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NAME ____________________________________ University of Illinois at Chicago October 9th, 2014 Finance 320 - Managerial Finance Dermot Murphy MIDTERM EXAM - PART 2 Fall 2014 Instructions 1) Please write your name at the top of this page. 2) This is a closed book, closed notes exam. You may use a calculator or a laptop, but only for the making calculations. 3) There is a formula sheet on the last page of the midterm. You may detach the formula sheet from the midterm if you like, but please do not submit the formula sheet if you detach it. 4) You must show your work to receive credit for your answers. Show the steps you use to arrive at the correct answer. This way, you can receive partial credit if you make a calculation error. Points will not be awarded to correct answers with absolutely no workings. 5) There are 3 questions for a total of 60 points. The points allocated to each question are indicated next to the question. 6) This document has a total of 9 pages (including this page and the formula sheet). Please make sure your exam is not missing any pages before you begin. 7) If you need extra space, you may use the back sides of the pages. Please make reference for when you do so. 8) Some parts in a question require the answer from a previous part. If you do not have the right answer to the previous part, you can still get full credit if you do the question properly with the incorrect number carried over. 9) You have 50 minutes to complete these questions. 10) Good luck! [Do not write on this page - your points will be reported here.] Question Points Possible 1 20 2 19 3 21 Total 60 Points Earned Question 1 (20 points) The CFO at Molony Corporation is currently deciding on dividend policy. Specifically, the CFO is trying to figure out if he should pay the usual dividend, increase the dividend by issuing shares, or cancel the next three dividends to invest in a project that requires a series of capital investments. Specifically, Molony Corporation is an all-equity firm that produces a free cash flow $15M per year in perpetuity, with the first cash flow being realized today (t=0). Assume for now that all free cash flows are paid out as dividends. Assume that the beta of equity for this firm is 2.0, a risk-free rate of 3 percent, and a market risk premium of 6 percent. There are 20M shares outstanding. a) What is the cum-dividend price per share? (4 points) b) Assume that the $15M free cash flow is paid as a dividend at t=0. What is the ex-dividend price per share? (4 points) c) Suppose instead that the CFO chooses to pay a $45M dividend at t=0 by issuing $30M of equity. How many shares does the firm need to sell? What is the ex-dividend price per share? (6 points) d) Suppose instead that the CFO has identified an investment opportunity that requires capital expenditures of $15M at each of t=0, t=1, and t=2. Therefore, if the CFO accepts this new investment opportunity, he will have to cancel the next three dividends. The investment opportunity would provide expected free cash flows of $5M per year in perpetuity starting at t=3. Assume that the cash flows from this opportunity have the same discount rate as the existing cash flows. What is the new price per share after the announcement of the new project at t=0? (6 points) Question 2 (19 points) In 1993, Compaq Computer Corporation was sued by its shareholders for failing to disclose that it was not properly hedging its foreign exchange risk (a significant portion of its sales came from overseas). It is now the end of 1993 - the lawsuit failed, but Compaq got the message and will now ensure its foreign cash flows are hedged against exchange rate risk in the future. Assume that Compaq expects to receive 10M pounds in cash flows from Great Britain in 1994 (t=1). a) Suppose first that Compaq chooses to not hedge it foreign currency risk. There is a 50 percent probability that it will exchange each pound for $1.70 and a 50 percent chance it will exchange each pound for $1.20. What is the expected cash flow at t=1 in US dollars? (3 points) b) Suppose now that Compaq chooses to hedge its foreign currency risk. It chooses to buy a put option with strike price $1.40 per pound and sell a call option with strike price $1.60 per pound. What is the payoff function for this options position? (Hint: instead of considering ranges for , you will be considering ranges for the exchange rate, in dollars per pound, at t=1) (6 points) c) Draw the payoff graph for this options position. (6 points) d) The long put option gives you the right to sell 10M pounds at $1.40 per pound while the short call option gives the counterparty the right to buy 10M pounds at $1.60 per pound. Suppose that the exchange rate ends up being $1.20 per pound at t=1. What is the payoff from your options position? (4 points) Question 3 (21 points) You are considering an investment in a project that produces revenues in the short-run that are fairly certain, but in the long-run are somewhat uncertain. Specifically, from t=1 to 5, the revenues from this project will be $10M per year and operating costs will be $8M per year. Starting t=6, there is a 50 percent probability that annual revenues will be $4M per year in perpetuity and a 50 percent probability that annual revenues will be $14M per year in perpetuity; operating costs are still $8M per year. It costs $20M at t=0 to begin the project. Assume a discount rate of 10 percent. a) What is the NPV of this project? (6 points) At t=5, you learn what operating revenues will be from t=6 onward. Suppose you have the option to abandon the project. b) Would you abandon the project if you learn that annual revenues will be $14M per year? (3 points) c) Would you abandon the project if you learn that annual revenues will be $4M per year? (3 points) d) What is the NPV of this project at t=0, given that you now have the option to abandon this project at t=5? (6 points) e) What is the value of the abandonment option? (3 points) Midterm Equation Sheet PV of annuity: Net Funding Need: = { } C 1 1 r 1+ = Free cash flow: PV of perpetuity: = C r = Operating cash flow: PV of growing annuity: = + + C 1+ 1 rg 1+ = Change in net working capital: = ( ) ( ) PV of growing perpetuity: C = rg Long Call Option Payoff: = + max( , 0) CAPM: Short Call Option Payoff: ( ) = + Weighted beta equation (version 1): = + + Long put option payoff: + = + max( , 0) Accounting identity: Short put option payoff: = 1 + 2 = + = max , 0) ( Weighted beta equation (version 2): = 1 1 + 2 1 + 2 1 + 2 2 Weighted average cost of capital (no taxes): ( ) = + = max( , 0) ( ) + + ( ) Price per share: = Market value of equity: = ( ) Effective dividend tax rate: Updating net property, plant, and equipment: = + Updating Shareholders' Equity: = + = 1 Price change after dividend payment: = (1 )