MIDTERM EXAM

COURSE TITLE: FINANCE II

PROFESSOR NAME: Faten moussa/ marwa jerbi/NOURHAINE NEFZI
Program: UPM
Term: Winter
Date: 25th February 2023
Time: 120

INVIGILATORS
Invigilator(s) name(s) Signature(s)

Statement of Academic Integrity

MSB does not tolerate academic fraud, an act by a student that may result in a false academic evaluation of that student or of another
student. Without limiting the generality of this definition, academic fraud occurs when a student commits any of the following offences:
plagiarism or cheating of any kind, use of books, notes, mathematical tables, dictionaries or other study aid unless an explicit written
note to the contrary appears on the exam, to have in his/her possession cameras, tape recorders, cell phones, or any other
communication device which has not been previously authorized in writing.

Statement to be signed by the student:

I have read the text on academic integrity and I pledge not to have committed or attempted to commit academic fraud in this
examination.

Signature: ______________________________________

Note: an examination copy or booklet without that signed statement will not be graded and will receive a final exam grade of
zero.

INSTRUCTIONS
1. Books and notes Not allowed.
2. Calculators are Allowed.
3. Cell phones are Not allowed.
 First name:……………………………..Last name:………………………………………

ID:………………………………….Group:…………………………………………………

Part1- MCQ: Multiple choice single answer questions: Select the best answer and post it
on the MCQ table! (10mn; 18 pts)

1. If a project undertaken today is profitable and creates the opportunity to invest in a second project a year
from now this is called _____________ (4 pts)
A. Capital Rationing
B. Project sequencing
C. Independent
D. None of the above

2. Panda, Corp. is considering two expansion projects with conventional cash flow patterns. The first project
streamlines the company’s warehousing facilities. The second project automates inventory utilizing barcode
scanners. Both Projects generate positive NPV, yet Panda, Corp. only chooses the bar-coding project. Why?
(4 pts)
A. The payback period is greater than the warehouse project’s life.
B. The IRR of the warehousing project is less than the company’s required rate of return for capital
projects.
C. The company is practicing capital rationing.
D. All of the above are true.

3. You have a multiple IRR problem when ______________ (4 pts)

A. The project has an NPV profile that crosses the y-axis in two rate values.
B. The project has an NPV profile that crosses the x-axis in two rate values.
C. The project crosses the NPV profile of another project in two rate values.
D. None of the above

4. MEGA Insurance Ltd. issued a fixed-rate perpetual preferred stock three years ago at $30 per share with a
$2.75 dividend. If the company were to issue preferred stock today, the yield would be 5.5%. The stock's
current value is: (6 pts)
A. $30.00.
B. $40.00
C. $50.00.

Part2- Problems: Multiple choice single answer problems: Circle the best answer, post
it on the MCQ table, and give detailed explanation! (80 min, 82 pts)

Problem 1 (30min; 30 pts)

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SMART Inc. would like to finance a new project with an initial investment amount equal to 1Million dollars
using four types of financing sources with Retained earnings representing 20% of the total investment; Debt and
preferred shares representing 65% and 70% of the new common shares’ weight. The company has a tax rate of
30% and a before tax cost of debt of 8%. The perpetual preferred stock was issued at 25$ and it is trading today
at 30$ with a preferred dividend of 6$. The risk-free rate is estimated at 6%, the market risk premium is 10%
and covariance between the stock and market returns is 0.031 with stock’s variance estimated at 0.015. Flotation
costs represent 2% of the new common share value and they are tax deductible. The project is expected to
generate the following future cash flows CF1: $200,000; CF2: $300,000; CF3: $460,000
Instructions:
1. Calculate the WACC. (20pts)
2. Calculate the NPV of the project and interpret (10pts)

Solution
1. Calculate the WACC. (20pts)
 Provide the weight of each of the four financing sources. (8pts)
• Wre is given 20% (1pt)
• Wd=65% wcs
• Wp= 70%* Wcs
 Wre+wcs+wp+wd=1 (1pt)
 20%+wcs+70%wcs+65%wcs=1
 2.35wcs=1-0.2
 WCS= 0.8/2.35=34.04% (2pt)
 Wd=65%*34%=22.1% (2pt)
 Wp=70%*34%=23.8%(2pt)
 Provide the cost of each of the four financing sources. (9pts)
• After tax Cost of debt=rd*(1-t)= 8%*(1-30%) =0.056 (2pt)
• Cost of preferred shares= rp= Dp/Pp=6/30=0.2 (3pt)
• Cost of common shares rcs= cost of retained earnings rre= cost of equity (re)= using capm = rf+
beta * RP (1pt)
Beta = cov /var = 0.06/0.015= 2.07
Re= 0.06+(2.07*0.1)= 0.267(3pt)
 WACC= wd * rd (1-t) + wp * rp + we* re (1pt)
 (0.221*0.056)+((0.2+0.3404)*0.267)+(0.238*0.2)= 20.43% (2 pt)
2. Calculate the NPV of the project and interpret (10pts)
NPV Formula (1pt)
200 000 300 000 460 000
• PV of future cash flows= 1
+ 2
+ 3
=636282.2425 (3pt)
1.2043 1.2043 1.2043
• I0=1,000,000$
• Flotation costs =0.02*0.3404*1,000,000=6808

