FIN 448

Advanced Financial Management

PRACTICE FINAL EXAM

– SOLUTION –

Disclaimer: This practice final exam roughly resembles what the upcoming exam will look like
in terms of its format. It has been designed to reflect mainly the materials that are related to our
course. However, this does not mean the practice exam will show exactly the same length,
difficulty, emphases, and weights on topics we have covered so far for the upcoming exam.

Instructions:

1. The exam is open-book and open-notes. You are allowed to use the textbook, lecture notes,
homework solutions, and self-prepared notes. Also feel free to use a calculator, laptop, or
tablet if needed. Everyone must type (or write) his/her own answers to exam questions.

2. Your work on this exam must represent your own effort and your own effort only. Any form
of collaboration including discussing exam questions and sharing answers with anyone (both
inside and outside your class) is strictly prohibited during the exam. Copying the work of
others including from previous semesters or online will be considered cheating.

3. You have three hours (180 minutes) to do the exam and submit your answers/files in Canvas.
There are 100 total points; points per question are indicated next to the question.

4. Round percentages and values up to four (4) decimal places.

5. Whenever in doubt, please try to state your reasoning as clearly as possible and, in particular,
explain any additional assumptions you may have used for obtaining your answers.

6. Read questions and instructions carefully, allocate your time wisely, and all the best of luck!
FIN 448 Practice Final Exam Fall 2020

Question 1 (0 points)

Please read the following important message before you start working on the exam.

Students are required to abide by the Olin Business School Code of Conduct. Academic dishonesty of
any form will not be tolerated. Penalties for academic offences such as plagiarism and cheating have
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WILL NOT BE GRADED.

Don’t forget to type your name in the box!

There are seven questions (Questions 2-8) in this exam. Please type your answer in the text box
provided underneath each question.

Question 2 (15 points)

Recapitalization in Perfect Markets (15 points)

1. What will be the market value of the equity?

The current value of the firm is (1/2) × (200 + 260) / 1.15 = $200 million.

This will not change after the change in capital structure because we are in a perfect markets
setting. But now we have $50 mm in debt, so:
E = V – D = 200 – 50 = $150 million

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FIN 448 Practice Final Exam Fall 2020

2. What will be the expected return to equityholders (rE)?

In the lower outcome, the equityholders get 200 – 50 × (1 + 6%) = 147.

In the better outcome, they get 260 – 50 × (1 + 6%) = 207.

Since the current value of the equity is 150 from part 1), the expected return to the equityholders is
then: rE = [(1/2) × 147 + (1/2) × 207] / 150 – 1 = 18%

Alternatively, use the M&M II formula:

rE = rU + (D/E) (rU – rD) = 15% + (50/150) × (15% – 6%) = 18%

3. What will be the weighted average cost of capital?

D = 50, V = 200, so D/V = 50/200 = 25%

WACC = 25% × 6% + (1 – 25%) × 18% = 15%
Note this is same as rU under perfect markets.

4. As a result of this higher debt level, we expect the weighted average cost of capital to be:
(Choose one.)
A. Lower than in part 3
B. Same as in part 3
C. Higher than in part 3

5. As a result of this higher debt level, we anticipate the expected return to equityholders (rE) will be:
(Choose one.)
A. Lower than in part 2
B. Same as in part 2
C. Higher than in part 2

6. As a result of this higher debt level, we expect the Price/Earnings ratio to be:
(Choose one.)
A. Lower than with $50 million in debt
B. Same as with $50 million in debt
C. Higher than with $50 million in debt

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FIN 448 Practice Final Exam Fall 2020

Question 3 (15 points)

Debt vs. Equity Financing (15 points)

1. Complete the market value balance sheet of James’ firm before the capital is raised.

Assets: 50 Debt: 0

Equity: 50

Assets in place: 4/10% = $40 million

NPV(growth opportunity): (0.5×3 + 0.5×1)/10% – 10 = $10 million
Total book value = 40 + 10 = $50 million

2. Complete the market value balance sheet of James’ firm after he raises the capital by issuing $10
million of new equity.

Assets: 50 + 10 = 60 Debt: 0

Equity: 60

3. What is James’ cost of equity after this $10 million of new equity is raised in Part 2? And, how
much is James’ equity stake worth after the financing in this case?

rE = 10% (same as before)

James’ equity stake worth = 50 + 10 – new investor’s stake = 60 – 10 = $50 million

4. Complete the market value balance sheet of James’ firm after he raises the capital by issuing $10
million of bond with rD = 5%.

