Question 1

In the case Computing the cost of capital at Marriott hotels, the three
different divisions have three different discount rates.
a) What causes the above phenomenon? [2 marks]

Different Lines of business hence different risks

Different mix of debt and equity in different divisions

b) What distortions are introduced if a single cost of capital is used to

discount the projects from all divisions. [3 marks]

Poor(low NPV) projects in higher risk divisions get accepted at the cost
of good projects in lower risk divisions, making the firm more riskier over
time

Over time, managers of the less risky division would understand the
biases introduced by the above process. To get their projects selected,
they are likely to give higher forecasts of cash-flows for the projects from
their division. This would undermine the entire process of capital
budgeting.

Question 2 [3 marks]
Sharda enterprises currently has $1 billion of loans which have to be
repaid in 5 years along with interest expenses of $40 million a year. The
company currently has a CCC bond rating and has a default spread of 7%
over the risk-free rate of 3%. What is the current market value of the debt
of the firm.

Market value of bank loan $ 772.55 ! PV of $40 million for 5 years + PV of

$1000 at end of year 5 @ 10%

Question 3
You are trying to estimate the levered beta for Cineastes Streaming, a
niche movie streaming business that focuses on just animated and
children’s movies. It has increasingly expanded its content arm, making
original content for its streaming subscribers, and its current business mix
with estimated values in millions is listed below:

Estimated Value (in $ Unlevered Beta

millions)
 Movies (Content) 400 1.2
Streaming 1200 0.8
(Subscription)

The company is trading at its fair value, has no cash and $600 million in
debt outstanding. The marginal tax rate is 25%

a) Estimate the levered beta for the firm [2.5 marks]

Estimated Unlevered
Value Beta
Movies (Content) 400 1.2
Streaming (Subscription) 1200 0.8
Debt = 600
Equity = 1000 (Firm value = 400+1200 = 1600; Equity = 1600-600 = 1000)
Unlevered Beta = 0.9 1. Weights wrong: -1 point
E/V ratio = 0.625 2. D/E ratio incorrect: -1 point
Levered Beta = 1.44

b) Now assume that Cineastes Streaming acquires an animated movie

company to augment its content business. If the acquisition was at fair
value, and was funded by issuing $200 million in new shares and $300
million in new debt, estimate the new levered beta for Cineastes
Streaming, after the acquisition. (You can assume that the animated
movie company is in the content business.) [3.5 marks]

Estimated Value
Movies (Content) 900 1.2
Streaming (Subscription) 1200 0.8
New Debt = 900
New Equity = 1200 1. New weights wrong: -1 point
Value 2100 2. New D/E ratio wrong: -1 point
New Unlevered Beta = 0.971429 3. All math errors: -1/2 point each
E/V Ratio 0.571429
New Levered beta = 1.700
Question 4 [5 marks]
Calico Restaurants is planning to create a new online meals-to-order service and
has estimated that creating it will have the following effects on its operations:
a. Annual revenues will increase from $800,000/year to $1,300,000/year,
for the next 3 years.
b. While the restaurant earns an EBITDA margin (EBITDA as percent of
sales) of 30% currently, it expects to earn an EBITDA margin of 40%
on just its incremental online sales.
c. The tax rate is 20% and the appropriate cost of capital for online
restaurant businesses is 12%.
Assuming that there will be an initial cost of $450,000 for creating the service,
which will be depreciated straight line over 3 years to a salvage value of zero,
estimate the NPV for the investment.
Without Online With Online
Revenues 800 1300
Cost of capital 12.00%
EBITDA margin 30.00%
Online EBITDA Margin 40.00%
Tax rate 20.00%
Initial investment ₹ -450.00

Incremental annual cash flows

Incremental revenue 500
EBITDA on incremental sales 200
- Depreciation 150
Taxable income 50
Taxes 10
After-tax income 40
+ Depreciation 150
FCFF 190

NPV = ₹ 6.35

Question 5 [5 marks]
You are planning to make an investment of $10 million in new servers for your
business and expect to be able to depreciate that investment, straight line over
five years down to a salvage value of zero. If your tax rate is 40% and you were
able to expense the investment today instead, what effect will that have on your
NPV (assuming a cost of capital of 12%)?
Capitalize and depreciate
Depreciation/year ₹ 2.00
Depreciation tax savings/year
₹ 0.80
PV of savings = ₹ 2.88

Tax saving from expensing ₹ 4.00

NPV effect of expensing $ 1.12

Question 6 [4 marks]
You work for a Nagpur Drugs, small biotechnology company that has a 10-year
patent for a drug that it plans to license to a larger pharmaceutical company and
it has two offers:
• Serum Institute has offered to pay $100 million today and $50 million a year,
each year for the next 5 years.
• Bharat Biotech has offered to pay $50 million today and share 15% of net
income, expected to be $400 million annually, each year for the next 10 years.
The Corporate finance team has indicated that the discount rate for the offers
from Serum and Bharat Biotech should be 5% and 9% respectively, considering
the risk. Which offer should you select?
NPV of Serum Offer $ 316.47
EAA ₹ 73.10

NPV of BB offer $ 435.06

EAA ₹ 67.79

Question 7 [2 marks]
In your interactions with your friend you had informed him that the return on
equities was proportional to the risk of the stocks measured by volatility. He has
observed the following two stocks in his portfolio and is puzzled by the data. He
has come to you asking for a reason why this is possible. What will you answer
him?
 Return Volatility
Stock A 10% 40%
Stock B 15% 25%

Ans: The systematic risk of Stock B is higher than stock A, which is why even though vol of
Stock A is higher, its returns are lower.