BUS 530
PRIVATE
BUS 530
Name:___________________________.
Notation and Formulae
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WACC = kd(1()Wd + ksWs +kpsWps
Hamada’s leverage adjustment: (L = (U XXXXXXXXXXD/S)
Options Pricing
Binomial Process
S0eσ√Δt
S0
XXXXXXXXXXS0/eσ√Δt
Risk Neutral Probabilities for solution of Stock Options
S0erΔt = puSu + (1pu)Sd, where r is the domestic RF rate
Section 1. 10 points each. Address only 10/13 questions in this section. Clearly strike out the questions not addressed. Show all work.
1. Modigliani & Miller argue that capital structure and dividend policies are relevant to the value of the firm only because of certain tax policies. Discuss this statement while highlighting the specific tax policies implied therein.
2. The management of RuNutz Construction has gathered the following data for a potential project in Beaverton to be financed by internal funds ($1 million) and a zerocoupon bond ($0.70 million) yielding 5%.
Year 0 Initial investment: $1.7 million
Year 1 Sale Price of Project = $4 million
Year 1 Operating Costs and expenses = $0.50 million
Year 1 Depreciation = $0.10 million
Year 1 Tax rate = 21%
The expected return on the Market is 10%.
a. Establish the Year1 Free Cash Flow from the Project.
b. Establish the NPV of the Project.
3. Cisco is raising funds for its project in Beaverton, OR. The project will need a capital outlay of $100 million, which will be financed in the following manner:
· $40m debt; yield to maturity based on bond proceeds after investment banking fees: 5.5%
· $60m equity; new issue of stock; the company paid $2 in dividends last year, and dividends are expected to grow at 3% per year forever. Cisco’s stock price is $42, and investment banking fees will be $1 per share issued.
What is the hurdle rate for the project? (The tax rate is 21%.)
4. You wish to estimate the required rate of return on your new mushroom farming business. You have borrowed $1million at the cost of 5%, and have used another $1million of your own funds. To estimate the cost of equity, you will use information available on the proxy company, MushroomsRus (MRU). MRU has a beta of 1 and has a debt to equity ratio of 2. The expected return on the Market is 10% and Treasury bonds are yielding 3%. Establish your projects required rate of return from the above data. (Tax rate is 21%.)
5. Notbad Corp. is to choose between 2 mutuallyexclusive projects that will be funded with retained earnings. The projects are expected to have the following cash flows:
Project A: Year 0: ($1,000), Years ending 1 – 5: $600.
Project B: Year 0: ($11,000), Years ending 1 – 5: $6200.
The beta of the projects is 1 and the expected return on the market is 10% and RF=5%. Which of the projects would be selected under the assumption that the company is rationing capital? _________
6. With NPV its preferred capital budgeting technique, your company is evaluating two mutually exclusive projects with unequal lives. Project X will incur a onetime cost of $1 million and will result in annual cashflows of $300,000 for the next 3 years. Project Y will incur a onetime cost of $1 million and result in annual cashflows of $200,000 for 9 years. The cost of capital is 8%. Which of the two projects ought to be selected?
7. Project X will require an initial investment of $10m to be financed with retained earnings. The beta of X is 1, and the expected return on the Market is 10%. The project is expected to produce the following free cash flows: year 1: $2, year 2: $5m, year 3: –$1m, year 4: $8m. Establish the NPV and MIRR of the project and indicate whether you would pursue it.
8. The management of Tarantulagoodies is considering a reduction in the corporation’s debt ratio. The following information is available:
Debt
$13,000,000, kd=7%, taxrate=21%
Common Stock
$20,000,000, (=0.9, RF=3.5%, E(RM)=10%.
The issuance of $5,000,000 in common stock and repurchase of debt in that same amount is expected to result in the reduction in kd to 6.5%. The impact of the action on the cost of equity is to be determined. Should management pursue the change in debt ratio? Why/why not?
9. Consider the following information on options on Crude Oil.
Current price
Strike
1 month Calls
1 month Puts
$45
40
7
$2.75
$45
50
3
$6.50
a. Provide a collar strategy for Shalen, an oil extraction company. Be specific and provide the total cost of the strategy.
b. Provide a collar strategy for Petrolen, an oil refining company. Be specific and provide the total cost of the strategy.
10. Consider the following information on INTC options
INTC
Strike
Call  July
Put  July
$50
$52
$1.90
$3.50
You wish to speculative $10,000 on the expectation that to be much more volatile (than indicated by implied volatility) until the third week of July (expiration). Discuss a speculative strategy based on this hunch. What is the payoff from your strategy if, at expiration, INTC is trading at $81?
11. Sock pricing – holding period:
The EPS of MCD is expected to grow at 10% over the next 5 years. The EPS over the last twelve months is $4. The beta of MCD is 1 and the E(RS&P)=10%. Provide the 1 year target price and fair value of stock if you believe the fair priced stock ought to have a PEG=1.
12. Stock pricing – DCF:
TSLA is expected to pay its first dividend of $100 five years from today. For years 6, 7, 8, 9, 10, you expect dividends to grow by 10% per year. Beyond year 10, you expect dividends will grow at 3%. The beta of TSLA is 1 and the expected return on the Market is 10%. Establish the fair value of the stock.
13. You ran a crosssectional regression of recent selling prices for condos in the zipcode 97203 on four variables with the following slope coefficients:
# Bedrooms: 20,000 (tstat: 12.60)
sq feet: 100 (tstat: 4.40)
Airconditioning (dummy with 1 for AC, 0 for none): 5,000 (tstat:3.5)
Distance to school in miles: 1,000 (tstat: 0.33)
Adjusted R2: 0.99
What is the fair value of a target property with the following features:
3 bedrooms, 2000 sq feet, no airconditioning, 10 miles from school.
Bonus Question – show work in each case (5 points)
1. Find the fair value of a call and put on AAPL employing a 1step binomial tree from the following information:
AAPL current price (S0)=$122
Strike (X)=120
Expiration (T) = 5 months
SD of AAPL returns (σ) = 25%
RF=3% (5 month Treasury bill rate)
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