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Date Posted: 16:50:38 04/25/00 Tue
Author: Charles Hodges
Subject: Most recent quiz with solutions

Quiz 3 FI4300 Spring 2000 Your Name ___________________________

MC1. (10 points) On the day an option expires, you observe a stock price of $ 34, an exercise price of $45, and an exercise value/option price of $11. If investors are rational, this option must be:
a. an in-the-money call. b. an in-the-money put. c. an at-the-money call. d. an at-the-money put. e. an out-of the money call. f. an out of the money put.
ANSWER IS B

MC2. (10 points) For a typical firm with a given capital structure, which of the following is correct? (Note: All rates are after taxes.)
a. kd > ks > WACC. b. ks > kd > WACC.
c. WACC > ks > kd. d. ks > WACC > kd.
e. None of the statements above is correct.

ANSWER IS D

TF 3. (5 points)In capital budgeting analysis, we always attempt to keep the investment and financing decisions separate.
a. True b. False

ANSWER IS TRUE

TF4. (5 points)When a high P/E firm acquires a low P/E firm, we generally expect the high P/E firm's P/E ratio to decrease.
a. True b. False

ANSWER IS TRUE

2. (25 points) Rollins Corporation is constructing its MCC schedule. The firm is at its target capital structure. Its bonds have a 8 percent coupon, paid semiannually, a current maturity of 17 years, and sell for $1,055. Rollins' beta is 1.3, the risk-free rate is 6 percent, and the expected return on the market is 12 percent. Rollins is a constant growth firm, which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 7 percent. The firm's tax rate is 30%.
The firm's book value balance sheet is as follows:
Asset $7,000 Long Term Debt $5,000
Equity ($2 par) $1500
Retained Earnings $500

What is the firm's leverage ratio?
CONVERT TO MARKET VALUE
DEBT IS 5* 1055 = 5275
EQUITY IS (1500/2) SHARES * 27 = 20250

LEVERAGE = 5275/(5275+20250) = 20.7%


What is Rollins' cost of debt%?
PV=-1055 PMT = 80/2=40
FV=1000 N= 17*2= 34 è I=3.71%*2=7.42%

What is Rollins' cost of retained earnings using the CAPM approach?

6 + 1.3 (12-6)=13.8%

What is the firm's cost of retained earnings using the DCF approach?

(2*1.07)/27 + 7% = 14.9%

Using your CAPM estimate of the cost of retained earnings, what is Rollins' WACC?

20.7% * 7.42% (1-30%) + (1-20.7%) * 13.8% = 12.0%

6. (10 points) A factory has a current market value of $35 million. Next year the value of the factory will either fall to $19 million or rise to $46 million. The risk free rate is 5%. What is the value of a 1-year call option on the factory?


SEE PAGE 260. 5% = P*( (46-35)/35) + (1-P) ((19-35)/35) è P=.6574

EXERCISE VALUE IS MAX (46-35, 0) OR MAX (11,0)

EXPECTED VALUE IN ONE YEAR .6574*11 = 7.23

PRESENT VALUE TODAY = 7.23/1.05 = 6.887

7. (25 points) Two firms plan to merge. There is 10 million in synergies but no acquisition expenses. A 15% premium is being paid to the acquiree. Prior to the merger, the acquirer has earnings per share of $2 and a price earnings ratio of 10. The acquiree has earnings per share of $6 a price earnings ratio of 20. The acquiror has 10 million shares of stock and the acquiree has 7 million shares of stock. What is the acquirer's market value, earnings per share, and Price-earnings ratio after the acquisition? What is the Net Advantage to Merger (NAM)?

NOTE BASED ON CLASS INPUT, I DECIDED TO IGNORE SYNERGY IN CALCULATING THE NEW EPS AND P/E RATIO.

PRE-MERGER
EPS P/E èP SHARES (*EPS)=NET INCOME MKT. CAP.
ACQUIRER 2 10 20 10 20 200
ACQUIREE 6 20 120 7 42 840

==>TOTAL NET INCOME = 62
FULL-CREDIT SOLUTION

TO DO MERGER, ACQUIREE PAYS 15% PREMIUM OR 120*115% = $138 PER SHARE
BASED ON 138/20, THIS GIVES EXCHANGE RATIO OF 6.9:1,
THUS ACQUIRER WILL ISSUE 6.9*7 = 48.3 MILLION NEW SHARES

NEW EPS = 62 / (10 + 48.3) = $1.06 PER SHARE
NEW P/E = 20 / 1.06 = 18.8

NET ADVANTAGE TO MERGE = 1040 + 10 - (200 + 966) = -116

FULL CREDIT SOLUTION THAT IS A BETTER ANSWER SINCE PREMIUM WILL BE REFLECTED IN ACQUIRERS STOCK PRICE

TO DO MERGER, ACQUIREE PAYS 15% PREMIUM OR 120*115% = $138 PER SHARE
BASED ON 138/20, THIS GIVES EXCHANGE RATIO OF 6.9:1,
THUS ACQUIRER WILL ISSUE 6.9*7 = 48.3 MILLION NEW SHARES

VALUE OF NEW COMPANY IS VALUE OF OLD COMPANIES PLUS SYNTEGIES
=200 + 840 + 10 = 1050
THUS NEW PRICE PER SHARE IS 1050/58.3= $18.01

NEW EPS = 62 / (10 + 48.3) = $1.06 PER SHARE
NEW P/E = 18.01 / 1.06 = 17.0

NET ADVANTAGE TO MERGE IS STILL = 1040 + 10 - (200 + 966) = -116

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