SECTION A (3 multiple-choice theoretical questions – Total: 6 marks)

Question 1

Which of the following statements is FALSE?

A. An important consequence of leverage is the risk of bankruptcy.

B. Whether default occurs depends on the cash flows, not on the relative values of the firm's assets and liabilities.

C. Economic distress is a significant decline in the value of a firm's assets, whether or not it experiences financial distress due to leverage.

D. Modigliani and Miller's results continue to hold in a perfect market even when debt is risky and the firm may default.

ANSWER: B

Explanation: Whether default occurs depends on the relative values of the firm's assets and liabilities, not on its cash flows.

Question 2

Consider the following equation:

  =  ×

the term  in this equation is:

A. the firm's target debt to value ratio.

B. the firm's target debt to equity ratio.

C. the investment's debt capacity.

D. the dollar amount of debt outstanding at time t.

ANSWER: C

Question 3

Which of the following statements is FALSE?

A. In the real option context, the dividends correspond to any value from the investment that we give up by waiting.

B. By delaying an investment, we can base our decision on additional information.

C. Given the option to wait, an investment that currently has a negative NPV can have a positive value.

D. If there is a lot of uncertainty, the benefit of waiting is diminished.

ANSWER: D

Explanation: If there is a lot of uncertainty, the benefit of waiting is increased.

SECTION B (2 multiple-choice numerical questions – Total: 4 marks)

Question 1:

Monsters Incorporated (MI) is ready to launch a new product. Depending upon the success of this product, MI will have a value of either $100 million, $150 million, or $191 million, with each outcome being equally likely. The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%. Assume that the capital markets are perfect.

Suppose that MI has zero-coupon debt with a $125 million face value due next year. The initial value of MI's debt is closest to:

A. $125 million.

B. $111 million.

C. $100 million.

D. $116 million.

ANSWER: B

Explanation:

Vdebt  =                     1.05                            million = $111. 11 million

Question 2:

Omicron Industries' Market Value Balance Sheet ($ Millions)

Omicron Industries' New Project Free Cash Flows ($ Millions)

Assume that Omicron has WACC of 9. 1%, and this new project is of average risk for Omicron, and that the firm wants to hold constant its debt to equity ratio.

The debt capacity for Omicron's new project in year 0 is:

A. $38.75 million.

B. $75.50 million.

C. $50.00 million.

D. $10.25 million.

ANSWER:  C

Explanation:

 =  +  +  = $124.87

 0  =  ×  =  × 124.87 = $49.95

SECTION C (2 short-answer questions – Total: 10 marks)

Question 1:

a. Between an office building and a brand name, which one is more likely to be liquidated for close to its full market value in the event of financial distress? Why?

b. Suppose Luther Industries is considering opening a new product line. The product line is expected to generate free cash flow of $2 million in the first year, and this free cash flow is expected to grow at a rate of 3% every year thereafter. Luther currently has a debt-equity ratio of 2, an equity cost of capital of 10%, a debt cost of capital of 7%, a corporate tax rate of 21%. Luther will maintain a constant debt-equity ratio for the expansion.

(i) Calculate the total value of this expansion using the WACC method (ii) Calculate the present value of the interest tax shield

Suggested solution

a. Compared with a brand name, an office building is more likely to be liquidated for close to its full market value in the event of financial distress. It is because there are many alternate users who would be likely to value the property similarly.

.

(i)

 =  ×  +  ×  × (1 −  ) =  × 10% +  × 7% × (1 − 21%) = 7.02%  =  = $49.75 

(ii)

Method 1:

 =  ×  +  ×   =  × 10% +  × 7% = 8%

0  =  = $40

(  ℎ) =  − 0  = 49.75 − 40 = $9.75

Method 2:

 0  =   ×  =  × 49.75 = $33. 17 

    1 =  × 0  = 7% × 33. 17 = $2.3219

  ℎ1  = 2.32 × 21% = $0.4876

(  ℎ) =  = $9.75

Question 2:

a. Describe the benefits and costs of delaying an investment opportunity.

b. R. Branson & Assoc. provides tourists with hot-air balloon flights over the city. As their current balloon is due to be retired, they must decide whether to replace it with a large or small model. The balloons have an expected life of 2 years, after which salvage value is zero. Market research has estimated that there is a 75% probability that demand will be high in the first year. If the demand is high in the first year, there is an 80% probability that it continues to be high in the second year. However, if the demand is low in the first year, there is an 80% probability that it continues to be low in the second year.

Mr. Branson has summarised the costs and cash flows below.

Initial Costs:

Large Balloon: $135,000                    Small Balloon: $90,000

Annual Cash Flows:

High Demand

Low Demand

Large Balloon

$100,000

$55,000

Small Balloon

$70,000

$45,000

In the event of low demand, the balloons can be sold for 45% of their initial cost at the end of the

first year.

Ignore the effect of taxes, and use  10% as the required rate of return. Mr. Branson has computed that the net present value of purchasing the small balloon is $18,574.38.

Which balloon should R. Branson & Assoc. purchase? Why?

Suggested solution:

a.  By delaying, you delay the benefits of taking on the project and your competitors might take advantage ofthis delay. However, by delaying, uncertainty can be resolved, so you can become better informed and make better decisions.

.