LONDON BUSINESS SCHOOL

EMBA Programme

Corporate Finance II
Paolo Volpin

FINAL EXAM

2 hours
Total Points: 100
Instructions: The exam is closed book but you may use four double side A4 sheets of notes.
You may use a pocket calculator. You should only write in the space allocated to you after each
question. You may use the blank sheets of paper in the back of each page to do any
calculations and/or for your rough answers. Partial credit is given to answers that are
numerically incorrect but that show correct understanding of the solution method. Therefore you
have the incentive to show the approach you use to get the solution. A wrong number without a
good explanation will not obtain any partial credit. If the question is not clear, state your
assumptions clearly and if they are reasonable you will be given credit. Allocate your time
optimally. Good luck!

CODE (or name): KEY

1. (20 points) You have gathered the following data on a potential project. The initial
investment cost is 10,000 (at the end of year 0), which includes equipment worth
8,000 (to be amortized over the next 2 years) and working capital worth 2,000.
Sales at the end of year 1 are expected to be 22,000, and they are expected to
grow by 10% in year 2. Expenses (excluding depreciation) are 75% of sales, and net
working capital is 10% of sales. Yearly capital expenditures are expected to equal
depreciation.
After the first two years you expect free-cash flows to stay constant in perpetuity.
The initial investment is financed with debt and equity in equal proportion. The
interest rate on this debt is 5%. The weighted average cost of capital is 10%. The
corporate tax rate is 30%. All cash-flows occur at year end.

a. (10 points) Calculate the free cash flows associated with this project for year
0, 1, 2 and 3.
FCF=EBIT*(1-t) CAPEX + Depreciation - Change NWC
Year 0:

FCF = -10,000

Year 1:

EBITDA = (1-0.75)* SALES = 5,500

CAPEX = Depreciation = 4,000
EBIT = 5,500 - 4,000 = 1,500
NWC = 10% SALES = 2,200
Change NWC = 200
FCF =1,500*0.7-200 = 850

Year 2:

SALES=24,200
EBITDA = 0.25*24,200 = 6,050
EBIT = 6,050 4,000 = 2,050
Change NWC = 220
FCF = 2,050*0.7-220 = 1,215

Year 3 (and following): FCF = 1,215

b. (10 points) What is the market value of the equity of this company just after
the initial investment has been made? How does it compare with the book
value?
EV = 850/1.1 +( 1215/0.1)/1.1 = 11,818
Book Value of Equity = 5,000 and Book Value of Debt = 5,000 [since the 10,000 are financed in
equal proportion by debt and equity]
Market value of debt = 5,000
Market Value of Equity = 6,818.

2. (20 points) Below are data on the performance of two mutual funds based on
monthly returns over the period from June 2008 to August 2011:

Enhanced Risk Fund (ERF)

Smart Bet Fund (SBF)

Raw returns
1.73%
1.41%

Alpha
+0.55
+0.40

Beta
1.35
1.15

Alpha and Beta are the intercept and the slope of a regression of the monthly returns
for each of the two funds on the market return. Over the same horizon, the average
monthly return on the market portfolio was 0.875% and on the riskless asset was
0%.
a.

(5 points) How well did these fund perform over the period? Which fund had
a better performance over the period?

Funds performance is measured by Alpha (= average abnormal return) not raw returns. ERF
performed better than SBF since his alpha was 0.55 compared to an alpha of 0.4.

b. (10 points) Over the month of September 2011, the stock market index went
up by 5.6%, the riskless rate stayed at 0%. The return on ERF was 7.7%
while the return on SBF was 6.7%. How well did the funds perform and which
fund had a better performance over this period?

Abnormal Return (ERF) = 7.7% - 1.35 * 5.6% = 0.14%

AR(SBF) = 6.7% - 1.15 * 5.6% = 0.26%
SBFs abnormal return was greater than ERFs. Hence, SBF performed better.

c. (5 points) How does your answer to a. change knowing that the annual fees
are 3% on ERF and 1% on SBF?
AR(ERF) net of fees = 0.55% - 3%/12 = 0.30%
AR(SBF) net of fees = 0.40% - 1%/12 = 0.32%
SBFs abnormal return was greater than ERFs net of fees. Hence, SBF performed better net of
fees.

3. (20 points) Mr A, CEO of firm A, is considering whether to acquire firm B. The market
capitalization of A is $100m; while the market capitalization of B has historically
floated around $50m but has recently grown to $60m on the basis of rumors about a
possible deal. Mr A expects to realize synergies worth $20m in present discounted
terms. Both firms have 1 million shares outstanding and are fully equity financed.
After some negotiations with firm B, Mr A realized that he has only three options: (i)
no deal; (ii) paying $65m in cash to acquire firm B; (iii) issuing 0.65 share of A for
each share of B to acquire firm B. The last two options are equally appealing for firm
B and are the only terms at which the deal can be done.
a.

