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COMM371 Theory of Finance

Practice Final Exam

Wayne T. Penn sat back in his extremely comfortable chair in his extremely
comfortable 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 could
smell them too. Mr. Penn thought back on his last few years as Chief Financial Officer of
Apex Drugs and Products. By 2010, Apex had become a major player in prescription
drugs 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 Chef
Girlardee 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 in
the volatile drug industry. Most of its new products were acquired or licensed after their
development by other firms. Others were copies and clever extensions of products
introduced by competitors. Apexs success was built on its expertise in marketing, which
eroded its competitors head start, and on cost control, which ensured substantial
margins. 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 liabilities
511.60 565.70 670.50 758.40 883.60
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 extremely
comfortable chair in his extremely comfortable office, Mr. Penn fell asleep.
Cash and equivalent 593.3
A/P and other non-interest
bearing liabilities 883.6
A/R 517.3 Long-term + short-term debt 13.9
Inventory 557.3 Total liabilities 897.5
PPE 450.5 Net Worth 1,472.8
Other 251.9
Total assets 2,370.3 Total liabilities + 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. Each
question 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 discussion
should 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? If
yes, explain its merits relative to alternative capital structures. If not, discuss this
capital structures main drawbacks, as well as the relative merits of the different
possible 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. He
realized that all industries undergo change at some point and the pharmaceutical industry
was no different. The Harper administration was threatening the industry with tighter
regulation with measures increasing the control of prices, and favoring the development
and diffusion of generic drugs. At the same time, some of Apexs most profitable patents
were 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 more
traditional ones. Developing these new drugs, as well as building up expertise in the new
industry, was bound to require a considerable R&D effort.

3) Mr. Penns quick forecast was that Apexs sales were likely to grow 11% the
following year, but that its margins (net income/sales) were likely to fall to 7%. He
wondered what his capital structure would look like the following year given that he
did not want to cut the dividend ratio, or issue equity. Please help Mr. Penn out with
these 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 think
Apexs 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 in
bankruptcy? Explain how this works!

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

Question 3. Suppose a firm which has filed for bankruptcy has a complicated capital
structure. There are two classes of stock: ordinary shares and preferred shares. There are
also 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 use
the proceeds to repay the firms claimants. However, the money raised is not enough to
repay all claims in full. What is the priority rule the judge should use in deciding how to
allocate the proceeds from the liquidation?

Question 4. Consider a firm with two types of bonds outstanding: junior unsecured debt
and 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 write
covenants 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 by
Maxwell 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 the
studio 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 to
produce a new movie. The movie, entitled Queens Speech, is a fictional drama about
how 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 the
movie 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 the
movie. 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 $2
billion and book value of debt equal to $1 billion and an average coupon of 5.5%. While
Rocks family owns a significant portion of Asteroid Pictures, Inc. they have a well
diversified portfolio of wealth. Recent gyrations in credit markets have pushed the
asteroid bond prices down to a market value of $93.50 / $100 of face value. Asteroids
current 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-tax
income 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 to
buy the script and bringing in actors and actresses to audition for the parts. If Asteroid
buys the script they would have to pay the script writers an additional $3 million when
they start shooting the movie. The movie would be shot on location in four different
countries and production costs are expected to be $50 million, all of which would be
required to be paid by the company when shooting for the movie began. Production costs
include paying the director and the cast (the star, Natasha Poshman, alone would get $5
million), travel and lodging costs expenses, and any fees associated with the use of the
property where they would be shooting. Also included in the $50 million in production
costs is $3.2 million for the crew (e.g., make-up people, grips, carpenters) who are
currently under contract with the studio and will get paid money regardless if Asteroid
decides to make this picture or not. Not included in the production costs are the costumes
used 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 sell
these costumes to a wax museum in Florida for $300,000. They plan to invest the funds
from the sale of these costumes in a project with relatively the same level of risk as the
Queens Speech movie. If they make the movie they will have to postpone the sale of the
costumes for one year.
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The studios marketing people are estimating the movie would gross $45 million in the
first 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 be
250,000 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 from
today.

The Internal Revenue Service will allow Asteroid to depreciate the cost of the script and
incremental production costs. The company plans on depreciating these costs to zero
over three years using the straight line method of depreciation. Also, the company
expects to sell items from the production of the movie for $1,000,000 in year three and
consider 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 the
studio does not make Queens Speech, these other DVDs have annual net profits of $2
million 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 these
other DVDs are predicted to increase to $3.5 million. After year three, net profits of the
DVDs for other movies would return to $2 million a year. Ms. Poshman has made three
movies for another studio, not associated with Asteroid and the DVD sales of these
movies are also expected to increase by $500,000 per year for three years following the
release of Queens Speech.

Rock also found a table of information about other companies in the folder labeled Table
1.


















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TABLE 1
Queens Speech Project Data








MGM /
Mirage
Casinos
Disney Pixar Harrahs
Casinos
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 14
P/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. YOUR ASSIGNMENT: DONT LET ASTEROID CRASH TO EARTH (40 POINTS)

1) (5 points) Discuss the issues you would want to consider in evaluating the debt
capacity 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 the
expected market return.

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

4) Cash flows
a) (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 calculations
necessary}

5) (10 points) Valuation of cash flows: Do you think Rock should go forward with this
movie? Calculate the value of the movie using the WACC method. Do the first part
of the of the APV valuation of the movie, i.e. calculate the value without the tax
shield 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 the
value of the tax shield of debt might be?


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

Question 1. Carefully discuss the differences between the sustainable rate of growth and
the 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 APV
approach.

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)/Sales
Net Profit Margin = (EBIT-Tax)/Sales
ROE = 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*D
t = corporate tax rate
D = (an estimate of) the market value of the firms debt.

Leverage Turnover Asset Margin Profit
NW
Assets
Assets
Sales
Sales
NI
Leverage ROA ROE - - = - =
NW
Assets
Assets
NI
d) (1
NW
NI
d) (1 ROE d) (1 g - - = - = - =
-
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Formula Sheet #2







Assets Net in Change - EBIT t) (1 FCF
NWC in Change - CAPX - on Depreciati t EBITD t) (1 FCF
NWC in Change - CAPX - on Depreciati EBIT t) (1 FCF
- =
- + - =
+ - =
. J . J )
f m a f Assets A
r r E r r E r + = =
E D
E
k
E D
D
t k WACC
E D
+
+
+
= ) 1 (
D E
D

D E
E

D E A
+
+
+
=
)
D A A E
(
E
D
+ =
E D

V
E

V
D
+ =
A
E D A
r
V
E
r
V
D
r + =
g WACC
=
1
FCF
MV
g k
E

=
1
E
P
10

Formula Sheet #3


If D is expected to remain stable, then discount tk
D
D using k
D

PVTS = tk
D
D/ k
D
= tD

If D/V is expected to remain stable, then discount tk
D
D using k
A

PVTS = tk
D
D/ k
A


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

Terminal value at continuation without growth: TV
T
= FCF
T+1
/ k

Terminal value at continuation with growth: TV
T
= FCF
T+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:

EBIT
less: 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

=
T
t
t
r
M r R
G
1
) 1 (
) (