Spring 1998
Problem 1
Bond Rating = BBB
Interest Rate = 9.00%
After-tax Cost of Debt = 5.40%
Unlevered Beta = 1.06/(1+(1-0.4)(.1111)) = 0.993756211
Beta at 25% D/E Ratio = 0.99(1+0.6(.25)) = 1.1428196426
Cost of Equity = 7% + 1.14 (5.5%) = 13.27%
Cost of Capital = 5.40% (.2) + 13.27% (.8) = 11.70%
Problem 2
Change in Firm Value = (250 + 50) (.11-.10)/(.10-.05) = 60
Change in stock price = 60/10 = $ 6.00 ($10.00 if you assume buyback at current price)
Problem 3
(100/250) (2) + (150/250) (X) = 5
Solve for X, X = 7 years
Spring 1999
Problem 1
Value of Bank Loan = 4 (PVA,7%,5) + 50/(1.07)^5 = $52.05 Alternatively, you can assume that the bank debt is at market value
Value of Bonds Outstanding = $50.00
PV of Operating Leases = 10 (PVA,7%,7) = $53.89
Market Value of Outstanding Debt= $155.94 Market Value of Debt = 153.94
Market Value of Equity = 15* 10 = $150.00 If you do this, the cost of debt will be a weighted average of 7% and
Debt Ratio = 155.94/(150+155.94) = 50.97% 8%, the cost of debt will be around 7.5%.
Problem 2
Change in Firm Value = 3 * 10 = $30.00
Firm Value (Chg in WACC)/(WACC(after)-.05) = 250 (Chg in WACC)/(.10 -.05)= 30
Chg in WACC = 0.60%
WACC before = 10.600%
Ke (.8) + 8%(1-.4) (.2) = 10.57%
Cost of Equity before transaction = (.106-.0096)/.8 = 12.05%
Problem 3
Value of firm before expansion = 300 + 70*10 = 1000
Duration of assets after expansion = 7.5 (1000/1250) + 1 (250/1250) = 6.2
Weighted Duration of Assets has to be equal to 6.2years
(200/550)(1) + (100/550)(4) + (250/550) (X) = 6.2
Solve for X
X = 11.24 years
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Equity
Value of stock = $ 3,000
Value of conversion option = 2500-1798= $ 702
Value of Equity = $ 3,702
Problem 2
Change in Firm Value = 500
5000 (.10 - WACC after)/WACC after = 500
Solve for WACC after,
WACC after = 500/5500 = 9.09%
Cost of Equity after = 5.5% + 1 (6.3%) = 0.118
11.8(X) + 5% (1-X) = 9.09%
Solve for X,
X = (9.09-5)/6.8 = 60%
Debt to Capital ratio = 40%
Problem 3
Cody's should have long term debt: Negative coefficient suggests duration of 7.5 years
BAM should have floating rate debt: Oper income tends to move with inflation
Spring 2000
Problem 1
a. False. It has to be weighed off against the increase in both costs
b. True. It will reduce the marginal tax advantage of debt
c. True. The net operating loss carry forward will reduce the tax benefit of the debt. (No matter how the
the argument is structured, the firm without net operating losses will be able to borrow more money and get
a larger tax savings. The NOL will reduce the income available from which interest expenses can be deducted.
d. False. If you are more uncertain about future investment needs, you will value flexibility more and borrow less.
Problem 2
Current cost of capital = Cost of equity (because firm has no debt) = 9.20%
Change in firm value = .1375 = (Cost of capital before - Cost of capital after)/Cost of capital after Common errors
0.1375 = (0.092 - Cost of capital after)/Cost of Capital after 1. Reversed the cost of capital before and after in
Solving, firm value change calculation.
Cost of capital after = 0.092/(1+.1375) = 8.09% 2. Computed change in firm value incorrectly
Cost of equity after = 10.48% 3. Did not use after-tax cost of debt
Cost of debt after = 4.5% 4. Other math errors.
10.48% (1-X) + 4.5% (X) = 8.09%
Solving for X,
X = 40%
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Problem 3
Duration of assets = 7 Common errors
Existing Debt = 1 (duration of this debt = 4 years) 1. Misread the problem to read change by instead of
New Debt = 3 change to.
(1/(1+3)) (4) + (3/(1+3)) X = 7 ! Since the asset mix does not change, the duration remains 72. Tried to change asset duration (why?)
