Mid-term Examination

| November 13, 2015

QuestionQuestion 1. (10 points) The exercise price on one of ORNE Corporation’s call options is $25 and the price of

the underlying stock is $29. The option will expire in 35 days and is currently selling at $5.50.

a. Calculate the option’s exercise value? What is the significance of this value?

b. Why is an investor willing to pay more than the exercise value for the option?

c. If the price of the underlying stock changes to $33 per share, will the market value of the option increase,

decrease, or remain the same? Why

d. If Orne Corporation had issued a put option (instead of the call), would its value increase, decrease, or

remain the same if the price of the underlying stock increased? Why?

Question 2. (15 points) Pierre Imports is evaluating the proposed acquisition of new equipment at a cost of $90,000. In addition the

equipment would require modifications at a cost of $10,000 plus shipping costs of $2,000. The equipment falls into the MACRS 3-year

class, and will be sold after 3 years for $35,000. The equipment would require increased inventory of 6,000. The equipment is expected to

save the company $35,000 per year in before-tax operating costs. The company’s marginal tax rate is 30 percent and its cost of capital is 11

percent.

a. What is the cash outflow at Time 0?

Cost of milling machine

Modifications to machine

Shipping costs

MACRS 3 year class

Salvage after 3 years

Increased inventory

Savings per year

Tax rate

$90,000

$10,000

$2,000

0.3333

$35,000

$6,000

$35,000

30%

0.4445

0.1481

0.0741

b. Calculate the net operating cash flows in years 1, 2, and 3?

c. Calculate the non-operating terminal year cash flow.

d. Calculate net present value. Should the machine be purchased?

Question 3. (15 points) Andrews Corporation plans a $10 million expansion. The firm wants to maintain a 45 percent debt-to-total-assets ratio in its

capital structure. It also wants to maintain its past dividend policy of distributing 30 percent of last year’s net income. Last year, net income was $4

million.

a. Calculate the amount of external equity needed.

b. If the company changed to a residual dividend policy, how much external equity will it need?

c. Is the company likely to change to a residual policy? Why or why not?

Question 4. (15 points) A U.S. company orders merchandise from a Japanese company at a cost of 100 million

yen. The merchandise must be paid for in yen

Spot

30-day forward

90-day forward

180-day forward

Yen per $1 $ per 1 yen

97.57

0.01025

97.45

0.01026

96.31

0.01038

92.45

0.01082

a. How many U.S. dollars must be raised if payment is due today?

b. Is the dollar appreciating or depreciating against the yen? Explain.

c. How many U.S. dollars must be raised if payment is due in 90 days?

d. Who bears exchange rate risk, the U.S. company or the Japanese company or both? Explain.

e. Describe 3 ways in which the company can reduce exchange rate risk.

Question 5. (15 points) Kern Corporation entered into an agreement with its investment banker to sell 10 million shares of the

company’s stock with Kern netting $225 million from the offering. The expected price to the public was $25 per share.

The out-of-pocket expenses incurred by the investment banker were $5 million.

a. What profit or loss would the investment banker incur if the issue were sold to the public at an average price of $25 per share?

b. What profit or loss would the investment banker realize if the issue were sold to the public at an average

price of $20 per share?

c. Is the agreement between the company and its investment banker an example of a negotiated or a bestefforts deal? Why? Which is riskier to the company? Why?

Question 6. (15 points) Reynolds Corporation plans to purchase equipment at a cost of $3 million. The company’s tax-rate is 30

percent and the equipment’s depreciation would be $600,000 per year for 5 years. If the company leased the asset on a 5-year

lease, the payment would be $700,000 at the beginning of each year. If Reynolds borrowed and bought, the bank would charge

11 percent interest on the loan.

a. Calculate the cost of purchasing the equipment with debt.

Cost of equipment

Depreciation per year

5-year lease

Lease payment -BGN year

Loan

Tax rate

After-tax rate

Purchase Option

CF0

CF1

CF2

CF3

CF4

CF5

CF1

CF2

CF3

CF4

CF5

Cost of equipment

Depreciation tax saving

Total cash flow

NPV

b. Calculate the cost of leasing the equipment.

Lease Option

CF0

Lease Payments

Tax saving

After-tax payments

c. Calculate NAL? Should the company buy or lease the equipment? Why?

Question 7. (15 points) Marcal Corporation is considering foreign direct investment in Asia. The company estimates that the project would require an initial investment of $18 million. and generate positive cash flows of $3 million a year at the end of each of the next 20 years. The project’s cost of capital is 13%.

a. Calculate the project’s NPV.

b. The company thinks there is a 50-50 chance that the Asian country will impose restrictions on the company in one year.

If the restrictions are imposed, cash flows will be $2,000,000 per year for 20 years. If restrictions are not imposed, cash flows will be $4,000,000 per year for 20 years. Cost of capital remains the same. In either case, the cost will remain at $18,000,000 and cost of capital at 13%. Calculate the value of the real option by waiting one year to decide.

c. Apart from real options, discuss 3 qualitative factors that the company should consider when making its decision on accepting the new project.

 

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