Final Cheat Sheet

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California State University, Fullerton *

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Finance

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Jan 9, 2024

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docx

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1. Perpetuity is a stream of equal cash flows that occur at regular intervals and last forever. TRUE 2. Opportunity cost of capital is the average of expected returns from all similar investments (in terms of risk and term) available in the market. FALSE 3. A security with a negative beta has a negative correlation with the market, which means that this security tends to perform well when the rest of the market is doing poorly, and vice versa. TRUE 4. Free cash flow is the cash left available to pay equity investors, after the firm has met all operational needs, tax obligations, and debt obligations. FALSE 5. When we apply the discounted free cash flow model to value a stock, we should use a firm's equity cost of capital (r E ) as a discount rate, because we are interested in knowing the firm’s stock price. FALSE 6. The “comparable” (multiples) method tends to generate a more accurate valuation than the DCF method and is especially reliable when the entire industry is overvalued. FALSE 7. An investment pays you $20,000 at the end of this year, and $10,000 at the end of each of the four following years. What is the present value (PV) of this investment, given that the interest rate is 4% per year? PV = $19,230.76 + $9,245.56 + $8,889.96 + $8,548.04 + 8219.27 = $54,133.60 8. A perpetuity will pay $ 800 per year, starting four years after the perpetuity is purchased (i.e., the first payment is to be made at time=4 ). What is the present value of this perpetuity on the date that it is purchased, given that the interest rate is 8%? 800/.08= 10,000 10000/(1+r)^N-1= 10000/(1+.08)^(4-1)= 10000/(1.08)^3= 7938.3 9. Clayton is a three -year-old boy (i.e., age 3) and he will go to college at age 18 (i.e., at t=15 ). Annual tuition at his dream college will be $50,000. Assume that Clayton will spend 4 years in college and that the interest rate will remain at 7% in the future. You will pay the tuition at the beginning of each college year (i.e., the first tuition is due in 15 years at t=15 , and so on). What is the present value of four years of college tuitions, evaluated today (i.e., at t=0 )? Pv = (50000*(1-(1+.07) ^-4)/.07*1)/ (1+.07)^14 = 65680 10. Clarissa wants to fund a growing perpetuity that will pay $6,000 per year to a local museum, starting next year. She wants the annual amount paid to the museum to grow by 6% per year. Given that the interest rate is 10%, how much does she need to fund this perpetuity? $ 6,000 / (10%-6%) = $6,000/4% = $150,000 11. A rich donor gives a hospital $100,000 one year from today. Each year after that, the hospital will receive a payment 5% larger than the previous payment, with the last payment occurring in ten years' time. What is the present value (PV) of this donation, given that the interest rate is 9%? PV = 100000/(9%-5%)*(1-((1+5%)/(1+9%))^10) 12. Jenny is considering opening an IRA in preparation for her retirement . She plans to save $9,500 per year with the first investment made one year from now (at t=1 ). Her retirement account earns 7% per year on her investments and she plans to retire in 25 years, immediately after making the last (25th) $9,500 investment. How much will she have in her retirement account on the day of her retirement? = 9500*((1+.07) ^25-1)/.07= 600865.9 13. Suppose that a young couple has just had their first baby and they wish to insure that enough money will be available to pay for their child's college education. They decide to make deposits into an educational savings account on each of their daughter's birthdays, starting with her first birthday. Assume that the educational savings account will return a constant 9%. The parents deposit $2400 on their daughter's first birthday and plan to increase the size of their deposits by 7% each year. Assuming that the parents have already made the deposit for their daughter's 18th birthday, then the amount available for the daughter's college expenses on her 18th birthday is closest to= FV of a growing annuity $2400 × (1 + 0.09)^18 =160,463 14. Dan buys a property for $250,000 . He is offered a 20-year loan by the bank, at an interest rate of 6% per year. What is the annual loan payment Dan must make? N = 20, I = 6, PV = 250,000, FV = 0, solve for payment and get 21,796 15. Jenny is considering opening an IRA in preparation for her retirement. She plans to save $9,000 per year with the first investment made one year from now (at t =1). She plans to retire in 25 years, immediately after making the last (25th) $9,000 investment. If she hopes to retire having $1,000,000 saved in her retirement account, what is the minimum annual return that her retirement account must earn for the next 25 years? 1000000= 9000* ((1+r%) ^25-1)/(r%) 1000000/9000= ((1+r%) ^25-1)/ (r%) = 10.81 16. Jenny has just retired with $1,000,000 saved in her retirement account. She decides to withdraw $60,000 per year in retirement with the first withdrawal one year after retiring (at time=1 ). How many years will it take until she exhausts her savings? Assume that her savings will continue to earn 3% in retirement. 1000000 = $60000[ 1-(1+0.03)^-n /0.03] = 23.45 17. Which of the following is(are) the main assumption(s) of the Capital Asset Pricing Model (CAPM)? Choose ALL that applies. ? 18. Which of the following statements regarding the beta in the CAPM is FALSE ? Although individual security's beta is easy to obtain, it is hard to compute a beta of a portfolio. 19. Suppose Intel stock has a beta of 1.73, whereas Boeing stock has a beta of 0.8. If the risk-free interest rate is 6.3% and the expected return of the market portfolio is 11.7%, according to the CAPM, a. What is the expected return of Intel stock ? i. 6.3 + 1.73 * (11.7-6.4) = 15.6 b. What is the expected return of Boeing stock ? i. 6.3% +0.8*(11.7%−6.3%) = 10.6% c. What is the beta of a portfolio that consists of 70% Intel stock and 30% Boeing stock? i. 1.73 * 70% +.8 * 30 = 1.45 d. What is the expected return of a portfolio that consists of 70% Intel stock and 30% Boeing stock ? i. .7 * 15.6 + .3 * 10.6 = 14.13 % 20. At the beginning of 2007 (the year the iPhone was introduced), Apple's beta was 1.1 and the risk-free rate was about 5.3%. Apple's price was $82.57. Apple's price at the end of 2007 was $197.71. If you estimate the market risk premium to have been 6.9%, did Apple's managers exceed their investors' required return as given by the CAPM? Yes a. Expected return = 5.3%+1.1 × 6.9%= 12.89% Realized Return = 197.71 - 82.57/ 82.57= 139.45 % 21. Pfd Company has debt with a yield to maturity of 7%, a cost of equity of 13% and a cost of preference stock of 9%. The market values of its debt, preference stock and equity are $10 million, $3 million and $15 million, respectively, and its tax rate is 35%. What is this firm’s WACC? WACC = [3/(10+3+15) * 9%] + [15/(10+3+15) * 13%] + [10/(10+3+15) * 7% * (1-0.35)] = 9.55 22. River Rocks, whose WACC is 12.1%, is considering an acquisition of Raft Adventures (whose WACC is 15.2%). What is the appropriate discount rate for RiverRocks to use to evaluate this acquisition? Raft Adventures' WACC is the most appropriate discount rate to account for the risk of Raft Adventures' cash flows. 23. Summit Systems will pay a dividend of $1.50 this year. If you expect Summit's dividend to grow by 6.0% per year, what is its price per share if the firm's equity cost of capital is 11.0%? a. Price of Share = Next Expected Dividend / (required return - growth rate)1.50 / (0.11 - 0.06) =$30. 24. CX Enterprises has the following expected dividends: $1 in on year, $1.15 in two years, and $1.25 in three years, after that, its dividends are expected to grow at 4% per year forever (so that year 4's dividend will be 4% more than $1.25 and so on). if CX's equity cost of capital is 12%, what is the current price of its stock? a. Value after year 3= (D3*Growth rate)/(Equity cost of capital-Growth rate)= (1.25*1.04)/(0.12-0.04)=16.25. Hence current price= Future dividend and value*Present value of discounting factor (rate%, time period) =1/1.12+1.15/1.12^2+1.25+16.25/1.12^3+ =$14.27(Approx). 25. Andyco, Inc. has the following balance sheet and an equity market to book ratio of 1.8. Assuming the market value of debt equals its book value, what weights should it use for its WACC calculation? If the assets is $1100, Debt is $500 and Equity is $600.

