Balance Sheet Current Assets Excess Cash 2,322 Required Cash 12,000 17,500 Inventory 2,671 4,699 Accounts Receivable 5,479 7,671 Total Current Assets 22,472 29,870 FIN 305W *QUICK SOLUTIONS * Midterm 2 *THERE WERE TWO VERSIONS OF THE Fall 2023 EXAM - JUST DIFFERUNT #s* 1) Free Cash Flows [9 points]: Calculate the Free Cash Flow for the Projected year 2023 given the information below. The projected relevant tax rate = 24% Assets Actual Projected 2022 2023 EBIT (1-E) = 9,760 (176) = 7,418 I/s = 19,500 =(30,000) -ANOWC = (27,856-18,912) = (8,939) + DEPR - CAPEX = BELOW (52,021) Net Equipment 195,000 245,500 FCF -52,021 Total Assets 217,472 275,370 Liabilities & Owners' Equity Actual Projected Current Liabilities Income Statement 2022 2023 Notes Payable Revenue 5,000 50,000 70,000 Cost of Sales Accounts Payable 1,233 2,014 (20,000) (24,500) Gross Profits 30,000 Total Current Liabilities 1,233 7,014 45,500 Operating Expenses Long Term Debt 30,000 50,000 Depreciation (18,000) (19,500) Total Liabilities 31,233 57,014 G&A (8,023) (16,240) Common Stock Total Opex (26,023) (35,740) Par and APIC Retained Earnings Total Stockholders' Equity 167,239 193,763 19,000 24,594 186,239 218,356 Interest Expense (2,400) Total Liabilities & Owners' Equity 217,472 275,370 Earnings before Tax Tax Expense Net Income 3,977 7,360 (795) (1,472) 3,182 5,888 NOWC 18.917 27,856 (NOT INCLUDE N/P OR EXC, CASH!) CAPEX ANPPE + DEPR = (245,500-195,000) +19,500 = 70,000 Formula Sheet Time Value of Money: PV FV / (1+r)* D E+D+P WACC = E E+D+P re+ D (1 tc) + P E+D+PP CAPM: E[R] = r + Bi(E[RM] - rf) BL Bu = [1+(1-T) x (D/E) ] CF PV perpetuity T-g T = Div / Price Net Capital Spending = Ending net fixed assets - beginning net fixed assets + depreciation The Bi (slope) Covariance (Ri,RM)/Variance (RM) = Correlation (Ri,RM); / OM FIN 305W Midterm 2 Fall 2023 2) [25 Points]: Given the assumptions below, calculate the Weighted Average Cost of Capital (WACC). The company has historically been 50% Technology and 50% Service, However, the forward-looking company's business mix is projected to be 65% Technology and 35% Service. When aggregating unlevered betas, use the equally-weighted averages for each business unit. To ease your calculation burden, you can assume that the average of the unlevered betas for the Technology Unit 1.0178. Service Business Unit Comparable Firms Firm A Observed Beta D/E Tax Rate 0.833 0.13 26% 0.942 0.28 31% 0.886 0.23 28% Firm B Firm C Technology Unit Observed Comparable Firms Beta D/E Tax Rate Firm X 1.510 0.65 27% Firm Y 1.589 0.76 31% Firm Z 1.927 1.27 25% Risk Free Rate 2.40% Expected Mkt Return 7.90% Preferred Stock Quarterly Dividend / Share $ 0.46 Price/Share when issued $ 25.00 Current Price/Share $ 26.75 Most Recent Debt Rating Default Spread Firm's Target Ratios Equity/Value Preferred/Value 2.06% 0.60 0.10 B's = Poes /(1+ (1-0)) B=833/(1+1)=7599 DLP = .942/(1+.28 (.69)) = .7835 Pu .866/(14.23 (132)) = .7430 BS STEAK 1.0178 TECH - B=7641 .65(1.0138) +.35(2641) .6616 4.2674 = .9290 09290 (14.6361-35)) = 1.334 CAPM Te = 2.40% 1.334 (7.90%-2.40%) = 9.737% r = 2.40% +2.06% = 4.46% Debt/Value 0.30 Debt/Equity 0.67 Firm's Marginal Tax Rate 35% Firm's Observed Beta 1.765 p= .46(4) 26.75 = 6.879% => WACC = .6 (9.737%) +.3 (4.46%) (1-.35) + .1 (6.879%) = 5.8422% +0.8697% 0.6879% =17.40% FIN 305W Midterm 2 Fall 2023 112 points] CLEARLY CHOOSE AND CIRCLE EITHER (A) OR (B) IN THE SPACE PROVIDED - I WILL NOT GRADE BOTH... A) Traditional Corporate Finance Theory typically assumes that bondholders are protected from shareholders (or managers) "ripping them off." Briefly explain two fundamentally different examples of shareholders potentially extracting value from bondholders. B) Managerial compensation packages often include stock options with the goal of aligning managers' incentives with those of the shareholders. These call options give the manager the right, but not the obligation to purchase shares at the strike price on or before a certain maturity date. Discuss two fundamentally different possible complications that might arise with certain options (think about option's maturity and the "moneyness" of the option). **Keep in mind that I accept other answers that are clearly communicated. My quick answers are the most the most immediate (in my mind). My responses below are WAY longer than what I expect!