EDHEC Business School

Corporate Finance 1
Mock Examination

20th November 2019

MSc in Finance
Duration: 2 hours
Financial Economics Track
Academic Year 2019-2020

Professor Enrique Schroth

Instructions: Answer

• ALL QUESTIONS in PART 1

• QUESTION 4 in PART2

• EITHER QUESTION 5 or QUESTION 6 of PART 2.

1
 Part 1

1. Suppose that the market portfolio is equally likely to increase by 24% or de-
crease by 8%. Security "X" goes up on average by 29% when the market goes up
and goes down by 11% when the market goes down. Security "Y" goes down on
average by 16% when the market goes up and goes up by 16% when the market
goes down. Security "Z" goes up on average by 4% when the market goes up
and goes up by 4% when the market goes down. What is the expected return
on security with a beta of 0.8 in this economy? (3 marks)

Answer: Security "Z" is the risk-free asset since its return is constant regardless
of the market. Therefore the risk-free rate is the return on security Z
which is 4%. The expected return on the market rate is 0.5 × (24%) +
0.50(−8%) = 8%. Using the CAPM, the return on a 0.8-beta stock must
be 0.04% + 0.8 × (0.08% − 0.04%) = 7.2%

2. Assume that Rose Corporation’s (RC) EBIT is not expected to grow in the future
and that all earnings are paid out as dividends. RC is currently an all equity
firm. It expects to generate earnings before interest and taxes (EBIT) of $6
million over the next year. Currently RC has 5 million shares outstanding and
its stock is trading for a price of $12.00 per share. RC is considering borrowing
$12 million at a rate of 6 and using the proceeds to repurchase shares at the
current price of $12.00. Show that the stock price of RC won’t change following
the debt issuance and share repurchase. (3 marks)

Answer: Note that Rose’s EPS is given by

EPS = EBIT/Shares outstanding

= ($6 million)/5 million shares = $1.20 EPS (unlevered).

But then the unleverd value of the firm is V = EPS rU

, implying that rU =
EPS $1.2 per share
V
= $12
= 10%. The return on levered equity must be

D
rE = rU + (rU − rD )
E
12
⇒ rE = 0.10 + × (0.10 − 0.06) = 11%.
60 − 12

2
The EPS of the levered firm is

EPS = (EBIT − Interest)/Shares outstanding

= ($6 million − 0.06 × $12 million)/4 million shares = $1.32 EPS.
$1.32
Finally, the value of the levered firm is V L = 0.11
= $12.00, which equals
the original value of the stock.

SEE NEXT PAGE

3
3. You own a small manufacturing plant that currently generates revenues of £2
million per year. Next year, based upon a decision on a long-term government
contract, your revenues will either increase by 20% or decrease by 25%, with
equal probability, and stay at that level as long as you operate the plant. Other
costs run £1.6 million dollars per year. You can sell the plant at any time to a
large conglomerate for £5 million, while the shut-down cost is £1 million. Your
cost of capital is 10%. What is the value of the option to sell the plant?(4 marks)

Answer: The decision tree for this problem is

The value of the plant if revenues increase is

1.2 × £2.0 million − £1.6 million

V = = £8 million.
0.10

4
 If revenues decrease, the value is
0.75 × £2.0 million − £1.6 million
V = = £ − 1 million,
0.10
however if you could sell the plant you would receive £5 million minus £1
million = £4 million. So the value with the embedded option is

V = 0.5 × £8 million + 0.5 × £4 million = £6 million.

Without the embedded option, the value would be

V = 0.5 × £8 million + 0.5 × £ − 1 million = £3.5 million.

So, the option to sell the plant is worth £6 million-£3.5 million = £2.5
million.
Note: An alternative and valid interpretation for this problem assumes that
the revenues of the government contract are only learned after a year of
operations. This interpretation does not change the payoffs nor the value
from continuing when the revenues increase. However, the present value
in case the revenues decrease would be
0.75 × £2.0 million − £1.6 million £4million
V = + = £3.54 million.
1.10 1.10
In this case, the value of the option is 0.5 ×£8 million + 0.5 × 3.54 million
-£3.5 million = £2.27 million.

SEE NEXT PAGE

5
 Part 2

4. Total marks: 5
d’Anconia Copper has $200 million in cash that it can use for a share repurchase.
Suppose instead that d’Anconia Copper invests the funds in an account paying
5% interest for one year. Assume that the corporate tax rate is 35%, the individual
capital gains rate is 15% and the individual rate on ordinary income is 30%.

(a) How much additional will d’Anconia Copper have at the end of the year
net of corporate taxes? 1 mark)

Answer: The amount will be:

Net amount = investment × interest × (1 − τc )

= $200 million × 5% × (1 − 35%) = $6.5 million.

(b) Net of capital gains taxes, what would be the increase in the value of
d’Anconia Copper shares? (1 mark)

Answer: The increase will be equal to

Net amount = investment × interest × (1 − τc )(1 − τe )

= $200 million × 5% × (1 − 35%)(1 − 15%) = $5.525 million.

(c) Suppose that d’Anconia Copper retained the $200 million in cash so that it
would not need to raise new funds from outside investors for an expansion
it has planned for next year. If it did raise new funds, it would have to
pay issuance fees. Assuming that these fees can be expensed for corporate
tax purposes, what is the amount that d’Anconia Copper needs to save in
issuance fees to make retaining the cash beneficial for its investors? (3
marks)

Answer: If the investors had invested the $200 million themselves:

Net amount = investment × interest × (1 − τd )

= $200 million × 5% × (1 − 30%) = $7.0 million.

6
The net that can be raised from these investors, after issuing fees f
and their tax shields would be

$7.0 million − f + Tax Shields = $7.0 million − f + f × τc × (1 − τe ).