Remark: [Students can also use 0.34  Flotation costs will be equal to 6800 (correct too)

 Flotation costs after tax=6808*(1-30%)= 4765.6$ (3pt)

 NPV=636282.2425 -1000000-4765.6=-368483.3575$ NPV<0 Reject(3pt)

Problem 2 (25 min; 26 pts)

Raynold wants to find a profitable investment opportunity. The marketing department suggested the following
projects with their associated information. The projects are mutually exclusive.
CF 0 CF 1 CF 2 CF 3 WACC Expected (Target) recovery period
(considering time value of money)
Project A -1000 900 1600 0 10% 2.5years
Project B -1000 0 1000 2600 10% 2.5years

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Instructions:
1. Which project should Reynold choose based on Net Present Value (NPV)? Explain! (7pts)
2. Which project should Reynold choose based on the Profitability Index? Explain! (6pts)
3. Which project should Reynold choose based on liquidity (Considering time value of money)? Explain !
(12pts)

Solution:
1. Which project should Reynold choose based on profitability? Explain!
 NPV A= -1000+(900/(1.1)) + (1600/(1.1^2))= 1140.5>0 (3pts)
 NPV B= -1000+ (1000/(1.1^2))+ (2600/(1.1^3))= 1779.9>0 (3pts)
 NPV B>NPVA  B (1pt)
2. Which project should Reynold choose based on the profit per one dollar invested? Explain!
PI =1+ (NPV /I0) (1pt)
PI A= 1+(1140.5/1000)= 2.14>1  good project (2pts)
PI B = 1+(1779.9/1000)=2.78>1  good project (2pts)
Select B (2pt)
3. Which project should Reynold choose based on liquidity? Explain!
CF 0 CF 1 CF 2 CF 3
Project A -1000 900 1600 0
DCF (0.5pt) -1000 (0.5pt) 818.1818 (0.5pt) 1322.314 (0.5pt) 0
ACC DCF -1000 (0.5pt) -181.818 (0.5pt) 1140.496
Project B -1000 0 1000 2600
DCF (0.5pt) -1000 (0.5pt) 0 (0.5pt) 826.4463 (0.5pt) 1953.418
ACC DCF -1000 (0.5pt) -1000 (0.5pt) -173.554 (0.5pt) 1779.865

DPBP A= 1+ (181.8/1322.3)= 1.137 years (2pts)

DPBP B= 2+ (173.6/1953.4)= 2.09 years (2pts)

Both projects have DPBP < TARGET BUT PROJECT A HAS A LOWER DPBP  choose A (1.5pt)
Problem 3: (15 mn; 16pts)
METRO INC currently has 4 million common shares of stock outstanding. It also has $18 million face value of
bonds that have 5 years remaining to maturity, 8% coupon with semiannual payments and a yield to maturity of
9%. If the company issues up to $2 million new bonds, the bonds, will have the same yield to maturity as the old
ones. If it issues bonds beyond $2 million, the expected yield on the entire issuance will be 10%. New common
shares of stock could be issued at $14 a share. The company raises $10 million of new capital while maintaining
the same debt to equity ratio.
Instruction:
Calculate the cost of the new issued debt.
Solution
The cost of the new issued debt is the YTM. To find the new YTM we need to find the new issued debt value
and compare it to 2M$.
Value of new debt = New raised capital * wd =wd*10M$
Let’s find wd:
The company will keep the same debt to equity ratio  weight of debt and equity will remain the same  let’s
find the weights using the old debt and equity values
1. Find the old debt value=P0
 Coupon payment= (8%/2)*18M$= 0.72 M$ (2pts)
 Number of period= 5*2=10 semesters (1pt)
 YTM= 9%/2=0.045 (1pt)
 P0=c .¿ ¿ (1pt)
= 0.72 ¿ ¿17.28785536M$= 17287855.4$ (2pt)
2. Let’s find the common share value = 4000000*14$=56000000$ (2pt)
3. Let’s find the weight of debt;
 D = 17287855.4$
 E=56000000$
 D+E=73287855.36$

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  Wd=D/(D+E)= 17287855.4/73287855.36= 0.23588977 (3pts)
 Wd=23.59%
4. Let’s find the new value of debt and the rd
New D= 23.59%*10M$=2.359M$ (2pt)> 2M$  YTM= 10%  rd=10% (2pt)

Problem 4 (10min; 10pts)

Harmon, Inc. has a weighted average cost of capital of 8.5%. The company’s cost of equity is 11% and its
before-tax cost of debt is 6.1%. The tax rate is 35%. What is the company’s target debt to equity ratio?
Solution:
Setting up the WACC equation, we find:
WACC = 0.0850 = 0.11 (E/V) + 0.061 (D/V) (1 − 0.35) (3pts)  (with V = E+D)
Multiplying by (V/E) and rearranging the equation, we find:
 0.085 (V/E) = 0.11 + 0.061 (0.65) (D/E)
 0.085 (V/E) = 0.11 + 0.04 (D/E)
 (V/E) = 1.29 + 0.47 (D/E)
 (D/E) + (E/E) = 1.29 + 0.47 (D/E)
 (1-0.47) (D/E) = 1.29-1=0.29
 (D/E) = 0.29/0.53
 (D/E) = 0.55

Assume that Mary Brown Inc. hired you as a consultant to help it estimate the cost of capital. You
have been
provided with the following data:

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