Mid-Term Examination NAME_______________________________________

FI 500 Summer 2011Pacific States University

Stock price $25Strike/Exercise price $30Market price of optio 5.50

Exercise value of opt $0.00

Premium value $5.50

Exercise value is what the option wouth be worth if it expired immediately.

Question 1. (15 points) The exercise price on one of ORNE Corporation's put options is $30 and the price of the underlying stock is $25. The option will expire in 25 days. The option is currently selling for $5.50.

a. Calculate the option's exercise value?

b. Calculate the value of the premium over and above the exercise value? Why would an investor pay more than the exercise value for the option.

c. Is this an out-of-the money option, at-the-money, or in-the-money? Why?

out the money because strike price exceeds the current stock price

d. What will happen to the value of the option if the underlying stock price changes to $24? Why?

It will remain zero because stock price still smaller than strike price

e. Would the value of the option likely be higher, lower, or the same if the option had 60 days to expiration instead of 25? Why?

For the longer expiration day, the value of the option would likely be lower. ( expectation)

c. Is this an out-of-the money option, at-the-money, or in-the-money? Why?

out the money because strike price exceeds the current stock price

d. What will happen to the value of the option if the underlying stock price changes to $24? Why?

It will remain zero because stock price still smaller than strike price

e. Would the value of the option likely be higher, lower, or the same if the option had 60 days to expiration instead of 25? Why?

For the longer expiration day, the value of the option would likely be lower. ( expectation)

NAME_______________________________________

document.xls 2

Michael C. Ehrhardt Page 4 04/09/2023

Question 3. (10 points) A company estimates the following free cash flows (FCFs) during the next 3 years, after which FCF is expected to grow at a constant 6% rate. The company's cost of capital is 12%. the company has $3 million in marketable securities, $50 million in debt, and 10 million shares of stock.

Calculate the value of operations Actual Year1 2 3

Long-term growth rate 6%Weighted Avg. Cost of Cap. (WACC) 12.00%Free Cash Flow( mil. $) -$5.00 $15.00 $30.00

Find the horizon value.

a. Horizon Value (Value at year 3) 530.00

Find the PV of the horizon value and of the free cash flows.

PV of Horizon Value @ WACC $377.244 PV of free cash flows @ WACC $28.847

b. Value of Operations $406.09

Find the total value of the firm.Value of operations $406.09 Plus: Value of nonoperating assets $3.00

Total value of firm $409.09

Find the value of equity.Total value of firm $409.09 Minus: Value of debt $50.00 Minus: Value of preferred stock $0.00

Value of equity $359.09

Find the price per share.

Value of equity $359.09

Divided by number of shares 10

c. Price per share $35.91

d. The stock is selling for $32.50. Is it appropriately priced in the market? Explain.

The horizon value is the value as of year 3 of all the free cash flows in year 4 and beyond, discounted back to year 3. The formula is: Hvyear 3 = [FCFyear 3 * (1+g)] / [ WACC - g]

document.xls 2

Michael C. Ehrhardt Page 5 04/09/2023

There are 2 reasons:

1 P/S is used for long term period but stock is selling by using daily price( it can increase/decrease)

2 Company over evaluate its P/E in order to increase its value.

document.xls 2

Michael C. Ehrhardt Page 6 04/09/2023

Question 3. (10 points) A company estimates the following free cash flows (FCFs) during the next 3 years, after which FCF is expected to grow at a constant 6% rate. The company's cost of capital is 12%. the company has $3 million in marketable securities, $50 million in debt, and 10 million shares of stock.

document.xls 2

Michael C. Ehrhardt Page 7 04/09/2023

P/S is used for long term period but stock is selling by using daily price( it can increase/decrease)

document.xls 2

Michael C. Ehrhardt Page 8 04/09/2023

Question 3. (10 points) A company estimates the following free cash flows (FCFs) during the next 3 years, after which FCF is expected to grow at a constant 6% rate. The company's cost of capital is 12%. the company has $3 million in marketable securities, $50 million in debt, and 10 million shares of stock.

Mid-Term ExaminationFI 500 Summer 2011

Pacific States University

(Mil. USD)Net Income $ 8 Pay out ratio 55%Debt ratio 45%New investment $ 20

Retain Earning 3.6Total equity required 11New external equity needed 7.4

Question 4. (15 points) Pierre Imports has a capital budget of $20 million. It wants to maintain a capital structure of 45 percent debt and 55 percent equity. This year it expects net income of $8 million.The company has 30 million authorized shares, and 10 million are outstanding. Last year the company paid a dividend of $0.20 per share.

a. How much equity does the company need to raise?

d. What are the advantages of following a residual dividend policy?The primary advantage of the residual policy is that under it the firm makes maximum use of lower cost retained earnings, thus minimizing flotation costs and hence the cost of capital.

e. What are the disadvantages of following a residual dividend policy? negative signals are associated with stock issues would be avoided.

c. How much external equity will the company require if it pays the same dividend as last year?

b. How much external equity does the company need to raise if it follows a residual dividend policy?

d. What are the advantages of following a residual dividend policy?The primary advantage of the residual policy is that under it the firm makes maximum use of lower cost retained earnings, thus minimizing flotation costs and hence the cost of capital.

e. What are the disadvantages of following a residual dividend policy? negative signals are associated with stock issues would be avoided.

