mid-term (1)

Question 1Name______________________________________Mid-term ExaminationFINC 5880Session 5Value of premium = $0.25The option premium represents the price that the buyer of the option would be willing to pay to have the right to buy the stock at $34, anytime before contract expiration.

Brigham 14ePage &P of &N&D

Question 1. (10 points) The exercise price on one of ORNE Corporation's call options is $35 and the price of the underlying stock is $34. The option will expire in 55 days. The option is currently selling for $0.25.

a. Calculate the option's exercise value? 0. Call option's Exercise Value = Current stock price - Exercise Price. In this case the current stock price is lower than the Exercise price i.e. the option is Out-of-the-money currently. Hence, Exercise Value is 0.

b. Calculate the value of the premium over and above the exercise value? What does this value represent?c. Is this an out-of-the money option, at-the-money, or in-the-money? Why?

This is an Out-of-the-money option. Its a call option where the Exercise price is higher than the underlying stock price.

d. What will happen to the time and exercise value of the option if the underlying stock price changes to $34.50? Why?

The Value of option will now become $0.5 i.e. (Stock price - Exercise price). It will become valuable now and the call option would be In-the-Money now, as Stock price has increased above Exercise price.

e. If Orne Corporation had issued a put option (instead of the call), would it have a greater or lesser value than the call option? Why?

If instead of Put option, Orne Corporation were to issue the Call option, its value would have been higher. This is because as the Underlying stock price is lower than the Exercise price, the option is In-the-Money and hence the option would be valuable.

Question 2Name______________________________________Mid-term ExaminationFINC 5880Session 5

b. What are the net operating cash flows in years 1, 2, and 3?Depreciable ValueCost of new equipment90,000add: Modifications10,000Shipping costs2,000Total Cost102,000

Depreciation per annum - 3 years MACRS123Beginning Book Value$102,000$68,003$37,776Depreciation Rate33.33%44.45%14.81%Depreciation$33,997$30,228$5,595Ending Book-Value$68,003$37,776$32,181

Calculation of Operating Cash Flows123Savings in annual operating costs before tax$35,000$35,000$35,000less: depreciation68,00337,77632,181Profit before tax(33,003)(2,776)2,819less: Tax 30%(9,901)(833)846Profit after tax(23,102)(1,943)1,973add: Depreciation68,00337,77632,181Net Operating Cash Flows$44,901$35,833$34,154

c. Calculate the non-operating terminal year cash flow.Salvage value $35,000Tax on Salvage Value0.0Book-Value$32,1810.0Tax on Salvage Value 30%846Salvage value post-tax34,154Additional Working capital - Inventory6,000Non-operating terminal value$40,154

d. Calculate net present value. Should the machine be purchased?Cost of capital

NPV0123Initial Cash Flow(108,000)Net Operating cash flows44,90135,83334,154Non-operating terminal cash flow40,154PV Factor @ cost of capital 11%10.90090.81160.7312PV(108,000)40,45129,08324,973NPV(13,493)Since the NPV is negative, its must not be accepted.


Question 2. (15 points) Pierre Imports is evaluating the proposed acquisition of new equipment at a cost of $90,000. In addition the equipment would require modifications at a cost of $10,000 plus shipping costs of $2,000. The equipment falls into the MACRS 3-year class, and will be sold after 3 years for $35,000. The equipment would require increased inventory of 6,000. The equipment is expected to save the company $35,000 per year in before-tax operating costs. The company's marginal tax rate is 30 percent and its cost of capital is 11 percent.

a. What is the cash outflow at Time 0?

Cost of new equipment = $90,000Modifications = $10,000Shipping Costs = $2,000Inventory cost = $6,000Total cash outflow at Time 0 = $108,000


Amount $ millionCapital budget10Percentage of capital budget funded by debt 40%4Percentage of capital budget funded by Equity 60%6

Net Income8Less: Equity reserved for capital budget(6)Residual Income available for dividend distribution2

b. What is the company's dividend payout ratio if it pays the dividends calculated above?

Dividend payout ratio = Dividend/Net IncomeHence, D/P Ratio = 25%

Amount $ millionNet Income8.0Less: dividend distributed4.5Balance Amount to meet capital budget3.5Required amount of capital budget to be met out of equity6.0Shortfall to be met out of Equity2.5


Question 3. (15 points) A company has a target capital structure that consists of 40 percent debt and 60 percent equity. The company's capital budget for next year is $10 million. Axel expects net income of $8 million. The company's cost of capital is 12 percent.

a. How much will the company pay out in dividends if it follows a residual dividend policy?

c. Is it likely the company will follow a residual dividend policy? Why or why not?