Solving 3. Set up new debt incorrectly (had two unknowns with
Duration of new debt = 8 one equation)
Proportion on new debt that has to be 2 year debt = 25% (.25(2) + .75(10) = 8) 4. Other errors.
Spring 2001
Problem 1
a. Current Cost of Equity = 10.72% ! 5% + 1.04*5.5% ! If you decide to use the effective tax rate, the rationale
Current cost of debt = 3.90% has to be that you do not have enough operating income to c
Current cost of capital = 8.47% ! 10.72% (.67) + 3.9% (.33) However, this will mean that the effective tax rate should be
If you did this, I gave you full credit.
b. New debt to capital ratio = 50%
New debt to equity ratio = 100.00% ! I gave full credit if you read the increase as 0.25%
Unlevered Beta = 0.8 of the existing interest rate (I did take off half a point
New Beta = 1.28 if you read it as 25%
New cost of equity = 12.0400% ! You lost a point if you did not unlever and relever betas
New after-tax cost of debt = 4.05%
New Cost of capital= 8.05%
c. Number of shares bought back = 21.7391304 ! Since the price at which you were buying back the stock wa
c. Change in annual financing cost = $6.30 cannot divide by the total number of shares outstanding.
Change in firm value = $78.26
Change per share = $0.58 ! Transfer of wealth to stockholders selling back stock = (11.
Problem 2
Market value of the firm = 2000 ! 1000/.5
Dollar debt at optimal of 25% = 500 ! Don't increase the size of th
Duration of debt at optimal
Let X be the proportion of the debt that is 5-year debt at optimal
X (4) + (1-X) (8) = 7
X = .25
The firm has to have $ 125 million in 5-year debt and $ 375 million in 10-year debt
It needs to pay off $ 275 million of 5-year debt and $ 225 million of 10 year debt.
Spring 2002
Problem 1
Part a: Current cost of capital
Beta = 1.15 Math error: -0.5
Cost of equity = 9.85% forgot to after-tax cost of debt: -0.5
Cost of capital = 9.23% ! Debt ratio = 10%
Part c
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Borrow money over next 5 years and pay dividends ! Closely held, outperformed: Not target of a takeover - No immediacy
Its stockholders like dividends, because it has paid large dividends in the past ! ROC < Cost of capital : Don't invest
Its projects earn less than its cost of capital ! History of paying dividends: Pay more dividends
Problem 2
Cost of capital before = 9.00%
Cost of capital after 8.00%
Change in firm value = 800 ! Forgot to consider the effect of growth : -1 point
Increase in dollar debt to get to 25% = 1000
Number of shares bought back = 12.5
Number of shares left = 37.5 ! Did not adjust the number of shares for buyback : -1
Increase in value per share = 21.3333333 ( Remember that you cannot divide by 50 if you are buying back at the current price)
Problem 3
a. Long term, Dollar, Fixed Rate, Straight ! Heavy infrastructure: Long term 0.25 points off for each mistake
! U.S. operations: Dollar
! No pricing power: Fixed
! Low growth: Straight
b. Long term, Mixed Currency, Floating Rate, Straight ! Brand Name: Long term
! Worldwide operations: Mixed Currency
! Pricing power: You can pass inflation through Hence, floating rate debt
! High margins and cashflows : Straight
c. Short term, Dollar, Fixed Rate, Convertible ! Speedy Obsolescence: Short term
! U.S. operations: Dollar
! High Uncertainty: Floating (but Competitive Industry: Fixed - So, I gave credit for both)
! High growth: Convertible
Spring 2003
Problem 1
Current cost of capital = 9%
Current debt ratio = 0.25
Current after-tax cost of debt = 0.036
Current cost of equity = 0.108
Current beta = 1.45
Change in firm value $393.82 ! (.09 - .0819) (4000)/.0819 ! If you had the NPV of the new investment, you can add that on.
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Problem 2
Duration of existing debt = 2.00
Spring 2004
Problem 1
New beta = 1.12
Cost of equity = 0.093984
Problem 2
a. Value of firm = 1050 ! 80*10+250
Cost of capital = 10%
Cashflow last year = 50 1050 = 50 (1+g)/ (Cost of capital -g)
Expected growth rate= 0.05 1050 = 50 (1+g)/(.10-g)
Problem 3
6 (150/500) + 8 (100/500) + X (250/500) = 10
Solving for X,
Duration of new bond = 13.2
Since the firm has little pricing power, you would go with fixed rate debt
Since half of its revenues come from the EU region, half of its total debt of $ 500 million should be in Euros
Hence the firm should use 100% Fixed rate, Euro debt
Spring 2005
Problem 1
Value of unlevered firm = 1000 !100 *10 !This firm has no debt. This is the unlevered firm value.
