CF Finals

Problem 1
Sector Averages
Business Revenues (in $ millions)
Enterprise Value/Sales
Computer hardware $1,000 0.80
Computer services $600 2.00
Risk free rate In local

Country currency Equity Risk Premium
United States 3.00% 5.00%
China 4.00% 7.00%
Risk free rate = 3.00%

To compute beta
Business Estimated Value Weight
Computer hardware $800.00 0.4
Computer services $1,200.00 0.6
$2,000.00
To compute ERP
Country ERP Revenues
United States 5.00% $800.00
China 7.00% $800.00
6.00% $1,600.00
Cost of equity in US $ = 9.2400%
Part b
First, estimate the divestiture value
Hardware revenues in US = $500
Estimated value = $400.00
Debt raised = $400.00
Invested in China services= $800.00
Incremental revenue $400.00 ! Invested value/ EV to Sales of sector
Business Estimated value Weight

Computer hardware $400.00 16.67%
Computer services $2,000.00 83.33%
New D/E ratio = 20.00% ! Debt raised/Old value

Levered Beta = 1.0733 ! Use US marginal tax rate, since borrowing is
Tax benefits are also in US.
To compute ERP
Country ERP Revenues
United States 5.00% $300.00
China 7.00% $1,200.00
6.60%
I gave full credit if you weighted the ERP by the values of the businesses in US (600) and C
Cost of equity in US $ = 10.08%
Problem 2
0 Years 1-10
Storage facility investment -2,250,000
Inventory investment -750000
Current After investment

Revenues $5,000,000.00 $7,500,000.00
EBITDA $900,000.00 $1,500,000.00
Incremental EBITDA $600,000.00

- Depreciation $200,000.00
Incremental operating income $400,000.00
- Taxes $160,000.00
Incremental after-tax operating income $240,000.00
+ Depreciation $200,000.00
After-tax cash flow $440,000.00
NPV = $89,152.82
Part b
With a perpetual life, assume that capital maintenance = depreciation & no salvage value
Initial investment = -3,000,000
NPV = -3000000 + X/.10 = 0 ! No salvage value, if you have perpetual life
Solving for X
Annual after-tax cash flow = $300,000.00
Incremental after-tax operating income $300,000.00
Incremental pre-tax operating income $500,000.00
+ Depreciation $200,000.00
Breakeven Incremental EBITDA $700,000.00
Breakeven EBITDA $1,600,000.00
Breakeven EBITDA margin = 21.33%
Note: Including depreciation while ignoring capital maintenance is not an option, since dep
Problem 3
Current beta = 3.06
Current cost of equity = 18.300%
Current after-tax cost of debt = 6%
Debt ratio = 80%
Cost of capital = 8.4600%
New Debt/Equity ratio = 1.5

Unlevered beta = 0.9
New levered beta = 1.71
New cost of equity = 11.5500%
New after-tax cost of debt = 4.50%
New debt ratio = 0.6
New cost of capital = 7.32%
Old firm value = 1000

Increase in firm value 214.2857142857
New firm value = 1214.2857142857
- New Debt = 600 ! Don't forget to subtract debt
New equity value = 614.2857142857
No of shares 40 ! Divide by total # shares
Value per share = $15.36
(You will get the same answer, if you divide the increase in value by total number the shar
Problem 4
Three years ago Two years ago
Revenues $1,000 $1,100
Net Income $100 $110
Depreciation $40 $45
Cap Ex $50 $60
Total Working capital $10 $30
Total Debt $10 $15
Dividend Payout ratio 0% 40%
Three years ago Two years ago
Net Income $100.00 $110.00
+ Depreciation $40.00 $45.00
- Cap Ex $50.00 $60.00
- Change in Working capital $10.00 $20.00
+ Increase in debt $10.00 $5.00
FCFE $90.00 $80.00
Dividends paid $0.00 $44.00
Change in cash balance $90.00 $36.00
Cash Balance $90.00 $126.00
Next year Year +2
Revenues $1,440.00 $1,728.00
Net Income $144.00 $172.80
+ Depreciation 55 60.5
- Cap Ex 77 84.7
- Change in Working capital $84.00 $28.80
- Debt repaid $25 $25
FCFE $13.00 $94.80
Dividends paid $72.00 86.4
Change in cash balance -$59.00 $8.40
Cash balance $137.00 $145.40
Problem 5
After-tax operating income = 60
Invested capital = 500
Return on capital = 12%
High Growth Stable growth
Expected growth rate = 9.00% 3%
Reinvestment rate = 75.00% 25.00%
1 2
After-tax operating income $65.40 $71.29
- Reinvestment $49.05 $53.46
FCFF $16.35 $17.82
Terminal value
Present value $14.86 $14.73
Value of operating assets = $688.43
+ Cash $50.00
- Debt $300.00
Value of equity $438.43
Price per share = $16.00
Undervalued by -8.766%
Sector Averages Grading template
Unlevered Beta
1.25
0.9
Marginal tax rate Total Revenues

40% $800.00
25% $800.00
1. Wrong risk free rate: -1/2 point

2. Used revenue weights on beta: -1/2 point
Unlevered Beta 3. Wrong ERP: -1/2 point
1.25 4. Math errors: -1/2 point
0.9
1.04
Weights
0.5
0.5
1. Wrong risk free rate: -1/2 point

2. Wrong levered beta: -1 to 1.5 points
3. ERP weighted incorrectly: -1 to 1.5 points
4. Math errors: -1/2 point each
lue/ EV to Sales of sector
Unlevered Beta
1.25
0.9
0.9583
ginal tax rate, since borrowing is in US.

are also in US.
Weghts
20%
80%
inesses in US (600) and China (1800).
Salvage Value
250000
750000 1. Initial investment in WC incorrect: -1 point
2. After-tax cash flow incorrect: -1 point
Incremental 3. Salvage value incorrect: -1 point
$2,500,000.00 4. PV incorrect: -1/2 point
$600,000.00 5. Math error: -1/2 point
1. Annuity not based on initial investment: -1 point

2. Included salvage value: -1 point
3. Did not consider capital maintenance: -1 point
s not an option, since depreciation will run out after ten years.
1. Did not after-tax cost of debt: -1/2 point

2. Wrong weights: -1/2 point
3. Math error: -1/2 point
1. Did not unlever & relever beta: -1 point

2. Did not after-tax cost of debt: -1/2 point
3. Wrong weights: -1/2 point
1. Incorrect estimate of increase in value: -1 point

2. Did not subtract out new debt: -1 point
3. Divided change in value by old shares: -1 point
t to subtract debt 4. Other math errors: -1/2 point each
otal # shares
by total number the shares and add to the value per share)
Most recent year
$1,200 1. Did not compute change in non-cash WC: -1 point
$120 2. Did not compute change in debt: -1 point
$50 3. Did not compute cash balance: -1/2 point
$70
$60
$75
50%
Most recent year
$120.00
$50.00
$70.00
$30.00
$60.00
$130.00
$60.00
$70.00
$196.00
Year +3
$2,073.60 1. Did not compute change in non-cash WC: -1 point
$207.36 2. Did not compute change in debt: -1 point
66.55 3. Did not compute cash balance: -1/2 point
93.17
34.56
$25
$121.18
103.68
$17.50
$162.90
1. ROC incorrect: -1 point

2. Did not compute reinvestment in years 1-3: -1 point
3. Did not recompute reinvestment in year 4: -1 point
4. Discounted at wrong discount rate: -1/2 point
3 Terminal year
$77.70 $80.03
$58.28 $20.01
$19.43 $60.02
$857.49
$658.84
1. Did not add cash: -1/2 point

2. Did not subtract debt: -1 point
3. Did not compare to current market value: -1/2 point
Problem 1 Grading template
US Brazil Total
Steel $800.00 $400.00 $1,200.00
Technology $600.00 $300.00 $900.00
Total $1,400.00 $700.00
Part a
For beta
Value Weight Unlevered beta
Steel $1,800.00 57.14% 0.9 1. Betas weighted incorrectly: -1 point
Technology $1,350.00 42.86% 1.2 2. ERP weighted incorrectly: -1 point
$3,150.00 1.02857 3. Math errors: -1/2 point
For ERP 4. Used Brazilian rate as risk free rate: -1/2 point
Value Weight ERP NOTES: You cannot use the Brazi
US $2,100.00 66.67% 6% because it is not a risk free rate i
Brazil $1,050.00 33.33% 9%
$3,150.00 7.00%
Cost of equity 10.200% ! 3% + 1.02857 (7.00%)

Part b
US Brazil Total
Steel $1,200.00 $600.00 $1,800.00 1. New D/E ratio wrong: -1 point
Technology $900.00 $1,200.00 $2,100.00 2. Betas not reweighted for business: -1 point
Total $2,100.00 $1,800.00 3. Betas not reweighted for country: -1 point
4. Did not relever beta: -1 point
Cost of capital for company 5. Math errors: -1/2 point
Debt = 1200 NOTES: Both the business and th
Equity = 2700 company restructures. So, both n
D/E ratio = 44.44%
New unlevered beta

For beta
Value Weight Unlevered beta
Steel $1,800.00 46.15% 0.9
Technology $2,100.00 53.85% 1.2
$3,900.00 1.06154
New levered 1.34461538
For ERP
Value Weight ERP
US $2,100.00 53.85% 6%
Brazil $1,800.00 46.15% 9%
$3,900.00 7.38%
Cost of equity 12.93%

After-tax cost 3.00%
Debt ratio = 30.77%
Cost of capita 9.87%
Problem 2
Part a
Initial invest -$5,000.00
Annual cash flow

Revenue $4,000.00 1. Did not treat depreciation correctly: -1 point
EBITDA $800.00 2. Forgot to take taxes: -1 point
- DA $500.00 3. Wrong discount rate: -1 point
EBIT $300.00 4. Math errors: -1/2 point each
- Taxes $120.00
Aftertax EBIT $180.00
+ DA $500.00
After-tax Cash $680.00
NPV = -$635.99
Part b
Annual after- $107.99 1. Did not compute annuity: -1 point
Revenues= $539.96 ! Divide by after-tax margin 2. Error in getting back to revenues from annuity:
3. Wrong discount rate: -1/2 point
Part c Existing New
Expensed $0.00 $2,000.00 1. Did not compute tax benefit from depreciaton:
Tax savin $0.00 $800.00 2. Did not compute tax benefit from expensing: -1
Depreciation $500.00 $600.00 3. Math errors: -1/2 point each
Depreciation $200.00 $240.00 NOTE: You don't have to redo all
Number of ye 10.00 5.00 only the depreciation changes. In
PV of tax savi $1,283.53 $933.52 cash flows will leave you with suc
Change in NP $449.98 unlikely that you will get the righ
Problem 3
Part a
Expected FCFF $250.00 1. All or nothing
Value of the f ###
Value = 5000 = 250/(.084-g)
Solving for g
Expected grow 3.400%
Part b
New Debt ### 1. Did not compute savings per year: -1 point
New Equit ### 2. Used wrong debt ratio in computation: -1 point
New D/E ratio 66.67% 3. Did not lever beta: -1 point
New D/C ratio 40.00% 4. Other errors: -1/2 point
New levered 1.26
Cost of equity ###
Cost of debt 7.0000%
Change in fir $415.94
Part c
If the cash is paid out a as a special dividend, the number of shares remains unchanged at 80 million
New firm valu ###
- Debt ### All or nothing
New Equity va ### NOTE: When a dividend is paid, t
New value per $34.16 by roughly the amount of the div
Part c
New firm valu ### 1. Did not set up for shares correctly: -1 point
- Debt ### Check your answer 2. Did not adjust number of shares: -1 point
Value of equit ### If buyback price = $60.57 3. Other errors: -1/2 point each
Let the stock buyback price Number of share bought 33.0206953 NOTE: Many of you treated the g
Number of sha2000/X Remaining shares 66.9793047 It is not. It is the price of the rem
Remaining sh 100-2000/X Price per share = 51
Value to buyb (X-50)*(2000/X)
(100 -2000/X)*51= 3415.94 Value of equity= $3,415.94
Solving for X
X= $60.57
Problem 4
1 2 3 1. Net income wrong: -1/2 point

Net Margin 12% 14% 16% 2. Change in non-cash WC wrong: -1 point
Total non-cas 30% 25% 15% 3. Other errors: -1/2 point
Part a 4. Error in getting to cash balance: -1 point
Base 1 2 3
Revenues $100.00 $140.00 $196.00 $274.40
Net Income $10.00 $16.80 $27.44 $43.90
Capital expen $40.00 $46.00 $52.90 $60.84
Depreciation $12.00 $15.00 $18.75 $23.44
Non-cash Work $36.00 $42.00 $49.00 $41.16
Chg in noncash WC $6.00 $7.00 -$7.84
FCFE -$20.20 -$13.71 $14.35
Cash balance $45.00 $24.80 $11.09 $25.44
Part b
Revenues $100.00 $140.00 $196.00 $274.40 1. Error on treating dividends: -1 point
Net Income $10.00 $16.80 $27.44 $43.90 2. Error on new debt: -1 point
Capital expen $40.00 $46.00 $52.90 $60.84 3. Error on cash balance: -1 point
Depreciation $12.00 $15.00 $18.75 $23.44
Non-cash Work $36.00 $42.00 $49.00 $41.16
Chg in noncash WC $6.00 $7.00 -$7.84
New Debt $4.00 $4.00 $4.00
FCFE -$16.20 -$9.71 $18.35
- Dividends paid $3.36 $5.49 $8.78
Cash balance $45.00 $25.44 $10.24 $19.81
Desired cash balance at end of year 3 $10.00
Cash available for buybacks $9.81
Problem 5
After-tax ope 10 Cost of capital (high growth) = 12.00%
Book value of 45 Cost of capital (stable growth) = 10%
Book value of 15
Cash 10 1. Did not compute expected growth: -1 point
Invested capit 50 2. Error on ROC: -1/2 point
Return on capi 20% 3. Error on reinvestment rate: -1 point
Net Cap ex $2.00 Terminal value