** A) This is a "what can go wrong" issue with the bondholder-shareholder (or firm) relationship. This was detailed in my notes, and we discussed in class the intuition behind the "optional HW Q2). One way is essentially taking cash from bondholders (like dividend surges, share buybacks, etc.). This would be more on the numerator side of discounting cash flows. Shareholders could try to borrow multiple times on the same asset, which might give bondholders less collateral (or might need to fight with other lenders to get that collateral). Another way, and more common way in industry, is risk-shifting. This is what we discussed during class for the "optional HW." Basically, shareholders shoving more risk toward the bondholders than they initially signed up for. This increases the discount rate (denominator side), and therefore decreases the value of the bond. There are many other ways to "rip off" bondholders if they are not adequately protected. B) We discussed this during the "optional HW" work that we did in class. If the option is deeply out-of-the- money, then it might not incentivize the manager at all- that's a problem. If the option is at-the-money, then the manager might take on bad risks (heads they win, tails they don't lose) - that's a problem. Some students also point out that if the expiration date is very close (like next week), then it could incentivize the manager to delay bad info (or cheat) to get the stock price up in the near-term. We didn't talk about that, but I would accept that answer. FIN 305W Midterm 2 Fall 2023 [12 points]: CLEARLY CHOOSE AND CIRCLE EITHER (A) OR (B) IN THE SPACE PROVIDED - I WILL NOT GRADE BOTH... A) Explain how practitioners estimate the beta of an asset via regressions. Also, briefly provide your intuition about the R-squared of the CAPM regression and how it related to different types of risk. B) Let's say that Under Armour's (Ticker: UA) standard deviation of historical returns is over 50% higher than Nike's (Ticker NKE) standard deviation of historical returns. However, UA's beta is lower than NKE's. Your colleague says, "something's wrong! UA should have a higher beta than NKE." Briefly explain why NKE might in fact have a higher beta than UA. Here, assume that there are no measurement errors in the betas. **Keep in mind that I accept other answers that are clearly communicated. My quick answers are the most the most immediate (in my mind). My responses below are WAY longer than what I expect!** A) We discussed this at length during class, and it is detailed in my CAPM intuition notes. Practitioners regress the asset's returns on the market's returns over a historical "estimation period." Then, they find the slope of the line-of-best-fit. That is beta. If you drew it out pictorially, which is good, then you needed to label the axes. R-squared relates to the proportion of the variability in the asset's returns (the ups and downs) that are attributable to the variability in the market's returns. CAPM calls this market risk (or systemic, or undiversifiable risks). Therefore, (1 minus R-squared) is not attributable to the market and this firm-specific (or idiosyncratic, or diversifiable). B) NKE can have a higher beta than UA if NKE's correlation with the market is much stronger than that of UA. One example that I gave during class was Tesla. A few years ago, TSLA had extremely high overall risk, but its beta was essentially zero. That's because it didn't correlate with the market. Students could have answered this more "mathy" by writing something like this: Bi = fijn (5) if the > Jums, but 5m , PUAM LL PNKE, M, then the BNKE > BUA *THERE ARE TWO PRIMARY COMPONENTS (FIRM ASPECTS) THAT GO INTO BE:. OVERALL RISKINESS, AND THE CORRELATION WITH THE MARKET.