Mid Term Exam

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FIN413 – Practice Midterm Exam
Fall 2012

Boris Nikolov

William E. Simon Graduate School of Business Administration
University of Rochester

Name ______________________________



Please do not open exam until instructed to do so



Exam is 2 hours



This is a closed book exam



One page of personal notes allowed



Please do not sit in adjacent seats



Please write only in the space provided for each question



You need a pocket calculator



Good luck!

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GRADE SHEET
INSTRUCTOR USE ONLY

Question 1: _____________
Question 2: _____________
Question 3: _____________
Question 4: _____________

Total number of points: _____________

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Problem 1
“The way I see it,” says the CFO of Milk Em Dry, Inc., “if I buy half of the 10,000 outstanding common shares with the proceeds from the sale of debt, I can increase earnings per share. After all, I can borrow at 10% and I am currently earning 20% on my al l-equity-financed firm. I estimate the beta of the borrowed money at 0.40 and the beta of my equity before borrowing at 1.20. The price-earnings ratio (P/E) of the common shares is 5 on operating income of $25,000; and I expect to continue to generate that amount of operating income after the debt financing. Seems to me this will be a good deal for shareholders, and they are the one’s I’m working for. In fact, it would be dumb not to go into debt.”

Your job is to help this CFO determine whether to borrow or not. Assume perfect capital markets with no taxes. Also, to make life easier assume all cash flows are perpetuities. Determine the EPS, the return on equity, and the value of the firm under the two scenarios. How do you interpret the results?

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Problem 2
Midcap Corporation (MC) will cease to operate in one year. The firm is currently all-equity financed, and has 10 million shares outstanding. In one year, MC’s projects will generate earnings before interest and taxes of $90 million, $180 million or $225 million with equal probabilities (in the Bad, Medium and Good states respectively). Assume that the physical assets are completely worthless in all three states of the world at that time. The risk is all idiosyncratic, and so all cash flows can be discounted at the same riskfree rate of 20%. The corporate tax rate is 20%.

(a) What is the current value of MC equity and its price per share?

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The firm is considering a debt issue whose proceeds will be used to repurchase some of its equity. Two sizes are being considered for this one-year debt contract: a promised payment of $60 million or a promised payment of $120 million. If MC defaults on its debt, it is anticipated that 80% of the available money will be lost to bankruptcy frictions (e.g., legal costs). To simplify calculations, assume that the entire payment on the debt (not just the interest payment) is tax deductible.

(b) Suppose that MC chooses the debt with the $60 million promised payment. After the debt issue and equity repurchase, what is the value of the debt, the value of the equity, and the total value of the firm? Also, what is the price per share, and how many shares are repurchased?

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(c) Suppose instead that MC chooses the debt with the $120 million promised payment. After the debt issue and equity repurchase, what is the value of the debt, the value of the equity, and the total value of the firm? Also, what is the price per share, and how many shares are repurchased?

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(d) What is the optimal financing of the firm (no debt, debt with a $60 million face value, or debt with a $120 million face value)? Intuitively explain why (in 2-3 sentences).

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Problem 3
Zymase is a biotechnology start-up firm. Researchers at Zymase must choose one of three different research strategies. The payoffs (after-tax) and their likelihood for each strategy are shown below. The risk of each project is diversifiable.

Strategy
A
B
C

Probability
100%
50%
50%...
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