Change in non $1.00 1. Did not recompute reinvestment rate: -1/2 poin
Normalized ac $3.00 2. Used wrong discount rate: -1/2 point
Reinvestment 60% 3. Math errors: -1/2 point each
Expected grow 12.00%
Expecedd grow 3.0% Value today
Reinvestment 15.00% 1. Used wrong discount rate: -1/2 point
2. Used wrong discount rate just on terminal valu
1 2 3 Term year 3. Cash not added: -1/2 point
After-tax ope $11.20 $12.54 $14.05 $14.47 4. Debt not subtracted out: -1/2 point
Reinvestment $6.72 $7.53 $8.43 $2.17
FCFF $4.48 $5.02 $5.62 $12.30
Terminal value $175.72 ! New reinvestment rate = 3%/20% = 15%
PV @ 12.5% $4.00 $4.00 $129.07
Value of oper $137.07
+ Cash $10.00 Note: Since you have FCFF, you h
- Debt $15.00 You then have to add cash (since
Value of equit $132.07 debt.
Value per sha $26.41
ed incorrectly: -1 point
d incorrectly: -1 point
n rate as risk free rate: -1/2 point

u cannot use the Brazilian $ government bond rate,
is not a risk free rate in US$.
o wrong: -1 point
weighted for business: -1 point
weighted for country: -1 point
er beta: -1 point
th the business and the country weights changes as the

estructures. So, both numbers have to be resestimated.
depreciation correctly: -1 point
e taxes: -1 point
unt rate: -1 point
-1/2 point each
pute annuity: -1 point

ng back to revenues from annuity: -1/2 point
unt rate: -1/2 point
pute tax benefit from depreciaton: -1 point

pute tax benefit from expensing: -1 point
-1/2 point each
don't have to redo all of the cash flows, since
epreciation changes. In fact, doing all of the
will leave you with such a mess that it is very
at you will get the right answer.
pute savings per year: -1 point

debt ratio in computation: -1 point
beta: -1 point
ed at 80 million
en a dividend is paid, the stock price will drop
y the amount of the dividend (about $20/share)
p for shares correctly: -1 point

t number of shares: -1 point
-1/2 point each
ny of you treated the given price as the buyback price.
is the price of the remaining shares.
wrong: -1/2 point

n-cash WC wrong: -1 point
ng to cash balance: -1 point
ting dividends: -1 point

debt: -1 point
balance: -1 point
NOTE: The acquisitons are a wild card. The problem states th

there is one acquisition every five years and gives you the am
The simplest solution is to average the amount and add it to
reinvestment. That pushes up the reinvestment rate and grow
pute expected growth: -1 point rate.
Here is why you cannot ignore it. This is clearly part of the co
vestment rate: -1 point strategy to grow. If you ignore it, you will understate reinves
and growth for this firm.
mpute reinvestment rate: -1/2 point

discount rate: -1/2 point
-1/2 point each
discount rate: -1/2 point

discount rate just on terminal value: -1/2 point
ed: -1/2 point
tracted out: -1/2 point
ment rate = 3%/20% = 15%
e you have FCFF, you have to discount at the cost of capital.

have to add cash (since you have not counted it yet) and subtract out
The problem states that
rs and gives you the amount
e amount and add it to your
vestment rate and growth
is clearly part of the company's
will understate reinvestment
Problem 1
Part a.
Business Estimated Val Weight Unlevered beta
Storage Devic 400 0.2 0.9 !
Electronics 600 0.4 1.2
Social Media 800 0.8 1.8
Firm 1800 1.4
Equity 1200
Debt 600
D/E ratio = 0.5
Levered beta = 1.82
Part b
Business Estimated Val Weight Unlevered Beta
Electronics 600 0.375 1.2
Social Media 1000 0.625 1.8
Firm 1600 1.575
Equity 1200
Debt 400
D/E ratio 0.33333333
Levered beta = 1.89
Part c
Business Estimated Val Weights Unlevered beta
Electronics 600 0.42857143 1.2
Social Media 800 0.57142857 1.8
Firm 1400 1.54285714
Equity 800
Debt 600
D/E 0.75
Levered Beta = 2.24
Problem 2
0 1 2 3 4 5
Investment -20 0
Incremental Revenue $10.00 $20.50 $31.53 $43.10 $55.26

Incremental EBITDA $2.00 $4.10 $6.31 $8.62 $11.05
Incremental Depreciation 4 4 4 4 4
Incremental EBIT -$2.00 $0.10 $2.31 $4.62 $7.05
Incremental Tax -$0.80 $0.04 $0.92 $1.85 $2.82
Incremental EBIT (1-t) -$1.20 $0.06 $1.38 $2.77 $4.23
+ Incremental Depreciaton 4 4 4 4 4
- Incrementa -10 $0.50 $0.53 $0.55 $0.58 $13.37
FCFF -10 $2.30 $3.54 $4.83 $6.19 -$5.14
NPV = -$0.32
Revenue befo 200 200 200 200 200 200

Revenue after $210.00 $220.50 $231.53 $243.10 $255.26
Incremental revenue $10.00 $20.50 $31.53 $43.10 $55.26
Working capit 20
Working capita 10 $10.50 $11.03 $11.58 $12.16 $25.53
Incremental 10 $0.50 $0.53 $0.55 $0.58 $13.37
b. Effect of expensing
Tax benefit of $8.00
Tax benefit of $6.07 ! Tax savings each year = 4 (0.4) = 1.6
Effect on NPV $1.93 ! Initial investment * tax rate
New NPV = $1.62
c.
NPV with sys -$0.32
Cost of syste -$13.93
NPV of increm $13.62
Annual after- $3.59 ! Annuity given NPV
Pre-tax expen $5.99 ! Pre-tax amount
Long way to d 0 1 2 3 4 5
Incremental EBITDA $2.00 $4.10 $6.31 $8.62 $11.05
Incremental EBIT $2.00 $4.10 $6.31 $8.62 $11.05
Incremental taxes $0.80 $1.64 $2.52 $3.45 $4.42
Incremental EBIT (1-t) $1.20 $2.46 $3.78 $5.17 $6.63
- Incrementa -$10.00 $0.50 $0.53 $0.55 $0.58 $13.37
FCFF $10.00 $0.70 $1.94 $3.23 $4.59 -$6.74
PV $13.62
Problem 3
Part a
Current lever 1.15
Market value o 800
Debt 200
Debt ratio = 0.2
Unlevered bet 1
New D/E ratio 9
Levered beta 6.4
Debt ratio = 90%
Change in cost 0.2100%

Savings each 2.1
Increase in fi $25.64
New firm valu $1,025.64
New debt (to $923.08
Old debt $200.00
Increase in d $723.08
If the operating income is only 60 million

Interest expe $69.23 ! Two things can affect your cost of capital. The first is that your
Operating in $60.00 ! Interest coverage ratio will decrease increasing your default spread.
Tax rate for c 34.67% ! That may be difficult to compute and I did not look for it.
Levered beta 6.88 ! However, you can compute your interest expense and it gives you an
After-tax cost 4.90% ! Interest expense> EBIT, which affects your cost of capital
You did not have to work your way through. If you showed the tax rate effect, you got full credit
Problem 4
Last12months 1 2 3 4 5
Revenues $1,000 $1,100 $1,200 $1,300 $1,400 $1,500
EBITDA $250 $275 $300 $325 $350 $375
Depreciation $60 $66 $72 $78 $84 $90
NetIncome $80 $88 $96 $104 $112 $120
NoncashWorki $75 $70 $65 $60 $50 $40
TotalDebtouts 150 145 140 135 130 125
Parta
FCFEwihtoutc 1 2 3 4 5 Cumulative
NetIncome $88 $96 $104 $112 $120 $520
+ Depreciati $66 $72 $78 $84 $90 $390
Changeinn ($5) ($5) ($5) ($10) ($10) ($35)
+(NewDebt -5 -5 -5 -5 -5 ($25)
FCFE(beforec $154 $168 $182 $201 $215 $920
Dividends $52.80 $57.60 $62.40 $67.20 $72.00 $312
Changeincashbalance -100
Capitalexpenditures $708
Partb,
Tokeepthecashbalanceconstant&paydowndebt
Exisitngdivide $312 ! You don't need cap ex to solve this part of the problem
Cashtopay 125 ! So, not credit for carry through of part a mistakes
Cashflowto 100
Remainingdivi $87
Cumularivenet $520
Payout ratio 16.73%
Partc
Thecompanyexpectsitsearningsgrowthandreinvestmentneedstodecreaseinthefuture
Problem 5
Current After year 5
EBIT (1-t) 10
Invested Capit 100
Net Cap Ex 7
Change in wor 2
Return on cap 10% 10%
Reinvestment 90% 30%
Expected grow 9% 3%
Cost of capita 12% 8%
Year 1 2 3 4 5 Terminal year
EBIT (1-t) $10.90 $11.88 $12.95 $14.12 $15.39 $15.85
- Reinvestme $9.81 $10.69 $11.66 $12.70 $13.85 $4.75
FCFF $1.09 $1.19 $1.30 $1.41 $1.54 $11.09
Terminal value $221.87
Present valu $0.97 $0.95 $0.92 $0.90 $126.77
Value of oper $130.51
+ Cash $15.00
- Debt $40.00
Value of equit $105.51
/ Number of s $8.00
Value per sha $13.19
! Used revenue weights: -1 point
! Wrong D/E ratio: -1 point
! Wrong weights on businesses: -1 point

! Wrong weights on businesses: -1 point

! Used total revenue instead of incremental: -1 point

! Change in working capital not computed each year: -1 point
! Forgot to reverse working capital at end of period (when it reverts): -0.5 point
! Other mistakes: -0.5 points each
! If you revert back to old revenue, WC in year 5 = 20

! Your NPV will be higher and you should get full credit
! Did not compute savings from expensing: -0.5 points

! Did not compute lost PV from depreciation tax savings correctly: - 0.5 points
(If you did the entire problem the long way - with the cash flows - you should
get the same effect where your NPV increases by this amount)
! Used NPV from part 1 without correcting for investment & depreciation: -1 point
! Did not annualize: -1 point
! Cost of equity incorrect: -0.5 point

! After-tax cost of debt incorrect: -0.5 point
! Did not unlever & relever beta: -1 point

! Did not after-tax cost of debt: -0.5 point
! Math errror: 0.5 point
! Change in firm value not computed: -1 point

! Did not use firm value change to get to debt: -1 point
! Mostly all or nothing

! I did give half a point, if you explicitly computed an interest coverage ratio
gives you an
! Working capital change shown as a cash outflow (instead of inflow): -1 point

! Paying down debt shown as cash inflow instead of outflow: -1 point
! Forgot depreciation add back: -1 point
! Payout ratio incorrect for any reason: -1 point
! All of the other reasons may sound plausible, but they are not defensible. You don't want
to pay dividends just because everyone else is or to attract dividend-liking investors just
for the sake of expanding your investor base. You certainly don't want to pay dividends
if you expect your reinvestment needs to be high in the future.
! Wrong growth rate: -1 point

! FCFF not consistent with growth: -1 point
! Did not compute reinvestment rate in year 6: -1 point

! Wrong discount rate on termnal value: -0.5 point
erminal year
! Discounted terminal value at wrong discount rate: -0.5 point
! Subtracted cash (instead of adding it): -0.5 point
tead of inflow): -1 point
utflow: -1 point
ble. You don't want

ng investors just
o pay dividends
Problem 1
a.
Market value of equity = 800 1. Did not capitalize leases: -1 point
Market value of interest bearing d 400 2. Used after-tax cost of debt to capitalize l
PV of lease commitments = 406.055365 ! PV of $ 80 million @5% 3. Unlevered and relevered beta for leases
Firm value = 1606.05537 4. Did not after-tax cost of debt: - 0.5 point
Debt ratio = 50.19%
Beta = 1.15
Cost of equity = 9.25%
Cost of debt (after-tax) 3.00%
b.
Value of entertainment = 963.633219
Value of electronics = 642.422146 1. Did not compute unlevered beta: -1 poin
Current unlevered beta = 0.71671564 ! 1.15/(1+(1-.4)(806/800)) 2. Did not back out unelvered beta of enter
Unlevered beta = 0.7167 = 0.90 (.4) + X (.6) 3. Did not estimate new D/E ratio correctly:
Solving for new unlevered beta 4. Did not adjust cost of debt: -0.5 point
Unlevered beta after divestiture = 0.59452606 5. Did not after-tax cost of debt: -0.5 point
Debt after transaction = 645.449829 ! 806 - 0.25*642.42
Equity after transaction = 318.18339 ! 800 - 0.75*642.42
D/E ratio after transaction = 2.02854658
Levered beta after transaction = 1.31814035
After-tax cost of debt = 3.90%
Problem 2
Initial investment = 60 1. Ignored working capital initial investmen
Initial investment in WC = 10 2. Errors on computing annual after-tax cas
3. Did not salvage working capital or show
0 Yrs 1-10 Year 10 4. Did not salvage initial investment: -0.5 p
Initial investment -70 5. Used company's cost of capital : -1 point
Salvage 20
Revenues 100
EBITDA 15 ! If you choose not to salvage working capi
- Depreciation 5 you will get in year 10 because you will be
EBIT 10 tax benefit will be 0.4(10) = 4
EBIT (1-t) 6
+ Depreciaton 5
Cash flow 11
NPV = 9.04245085
b. If project continues in perpetuity

Initial investment -70 Forever ! Note that if the project is to continue fore
Terminal value will deplete your assets' earning power and
Revenues 100
EBITDA 15 ! Used cash flow from part a in perpetuity:
- Depreciation 5 There will be nothing to depreciate after ye
EBIT 10 ! Adjusted cash flow just for perpetuity in y
EBIT (1-t) 6 is not mathematically impossible, but it is e
+ Depreciaton 5 ! Other errors: -0.5 point each
- Cap maintainence exp 5 ! Salvaged working capital and initial inves
Cash flow 6
NPV = -3.33333333 ! -70 + 6/.09
c.
PV of synergy = 28.2511151 ! 5 million @12% ! Used wrong discount rate: -0.5 point
! Error in PV = -0.5 point
Problem 3
a.
Current cost of equity = 0.085 1. Did not after-tax cost of debt: -0.5 point
After-tax cost of debt = 0.027 2. Error on weights: 0.5 point
Debt ratio 0.2
Cost of capital 0.0734
b.
New debt ratio = 0.6 1. Did not adjust beta: -1 point
Unlevered beta = 0.86956522 ! 1/(1+(1-.4)(0.25)) 2. Errors in unlevering and relevering beta:
New levered beta = 1.65217391 ! 0.8686(1+(1-.4)(1.50)) 3. Errors in pre-tax cost of debt: -0.5 point
Cost of equity = 0.1176087 4. Did not after-tax cost of debt: -0.5 point
After-tax cost of debt = 0.039
Cost of capital = 0.07044348
c.
Increase in firm value = 52.4626589 ! (.0734-.0704)(1250)/.0704 ! Did not compute change in
! Error in computing change
Price per share in buyback = 11 ! Did not net out portion of v
Number of shares bought back = 45.4545455 ! 500/11 ! Did not adjust number of sh
Portion of value to bought back s 45.4545455 ! 45.45 (11-10)
Remaining value increase= 7.00811348 ! 52.46-45.45)

Remaining shares = 54.5454545 ! 100-45.45
Value increase per remaining shar 0.12848208 !7.008/54.54
Price per share = 10.1284821
d. The value per share will be higher than computed in part c, because stockholders
will get a bonus from being able to keep existing debt at lower rates on the books.
Problem 4
Most recent y Next year
Revenues 60 90 Part a
Net income 10 15 1. Error on dealing with change in working
+ Depreciation 5 7.5 2. Error on dealing with change in debt: -0.
- Cap Ex 8 10 3. Other errors in computing FCFE: -0.5 poi
- Change in WC -1 3 4. Change in cash balance incorrect: -0.5 p
- (Debt repaid + Debt issued) -1 2.75
FCFE 9 12.25 Part b
Dividends 2 10.25 1. Did not compute change in working capi
Change in cash balance 7 2 2. Did not compute change in debt correctl
Cash balance at start of year 3 10 3. Other errors: -0.5 point each
Cash balance at end of year 10 12 4. Divided dividend by revenues or some o
Total reinvestment = 2
Debt used = 1
Debt ratio = 0.5
Payout ratio = 0.2 0.68333333 ! 10.25/15
c.
iii.NegativeJensensalpha,negativeEVA
I would not trust the managers of the company and want my cash back.
Problem 5
High growth Stable growth
Return on capital = 25.00% 15% Return on capital = EBIT (1-t)/ (BV of debt +
Expected growth = 10% 3%
Reinvestment rate = 0.4 0.2 ! g/ ROC
Cost of capital 12% 10%
Year Current 1 2 3 4
EBIT (1-t) $20.00 $22.00 $24.20 $26.62 $29.28
Reinvestment $8.80 $9.68 $10.65 $11.71
FCFF $13.20 $14.52 $15.97 $17.57
Terminal value
Present value (at 12%) $11.79 $11.58 $11.37 $11.17
Value of operating assets = 272.006833
+ Cash 20
- Debt 50
Value of equity 242.006833
Value per share $12.10
alize leases: -1 point
x cost of debt to capitalize leases: - 0.5 point
d relevered beta for leases (why?): 0.5 point
tax cost of debt: - 0.5 point
pute unlevered beta: -1 point

out unelvered beta of entertainment business: -1 point
mate new D/E ratio correctly: -1 point
t cost of debt: -0.5 point
tax cost of debt: -0.5 point
ing capital initial investment: -0.5 point

mputing annual after-tax cash flow: -1 point
ge working capital or show tax benefit from not salvaging: -0.5 point
ge initial investment: -0.5 point
ny's cost of capital : -1 point
not to salvage working capital, you have to show the tax benefit
ear 10 because you will be writing off the investment. That
be 0.4(10) = 4
e project is to continue forever, the cap ex = depreciaation. Otherwise, you

r assets' earning power and not be able to go on forever.
w from part a in perpetuity: -1 point (This is mathematically impossible.

