a choice of payouts. You can either take a $15 million lump-sum today or you can receive an annuity of $1 million for the next 20 years. Assuming a discount rate of 3% which one should you choose? What if the annuity grows at 1% per year? Please show all calculations. Nida Rasool Nida Rasool 4 12. You have been asked by your CFO to analyze three (3) positive NPV projects. She wants to know which ones to pursue and which ones to forego. In general terms, how would you advise her? Where does IRR come into play? She doesn’t want to make a costly mistake so she tells you to crunch the numbers using conservative cash-flow and discount rate estimates. What are your thoughts about this? She is particularly intrigued with one project with a positive initial cash flow and a very high IRR. How should you proceed? 13. The CEO of your company has told you, in confidence, that he is willing to forego positive NPV projects if it means he can avoid negative NPV projects. What do you think of this comment? Assess the validity of his opinion from both a financial and organizational perspective. What advice would you give the CEO? How does the concept of Opportunity Cost influence this decision? 14. We are experiencing a possible worldwide pandemic of the so-called Coronavirus (COVID-19). Please describe what Type I & II statistical errors would look like with reference to COVID-19 testing. Which one is worse from a public health standpoint? 15. In the Midland Energy case, what is the inevitable result of using a consolidated WACC rather than individual WACCs for each division? How do Type I & II statistical errors come into play? Is either error worse than the other? Why or why not? Please illustrate the Midland statistical errors with a diagram. 5 16. Describe the relationship between the corporate tax rate and WACC. How does the presence of taxes affect the Modigliani-Miller Model? How would you calculate the value of a company’s tax shield? For any given company, what is the upside limit of WACC? 17. It has been argued by some that lowering the corporate tax rate in 2018 did not lead to new jobs and investment, but rather companies using their tax savings to buy back their own stock. Evaluate Janet Mortensen’s policy of buying back Midland Energy stock. Why does she do this? Are her reasons valid? What discount rate should she use to calculate Midland’s enterprise value? Generally speaking, can a company increase its value by buying back its own stock? Why or why not? ______________________________________________________________________________________ 2 Point Questions: 18. Every company can be valued as _______________________________________________________. 19. The Modigliani-Miller Model is a formalized version of _______________________________________. 20. The “Law of One Price” can also be called ________________________________________________. 21. The concept describing a company’s value as the sum of its projects is _________________________. 22. The Waldorf-Astoria Hotel in NYC is an example of _________________________________________. 23. Where can 95% of tough analytical problems be solved?_____________________________________. ______________________________________________________________________________________ 6 1-Point Extra Credit Freebies: 24. A restaurant can have great food and a so-so atmosphere. Or it can have average