Final exam: Case studies in Corporate Finance

PGE-M5-FIN-005-E-L-MRS M2

March 13, 2020 (2PM-5PM)

Important! Where questions mention: “explain your calculation”, an explanation is mandatory. A

right answer without the details of calculation will be considered as FALSE.
Note. Quiz replies must be ticked on the EXAM BOOK.

QUIZ (7 points)

1) (1 point) How do you compute free cash flow? (select the right answer)
A- Cash flow generated by financing activities – Cash flow used by investing activities
B- Cash flow generated by operating activities – Cash flow used by investing activities
C- Cash flow generated by financing activities + Cash flow used by investing activities
D- Cash flow generated by operating activities - Cash flow used by financing activities

2) (1 point) A high Price-to-Earnings ratio could mean that: (select all correct answers)
A- The company’s stock is overvalued.
B- Investors are expecting low growth rate in the future.
C- The company’s stock is undervalued.
D- Investors are expecting high growth rate in the future.

3) (1 point) The weighted average cost of capital represent: (select the right answer)
A- The company’s average cost of debt.
B- The ratio of financial expenses to average debt for the year.
C- A firm’s cost of capital in which each category of capital is proportionately weighted.
D- The after-tax cost of debt.

4) (1 point) Among the five statements below, only one is wrong. Select which one.
A- The multiple of EBITDA method expresses the value of the firm’s equity capital.
B- The comparable method is a peer comparison approach to value a company or a stock price.
C- The comparable method relies on the market efficiency hypothesis.
D- With the comparable method, the company is valued at a multiple of its profit-generating
capacity.

5) (1 point) In the case of a share buyback program, an EPS accretion will occur if (select the right
answer):
A- The inverse of the Price-to-Earning ratio is higher than the after-tax interest rate on interest
paid on short-term debt securities.
B- The inverse of the Price-to-Earning ratio is equal to ROE (Return on Equity).
C- The inverse of the Price-to-Earning ratio is higher than the after-tax interest rate on interest
paid on incremental debt.
D- The inverse of the Price-to-Earning ratio is lower than the after-tax rate of return on
reinvested funds.
E- The inverse of the Price-to-Earning ratio is lower than the after-tax interest rate on interest
paid on short-term debt securities.

6) Let’s take the following data about a SEO (Seasoned Equity Offering):
5,000 new shares are issued at €10 per share, with preferential subscription rights.
The firm’s value is estimated at €150,000 prior to the SEO and its share capital is composed of 10,000
shares with a face value equal to €9.

a- (1 point) Compute the theoretical value of the preferential subscription right (select the right
answer and clearly explain your calculation):

1
Share value prior to the capital increase: 150,000/10,000=€15
Share value after the capital increase=(10,000*15+5,000*10)/15,000=€13.3
Value of the PSR=15-13.3=€1.7

b- (1 point) Compute the subscription parity (select the right answer and clearly explain your
calculation):

SP=10,000/5,000=2
One needs 2 PSR to subscribe to 1 new share.

EXERCISE 1 (4 points)
Let’s consider company ABC whose common stock is made up of 50 million shares and market value
equals 5500 million euros. ABC’s EBIT equals 200 m€ and the corporate income tax rate equals 30%.
The company has 330 million euros to invest, either on the money market at 6% or in stock
repurchase.
1) (2 x 1.5 point). Compute the expected EPS in each scenario (firm invest on the money market or
repurchase stock).

Stock repurchase Money Market Investment

Number of shares 50m 50m
Market value 5500m 5500m
Funds to invest 330m 330m
Repurchased shares 3m -
Final number of shares 47m 50m
EBIT 200m 200m
+ Financial income - 19.8m
= Pretax income 200m 219.8m
- Income taxes 60m 65.94m
= Net income 140m 153.86m
EPS €2.98 €3.08

2). (2 x 0.5 point). Based on your results, what is your advice to this company regarding its 330 million
euros to invest? Why?

The company should invest in the money market since its simulated EPS is higher than if it
repurchases shares.

EXERCISE 2 (6 points)
Let’s take the following data about the company ABC:

1. Financial data (million EUR)

Fixed Assets 30,000
Operating Working Capital 2,500
Capital employed 26,000
Shareholders’ equity 15,000
Net debt 12,000
Capital invested 27,000

2
 After-tax ROCE 9%
ROE 15%
Before-tax cost of debt 6.5%
Corporate income tax rate 30%
2. Stock market data
Stock market capitalization 11,000
Beta 1.3
Risk-free rate 3%
Market risk premium 8.0%
1). (1 point). Compute the cost of equity of company ABC (clearly explain your calculation).

Ke=3%+1.3*8%=13.4%
2). (1 point). Compute the average cost of capital of company ABC (clearly explain your calculation).

WACC=E/(D+E)*Ke+D/(D+E)*Kd

Kd=6.5%*(1-30%)=4.55%
D=12,000
E=11,000

WACC=11,000/23,000*13.4%+12,000/23,000*4.55%
WACC=8.78%
3). (1.5 point). The required rate of return from the stockholders and lenders – given the risk they
take by investing in this firm – is greater than the return on the operating assets (circle your
answer and explain clearly and straightforwardly why):
RIGHT
WRONG: WACC (8.78%) < After-tax ROCE (9%)
4). (1 point). The required rate of return from the stockholders is lower than ABC’s accounting rate of
return on equity (circle your answer and explain clearly and straightforwardly why):
RIGHT: Ke (13.4%) < ROE (15%)
WRONG
5). (1.5 point). The company ABC creates value (circle your answer and explain clearly and
straightforwardly why):
RIGHT: WACC < after-tax ROCE: the required rate of return of operating assets required by
shareholders and lenders is lower than the return on operating assets.
WRONG
EXERCISE 3 (3 points)
Proposals X and Y require an initial investment of $10,000 and are expected to generate an equal cash
inflow of $20,000 over their life of four years. The net cash inflow for each year of life of both
proposals is given (in $):

Years Proposal X Proposal Y

1 2,000 8,000
2 4,000 6,000
3 6,000 4,000
4 8,000 2,000
Total 20,000 20,000

3
 1) (1 points) Compute the net present value of cash inflows generated by each proposal
assuming a discount rate of 18%.

NPVx=$2,346
NPVy=$4,555

2) (1 point) Could you accept these projects? Which of the two proposal is better based on the
NPV?

The NPV of both proposals are positive and therefore both the proposals are acceptable, based on the
NPV method. The proposal Y, however, promises a higher NPV than proposal X and is therefore a
better investment to choose.

3) (1 point) Give two other selection criteria that you could have used.

IRR and payback period