Question 1

GBU Corporation stock is currently trading at $40 per share. There are 20 million
shares outstanding, and the company has no debt. You are a partner in a firm that
specializes in leveraged buyouts. Your analysis indicates that the management of
this corporation could be improved considerably. If the managers were replaced
with more capable ones, you estimate that the value of the company would increase by 50%. You decide to initiate a leveraged buyout and issue a tender offer
for at least a controlling interest, which is 50% of the outstanding shares.
(a) Explain how a leveraged buyout works.
In a leveraged buyout (LBO), a group of private investors purchases all the
equity of a public corporation using borrowed funds, pledging the to-bepurchased shares as collateral for the loan. The investors make a tender
offer to buy a majority in the firm. It it succeeds, you can attach the debt to
the firm, essentially gaining control for free.

(b) What is the maximum amount of value you can extract and still complete
the deal?
Currently, the value of the firm is $4020 million = 800 million. If you borrow $400 million and your tender offer (at $40/share) succeeds, you will take
control of the firm, and the firm will be worth 50% more, that is, $1.2 billion.
You attach the debt of 400 million to the firm, and therefore the firms equity
will be worth $1.2 billion - $400 million = $800 million. You now own shares
worth $400 million and you extracted all of the value you added by changing
the mangement.

(c) What is the maximum amount of value you can extract if you use a toehold
of 10% instead of the leveraged buyout.
Suppose you could acquire the toehold for the pre-annoucement shareprice
of $40. To gain the control, you have to purchase another 40% of the firm at
the new value of $60 per share. In total you pay $402 million + $608 million
= $560 million to gain control of the firm. After you change managment, your
stake will be worth $600 million. This means you only extract $40 million of
the total value of $400 million you created by changing management.

Question 2
Tybo Corporation adjusts its debt so that its interest expenses are 20% of its free
cash flow. Tybo is considering an expansion that will generate free cash flows of
$2.5 million this year and is expected to grow at a rate of 4% per year from then
on. Suppose Tybos marginal corporate tax rate is 40%.
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(a) If the unlevered cost of capital for this expansion is 10%, what is the unlevered value of the expansion?
Unlevered value V U = FCF/ (rU g) = 2.5/ (10% 4%) = $41.67 million

(b) What is the levered value of the expansion. Use the APV method.
This is an example of APV with constant interest coverage (p. 594): V L =
(1 + c k) V U = (1 + 0.4 0.2) 41.67 = 45 million

(c) If Tybo pays 5% interest on its debt, what amount of debt will it take on
initially for the expansion.
Interest = 20% of FCF = $0.5 million. Interest is also 5% of outstanding debt,
therefore 0.5 = 0.05D, which implies that D = $10 million.

(d) What is the debt-to-value ratio for this expansion? What is its WACC?
Debt-to-value = D/V L = 10/45 = 0.222. From equation 18.11: rwacc = rU
dc r = 9.556%.
(e) What is the levered value of the expansion using the WACC method?
Levered value V L = FCF/ (rwacc g) = 2.5/ (9.556% 4%) = $45 million

Question 3
You are a manager at Perforated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. The expansion project would require an
up-front investment of $20 million and produce extra sales of $32 million per year
for the next ten years.
Assume that gross profits are 40% of sales, that Selling and Administrative
Expenditures will be $2 million with the project, but only $1 million without the
project, that the firm uses straight-line depreciation over the life of the project,
and that the corporate income tax rate is 35%.
(a) Prepare a pro-forma income statement for the project over the next 10 years.

