NOTICE – FINAL EXAM

DATE: Monday, August 20th from 6:30 – 9:30

LOCATION: Henry Angus 098

WE WILL MEET IN Henry Angus 098 ON Sunday, August 19 FROM Noon-3 pm

(NOT 3-6 pm) FOR QUESTION/ANSWER SESSION. PLEASE BRING THE
FINAL QUESTIONS AND OTHER RELEVANT MATERIALS WITH YOU.

I WILL BE AVAILABLE FOR OFFICE HOURS ON SUNDAY, August 19 FROM

11-12 and August 20 from 3-6 pm IN MY OFFICE (HA 351). I WILL HAVE TO
LEAVE PROMPTLY ON SUNDAY AT 3 PM. Feel free to e-mail me as needed;
however, include your phone number in the e-mail (in case, I need to talk to
you).

Please note that CELL PHONES ARE NOT ALLOWED ON THE DESKS DURING
EXAMS. THUS, MAKE SURE YOU HAVE A WATCH TO KEEP TRACK OF TIME
(in case the computer malfunctions). Please turn your cell phones OFF and
PUT THEM AWAY in your jacket/pants/bag/purse/“murse”. Thanks.

Finally, make sure and bring your student identification card with you and
place it in front of you before the exam starts.

1. The exam is 3 hours in length and 100 marks. NO EXTRA TIME WILL BE
PROVIDED. Thus, time management is important.

2. The final exam covers everything beginning Chapter 14 until the end of
term. Thus, only post-midterm materials will be examined.

2. The final exam can be worth up to 65% of your grade.

3. There will be 10 marks for ten multiple choice questions.

4. There will be seven computational questions- the biggest questions being

Capital Budgeting, WACC and Lease/Buy. Other questions will relate to
the following topics: Bond/Preferred share refinancing, Chapter 13, and
Chapter 14.

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NOTE:
No complete final exam has been provided. Capital Budgeting, WACC and
Lease/Buy will be the three biggest problems on the final exam. Accordingly, old
exam/assignment problems relating to these two areas are provided below. With
respect to the other problems on the final, as long as you can do (and
understand) the in-class examples and problems, the supplementary textbook
problems and the assignment problems, you should be properly prepared.

The instructions on the cover page will be exactly as follows:

BUSI 370 – FINANCE

FINAL EXAM – SUMMER 2012
Time: 180 minutes Total Marks: 100
Name (Last, First): __________________________ Student # ___________
Signature: _____________________________
1. Please be careful to budget your time carefully so that you can attempt all
the questions.
2. Please do not ask any questions concerning the INTERPRETATION of the
questions. If you believe there is missing or incorrect information, state your
assumption and proceed.
3. Read the whole question before you start answering. Read carefully!!!
4. Unless indicated otherwise, take (intermediate) calculations to FOUR
decimal places- i.e., 0.0123 or 1.2345%. For leasing, take calculations
of dollar amounts to the closest dollar (no cents needed). You must
show all keys punched in (including −, BEG, if applicable).
5. Formula Sheets are provided separately. Put your name on the formula
sheet and return it with your exam (ON TOP OF THE EXAM).
6. You MUST show your work to get the marks.
7. If you write on the back of a page, please indicate so.
8. PLEASE TURN YOUR CELL PHONES OFF AND PUT THEM AWAY.
THANKS. CELL PHONES ARE NOT PERMITTED ON THE TABLE.
9. Do NOT tear any pages out (unstaple and restaple, if you have to).
10. Where applicable, the tax rate is 40%.