It is likely that the company will follow a residual dividend policy. This is because the Net Income is sufficient to meet the needs of equity funding required for capital budget. The remaining amount to meet the capital budget may be met by debt as mandated by the target capital structure.d. If the company decided to pay out $4.5 million in dividends, how much would it need to raise in equity outside the company?e. Should the company go ahead with a project of average risk that generates a 10 percent rate of return? Why or why not? The company must not go ahead with accepting a project which generates a 10% rate of return. This is so because the cost of capital of the company is 12%, which is higher than the rate of return generated by the projected. Hence, the project generates rate of return which is lower than the hurdle rate. It would therefore deplete capital and must not be accepted.

Question 4Name______________________________________Mid-term ExaminationFINC 5880Session 5$ per 1 euro$ per 1 francPeso per $1 Spot rate1.331.0812.830-day forward rate1.311.1113.160-day forward rate1.291.2213.9 Spot $/Eur Rate1.33Spot $/Franc Rate1.08Hence, Franc/$ Rate0.93Spot Franc/Eur Rate1.23Hence 1.23 Francs will buy 1 Euro

Spot $/Franc Rate1.080Spot Peso/$ Rate12.8Peso/Franc Rate13.824Hence, 13.824 Pesos will buy 1 FrancSpot $/Eur Rate1.33Spot Peso/$ Rate12.8Peso/Euro Rate17.024Hence, 17.024 Pesos would buy 1 Euro


a. Is the euro appreciating or depreciating against the U.S. dollar? Explain.

Euro is depreciating against US Dollar. The reason is that less $ is required to buy 1 Euro as implied by the forward rate.

b. Is the Swiss franc appreciating or depreciating against the U.S. dollar? Why?

Swiss Franc is appreciating against the US Dollar. The reason is that more $ is required to buy 1 Swiss Franc as implied by the forward rate.

c. Is the Mexican peso appreciating or depreciating against the U.S. dollar? Why?

Mexican Peso is depreciating against the US Dollar. The reason being that more Pesos are required to buy $1 as implied by the forward rate.

d. Using cross-rates, based on the spot rate, how many francs will the euro buy, how many pesos will the franc buy, and how many euro will the peso buy?e. A U.S. company purchases goods from several foreign companies with payment due in euros, francs, and pesos. Would the company be better off paying now or waiting for 60 days? Why?

Payment due in Euros: US Company would be better waiting 60 days as Euro is depreciating.

Payment due in Francs: US Company would be worse-off as Franc is appreciating against US Dollar.

Payment due in Pesos: US Company would be better since Peso is depreciating against US Dollar.Question 4. (15 points) Shown below are exchange rates for several currencies.


Calculation of Profit/Loss incurred by Investment Banker when shares sold at average of $25 per share

Number of shares sold million15Average price per share$25Total proceeds million$375less: Proceeds passed to Kern$(300)Gain million$75Assumed that the out-of-pocket expenses incurred by the Investment Banker would be reimbursed by the Company.

Number of shares sold million15Average price per share$20Total proceeds million$300less: Proceeds passed to Kern300Gain million0.0Assumed that the out-of-pocket expenses incurred by the Investment Banker would be reimbursed by the Company.


Question 5. (15 points) Kern Corporation entered into an agreement with its investment banker to sell 15 million shares of the company's stock with Kern netting $300 million from the offering. The expected price to the public was $25 per share.

The out-of-pocket expenses incurred by the investment banker were $5 million.

a. What profit or loss would the investment banker incur if the issue were sold to the public at an average price of $25 per share?

b. What profit or loss would the investment banker realize if the issue were sold to the public at an average price of $20 per share?c. Is the agreement between the company and its investment banker an example of a negotiated or a best-efforts deal? Why? Which is riskier to the company? Why?

The agreement between the company and its investment banker is an example of negotiated deal. This is because the proceeds to be passed on to the company has already been decided irrespective of the actual reults. Investment bank has undertaken to give a promised amount to Kern on issuance, irrespective of the final issue price and number of shares issued to the public which is $300 million.

The riskier proposition to the company is Best-efforts deal. In Best-efforts deal, the amount to be received by the company is not known with certainty. Investment Bank gets commission but the fate of the issue hangs in balance and is unknown.