othing to depreciate after year 10)
flow just for perpetuity in year 10: -0.5 point (This is a lesser sin. It
tically impossible, but it is economically infeasible. Think Apple iTV)
0.5 point each
king capital and initial investment: -0.5 point
scount rate: -0.5 point

hts: 0.5 point
t beta: -1 point
vering and relevering beta: - 0.5 point
Did not compute change in firm value: -1 point

Error in computing change in firm value: -0.5 point
Did not net out portion of value to buyback shares: -1 point
Did not adjust number of shares: -1 point
! All or nothing: -1 point
ing with change in working capital: -1 point

ing with change in debt: -0.5 point
in computing FCFE: -0.5 point
sh balance incorrect: -0.5 point
pute change in working capital correctly: -1 point

pute change in debt correctly: -1 point
-0.5 point each
end by revenues or some other variable: -0.5 point
BIT (1-t)/ (BV of debt + BV of eqPart a
a. Did not compute reinvestment: -1 point
b. Computed ROC incorrectly: -0.5 point
5 Terminal year Part b

$32.21 $33.18 a. Did not compute reinvestment: -1 point
$12.88 $6.64 b. Did not use new cost of capital;: -0.5 point
$19.33 $26.54 c. Other errors in computation: -0.5 point
$379.16
$226.11
Part c
a. Used wrong discount rate for term value: -0.5
b. Did not compute PV of FCFF: -0.5 point
c. Forgot to add cash: -0.5 point
d. Forgot to subtract debt: -0.5 point
Problem 1
Book Value Market Value Unlevered beta of business
Cement $500 $900 0.90
Steel $500 $600 1.20
Total $1,000 $1,500
a,
Market value of equity = $1,000 ! Used book value weights for unlevered beta: -0.5 point
Market value of debt = $500 ! Debt to equity ratio set to zero or ignored: -1 point
Debt/equity ratio = 50.00% ! Did not use after-tax cost of debt: -0.5 point
! Math errors: -0.5 point
Unlevered beta for firm = 1.02
Levered beta for firm = 1.33 Computational notes
Cost of equity = 10.63% The unlevered betas should always be weighted based upon the market value
After-tax cost of debt = 3.60% Since balance sheets have to balance, the market value of assets (businesses
Debt Ratio = 33.33% Thus even though the debt is not given, it can be backed out of the market va
b After-tax operating income

Book value ROC Levered Beta Cost of equity
Cement $75 $500 15.00% 1.17 9.8500%
Steel 25 $500 5.00% 1.56 11.8000%
Problem 2
Pre-tax cost ofAfter-tax
debt cost of debt
Cost of equityCost of capital
Life Products 8.00% 4.80% 14.00% 12.50%
Pfizer 5.00% 3.00% 9.00% 7.50%
a. Invest and produce

Initial investment = $750.00 ! Did not comptue after-tax cash flow right: -1 point
! Used wrong discount rate: -1 point
After-tax Cash flow ! Forgot to subtract out initial ivnestment: -1 point
After-tax Operating inc 90.00
+ Depreciation = $50.00
Cash flow to firm= $140.00
Discount rate = 12.50%! Pre-debt cash flows

PV of cash flows = $928.61
NPV = $178.61
b. PV of licensing fees has to be greater than the NPV of investing an ! Used wrong discount rate: -1 point
PV of cash flows = $178.61 ! PV formula not set up: -1 pont
Annual after-tax cash flow $17.21 ! Use pre-tax cost of debt fo (I gave full credit for both 15-year annuity and pe
Annual licensing fee = $28.68 ! Tax rate implicit in pre-tax and after-tax cost of debt. No points off for not do
Problem 3
Current cost of equity = 10.00% Compuatational notes
Current after-tax cost of 3.60% The key part of this problem is recognizing that when investors
Current firm value = $2,000.00 and those who do not will be a function of the buyback price. W
Debt Ratio = 25.00% a buyback price is provides is an indication that they are not. Af
Current cost of capital = 8.40% Thus, you need to go through the following steps:
New cost of capital= 8.00% 1. Estimate the change in firm value from the change in the cos
Savings in cost of capital 0.40% 2. Estimate how many shares you will buy back at the buyback
PV of savings = $100.00 3. Estimate how much buyback stockholders get of the value ch
4. Estimate how much remaining value change there is for thos
Part a: Buy back stock at $10.25 5. Divide by the remaining shares outstanding to get the value
# of shares bought back 48.78
Premium paid = $0.25 ! Did not compute pre-change cost of capital correctly: -0.5 to -1 point
Value paid to buyback sh $12.20 ! Firm value change computed incorrectly: -1 point
Remaining value increas $87.80 ! Did not allocate a portion of firm value change to buyback shares: -1 point
Remaining shares = 101.22
increase in value for rem $0.87
Part b: Buyback price to make value change zero

Let the price paid back be X
Number of shares bought 500/X ! Kept number of shares bought back fixed: 1.5 points
Premium paid = X-10 ! Equation set up incorrectly for soluation: -1 point
Value paid to buyback sh(500/X) (X-10)
For the value per share on remaining shares to be unchanged
Value paid to buyback sh $100.00
(500/X) (X-10) = 100
X= $12.50
Problem 4
-3 -2 Last year ! Used 3 years instead of 2 years to
Revenues $1,000 $1,200 $1,500 ! Working capital change not dalt w
Net Income $100 $120 $150 1 Forgot dividends: -1 point
Depreciation $25 $40 $50 ! Did not deal with change in cash c
Non-cash Working capital $100 $90 $75
FCFE without cap ex

Net Income $120 $150
+ Depreciation $40 $50
- Change in non-cash WC -$10 -$15
FCFE (without cap ex $170 $215
Dividends paid $48.0 $60.0
Change in cash balance = FCFE - Dividends - Stock buybacks

(120-100) = FCFE - 108 -0
FCFE = 128
FCFE without cap ex = $385

FCFE with cap ex = 128
Cap ex over two years = $257.00
Next year
Revenues $1,725.0 ! Debt change computed incorrectly or ignored: -1 point
Net Income $172.5 ! Change in working capital incorrect or ignored: -0.5 to -1 point
Cap Ex $86.25 ! Forgot to net out dividends: -0.5 to -1 point
Depreciation $57.5 ! Math errors: -0.5 point
Chg Non cash Working Capit 11.25
New Debt issued 10.00
FCFE $142.50
Dividends $69.0
Change in cash balance = FCFE - Dividends - Stock buybacks
(100-120) = 142.5 - 69 -X
Stock Buybacks = $93.50
Problem 5 Current 1 2 3 4
Loans $5,000.00 $5,500.00 $6,050.00 $6,655.00 $7,320.50
Book value of equity $400.00 $451.00 $508.20 $572.33 $644.20
Capital Ratio 8.00% 8.20% 8.40% 8.60% 8.80%
Capital invested $51.00 $57.20 $64.13 $71.87
Net income $100.00 $110.00 $121.00 $133.10 $146.41

- Capital invested $51.00 $57.20 $64.13 $71.87
FCFE $59.00 $63.80 $68.97 $74.54
b. Stable growth
ROE = 12.00%
Expected growth rate = 4.00% ! Did not compute FCFE in year 6 correctly: -1 point
Equity Reinvestment Rate = 33.33% ! Used wrong discount rate: -0.5 point
! Used wrong growth rate: -0.5 point
Net income in year 6 = $167.49 ! 161.05*1.04
FCFE in year 6= $111.66
Cost og equity ;in year 6 = 10.00%
Terminal value of equity in $1,861.03
c. Value today
Year 1 2 3 4 5
FCFE $59.00 $63.80 $68.97 $74.54 $80.53
Terminal value of equity $1,861.03
PV $52.68 $50.86 $49.09 $47.37 $1,101.69
Value of Equity $1,301.69
/ number of shares 50
Value per share $26.03
ta: -0.5 point
hted based upon the market values of the businesses, not book values
market value of assets (businesses) = market value of equity + debt
an be backed out of the market value of the assets
Cost of capita EVA ! Computed return on capital using market value: -1 point
7.77% $36.17 ! Did not compute costs of capital for businesses (used company cost of capit
9.07% -$20.33 ! Multiplied return spread by market value: -0.5 point
Computational notes
The key aspect of the licensing fee is that it is a fixed amount
and that the only risk you face is the default risk in Pfizer. Since it is a fixed amount (anld
not a function of operating income or risk), the discount rate is the pre-tax cost of debt
for Pfizer. It is not the cost of capital.
If the licensing fee had been a percentage of operating income on the product, it would have
been appropriate to use Pfizer's cost of capital to discount the cash flows.
Com
scount rate: -1 point

t set up: -1 pont
it for both 15-year annuity and perpetuity answers)
st of debt. No points off for not doing this.
s recognizing that when investors are not rational, the value allocation between those who sell back shares
a function of the buyback price. While the problem does not specify that investors are not rational, the very fact that
an indication that they are not. After all, when investors are rational, the buyback price = price for the remainign shares.
the following steps:
m value from the change in the cost of capital (as you always do)
you will buy back at the buyback price (Dollar debt taken/ Buyback price)
ck stockholders get of the value change (Buyback price - Original price) (No of shares bought back)
ing value change there is for those who do not sell back their shares
ares outstanding to get the value change for remaining stockholders
al correctly: -0.5 to -1 point
ange to buyback shares: -1 point
Used 3 years instead of 2 years to get to cash flows: - 0.5 point

Working capital change not dalt with correctluy: - 0.5 point
Forgot dividends: -1 point
Did not deal with change in cash correctly: -1 point
rrectly or ignored: -1 point

correct or ignored: -0.5 to -1 point
-0.5 to -1 point
5 Compuational notes
$8,052.55 For a bank, investment in regulatory capital becomes the equivalent of net cap ex and work
$724.73 capital change. Thus, the amount you have to invest in regulatory capital has to be taken o
9.00% of net income each year to get to FCFE. I gave full credit, if you estimated the investment in
$80.53 regulatory capital to be an absolute number ($64.95 million a year)
$161.05 ! Did not compute change in regulatory capital: -1 point

$80.53 ! Did not treat it as reinvestment for FCFE: -1 point
$80.53 ! Subtracted out other items (like loans) to get to FCFE: -1 point
ar 6 correctly: -1 point
! Forgot to add PV of FCFE in years 1-5: -0.5 point

! Forgot to PV terminal value: -0.5 point
! Subtracted out debt from PV: 0.5 point
value: -1 point
esses (used company cost of capital): -2 points
the very fact that

the remainign shares.
equivalent of net cap ex and working
gulatory capital has to be taken out
if you estimated the investment in
Problem 1
Achilles
Trident (acquirer) (Target)
Levered Beta 1.2 1.5
Tax rate 40% 40%
Market value of equity 12000 6000
Book value of equity 8000 8000
Market & Book value of debt 3000 4000
a. Unlevered beta 1.04347826 1.07142857

Value of the firm = 15000 10000
Weights of the firms = 60.00% 40.00%
Unlevered beta for the firm = 1.05
b.
Levered beta after transaction = 1.35
To compute D/E ratio
1.05 ( 1+ (1-.4)* D/E) = 1.35
Solving for the D/E ratio
Debt to equity = 46.67% ! You cannot keep equity value fixed while you so
Value of combined firm = $25,000.00 Instead, you have to estimate th value of the com
Debt in combined firm = $7,955.23 and take the proportion that is debt.
Debt in existing firms = $3,000.00
New debt for deal = $4,955.23
c.
Cost of debt = 3.300%
Debt ratio = 31.821%
Problem 2
a. Correct discount rate is cost of capital (since operating cashflows are being discounted)
b. Computed NPV = 20
Discount rate used = 12%
Initail investment = 600
PV of 10 years of earnings = 620
Annual after-tax OI = $109.73 ! Annuity given r=12% and 10 years
c. Initail invest Salvage

Assets 600 0
Non-cash WC 50 50
EBIT (1-t) $109.73

+ Depreciation 60
- Change in WC 0
FCFF $169.73
NPV = $470.44 ! -650+169.73(PV of annuity, 8.8%,10) + 50/1.088^10
PV of tax benefits from 5-yr depr $187.68 ! Deprcn=120; Tax savings=48; n=5 year
PV of tax benefits from 10-yr depr $155.39 ! Deprecn=60; Tax savings=24; n=10
Change in NPV from shift $32.29
New NPV = $502.72
Problem 3
a. Current debt ratio = 0.2
Cost of equity = 0.094
b. Implied growth rate

Current value of firm = 1500
Expected cash flow next year= 80
Value of firm = 1500 = 80/ (Cost of capital -g) ! Already next year's cashflow. No growth needed in numerator.
Solve for g,
Implied growth rate = 2.91%
c. New cost of capital = 8.00%