a). What is the weight for the debt in %? (Enter as percent rounded to two decimal places). Weight for Debt = Debt / (FMV Equity + Debt) = 500 / (1,080 + 500) = 0.316456. Weight for Equity = FMV Equity / (Debt + FMV Equity)= = 1,080 / (500 + 1,080) = 0.683544 26. Which of the following statements is FALSE regarding the discounted free cash flow model? It takes the perspective of a sole owner of the company who holds all of the firm’s equity, but not debt. 27. Victoria Enterprises expects earnings before interest and taxes (EBIT) next year of $2.4 million . Its depreciation and capital expenditures will both be $288,000, and it expects its capital expenditures to always equal its depreciation. its working capital will increase by $45,000 over the next year. Its tax rate is 40%. If its WACC is 11% and its FCFs are expected to increase at 4% per year in perpetuity, what is its enterprise value? a. Free Cash Flow=EBIT×(1−Tax Rate)+Depreciation−Capital Expenditures−Increases in Net Working Capital i. 2,400,000*(1-.4) +288,000-28,000-45000= 1655000 ii. What is its enterprise value =FCF next year/(WACC-g) =1655000/(.11-.04)= 23642857.14 28. The present value of JECK Co.'s expected free cash flow is $100 million . If JECK has $27 million in debt, $8 million in cash, and 2 million shares outstanding, what is its share price? a. Enterprise Value = Value of Equity - Value of debt + Value of cash. Value of Equity = Enterprise vale - Value of debt + Value of cash = 100 million - 27 million + 8million = 81 million. Share price = Value of Equity/No. of outstanding shares = 81 million/2 million = $40.50 29. You are evaluating the stock price of Kroger, a grocery store chain . It has forward earnings per share of $3. You notice that its competitor Safeway has a P/E ratio of 13. What is a good estimate of Kroger's stock price? a. Stock Price = PE Ratio x Earnings per share 13 x 3 = 39 hence, estimated stock price is 39 30. CSH has EBITDA of $5 million . You feel that an appropriate EV/EBITDA ratio for CSH is 9. CSH has $10 million in debt, $2 million in cash, and 800,000 shares outstanding. What is your estimate of CSH's stock price? The estimate of CSH's stock price is a. EV/EBITDA = 9 EV=45 mil Net worth = 45mil - 10 mil + 2mil = 37 mil Stock Price = 37 000 000 / 800000 = 46.25 $ 31. Suppose Rocky Brands has earnings per share of $2.232.23 and EBITDA of $30.830.8 million. The firm also has 5.15.1 million shares outstanding and debt of $140140 million (net of cash). You believe Deckers Outdoor Corporation is comparable to Rocky Brands in terms of its underlying business, but Deckers has no debt. If Deckers has a P/E of 13.213.2 and an enterprise value to EBITDA multiple of 7.67.6, estimate the value of Rocky Brands stock using both multiples. Which estimate is likely to be moreaccurate? a. The value of Rocky Brands stock using the P/E ratio is? (Round to one decimal place.) i. Stock Price= 2.23*13.2= 29.436 value = 29.436* 5.15 mil = 151.5954 b. The value of Rocky Brands stock using the EBITDA ratio is ?. (Round to one decimal place.)Which estimate is likely to be more accurate? i. Value of rocky’s brand by using ebitda= Estimate value = (EBITDA x EBITDA MULTIPLE)- debt. (30.83mil x 7.6)7 = 236.466 236.466-140.14= 96.326 ii. Rocky brands’ stock value by using ebitda= 96.326/5.15=. 18.7 or value of rockys brand/ shares outstanding iii. Estimation using EBITDA is most appropriate. 32. Heavy Metal Corporation is expected to generate the following free cash flows over the next three years. Thereafter, the free cash flows are expected to grow at the industry average of 2% per year (so that Year 4 FCF is 2% larger than Year3 FCF, and so on). Using the discounted free cash flow model and a WACC of 10%, estimate the current enterprise value (EV 0 ) of Heavy Metal. a. enterprise value= 52.1 /(1.136)^1 + 68.6/(1.136)^2 + 78.3/(1.136)^3+74.4/(1.136)^4+81.1/(1.136)^5 + ((81.1*(1.044))/(0.136-0.044))/(1.136)^5 = $726.43 million. enterprise value = market capitalization + debt - excess cash. Midterm 2 1. Which of the following statements is NOT true regarding angel investors? They are typically arranged as limited partnerships. 2. Which of the following statements is NOT true regarding venture capital firms/capitalists? They might invest for strategic objectives in addition to the desire for investment returns. 3. Which of the following is NOT one of the benefits of obtaining VC money? Securing funding from a quality venture capital firm can send a strong signal to the market. 4. You have started a company and are in luck —a venture capitalist has offered to invest. You own 100% of the company with 4.62 million shares. The VC offers $1.03 million for 830,000 new shares. a. What is the implied price per share ? Price= VC offer/ number of shares = 1,030,000 / 830,000. =. 1.24 per share b. What is the post-money valuation ? Post money valuation= implied price per share x New total number of shares = 1.24. x (4,620,000+830000) = 6,758,000 c. What fraction of the firm will you own after the investment ? Fractional ownership= original # of shares/ New total shares= 4620000/ 5450000= .8477 5. Which of the following is NOT a reason why an IPO is attractive to the managers of a private company? It reduces the complexity of requirements regulating the company’s management. 