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Name (Last, First) _____________________
FORMULA SHEET ─ BUSI 370 FINAL
Future value of a cash flow
FV = PV(1 + i)n

Present value of a cash flow

PV = FV/(1 + i)n

Future value of an annuity (USE YOUR CALCULATOR)

FV = A {[(1 + i)n –1]/i}

FVANNUITY DUE = FVREG ANNUITY × (1 + r)

Present value of an annuity (USE YOUR CALCULATOR)

PV = A {[1- 1/(1 + i)n]/i}

Present value of a perpetuity

PV = A1/i

PVANNUITY DUE = PVREG ANNUITY × (1 + i)

Effective annual rate of return

rannual = (1 + QR/m)m -1

Effective period rate of return

r = (1 + QR/m)m/f -1

Nominal Interest Rate [Fisher Formula]

(1 + nominal) = (1 + real) (1 + expected inflation)

Interest Rate Parity Relationship

fab/sab = (1 + ra) ÷ (1 + rb)

Dividend Discount Model

P0 = Σ Dt ÷ (1 + kc)t

DDM – No Growth-Rate
P0 = D0 ÷ k

DDM – Constant-Growth-Rate
P0 = D1 ÷ (r − g) r = (D1 ÷ P0) + g Pn = Dn+1 ÷ (r − g)

Dividend Payout
Dividend Payout = Dividend/Common Share
Earnings/Common Share (EPS)

Sustainable Growth Rate

g = ROE x (1 – Payout ratio)

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Total Return
TR = [CF1 + (P1 − P0)]/P0 = [D1 + (P1 − P0)]/P0

Expected Return
E(R) = ΣRipri
Variance of Returns
m
Variance of returns = σ = ∑ [Ri − E ( R)] pri
2 2

i =1

Standard Deviation of Returns

Standard deviation of returns = σ = σ 2

Coefficient of Variation
Standard deviation ÷ Expected return
Portfolio Expected Return
E(Rp) = ΣwiE(Ri)

Portfolio Risk
σ P = w A2 σ A2 + wB2 σ B2 + 2w A wB ρ ABσ Aσ B

Required Rate of Return [CAPM]

RCAPM = rf + Beta (rm – rf)

PV of CCA Tax Shield [Half Year Rule]

[(CdT) ÷ (k + d)] x [(1+ (k ÷ 2)) ÷ (1 + k)]
PV (on day sold) of Lost CCA Tax Shield
[(SndT) ÷ (k + d)]
UCC Of An Asset At The End Of A Year [Half Year Rule]
UCCn = C(1 – (d ÷ 2))(1–d)n–1
Taxable Capital Gain
(Proceeds – Cost)(1/2)(Tax Rate)
Profitability Index
PI = PVCIFs
PVCOFs
Other Formulas
Int b (1 − T ) Dp Dp
kb = rb (1 – T) kb = rp = kp =
NPb Pp NPp

D1 D1 Pe
re = +g ke = +g ke = × re
Pe NPe NPe

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WACC QUESTION (18 marks; suggested time 32 minutes)
You have been asked by Porky Pig Ltd. (“PPL”), a manufacturer of skateboards
to estimate its weighted-average cost of capital (WACC).

PPL currently has $200 million face value bonds outstanding. The bonds have 6
years remaining until maturity and carry a 12% coupon rate with semi-annual
payments. The bonds ($1,000 face value) are currently selling at $1,077.

PPL also has 10 million preferred shares outstanding. These shares pay a
dividend of $1.50 and are currently trading at $18.75.

Finally, PPL has 15 million common shares outstanding, which are currently
trading at $21. PPL just paid a dividend of $1.25 per share and investment
analysts have projected these dividends to grow at an average annual rate of 3%
for the foreseeable future. The shares have a beta of 0.75, the risk-free rate of
return is 5% and the return on the market is 12%.

PPL has been advised by its underwriters that flotation costs would be 4% after-
tax on new debt and preferred shares, and 6% before-tax on common shares.
PPL’s tax rate is 40%.

Calculate PPL's weighted-average cost of capital, assuming it must issue

common shares.