Annual savings = 3.6
PV of savings with implied growth = $70.68
Debt at the optimal debt ratio $600.00 ! 40% of firm value
Existing debt = $300.00
New Debt issued = $300.00
# Shares bought back = 29.27
Preimium to shares bought back = $7.32
Remaining premijm = $63.36
Remaining number of shares = 90.73
Increase in value per share = $0.70
d. Only if new investments earn more than the new cost of capital. After you borrow the money,
the new cost of capital is the only one you care about.
Problem 4
Revenues = 100
Net Income = 25
Depreciation = 10
Cap Ex = 15
Non-cash Working capital = 12
Expected growth rate = 20%
Debt ratio for funding new investments 25%
Year 1 2 3
Revenues 120 144 172.8
Non-cash Working capital 14.4 17.28 20.736
Net Income 30 36 43.2
+ Depreciation 12 14.4 17.28
- Cap ex 18 21.6 25.92
- Change in WC 2.4 2.88 3.456
+ New debt issued 2.1 2.52 3.024
FCFE 23.7 28.44 34.128
Total FCFE = 86.268
Dividends to be paid = 76.268
Total Net income = 109.2
Payout ratio -= 69.84%
b. Effect of using 40% debt ratio for reinvestment
Net Income 30 36 43.2
+ Depreciation 12 14.4 17.28
- Cap ex 18 21.6 25.92
- Change in WC 2.4 2.88 3.456
- Debt repaid 10 10 10
FCFE 11.6 15.92 21.104
Total FCFE= 48.624
Change in cash balance 0
Dividends paid 48.624
Payout ratio 44.53%
c. Firms are less certain about future earnings (buybacks are flexible)
The other answers either do not make sense (more certain about earnings would increase dividen
or would have applied even more strongly prior to the last decade (dividends taxed at a higher rat
(I know we talked about mgmt compensation containing options, but more as a contributing factor
than the main factor. If you did circle other, and mentioned this, you did get 0.5 point)
Problem 5
EBIT (1-t) 4000
- Net Cap Ex 1000
- Chg in non-cash WC 200
FCFF 2800
Book Capital invested = 12000
Reinvestment rate = 30.00%
Return on capital = 33.33%
Expected growth rate = 10.00%
a. FCFF for next 3 years
Year 1 2 3
EBIT (1-t) $4,400.00 $4,840.00 $5,324.00
- Net Cap Ex $1,100.00 $1,210.00 $1,331.00
- Chg in WC $220.00 $242.00 $266.20
FCFF $3,080.00 $3,388.00 $3,726.80
PV (at 12%) $2,750.00 $2,700.89 $2,652.66
b. Terminal value
Growth rate = 3%
EBIT (1-t) in year 4 = $5,483.72
- Reinvestment in year 4 = $493.53
FCFF in year 4 $4,990.19
Terminal value = $71,288.36 ! Use stable period cost of capital
c. Value of equity per share today

PV of FCFF for next 3 years = $8,103.56
PV of terminal value = $50,741.65 ! Discount at 12% for 3 years
Value of operating assets = $58,845.20
- Debt $4,000.00
Value of equity $54,845.20
Per share value = $10.97
! Used book value instead of market: -1 point
Wrong weights on companies: -1 point
Math errors: -0.5 point
! Kept equity value fixed; -1 point

Math errors: -0.5 point each
ep equity value fixed while you solve for debt.

ve to estimate th value of the combined firm
oportion that is debt.
! Math error: -0.5 point
! Did not set up annuity: -1 point

! Used 8.8% rate: -1 point
! I gave full credit, if you misread the problem and subtracted
depreciation from this number
! Forgot WC initial investment: -0.5 point

! Forgot salvage value: -0.5 point
Did not add back depreciation: -1 point
Math errors: -0.5 point
8.8%,10) + 50/1.088^10
! Forgot the tax effect: -0.5
! Multipled by (1-t) instead of t: -0.5 point
! Math error: -0.
! Used equity value: -0.5 to -1 point

Did not set up equation: -2 points
w. No growth needed in numerator.
! Bought back shares at today's price: -1 point

Used wrrong WACC in discounting: -0.5 point
! Did not estimate surplus paid to buyback shares: -0.5 point
Did not adjust number of shares for biuyback:-0.5 point
! Counted all of WC: -0.5 point

! Did not adjust for debt : -0.5 point
! No changei n non-cash WC: -0.5 point
! Computed payout ratio incorrectly: -0.5 point
Did not count cash flow from debt properly: -1 point
! When you are replaying debt, you cannot also multiply
your reinvestment by (1-Debt ratioj since that works only
if the debt raito is constant.
Consequently, you have to subtract out the debt repayment
to get to FCFE
! Counted the debt ratio adjustment: -1 point
Problem 1 Grading Guidelines
a. Unlevered Beta = 1.04 1. Error on weighting or used levered
b. Debt = 500 1. Used book value of equity: -1
Equitty = 2000 ! Value of the firm - Debt 2. Used effective tax rate: -.5
D/ E Ratio = 0.25 3. Math error: -0.5
Levered Beta = 1.196
c. New unlevered beta = 1 1. Did not recompute unlevered beta
New Debt = 1500 2. Error on new business weights: -0.
New Equity = 1500 3. Error on new debt to equity ratio:
D/E Ratio = 1 4. Used book equity in D/E ratio: -1 p
New levered beta = 1.6 twice but there were clues in the sec
Problem 2
Investment in upgrade = 10 1. Computed PV of future cash flows
- Salvage of old plant 2.5 ! Depreciation of $500,000 for next 5 year2. I have no clue what you were doin
Initial investment 7.5
b. Annual incremental cashflow - Yrs 1-5

Existing Upgraded Incremental 1. Reported total annual cash flow: -1
EBIT 1 2.5 1.5 2. Used total depreciatioin instead of
EBIT (1-t) 0.6 1.5 0.9 3. Other errors: -0.5 point to -1 point
+ Depreciation 0.5 1 0.5 (I gave full credit if you treated EBIT
After-tax Cashflow 1.1 2.5 1.4 in incremental cash flows from years
In yrs 6-10, the entire upgrade cash flow of $2.5 million is incremental
c. NPV = $3.69 ! -7.5 + PV of 1.4 million from yrs 1-5 1. Did not estimate higher cashflows
+PV of 2.5 million from yrs 6-10 2. Ignored years 6-10 completely: -1.
Problem 3 3. Ignored initial investment: -1 point
a. Cost of equity today = 9.400%
Cost of debt today = 3.00% 1. Weights on debt and equity wrong
Debt Ratio = 0.2 2. Wrong cost of equity: -0.5 point
Cost of capital today -= 8.12% 3. Forgot after-tax cost of debt: -0.5 p
b. Unlevered beta = 1.04347826
New levered beta = 1.46086957 1. Did not recompute beta: -1 point
New cost of equity = 10.57% 2. Errors on weights: -0.5 to -1 point
New cost of debt = 0.036 3. Forgot to after-tax cost of debt: -0.
New debt ratio = 0.4
c. Annual savings = 3.35652174 ! (.0812-.0778) (1000) 1. Used equity value instead of firm v
PV of savings = 88.6948529 ! 3.36/(.0778-.04) 2. Did not compute PV of savings wit
Increase in value/share 1.10868566 ! Divide by 80 million 3. Did not divide by the total number
New share price = 11.1086857 4. Other math errors: -0.5 point
Amount of buyback = 200
# of shares bought back 18.0039301
Problem 4
Year -3 -2 -1 Total
Revenues 1000 1200 1500 3700 I gave full credit for both net and gro
Net Income 100 120 150 370 1. Forgot cash balance change: -1 po
Deprecistion 50 60 75 185 2. Subtracted change in cash baqlan
Dividends paid 40 48 60 148 Any mistake in this problem cost you
simply because tracing out math erro
Decrease in cash balance 40
FCFE over 3-year period = 108
Net Reinvestment 262 ! Net Income - Dividends + Chg in Cash
Gross Reinvestiment 447 ! Add depreciation
1 2 Total
Revenues 1650 1815 3465 1 Used total working capital instead
Net Income 165 181.5 346.5 2. Error on FCFE computation: -1 poin
Depreciation 82.5 90.75 173.25 3. Misplayed the change in cash bala
Capital Expenditures 165 181.5 346.5 4. Other errors: -0.5 point each
Change in working capital 37.5 41.25 78.75
Dvidends 66 72.6 138.6
Total dividends = 138.6 If you got the dollar debt used (84.1)
Increase in cash balance 40 full credit even if your ratio did not m
Required FCFE = 178.6
Net Reinvestment 167.9
Total Reinvestment 252
Debt used = 84.1
As % of Reinvestment = 33.37%
Problem 5
Year Current 1 2 3 1. Did not compute Reinvestment rat
EBIT(1-t) $80.00 $92.00 $105.80 $121.67 2. Did not compute growth rate right
FCFF $20.00 $23.00 $26.45 $30.42 3. Error on ROC formula = -0.5 to -1
Reinvestment Rate = 75.00%
Expected growth rate= 15.00%
Return on capittal = 20.0%
Stable growth rate = 4% 1. Did not recompute reinvestment r

Stable reinvestment rate= 0.33333333 2. Used wrong cost of capital (12% in
EBIT (1-t) in year 4 $126.54 3. Grew operating income twice: -0.5
FCFF in year 4 = 84.3578667
Termnal value = 1405.96444
1 2 3
FCFF $23.00 $26.45 $30.42 1. Forgot cashflows from years 1-3: -
Terminal Value 1405.96444 2. Forgot to discount terminal value:
PV @ 12% $20.54 $21.09 $1,022.39 3. Used wrong discount rate (10% in
Value of operating assets $1,064.01 4. Subtracted cash instead of adding
+ Cash 50 5. Added debt instead of subtracting
- Debt 250
Value of equity $864.01
/ Number of shares 100
Value of equity per share $8.64
rading Guidelines
. Error on weighting or used levered betas: -0.5 each
. Used book value of equity: -1
. Used effective tax rate: -.5
. Math error: -0.5
. Did not recompute unlevered beta: -1.5

. Error on new business weights: -0.5 to -1 point
. Error on new debt to equity ratio: -0.5 point
. Used book equity in D/E ratio: -1 poiint (Feels like you are being punished
wice but there were clues in the second part that should have led to fixing the error)
. Computed PV of future cash flows : -0.5 point

. I have no clue what you were doing: -0.5 point to -1 point
. Reported total annual cash flow: -1 point

. Used total depreciatioin instead of incremental: -1 point
. Other errors: -0.5 point to -1 point
gave full credit if you treated EBIT as EBITF+DA. That would have given you $1.1 million
n incremental cash flows from years 1-5 and $1.9 million from years 6-10.
. Did not estimate higher cashflows from years 6-10: -1 to 1.5 points
. Ignored years 6-10 completely: -1.5 point
. Ignored initial investment: -1 point
. Weights on debt and equity wrong: -0.5 point

. Wrong cost of equity: -0.5 point
. Forgot after-tax cost of debt: -0.5 point
. Did not recompute beta: -1 point

. Errors on weights: -0.5 to -1 point
. Forgot to after-tax cost of debt: -0.5 point
. Used equity value instead of firm value in computing savings

. Did not compute PV of savings with growth: -1 point
. Did not divide by the total number of shares: -0.5 point
. Other math errors: -0.5 point
1
gave full credit for both net and gross reinvestment
. Forgot cash balance change: -1 point
. Subtracted change in cash baqlance: -1 point
ny mistake in this problem cost you a point, even if it were a math error
mply because tracing out math errors was very messy.
Used total working capital instead of change: -1 point
. Error on FCFE computation: -1 point
. Misplayed the change in cash balance: -1 point
. Other errors: -0.5 point each
you got the dollar debt used (84.1) correct, you got
ull credit even if your ratio did not match up.
. Did not compute Reinvestment rate right: -0.5 to -1 point

. Did not compute growth rate right: -1 point
. Error on ROC formula = -0.5 to -1 point
. Did not recompute reinvestment rate: -1 point

. Used wrong cost of capital (12% instead of 10%) -0.5 point
. Grew operating income twice: -0.5 point
. Forgot cashflows from years 1-3: -0.5 point

. Forgot to discount terminal value: -0.5 point
. Used wrong discount rate (10% instead of 12%) -0.5 point
. Subtracted cash instead of adding: -0.5 point
. Added debt instead of subtracting: -0.5 point
Problem 1
a. Market value of equity = 200 Firm value = 250
Debt value = 50 Cash = 25
Debt to equity ratio = 0.25 Operating ass 225
Unlevered beta corrected for cash = 1.2
Unlevered beta for Vaudeville = 1.08 ! 1.2(225/250)+ 0 (25/250)

Levered beta for Vaudeville = 1.242 ! 1.08(1+(1-.4)(.25))
b. New debt = 150 ! Old debt + New debt issue

Equity = 200 ! Stays unchanged
New Debt/Equity ratio = 0.75
Firm value = 350
New unlevered beta = 1.486 Movie = 225
New levered beta = 2.154 Software = 125
Problem 2
a. NPV of project = -1.2
PV of cashflows over next 5 years = 8.8 ! Initial investment + NPV
Annual after-tax cashflow = $2.32 ! Five year annuity with r=10%
Annual after-tax operating income = $0.32 ! Subtract out depreciation of $ 2 million
b. PV of tax benefits
From straight line depreciation = $3.03 ! Annual tax benefit = $0.8 million: PV over 5 years
From accelerated depreciation =
Year Tax benefit PV
1 $1.60 $1.45
2 $1.20 $0.99
3 $0.60 $0.45
4 $0.40 $0.27
5 $0.20 $0.12
$3.29
NPV will increase by $0.26 ! Difference in present values
c. After tax return on capital = 6.00% ! After-tax operating income/ BV of capital

Economic Value Added= -16
Problem 3
a. Current cost of equity = 9.80%
b. New Debt to Equity = 33.33% ! Debt increases by $25 million; Equity decreases
New beta = 1.44 ! Unlevered beta (1+(1-t)(D/E))
New cost of capital = 9.12% ! Cost of debt =7% (1-.4)
Change in firm value = $11.11 ! (Change in cost of capital * 100)/(.0912-.03)
Change in value per share = $2.78
c.
Debt to Equity = 0.25 ! Debt increases by $25 million; Equity does not change
New beta = 1.38 (This is an approximation. The NPV will add to equity va
New cost of equity = 10.52000% making the debt ratio even lower)
New cost of capital = 9.26% ! Uses new weights for debt and equity
Change in firm value = 8.69565217 ! (Change in cost of capital * 100)/(.0926-.03); note that even thou
NPV from project = $5.00
Total increase in firm value = $13.70
Increase in value per share = $3.42
Problem 4
Year 3yearsago 2yearsagoMostrecentyear
Next year
NetIncome $100.00 $120.00 $150.00 $180.00
NetCapex $30.00 $50.00 $55.00 $66.00
ChangeinnoncashWC $10.00 $20.00 $10.00 $4.00
+Changeindebt $0.00 $40.00 $10.00 $0.00
FCFE $80.00 $90.00 $75.00 $110.00
Change in cash balance over 3

years= 30
TotalFCFEover3years= $245.00
Totaldividendspaidover3years= $215.00 ! FCFE - Change in cash balance
Dividendpayoutratio= 58.11%
b.ExpectedFCFEnextyear $110.00
Cashavailableforstockholders= $110.00
Problem5
Current 1 2 3
EBIT (1-t) $20.00 $23.00 $26.45 $30.42
- Net Cap Ex $10.00 $11.50 $13.23 $15.21
- Change in non-cash WC $5.00 $5.75 $6.61 $7.60
FCFF $5.00 $5.75 $6.61 $7.60
PV (at current cost of capital of 12%) $5.13 $5.27 $5.41
b. Reinvestment rate in first 3 years = 75% ! (Net cap ex + Chg in WC)/ EBIT (1-t)
Growth rate during firt 3 years = 15%
Return on capital first 3 years = 20.0% ! Growth rate in high growth period/ Reinvestment Rate
Growth rate after year 3 = 0.04
Reinvestment rate = 0.2 ! Growth rate/ ROC
EBIT (1-t) in year 4 = $31.63 ! EBIT (1-t) in year 3 (1.04)
FCFF in year 4 = $25.31 ! Net of reinvestment
Terminal value of firm = $421.79 ! FCFF in year 4 / (New cost of capital -g)
c. Value of firm today = $316.04 ! PV of cash flows in first 3 years + Terminal value/1.12^3
+ Cash $25.00 (Terminal value gets discounted back at today's cost of c
- Debt $80.00
Value of equity today = $261.04
Value per share today = $26.10
a. Weights on cash incorrect: -0.5 points
b. Did not consider cash: -1 point
c. Debt to Equity ratio wrong; -0.5 point
a. Wrong weights on new beusinesses: -0.5 point

b. Wrong debt to equity ratio: -0.5 point
a. Computed break-even cashflow incorrectly: -1 point

b. Did not consider depreciation: -1 point
c. Added back depreciation: -0.5 point
illion: PV over 5 years a. Tried to adjust cashflows for new depreciation: -1 point
(Very difficult to do. You have to subtract out old depreciation_
b. Computed tax benefit incorrectly: -0.5 point
c. Other errors: -0.5 point each
BV of capital a. Computed ROC incorrectly: -0.5 points

b. Used market value instead of book value: -1 point
n; Equity decreases a. Used old cost of equity in computation: -1 point

b. New cost of capital incorrect: -0.5 point
c. Adjusted number of shares for buyback: -1 point
(If investors are rational, this is not necessary)
100)/(.0912-.03)
n; Equity does not change a. Did not compute new debt ratio and cost of capital: -1 point
e NPV will add to equity va b. Did not add back NPV of new invstment: -1 point
100)/(.0926-.03); note that even though firm value increases to 125, you save only on the old firm value which was invested at the o
a. Computed FCFE incorrectly: -1 point

b. Dividends computed incorrectly: -1 point
c. Mechanical errors: -0.5 point each
! The non-cash WC =30
Increase of 20% =6
a. Reduced FCFE by cash balance (this will double the cash balance): -0.5 to 1 point
b. change in WC incorrect: -1 point
c. Other error: -0.5 to -1 point
a. FCFF computed incorrectly: -0.5 to -1 point
a. Did not compute new reinvestment rate: -1 point

b. Mechanical errors; -0.5 point each
period/ Reinvestment Rate
a. Discounted terminal value at wrong rate or for 4 years: -0.5 points

ars + Terminal value/1.12^3
ed back at today's cost of cb. Did not subtract debt and add back cash: -0.5 each
value which was invested at the old cost of capital.
5 to 1 point
Problem 1
Part a
Market value of equity = 700
Market value of debt = 300

