Practice Final Comm371

8/3/2019 Practice Final Comm371

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COMM371 Theory of Finance

Practice Final Exam

Wayne T. Penn sat back in his extremely comfortable chair in his extremelycomfortable office looking out over the Lions Gate Bridge. He could see the smoke

billowing out of the oil containers in the English Bay, if he opened his window, he couldsmell them too. Mr. Penn thought back on his last few years as Chief Financial Officer ofApex Drugs and Products. By 2010, Apex had become a major player in prescriptiondrugs with sizable market share in quite a few of them, and several blockbuster drugs.Apex also had numerous brand name home products such as Clean detergent and ChefGirlardee canned food.

The three pillars of Apexs strategy were conservatism, marketing and cost control.Apex consistently avoided much of the risk of product development and introduction inthe volatile drug industry. Most of its new products were acquired or licensed after theirdevelopment by other firms. Others were copies and clever extensions of products

introduced by competitors. Apexs success was built on its expertise in marketing, whicheroded its competitors head start, and on cost control, which ensured substantialmargins. The results were impressive. Selected financial data for Apex (in $ millions):

2006 2007 2008 2009 2010

Sales 2,471.7 2,685.1 3,062.6 3,406.3 3,798.5

Net income 277.9 306.2 348.4 396.0 445.9

EPS 1.75 1.94 2.21 2.51 2.84

DPS 1.00 1.15 1.33 1.50 1.70

Cash 358.8 322.9 436.6 493.8 593.3

Total assets 1,510.9 1,611.3 1,862.2 2,090.7 2,370.3

A/P and other non-interest

bearing liabilities511.60 565.70 670.50 758.40 883.60

Long-term + short-term debt 7.8 10.3 13.7 10.3 13.9

Net worth 991.5 1,035.3 1,178.0 1,322.0 1,472.8

As he thought more about Apexs past performance, and sat further back in his extremelycomfortable chair in his extremely comfortable office, Mr. Penn fell asleep.

Cashand equivalent 593.3

A/P and othernon-interest

bearingliabilities 883.6

A/R 517.3 Long-term + short-term debt 13.9

Inventory 557.3 Totalliabilities 897.5

PPE 450.5 Net Worth 1,472.8

Other 251.9

Totalassets 2,370.3 Totalliabilities + Net worth 2,370.3

Balance Sheet 2010

Assets Liabilities


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Part I.Please answer the following 4 questions on the attached blank sheets. Eachquestion is worth 5 points. If you make assumptions, mention them explicitly. (No

need to write a novel).

1) Before Mr. Penn wakes up, describe Apexs capital structure over the period 2006-

2010. What are the likely factors that explain this capital structure? (Your discussionshould be based on simple statistics computed from the available data).

2) Based on the information given above, is this capital structure likely to be optimal? Ifyes, explain its merits relative to alternative capital structures. If not, discuss thiscapital structures main drawbacks, as well as the relative merits of the differentpossible paths to a more suitable capital structure. (No calculations needed).

After several hours of snoozing, Mr. Penn woke up with a start and a stiff neck. Herealized that all industries undergo change at some point and the pharmaceutical industrywas no different. The Harper administration was threatening the industry with tighter

regulation with measures increasing the control of prices, and favoring the developmentand diffusion of generic drugs. At the same time, some of Apexs most profitable patentswere about to expire. Also, many industry analysts believed that advances in bio-technologies would lead, in the longer run, to a new generation of drugs replacing moretraditional ones. Developing these new drugs, as well as building up expertise in the newindustry, was bound to require a considerable R&D effort.

3) Mr. Penns quick forecast was that Apexs sales were likely to grow 11% thefollowing year, but that its margins (net income/sales) were likely to fall to 7%. Hewondered what his capital structure would look like the following year given that hedid not want to cut the dividend ratio, or issue equity. Please help Mr. Penn out withthese calculations, as he is not very good with numbers. (Calculations needed).

4) Given these changes in the industry and assuming that they persist, what do you thinkApexs target capital structure should be in the long run? What impediments, if any,might Mr. Penn face in maintaining this target?


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Part II. Provide short answers to the following questions. Each question is worth 4

points.

Question 1. Who runs the corporation when the firm is solvent and who runs it inbankruptcy? Explain how this works!

Question 2. What are the key tax differences between dividend payments and interestpayments?

Question 3. Suppose a firm which has filed for bankruptcy has a complicated capitalstructure. There are two classes of stock: ordinary shares and preferred shares. There arealso three types of debt: senior unsecured debt, junior unsecured debt, and secured debt.Since the firm is not viable, the bankruptcy judge decided to liquidate the firm and usethe proceeds to repay the firms claimants. However, the money raised is not enough torepay all claims in full. What is the priority rule the judge should use in deciding how toallocate the proceeds from the liquidation?

