EXAMINATION QUESTION PAPER - Take-home examination

Component of continuous assessment

GRA 65141
Corporate Finance

Department of Finance

Start date: 01.12.2020 Time 09.00

Finish date: 01.12.2020 Time 11.15

Component weight: 70% of GRA 65141

Total no. of pages: 4 incl. front page

No. of attachments files to

question paper: 0
To be answered: Individually

Answer paper size: 8 excl. attachments

Max no. of answer paper 3

attachment files:

Allowed answer paper file pdf

types:

Allowed answer paper docx, jpg, pdf, xlsx

attachment file types:
 GRA 6514 Corporate Finance
Final Exam – Fall 2020
Make sure to write in a legible way, also motivate your answers and show all the calculations
that lead to the final results for the questions in Part 2 and Part 3. Write just what is needed to
answer the questions, extraneous material in your answers will lower your grade. Make
sure to follow the instructions given for answering the questions. If you use excel for your
calculations, please make sure to turn in a written or typed document that explains the
process/rationale behind such calculations. In the document you turn in, please answer the
questions in the same order they are reported below. Clearly show the question number at the
beginning of your answer.

1. The answer paper must be written and prepared individually. Collaboration with others is
not permitted and is considered cheating.

2. All answer papers are automatically subject to plagiarism control.

PART 1: Multiple Choice Questions

Question M1 [5 Points]
Which of the following is True?
a) In a Modigliani Miller setting, the return of levered equity does not depend on the
capital structure policy adopted by the firm.
b) Consider the Modigliani Miller setting with taxation. Assume you have computed
the value of levered assets via the WACC method, if you subtract from it the value of
the unlevered assets, the difference will return the PV of the interest tax shield for
any capital structure.
c) Consider the Miller model setting, if the corporate tax rate is lower than the personal
interest tax rate, then an all-equity capital structure is optimal.
d) If the company keeps a constant debt-to-equity ratio policy, when applying the wacc
method, you should use the pre-tax wacc rate to compute the value of levered assets.

Question M2 [5 Points]
Which of the following is False?
a) Modigliani and Miller's conclusions in the presence of taxation, agree with the
common view which states that leverage would affect a firm's value.
b) Leverage increases the risk of equity even when there is risk that the firm may
default.
c) The expected return of equity increases in leverage, since investors require a higher
expected return to compensate for the increased risk in asset return.
d) Both a) and c).
Question M3 [5 Points]
Which of the following statements is False?
a) The project's free cash flow to equity (FCFE) shows the expected amount of
additional cash the firm will have available to pay dividends but not to buy back
shares each year.
b) The NPV of the project's FCFE should be identical to the NPV computed using the
WACC and APV methods.
c) The value of the project's FCFE represents the gain to shareholders from the project.
d) None of the above.

Question M4 [5 Points]
Which of the following statements is True?
a) The debt overhang problem is part of the pecking order theory.
b) The debt overhang problem can be alleviated by issuing longer term debt.
c) The debt overhang problem can be alleviated by issuing shorter term debt.
d) The debt overhand problem can be alleviated if debt holders refuse to accept a loss
on the debt they hold.

PART 2: Short Questions

Answer concisely to the following questions.

Question S1 [10 Points]

The assets of a projects will produce in a year $90,000 if the economy is bad or $117,000 if
the economy is good. Both outcomes are equally likely. After that the project will be over.
The project requires an initial cash outlay of $80,000. The project's expected unlevered
return on equity is 15% while the risk-free rate is 5%. A firm is considering investing in the
project and it is evaluating two different funding alternatives. The first option is to raise the
entire $80,000 issuing equity, while the second alternative is to issue debt for $45,000 at the
risk-free rate and use equity to finance the remainder of the initial investment. Calculate the
equity risk premiums for both the levered and unlevered firms, after the project is
undertaken. Assume corporate tax rate of 10%.

Question S2 [12 Points]

Consider two companies, A and B, both unlevered. There can be two possible states of the
world in one year, State 1 and State 2, which can occur with probability 50% each. The value
of the stocks of the two companies in each of the two states, is reported below together with
the stocks’ market prices today. In the market we only have these two companies and they
have the same market capitalization. Agents are risk averse.
Market price today State 1 State 2
Company A 10 15 10
Company B 20 20 30
a) Company B has 100,000 shares outstanding. Company A decides to issue debt with
460,000 face value and one year maturity, and to buy back equity. What is the value of
Company A’s equity after the recapitalization? [7 Points]
b) Assume Company B stays unlevered, what is the risk premium of its equity? [5
Points]
Question S3 [12 Points]
A company can invest in one of two mutually exclusive projects. The first one is safe and its
assets will have a value of EUR 1,000,000 in one year. The other project is risky and its
assets, in one year, will have a value of EUR 1,800,000 or EUR 100,000 with equal
probability. The initial investment for either projects is 500,000. The company plans to raise
the EUR 500,000 by issuing a zero-coupon bond (the project is financed 100% with debt) that
will be paid back in one year. The firm cannot commit ex-ante to choose a project. All agents
are risk neutral and the interest rate is 0.
a) What is the face value of debt? [7 Points]
b) What is the increase in the equity value after the issuance of the bond is announced? [5
Points]

PART 3: Long Questions

Question L1 [21 Points]

Your company has a cost of debt of 3.45% and a return on levered equity of 9.00%. The
unlevered value of equity is 23,500,000 Eur and the company’s expected perpetual EBITDA
is 1,762,500. Assume all assets are depreciated, there is no taxation and no bankruptcy costs.
a) What is the debt to equity ratio of the firm? [7 Points]
b) In one year the state of the world can be good or bad. The value of the company assets
in one year can be 36,000,000 with probability 50% if the state of the world is good.
What is the value of the assets in the bad state? [7 Points]
c) The company now decides to issue a debt, that will be due in one year, with face value
20,000,000 Eur. Assume that, differently from before, the bankruptcy costs are
3,200,000 and that the debt price is 75% of its face value. If the market risk premium
is 5.00% and the expected return on the market portfolio is 7.00%, what is the beta of
debt? [7 Points]

Question L2 [25 Points]

You are about to start a new project. The project will require an initial investment of 40,000
that will be depreciated straight-line over 4 years, which is the life of the project. The
depreciation tax shield is as risky as the project assets. The unlevered return on equity is 6.50%
while the cost of debt (interest rate) is 3.50%. The corporate tax rate is 34%. The company will
issue 30,000 worth of debt that will be reimbursed according to a predetermined schedule. The
table below reports the EBITDA and outstanding debt values at the end and beginning of each
year, respectively.
YEAR 1 2 3 4
EBITDA (End of year) 12,000 14,000 23,000 11,000
DEBT (Beginning of year) 30,000 20,000 20,000 5,000

a) Compute the unlevered value of the assets at time 0. [10 Points]

b) Compute the NPV of the project. [5 Points]
c) Compute the levered return on equity for each one of the 4 years. [10 Points]