Retake Exam: Corporate Finance 22/23

Thomas Geelen

February 8, 2023

You need to hand in two documents:

1. Filled out Excel sheet that I supplied to you. This file must
contain your answers to Q1 to Q18.

2. A PDF document with your answers and explanations for the

remaining questions.

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 READ THE INSTRUCTIONS BELOW CAREFULLY!

• This exam is open book, lasts 4 hours, and is 9 pages long.

• Unless otherwise specified, assume discount rates are strictly positive.

• For Q1 to Q18, you need to fill in your answers in the Excel sheet supplied.
For these questions, no further explanation of your results is required. For
the remaining questions, you need to hand in your results plus an explana-
tion of how you came to these results.

• Sub questions are indicated with lower case letters (a,b,c,...). Multiple choice options
are indicated with upper case letters (A,B,C,...).

• All your numerical final answers must be given in rounded 3-digits behind the decimal
separator unless otherwise stated, i.e. if you get 0.1234 then your answer should be
0.123 and if you get 0.2345 then your answer should be 0.235.

• Intermediate answers should not be rounded unless otherwise stated! This implies that
if in question a. you got 0.1234 you report 0.123 but if you need to use the answer from
question a. in question b. you continue to work with the number that is not rounded
0.1234.

• When I ask for percentages report them as follows: 7% should be reported

as 0.070 and 16.3% as 0.163.

• You need to hand in two documents: 1) Filled out Excel sheet with your
answers to Q1 to Q18 and 2) a pdf with your answers and explanations for
the remaining questions.

• Good luck!

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Part I
Answer the questions by filling in the provided Excel sheet.

Q1. A project costs 7 today and generates a yearly cash flow starting from next year. This
cash flow is 3 next year and after that grows at a rate of 2% per year. Besides these
cash flows, there is an additional −5 cash flow in year 3. Given a discount rate of 5%,
what is the NPV of this project?

Q2. A project costs 6 today and generates a yearly cash flow that grows at a rate of 3% per
year. The first cash flow is paid today and is 0.5. Given a discount rate of 5%, what is
the NPV of this project?

Q3. What is the internal rate of return (IRR) of the project in Q2?

Q4. Assume rM = rf . Increasing an asset’s β ...(fill in)... its expected return.

A. Increases
B. Does not change
C. Decreases

Q5. Assume an asset’s β > 1. Increasing the risk-free rate rf ...(fill in)... the asset’s
expected return.

A. Increases
B. Does not change
C. Decreases

Q6. Assume the Modigliani-Miller assumptions hold true. Increasing a firm’s leverage ...(fill
in)... its firm value.

A. Increases
B. Does not change
C. Decreases

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 Q7. Assume the Modigliani-Miller assumptions hold true, a firm’s assets have positive β > 0,
and its debt is risk-free. Increasing a firm’s leverage ...(fill in)... the expected return
on its equity.

A. Increases
B. Does not change
C. Decreases

Q8. A firm’s debt has a senior and junior tranche. In default, the junior tranche ...(fill in)....
the senior tranche is paid back.

A. Is paid back before

B. Is paid back at the same time as
C. Is paid back after

Q9. Underwriting fees are ...(fill in)... debt issuance.

A. Higher for equity issuance than for

B. Roughly the same for equity issuance and
C. Lower for equity issuance than for

Q10. In a frictionless world, share repurchases at market value ...(fill in)... a companies share
price.

A. Increase
B. Do not affect
C. Decrease

Q11. Increasing accounts payable days ...(fill in)... a companies cash cycle.

A. Lengthens
B. Does not affect
C. Shortens

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Q12. You want to purchase a good using trade credit with terms of 2/30, Net 50. What is
the effective annual cost of not taking the discount?

Q13. If a takeover becomes more likely and the acquirer pays a premium, then the merger-
arbitrage spread ...(fill in)...

A. Increases
B. Does not change
C. Decreases

Q14. We are in the Black and Scholes world and there is a stock that does not pay dividends
for the next two years. The stock price today is 75. A put option with a strike price of
70 that matures in two years is traded for 7.01224. The discretely compounded risk-free
interest rate is 4.5%. What is the implied volatility?

Q15. Using the information from Q14, what is the price of a call option on the stock from
the previous question with a strike price of 75 that matures in two years?

Part II
Answer the questions by filling in the provided Excel sheet.

Q16. An investment project that requires an year-0 capital investment of 16, which is de-
preciated in a straight line over 8 years. Furthermore, in year 1 net working capital
increases by 8 and in year 9 this extra net working capital is returned. The project
generates the following EBIT:

Time 1 2 3 4 5 6 7 8 9

EBIT 3 3 2 2 4 4 5 6 7

The β of the (unlevered) project is 1.25, the risk-free interest rate is 4.5%, and the
market risk premium is 4%. The corporate tax rate is 25%.

a. What is the free cash flow that the company generates in each year?

The firm wants to keep a constant debt to equity ratio (debt/equity) of 0.45, and given
this debt to equity ratio, debt is risk-free.