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Problem 2
Current market value of equity = 4000 1. Error in estimating current cost of equity: -0.5
Market value of debt = 1000 2. Did not unlever beta: -0.5
Value of firm = 5000 3. Estimated new cost of equity wrong: -0.5
4. Used old cost of equity instead of capital in computing firm value change: -0.5
Cost of capital = 10.44% = Cost of equity (.80) + 4.2% (.20) 5. Did not compute PV of annual savings: -0.5
Cost of equity = 0.12 6. Did not compute increase in firm value at all: -1
Current beta = 1.75
Problem 3
a. Current asset duration = 0.75(10) + 0.25 (5) = 8.75 Current Balance Sheet
Transporation 0.75 Debt 0.5
b. Expected asset duration if tourism business doubles = (0.75/1.25)(10) + (0.5/1.25) (5) = Tourism 0.25 Equity 0.5
To solve for duration of new debt
(.5/.75)*6+(.25/.75)*X = 8 ! New debt issue = 0.25 New Balance Sheet
Transporation 0.75 Debt 0.75
Duration of new debt = 12 Tourism 0.5 Equity 0.5
Fall 2006
Problem 1
a. Cost of equity = 4.5% + 1.00*4% = 8.50% ! Mechanical errors: -0.5
Cost of capital = 8.5% (.9) + 5% (.1) = 8.15% ! Tax effect: -0.5
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Prtoblem 2
Duration of assets after divestiture = 8.25 ! Duration for assets computed incorrectly: -1.5 to -2
Spring 2007
Problem 1
a. Cost of capital at existing debt r 8.44% ! 13%(.4)+9%(1-.4)(.6)
b.
Beta at current cost of equity = 2 ! (13-5)/4
Unlevered beta = 1.0526
New Debt to Equity Ratio = 42.86% ! (600-300)/(400+300)
Levered Beta = 1.32330827
New cost of equity 10.29%
New cost of capital 8.29%
Problem 2
a. Change in firm value = $11.11 ! (80+20)(.10-.09)/.09
b. Number of shares bought back = 6
Share of firm value to buy back $6.00 ! 6* $1/share
Share of firm value to remaining $5.11
Number of shares remaining 14 ! 20-6
Value increase per remaining sha $0.37
Problem 3
Duration of existing assets = 8 ! 2(5/20)+10(15/20)
Duration of existing debt = 8
Spring 2008
Problem 1 Grading Guidelines
Old debt to equity = 0% 1. Did not adjust the cost of equity at all: -1.5 points
Current beta = 1.00 ! Cost of equity is 9%; Rf =5% and Risk premium =4% 2. Error in beta estimation: -0.5 to -1 point
New debt to equity = 42.86% ! 600/1400; Debt used to buy back stock 3. Weights incorrect: -0.5 point
New beta = 1.2571 4. Forgot to after-tax cost of debt: -0.5 point
New cost of equity = 10.03%
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Problem 2
Current cost of capital = 12% 1. Cost savings per year incorrect: -0.5 point
New cost of capital = 10.00% 2. PV of savings incorrect: -1 point
Market value of firm = 1000 ! 200 + 800 3. Math errors: -0.5 point each
Annual cost savings = 20
PV of savings (with g=4%) = 333.333333 ! 20/ (.1-.04): Okay if you used (1+g)
New firm value = 1333.33333
Spring 2009
Problem 1
a. Existing cost of capital
Estimated val Weoight Cost Risk measure
Debt 600 0.6 6.00% BB ! Wrong cost of debt : -.5
Equity 400 0.4 17.68% 2.28 ! Math error: -.5
Capital 1000 10.67%
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Problem 2
Current cost of equity = Current cost of capital = 10.00% ! Firm value computed incorrectly: -1
If investors are rationa, all shares get an equal portion of increase in firm value ! Did not lever beta: -1
Increase in firm value = 100 ! Since investors are rational, ! Error in setting up new WACC: -.5 to -1
all shares gain $1.00.