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SOLUTION – WACC QUESTION
COST OF DEBT:
−1,077 PV
1,000 FV
60 PMT
12 N
I/YR = 5.1251% (paid every 6-months)

−960 PV (1,000 – 40)

1,000 FV
30.75 PMT [(1,000)(.051251)(1–.40)]
12 N
I/YR = 3.4887%

EAR = (1.034887)2 – 1 = 7.10%

COST OF PREFERRED SHARES:

k = 1.50 = 8.33%
18.75(.96)

COST OF COMMON SHARES:

Dividend Growth Model:
k= (1.25)(1.03) + .03 = 9.35%
21[(1 – (.06)(1–.40))]

CAPM:
r = 5% + .75(12% - 5%) = 10.25%

k= 21(10.25%) = 10.63%
20.2440

Average = 9.35 + 10.63 = 9.99%

2
WACC:
Debt = (200,000)($1,077) = $215,400,000
Preferred Shares = (10,000,000)($18.75) = $187,500,000
Common Shares = (15,000,000)($21) = $315,000,000
$717,900,000
WACC = ($215.4M÷$717.9M)(7.10%)+($187.5M÷$717.9M)(8.33%)
+ ($315M÷$717.9M)(9.99%)
= 8.69%
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LEASE VS. BUY QUESTION (16 marks; suggested time 29 minutes)

The production department of ABC Ltd. has decided that the addition of a new
machine will greatly reduce the marginal cost of its products, allowing ABC to
price its products more competitively. This machine has a price of $380,000 and
is expected to be sold on the first day of year 6 for $65,000. ABC’s tax rate is 40
percent, and the asset will be subject to a CCA rate of 20 percent. The
company's WACC is 20%. ABC’s bank is willing to lend the money for five years
at 15 percent. Your superiors, who are about to enter negotiations on the lease,
want to know what is the maximum (end-of-the-year) lease payment they
could agree to (with the lessor)? What would the maximum lease payment
be if the payments were beginning-of-year payments?

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SOLUTION – LEASE VS. BUY QUESTION
Discount rate = 15%(.6) = 9%

Discount rate for salvage value = WACC = 20%

Let L = the amount of the lease payment

1 PMT
5 N
9 I/YR
PV = 3.8897
LEASE BUY
3.8897L(1 − .4) = 2.3338L − 380,000
+ 380,000(.2)(.4) x (1.045) = 100,500
.09 + .2 (1.09)
+ 65,000 x 1 = 26,122
1.205
− 65,000(.2)(.4) x 1 = 7,206
.09 + .2 1.205
= 260,584 cost

2.3338L = 260,584 and L = 111,656

0R
260,584 PV
9 I/YR
5 N
PMT = 66,994

66,994 is the maximum after-tax payment; thus, the payment to the lessor must be 66,994 ÷ .6
= 111,657 (before-tax).

BEGINNING-OF-YEAR PAYMENTS:
Let L = the amount of the lease payment
BEG
1 PMT
5 N
9 I/YR
PV = 4.2397
Thus, PVLP = 4.2397L

Tax shield would be at the end of the year. Thus, Tax shield = (.4)(3.8897L) = 1.5559L
[3.8897 is based on end-of year PMT- i.e., BEG OFF 1 PMT, 5 N, 9 I/YR, PV = 3.8897 OR
4.2397 ÷ 1.09 = 3.8896 (different due to rounding)]

ATLP = 4.2397L – 1.5559L = 2.6838L

2.6838L = 260,584 and L = 97,095

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LEASE VS. BUY − QUESTION
The firm for which you work requires the use of a particular type of machine. To purchase the
machine would cost $18,000 plus $500 to install. The machine falls in an asset class for which
the allowable depreciation rate for tax purposes is 20 percent. The machine would be sold in
five years and the firm estimates that it would be able to get $6,000 for it at that time. Instead
of buying the machine, the firm also has the opportunity to lease it (the lessor would provide
the machine and also cover the installation cost). The firm could sign a five year lease in
which the first lease payment would be $3,000 and would be due immediately. A clause in the
lease contract states that future yearly payments will increase at the rate of inflation (payments
to be rounded to the next dollar). Inflation is expected to be 3% a year for the foreseeable
future and the firm’s tax rate is 40 percent. The company’s cost of borrowing is 10 percent and
its WACC is 15 percent.