Levered beta = 1.20685714
Part b
New business mix after acquisition
Hotels 1000
Transportation 400
New value for Equity = 800

New value for debt = 600
Unlevered beta= 0.91428571
New debt to equity ratio = 0.75
Levered beta = 1.32571429
New cost of equity = 0.09802857
Problem 2
Iniital investment = -15
Reduction in Inventory = 4
Savings from storage facility 4 ! Investment in new facility - Capital Gains tax - Investment in old facility
Net Initial Investment = -7
Annual Cash flow Yr 1 yrs 2-10

Increased Revenue 15 15
Increase in EBIT 1.8 1.8
- Depreciation 1.5 1.5 ( No incremental depreciation from storage facility, since b
Increase in EBIT 0.3 0.3 the old and the new system have same book value)
Increase in EBIT (1-t) 0.18 0.18
+ Depreciation 1.5 1.5
- Change in WC 1.2
Annual Incr CF 0.48 1.68
NPV = $2.23
Problem 3
Cost of equity - 0.1074
Cost of debt (after-tax) 0.03
Market value of debt 46.1391325 ! You have to compute market value based upon interest expenses and c
Part b
New market value of equity = 100
New market value of debt = 96.1391325 ! I did give full credit if you assumed that refinancing would alter market
New cost of equity = 0.12806441
New cost of debt = 0.042
Change in firm value = $11.63

Shares bought back = $4.65
Share of those sold back = $3.49 ! Don't forget to net out the share of the surplus given to those who sel
Remaining firm value = $8.14
Remaining shares = $10.35
Increase in value/share $0.79
Problem 4
Year 1 2 3 4
Revenues $50.00 $55.00 $60.50 $66.55 $73.21
Non-cash WC $10.00 $11.00 $12.10 $13.31 $14.64
Net Income $15.00 $16.80 $18.82 $21.07 $23.60

+ Depreciation $10.00 $11.00 $12.10 $13.31 $14.64
- Cap ex $16.00 $17.60 $19.36 $21.30 $23.43
- Change in non-cash WC $1.00 $1.10 $1.21 $1.33
FCFE $9.20 $10.46 $11.88 $13.49
Dividends paid $8.40 $9.41 $10.54 $11.80
Cash balance $15.00 $15.80 $16.85 $18.19 $19.87
b. To maintain its cash balance at $ 15 million, the firm can afford to pay out $ 4.87 million more in dividends over the e
Total dividends paid = $45.02 ! No need for elaborate mathematical equaltions. Just co
Total net income = $80.29 ! I did give full credit to those who used only year 4 numbe
Payout Ratio = 56.07%
c. To get to a cash balance of $ 30 million, you would have to issue $ 10.13 million in debt
Total reinvestment 1 2 3 4
$7.60 8.36 9.196 10.1156
Debt Ratio = 28.72%
Problem 5
Expected dividends next year = 60
Cost of equity = 8% ! Since you are given next year's income, yo
Growth rate = 4% who did use it..
Value of Equity = 1500
b. Growth Rate = 4%
Retention Ratio = 40%
Return on equity = 10.0%
c. New Return on equity = 12%

New retention ratio = 33.333%
Value of equity = 1500 = 100 (1-.3333)/(r - .04) ! Don't forget to recompute the new payout
Solve for r
d. When the return on equity is less than the cost of equity. As the payout ratio is increased, the expected growth rate (w
! I did give you full credit if you showed the inventory reduction in year 1.
ax - Investment in old facility
! Only incremental revenues and operating income matter

! Depreciation on storage facility is not incremental since it is the same for
from storage facility, since both both old and new facility
ave same book value)
! I was very, very generous on this problem. I did take off 1 point for using non-incremental revenue (operating income)
and 0.5 points for using non-incremental depreciation.
upon interest expenses and cost of borrowing
financing would alter market value of existing debt.

rplus given to those who sell their share back at 10.75/share
more in dividends over the entire period.

ematical equaltions. Just compute the total FCFE/Total net income
who used only year 4 numbers..
Total
! Divide additional debt by total reinvestment
$35.27
given next year's income, you don't need (1+g), though I did not take off credit for those
o recompute the new payout ratio (you cannot keep dividends fixed while raising ROE and holding g constant)
, the expected growth rate (which is = (1- payout ratio) ROE) will decrease. If the ROE < COE, the second effect will dominate.
uction in year 1.
it is the same for
ental revenue (operating income)

second effect will dominate.
Problem 1
a. Unlevered beta prior to restructuring
Levered beta from regression = 1.2
Average debt to equity ratio = 25%
Tax rate = 40%
Unlevered beta from regression= 1.0435
b.
.30 (.80) + .70 (X) = 1.0435
Solving for X,
Unlevered beta of remaining business = 1.147826087
Cash of 30% of firm value is used to retire debt (10%) and buy back stock (20%)
Debt to Equity after = 0.166666667 ! The easiest way to do this is to set up a balance sheet.
D =20 and E =80 before the restructuring; D=10 and E = 60 after
Levered beta after = 1.262608696
Problem 2
As set up by the analyst,
NPV = 1.5 = -10 + Annual Cashflow (PV of annuity, 10 years, 12%)
Solving for the annual cashflow
Annual Cashflow estimated by analys $2.04
b. Corrections for errors

The cashflows are pre-debt cashflows. The analyst should have used the cost of capital
a. One solution is to discount the pre-debt cashflows at the cost of capital
Cost of capital =` 0.096
Depreciation correction
Depreciation used = 1
Correct depreciation = 0.8
Reduciton in depreciation = 0.2
Reduction in tax savings (CF) - 0.08
Salvage value = 2 (in year 10)
Working capital (initial investment)= 1.5 ! Negative cashflow in year 0

Working capital salvage = 1.5 ! Salvage value in year 10
Correct Cashflows Year 0 Years 1-10 Year 10

Cashflow to fir- -11.5 $1.96 3.5
Net present value = $2.12
b. The other and more complicated solution is to estimate cashflows to equity and discount at the cost
of equity
0 1-9 10
Investment -$11.50 Debt = 30% of investment
Salvage 3.5
Debt $3.45 -$3.45 (Debt creates cash inflow
when borrowed, and has
After-tax interest expenses $0.14 to be repaid at end)
Cashflow to Equity -$8.05 $1.82 $0.05
Net present value at 12% = $2.23
Problem 3
a.
Market value of debt = $471.27
Market value of equity = $300.00
Debt to capital ratio = 61.10%
Cost of debt = 4.80%
b.
If the value of the firm does not change, the cost of capital after the change should be the same as before.
Cost of capital after = 8.71%
Unlevered Beta = 1.158281117
New Debt ot capital ratio = 0.305514773
New cost of equity= 11.06%
After-tax Cost of debt after = 3.37%
Pre-tax Cost of debt = 5.61%
Problem 4
Halifax Donnell Rutland
NetIncome $100 $80 $50
CapitalExpenditures $150 $60 $30
Depreciation $60 $30 $15
IncreaseinNoncashWorking $10 $10 $5
DebttoCapitalRatio 0% 20% 20%
Dividends $0 $40 $30
FCFE $0 $48 $34
a.
Cashbalanceatbeginning $10.00 $10.00 $10.00
+ FCFE $0 $48 $34
Dividends $0 $40 $30
EndingCashBalance $10 $18 $14
b.
NetIncome $100
(CapExDepreciation)(1 72
ChginWC(1DR) 8
FCFE $20
Dividendsthatcouldhavebe $20
c.Expectednetincomenext $100
(CapExDeprecn)*(1DR 18
ChginWC(1DR) 12
FCFE $70
Increaseincashbalance= 20
Amountavailablefordividen $50
Increaseovercurrentyear $20
Problem5
a.NetCapEx= 50
ChangeinWorkingcapital= 10
TotalReinvestment= 60
ReinvestmentRate= 60.00%
Retunoncapital= 10.00%
Expectedgrowthrate= 6.00%
current 1 2 3
EBIT(1t) $100.00 106 112.36 119.1016
Reinvestment 60.00 63.6 67.416 71.46096
FCFF $40.00 42.4 44.944 47.64064
b.Retunoncapitalinperpetui 9%
Expectedgrowthinperpetuit 3%
Reinvestmentrateinperpetuit 33.33%
FCFFinyear4= 81.78309867
Terminalvalueatendofyear 1635.661973
c.
Valueofthefirmtoday 1 2 3
FCFF $42.40 $44.94 $47.64
TerminalValue $1,635.66
PresentValue $38.55 $37.14 $1,264.69
Valueofthefirmtoday= $1,340.38
ValueofDebt= $400.00
ValueofEquity $940.38
Valuepershare $9.40
to set up a balance sheet.
estructuring; D=10 and E = 60 after)
ty and discount at the cost
ebt = 30% of investment
Debt creates cash inflow

hen borrowed, and has
o be repaid at end)
be the same as before.
Problem 1
a.
Business Unlevered beta Sales Value/Sales Estimated Value of Business
House Furnishings 1.3 400 1.6 640
Construction Services 0.9 600 0.6 360
Unlevered beta = 1.3(640/1000) + 0.9 (360/1000) = 1.156
Debt/ Equity ratio = 0.666666667
Levered Beta = 1.6184
b.
Cost of capital = 11.4736 (.6) + 6.8 (1-.4) (.4) = 8.52%
c. After expansion plan

New value of construction business = 560
Value of house furnishings = 640
Debt to Equity ratio = 1
Problem 2
Yrs 1-10 Check
Revenues $8,400,000 7903703.15 ! Any errors in the cashf
- Printing & production $2,400,000 2258200.9
- Payroll costs $2,000,000 2000000
- Depreciation $1,500,000 1500000
EBIT $2,500,000 2145502.25
- Taxes $1,000,000 858200.899
EBIT (1-t) $1,500,000 1287301.35
+ Depreciation $1,500,000 1500000
CF to firm $3,000,000 2787301.35
NPV = -20,000,000+ 3,000,000 (Pv of annuity for 10 years at 9%) + PV of 5,000,000 at end fo year 10 =
$1,365,027.14 ! Forget salvage value: -
To get a NPV of zero,

Annual cash flow has to be = $2,787,301 ! - 20,000 + 5,000/1.09^10 + X(PVA
Difference in after-tax cash flow = $212,699
Difference in pre-tax cashflow = $354,498
Difference in number of papers/year = $141,799 ! Divide by $ 2.50 (difference betwee
Difference in number of papers/month = $11,817
Breakeven number of papers = 188183.41
Problem 3
Market value of debt = $22.30 1. Use wrong cost of deb
PV of Operating leases = $19.45 ! Other math errors: -0
Total Debt= $41.75
Market value of equity = $20.00

Cost of capital at optimal
Cost of equity at optimal debt ratio ! If you use the old cost
Debt/Equity Ratio = 1
Cost of capital = 8.25% = 12.96% (.5) + Pre-tax cost of debt (1-.4) (.5)
Pre-tax cost of debt = 5.91%
Problem 4
Year Base 1 2 3
Revenues 500 550 605 665.5
EBIT 150 165 181.5 199.65
- Interest expenses 10 10 10 0 ! Did you remember to t
Taxable income 140 155 171.5 199.65
- Taxes 42 62 68.6 79.86 ! Did you switch to a 40%
Net Income 98 93 102.9 119.79
+ Depreciation 40 44 48.4 53.24
- Cap Ex 50 50 50 50
- Chg in WC 10 11 12.1 ! Did you compute the ch
- Debt repayment 100 ! Did you show repayme
- Acquisition 50
FCFE 27 -9.7 110.93
Cash Balance 80 107 97.3 208.23

Target cash balance 50
Cash that can be paid out over next 3 years = 158.23 ! Did you consider the st
Total net income over next 3 years = 315.69
Maximum dividend payout ratio over next 3 years= 50.12% ! I did give you full cred
Problem 5
Return on capital for the firm = 0.15 ! 60/400: : I also gave full credit i
Reinvestment rate for first 3 years = 0.66666667
1 2 3
EBIT (1-t) $66.00 $72.60 $79.86
- Reinvestment $44.00 $48.40 $53.24 ! Forget reinvestment (-
FCFF $22.00 $24.20 $26.62
Terminal value $940.07 ! 79.86 (1.03) ( 1 - 0.2
PV of cashflows $19.64 $19.29 $688.07
Reinvestment rate in stable growth = 0.2
Terminal value = $940.07
Value of firm today = $727.00

+ Cash 100 ! Since you began with o
- Debt 150 ! You have to add back c
Value of Equity = $677.00
ue of Business
If you use revenue weights: -1
Any errors in the cashfl
00 at end fo year 10 =
Forget salvage value: -
5,000/1.09^10 + X(PVA,
2.50 (difference between
. Use wrong cost of debt

Other math errors: -0.
If you use the old cost
Did you remember to tak
Did you switch to a 40%
Did you compute the cha

Did you show repayment
Did you consider the st
I did give you full cred
also gave full credit i
Forget reinvestment (-1
79.86 (1.03) ( 1 - 0.2
688.068204
Since you began with o

You have to add back ca
Problem 1
a. Unlevered beta for the firm =0.9 (.6) + 1.4 (.4) = 1.1 On part a and b, the key question w
Debt to equity ratio = 900.00% a levered beta and a cost of capital
Levered beta = 1.1 (1 + (1-0) (9)) = 11 would be determined by the margin
the problem asked for next year's b
b. Cost of equity for the firm = 49.00% debt. Thus, harsh though it might s
Cost of capital = 49% (.1) + .17 (1-0) (.9) = 20.20%
c. If 1/2 of the internet business is divested,