Assets: 50 + 10 = 60 Debt: 10

Equity: 50

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FIN 448 Practice Final Exam Fall 2020

5. What is James’ cost of equity after this $10 million of bond is raised in Part 4? And, how much is
James’ equity stake worth after the financing in this case?

rE = rU + (D/E)(rU – rD) = 10% + (10/50)(10% – 5%) = 11%

James’ equity stake worth = E = V – D = 60 – 10 = $50 million

6. If James were not operating in a perfect capital market, which financing choice would:
(Choose one in each row.)

Minimize the riskiness of

Debt Equity No Difference
James’ equity?

Minimize the firm’s pre-tax

Debt Equity No Difference
WACC (rU)?

Minimize the firm’s after-tax

Debt Equity No Difference
WACC (rL)?

Minimize dilution at issuance

Debt Equity No Difference
due to asymmetric information?
Minimize James’ incentive to
contribute additional equity in
Debt Equity No Difference
the future to fund any new
projects that may arise?

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FIN 448 Practice Final Exam Fall 2020

Question 4 (10 points)

Tax-Bankruptcy Tradeoff (10 points)

VL = D + E = 600 + 20 × 50 = 600 + 1,000 = $1,600 million

(1−𝜏𝜏𝑐𝑐 )(1−𝜏𝜏𝑒𝑒 ) (1−30%)(1−15%)

PVTS = 𝐷𝐷 ∙ 𝜏𝜏 ∗ = 𝐷𝐷 �1 − (1−𝜏𝜏𝑖𝑖 )
� = 600 × �1 − (1−35%)
� = $50.77 million

EBITDA / Interest coverage = 195 / (600×5%) = 6.5 ⇒ BBB rating ⇒ 0.50% default rate
𝑝𝑝 0.50%
PV[E(bankruptcy costs)] = �𝑝𝑝+𝑟𝑟 � 𝑐𝑐 = �0.50%+3%� (20% × 1,600) = $45.71 million
𝑓𝑓

VL = VU + PVTS – PV[E(bankruptcy costs)] = $1,600 million

VU = VL – PVTS + PV[E(bankruptcy costs)] = 1,600 – 50.77 + 45.71 = $1,594.94 million

n × P = 600
(50 + n) P = 1,594.94 ⇒ 50P + 600 = 1,594.94
P = $19.90 per share and n = 30.15 million shares

Or, net value of leverage = – 50.77 + 45.71 = –$5.05 million

P = 20 + (–5.05) / 50 = $19.90 per share

Question 5 (15 points)

IPO (15 points)

1. Assume that after the stock started trading, the price rose to $26 per share. What were the proceeds
to the firm from this IPO?

Primary shares = 15.533 million shares

IPO price = (21 + 23) / 2 =$22 per share
Proceeds to the firm = 15.533 × 22 × (1 – 6%) = $321.22 million

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FIN 448 Practice Final Exam Fall 2020

2. Again, assume that after the stock started trading, the price rose to $26 per share. What was the
profit of the investment bank from underwriting this IPO?

6% × 22 × (Primary shares + secondary shares + over-allotment)

= 6% × 22 × (15.533 + 6.667 + 3.33)
= $33.70 million

3. Now, assume that after the stock started trading, the price fell to $18 per share. Calculate the
investment bank’s total profits from both underwriter fees and trading profits.

Underwriting fees = 6% × 22 × (Primary shares + secondary shares)

= 6% × 22 × (15.533 + 6.667) = $29.304 million

Trading profits = (22 – 18) × 3.33 = $13.32 million

Total profits = 29.304 + 13.32 = $42.624 million

4. As discussed in class, an IPO firm can use either the book-building process or an auction for
pricing and allocation of the IPO shares. Give one reason that supports book-building and one
reason that supports auctions.

Book-building: Reduce information asymmetry by providing certification, eliciting info from

informed institutional investors, allocating shares, providing analyst coverage after the IPO

Auction: Intend to reduce underpricing (closer to a true market-clearing price), broaden the
investor base by allowing for more retail and small investor participation

5. Consider selling a firm to the public via an IPO or to a private equity firm through a leveraged
buyout (LBO). Which transaction better addresses each of the following market frictions?
(Choose one in each row.)

Corporate taxes IPO LBO

Information asymmetry IPO LBO
Expected costs of financial distress IPO LBO
Agency conflicts between managers and outside shareholders IPO LBO
Agency conflicts between debtholders and equityholders IPO LBO

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FIN 448 Practice Final Exam Fall 2020

Question 6 (15 points)

Debt and Payout Policy (15 points)

1. What impact do you expect this transaction to have on Olin’s cost of equity capital?
(Choose one.)
A. Olin’s cost of equity capital will increase.
B. Olin’s cost of equity capital will decrease.
C. Olin’s cost of equity capital will stay the same.

2. What do you expect the share price to be on April 28th, assuming no other news relevant to the
value of the firm comes out before then?

