Summer 2019 Exam

FM304
Applied Corporate Finance

Suitable for all candidates

Instructions to candidates

This paper contains three questions. Answer all questions.

If you need to make any additional assumptions in order to answer the questions, please state
these assumptions clearly in your answers.

Time Allowed Reading Time: None

You are supplied with: No additional materials

You may also use: No additional materials

Calculators: Calculators are allowed in this examination

© LSE ST 2019/FM304 Page 1 of 3

Suppose that today's date is January 1, 2019. You are considering the valuation of company
XYZ, which will last for 4 years (i.e. until December 31, 2022). Company XYZ will require up front
capital expenditures today of $1 million dollars for machinery. Starting at the end of this year,
the company will generate revenues of $3 million dollars annually till December 31, 2022. The
company will need to employ workers that earn $300K per year, with wages being paid starting
at the end of this year. The cost of goods sold will be $200K per year every year. The machinery
used for the company will depreciate according to a straight-line schedule over 4 years, and will
have zero salvage value by the end of the 4 years. Assume all cash flows (except for capital
expenditures) are realized at the end of each year.

The tax rate is 35%. The net working capital needs of the firm are minimal. The firm's accounts
receivables will reflect an average days sales outstanding of 30 days (out of a 360-day cycle).
Accounts payables will reflect an average 30 days payables outstanding (out of a 360-day cycle),
and will only be based on labor costs. The firm's inventory will be 10% of the firm's COGS in a
given year. There will be no other working capital needs for the firm. Assume that the net working
capital is fully recovered in the last year of operations (so the level of networking capital on
December 31, 2022 is zero).

a) Please project the cash flows for the company. If the discount rate for the company
is 10%, what is the company’s NPV? [15 marks]

b) If revenues increased by $200K every year (so that annual revenues are $3.2 million,
and accounts receivables changes accordingly), how much would the NPV of the
company change? (Assume all other information in the problem is as originally
stated). [5 marks]

c) Suppose you evaluate a different company called Grips & Co. You have to determine
the appropriate weighted average cost of capital for this company.

Luckily, you have the following data on comparable firms available to you:
Assume all firms in the industry target constant leverage ratios.
Company Name D/E Ratio Equity beta Debt beta Tax Rate
Handles Inc. 60% 1.7 0 35%
Sticks and Sons 50% 1.2 0 40%

If the firm Grips & Co. wants to target a 10% debt to value ratio (assume it can obtain debt
financing at the risk-free rate of 5%, and the market risk premium is 8%), what would be the
firm's weighted average cost of capital? Assume the firm’s asset beta is the same as the
average of the asset betas of the comparable firms in the industry, and that Grips & Co. pays
a tax rate of 35%. [10 marks]

d) Suppose the firm Grips & Co. wants to target a debt to value ratio such that the
weighted average cost of capital for the firm is 11.4%. Please solve for the desired
debt to value ratio that yields this weighted average cost of capital, assuming that the
debt is priced at the risk free rate at the desired leverage ratio. [20 marks]

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Suppose you are evaluating a firm that will require capital expenditures of 400M now (time 0),
and then produce revenues of 1100M at the end of this year (time 1) and 1500M at the end of
next year (time 2). The firm will incur labor expenses of 300M in each of the first two years (at
times 1 and 2).

There are no depreciation expenses or net working capital needs, and the equipment used for
production has zero salvage value. The tax rate is 35%. The firm has an asset beta of 1.1, and
the debt is priced at the risk-free rate of 5%. Assume a market risk premium of 7%. Assume for
all parts of this question that all cash not used for operations is paid out as a dividend.

a) If the firm targets a 20% debt to value leverage ratio every period, what is the value of
the firm's equity? [10 marks]

b) If you are a private equity investor who wishes to purchase all the firm's equity in a
leveraged buyout, what is the maximum you'd be willing to pay for the firm's equity if
you were to maintain a 30% debt to value ratio (in which case, the cost of debt
becomes 7%)? [10 marks]

c) Suppose that instead of purchasing the firm and increasing its leverage ratio from 20%
to 30%, you decide to maintain a 20% leverage ratio, but improve operating efficiency
by reducing labor costs by the same amount each year. What would your operating
expenses need to be each year in order for you to pay the same premium that you
calculated in part b? Assume the cost of debt and equity capital remains the same as
in the original problem (i.e. part a). [10 marks]

Question 3 [20 marks]:

a) True/False/Uncertain and Explain: An increase in the competitiveness of the banking

Please answer this question qualitatively (i.e. in words only). [10 marks]

b) True/False/Uncertain and Explain: An increase in equity investors' risk aversion means

Please answer this question qualitatively (i.e. in words only). [10 marks]

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