Unlevered beta = 0.9 *.75 + 1.4 *.25 = 1.025 I gave full credit even if you did con
New Debt to equity ratio = 7 If you did not recompute the unleve
Problem 2
The maximum amount of initial investment will be the amount that makes the net present value zero.
First compute the PV of the cashflows ignoring depreciation
EBIT on Dried Flowers = $2.00
EBIT on Traditional offerings = $1.80 ! I was gentle here and allowed for multiple
- Over time Salary $1.00 in overtime is already considered in the oper
EBIT w/o depreciation $2.80 still got full credit.
Taxes $1.12
Incremental EBIT = $1.68
PV of EBIT for 10 years = $10.32 ! If there was no depreciation, this would be your breakeven ini
A second best solution for those who abhor algebra
Assume you invest $10.32 million and compute depreciation on that basis
Depreciation tax benefit each year = $0.41 ! Depreciation * Tax rate
PV of depreciation tax benefits for 10 yea $2.54 0
Initial investment with depreciation tax be $12.86 ! I have added the depreciation tax benefit to the PV of EBIT. It
will now change to 1.286 million and you will be in iterating fore
The correct solution
If your initial investment is $1, your depreciation each year would be $.10 and the tax benefit would be $0.04
PV of tax benefit on $ 1 iniitial investment = PV of $0.04 for 10 years 0.24578268
If your initial investment was X, your tax benefits would be $0.2458
X = 10.32 + .2458 X
Solving for the initial investment, Initial investment = $13.69
Problem 3
a. Current cost of equity = 0.086
Current cost of capital = 7.72% ! Errors here mostly math
b. Unlevered beta = 0.7826087
New levered beta = 1.48695652 ! If you forgot to reestimate the cost of equity, you lost a point
New cost of equity = 0.10947826 ! Wrong weights for debt and equity also cost a point
c. Increase in firm value = 75 ! With rational investors you have to multiply by the total numb
Annual Savings = 2.88043478 ! (.0772 - .0726) (625) Don't use market value of equity alone
Annual savings/ (WACC - g) = 2.88/(.0726 -g) = 75
Solve for g,
Expected growth rate= 3.42% ! If you set the problem up right but got the wrong answer, you
Problem 4
Most recent fi Previous year
Earnings 110 100
Dividends 44 40
Cash Balance 100 78
Increase in cash balance = 22

Dividends paid by the firm = 44
Free Cashflows to Equity = 66
Net cap ex in most recent year = 44 ! If you got net cap ex wrong, you lost a point
Estimates for the future

1 2 3
Earnings $121.00 $133.10 $146.41
- Net Cap Ex $52.80 $63.36 $76.03
FCFE $68.20 $69.74 $70.38
Dividends $0.00 $0.00 $0.00 ! Dividends are eliminated. If you continued to pr
Cash balance $168.20 $237.94 $308.32 ! Add the FCFE every year to the previous year's
b. .85 = (1- ord tax rate)/ (1- cap gains rate)

.85 = (1- ord tax rate)/ (1-.2)
Ordinary tax rate = 32.00% ! For some reason, if you inserted a dollar dividen
Problem 5
Reinvestment last year = 50
EBIT (1-t) last year = 60 ! If you use average return on capital, you would
Expected growth for next 3 years = 10.00%
b. Terminal value calculation

Stable period reinvestment rate = 0.33333333 ! A common error was not recomputing the reinve
Expected EBIT (1-t) in 4 years = 83.0544
Terminal value = 1107.392 ! A minor error is pulling this out an extra year. It
c. Value today
1 2 3
EBIT (1-t) $66.00 $72.60 $79.86
Reinvestment $55.00 $60.50 $66.55 ! I gave you full credit if you took your FCFF and t
FCFF $11.00 $12.10 $13.31 a. discounted EBIT (1-t) instead of FCFF
Terminal value $1,107.39 b. discounted the terminal value back at 10% inst
Present value $10.00 $10.00 $842.00 c. discounted the terminal value back 4 years ins
Value of firm $862.00
n part a and b, the key question was whether to consider the marginal tax rate. If the problem had asked for
levered beta and a cost of capital without specifying a time period, a reasonable case can be made that the eventual beta
ould be determined by the marginal tax rate of 40% (giving you a beta of 7.04) and the cost of debt would be 10.2%. However
he problem asked for next year's beta and cost of capital. Next year, there is no way the firm will be getting any tax benefits of
ebt. Thus, harsh though it might seem, you lost a point on each if you did consider taxes.
gave full credit even if you did consider a tax rate. I felt you had borne enough punishment
you did not recompute the unlevered beta or used the wrong one, you did lose a point.
e net present value zero.
here and allowed for multiple interpretations. For instance, if you assume that the $ 1 million
already considered in the operating margin, your incremental EBIT would be $2.28 million. You
, this would be your breakeven initial investment. If you go to this point, you got 4 points
on tax benefit to the PV of EBIT. It is an approximate solution because the depreciation

on and you will be in iterating forever. If you go this far, you got 5 points.
benefit would be $0.04
he cost of equity, you lost a point

equity also cost a point
have to multiply by the total number of shares outstanding. If you used remaining shares, you lost a point
t use market value of equity alone which is 500
ht but got the wrong answer, you lost only 1/2 point.
cap ex wrong, you lost a point
eliminated. If you continued to project dividends, you lost a point

every year to the previous year's balance to get to final cash balance. Start at 100
on, if you inserted a dollar dividend or put the wrong sign on price change, you would have lost a point
rage return on capital, you would have got a lower return on capital but still should have got full credit.
or was not recomputing the reinvestement rate = g/ ROC = 4/12 = 33.33%
is pulling this out an extra year. It would have cost you 1/2 point
credit if you took your FCFF and terminal value and discounted back at 10%. However, you would have lost credit if you
BIT (1-t) instead of FCFF
he terminal value back at 10% instead of 9%
he terminal value back 4 years instead of 3 years
e that the eventual beta
bt would be 10.2%. However
e getting any tax benefits of
have lost credit if you
Problem 1
Market value of debt = 2000 ! Value of firm (4000) - Value of equity
Debt/Equity ratio 1
Bottom-up unlevered bet 0.9625

Bottom-up levered beta 1.54
Cost of capital = 9.08% ! Debt to capital ratio = 50%; Cost of debt = 10%
b. New unlevered beta = 1.08

New D/E ratio = 0.5 ! Debt drops to $ 1 billion
Problem 2
Stated NPV = 100 !
- 700 + CF (PVA, 10 years, 10%) = 100 ! The analyst expensed the entire investment in computing NPV
Solve for the CF,
Annual operating cashflow (prior to depreciation) $130.20
Correct initial investment = 1000

Correct after-tax annual cashflow = $160.20 ! Add the tax benefit from depreciation to each year's c
Correct NPV = -1000 + 160.20 (PVA, 10 years, 12%) = -$94.86
Problem 3
Cost of equity before = 9.600%
Cost of capital before = 9.0600%
Increase in firm value = (Cost of capital before - Cost of capital after) * Firm value/ (Cost of capital after - Expected grow
150 = (.0906 - X) (1000)/(X - .05)
Solving for X,
Cost of capital after = 8.53%
Cost of capital = 8.55% = 10.24%(.7) + After-tax cost of debt (.3)
After-tax cost of debt = 4.61%
Pre-tax cost of debt = 7.68%
Problem 4
Current year Next year
Net Income 100 110
- Reinvestment 70 77
+ Net debt issued 0 15.4
FCFE 30 48.4
Payout ratio 30.00% 44.00%
b.
Dividends paid 44
Stock buyback 50
Cash returned to stockholders 94
Effect on cash balance = FCFE - Cash returned = -45.6
Cash balance at end of year = 54.4 ! 100 - 45.6
Problem 5
Firm value = 1500
Firm value = 1500 = 100 (1- Reinvestment rate)/ (.10- .05)
Solve for the reinvestment rate
Reinvestment rate = 25%
Return on capital = g/ Reinvestment rate = 20.00%
If the ROC = Cost of capital = 10%

Reinvestment rate = 0.5
Firm value = 100 (1-.5)/ (.10 - .05) = 1000
Value of equity = 700
nt in computing NPV
preciation to each year's cashflow
ital after - Expected growth rate)

Spring 2000
Problem 1
Unlevered beta for AT&T = 0.86 ! =0.92/(1+(1-.4)(.12)) ! Use average D/E ratio duri
Unlevered beta for Media One = 1.22 ! =1.40/(1+(1-.4)(.25))
Unlevered beta for combined firm = 0.95 ! Weighted average = 0.86 (300/400) + 1.22 (100/400
Debt for AT&T after merger = 125

Equity for AT&T after merger= 275
Problem 2
Net present value estimated by analyst ($750.00)
- PV of Working capital investments = $264.99 ! I also gave you full credit if you counted only the s
(I counted 200 right away and 100 in five years)
- PV of Salvage = $844.82
+ PV of Terminal Value = $1,631.56 Comment: You were incredibly creative in trying to c
each year for the 10 years. Given the information in
- PV of depreciation tax benefits $513.41
+ PV of expensing tax benefit $800.00 ! It is only the difference in tax benefits that matters.
Corrected net present value $58.33
Problem 3
Current Cost of Equity = 9.96%
Current after-tax cost of debt = 3.72%
Current Cost of Capital = 9.07% ! Current cost of capital'
Unlevered Beta = 0.9

New Levered beta = 1.26
New Cost of Equity = 11.04%
New After-tax cost of debt = 0.045
Cost of Capital = 8.42% ! New cost of capital
Change in firm value = $21.62 ! In billions

Change per share = $5.40
b.
Current interest expense on debt = 2.48
Book Value of Debt outstanding = 40 ! Before you issue new debt, this debt is trading at b
Market value of debt at 7.5% = $36.43 ! When you borrow more and make yourself riskier, t
Drop in value of debt = $3.57 ! This is the drop in value in debt, but it goes to stock
Total Change in firm value = $25.19 ! I added the drop in bond value to the answer of th
Change per share = $6.30
Many of you tried to solve the problem by reestimati
the old debt and new debt. You then used the lower co
which provides you with an increase in the stock pric
While you are on the right track, doing this will lock
fact, you will be able to get this benefit for only 10 y
Problem 4 Check
a. Change in cash balance = 1500 1500
Dividends Paid = .2 X 950
Stock Bought back = 1000 1000
FCFE 2500 +.2 X 3450
Using the statement of cash flows,
Net Income X 4750
+ Depreciation 2000 2000
+ Capital Expenditures -3000 -3000
+ Change in non-cash working capital 500 500
+ Net Debt Issued -800 -800
= FCFE 2500 +.2X 3450
Solve for X
Net Income in 1998 = 4750
Problem 5
1 2 3 Term. year (4)
Exp. Growth 15% 15% 15% 5%
EBIT (1-t) 115 132.25 152.09 159.69
ROC 20% 20% 20% 15%
Cost of Capital 12% 11% 10% 9%
Reinvestment Rate 75.00% 75.00% 75.00% 33.33% ! Reinvestment Rate = g /
EBIT(1-t) $115.00 $132.25 $152.09 $159.69

- Reinvestment $86.25 $99.19 $114.07 $53.23
FCFF $28.75 $33.06 $38.02 $106.46
Terminal Value $2,661.50 ! Terminal value in year 3=
Cumulated Cost of Capital 1.12 1.2432 1.36752 ! When costs of capital ch
Present Value $25.67 $26.59 $1,974.03 take the cumulated cost. W
Value of Firm = $2,026.29 the valuation we had in th
- Value of Debt outstanding = 800
Value of Equity = $1,226.29
Value per share = $12.26 1974.02597
Reinvestment Rate = g / ROC
Terminal value in year 3= CF in year 4/(.09-.05)

When costs of capital change each period, remember to
ake the cumulated cost. We had to do this for Disney in
he valuation we had in the lecture notes.
Spring 1999
Problem 1
Unlevered Beta for Pepsi = 1.2 / (1 + 0.6*(0.1)) = 1.13
Current Levered Beta = 1.13 (1 + 0.6*(10/40)) = 1.30
Unlevered Beta of the firm after divestiture = (1.13 - 1.35*(10/50))/(40/50) = 1.0750

New Debt = 10 + 2 = 12
New Equity = 40 - 12 = 28
Levered Beta = 1.075(1 + 0.6*(12/28)) = 1.35
Problem 2
Cost of Equity = 5% + 1.25 (6.3%) = 12.875%
PV of Cash Flows = 15/.12875 = $ 116.50 ! Net cap ex and working capital are both zero
Equity Invested in Project = 0.6*150 = 90 ! Only equity investment considered
NPV of Project = 116.5 - 90 = $ 26.5 million
If you want to do this analysis on a firm basis, you have to compute the EBIT (1-t)
EbIT (1-t) = FCFF = 15 + 60*.08*(1-..4) = 17.88
Cost of Capital = 12.875% (0.6) + 4.8% (.4) = 0.09645
NPV = 17.88/.09645 - 150 = $ 35.38
Problem 3
Current Cost of Equity = 5% + 0.9 (6.3%) = 10.67%
Current Cost of Capital = 10.67% (.9) + 6% (1-.4) (.1)= 9.963%
Unlevered Beta = 0.9/(1+0.6*(1/9)) = 0.84375

New Levered Beta = 0.84375 (1 + (1-.4)(40/60)) = 1.18125
Cost of Equity = 5% + 1.18 (6.3%) = 12.43%
Cost of Capital = 12.43% (0.6) + 7% (1-.4)(.4) = 9.138%
Change in firm value = 10000 (.09963 - .09138)/(.09138 - .05) = $ 1,994

Change in value per share = 1994/300 = $ 6.65
Number of shares bought back = 3000/30 = 100 ! New Debt taken = Debt at optimal - Current debt = 4000 - 1000 = 3000
Shares remaining = 300 - 100 = 200
Change in value per share = 2093/200 = $ 9.97
c. If you overpay on the acquisition,

Effect of overpaying on value per share = 500/300 = $ (1.67) ! Value per share will be $ 1.67 lower than whatever your optimal value
Thus, your move to the optimal, and whether you use debt is independent of this assessment. Any answer that incorporated this drop in the
stock price got full credit.
Problem 4
1996 1997 1998 1999 2000
Net Income $150 $225 $315 $394 $492
Capital Expenditures $200 $250 $300 $375 $469

Depreciation $125 $190 $250 $313 $391
Non-Cash Working Capital $300 $330 $375 $469 $586
Net Income $150 $225 $315 $393.75 $492.19

- Net Cap Ex (1- Debt ratio) 67.5 54 45 $56.25 $70.31
- Chg in WC (1-DR) 22.5 27 40.5 $84.38 $105.47 ! Change in 1999 computed from total WC
FCFE $60 $144 $230 $253 $316 below
Dividends $30 $45 $63 $79 $98
Cash Balance $130 $229 $396 Total
Non-cash WC $375 468.75 585.9375
Cash available for stock buybacks = $174 $218 $392
Problem 5
Return on Capital in 1998 = 600 (1-.4)/2000 = 18.00%
Reinvestment Rate in 1998 = (360-300+50)/360 = 0.30555556
Expected Growth Rate = 18% (.3056) = 5.50%
Cost of Equity = 5% + 1.1 (6.3%) = 0.1193
Cost of Capital = 11.93% (.7) + 7.5% (1-.4) (.3) = 9.70%
FCFF = EBIT (1-t) - (Cap Ex - Depreciation) - Chg in WC = 360 - (360-300) - 50 = 250
Firm Value = 250*1.055/(.097-.055) = $ 6,280 ! Getting the right answer is not enough. You have to justify the growth rate.
0 - 1000 = 3000
optimal value
fy the growth rate.

