Practice Final Exam: Good Luck!
Practice Final Exam: Good Luck!
Practice Final Exam: Good Luck!
Before you do anything else, write your name at the top of every page of the exam.
This exam is worth 35% of your final grade. The work on this exam must be entirely your own. The
exam is closed book and closed notes. You may use your own formula sheet. Calculators, financial or
otherwise, are allowed during the exam.
In problems which ask you to calculate something, first write out the appropriate formula and then fill in the
relevant information which you use to calculate the answer to the question. Provided that you have used the
correct formula and filled-in the correct information, you will receive most of the credit for the question.
Answers that do not show how you arrived at the answer will receive little or no credit.
If a question asks "why?" or instructs you to "explain," you should give a complete and meaningful
explanation that would convince a skeptic.
Please try to write only in the space provided for each question. If you really need more space, continue on
the back of the page. Be clear and concise in your answers (remember: if I can’t read it, I can’t give you
credit!). There are 100 points on this exam and each question's point value is marked.
If you do not know how to do something, try breaking-it down into doable pieces. If you still don't know
what to do, move on to another question. There are a variety of questions on the exam and they are not in
order of difficulty. Remember to stay calm—you know more than you think. More often than not, your
mind’s first unfettered response to a question will lead you in the right direction.
Name:___________________________________
Good luck!
NAME_____________________
1. Define portfolio diversification and explain how it benefits from imperfectly correlated assets. [8]
2. What is the difference between systematic and non-systematic risk? Which risk is priced? Why? [8]
Non-systematic risk – asset-specific risk, which can be eliminated via diversification.
Systematic risk – portion of asset’s volatility that is common to the market and cannot be
eliminated via diversification.
Investors can eliminate non-systematic risk simply by holding a diversified portfolio (e.g. a
tracking stock for a broad market index). Since non-systematic risk can be eliminated nearly
costlessly, investors are not compensated for bearing this risk. However, systematic risk cannot
be diversified away, and investors require a compensation for their exposure to this risk
3. How does capital structure affect firm value? Compare your answer to capital structure in a perfect
world (Modigliani and Miller). [8]
Capital structure affects firm value through: (1) Tax shields - Higher leverage and interest
payments generate tax savings for the firm, thereby increasing firm value; (2) Bankruptcy
costs - Higher leverage increases the risk of incurring costs of financial distress, thereby
reducing firm value. The optimal capital structure minimizes the WACC and maximizes firm
value.
In a perfect world, with no taxes, no transaction costs, no information asymmetry, and where
individuals and companies have the same interest rate, capital structure does not affect firm
value. The reason is that if there are no transaction costs and tax shields, investors can create
home-made leverage and replicate any leverage of the firm. Therefore, managers cannot create
value by changing capital structure
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NAME_____________________
If you need extra space, please use the back of each page.
Your company’s target capital structure consists of 45% debt and 55% equity. The firm’s unlevered beta is
1.2. The risk-free rate is 5%, the expected market return is 10%, and the tax rate is 40%. If the firm’s WACC
is 10.1%, what is the firm’s pre-tax cost of debt?
Assume that the CAPM holds, the risk-free rate is 3%, and the market risk premium is 7%. Stock A has an
expected return of 10%. Stock B has a beta of 1.2 and a standard deviation of 0.4. Stock C has twice as
much exposure to systematic risk as stock B. If you put 30% of your money in A, 40% in B and 30% in C,
what will the beta of your portfolio be?
. . . . . . %
. . . . . . . . . .
.
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NAME_____________________
a) Compute the equity beta of stock X and the correlation between stock X and the market. [8]
β x = (ρx,m * σx) / σm
σx = 3σm
2.5714 = (ρx,m * 3σm) / σm => ρx,m = 0.8571 = 85.71%
b) Stock X is currently trading at $100 and pays no dividends. An equity analyst has a one-year target
price of $121 for this stock. If the analyst’s forecast holds true, what alpha will be earned next year by
a portfolio that has a beta of 0.8 and is invested in stock X and the risk-free asset? (Assume next year’s
market return and the risk-free rate will be 11% and 4%, respectively.) [8]
First, compute the weights of stock X and the risk-free asset in the portfolio:
Next year return on stock X according to the analyst: rx = (P1 – P0) / P0 = (121 – 100) / 100 = 21%
Next year return on the portfolio: r portfolio = Wx * rx + Wrisk-free * rrisk-free
r portfolio = 0.3111 * 0.21 + 0.6889 * 0.04 = 0.0929 = 9.29%
Now, we can calculate the alpha by subtracting the CAPM expected return:
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NAME_____________________
The company’s debt consists of 180,000 bonds, which have a face value of $1,000 per bond, mature in 5
years, and pay an annual coupon of 6%. The yield-to-maturity on these bonds is 7%. The management’s
target capital structure is 25% debt and 75% equity.
Assume that the company does not have non-operating assets. Other financial information, industry
comparables, and the forecast of free cash flows are summarized below. The tax rate for Liberty and all peer
companies is 40%, the risk-free rate is 4%, and the expected market return is 11%.
To guide you through the solution, the problem is broken down into four parts – a through d.
a. What is the TTM free cash flow of Liberty? Please use the table below. [6]
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NAME_____________________
b. Based on its peers, what is Liberty’s equity beta? Please use the table below. [6]
c. What is Liberty’s cost of equity according to the CAPM? What is its WACC? [6]
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NAME_____________________
d. What is Liberty’s enterprise value, equity value, and price per share according to the DCF method?
Please use the table below. [6]
Year 0 1 2 3
FCF growth rate N/A 12% 7% 4%
Nominal FCF, $mil 50 56 59.92 62.32
Discounted FCF @ 11.35% 50 50.29 48.33 45.14
Sum of discounted FCFs - 143.76