Principle of Finance

ESSEC        T1

Pre-M.Sc. Finance        October-December 2015

FING 31081 FINANCE REFRESHER

Final Exam: solutions

The time limit for the final exam is 2h30. Answer directly on this sheet. During the calculations, explain each of your steps and assumptions clearly: getting the “exact” figure is not important by itself. Good luck!

1. (3 points) Please comment on the following sentences (10 lines each maximum):

“The average debt to total capital ratio in the computer industry is quite low, around 7%. According to the tradeoff theory, software firms are acting sub optimally, they should increase their leverage to benefit more from the debt tax shield”

Solution:

False. In the tradeoff theory, companies trade off the tax benefits of debt and the expected bankruptcy costs. These latter are likely to be quite high in the computer industry due to the importance of intangibles (R&D…), so computer firms have a valid reason to be cautious in taking on more debt.

1. (6 points) You just got a new job as an investment banking analyst. At 7:15 am, your boss drops on your desk the following report concerning three stocks:

In addition to this information, you know that the firms have constant retention ratios, constant returns on investment and do not issue extra equity. The discount rate required by investors is 15% for the internet industry and 10% for the metallurgic industry. Your boss wants you to answer a couple of questions (quantify your answers properly).

1. (1 point) “Which of these companies does the market think will grow more rapidly: Atrazon or Yipee.com?”

1. (3 points) “One of our clients is thinking of issuing shares of his company, which is in Internet Industry. We know that the company has managed so far to enjoy returns of 16% on their investments and is expected to do so in the future. If he sells the shares, he will implement a policy of reinvesting 75% of the firm’s earnings in the business every year starting from the end of this year (year 0). The company‘s current EPS is

10. Assume the new shareholder will not receive the dividend of this year. What is the price-earning ratio of this company based on Gordon Growth Model? By comparing the growth rate and payout ratio, how do you think the price-earning ratio of this company compares to the price-earning ratio of Atrazon?”

1. (2 point) “The CEO of Old Steel Co. has just called me. The ROE of the company has recently been as low as 8%. He has been recently criticized by the investment community, which wants him to pay out as much money as possible to his investors. They claim this would increase the firm’s share price. Are they right? Give me the numbers.”

Solution:

1. Use the Gordon Model P0 = Div 1 . Then

[pic 1]

r  − g

Yipee.com: 20 =

0.25

[pic 2]

0.15 − g

⇔ g = 0.1375

Atrazon: 48 =

1.2

[pic 3]

0.15 − g

⇔ g = 0.125

The market expects Yipee.com to grow faster.

1. Estimate the necessary parameters: (1-p) = 0.75

g = (1-p) · ROE = 0.75 · 0.16 = 0.12

div1 = p · EPS1 = p · EPS0 · (1+g) = 0.25 · 10 · 1.12 = 2.8 P0 = 2.8 / (0.15 – 0.12) = 93.3333 P0/E0=93.3333/10=9.333