Solving for cost of capital after,
(Cost of capital before - Cost of capital after)*Existing firm value/ Cost of capital after =100
(.10-Cost of Capital after)*1000/ cost of capital after = 100
Cost of capital after = 9.09%
Beta after = 1.4 ! Lever the beta, using new debt/equity ratio
Cost of equity after= 12.400%
12.4% (.6) + X(1-.4) (.4) = .0909
Pre-tax cost of debt = 6.88%
I kept the firm value constant at 1000 in the example above. If you use 1100 as firm value, the answers will be different.
D/E ratio after = 0.57142857
Beta after = 1.34285714
Cost of equity after = 12.06%
12.06% (700/1100) + X (1-.4) (400/1100)= .0909
Pre-tax cost of debt = 6.49%
Problem 3
Weighted duration of assets after cash is used = 8.4 ! Weighted average of just operating asse! Computed beta of assets including cash: -1
Duration of the debt has to be equal to this after the debt is paid off: (since cash is being used for retiring de (Cash is used up after the transaction)
X (10) + (1-X) (0) = 8.4 Did not comptue the new debt level right: -1
84% of the debt has to be 10-year zero coupon debt. Other math errors: -.5 point
Total debt outstanding after debt retirement = 1300 ! Debt outstnading before - Debt repaid
!0-year zero coupon debt = 1092 ! 84% of outstanding debt
10-year coupon debt to be paid off = 108 ! Long term debt repaid
Short trm debt to be paid off = 92 ! Short term debt repaid
Spring 2010
Problem 1
a. Current cost of capital
Cost of equity= 10%
After-tax Cost of debt = 3.60% ! Wrong weights: -0.5 pt
Debt/Capital ratio = 20.00% ! Did not after-tax debt: -.5
Cost of capital = 8.72%
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Problem 2
Current firm value = 1000 ! Did not set up firm value change : -2 to -3 point
Current cost of capital = 9% ! Used wrong firm value: -0.5 point
! Computed change in firm value wrong: -1 point
Since the shares were bought back at $10.50 and investors are rational
Increase in firm value = 50 ! Everyone has to receive $0.50 more ! No penalty for using (1+g)
Increase in firm value = (Old cost of capital - New cost of capital) Firm value/
(New cost of capital - growth rate)
50 = (.09-X) (1000)/(X-.03)
Solving for X,
New cost of capital = 8.71%
Problem 3
Duration of debt currently = 8 !Duration of debt incorrect: -1 point
Duration of all assets = 8 ! Weigths for assets incorrect: -1 point
Spring 2011
Problem 1
Current D/(D+E) = 40.00% Error in computing current cost of equity/beta: -1 point
Current after-tax cost of debt = 4.80% Used wrong debt to equity ratio in unlevering beta: -0.5 point
Cost of capital = Cost of equity (.60) + 4.80% (.40) = .0972 Did not unlever beta: -1 point
Current cost of equity = 13% Did not compute new cost of capital correctly: -1 point
Current beta (levered) = 2
Unlevered beta = 1.42857143
New cost of equity (capital) = 10.14%
Problem 2
Current value of equity = 400 Used equity value instead of firm value in computation: -1 point
Current value of debt = 200 Used old cost of capital to discount savings: -1 point
Current firm value = 600 Math errors: -0.5 point
Current cost of capital = 10.50% Did not compute new stock price correctly: -1 point
New cost of capital = 10%
Annual savings = 3 (Okay if you used (1+g) in numerator)
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Problem 3
Value of acquirer = 400 Errors on weights for duration of assets: -1 point
Value of target = 400 Errors on weights for duration of debt: -1 point
Duration of combined firm's assets 5.5 Math errors: -0.5 point each
Total debt of combined firm = 600
Duration of debt = (200/600)*4+(100/600)*6+(300/600)*X = 5.50
Duration of new debt = 6.33333333
Spring 2012
Problem 1
a. Current Beta = 2.72 ! Did not after-tax cost of debt: -1/2 point
Cost of Equity 19.32% ! Error on weights: -1/2 point
After-tax Cost of Debt 5.40% ! Math errors: -1/2 point each
Market value of equity = $20.00
Market value of debt = $80.00
Debt to capital ratio 80.00%
Cost of capital 8.18%
Problem 2 ! Used wrong discount rate for change in firm value: -1 point
Pre-change cost of capital = 8.25% ! Used equity value instead of firm value: -1/2 point
Post-change cost of capital = 8.00% ! Error on increase in firm value: -1 point
Pre-change value of firm = $1,000.00 ! Market value of equity + Debt ! Did not compute change in value from buyback: -1.5 points