D = $1 billion (also = $10 × 100 = $1,000 million)

PVTS = (D × rD × τc) / (rU – g) = (1,000 × 5% × 30%) / (10% – 1.5%) = $176.47 million

VL = VU + PVTS = 56 × 100 + 176.47 = $5,776.47 million

E = V – D = 5,776.47 – 1,000 = $4,776.47 million

P = 4,776.47 / 100 = $47.76 per share

3. Suppose Olin uses the proceeds of the debt issuance to repurchase shares rather than pay a special
dividend. What do you expect the share price to be on April 28th in this case? Assume the entire
repurchase is completed prior to the 28th.

VL = VU + PVTS = 56 × 100 + 176.47 = $5,776.47 million

E = V – D = 5,776.47 – 1,000 = $4,776.47 million

n × P = 1,000
(100 – n) P = 4,776.47 ⇒ 100P – 1,000 = 4,776.47
P = $57.76 per share
n = 17.31 million shares

4. Assume again that Olin uses the proceeds of the debt issuance to repurchase shares. What will be
Olin’s expected earnings per share after the transaction?

Earnings = (EBIT – Interest) × (1 – τc) = (800 – 1,000 × 5%) × (1 – 30%) = $525 million
# of shares outstanding = 100 – (1,000 / 57.76) = 82.69 million shares

EPS = 525 / 82.69 = $6.35 per share

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FIN 448 Practice Final Exam Fall 2020

5. You observe the following tax rates for two different countries:

Country A Country B
Corporate 35% 35%
Personal – interest 30% 35%
Personal – dividends 20% 35%
Personal – capital gains 15% 35%

Answer questions in the following table. (Choose one in each row.)

Which country’s tax code favors

Country A Country B No Difference
debt financing more? (τ*)

Which country’s tax code favors a

Country A Country B No Difference
high payout level more? (τi vs. τc)
In which country would you
expect to see a larger drop in the
share price (per dollar of dividend Country A Country B No Difference
paid) on the ex-dividend date?
1−τ
(price drop = DIV �1−τd�)
e

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FIN 448 Practice Final Exam Fall 2020

Question 7 (15 points)

Risk Shifting and Debt Structure (15 points)

1. If HighFly were an unlevered firm, would it stay as a print shop or switch to the smartphone design
business? Show why.

Expected payoff from switching:

9,000 × 15% + 2,000 × 85% = $3,050

Expected payoff from staying: $5,000 > $3,050

Thus, will stay, NOT switch

2. If the $4,700 debt obligation is straight debt, would HighFly stay as a print shop or switch to the
smartphone design business? Assume that equityholders control the investment decisions. Again
show why.

Low High Expected

Probability 85% 15%
Firm Value 2,000 9,000 3,050
Debt Value 2,000 4,700 2,405
Equity Value 0 4,300 645

Expected payoff for equity holders from switching: $645

Expected payoff for equity holders from staying: 5,000 – 4,700 = $300 < $645

Thus, will switch

3. If the $4,700 debt obligation is convertible debt (convertible into 80% of the firm’s shares at the
debtholders’ option), would HighFly stay as a print shop or switch to the smartphone design
business? Again assume that equityholders control the investment decisions. Also, show why.

Low High Expected

Probability 85% 15%
Firm Value 2,000 9,000 3,050
Debt Value if 1,600 7,200 2,440
Convert
Debt Value if 2,000 4,700 2,405
Not Convert
Debt Value 2,000 7,200 2,708
Equity Value 0 1,800 270

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FIN 448 Practice Final Exam Fall 2020

Expected payoff for equity holders from switching: $270

Expected payoff for equity holders from staying: 5,000 – 4,700 = $300 > $270

Thus, will stay, NOT switch

4. Explain briefly why the firm makes different decisions as we change the debt structure from Part 1
to Part 2, then to Part 3?

From 1) to 2): Equityholder have an option-like payoff, they benefit from upside risk, but are
protected from downside risk (by limited liability). The downside risk is borne by debtholders.

From 2) to 3): With convertible debt, equityholders have to share the upside with the debtholders,
eliminating their incentive to take higher risk.

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FIN 448 Practice Final Exam Fall 2020

Question 8 (15 points)

Valuation of Leveraged Buyout (15 points)

1. Calculate the IRR of the investment from the private equity group’s perspective.

(in $millions) 2006 2007 2008 2009 2010

EBITDA 860.8 860 877.2 914.8 956.9
Depreciation & amortization 339.7 322.4 318.3 328 339.9
EBIT 521.1 537.6 558.9 586.8 616.9
Interest income 40.5 46.8 53 59.2 65.5
Interest expense 536 524.9 512.6 498.7 482.1

