ECON F 315 / FIN F 315 - Comprehensive Exam Part B - 95 marks

Note:
All returns are on per annum basis unless explicitly mentioned
Underline the final answers
ONLY if any question lacks information, state your reasonable assumption and proceed
ATTEMPT ALL QUESTIONS SEQUENTIALLY 

1. ABC Limited is considering the purchase of a firm that would require an initial
investment of $300 million. The firm’s financial manager estimates that in all likelihood
the project will provide net cash flows of $40 million at the end of each of the next 20
years. The best estimate of the firm’s cost of capital for this as well as all the other
projects is given to be 13%.
However, the board of directors are sceptical of the management’s decision regarding
undertaking this project and you are privately hired by the board to provide
consultation services regarding the feasibility of this project.
You are now required to provide your analysis / estimates on the below tasks (show all
calculations, no subjective explanations required):

a. If the board believes that the manager’s claims regarding the project’s cash flows are
true, should the firm undertake this investment? Provide an objective (quantitative)
reason to support your conclusion.

b. Upon completion of the above task, you suggest to the board that, since economic
scenarios are not always very certain therefore it is advisable to construct probabilities
associated with the future cash flows. You advise the board to ask the management to
construct two probabilistic scenarios for project’s future cash flows. It is agreed that
that the projects cash flows may be as low as $30 per year or as high as $50 per year for
each of the next 20 years. You as a consultant provide the board your own minimum
acceptable probability estimate for the positive scenario. If the management’s estimate
exceeds your estimate the project will be accepted. What was your estimate of the
threshold probability of the good scenario (round off to the nearest whole number)?

2. Suppose you purchased an asset at the mid-year of a given year and want to
depreciate it using the MACRS approach. Prepare the annual depreciation schedule
(tabulate as given below) for the asset assuming its depreciable life of four years i.e.
asset classified as a 4 year property for tax purposes.

3. You are provided with the financial statements (including information on common
dividends) of the firm ABC Ltd. for two years 2012 and 2013. The firm’s tax rate is 40%.
Use the information given below to answer the following question. Show all necessary
steps and calculations and UNDERLINE the final answers.
a. What is the net operating profit after taxes (NOPAT) for 2013?
b. What is the investment (cash inflow/outflow) made by the firm on net operating
working capital (NOWC) that you will use for estimating the Free Cash Flow
(henceforth, FCF) for the year 2013?
c. What is the investment (cash inflow / outflow) made on fixed assets for FCF
calculation?
d. What is the FCF for the year 2013?
e. How much of the FCF did the firm use for each of the following (Hint: Remember that
a net use can be negative). In short, reconcile the FCF for the year with each of the
purposes given below.
a. After tax-interest payments.
b. Dividends to be received from other firms.
c. Net purchases of short-term investments.
d. Payment of dividends
e. Net short-term debt repayments
f. Net long-term debt repayments
f. Net common stock repurchases (buy-back)

4. A furniture manufacturer, call it FEO Ltd, is considering replacing its existing

finishing machine with a new machine. The existing machine has 6 years of remaining
usable (depreciable) life after which it can be sold for $800. The existing machine, if not
replaced, will have depreciation expenses of $650 for five years and $325 for the sixth
year. Its current book value is $3,575, and has a current market value of $5,200.
FEO Ltd. is considering replacing its old machine by a new improved machine that will
cost the firm $10,000 and in addition, 20% of the purchase price is charged as the
installation cost. The new machine has a useful life of 6 years with an estimated salvage
value of $1,450. The machine falls into the MACRS 5-year class, so the applicable
depreciation rates are 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76%. The new
machine is an improved version of the old machine and thus allows for expansion in the
firm’s output. Therefore, the sales are expected to rise by $1,800 per year; the new
machine’s greater efficiency would also reduce cash operating expenses by $1,700 per
year. Since the sales are expected to increase the firm will also make an additional
investment in the current assets to the tune of $3,200, at the time of making the
investment in the new machine. However, the accounts payables would simultaneously
increase by $900. The firm is in 40% tax bracket, and its WACC is 15%. Should the firm
replace the old machine? Clearly identify the initial, operating, and terminal cash flows
separately. Tabulate the operating cash flows. Note: Do not deduct the salvage value
from the original acquisition cost for estimating depreciation expense.