Spot 115 1.81 11.130-day forward 112 1.82 11.390-day forward 110 1.84 11.4180-day forward 108 1.845 11.5

a. Is the U.S. dollar appreciating or depreciating against the Japanese yen? Explain.

US dollar is depreciating vs Japanese yen because 1 US dollar is buying fewer Japanese Yen

Is the U.S. dollar appreciating or depreciating against the British pound? Why?

Us Dollar is depreciating vs British Pound because 1 pound is buying more Us dollars

c. Is the U.S. dollar appreciating or depreciating against the Mexican peso? Why?

Appreciating because 1 us dollar is buyng more mexican peso.

d. The U.S. company orders merchandise from companies in Japan, Britain, and Mexico, and pays in the foreign currency of each country at the end of 3 months. From a foreign exchange standpoint, would it be to the advantage of the U.S. company to pay now instead of waiting 3 months? Why or why not?

In Japan : wait 3month because forward rate<spot rateBritain Pay now because spot rate<forward rateMexico Pay now because spot rate<forward rate

e. Who bears the foreign exchange risk, the U.S. company or the foreign suppliers? Explain.

Exchange risk is simple in concept: a potential gain or loss that occurs as a result of an exchange rate changeIt will depend on the exchange rate change.

U.S. Dollar / Japanese yen

(indirect)

British Pound / U.S. Dollar

(direct)

U.S. Dollar / Mexican Peso

(indirect)

Question 5. (15 points) Exchange rates for several countries are shown below. The MLC Company which is based in the U.S. does business with companies in those countries. The rates are shown as direct or indirect from the standpoint of the U.S. Company.

d. The U.S. company orders merchandise from companies in Japan, Britain, and Mexico, and pays in the foreign currency of each country at the end of 3 months. From a foreign exchange standpoint, would it be to the advantage of the U.S. company to pay now instead of waiting 3 months? Why or why not?

Exchange risk is simple in concept: a potential gain or loss that occurs as a result of an exchange rate change

d. The U.S. company orders merchandise from companies in Japan, Britain, and Mexico, and pays in the foreign currency of each country at the end of 3 months. From a foreign exchange standpoint, would it be to the advantage of the U.S. company to pay now instead of waiting 3 months? Why or why not?

$740,061.43

New Equipment cost $1,000,000 New Equipment life 5Equip. Salvage Value $0 Tax Rate 30%Loan interest rate 11%Annual rental charge $230,000 Depreciation MACRSAfter-tax cost of debt 7.70%

NPV LEASE ANALYSIS

Year = 0 1 2 3 Cost of OwningEquipment cost ($1,000,000)Loan amount $1,000,000 Interest expense ($110,000) ($110,000) ($110,000)Tax savings from interest 33,000 33,000 33,000 Principal repaymentDepreciation (based on 3 years MACRS table) 330,000 450,000 150,000 Tax savings from depreciation $99,000 $135,000 $45,000 Net cash flow $0 $22,000 $58,000 ($32,000)PV ownership cost @ 7.7% ($740,061.43)Cost of Purchasing $740,061

($230,000) ($230,000) ($230,000) ($230,000)Tax savings from lease $69,000 $69,000 $69,000 $69,000 Net cash flow ($161,000) ($161,000) ($161,000) ($161,000)PV of leasing @ 7.7% ($697,832.79)Cost of Leasing $697,833

PV ownership cost @ 7.7% ($740,061.43)PV of leasing @7.7% ($697,832.79)Net Advantage to Leasing $42,228.64 LEASE because Cost of leasing< Cost of purchase

Cost of LeasingLease payment (beginning of the year)

Cost Comparison

Question 6. (15 points) Thomas Corporation is evaluating whether to lease or purchase equipment. Its tax rate is 30 percent. The company expects to use the equipment for 5 years, with no expected salvage value. The purchase price is $1 million and MACRS depreciation, 3-year class, will apply. If the company enters into a 5-year lease, the lease payment is $230,000 per year, payable at the beginning of each year. If the company purchases the equipment it will borrow from its bank at an interest rate of 11 percent.

a. Calculate the cost of purchasing the equipment.

4 5

($110,000) ($110,000) 33,000 33,000

($1,000,000) 70,000

$21,000 ($56,000) ($1,077,000)

($230,000)$69,000

($161,000)

because Cost of leasing< Cost of purchase

Question 6. (15 points) Thomas Corporation is evaluating whether to lease or purchase equipment. Its tax rate is 30 percent. The company expects to use the equipment for 5 years, with no expected salvage value. The purchase price is $1 million and MACRS depreciation, 3-year class, will apply. If the company enters into a 5-year lease, the lease payment is $230,000 per year, payable at the beginning of each year. If the company purchases the equipment it will borrow from its bank at an interest rate of 11 percent.

a. Calculate the cost of purchasing the equipment.

Par value = $1,000.00Conversion price = $25.00Stock price = $20.00

Conversion ratio = 40

Conversion value = $800.00

b. If stock price $23

Bond price $920.00

Stock price increase will lead to bond price increase.

c. Total mkt value 1400

d. Does the company's balance sheet change at the point the bondholders convert their bonds to common stock? Explain?

NO because Total equit& Liability same

d. Does the company's balance sheet change at the point the bondholders convert their bonds to common stock? Explain?