Download faculty of management - University of Calgary

FACULTY OF MANAGEMENT
UNIVERSITY OF CALGARY
FINANCE 751 – ADVANCED FINANCIAL MANAGEMENT
Sample Final Examination
Instructions:
1. Answer any FOUR questions. Please write CLEARLY and LEGIBLY. Failure to do so
may result is deduction of points.
2. This exam is an open-book exam
3. You have three hours to complete the exam
Question 1
a) FastTrax Inc is a medium size manufacturer of running shoes. Management at the company
knows that its (total) production costs per unit are $5 per pair, which is considerably lower
than the average for the industry of $9 per pair. Investors, on the other hand, are fairly
certain that the company will manufacture and sell 10 million pairs of shoes next quarter,
but since actual production costs are difficult to confirm, FastTrax is currently being
valued as a firm with average costs. Next quarter, running shoes of the quality of
FastTrax’s will sell for an average of $40 per pair if demand is strong, $30 per pair if
demand is average, or $20 per pair if demand is weak. FastTrax’s management is
considering using debt to signal it superior productivity. Assume that interest rates are
zero, the risk neutral probability of each outcome is 1/3, and if bankruptcy occurs it will
incur costs of $25 million. If the common management compensation for the industry is
such that it places a 60% weight on intrinsic value and a 40% weight on current value, is
there a debt level (or range) that FastTrax can use to credibly send a good signal? (17
points)
b) Use the theory of asymmetric information between (inside) managers and (outside)
investors to explain the Pecking Order Theory. (8 points)
Question 2
a) List four different kinds of bankruptcy costs and explain what the impact of each one of
these costs has on the cost-of-debt, the cost-of-equity, and the cost-of-capital. (10 points)
b) Steed Enterprises is considering making an investment of $300,000 in one of two mutually
exclusive projects. The first project will generate cash flows of $450,000 if the economy is
up or $310,000 if the economy is down while the second project (counter-cyclical and
riskier) will generate cash flows of $180,000 if the economy is up or $720,000 if the
economy is down. Steed has decided to use debt to finance the project and their bankers
have agreed to lend Steed the money at the risk free rate which is currently at 2.5%. If the
risk neutral probability of the economy being up next quarter is 0.75, what are the NPV’s
of projects and show that at the current risk free rate, Steed will choose the better project.
Suppose the risk free rate were to suddenly increase to 7.5%, show that at this rate, Steed
would be unable to raise debt financing for their investment due to credit rationing. (15
points)
Question 3
a) Do Real Options always increase the value of a firm? Explain your answer. (8 points)
b) Consider a project that requires an initial investment of $100 million. One year from now
the economy may be “good”, “average”, or “bad” with each state having a risk-neutral
probability of 1/3. After one year, there is no more uncertainty. In the first year, the firm
generates cash flows of $40 million in all states, and in the second year, it assets will have
a value of $100 million if the economy is good, $80 million if the economy is average, and
$40 million is the economy is bad. However, the firm has the “real option” to make an
additional investment in Year 1 of $100 million which would result in its assets’ values
increasing to $240 million if the economy is good, $200 if the economy is average, and
$75 million is the economy is bad. What would be the value of this project without the real
option and hence, what is the (optimal) value of the real option? (5 points)
Assuming that the managers of this firm always have the incentive to over-invest,
determine if there is an optimal range for the capital structure. (12 points)
Question 4
a) In the fiberoptics industry, investors are unable to distinguish between good firms (worth
$55 per share), average firms (worth $35 per share) or bad firms (worth $15 per share) and
therefore prices all such firms at the average of $35 a share. However, in one year the
market will know whether a firm is good, average, or bad. The management of BGG Corp,
a fiberoptics firm, knows that the firm is a bad firm and they are considering taking
advantage of the current overvaluation by raising equity capital and investing in a project
that costs $5 million and will generate cash flows with a PV of $6 million. If BGG
currently has 1 million shares outstanding and can actually raise equity at its current stock
price, determine what the increase in wealth of BGG’s current shareholders will be per
shareholder. (8 points)
If the investors in the market also knows the cost and cash flows of the investment
project, how do you believe they will respond to the equity issue announcement and at
what price will BGG actually be able to issue equity? (9 points)
b) Does the asymmetry of information between (inside) managers of a firm and (outside)
investors result in a breakdown of the Efficient Market Hypothesis? Explain your answer.
(8 points)
Question 5
a) A firm currently has 100,000 shares and 4000 bonds outstanding. Each bond has a face
value of $1000 and covenants that prohibit the firm from issuing debt of equal or greater
seniority. One year from now, if the economy is “good”, the firm’s assets will be worth $6
million while if the economy is “bad”, the assets will be worth only $2 million. However,
the firm has an investment opportunity that costs $1.2 million, and will generate 2 million
if the economy is good, or 1 million if the economy is bad. Assuming that the risk-neutral
probability is ½ and the risk free rate is zero, show that the firm will not be able to finance
this project either with (junior) debt or with equity. (8 points)
The firm is considering a capital restructure that will enable it to take on the project. It is
proposing to exchange 2000 bonds at $625 per bond (via a redeemable clause) for newly
issued shares. Show that current shareholders would not approve of this restructure on its
own, but would approve of it when combined with the project. (You may assume that the
project will eventually be financed with equity). (9 points)
b) Discuss the free rider problem of the firm’s bondholders, and why it may make the firm’s
plans to restructure impossible. What are the alternatives that the firm has to overcome the
free rider problem? (8 points)