Management Engineering - Finance Lab + Corporate FInance

Full exam

Exercise 1 Surprise Inc. is a company financed with both equity capital and debt. The number of shares outstanding is equal to 80 million and the market price of the shares is currently equal to € 1.25 each. The value of the debt is € 20 million and the annual intere st rate charged by the bank is equal to 4%. On average the annual gross operating margin (revenues net of operating cash costs) is equal to € 8 million; the tax rate on company gross profit is equal to 30%. Compute: 1) The total market value of the assets tod ay 2) The expected profitability of the company assets kA today, gross of taxes (i.e. consider the gross operating margin) 3) The earning -per -share (EPS) 4) The expected profitability k E for shareholders today 5) The total market value of the assets if the company is financed with equity capital only (introducing proper assumptions) 6) The expected profitability k E for shareholders if the company is financed with equity capital only Now assume that the controlling shareholders want to raise new debt, but according to the market this will increase the probability of financial distress. The company will access to a new loan, amount € 25 million, that will cumulate with the previous debt. The annual interest rate on the new debt will be 6% while the interest debt on the ‘old ’ debt will not change. The cash raised will be used to finance new investments with the same return kA computed in question 2). Assuming that the new debt generates costs of financial distress equal (in present value) to 3% of the same new debt, compute: 7) The new total market value of the assets 8) The new EPS 9) The new expected profitability k E for shareholders Exercise 2 Scotch&Rock (S&R) is going to be listed on the Euronext Stock Exchange in a few months. Financial analysts agree on the following expectations about the company: Year 1 Year 2 Year 3 Year 4 and thereafter Return on equity (ROE) ROE 1=1 2% ROE 2=14% ROE 3=1 4% ROE LT=1 6% Payout ratio (PR) PR 1=20% PR 2=50% PR 3=70% PR LT=80% The return on equity is the ratio between the net profit during the year and the book value of the equity capital at the beginning of the year. The company is not levered and for sake of simplicity there are no taxes on corporate income. The equity capital is made up by 100 million shares and the book value per shares is today 0. 25 €. The annual cost of equity capital k E is equal to 1 2% while the risk free rate on the market is equal to 0.5 %. Compute: 1. The expected dividends in the short run (and the growth rate in the long run) 2. The theoretical market value of the shares 3. The present value of growth opportunity (PVGO) 4. The theoretical value of a European call option on the shares, strike price 0.5 €, maturity 11 months (assume the annual volatility of the share return is 24%) 5. The theoretical value of the corresponding Europ ean put option 6. Explain if call options or put options should be used in order to hedge against a fall of the price of S&R shares after the listing (and how many options do we need in general) Exercise 3 A company is planning future investments in the cybersecurity business. The initial investment required is equal to € 5 00,000. The following cash flows, gross of taxes, are expected in the future: first year € 50,000; second year € 190,000; third year € 450,000; fourth year € 290,000. The tax rate to be applied to cash flows is equal to 28%. The cost of capital (unlevered) is equal to 10%. The compa ny is considering five different opportunities to finance the project: 1. Equity capital only 2. Equity and debt ( bank loan € 2 20,000 to be paid back at time 4 ; annual interest rate 4%) 3. Equity and debt ( bank loan € 240,000 to be paid back in 4 years, i.e. € 60,000 must be paid back each year; annual interest rate 4%) 4. Same as the previous point 3. but the debt is guaranteed (up to 80% of the value) by the Italian G overnment (Fondo Centrale di Garanzia); this allows to reduce the interest rate from 4% to 2% 5. Equity and debt (loan with leverage L=debt to value of the project equal to 40% each year; annual interest rate 4%) Compute the net present value of the project u nder the five alternatives. Compute the expected profitability (cost of capital) for shareholders under the alternatives 2 and 5. Academic year 20 20 -20 21 The test must be completed in 120 minutes . Write immediately surname and name on papers provided by the staff. During the test you cannot read personal notes or books. If – to your opinion – the text is not clear, or is ambiguous, you can introduce proper assumptions. Corporate Finance (Prof. G. Giudici) Written test – June 14th 20 21