Question 4. Consider a firm with two types of bonds outstanding: junior unsecured debtand senior secured debt. Which of these bonds should have higher yields and why?

Question 5. Briefly explain what debt covenants are, and list two types. Why writecovenants into the debt contract? What happens if a firm violates a debt covenant?


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ASTEROID PICTURES,INC.

Asteroid Pictures is a movie studio that was founded in 1958 in Hollywood, California byMaxwell Roid. Earlier 2011, after over fifty years in the movie business, Maxwell Roid

decided to step down from the helm of the company and he handed the control of thestudio over to his grandson, Max (Rock) Roid III. On his first day as the new studio president, Rock is asked to decide if the studio should go forward with its plans toproduce a new movie. The movie, entitled Queens Speech, is a fictional drama abouthow a young queen overcomes her shyness to be able to address her subjects in public.Given the recent popularity of drama on the royal families, industry buzz is that themovie has great promise.

Rock has a sinking feeling in his stomach. He realizes that he has a decision to make.By the end of the day he has to determine if the studio should go forward and make themovie. Otherwise, the writers can take the script to another studio. Assume that once

Rock tells the writers he will make the movie, he cannot back out of his decision.

The Asteroid Files

Asteroid Pictures is privately held but recent estimates put the equity market value at $2billion and book value of debt equal to $1 billion and an average coupon of 5.5%. WhileRocks family owns a significant portion of Asteroid Pictures, Inc. they have a welldiversified portfolio of wealth. Recent gyrations in credit markets have pushed theasteroid bond prices down to a market value of $93.50 / $100 of face value. Asteroidscurrent credit rating is thought to be BBB. The companys marginal tax rate is 40%.Assume the company has other divisions that have positive pre-tax income. So if pre-taxincome is negative, it can be used to reduce the taxable income of these other divisions.

The studio has already invested $1.5 million into the movie by purchasing the right tobuy the script and bringing in actors and actresses to audition for the parts. If Asteroidbuys the script they would have to pay the script writers an additional $3 million whenthey start shooting the movie. The movie would be shot on location in four differentcountries and production costs are expected to be $50 million, all of which would berequired to be paid by the company when shooting for the movie began. Production costsinclude paying the director and the cast (the star, Natasha Poshman, alone would get $5million), travel and lodging costs expenses, and any fees associated with the use of theproperty where they would be shooting. Also included in the $50 million in productioncosts is $3.2 million for the crew (e.g., make-up people, grips, carpenters) who arecurrently under contract with the studio and will get paid money regardless if Asteroiddecides to make this picture or not. Not included in the production costs are the costumesused in the movie. These costumes originally cost $500,000 and were purchased for a previous movie Asteroid made several years ago. Asteroid has already agreed to sellthese costumes to a wax museum in Florida for $300,000. They plan to invest the fundsfrom the sale of these costumes in a project with relatively the same level of risk as theQueens Speech movie. If they make the movie they will have to postpone the sale of thecostumes for one year.


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The studios marketing people are estimating the movie would gross $45 million in thefirst year of release. In the following year, when Queens Speech is released on DVD,they expect to sell 500,000 DVDs. In the third year, DVD sales are projected to be250,000 DVDs. After year three, revenues from the movie should be close to 0. These

DVDs would be sold for $20 each and the cost to making the DVD would be $4 each.The company will require $100,000 worth of DVDs in inventory beginning 1 year fromtoday.

The Internal Revenue Service will allow Asteroid to depreciate the cost of the script andincremental production costs. The company plans on depreciating these costs to zeroover three years using the straight line method of depreciation. Also, the companyexpects to sell items from the production of the movie for $1,000,000 in year three andconsider this to be the salvage value from the project.

The company also expects that once the movie is released, the DVD sales of the other

movies they have made previously starring Natasha Poshman should also increase. If thestudio does not make Queens Speech, these other DVDs have annual net profits of $2million a year and would remain at that level forever. If they do make Queens Speech,in the first three years following the release of Queen Speech the net profits from theseother DVDs are predicted to increase to $3.5 million. After year three, net profits of theDVDs for other movies would return to $2 million a year. Ms. Poshman has made threemovies for another studio, not associated with Asteroid and the DVD sales of thesemovies are also expected to increase by $500,000 per year for three years following therelease of Queens Speech.

Rock also found a table of information about other companies in the folder labeled Table1.