6. The firm you founded currently has 12 million shares , of which you own 4 million. You are considering an IPO where you would sell 2 million shares for $27 each. If all of the shares sold are primary shares , how much will the firm raise ? 2 mil x 27 = 54 mil What will be your percentage ownership of the firm after the IPO? Your ownership = # of shares you own/ total # of shares 4 mil / 14 mil= 28.6 7. Which of the following statements regar ding best efforts IPOs is FALSE? If the entire issue doesn’t sell out, the underwriter is on hook. 8. Which of the following statements is FALSE regarding the IPO procedures? The quiet period begins when the registration statement is filed and ends when the final prospectus is filed. 9. You obtain the following information from the final prospectus (Form 424B4) filed with the Securities and Exchange Commission (SEC) before Alibaba Group's IPO. 10. Both the payments to debtholders (lenders ) and equity-holders (shareholders) are liabilities of the firm, and both kinds of investors can legally claim the assets of the firm when the firm fails to make the promised payments. FALSE 11. Which of the following statements regarding the private debt market is FALSE? The public debt market is larger than the private debt market. 12. Which of the following statements is false? Most debenture issues contain clauses restricting the company from issuing new debt with equal or lower priority than existing debt. 13. Suppose a firm is in default. The firm sold off all valuable assets (including collaterals) and raised total proceeds of $160 million. 14. The following table lists different classes of debt and the outstanding claim amount for each class. What would be the recovery rate for the Subordinated Unsecured debt holders? Secured-100 mill, senior 100, subordinated-100, = 0%

15. The table below shows the YTM on a number of four-year, zero-coupon securities. What is the credit spread on a four-year, zero-coupon corporate bond with a BBB rating ? Bbb corp- treasury= 6.8-5.2= 1.6 16. Bond credit rating depends on the risk of bankruptcy as well as the priority of the bond in the event of bankruptcy. TRUE 17. Gepps Cross Industries issues debt with a maturity of 25 years. In the case of bankruptcy, holders of this debt may only claim those assets of the firm that are not already pledged as collateral on other debt. Which of the following best describes this type of corporate debt ? A debenture 18. The Sisyphean Company has a bond outstanding with a face value of 5000 that reaches maturity in 5 years. Coupon rate is 8.1% and YTM is 10%, the bond will trade at ? A discount since coupon rate < YTM. 19. Luther Industries needs to raise $25 millio n to fund a new office complex. The company plans on issuing ten-year bonds with a face value of $1,000 and an annual coupon rate of 7.40%. The following summarizes the YTM for similar ten-year corporate bonds of various credit ratings. What rating must Luther receive on these bonds if they want bonds to be issued at par ? Bbb rating is 7.4, so BBB rating. We want to match coupon rat 20. Even in a setting where there is no risk that a firm will default, leverage does increase the risk of equity. TRUE 21. Which of the following is an assumption(s) of the Modigliani & Miller’s perfect capital markets? Choose ALL that apply. No taxes, no bankruptcy or financial distress, perfect competition 22. Consider two firms, Firm X and Firm Y, that have identical assets that generate identical cash flows. Firm Y is an all−equity firm, with 1 million shares outstanding that trade for a price of $24 per share. Firm X has 2 million shares outstanding and $12 million in debt at an interest rate of 5%. According to MM Proposition I, the stock price for Firm X is closest to (24-12)/2 = 6 23. Hardmon Enterprises is currently an all-equity firm with an expected return of 12.9%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares. Assume perfect capital markets. a . Suppose Hardmon borrows to the point that its debt -equity ratio is 0.50. With this amount of debt, the debt cost of capital is 4%. What will be the expected return of equity after this transaction? Expected Return on Equity of leveraged Firm= Expected return on unlevered firm + Debt/Equity (Expected return on Unlevered Capital-Cost of debt) = .129+.5 (.129-.04) = 17.35 b. Suppose instead Hardmon borrows to the point that its debt-equity ratio is 1.50. With this amount of debt, Hardmon's debt will be much riskier. As a result, the debt cost of capital will be 6%. What will be the expected return of equity in this case? . 129+ 1.5 (.129-.06) = 23.25 24. A senior manager argues that it is in the best interest of the shareholders to choose the capital structure that leads to the highest expected return for the stock. How would you respond to this argument? False, because returns are higher because risk is higher, and the return fairly compensates for the risk 25. The expected direct costs of bankruptcy are too small relative to the tax advantage of debt to have impact on capital structure decision. TRUE 26. Milton Industries expects free cash flows of $22 million each year. Milton's corporate tax rate is 37%, and its unlevered cost of capital is 17%. Milton also has outstanding debt of $63.41 million, and it expects to maintain this level of debt permanently. a. What is the value of Milton Industries without leverage ? Free cash flow / unlevered cost of capital = 22 mil / .17 = 129.41 b. What is the value of Milton Industries with leverage ? 