EXAMPLE EXAM

Examination in the Master of Finance

Module title: Corporate Finance
Semester: Summer Semester 2016
Lecturer: Prof. Dr. Zacharias Sautner & Prof. Dr. Jing Zeng
Examination date: May 6, 2016

Aids: non-programmable calculator or HP 17B (and newer versions) or TI BA II+

professional
Reading / Preparation Time: 10 Minutes

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Please note:

The exam consists of 3 questions of which you will have to answer all 3 questions. You have 40
minutes to complete the examination. The maximum of points to be reached is 40. Please use the
enclosed answer sheet to answer your questions and add your student ID on its cover. Please make
appropriate assumptions if you think information is missing.

We wish you all the best for your examination!

Internal use only!

Question 1 2 3 Total
Possible points: 10 10 20 40
Points achieved:

Signature of corrector
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Question 1 (10 points)

You are analyzing a valuation done on a stable firm by a well-known analyst. Based on the expected
free cash flow to the firm, next year, of $30 million, and an expected growth rate of 5%, the analyst
has estimated a firm value of $750 million. However, he has made a mistake of using the book value of
debt and equity is his calculations. Although you do not know the book value weights that he has used,
you know that the firm has a cost of equity of 12% and an after-tax cost of debt of 6%. You also know
that the market value of equity is three times the book value of equity.

a.) What book value weights did the analyst use? (5 points)

b.) Estimate the correct value for the firm. (5 points)

Solution:

a.)
30 30
Value = 750 = = → rWACC = 9%
rWACC − g rWACC − 5%

(2.5)

rWACC = 9% = 12% × (1 − X ) + 6% × ( X ) → X = 50%

(2.5)

So the book value of debt that has been used is: 50% of value.

b.)

Market value of equity = 3x book value of equity

market value of debt=book value of debt

E/V=75% and D/V=25%.

rWACC = 12% × 0.75 + 6% × 0.25 = 10.5%

30
Value = = $545.45million
10.5% − 5%

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Question 2 (10 points)

You work as CFO at a company and you have to make a decision on how much to borrow. You
currently have 10 million shares outstanding, and the market price per share is EUR 50. You also
currently have EUR 200 million in debt outstanding (market value). You are rated as a BBB corporation
now. Your stock has a beta of 1.5 and the riskfree rate is 8%. Assume that the market risk premium is
5.5%. The marginal tax rate is 46%. You estimate that your rating will change to a B if you borrow
EUR 100 million. The BBB rate now is 11%. The B rate is 12.5%.

a.) What is your weighted average cost of capital with and without the EUR 100 million in
borrowing? (2.5 points)

b.) Given the marginal costs and benefits of borrowing the EUR 100 million, should you go ahead
with it? (2.5 points)

c.) If you borrow the EUR 100 million, what will the price per share be after the borrowing?
(5 points)

Solution

a.) The current D/E ratio = 200/500 = 0.4, and the debt to capital ratio is 200/700 = 0.2857.

The cost of capital =

(1-0.2857)(8+1.5(5.5)) + (0.2857)(1-0.46)(11) = 13.30%.

The unlevered beta is 1.5/(1+(1-0.46)(0.4)) = 1.234.

With the new borrowing, the beta becomes 1.234(1+(1-0.46)(0.6)) = 1.634, and the D/E ratio
becomes 0.6; the leverage ratio = 0.375.

The new cost of capital =

(0.625)(8+1.634(5.5)) + (0.375)(1-0.46)(12.5) = 13.15%.

b.) Since the cost of capital drops, you should go ahead with the borrowing, assuming that the new
funds are invested in similar projects as the existing firm.

c.) At this capital structure, the equity would change in value by

(200+500)(0.0015/0.1315) = EUR 7.984 million

Hence the price per share increases to EUR 50 + EUR 7.984 million/10 million = EUR 50.8.

(Assuming no growth. If we were able to estimate future growth, the value change would be greater)

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Question 3 (20 points)

The French government wants to pass a new law that would automatically award double voting rights
to long-term shareholders in French companies. Long-term shareholders are defined as shareholders
that have been holding their shares for at least two years. Discuss the costs and benefits of such a law.

Solution:

(Different answers possible; full points if answer is well-structured and well-reasoned)

Benefits (10 points)

• If managerial short-termism caused by investors with short horizons is a problem, this may lead
to better and more long-run decision making as long-term investors have more influence.
• Incentives to hold shares for the long term encourages better corporate governance as long-
term investors have better knowledge how to monitor effectively and are more likely to reap
the benefits from monitoring.
• …

Costs (10 points)

• It may preserve the interests of the dominant shareholders; in some cases the state or a family.
Dominant shareholders may use their extra power to take actions that are detrimental to the
interests of small shareholders (e.g., tunneling, expropriation). So rights of small shareholders
are weakened.
• May lead to a discount in the valuation of French firms as small shareholders feel expropriation.
• …