(10 points) Assume that the market capitalization of A has been floating
around $100m for a long-time. What should Mr A choose among the three
options?

The GAIN from the takeover is the present discounted value of the synergies: $20m.
The COST of a cash deal = $65m - $50m = $15m
Notice that we must use the value of B before the recent run-up in price as the stand-alone
valuation of B.
The COST of the stock deal = 0.65/1.65 * (100 + 20 + 50) 50 = $16.97m
Hence, the deal should be done and the means of payment should be cash.

b.

(10 points) Assume now that firms A market capitalization has only recently
moved to $100m from its historical level of $90m on expectations of a
possible deal. How would your answer to part a. change? Explain.

The GAIN from the takeover is still $20m.

The COST of a cash deal is still $15m
However, the COST of the stock deal = 0.65/1.65 * (90 + 20 + 50) 50 = $13.03m, where we
used the value of A before the recent run-up in price as the stand-alone valuation of A.
Hence, in this case the deal should be done and the means of payment should be stock.

4. (20 points in total) The 6-month euro/pound forward rate is 1.1864/; the spot
euro/pound rate is 1.1412/; the nominal (risk-less) interest rate on pounds is 1%
per annum; while the nominal (risk-less) interest rate on euro is 5% per annum.
Assume that you want to end up with a profit in pounds and that today you can borrow
1m or its euro equivalent for the purpose of speculation. Is there an arbitrage
opportunity? If yes, can you devise an investment strategy that makes a riskless profit
with zero initial wealth?
First, try to see whether the Covered Interest Parity holds:
F is 1.1864/; while S * (1 + r)/(1 + r) = 1.1412 * (1.05/1.01)0.5 = 1.1636.
Since, F > 1.1636, pound are more expensive than they should be in the forward market.
Hence, we want to sell pounds forward or buy euro forward.
To do so, we should borrow in euro and invest in pounds:
Now:
(i) Borrow 1.1412m euro (equivalent to 1m pounds) at 5% per annum
(ii) Convert them into pounds at the spot rate (1m pounds) and invest the pounds at 1%
rate per annum
(iii) Buy X euro in the forwards market at the 1.1864/ rate.
After 6 months:
(i) Must pay 1.1412*(1.05)^0.5 = 1.6938m euro
(ii) Investment in pounds pays 1*(1.01)^0.5 = 1.004987m pounds
(iii) To pay for (i) you must buy 1.6938m euro (thus X=1.6938m) forward at the cost in
pounds of 1.6938m/1.1864=0.985656m pounds.
The net payoff of this strategy is 0 now and 19,331 in six months.

5. Ms K, CEO of firm K, a technology company headquartered in the UK, is considering

whether to undertake a cross-border investment in the US which lasts for two years.
The investment cost at date 0 is $15m and will produce a Free Cash Flow of $9.6m
at date 1 (one year from date 0) and at date 2 (two years from date 0). The
appropriate WACC for an investment of this type in the UK is 18%. The spot
exchange rate at date 0 is $1.5/. Assume that the one-year riskless nominal rate in
both the US and the UK is 5% and that the two countries have internationally
integrated capital markets.
a. (10 points) Assume that the interest rates in the two countries are expected
to stay at their current level for the next two years. What is the NPV of the
investment? Should K invest?

Use WACC in domestic country:

FCF(0) = -15m/1.5= 10m
Need to compute forward rate at date 1 and 2:
F(1) = S * 1.05/1.05 = S = 1.5.
F(2) = S * (1.05)2/(1.05)2 = S = 1.5.
Hence,
FCF(1) = 9.6/1.5 = 6.4m
FCF(2) = 9.6/1.5 = 6.4m
NPV = -10 + 6.4/1.18 + 6.4/(1.18)2 =20,109 > 0
Decision: Investment.

b.

(10 points) Assume now that the interest rates in the US is expected to be
5% in the first year (from date 0 to date 1) and 0% in the second year (from
date 1 to date 2), while the UK rate is expected to stay at 5% for both years.
How does your answer to question a. change? Please comment

WACC (in pounds) stays as before: 18%

F(1) = S = 1.5. (as before)
F(2) = S * (1.05)/(1.05)2 = 1.4286.
(This means that the dollar is expected to strengthen)
Hence,
FCF(1) = 6.4m (as before)
FCF(2) = 9.6/1.4286 = 6.72m
NPV = -10 + 6.4/1.18 + 6.72/(1.18)2 = 249,933 > 0
Decision: Investment.
Investing in this case is even better because the cash flows in pounds are now higher given that
the project is generating cash flows in dollars and the pound is expected to weaken.