Equipment cost$100,000

Current Balance SheetCurrent assets300,000Debt400,000Net Fixed assets600,000Equity500,000Total assets900,000Total claims900,000

a. Current debt ratioDebt/Total Assets0.44

b. Calculate the company's debt ratio if it purchases the equipment with debt.New Debt Amount = Existing debt + Borrowing500,000Total Assets = Existing assets + Equipment 1,000,000

Debt Ratio0.50

c. Calculate the company's debt ratio if it leases the equipment?When the company leases the equipment, both debt and assets will not increase.Debt Ratio0.44


c. Is the bank likely to make the loan? Why or why not?

No, the company appears to be carrying excess inventory and financing extensively with debt. Bank borrowings are already high, and the liquidity situation is poor. On the basis of these observations, the loan should be denied, and the treasurer should be advised to seek permanent capital, especially equity capital.a. How much bank financing is needed to eliminate the past-due accounts payable?b. Calculate the company's debt ratio, current ratio, and quick ratio.Question 6. (15 points) Epoty Corporation is evaluating whether to lease or purchase needed equipment at a cost of $100,000. If the equipment is leased, the lease would not have to be capitalized. The company's balance sheet prior to the acquisition of the equipment is shown below.

a. Calculate the company's current debt ratio?

d. Will the company's ROA and ROE ratios be affected by its decision to lease or purchase? Why or why not?

If a decision to lease the asset is taken instead of purchase, there is no increase in either the debt or the asset. Because of this the ROA would be pushed higher. However, there are other concerns too. Typically lease payments are higher than interest payments,which may bring down the Net Income. Hence, the numerator in calculation would be lower with leasing decision. Hence, we can conclude that both ROA and ROE will be affected differently when lease or purchase decision is taken. Whether it is higher or lower with one decision vs other, is dependent on the facts of the case.

e. What factors should the company consider in coming to its decision other than net advantage to leasing? Why?

There are several factors to be considered than just the net advantages to leasing:

1. Modification/Customisation to suit the needs: In case of leased assets, it is difficult to modify/customise the assets to suit the changing needs. This may be loss-making proposition in the long run.

2. Early termination/replacement: In case of lease, early termination of lease contract may attract penalties, law suits

3. Asset ownership: Having well capitalised balance-sheet is suggestive of strong financials. These also serve as guarantee for taking further loan. This advantage is not present in Lease.


Expected NPV of the project = PV of cash inflows at the cost of capital - Cost of project

NPV at the cost of capital 12%YearSum of PV Factor @ 12%Amount $PV $01(10,000,000)(10,000,000)1-53.60483,000,00010,814,400NPV$814,400

ScenarioProbabilityCash-FlowsYearPV Factor @12%PV $Cost $NPV $Tax will be imposed40%$2.52-63.21868.05-10(1.95)Tax willl not be imposed60%$3.22-63.218610.30-100.30Project NPV = $(0.60)Since the Estimated NPV is negative, the recommendation to the Company would be to abandon the project.


Question 7. (15 points) Calhoun Resorts is interested in developing a new facility in Toronto. The company estimates that the hotel would require an initial investment of $10 million. The company expects that the facility will produce positive cash flows of $3,000,000 a year at the end of each of the next 5 years. The project's cost of capital is 12%.

a. Calculate the expected net present value of the project.b. A hotel tax may be imposed that would affect cash flows. In one year, the company expects to know whether the tax will be imposed. The company believes there is a 40% change that the tax will be imposed, in which case annual cash flows will be $2.5 million for 5 years. If the tax is not imposed, annual cash flows will be $3.2 million for 5 years . It is deciding whether to proceed with the facility today or to wait 1 year to find out whether the tax will be imposed. If it waits a year, the initial investment will remain at $10 million, and incoming cash flows will be delayed 1 year. Cost of capital will remain at 12%. If the company waits one year, calculate the project's NPV in Year 1 with restrictions and without restrictions. What would you recommend to the company?c. Apart from real options, discuss 3 qualitative factors that the company should consider when making its decision on accepting the new project.

The 3 qualitative factors that a company should consider when making its decision on accepting a new project are:

1. Environmental Factors: Will the new project have far-reaching impact on environment. If it will then the company besides being wrong ethically would also be inviting the ire of Government, environmental authorities and local public.

2. Product quality: Whether the new capital project would lead to lower quality than the exisiting standards. In that case the brand and reputation would suffer.

3. Internal Culture: How would the acceptance of the new poject impact the internal culture of the organisation? If the existing managers are not comfortable, the new project may be detrimental.

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