Question Four (20 Marks)

i. Some companies measure performance by requiring both "top line" growth and "bottom

line" growth (growth in revenue and growth in net income). Is this performance measure consistent with shareholders wealth creation? Why or why not? Illustrate your answer with relevant examples. (10 Marks)

ii. Consider ABC Bank as an unlevered firm and firm KCB Bank as a levered firm with target debt-to-equity ratio (B/S) =1. Both firms have exactly the same perpetual net operating income, NOI = 180, before taxes. The before-tax cost of debt, Kb is the same as the risk free rate. The corporate tax rate is 30%. Given the following market parameters:

E (Rm) = 12%, m = 0.0144, Rf = 0.06, B = 1, C = 1.5

a. Find the cost of capital and the value for each firm.( Ignore any effect from personal

income taxes) (5 Marks)

b. Evaluate the following four projects to determine their acceptance or rejection by ABC Bank and KCB Group. What do the results of this evaluation tell you about leverage in a world with corporate taxes but no personal taxes (Note: rjm is the correlation between the unlevered free cash flows of each project and market)

Project j Cost j E(NOIj) After- Tax j rjm Correlation of j withthe market

1 100 9 .10 .6

2 120 11 .11 .7

3 80 9 .12 .8

4 150 18 .20 .9 (5 Marks)