Part I

(0.7 points per question)

A company is exposed to the unsystematic risk that a fire breaks out in its production
facility, which would cause a total damage of 105mn €. The risk-free interest rate is 5%.
1.1 An insurance company offers to insure the fire risk at an actuarially fair premium of
10mn €. What probability of the fire does the insurance company assume to charge
this premium?
i) 9%
ii) 9.5%
iii) 10%
iv) 10.5%

1.2 Imagine you have the possibility to reduce the damage in case of a fire to 50 million
€, next year only, by installing a sprinkler system. What is the maximum price the
company would be willing to pay to install this system, assuming a probability for a fire
of 10%?

i) 0
ii) 5
v) 5.2
iii) 55

3. Assume that Rose Corporation's (RC) EBIT is not expected to grow in the future and
that all earnings are paid out as dividends. RC is currently an all-equity firm. It expects to
generate earnings before interest and taxes (EBIT) of $6 million one year from now.
Currently RC has 5 million shares outstanding and its stock is trading for a price of $12.00
per share, just after paying out the annual dividend. RC is considering borrowing $12
million at a rate of 6% and using the proceeds to repurchase shares at the current price
of $12.00. Assume perfect capital markets.
Prior to any borrowing and share repurchase, the equity cost of capital for RC is closest
to:
A) 11%
B) 10%
C) 12%
D) 9%

4. Activision would like to invest in a division to develop software for a new video game.
Its CFO has developed the following estimates associated with the project (in million
dollars):
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Year 1 2 3
Operating Cash 6 12 15
Accounts 21 22 24
Receivable
Inventory 5 7 10
Accounts Payable 18 22 24
If Activision currently does not have any working capital invested in this division, what is
the impact on free cash-flow from working capital investments in the third year?
A) -$25 million
B) -$15 million
C) -$10 million
D) -$6 million
5. Which of the following is NOT a way that a firm can increase its dividend?
A. By increasing its retention rate
B. By decreasing its shares outstanding
C. By increasing its earnings (net income)
D. By increasing its dividend payout rate
6. A type of agency problem that results in shareholders gaining from decisions that
increase the risk of the firm sufficiently, even if they have negative NPV is:
A. Asset substitution.
B. Debt overhang.
C. Underinvestment.
D. Cashing out.
7. An all-equity company has contacted the bank to ask for a loan with a market value
of $100 million. The bank analyst believes that the company’s assets will be worth $135
million (with probability of 50%), $110 million (30%), or $95 million (20%). This risk is
diversifiable. The risk-free rate is 5%. In the event of default, 30% of the value of the
firm’s assets will be lost to bankruptcy costs. What is the face value of the debt?
A) $115 million
B) $135 million
C) $137 million
D) The loan cannot be stipulated

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8. Consider Great Almonds Corporation, a company anticipating increased market

competition, leading to a projected 1% decline in revenues starting next year and
persisting indefinitely. The company is expected to generate revenues of $12 million one
year from now. The company distributes 4% of its revenues as dividends to its
shareholders. Assume that the company has 10 million stocks and the required rate of
return for the company's stock is 8% per year. Calculate the price of the company’s share
today.
A. 0.528
B. 0.533
C. 0.686
D. 0.692

9. Consider the following statements:

i. The existence of at least one incremental IRR implies that both projects have
at least one IRR.
ii. At least one IRR exists if the project with positive NPV has an outflow at time
zero.
iii. The profitability index method provides an accurate answer if the constraint is
fully saturated.
What is the correct answer:
A. Only (i) and (iii) are true
B. Only (ii) and (iii) are true
C. All statements are true
D. All statements are false
E.
10. Currently the shareholders of Company Bigfloor Inc (Bf) expect earnings at the end
of this year, i.e., one year from now, of 6.2 per share and dividend per share of €2.9 at
that time. Bf is expected to retain €3.3 per share of its earnings to reinvest in new projects
with an expected return of 12% per year. Shareholders expect that Bf will maintain the
same dividend payout rate, retention rate, and return on new investments in the future
and will not change its number of outstanding shares. The equity cost of capital is 9%.
Tomorrow the CEO is planning to announce that a dividend of €3.9 will be paid per share