129.41 + .37 x 63.41 = 152.87 27. Assume that Microsoft has a total market value of $310 billio n and a marginal tax rate of 35%. If it permanently changes its leverage from no debt by taking on new debt in the amount of 13.7% of its current market value, what is the present value of the tax shield it will create? = 35 * (310 * 13.7) = 14.86 28. Summit Builders has a market debt-equity ratio of 1.85 , a corporate tax rate of 37%, and pays 10% interest on its debt. By what amount does the interest tax shield from its debt lower Summit's WACC? 1.85/(1+1.85)= .649 -.649* .1 * .37 = 2.4 29. Firms in industries such as real estate tend to have low distress costs because of a large proportion of tangible assets. True 30. The Tradeoff Theory suggests that a firm should choose a debt level where the tax savings from increasing leverage are just offset by the increased probability of incurring the costs of financial distress. 31. Which of the following is NOT one of the four characteristics of IPOs that puzzle financial economists? The long-run performance of a newly public company (three to five years from the date of issue) is superior to the overall market return. 32. You obtain the following information from the final prospectus (Form 424B4) filed with the Securities and Exchange Commission (SEC) before Alibaba Group's IPO. "This is the initial public offering of Alibaba Group. We are offering 123,076,931 American Depositary Shares, or ADSs, and the selling shareholders named in this prospectus, including Yahoo, one of our principal shareholders, Jack Ma, our executive chairman, and Joe Tsai, our executive vice chairman, are offering, in the aggregate, 197,029,169 ADSs. Total number of ADSs to be offered is 320,106,100 shares. Each ADS represents one ordinary share. The initial public offering price of the ADSs is US$68.00 per ADS. Prior to this offering, there has been no public market for our ADSs or ordinary shares. Our ADSs have been approved for listing on the New York Stock Exchange under the symbol BABA. The underwriting discounts and commissions given to our underwriters were $0.816 per ADS. We, Yahoo, Jack Ma and Joe Tsai have granted the underwriters the right to purchase up to an aggregate of 48,015,900 additional ADSs to cover over-allotments.” A. What is the percentage of the offering that comprised primary shares ? 100% B. Alibaba’s stock (NYSE:BABA) closed at $89.89 after the first trading day. What was the magnitude of underpricing ( in percentage terms )? How does this compare to a typical (U.S. average) IPO underpricing magnitude? 32.2%, larger than a typical IPO underpricing magnitude. Chapter 17 1. Which of the following statements is FALSE ? Most companies that pay dividends pay them semiannually. 2. ABC Corporation announced that it would pay a dividend to all shareholders of record as of Monday, April 5, 2010. It takes three business days for the new owners of a share of stock to be registered. a. When was the ex-dividend day? April 1 b. When was the last day an investor could purchase ABC stock and still get the dividend payment? March 31 3. In a perfect capital market , when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex- dividend. True 4. With perfect capital markets , an open market repurchase increases the stock price as the number of outstanding shares is decreased. False 5. Suppose a firm does not pay a dividend but repurchases stock using $28 millions of cash, the market value of the firm decreases by? 28 million 6. A firm has $300 million of assets that includes $40 million of cash and 10 million shares outstanding. If the firm uses $30 million of its cash to repurchase shares, what is the new price per share? 300/10= 30, 30mil/ 30= 1 mil 10mil- 1mil= 9 mil 300mil- 30 mil = 270 mil 270/9 = 30 7. When a firm repurchases shares , the supply of shares is ________, but at the same time, the value of the firm's assets ________. Reduced, declines 8. Homemade dividend refers to the process by which an investor ________. Can sell shares to create a dividend policy to suit his preferences. 9. Which of the following statements is false? In perfect capital markets, an open market share repurchase has no effect on the stock price, and the stock price is the same as the ex−dividend price if a dividend were paid instead. 10. Omicron Technologies has $60 million in excess cash and no debt . The firm expects to generate additional free cash flows of $48 million per year in subsequent years and will pay out these future free cash flows as regular dividends. Omicron's unlevered cost of capital is 10% and there are 12 million shares outstanding. Omicron's board is meeting to decide whether to pay out its $60 million in excess cash as a special dividend or to use it to repurchase shares of the firm's stock. Assume that Omicron uses the entire $60 million in excess cash to pay a special dividend. a. The amount of the special dividend is closest to: 60/ 12 mn shares = 5 b. Assume that Omicron uses the entire $60.00 million in excess cash to pay a special dividend. Omicron's ex-dividend price is closest to: 48/.09 = 533.33 533.33+60= 593.33 593.33/12= 49.44 60 mil /49.44= 1,213,483.

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