(a) Should the firm lease or buy the machine? Show your calculations.
(b) Ignore your answer to (a) and assume that, your answer to (a) is that there is a net
advantage to leasing (based on the salvage value above) of $2,500 (which is not the
correct number). Calculate the salvage value that would make you indifferent between
buying and leasing.

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LEASE VS. BUY − SOLUTION
(a)
COST OF BUYING:
After-tax Cost of Borrowing = 10% (1 − .4) = 6%

Purchase cost [18,000 + 500] − 18,500

PV of Tax Shield due to CCA
18,500(.2)(.4) x 1.03 + 5,531
(.06 + .2) 1.06
PV of Salvage [6,000 ÷ 1.155] + 2,983

PV of Tax Shield Lost due to Salvage Value

(6,000)(.2)(.4) x 1 = (2983)(.2)(.4) − 918
(.06 + .2) 1.155 .26 − 10,904

COST OF LEASING:

TIME LEASE PAYMENT TAX SHIELD##

Year 0 (today) 3,000 [CF0] 0 [CF0]
Year 1 3,000(1.03) = 3,090 [CF1] 3,000(.4) = 1,200 [CF1]
Year 2 3,090(1.03) = 3,183 [CF2] 3,090(.4) = 1,236 [CF2]
Year 3 3,183(1.03) = 3,279 [CF3] 3,183(.4) = 1,273 [CF3]
Year 4 3,279(1.03) = 3,378 [CF4] 3,279(.4) = 1,312 [CF4]
Year 5 No lease payment 3,378(.4) = 1,351 [CF5]
[6 I/YR] [6 I/YR]
2nd F NPV = 14,177 2nd F NPV = 5,350

## The lease payments are at the BEGINNING; the tax shield IS ALWAYS AT THE END.

QUICK WAY OF CALCULATING TAX SHIELD:

14,177 x .4 = 5,671 for BEG annuity. To convert to END annuity, 5,671 ÷ 1.06 = 5,350.

PVATLP = PVLP − PVTS = 14,177 – 5,350 = 8,827

USING REAL DOLLARS AND REAL RATE:

1.06 – 1 = 2.9126% real rate.

1.03

PV = 14,175 [BEG; 3,000 PMT; 2.9126 I/YR; 5 N] (difference of $2 due to rounding)

PV of Tax Shield on Lease Payments:

In order to use the “quick way”, the amount must be in Year 0 dollars. The tax shield of 1,200
is at the end of Year 1. Year 0 equivalent = 1,200 ÷ 1.03 = 1,165

PV = 5,349 [1,165 PMT; 2.9126 I/YR; 5 N] (difference of $1 due to rounding)

Thus, the cost of leasing is 14,175 – 5,349 = 8,826

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THUS, THE FIRM IS BETTER OFF LEASING THE MACHINE (8,826 is less than 10,904
giving a net advantage to leasing (“NAL”) of 2,078.

TEXTBOOK APPROACH:
D1
P0 = = (3,000)(1.03) / (.06 − .03) = 3,090 / .03 = $103,000 + 3,000 (today) = $106,000
r −g
LESS
D5 D0 (1 + g ) 5
P0 = = = 3,000(1.03)5 / (.06 − .03) = $3,477.82 / .03 = 115,927 / (1.06)4 = $91,825
r −g r−g

106,000 − 91,825 = 14,175 (difference of $2 due to rounding)

PV of Tax Shield on Lease Payments:

D1
P0 = = (1,200) / (.06 − .03) = 1,200 / .03 = $40,000
r −g
LESS
D6 D (1 + g ) 5
P0 = = 1 = 1,200(1.03)5 / (.06 − .03) = $1,391.13 / .03 = 46,371 / (1.06)5 = $34,651
r −g r−g

40,000 − 34,651 = 5,349 (difference of $1 due to rounding)

Thus, the cost of leasing is 14,175 – 5,349 = 8,826

(b)
Based on the facts above (i.e., a salvage value of 6,000), there is a NAL to leasing of 2,500.
Thus, in order to eliminate this advantage of 2,500, what must the (additional) salvage value
have to be?

