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Final Examination
Answer each of the questions using the space provided. Each question is worth the points shown. You must show your work to receive the credit.
1. (6 pts) AIC Inc. is considering a debt issue and is trying to determine the appropriate amount to issue. Considering the information in the table below, indicate which amount borrowed you believe to the optional level of debt and explain why.
Amount borrowed |
Value of Equity |
Value of the Firm |
Stock Price |
WACC |
EPS |
0 |
18,460 |
18,460 |
18.46 |
13.0% |
2.40 |
2 million |
17,320 |
19,320 |
19.32 |
12.42 |
2.55 |
4 million |
15,830 |
19,830 |
19.83 |
12.10 |
2.70 |
6 million |
14,020 |
20,020 |
20.03 |
11.99 |
2.54 |
8 million |
16,570 |
24,570 |
24.57 |
11.50 |
3.04 |
10 million |
12,000 |
22,000 |
22.00 |
12.00 |
3.20 |
Note: Value of the Firm = Amount Borrowed + Value of Equity
2. (5pts) True or False (explain): The recent trend in executive compensation incentivizes companies to increase repurchases while disincentivizing dividends.
3. (15 points) Bullock Gold Mining is evaluating a new gold mine in South Dakota. All of the analysis has been done and the CFO has forecast some of the relevant cash flow information. If BGM opens the mine, it will cost $635 million today (Time 0). Of the initial costs, BGM will depreciate $500 million over 8 years using straight line method. Expected earnings before taxes for the eight years of operation are shown below. BGM has a required rate of return for all of its gold mines of 12%.
Earnings before taxes (in $1,000s):
0 |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
|
37,857.14 |
60,714.29 |
96,428.57 |
157,857.1 |
203,571.4 |
132,142.9 |
117,857.1 |
85,000.00 |
|
Find the relevant cash flows for each of the relevant periods (Time 0 – Time 9). Calculate the NPV, IRR and Payback Period for the cash flows and indicate whether BGM should pursue the mining project or not.
Operating cash flows for Time 1-8 should include:
Earnings before taxes
Taxes (30%)
Net Income
Depreciation
Free Cash flows
4. (20 points ) As connoisseurs of elegant fast food cuisine, we are interested in making a bid for the Greens-to-Go restaurant division of SlurpCo, Inc.. SlurpCo has three primary divisions, soft drinks, Major League football franchises, and the Greens-to-Go restaurants. Given the unique risk profiles for each of these divisions, it is imperative we estimate Greens-to-Go’s divisional beta to determine its fit into our company. Consider the following information:
Company Name |
Debt Ratio |
Levered Equity Beta |
Marginal Tax Rate |
Revenues ($ Mill) |
Parent Company |
60% |
0.95 |
40% |
|
Greens-to-Go |
65% |
?? |
40% |
|
|
|
|
|
|
Burger Doodle |
35% |
0.75 |
35% |
1.95 |
Southern Fried Taco |
45% |
1.25 |
30% |
2.85 |
Buffet Pizza Company |
40% |
1.05 |
27% |
0.75 |
a) Calculate the unlevered asset betas for each of the three comparable firms being sure to adjust appropriately for their respective marginal tax rates
b) Calculate the arithmetic industry average of the three asset betas
c) Calculate the weighted average asset beta using the revenues to determine the weights
d) Estimate a levered equity beta for the Greens-to-Go division for both the arithmetic and the weighted averages.
5. (20 points) Sunshine Inc., a large catering service provider, is evaluating the possible acquisition of Tasty Food Corp. (TFC), a regional catering service provider. Sunshine’s analysts project the following post-merger data for TFC (in thousands of dollars):
|
2024 |
2025 |
2026 |
2027 |
2028 |
Net sales |
$500 |
$600 |
$700 |
$760 |
$806 |
Selling and administrative expense |
60 |
70 |
60 |
90 |
96 |
The acquisition will occur in early 2024 if the acquisition will be made. TFC currently has a capital structure of 30 percent debt, which costs 9 percent, but Sunshine Inc. would increase that to 40 percent debt, costing 10 percent if the acquisition were made. TFC, if independent, would pay taxes at 25 percent, and its income would be taxed at 25 percent if it were consolidated. TFC's current market-determined beta is 1.40. The cost of goods sold is expected to be 65 percent of sales. Gross investment in operating assets is expected to be equal to depreciation--replacing worn out equipment, so net investment in operating assets will be zero. The risk-free rate is 7 percent, and the market risk premium is 6.5 percent.
Tax rate of ACC before the merger |
|
|
25% |
|
Tax rate after merger |
|
|
|
25% |
Cost of goods sold as a % of sales |
|
|
65% |
|
Debt ratio (percent financed with debt) before the merger |
30% |
|||
Cost of debt before merger |
|
|
9% |
|
Debt ratio (percent financed with debt) after the merger |
40% |
|||
Cost of debt after merger |
|
|
10% |
|
Beta of TFC |
|
|
|
1.40 |
Risk-free rate |
|
|
|
7% |
Market risk premium |
|
|
|
6.5% |
Terminal growth rate of free cash flow |
|
|
6.0% |
Note: βUnlevered = βLevered x 1+(1-Tc)x(E/D) and βLevered = βUnlevered x [1+(1-Tc) x (E/D)]
a. What is the unlevered beta for TFC pre-merger?
b. What is the levered beta for TFC post-merger?
c. What is the WACC for TFC post-merger?
d. Construct Free cash flow of TFC post-merger and calculate the present value of TFC after the merger
6. (8 points) This is based on “Dividend Policy at Linear Technology”.
a. What features of Linear Technology positively contribute to its profitability level especially during recession years, such as 2002, 2003? Please explain.
b. For 2002, calculate the payout ratio of Linear Technology.
7. (6 points) This question is based on “Hershey Foods Corporation”. If Nestle values Hershey for $95 per share, what is Nestle’s NPV from the merger?
8. (20 points) This question is based on “Landmark Facility Solutions”. Assume the following forecast is made by the Task force of Broadway regarding the acquisition deal of Landmark:
For Broadway, the task force suggests that:
Due to premium pricing strategy, its revenue would decline by 8% in 2015, 2016, 2017, and then grow at 5% thereafter. Premium pricing strategy would improve Broadway’s operating margin to 4% in 2015, 4.5% in 2016 and 2017, and 5% thereafter. Change in net working capital would be 0.5 million in 2015 and stays at the same level thereafter. Capital expenditure were expected to remain at 1% of annual sales. Depreciation would grow by $300,000 a year.
For Landmark, the task force suggests that:
Landmark’s revenue growth rate would be 6% from 2015 to 2018 and 6.5% in 2019 and thereafter. Its gross margin would be 5.5% in 2015, 6% in 2016, 6.5% in 2017 and thereafter. Its operating expenses as a percentage of sales would remain constant at 1%. Depreciation would grow by $200,000 a year. Capital expenditure were expected to be at 1.5% of annual sales in 2015 and thereafter. Its change in net working capital would be 1 million in 2015 and stays at the same level thereafter.
Based on these predictions and assume WACC is 8.44%.
(a) What is the value of Landmark to Broadway?
(b) What is the total amount of synergy of this merger?
(c) What is the NPV of this merger if the cost to buy Landmark is $80 million?
(d) what would be your answer to (b) if WACC is 7.5%?