Pre-tax income 25.6 59.5 99.3 147.3 200.3

Taxes (35%) 9.0 20.8 34.7 51.6 70.1
Net Income 16.6 38.7 64.5 95.8 130.2

Capital expenditures 217.5 209.1 208.1 214.8 222.8

Δ NWC 0.1 -1.3 0.3 2 2.3

CF available to pay down debt 138.7 153.3 174.4 207.0 245.0

Beginning debt balance 6,700 6561.3 6408.0 6233.6 6026.6

Ending debt balance 6561.3 6408.0 6233.6 6026.6 5781.6

Enterprise value at exit = EBITDA × 9 = 956.9 × 9 = $8,612.1 million

Equity value at exit = 8,612.1 + 1,250 (cash) – 5,781.6 (ending debt) = $4,080.5 million

IRR = (4,080.5 / 1,300) (1/5) – 1 = 25.71%

2. Will the private equity group be willing to make the investment given these assumptions? [Hints:
Compare the IRR of this investment for the private equity group and to the appropriate hurdle rate.]

The hurdle rate for the private equity group is the required return on equity (reflecting the capital
structure after the LBO transaction). It is estimated as follows:

The unlevered cost of capital: rU = rf + βU × (rm – rf) = 4% + 0.85 × 6% = 9.1%

The expected return on debt: rD = rf + βD × (rm – rf) = 4% + 0.3 × 6% = 5.8%
Then, the required return on equity is:
𝐷𝐷 6.7
𝑟𝑟𝐸𝐸 = 𝑟𝑟𝑈𝑈 + (𝑟𝑟𝑈𝑈 − 𝑟𝑟𝐷𝐷 ) = 9.1% + � � (9.1% − 5.8%) = 26.11%
𝐸𝐸 1.3

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FIN 448 Practice Final Exam Fall 2020

Since the IRR from part 1 is less than rE (25.71% < 26.11%), the private equity group will not be
willing to invest at these terms.

An important note: You are given both an interest rate of 8% on the debt and the debt beta of 0.3
in the problem. This is where we need to make the distinction between a promised yield and an
expected yield. The 8% interest rate is the promised yield on debt given that the firm does not
default on its debt, and the 0.3 debt beta corresponds to the expected yield on debt taking default
probability into account. If the default probability is negligible, the promised yield and the
expected yield are close to each other. But, if there is a significant chance to default (e.g., in an
LBO transaction with high leverage), the promised yield on debt should be noticeably higher than
the expected yield. As a result, we use the 8% promised interest rate to compute interest payments,
but the 0.3 debt beta to compute the expected return on debt.

3. Suppose that due to regulatory concerns, banks were unwilling to lend more than $5 billion to fund
the deal, but the total purchase price remains $8 billion. How would this affect the private equity
group’s estimated IRR and investment decision?

In this case, we change the initial debt balance to $5 billion and the initial equity investment to $3
billion. Repeating the analysis in parts 1 and 2, we get the following:

(in $millions) 2006 2007 2008 2009 2010

EBITDA 860.8 860 877.2 914.8 956.9
Depreciation & amortization 339.7 322.4 318.3 328 339.9
EBIT 521.1 537.6 558.9 586.8 616.9
Interest income 40.5 46.8 53 59.2 65.5
Interest expense 400 381.8 362.1 340.3 315.6

Pre-tax income 161.6 202.6 249.8 305.7 366.8

Taxes (35%) 56.6 70.9 87.4 107.0 128.4
Net Income 105.0 131.7 162.4 198.7 238.4

Capital expenditures 217.5 209.1 208.1 214.8 222.8

Δ NWC 0.1 -1.3 0.3 2 2.3

CF available to pay down debt 227.1 246.3 272.3 309.9 353.2

Beginning debt balance 5000 4772.9 4526.6 4254.3 3944.5

Ending debt balance 4772.9 4526.6 4254.3 3944.5 3591.2

Enterprise value at exit = EBITDA × 9 = 956.9 × 9 = $8,612.1 million

Equity value at exit = 8,612.1 + 1,250 (cash) – 3,591.2 (ending debt) = $6,270.9 million

IRR = (6270.9 / 3000) (1/5) – 1 = 15.89%

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FIN 448 Practice Final Exam Fall 2020

As in part 2, the unlevered cost of capital remains at 9.1%, and the expected return on debt is 5.8%.
We compute the required return on equity with the new capital structure:
𝐷𝐷 5
𝑟𝑟𝐸𝐸 = 𝑟𝑟𝑈𝑈 + (𝑟𝑟𝑈𝑈 − 𝑟𝑟𝐷𝐷 ) = 9.1% + � � (9.1% − 5.8%) = 14.6%
𝐸𝐸 3

With the lower initial debt level, both IRR and levered rE are lower than before. But with IRR > rE
(15.89% > 14.6%), the private equity group will be willing to invest now.

Question 9 (0 points)

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