5. At the beginning of the new-year 2018 the total market value of ABC Ltd. was $60
million. During the year, the company plans to raise and invest additional $30 million in
new projects. The firm's current market value capital structure, given below, is
considered to be optimal. The same can be verified by comparing with the capital
structure of previous year. Also, there is no short-term debt.

Year begin. 2018 begin. 2017

Debt $30,000,000 $20,000,000
Equity $30,000,000 $20,000,000
Total Capital $60,000,000 $40,000,000

New bonds have an 8% coupon rate, and they will be sold at par. Common stock is
currently (begin. 2018) selling at $30 a share. The analysts use constant growth model
for estimating the required return on the firm's stock. The most recent (end of last year)
dividend paid by the firm is $1.11 and the firm is expected to pay $1.2 per share
dividend by this year-end (end of 2018). The firm's marginal tax rate is 40%.

a. In order to maintain the present capital structure, how much of the new investment
must be financed by common equity?
b. Assuming there is sufficient cash flow available with the firm to maintain its target
(optimal) capital structure without issuing additional shares of equity, what is its
WACC?
c. Suppose now that there is not enough internal cash flow and the firm must issue new
shares of stock. Qualitatively speaking, what will happen to the WACC? No calculations
or numbers are required to answer this part.

6. Given a random variable (stock) X:

Probability State of Return

of State of Nature
Nature
.2 I 18
.2 II 5
.2 III 12
.2 IV 4
.2 V 6

Calculate:
a. Mean (X) b. Variance (X) c. Coefficient of variation (X)
d. If this asset were to be combined with a risk-free asset to form a portfolio, then show
that the investor will short the risk-free asset if the risk of the portfolio exceeds the risk
of stock X.

7. As an analyst you believe that a real option approach to project evaluation is valuable
for financial manager because it addresses the shortcomings and the myopic approach
followed in the conventional NPV analysis. Once, while discussing the project proposal
with the financial manager you argue that overlooking real options approach for project
evaluation may result in rejecting several viable projects. One such case comes up
during the discussion when the manager puts forth her estimates regarding
undertaking a project for which the firm has a patent that was bought through auction
for $3 million. This patent provides the legal right of production and sales to the patent
holder and thus grants immunity to the firm from any possible outside competition for
several years (i.e. it acts like a barrier to entry).
According to her estimates, the project requires an investment of $100 million. The
project has a life of 3 years and the appropriate cost of capital for this project is 10%.
The project’s cost of capital is estimated at 4% premium over the risk free rate. The
manager also provides her estimates regarding the likelihood of all possible economic
scenarios that will prevail from t=1 through t=3 and its associated cash inflows under
each possibility. For the sake of simplicity it is assumed that under all economic scenarios
the future cash flows are known with certainty (refer to the table given below).
The financial manager is concerned because the expected NPV of this project is very
negative under one scenario and thus proposes that the project must not be undertaken
because of the uncertainty involved.
Probability Year 1 Cash Flow Year 2 Cash Flow Year 3 Cash Flow
($ mn) ($ mn) ($ mn)
.3 (good) 65 65 65
.4 (normal) 42 42 42
.3 (bad) 17 17 17

After analysing the above given information you are even more convinced of the
application of real options approach in this case. As an analyst you are required to
provide consultancy services to your client by answering the following questions (Use
decision trees wherever appropriate):

a. Given the above information, carry out a quantitative analysis to show that utilizing
the investment-timing option makes this project more attractive compared to static
(traditional) NPV analysis? Show steps and necessary calculations for arriving at the
conclusion supporting your argument in favour of the importance of investment timing
option in this case. No subjective / qualitative explanations required. (Hint: compare
the expected NPV of the project with / without investment timing option).

b. Help the financial manager by calculating the value of the real option using Black-
Scholes model. Clearly identify all the variables required for valuing the real option with
appropriate calculations / steps wherever required. The standard deviation (σ) of the
project’s cash flows’ rate of return for the Black-Scholes model is 35%.
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