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TABLE 1Queens Speech Project Data

MGM /Mirage

Casinos

Disney Pixar HarrahsCasinos

Book Equity 2.7 B 23.3 B .629 B 1.5 B

Book Debt 5.2 B 14.6 B 0.0 B 3.5 B

Average Coupon on LT Debt 6.7% 5.8% n.a. 7.0%

Shares Outstanding 155 M 1.95 B .05 B .11B

Stock Price per share $33.00 $18.15 57.70 $39.00

YTM on Recent Debt Issue n.a. 5.0% 0 5.8%

Bond Rating BB A n.a. BBB

Tax Rate 35% 35% 35% 35%

Annualized Volatility .40 .35 .42 .40

P/E 19 28 35 14P/Sales 1.3 1.4 16 1.1

Proportion in Film Business 50% 20% 90% 0.0%

Equity Beta(estimated w/ daily returns)

.90 1.10 1.00 .80

Equity Beta(Estimated w/ monthly returns)

1.20 .95 1.30 .90

Current Credit Market Conditions

Ten year BB Industrial Yield 6.50%Ten year AAA Industrial Yield 4.80%

Ten year Government Yield 4.10%

Two year Government Yield 3.00%


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Part III. YOURASSIGNMENT:DONT LET ASTEROID CRASH TO EARTH (40 POINTS)

1) (5 points) Discuss the issues you would want to consider in evaluating the debtcapacity of the Queens Speech film.

2) (5 points) Using these data, estimate the WACC Rock should use in evaluating this project. Explicitly state your reasoning behind your assumptions concerning theexpected market return.

3) (5 points) What discount rate or rates should Rock choose for his APV calculations?

4) Cash flowsa) (10 points) Estimate the relevant free cash flows for Rocks decision. Assume

that the expected annual inflation rate is 0%.b) (5 points) If the tax authorities give Asteroid Pictures a choice in calculating

annual depreciation, would they rather depreciate straight-line to zero or

depreciate to a salvage value of $1,000,000, why?. {Explain, no calculationsnecessary}

5) (10 points) Valuation of cash flows: Do you think Rock should go forward with thismovie? Calculate the value of the movie using the WACC method. Do the first partof the of the APV valuation of the movie, i.e. calculate the value without the taxshield of debt. Explain conceptually how you would calculate the tax shield of debt(no actual calculations needed). Do your calculations so far allow you to see what thevalue of the tax shield of debt might be?

Part IV. Provide short answers to the following questions. Each question is worth 4points.

Question 1. Carefully discuss the differences between the sustainable rate of growth andthe economic value added.

Question 2. Carefully discuss the differences between free cash flow, capital cash flow,and equity cash flow.

Question 3. Carefully discuss the pros and cons associated with WACC and APVapproach.

Question 4. Carefully discuss the pros and cons associated with the discounted cash flow(DCF) valuation approach and multiple-based approach.

Question 5. Carefully discuss the potential biases associated with the Equity Cash Flow(ECF) valuation approach and potential fixes.


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Formula Sheet #1

Days of Inventory = 365(Inv /COGS)

Collection Period = 365(AR /Sales)

Payables Period = 365((AP+Trade Credit) /Purchases)Gross Profit Margin = (Sales-COGS)/SalesNet Profit Margin = (EBIT-Tax)/SalesROE = Growth in Net Worth = Net Income / Net Worth (Last Period)ROA = Net Income / Total Assets (Last Period)

V(with debt) = V(all equity) + PV[tax shield] Expected Bankruptcy Costs

PV[tax shield] = t*Dt = corporate tax rateD = (an estimate of) the market value of the firms debt.

LeverageTurnoverAssetMarginProfit

NW

Assets

Assets

Sales

Sales

NILeverageROAROE vv!v!

NW

Assets

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Formula Sheet #2

AssetsNetinChange-EBITt)(1FCF

NWCinChange-CAPX-onDepreciatitEBITDt)(1FCF

NWCinChange-CAPX-onDepreciatiEBITt)(1FCF

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Formula Sheet #3

If D is expected to remain stable, then discount tkDD using kD

PVTS = tkDD/ kD= tD

If D/V is expected to remain stable, then discount tkDD using kAPVTS = tkDD/ kA

Terminal value at liquidation: SV*(1- t) + t*PPE + Recovery of net working capital

Terminal value at continuation without growth: TVT = FCFT+1 / k

Terminal value at continuation with growth: TVT = FCFT+1 /(k - g)

EVA = EBIT*(1 - t) - k*NA

Capital Cash Flows: Take Net Income (builds in tax shields directly). Add depreciation and special charges. Subtract change in NWC. Subtract incremental investment. Add interest.

Equity Cash Flows:

The size of bias under the equity cash flow valuation approach:

EBITless: Interest

Income before taxes

less: Taxes

Net income

plus: Depreciation

less: Capital expenditures

less: Increase in NWC

less: Principal repayments

plus: New borrowing

Equals: Equity Cash Flows

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Practice Final Comm371