S − S(.2)(.4) x 1 = 2,500
1.155 .26 1.155

S − .3077S = 2500(1.155)
.6923S = 5028
S = 7,263

Thus, to be indifferent to buying/leasing, the salvage value must be an additional 7,263. Thus,
it must be the original 6,000 + 7,263 = 13,263.

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CAPITAL BUDGETING QUESTION—20 Marks [suggested time 36 minutes]

You have been asked to help a manufacturing firm decide whether it should invest in a new 4-
year project that it believes will improve the company’s profitability. The project will require an
investment of $2 million for a new building and $1.5 million for new equipment. The company
recently purchased a block of land at a cost of $400,000 to build on if it decides to go ahead
with the project. An independent appraiser has indicated that the value of the land should be
approximately $500,000 in 4 years, based on current real estate trends. If they invest in the
project, select current assets/liabilities will be affected as follows: receivables will increase
$400,000; inventory will increase $200,000; and accounts payable will increase $100,000.

The equipment is estimated to have a 4-year useful life, at the end of which it is expected to
have zero salvage value. The building is estimated to have a 25-year useful life, at the end of
which its salvage value is expected to be equal to 40% of its original cost. At the end of year 4,
the building is expected to be worth 75% of its original cost. However, the company believes
that it will have other uses for the building at the end of the project and intends to retain it.
Both the building and equipment will be amortized on a straight-line basis.

To help with your analysis, the firm has provided you with the following projected income
statements for the project:

(In $000s) Year 1 Year 2 Year 3 Year 4

Revenues $ 8,000 $ 8,500 $ 9,000 $ 9,500
Cost of goods sold 6,000 6,300 6,500 6,800
Amortization 423 423 423 423
Interest expense 200 200 200 200
Tax expense 550.80 630.80 750.80 830.80
Net income $ 826.20 $ 946.20 $ 1,126.20 $ 1,246.20

The company’s cost of capital is 14% and the CCA rate is 20%.

Required
Should the project be undertaken?

12
CAPITAL BUDGETING − SOLUTION

Building ($ 2,000,000)
Land (400,000)
Equipment (1,500,000)
Investment in NWC $400,000 + $200,000 − $100,000 (500,000)
CCA tax shield:
Building & Equipment 772,962
(3,500,000)(0.20)(.40)÷(0.14+0.20)x(1.07÷1.14)
Salvage value:
Land 500,000÷(1.14)4 296,040
4
Capital gains tax (500,000 – 400,000)(1/2)(0.40)÷(1.14) (11,842)
4
Building (0.75)(2,000,000)÷(1.14) 888,120
CCATS lost (888,120)(0.20)(.40)÷(0.14+0.20) (208,969)
4
Recovery of NWC 500,000÷(1.14) 296,040
After-tax NOI: 0 CF0
(8,000−6,000) = 2,000 CF1 (8,500−6,300) = 2,200 CF2
(9,000−6,500) = 2,500 CF3 (9,500−6,800) = 2,700 CF4
14 I/YR 2ndF NPV = 6,733,260 x .6 4,039,956
NPV $1,672,307

The project should be undertaken because it has a positive NPV.

NOTE: Even though the company doesn’t intend to sell the land/building, we MUST consider
the salvage values at the end of the project’s 4-year life. We are analyzing the project
over its 4-year life; we are NOT analyzing the company.

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