Change in cost of capital = 0.25% ! Did not subtract out premium paid in buyback: -1 point
Savings in financing costs = $2.50 ! Change in cost of capital * Firm value ! Divided change by total number of shares: -1.5 points
Increase in firm value = $31.25 ! Savings per year/ New cost of capital
Remaining change in value = -$8.75 ! Increase in firm value - Premium paid in buyback
Remaining shares outstanding = 40.00 ! Original shares outstanding - Bought back shares
Change in value/share -$0.22 ! Remaining change in value/ Remaining shares outstanding
Price per share $9.78
Problem 3
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Existing debt
Duration of existing debt = 2 ! 0.5 (3) + 0.5 (1)
Value of new debt = 1500 ! Set equal to acquired company
(500/2000) (2) + (1500/2000)(X) = 5.75
Duration of new debt = 7
Spring 2013
Problem 1 Grading template
Current cost of capital = Current cost of equity = 10% 1. Did not back out beta: -1 point
Unlevered beta for the firm = 0.75 2. Did not adjust tax rate: -1 point
Current value of firm = 1000 3. Did not relever beta: -1 point
If it borrows $ 800 million 4. Did not after-tax cost of debt: -1/2 point
Interest expense = 60 5. Error on new debt ratio: -1 point
EBIT = 45 6. Math errors: -1/2 point each
Adjusted marginal tax rate = 30.0%
New Debt to equity ratio = 400% ( I gave full credit, if you relevered the beta using the 40% tax
New Debt to capital ratio = 80% rate instad of the adjusted marginal tax rate)
New levered beta = 2.85
New cost of equity = 20.100%
After-tax cost of debt = 5.25%
Cost of capital = 8.22%
Problem 2
The first step is to estimate the current value of the firm
Debt outstanding = 100 1. Did not compute change in value correctly: -1 point
Market value of equity = 400 2. Did not set up for new cost of capital: -1 point
Value of the firm = 500 3. Used new firm value in computation: -1/2 point
The next step is to compute the value gained by stockholders in the buyback 4. Math errors: -1/2 point each
Number of shares bought back = 5
Premium paid on buyback = 5
Value gained by buyback investors 25
Remaining shares = 11
Premium on remaining shares = 2
Value gained by remaining shares 22
Total value gained = 47
The third step is to set the value gain, relative to the original firm value
(.09 - New Cost of capital)* 500/ New cost of capital = 47
New cost of capital = 8.23%
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Problem 3
a. Duration of assets = 6.8 1. All or nothing, unless egregious math error
b. Duration of debt = 6.4 1. All or nothing, unless egregious math error
c. After acquisition of new business 1. Did not compute new asset duration: -1 point
Duration of assets = 7.25 2. Did not set up for new debt duration: -1 point
To set the duration of the debt to 7.25 years after the debt issue 3. Math errors: -1/2 point each
Let the value of new bonds issued be X (Here is a test of the second part. If you plug in 7.25
Debt oustanding after = 5+X and don't get the right answer, the second part of
(3/(5+X)) *4+ (2+X)/ (5+X) *10 = 7.25 the problem is set up incorrectly)
Solving for X
X= $1.55
Check the answer 7.25
Spring 2014
Problem 1 Grading template
a. Current cost of capital
Current levered beta = 1.15 1. Wrong debt ratio: -1/2 point
Cost of equity = 8.7500% ! 3% + Beta *5% 2. Math errors: -1/2 point each
After-tax cost of debt = 3.00% ! Pre-tax cost of debt (1-.40)
Debt to capital ratio = 20%
Cost of capital = 7.600%
Problem 2
Value of firm before buyback 2400
Cost of capital before buybac 10%
Growth rate in perpetuity = 2%
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Problem 3
a. Duration of assets today Duration Weight Value
Hotel business 20 60% 600 ! Value of business = Debt + Equity = 800 + 200 = 1000
Travel business 2 40% 400 1. Weights incorrect: -1/2 point
Company assets 12.8 2. Math errors: -1/2 point
c. After expansion
Expansion investment = 200
Duration of assets Duration Weight Value
Hotel business 20 0.5 600 1. Used old asset duration: -1 point
Travel business 2 0.5 600 2. Weights wrong for new duration: -1 point
Company assets 11 3. Weights wrong for debt: -1 point
5. Math errors: -1/2 point
Duration of debt
Existing debt 8 0.5 200
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