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instead at the end of this year and retain only €2.3 per share in earnings. If Bf maintains
this higher payout rate forever, what is the stock price change closest to?
A. Decrease by €4.80
B. Increase by €4.80
C. Decrease by €25.25
D. Increase by €25.25

11. Suppose that a firm is considering buying a new machine that will last 5 years. The
upfront cost of the machine is $20,000 and additional maintenance checks are $4,000
every year (from year 1 to 4). Alternatively, the company could rent the machine, which
would require an upfront annual rent payment every year, starting today (from year 0 to
4). What is the rental price that would make the company indifferent between buying or
renting? Assume a cost of capital of 10%.
A. $9,483
B. $7,837
C. $4,000
D. None of the above

12. A company was founded to carry out the project below. To fund the initial investment
of 1000€, the firm raises 500€ risk-free debt at an interest rate of 10%. The amount of
debt remains unchanged for the lifetime of the project. The cost of capital of a comparable
unlevered firm is 20%.
Period 1 2
FCFF (€) 800 500

Assume a tax rate of 40%.

What is the approximate value of the tax shield?
a) 86.9
b) 50
c) 39.6
d) 34.7
e) 30.5

13. What is the approximate market value of the firm?

a) 1300
b) 1181.90
c) 1140.50
d) 1048.60
e) 1013.90

14) In December 2005, the spot exchange rate for the British Pound was $1.7188/£ and
the one‐year forward rate was $1.8675/£. Suppose that at the same time Luther Industries
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entered into a contract to purchase goods with a price of £375,000 to be delivered in one
year. Simultaneously Luther entered into a one‐year forward contract to purchase
£375,000. At the time the contract payment was due, the spot exchange rate was
$1.9975/£. What is the amount of the payment in U.S. dollars that Luther Industries
paid?
A) $700,312.50
B) $644,550.00
C) $749,062.50
D) $200,803.20

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Part II
A firm could invest in the following one-period projects, each requiring an initial
investment of 500. The projects are mutually exclusive.
State 1 2
Probability P (1-P)
Project 1 825 825

Project 2 1110 0

All agents are risk-neutral and the risk-free rate equals 10%.
a) For which probability p are equityholders exactly indifferent between Project 1
and Project 2?

Solution: p=0.74

b) Assume P=0.7 and that debt holders fund half of the initial investment with risk-
free debt. Which project will equity holders prefer and what is the NPV they realize?

Solution:
Project 1: 250

Project 2: 281

c) What is the maximum amount that the firm will be able to finance with debt to
ensure that debt holders will not ask more than 10% interest rate? Assume p=0.7.

Solution: 145.45
Part III

Kinston Industries has come up with a new idea for a mountain bike. The pilot production
of a prototype and test marketing phase will last for one year and cost $500,000, paid

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immediately. Your management team believes that there is a 50% chance that the test
marketing will be successful and that there will be sufficient demand for the new
mountain bike. If the test-marketing phase is successful, then Kinston Industries will
invest $3 million in year one to build a plant that will generate expected annual after-tax
cash flows of $400,000 in perpetuity beginning in year two. If the test marketing is not
successful, Kinston can still go ahead and build the new plant, but the expected annual
after-tax cash flows would be only $200,000 in perpetuity beginning in year two. Kinston
has the option to stop the project at any time and sell the prototype mountain bike to an
overseas competitor for $300,000. Kinston's cost of capital is 10%.
a) Assuming that Kinston has the ability to sell the prototype in year one for $300,000,
what is the NPV of the Kinston Industries Mountain Bike Project?

Solution: NPV = $90,909

b) Assume that Kinston has to go ahead and build their manufacturing plant
immediately without the pilot production and test marketing. Assuming that the
probability of high or low demand is still 50% and that cash flows accrue one year
after investment, what is the NPV of the Kinston Industries Mountain Bike Project?

Solution: NPV = $0

c) What is the value of the option to do pilot production and test marketing? And what
is the value of the option to sell the prototype, conditional on doing the pilot
production and test marketing?

Solution: The value of the option to abandon=$136,364