To see why, note that for each dollar of fees, the firm saves τc in taxes,
which is then taxed for capital gains, netting 1−τe per dollar shielded.
Comparing both amounts, it is optimal to retain the cash and reinvest
if and only if

$5.525 million ≥ $7.0 million − f + f × τc × (1 − τe ).

$7.0−$5.525
Therefore, the total savings must be equal to 1−0.35×(1−0.15)
= $2.0996
million in fees.

SEE NEXT PAGE

7
5. Total marks: 5
WRT Inc. is considering expanding into a new geographic market. The expan-
sion will have the same business risk as WRT’s existing assets. The expansion
will require an initial investment of e50 million and is expected to generate
perpetual EBIT of e20 million per year. After the initial investment, future cap-
ital expenditures are expected to equal depreciation, and no further additions
to net working capital are anticipated.

WRT’s capital structure is composed of e500 million in equity and e300 mil-
lion in debt (market values), with 10 million equity shares outstanding. The
unlevered cost of capital is 10%, and WRT’s debt is risk free with an interest
rate of 4%. The corporate tax rate is 35%.

(a) WRT initially proposes to fund the expansion by issuing equity only. If
investors were not expecting this expansion, and if they share WRT’s view
of the expansion’s profitability, what will the share price be once the firm
announces the expansion plan? (1 mark)

Answer: The NPV of the expansion is

e20 milion × (1 − 0.35)
− e50 million = e80 million.
0.1
The share price is the total value of unleverd equity divided by the
number of shares outstanding, i.e.,
e500 milion + e80 milion
= e58 per share.
10 milion shares
(b) Suppose that investors think that the EBIT from WRT’s expansion will be
only e4 million per year. What will be the share price in this case? How
many shares will the firm need to issue? (1 mark)

Answer: In this case, the NPV of the expansion is

e4 milion × (1 − 0.35)
− e50 million = −e24 million.
0.1
The share price would then be
e500 milion − e24 milion
= e47.6 per share.
10 milion shares
8
 At this price, the number of shares to be issued is
e50 milion
= 1.05 million shares.
e47.6 per share
(c) Suppose that WRT issues equity as in part (b). Shortly after the issue,
new information emerges that convinces investors that management was,
in fact, correct regarding the cash flows from the expansion. What will the
share price be now? Why does it differ from that found in part (a)? (2
marks)

Answer: The share price must be updated to

e500 milion + e50 milion + e80 milion
= e57.01 per share.
11.05 million shares
The share price is now lower than in part (a), because there equity
was fairly valued. Shares in part (b) are undervalued. Shareholders
who bought the issue gained (57.01 − 47.6) × 1.05 = e9.88 million.
The old shareholders made a loss of exactly (58 − 57.01) × 10 = e9.9
million.
(d) Suppose WRT instead Ofinances the explansion with a e50 million issue
of permanent, risk-free debt. If WRT undertakes the expansion using debt,
what is its new share price once the new information comes out? Com-
paring your answer with that in part (c), what are the TWO advantages of
debt finance in this case? (1 mark)

Answer: The tax shield from permanent debt financing is equal to 35% ×
e50 million = e17.5 million. Hence, the share price in this case is
e500 milion + e50 milion + e80 milion + e17.5 milion − e50 milion
10 million shares
= e59.75 per share.

There is now a gain of e2.75 per share compared to case (c). Of these
gains, e1 per share is from avoiding issuing undervalued equity and
e1.75 is from the interest tax shield.

SEE NEXT PAGE

9
6. Total marks: 5
Revtek, Inc. has an equity cost of capital of 12% and a debt cost of capital of
6%. Revtek maintains a constant debt-equity ratio of 0.5 and its tax rate is 35%.

(a) What is Revtek’s WACC given its current debt-equity ratio? (1 mark)

Answer: The WACC is

E D
rW ACC = rE + rD (1 − τC )
E +D E +D
1 0.5
= × 12% + × 6% (1 − 0.35)
1.5 1.5
= 9.3%

(b) Assuming no personal taxes, how will Revtek’s WACC change if it increases
its debt-to-equity ratio to 2? (1 mark)
Answer: In that case we have an unlevered cost of capital of

E D
rU = rE + rD
E +D E +D
1 0.5
= × 12% + × 6%
1.5 1.5
= 10%;

and to calculate the WACC

D
rW ACC = rU − τC rD
E +D
2
= 10% − × 0.35 × 6%
3
= 8.6%

(c) Now suppose an investor pays a tax rate of 40% on interest income and
15% on income from equity. How will Revtek’s WACC change if it increases
its debt-to-equity ratio to 2 in this case? (2 marks)
Answer: Given the initial capital structure, we can estimate Revtek’s un-
levered cost of capital as

E D
rU = rE + r∗ ,
E +D E +D D

10
 1−τi 1−0.40
where rD∗ = rD × 1−τe
= 6% × 1−0.15
= 4.235%. Solving,

E D
rU = rE + r∗
E +D E +D D
1 0.5
= × 12% + × 4.235%
1.5 1.5
= 9.41%.

We can also recalculate rE with higher leverage from

1 2
9.41% = × rE % + × 4.235%
3 3
⇒ rE = 19.76%.

Finally,

E D
rW ACC = rE + rD × (1 − τc )
E +D E +D
1 2
= 19.76% + 6% × 0.65 = 9.19%.
3 3
(d) Provide an intuitive explanation for the difference in your answers to parts
(b) and (c). (1 mark)
Answer: When investors pay higher taxes on interest income than equity
income, the tax benefit of leverage is reduced. Thus, for the same in-
crease in leverage, the decline in the WACC is smaller in the presence
of investor taxes.

LAST PAGE

11