Finance Re-Exam 3

HA/RUC
Re-Exam Finance 26th of January 2015
4 hours written exam

Open Book
It is not allowed to connect the internet during the exam.
The exam consists of 4 questions. A percentage is given at each question, which is guidance concerning the
time to use on the answers. These percentages should not be interpreted as a weight of the total points.
Question 1 (25%) – Future Values, Present Values and Annuities
You finish university and start working at a company when you also start thinking about planning your pension.
You still have 30 years of work in front of you before going in pension and wish to start contributions as soon as
possible. You believe that you can get a good return to your pension fund that equals r = 6% a year
compounded monthly. Ignore taxes in your calculations and assume that the company does not contribute
with your pension fund.
a) What is the effective annual rate you expect for your pension fund?
b) If you expect to live 25 years after your retirement date, and you wish to receive a pension of DKK
40,000 a month during this time, how much money should you have in your pension fund’s account in
the day of your retirement?
c) In order to achieve the value you have calculated in question “b”, how much should you contribute
every month to your pension fund during the 30 years of your working life (find the value for a fixed
contribution)?
d) Now, assume that the company will contribute with your pension fund with 2 million DKK paid at once
when you complete 15 years of work. With how much should you contribute monthly to achieve the
same value in your pension’s fund account at the day of your retirement?
e) Please explain the concept of “time value of money” and its connection to the financial techniques you
used in the prior questions.
Hint: You can answer question “e” without having answered the prior questions.
Question 2 (25%) – NPV x IRR
You were just hired as financial analyst for the Wayne Enterprises and your first job is to evaluate the viability
and return of 3 different mutually exclusive investments. The cash flows of these investments are summarized
in the table below. In a meeting with Mr. Fox, you find out that the company has no debt, the risk free rate is
4% per year, the expected return of the equity market index is 10% per year, and the beta of Wayne
Enterprises equals 1.5. Ignore taxes in your calculations.
Year Investment A Investment B Investment C

0 -100,000 -100,000 -100,000
1 10,000 70,000 1,000
2 50,000 50,000 55,000
3 80,000 10,000 10,000
4 20,000 20,000 120,000
a) Calculate WACC.
b) Use WACC to calculate the net present value (NPV) of each of the different projects? Which is the best
investment according to this criterion?
c) What is the Internal Rate of Return (IRR) of the 3 different investments? Which of them would you
choose according to this criterion?
d) Which criterion would you finally chose (NPV or IRR) to take the final decision? Why? Explain the
ranking problem associated to the IRR.
e) A friend of yours advices you that the solution of simply using WACC as discount rate to the 3 different
projects could be “dangerous” and that the NPVs calculated in question “b” are questionable. Please
comment why he believes that different rates should be used according to each project. Do you agree?
Hint: You can answer questions “d” and “e” without the results of questions “a”,” b” and ”c“.
Question 3 (25%) – Loans
You decide to take a loan at a bank in order to have money to spend during your lovely vacations in Disneyland.
You calculate that you need around 50,000 DKK to pay the costs of your vacations and decide to take a loan of
exactly the same amount (50,000). The interest rate the bank will charge you is 8% per year. You plan to pay
the loan back to the bank in equal monthly payments during a period of 5 months (payments are done at the
end of each month).
a) Which is the value of the constant payment you will need to do?
b) Compute the amortization schedule.
c) Now, assume you would prefer to pay the loan back to the bank in a lump sum (all at once) in the
end of the 5th month. How much would have to pay to the bank at the end of the 5th month,
assuming the bank would charge you the same interest rate of 8% on the loan?
Question 4 (25%) - Modigliani and Miller without taxes
Mr. Jameson, chief publisher of the tabloid “The Daily Bugle” is willing to make a valuation of his company in
order to access his fortune as single owner. As always, he leaves the hard work for one of his photographers
Mr. Parker, who asks your help as financial analyst to assess the value of the company. Below some of the
company’s characteristics:
D/E 0
Rd 11%
T 0%
EBIT 100,000 every year forever
Rf 11%
Rm 18%
Beta 1.5
“D” is the market value of debt, “E” is the market value of equity, “Rd” is the cost of debt before taxes,” T” is
tax rate, “EBIT” is earnings before interest and taxes, “Rf” is the risk free rate, “Rm” is the market return of the
stock index and “Beta” is a measurement of systematic risk of the company. Assume that both depreciation
and net-investment (replacement) are zero, the company has no current assets and no current liabilities and
that it will add nothing to retained earnings in the future. All net income is paid out as dividends.
a) Calculate the cost of equity capital “Re” of the company using the security market line (CAPM).
Calculate WACC.
b) What is the total value of the company? What is the value of debt? What is the value of equity?
When analyzing the cost of capital of the company, you advice Mr. Parker about what you have learned in the
financial lectures at RUC regarding the propositions of Modigliani and Miller without taxes.
c) If the company borrows 100,000 and uses the money to repurchase shares of Mr. Jameson, what is the
new total value of the company, the value of equity and the value of debt?
d) In this case, what would the cost of equity (Re) be? Please calculate also the new value for WACC.
e) Does the choice of capital structure influence the total value of the company and WACC when there
are no corporate taxes? Why?
Hint: You can answer question “e” without the answers of the prior ones.
Good Luck!!!!

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HA/RUC

Re-Exam Finance 26th of January 2015

4 hours written exam

It is not allowed to connect the internet during the exam.

Question 2 (25%) – NPV x IRR

Year Investment A Investment B Investment C

Question 3 (25%) – Loans

Question 4 (25%) - Modigliani and Miller without taxes

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