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 b. What is the rwacc ?
c. What is NPV of the levered project?

Assume now that instead of keeping a constant leverage ratio the firm wants to issue
risk-free debt worth 25 that matures in 8 years and makes coupon payments in years 1
to 8. From year 9 onwards, the firm will be unlevered

d. What is NPV of the unlevered project?

e. What is NPV of the levered project?

Q17. Company A has the following balance sheet in market values with duration in brackets

Assets Liabilities and Equity

Foreign Subsidiary 50 (15) Short-term debt 25 (5)
Equipment ? (5) Long-term debt 25 (?)
Government bonds 15 (10) Equity 50 (10)
Cash 15 (0)
Receivables 10 (1)

a. What is the duration of the long-term debt?

b. The yearly compounded risk-free interest rate currently is 3%. If it would go down
by 1% percentage point then what would approximately be the new equity value?
c. The company can exchange government bonds for cash or vice verse. How much
should the company hold in government bonds such that the equity has a duration
of 9 years?

Q18. In the market, four assets are traded with payoffs

 
1.1 1.3 1 1
S = 1.1 1 1 1.3 .
 

1.1 1 1.3 1

The price of all assets is 1.

There is an investment opportunity that costs 2. This investment pays off 5 minus the
payoff of the third asset (third column) to the power three.

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 a. What is the payoff of this investment opportunity?

The central bank imposed a restriction on portfolio holdings. You aren’t allowed to
short sell the risky assets so x2 ≥ 0, x3 ≥ 0, and x4 ≥ 0.

b. Given this restriction, what is the replicating portfolio for the payoff of the invest-
ment opportunity?
c. What is the NPV of the investment opportunity?
d. What are the risk-neutral probabilities for each state?

Part III
For the remaining questions you need to hand in your results plus an explanation
of how you came to these results.

Q19. There is a two period world (with dates zero, one, and two) with two assets as described
below.

(1.042 , 1.3)
Up
(1.04, 1.15) Dow
n
Up (1.042 , 1)

(1, 1)
Do
wn
(1.042 , 1)
Up
(1.04, 0.85) Dow
n
(1.042 , 0.7)

You have an investment opportunity that can be undertaken today (date zero), at date
one, or date two. Undertaking the investment opportunity costs 5 today, 4.8 on date
one, 4.6 on date two. The PV of future cash flows after the investment cost is paid
(so on the date you undertake the investment) depend on the timing of the investment
and are given below. For example, if I would undertake the investment opportunity on
date one in the up state then the PV (at date one) of future cash flows after investment
would be 7. Additionally, on date one I would also need to pay the investment cost
of 4.8. This implies that at date one in the up state the NPV from undertaking the

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 project would be 7 − 4.8 = 2.2. What is the PV of this real option and what is the
optimal exercise strategy?

Up 7.75

7 Down
Up 6.5

7.4
Do
wn
Up 4

7 Down

Q20. Assume there is a firm that generates a risk-free cash flow X > 0 at date one. The
manager can abscond (“run away with”) with a fraction α ∈ (0, 1) of the cash flow. All
cash flows are discounted at a rate r.

a. What is the value of the firm if it is all equity financed?

Debt can be used to alleviate this agency problem. The firm can issue debt with a
principal D that needs to be repaid at date one. In this case, the manager can only
abscond with a fraction α ∈ (0, 1) of what is left of the cash flow after the debt has
been repaid.

b. What is the optimal amount of debt principal D∗ ≤ X that the firm should issue?

The cost of issuing debt at time zero with a principal amount D is βD2 with β > 0.

c. What is the optimal amount of debt principal D∗ the firm should issue in the
presence of debt issuance cost? Assume that β is sufficiently large such that
D∗ < X.
d. Given D∗ , assume that the firm pays out as much as possible to shareholders on
dates zero and one. What is the payout the firm makes to shareholders on date
one?

Q21. Assume there is a target T . The value of the target if it does not get acquired is VT > 0.
There is a first acquirer that values the target at V1 > VT .

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 a. What is the lowest offer P 1 ≥ 0 by the first acquirer that the target would be
willing to accept?
b. What is the highest offer P̄1 ≥ 0 that the first acquirer would be willing to make
for the target?

Assume now a second acquirer for the target arrives. This second acquirer values the
target at V2 with V2 > V1 .

c. Assume the target accepts the highest offer and the first acquirer offers P1 ≥ 0
then what offer would the second acquirer make?
d. Assume the target accepts the highest offer and the second acquirer offers P2 ≥ 0
then what offer would the second acquirer make?
e. What is the price the second acquirer pays for the target? Assume that if the
first and second acquirer’s offer are the same then the target accepts the second
acquirer’s offer.

Q22. For i ∈ {0, 1, 2, ...} we have that

C3∗i+1 = C,
C3∗i+2 = −C,
C3∗i+3 = C.

Assume r > 0. What is the closed-form solution for

∞
X Ci
?
i=1
(1 + r)i