Spring 1998
Problem 1
a. Cost of Equity = 6% + 0.67 (5.5%) = 9.69%
b. Bottom-up Beta
Pharmaceutical Business = 1.15/(1+0.6*0.1) = 1.08
Specialty Chemical Business = 0.70/(1+0.6*0.35) = 0.58
Unlevered Beta for Mallinckrodt = 1.08 (255.4/306.9)+ 0.58 (51.5/306.9) = 1.00
c.
Current Debt/Equity Ratio = 556.9/(32*73) = 23.84%
Levered Beta for Mallinckrodt = 1.00 (1 + 0.6*(.2384)) = 1.14
Problem 2
a. Return on Equity = $ 190.10/1231.20 = 15.44% ! I used the beginning of the year book value of e
b. Equity EVA = (.1544 - .0969) (1231.20) = $ 70.80
c. Divisional EVAs
Division EBIT Capital Inves ROC Levered Beta Cost of Equit Cost of Capita
Pharma $ 255.40 $ 1,298.00 11.81% 1.24 $ 0.1282 11.14%
Spec Chem $ 51.10 $ 601.00 $ 0.05 0.66 9.64% 8.57%
Problem 3
Pre-tax Cost of Debt for Mallinckrodt = 6.80% (Based upon interest coverage ratio and rating of A+)
Cost of Capital = 9.69% (32*73/(32*73+556.9)) + 6.80% (1-.4) (556.9/(556.9/(32*73+556.9)) =
b. Optimal Cost of Capital
Pre-tax Cost of Debt at Optimal = 7.25% (Based on interest coverage ratio at optimal)
Unlevered Beta = 0.67/(1+0.6*0.2384) = 0.58615622
New Beta = 0.60 (1+0.6*(40/60)) = 0.8206187
New Cost of Equity = 6% +0.84*5.5% = 10.51%
New Cost of Capital = 10.62% (.6) + .0725*.6*.4 = 8.05%
c. Value of Firm = 32*73+556.9 = 2892.9
New Dollar Debt at 40% Debt Ratio = 0.4*2892.9 = 1157.16
Additional Debt to be taken = 1157 - 556.9 = 600.26
Weighted Duration of Debt = (12/1157)(0.5) + (545/1157)(3)+(600/1157)X = 6.5
Solve for X,
X= 9.80
Problem 4 1996 1997

Net Income 212 190
+ Depreciati 149 128
+ Cex -169 -170
+ Chg in WC -152 34
+ Net Debt i 608 -113
FCFE 648 69
Dividends $ 45.70 $ 48.20

+ Buybacks $ 131.00 $ 150.00 ! I did not net out stock issues. If you did, specify that you did so
Cash Returne $ 176.70 $ 198.20
Cash Returne 27.27% 287.25%
c.
Return on Capital = 307(0.6)/(109+558+1232) = 9.70%
Net Cap Ex/Revenues = (170-128)/1861 = 2.26%
Predicted Dividend Yield = 0.03 - 0.053(.097) - 0.15(.0226) = 2.15%
Predicted Dividend = 0.0215 * $ 32 = $ 0.69
Problem 5
Base 1 2 3 Terminal Year
EBIT (1-t) $ 184.20 $ 202.62 $ 222.88 $ 245.17 $ 252.53
+ Deprecn $ 128.00 $ 140.80 $ 154.88 $ 170.37 $ 175.48
- Cap Ex $ 170.00 $ 187.00 $ 205.70 $ 226.27 $ 193.03 ! Used industry average cap ex/dep
- Chg in WC $ 50.30 $ 55.33 $ 60.86 $ 20.08
FCFF $ 106.12 $ 116.73 $ 128.41 $ 214.89
Revenues $ 1,861.00 $ 2,047.10 $ 2,251.81 $ 2,476.99 $ 2,551.30

WC $ 503.00 $ 553.30 $ 608.63 $ 669.49 $ 689.58
% of Revenue 27.03% 27.03% 27.03% 27.03% 27.03%
b. Terminal Value Calculation

Cost of Equity in stable growth = 6% + 1(5.5%) = 0.115
Cost of Capital in Stable growth = 0.115(.6)+.07*.6*.4 = 8.58%
Terminal Value = 215/(.0858-.03) = $ 3,851
c. Cost of Capital = 9.69% (32*73/(32*73+556.9)) + 6.80% (1-.4) (556.9/(556.9/(32*73+556.9)) =

Value of the Firm = 106/1.0861+117/1.0861^2+(128+3851)/1.0861^3 = $ 3,302.81
Value of Debt Outstanding = $ 556.90
Value of Equity = $ 2,745.91
Value of Equity per Share = $ 37.62
8
inning of the year book value of equity
EVA
$ 8.67
$ (20.83)
0.80749421
d rating of A+)
8.61%
atio at optimal)
pecify that you did so

Used industry average cap ex/deprciation in year 4.
3+556.9)) = 8.61%
Spring 1997
Problem 1
Cost of Equity for the project = 7% + 1.5 (5.5%) = 0.1525 ! Since I did not give a premium, use a reaso
Cost of Capital = 15.25% (.6) + 10% (1-.4) (.4) = 11.55%
NPVof project = -40 + 10 (1-.4)/.1155 = $ 11.95
Problem 2
Business Unlevered BetWeight Beta *Weight
Tech 1.51 33.33% 0.50314465
Auto Parts 1.02 26.67% 0.27118644
Financial Services 0.72 40.00% 0.2875
1.06
Levered Beta = 1.06 (1+ (1-.4) (40/60)) = 1.49 ! Use debt to equity, not debt to capital
Problem 3
Firm Value before change = 2000
Firm Value after change = 2200 ! I have assumed investors are rational and that they sold their stock bac
If you assume that the stock buyback was at $ 40, you will get a smaller
Change in firm value = 200
Cost of Capital before the buyback = 11.40% ! The cost of equity (using the 5.5% premium
Since no growth is given, I have taken the simpler assumption of no growth:

(.114 - New Cost of Capital) (2000) /New Cost of Capital = 200
New cost of Capital = 228/2200 = 10.36%
Levered beta after transaction = 0.8 (1 + (1-.4) (500/1500)) = 0.96

Cost of Equity after the transaction = 12.28%
Let X be the pre-tax cost of new debt =
12.28% (.75) + X (1-.4) (.25) =10.36%
Solving for X,
Pre-tax cost of borrowing on new debt = 7.67%
Problem 4
a. FCFE during year = Dividends paid + Increase in cash balance = 500 + 250 = 750
FCFE = Net Income - Net Cap Ex (1- Debt Ratio) - Change in Working Capital (1- debt ratio)
750 = 2000 - Net Cap Ex (1-.3)
Net Cap Ex = $ 1,785.71
b. Drop in the stock price = $ 1.80
Dividend Paid = $ 2.40 ! Change in stock price = Dividends (1- ord tax rate)/ (1- capital gains ra
Number of shares = 500/2.40 = 208.33 ! Divide total dividends paid by dividends per share
Problem 5
a. Expected growth rate in perpetuity = ROE * Retention Ratio = .15 * .4 = 6.00% ! Cannot just assume a growth
Value per share = EPS (Payout ratio) (1+g)/(r-g) = $ 19.57 ! Used 5.5% risk premium and beta of 1
b. New growth rate with higher retention ratio = 14% *.5 = 7%

Value per share = EPS (Payout ratio) (1+g)/(r-g) = $ 19.45
Problem 6
a. False
b. False. Firms may pay out more in dividends than they have available in FCFE.
c. True
d. True. It may be the same for an unlevered firm, but it cannot be lower.
give a premium, use a reasonable number
that they sold their stock back at $ 44

t $ 40, you will get a smaller number (2150)
uity (using the 5.5% premium) is the cost of capital
tax rate)/ (1- capital gains rate)
Cannot just assume a growth rate

k premium and beta of 1
Spring 1996
Problem 1
a. Unlevered Beta for Samson = 0.90/(1+(1-0.4)(.05)) = 0.87378641 ! Used the average debt/equity rat
New Levered Beta = 0.87(1+(1-.4)(.25)) = 1.0005
New Cost of Equity = 8% + 1(5.5%) = 13.50%
b. Cost of Capital = 13.50%(.8) + 10%(1-.4)(.2) = 12.00%
c. The debt ratio currently is 20%. Doubling the debt ratio will increase it to 40%.
New Levered Beta = 0.87(1+(1-.4)(.40/60)) = 1.218
New Cost of Equity = 8% + 1.22(5.5%) = 14.71%
New Cost of Capital = 14.71%(0.6)+11.5%(1-.4)(0.4) = 11.59%
d. Value of Firm today = 240+60 = 300
Dollar Debt at 40% debt ratio = 0.4*300 = 120
Additional Debt needed = 120 - 60 = 60
e. Value of Equity in 3 years = 240(1.135)^3 = $ 351 ! This is probably understated. The beta will rise o
Dollar Debt in 3 years = (0.4/0.6) ($ 351) = $ 234.00
f. Return on Capital in most recent year = 40(1-.4)/100 = 24.00% ! I used the book value at the begin
The firm is making a return on capital that is higher than the cost of capital. If it can continue to do so, I would suggest
Problem 2
a. FCFE in 1995 = Net Income + Deprecn - Cap Ex - Chg in Non-cash WC -(Principal Repaid + new Debt issued)
=150+20-70-10+15 = 105
Cash Balance increased by $ 50 million
Dividends paid must have been $ 55 million
b. Capital Expenditures = Change in Fixed Assets + depreciation = 50 + 20 = 70
Cash Balance increased by $ 50 million
c.
Net Income 165
- Net Cap (1-DR) 21 ! See below for calculation of net cap ex.
- Chg in WC (1-DR) 4.5
FCFE $ 139.50
Project ROC Beta Cost of EquityCost of Capital

A 13.34% 1.2 13.60% 11.40% ! Use firm's debt ratio of 25% and firm's after tax
B 9.99% 1 12.50% 10.58%
C 12.51% 1.1 13.05% 10.99%
D 14.28% 2 18.00% 14.70%
Accept projects A and C; total cap ex = $ 50 million
Depreciation next year = 20*1.1 = 22
Net Cap Ex = 50-22 = 28
Problem 3
a. Return on Capital = 25%
Debt/Equity Ratio = 25%
Interest rate on debt = 8%
Expected Growth = .67(25% + .25(25%-8% (1-.4))) = 20.13%
b. Current 1 2 3 Term. Year
EPS $ 3.00 $ 3.60 $ 4.33 $ 5.20 $ 5.51 ! Use a stable growth rate; I used 6
DPS $ 1.00 $ 1.20 $ 1.44 $ 1.73 $ 3.63
Payout Ratio 33.33% 33.33% 33.33% 33.33% 65.81% ! Payout Ratio in stable growth=1 -
c. Terminal Value per share = 3.63/(.125-.06) = $ 55.85
d. Value per share today = 1.20/1.1415 + 1.44/1.1415^2+(1.73+55.85)/1.1415^3 =
Cost of Equity today = 7% + 1.3 (5.5%) = 0.1415
e. If there is no net cap ex or working capital investment, the expected growth after year 3 has to be zero
EPS $ 3.00 $ 3.60 $ 4.33 $ 5.20 $ 5.20
- Net Cap Ex 1.2 $ 1.44 $ 1.73 $ 2.08 0
- Chg in WC 0 0 0 0 0
FCFE $ 2.16 $ 2.60 $ 3.12 $ 5.20
Current debt ratio = 20% (D/E ratio of 25% translates into debt ratio of 20%)
Terminal Value per share = 5.20/.125 = $ 41.61
Value per share today = 2.16/1.1415+2.60/1.1415^2+(3.12+41.61)/1.1415^3 = $ 33.96
(If you had used a 6% growth rate forever in this case as well, the assumptions would have been inconsistent.)
6
Used the average debt/equity ratio over period)
ly understated. The beta will rise over time.
I used the book value at the beginning. If you decide to use averages, specify it here
continue to do so, I would suggest it take projects
paid + new Debt issued)
t ratio of 25% and firm's after tax cost of debt of 4.8%
Use a stable growth rate; I used 6%.
Payout Ratio in stable growth=1 - .06/(.15+.25(.15-.048))
$ 40.87
ear 3 has to be zero
have been inconsistent.)

Fall 1995
Problem 1
a. To estimate market interest rate,
Yield to maturity on the debt = 9.31% ! If you are short of time, you can use the short cut = Inte
Estimated market value of bank debt = $ 39.52 ! Assumed that it was balloon payment debt.
Total Market Value = 42.5+39.5 = 82
After-tax Cost of Debt = 9.31%(1-.4) = 5.59%
b. Average Beta for comparable firms = 1.04
Average D/E Ratio for comparable firms = 22%
Unlevered Beta for comparable firms = 0.91872792
Levered Beta for SDL = 0.92 (1+0.6*(82/400)) = 1.03
(See below for calculation of debt)
Cost of Equity = 6% + 1.03 (5.5%) = 11.68%
c. Cost of Capital = 11.68% (400/482) + 5.59% (82/482) = 10.76%
d. SDL's debt seems much too long term for its needs. (The debt duration is only 1.5 years)
I would convert the debt into shorter term debt. I would keep it dollar debt since it does not seem to be affected by the
e. Unlevered beta after acquisition = 0.92(482/632)+1.25(150/632) = 0.99832278
New Dollar Debt = 82 + 150 = 232
New Debt/Equity ratio = 232/400 = 0.58
New Levered Beta = 1.00 (1+0.6*0.58) = 1.348
New Cost of Equity = 6% + 1.348(5.5%) = 13.41%
New Cost of Capital = 13.41% (400/632) + 9.5%(1-.4) (232/632) = 10.58%
Problem 2
a.
Net Income 150
- Net Cap Ex 75 ! No debt
- Chg in WC 20
FCFE 55
If cash balance increased by $ 25 million, the dividend must have been $ 30 million.
b.
Project ROE COE
A 13% 11.50% ! Assuming that betas given are levered betas
B 16% 17.00%
C 12% 10.40%
D 15% 12.05%
Take projects A, C and D
Net Income 165

- Net Cap Ex (1-.2) 72
- Chg in WC (1-.2) 8 ! Working capital will increase by 10%, if revenues increase 10%
FCFE 85
The firm can afford to return $ 85 million to its equity investors
Problem 3
a. Expected growth during high growth period = 0.8 (20%) = 16% ! ROE = EPS/BV ofEquity = 2/1
b.
1 2 3 Terminal year
EPS $ 2.32 $ 2.69 $ 3.12 $ 3.31
DPS $ 0.46 $ 0.54 $ 0.62 $ 2.10
Payout ratio 20% 20% 20% 63.53% ! Payout ratio in stable phase=.06/(.14+.25(
Cost of Equity 14.25% 14.25% 14.25% 11.06% ! Levered Stable beta = 0.8(1+0.6*.25) ); Ta
(I used a cost of debt of 7% after year 3. It has to be greater than 6%, which is the T.Bond rate)
Terminal Value = 2.10/(.1106-.06) = $ 41.50
c. Value per Share = 0.46/1.1425+0.54/1.1425^2+(0.62+41.50)/1.1425^3 = $ 29.06

can use the short cut = Interest exp/ MV of debt = 70/850 = 8.24%
payment debt.
ot seem to be affected by the $/DM rate.