(in thousands)
t=1
...
Sales
32,000
Gross Profit
12,800
Selling&Admin 1,000
Depreciation
2,000
EBIT
9,800
Income tax
3.430
Unlevered NI
6,370

t=10
32,000
12,800
1,000
2,000
9,800
3.430
6,370

Note: Selling and Administrative expenses are only 1 million because this is
the opportunity cost!
(b) The project requires extra net working capital equal to one-year sales upfront. The extra working capital will be fully recovered in year 10. Estimate
the free cash flows of the project in years 0-10.
(in thousands)
t=0
t=1
...
t=9
t=10
Unlevered NI
0
6,370
6,370
6,370
+Depreciation
0
2,000
2,000
2,000
-NWC
-32,000
0
0
+32,000
-Capital Expend. -20,000
0
0
0
Free CFs
-52,000 8,370
8,370 40,370

(c) Assuming a cost of capital of 15%, should the project be done? Ignore tax
shield effects.
NPV(Free CFs, discounted at 15%) = $-2.08 million. The project should not
be done.
(d) How would your answer in (c) change if the firm could increase its debt
capacity because of the project? Explain in words.
With increased debt capacity, the firm might increase debt and therefore increase its tax shield. The savings in taxes may make this project desirable
(but it depends on the amount of debt).

Question 4
The current price of W Corporation stock is $70. In each of the next two years,
this stock price can either go up by 6% or go down by 5%. The stock pays no
dividends. The one-year risk-free interest rate is 3% and will remain constant.
(a) Draw the event tree. At t=2, what are the possible values the stock price
can take on?
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At t=1: Su = 74.2, Sd = 66.5

At t=2: Suu = 78.652, Sud = Sdu = 70.49, Sdd = 63.175
(b) Calculate the price of a two-year European call option on W stock with an
strike price of $75.
At t=2: Cuu = 3.6520, Cud = Cdu = 0, Cdd = 0
The risk-neutral up-probability is p = 0.7273, 1 p = 0.2727
At t=1: Cu = 1.031 (0.7273 3.6520 + 0.2727 0)
1.031 (0.7273 0 + 0.2727 0) = 0

2.5786, Cd

At t=0: C = 1.031 (0.7273 2.5786 + 0.2727 0) = 1.8208

(c) Using put-call parity, calculate the price of a two-year European put option
on W stock with an strike price of $75.
P = C + P V (K) S = 1.8208 + (1.03)2 75 70 = 2.5154
(d) How do your answers to (b) and (c) change if the options are American-style
instead of European-style?
The price of the Call does not change. The put may be exercised early, which
is what happens here if the stock price goes down to 66.5 in one period.
P = 3.0939

Question 5
Answer all questions:
(a) How does the volatility of an equally weighted portfolio change as more
stocks are added to it? Explain briefly.
An equally weighted portfolio is a portfolio in which the same amount is invested in each stock. If n is the number of stocks in this portfolio, the variance
of the portfolio can be written as:
1
V
ar(Rp )
=
(Average Variance of the Stocks)
n

1
1 n (Average Covariance between the Stocks).

(See p. 333 in the book)

Adding a stock stock to the portfolio could increase or decrease depending on
how it influences the Average Variance and the Average Covariance. In general it will decrease as n increases. For large n, only the covariance matters.

(b) In the year 2000, short-term U.S. government bond rates were about 5.8%
and the rate of inflation was about 3.4%. In 2003, interest rates were about
1% and inflation was about 1.9%. What was the real interest rate in 2000
and 2003?
2000: rr =
2003: rr =

0.058
1+0.034
0.01
1+0.019

1 = 2.32%
1 = 0.88%

(c) How does the option to wait affect the capital budgeting decision? Explain
in a few sentences.
By waiting before committing to an investment, a firm can obtain more information about the investments returns. By correctly choosing the time to
commit to an investment, it can add value. As a result, given the option to
wait, an investment that currently has a negative NPV can have a positive
value.
(d) With perfect capital markets, does the risk of default reduce the value of the
firm? Does the Modigliani-Miller Proposition I still hold? Explain.
With perfect capital markets, MM Proposition I applies: the total value to all
investors does not depend on the firms capital structure. Investors as a group
are not worse off because a firm has leverage. In particular, investors anticipate the probability of default and discount the value of debt accordingly.

(e) Explain the IRR rule of capital budgeting? How does it differ from the NPV
rule and which rule is better?
see book