! Beta fpr XLNT is unlevered
ROE = EPS/BV ofEquity = 2/10 = 20%

n stable phase=.06/(.14+.25(.14-.07*.6))
e beta = 0.8(1+0.6*.25) ); Tax rate used =40%]
Fall 1994
Problem 1
a. Market Value of debt = 5 (PVA,10%,10) + 60/1.1^10 = $ 53.86
b.
Business Beta D/E Unlev Beta
Record/CD 1.15 50% 0.88
Concert 1.2 10% 1.13
Unlevered Beta for JP = 0.88 (.75) + 1.13 (0.25) = 0.9425
Levered Beta for JP = 0.9425 (1+(1-.4)(53.86/240)) = 1.07
Cost of Equity = 8% + 1.07 (5.5%) = 13.89%
c. Cost of Capital = 13.89% (240/293.86) + 10%(1-.4)(53.86/293.86) = 12.44%
d. If the treasury bond rate rises to 9%,
New Market Value of Debt = 5 (PVA,11%,10) + 60/1.11^10 = $ 50.58
Cost of Equity = 9% + 1.07 (5.5%) = 14.89%
Cost of Debt = 11%
Cost of Capital = 14.89% (240/290.58) + 11% (1-.4) (50.58/290.58) = 13.45%
Problem 2
Project IRR to Equity Cost of Equity
A 16.00% 16.80%
B 15.00% 14.88%
C 12.50% 13.50%
D 11.50% 10.75%
Accept projects B and D
a.
Net Income $ 57.60
- (Cap Ex - Depr) (1-DR) $ 28.10 ! (50 - 13(1.2))(1-(53.86/293.86)) ! I would also have given you credit if
- Chg in WC (1-DR) $ 4.90 ! Working capital is 20% of revenues
FCFE $ 24.60
b. Dividends next year = 0.25*(57.60) = $ 14.40
Expected increase in cash balance = (24.60-14.4) = $ 10.20
Problem 3
a. Expected growth rate = .75(.48) = 36% ! If you use current ROE = 48/100 = 48%
The expected growth rate will be slightly lower if the market value debt to equity ratio and interest rate is used to get t
Expected growth = .75 (.3188+ 53.86/240 (.3188-.06)) = 28.26%
If book value debt/equity ratio and book interest rate is used, the answer will be 35.55%
I am going to use the 27.46% growth rate because I think it is more sustainable.
b. Expected Dividends
Current 1 2 3 4
EPS $ 4.00 $ 5.13 $ 6.58 $ 8.44 $ 10.83
DPS $ 1.00 $ 1.28 $ 1.65 $ 2.11 $ 2.71
Payout Ratio 25.00% 25.00% 25.00% 25.00% 25.00%
c. Stable Payout Ratio = 1 - [.06/(.15+(53.86/240)(.15 - .06)] = 64.75%
d. Terminal Value
Cost of Equity in stable growth = 13.50%
Terminal Value = $ 9.53/(.135-.06) = $ 127.06
e. Value today (discounting at current cost of equity of 13.89%)
Cost of Equity during high growth = 13.89% ! See problem 1
DPS + Term Price $ 1.28 $ 1.65 $ 2.11 $ 2.71
PV $ 1.13 $ 1.27 $ 1.43 $ 1.61
Value per share = $ 73.55
Problem 4
a. New Fundamentals:
Return on Capital = (85-5)*(1-.4)/(160-50) = 43.64% : Book Value of capital drops $ 50 mil
Debt/Equity Ratio after buyback = 53.86/190 = 28.35% ! Market value of equity drops $ 50 m
Interest rate on debt is assumed to stay at 10.00% ! Interest rate on debt is assumed not
Retention Ratio = 15.00%
new Expected Growth Rate = .85 (.4364 + .2835 (.4364-.06)) = 46.16%
Proportion of the firm in record/CD business after sale = 69.87% ! It used to be 75% of $ 293.86 million
! Now it is = .75 * 293.86 million - 50
! New Proportion = (.75*293.86-50)/(2
New Unlevered Beta = 0.88 (.70) + 1.13 (.30) = 0.955
New Levered Beta = 0.955 (1+0.6*(.2835)) = 1.12
1994
! I estimated the market value of the debt

given the current market interest rate of 10%
! You can even re-estimate the levered beta with this new debt
but it won't change by much.
I would also have given you credit if debt=60
0.0034
ent ROE = 48/100 = 48%
atio and interest rate is used to get the growth rate
ROC = 31.88%
{85*0.6/(100+60)) ! I am assuming that there was no cash at the start of the year. If there
had been, I would have netted it out.
5 Term Year
$ 13.88 $ 14.72
$ 3.47 $ 9.53
25.00% 64.75%
$ 130.53
$ 68.12
Book Value of capital drops $ 50 mil after buyback: I am adjusting the beginning of the year book capital by this.
Market value of equity drops $ 50 mil after buyback
Interest rate on debt is assumed not to change
It used to be 75% of $ 293.86 million.

Now it is = .75 * 293.86 million - 50 million
New Proportion = (.75*293.86-50)/(293.86-50)
he start of the year. If there
apital by this.
Fall 1993
Problem 1
KentuckyFriedChicken 1.05 0.2

Hardee's 1.2 50%
Popeye'sFriedChicken 0.9 10%
RoyRogers 1.35 70%
1.125 0.375
UnleveredBeta= 0.9183673
1a.Firstcalculatethebetabaseduponcomparablefirms:
AverageBeta= 1.125
AverageD/ERatio= 0.375
Unleveredbeta= 0.91836735
BetaforBostonTurkey= 1.2627551
Usethisbetatocalculatethecostofequity
CostofEquity=6.25%+1.26*5.5%= 13.18%
(Alternativelythelongbondratecouldhavebeenusedastheriskfreerate,witha5.5%premium)
1b.AftertaxCostofDebt:
Firstcomputetheinterestcoverageratio=EBIT/InterestExpense= 5
ThisyieldsabondratingofA,andapretaxrateof7.50%=6.25%+1.25%
Aftertaxcostofdebt=7.5%(10.4)= 4.50%
1c.MarketValueofEquity=20*100000= $2,000,000
MarketValueofDebt=1.25*1000000= $1,250,000
1c.CostofCapital=13.18%(2/3.25)+4.5%(1.25/3.25)= 9.84%
1d.NewDebtEquityratioafterrepurchase= 1.1666666667
Newbetaafterrepurchase= 1.5612244898
Newcostofequity=6.25%+1.56*5.5%= 14.83%
1e.Newaftertaxcostofdebt=7.75%(10.4)= 4.65%
Newcostofcapital=14.83%(1.5/3.25)+4.65%(1.75/3.25)= 9.35%
ChangeinFirmValue= 3,250,000(.0984.0935)/.0935= $171,419
Changeinstockpricepershare= $1.71 !Dividebythetotalnumbe
2a.Firstdecidewhichprojectsyouwillaccept
Project ROE CostofEquity
A 12.50% 11.75% Accept
B 14.00% 14.50% Reject
C 16.00% 16.15% Reject
D 24.00% 17.25% Accept
Nextcalculateworkingcapitalas%ofRevenues
WorkingCapital=CurrentAssetsCurrentLiabiliti $500,000
WorkingCapitalas%ofRevenues=50%
IncomeStatementNextyear
Revenues 1100000
Expenses 440000
Depreciation 100000
=EBIT 560000
InterestExp 100000
=TaxableInc. 460000
Tax 184000
=NetIncome 276000
(CapExDeprec)(1) 30000 (150000100000)(10.4)
WC(1) 30000 (50%ofincreaseinrevenues($100000))*(10.4)
=FCFE 216000
2b.CashBalancenextyear=CurrentBalance+FCFEDividends=150000+216000100000=266000
2c.Ordinarytaxrate=40% CapitalGainstaxrate=28%
(PricebeforePriceafter)/Dividend=(10.4)/(10.28)=0.833
Changeinprice=$0.833
3a.RetentionRatio=1(1/2.4)= 58.333%
ROC=(EBIT(1t))/(BVofDebt+BVofEquity) 12.00% ! You can estimate ROE directly by dividing n
Debt/EquityRatio=1.25/2= 0.625 !Ifyoudecidetousebookvaluedebttoequityratio,specif
Interestrate=Marketinterestrateondebt= 7.50%
ExpectedGrowthRate=0.5833(0.12+0.625(0.120.045)= 9.73%
3b.Terminalprice=Priceattheendofyear3
CostofEquity=6.25%+1(5.5%)= 11.75%
PayoutRatioattheendofyear3=1(0.06/(0.12+0.625(0.120.045)))= 0.64044944
Terminalprice=($2.40*1.0973^3*1.06*0.6404)/(0.11750.06)= $37.44
3c. Year DPS

1 $1.10 !Growingat9.73%estimatedabove
2 $1.20
3 $1.32 $37.44
CurrentCostofEquity(baseduponcurrentbeta)= 13.18% !Seeproblem1forcalculation
PresentValueofDividendsandTerminalPrice= $28.65
Dividebythetotalnumberofsharesoutstanding.
100000=266000
e ROE directly by dividing net income by book equity, but your answer will be different.
debttoequityratio,specifyithere
forcalculation
Fall 1992
1a. Current Cost of Equity = 8% + 1.15 (5.5%) = 14.33%
Current after-tax Cost of Debt = 10% (1- 0.4) = 6.00%
Current Weighted Average Cost of Capital = 14.33% (0.8) + 6.00% (0.2) =
1b. New Debt Ratio = (200+200)/1000 = 40.00%
Unlevered Beta = 1.15/(1+0.6*.25) = 1.00
New levered beta = 1.00 (1+0.6*0.67) = 1.40
New Cost of Equity = 8%+1.40 (5.5%) = 15.70%
New Cost of Capital = 15.70% (0.6) + 6.60% (0.4) = 12.06%
1c. Change in Firm Value = 1000 (.1266-.1206)/.1206 = $ 49.75 millions
Increase in Stock Price = $49.75 million/ 40 million = $ 1.24
1d. Debt next year = $ 200 + $150 = $350 million
Expected Price Appreciation in Equity = Expected Return - Dividend Yield = 14.33%-10% = 4.33%
Expected Value of Equity = 800 (1.0433) = $ 834.64
Expected Debt/Equity Ratio at end of next year = $350/$835 = 41.92%
2a. - 1 2 3
Net Income $ 100.00 $ 110.00 $ 121.00 $ 133.10
+ Deprec'n $ 50.00 $ 54.00 $ 58.32 $ 62.99
- Cap. Ex. $ 60.00 $ 60.00 $ 60.00 $ 60.00
- Chg. WC $ 10.00 $ 10.00 $ 10.00 $ 10.00
= FCFE $ 94.00 $ 109.32 $ 126.09
Dividends $ 66.00 $ 72.60 $ 79.86
(Assuming that net capital investment and working capital is financed with equity)
Cash Balance $50.00 $78.00 $114.72 $160.95
b. If the firm had financed its net capital investment and working capital with 20% debt
Net Income $ 100.00 $ 110.00 $ 121.00 $ 133.10
- (CE-Dep) (1-) $ 8.00 $ 4.80 $ 1.34 $ (2.39)
- (Ch WC) (1-) $ 8.00 $ 8.00 $ 8.00 $ 8.00
= FCFE $ 97.20 $ 111.66 $ 127.49
Dividends $ 66.00 $ 72.60 $ 79.86
Cash Balance $ 50.00 $ 81.20 $ 120.26 $ 167.88
2b. Ordinary Tax Rate = (0.3)(0.15) = 4.50%

Capital Gains Tax Rate = 20.00%
Dividends Per Share = $2.00
Price Change per share on Ex-Dividend Day = [(1-.045)/(1-.20)]($2.00) = $ 2.39
Problem 3 1 2 3 4
EPS $ 2.40 $ 2.78 $ 3.12 $ 3.31
Payout Ratio 0.00% 25.65% 36.17% 61.54% ! Payout ratio = 1 - g/ROE, where ROE
DPS $ - $ 0.71 $ 1.13 $ 2.03
Beta 1.4 1.25 1.1 1
Cost of Equity 0.142 0.13375 0.1255 0.12
Note: The alternative to estimating a levered beta in year 4 is to assume a beta of 1.
Terminal Price = $2.03/(.12 - .06) = $ 33.90
DDM Value = $0.71/(1.142*1.13375)+(1.13+33.90)/(1.142*1.13375*1.1255) = $ 24.59

12.66%
3%-10% = 4.33%
Payout ratio = 1 - g/ROE, where ROE = ROC + D/E (ROC - I (1-tax rate))

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CF Finals

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Problem 1

Risk free rate In local

Risk free rate = 3.00%

Business Estimated value Weight

New D/E ratio = 20.00% ! Debt raised/Old value

Current After investment

Incremental EBITDA $600,000.00

New Debt/Equity ratio = 1.5

Old firm value = 1000

Marginal tax rate Total Revenues

1. Wrong risk free rate: -1/2 point

1. Wrong risk free rate: -1/2 point

ginal tax rate, since borrowing is in US.

inesses in US (600) and China (1800).

1. Annuity not based on initial investment: -1 point

1. Did not after-tax cost of debt: -1/2 point

1. Did not unlever & relever beta: -1 point

1. Incorrect estimate of increase in value: -1 point

1. ROC incorrect: -1 point

1. Did not add cash: -1/2 point

Cost of equity 10.200% ! 3% + 1.02857 (7.00%)

New unlevered beta

Cost of equity 12.93%

Annual cash flow

1 2 3 1. Net income wrong: -1/2 point

Net Cap ex $2.00 Terminal value

n rate as risk free rate: -1/2 point

th the business and the country weights changes as the

pute annuity: -1 point

pute tax benefit from depreciaton: -1 point

pute savings per year: -1 point

p for shares correctly: -1 point

wrong: -1/2 point

ng to cash balance: -1 point

ting dividends: -1 point

NOTE: The acquisitons are a wild card. The problem states th

mpute reinvestment rate: -1/2 point

discount rate: -1/2 point

ment rate = 3%/20% = 15%

e you have FCFF, you have to discount at the cost of capital.

Incremental Revenue $10.00 $20.50 $31.53 $43.10 $55.26

Revenue befo 200 200 200 200 200 200

Change in cost 0.2100%

If the operating income is only 60 million

! Wrong weights on businesses: -1 point

! Wrong weights on businesses: -1 point

! Used total revenue instead of incremental: -1 point

! If you revert back to old revenue, WC in year 5 = 20

! Did not compute savings from expensing: -0.5 points

! Cost of equity incorrect: -0.5 point

! Did not unlever & relever beta: -1 point

! Change in firm value not computed: -1 point

! Mostly all or nothing

! Working capital change shown as a cash outflow (instead of inflow): -1 point

! Payout ratio incorrect for any reason: -1 point

! Wrong growth rate: -1 point

! Did not compute reinvestment rate in year 6: -1 point

ble. You don't want

b. If project continues in perpetuity

NPV = -3.33333333 ! -70 + 6/.09

Remaining value increase= 7.00811348 ! 52.46-45.45)

Payout ratio = 0.2 0.68333333 ! 10.25/15

pute unlevered beta: -1 point