MGT 2281 Fall 2019

Assignment Solution Outline

QUESTION 1

Hickock Mining is evaluating when to open a gold mine. The mine has 48,000 ounces of gold left that can be
mined, and mining operations will produce 6,000 ounces per year. The required return on the gold mine is 12
percent, and it will cost $34 million to open the mine. When the mine is opened, the company will sign a contract
that will guarantee the price of gold for the remaining life of the mine. If the mine is opened today, each ounce
of gold will generate an after-tax cash flow of $1,400 per ounce. If the company waits one year, there is a 60
percent probability that the contract price will generate an after-tax cash flow of $1,600 per ounce and a 40
percent probability that the after-tax cash flow will be $1,300 per ounce. What is the value of the option to wait?

The remaining life of the mine = 48,000 ounces / 6,000 ounces per year = 8 years
The after-tax cash flow per year if opened today is: After-tax CF = 6,000 × $1,400 = $8,400,000
So, the NPV of opening the mine today is:
.
NPV = –$34,000,000 + $8,400,000 * = $7,728,174.04
.
If you open the mine in one year, the cash flow will be either:
CFUp = 6,000 × $1,600 = $9,600,000 per year
CFDown = 6,000 × $1,300 = $7,800,000 per year

The PV of these cash flows is:

.
Price increase CF = $9,600,000 * = $47,689,341.76
.
.
Price decrease CF = $7,800,000 * = $38,747,590.18
.
NPV in one year = –$34,000,000 + [(0.60 × $47,689,341.76) + (0.40 × $38,747,590.18)]
NPV in one year = $10,112,641.13

NPV today = $10,112,641.13 / 1.12 = $9,029,143.87

Value of the option to wait = $9,029,143.87 – $7,728,174.04 = $1,300,969.83

QUESTION 2

Applied Nanotech is thinking about introducing a new surface-cleaning machine. The marketing department
has estimated that Applied Nanotech can sell 15 units per year at $305,000 net cash flow per unit for the next
five years. The engineering department has estimated that developing the machine will take a $15 million initial
investment. The finance department has estimated that a 16 percent discount rate should be used.
a. What is the base-case NPV?

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 b. If unsuccessful, after the first year the project can be dismantled and will have an after-tax salvage
value of $11 million. Also, after the first year, expected cash flows will be revised up to 20 units per
year or to 0 units, with equal probability. What is the revised NPV?
a. The annual cash flow for the project is the number of units sold times the cash flow per unit, which
is:
Annual cash flow = 15 units × $305,000 = $4,575,000
The cash flows from this project are an annuity, so the NPV is:
.
NPV = –$15,000,000 + $4,575,000* = –$20,106.53
.

b. The company will abandon the project if unit sales are not revised upward. If the unit sales are revised
upward, the after-tax cash flows for the project over the last four years will be:
New annual cash flow = 20 units × $305,000 = $6,100,000

The NPV of the project will be the initial cost, plus the expected cash flow in year one based on 15
unit sales projection, plus the expected value of abandonment, plus the expected value of cash flow
after year one for next four years on 20 units sales projection. We need to remember that the
abandonment value occurs in year one, and the present value of the expansion cash flows are in year
one, so each of these must be discounted back to today. So, the project NPV under the abandonment
or expansion scenario is: NPV = - $15,000,000+$4,575,000 /1.16+0.50×($11,000,000)/1.16
.
+[0.50×$6,100,000( )] /1.16 = $1,042,630.13
.

QUESTION 3

ABC Ltd. pays out all earnings as dividends and has no growth. Its current earnings per share is $5.00 in
perpetuity. It has a new opportunity that requires an investment of $5/share per year for the next two years. This
opportunity will increase the earnings per share by $2.5 in the third year and this increment will grow at a rate
of 5% per year. The required rate of return on equity for the firm is 20%. What would be the value per share of
ABC's stock if it does not undertake the project? What would the value per share if the company undertakes the
project?
If the firm does not undertake investment, then: P0 = EPS/r = 5/0.2 = $25
If the firm undertakes the investment, then: P0’ = EPS/r + NPVGO

NPVGO = -5/1.2+(-5)/1.2^2+2.5/(.2-.05)/1.2^2=3.94 then: P0’ = 25+3.94= $28.94

QUESTION 4

Suppose you are hired by a company to advise it on a potential takeover of another company in a somewhat
different (but not completely different) product line. Explain a good procedure for estimating the value of the
potential takeover. In your discussion, describe (1) appropriate measures of the riskiness of this venture; (2)

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how these risks get reflected in the discount rate; and also (3) comment on the measure beta and its advantages
and disadvantages as a risk measure.
Refer to class notes and discussions. Below is a sample discussion.

Value of a company could be estimated in several different ways; however the most common approach is
discounted cash flows. The acquiring company should (1) forecast the future cash flows of the target company
and (2) discount the cash flows using a rate that properly reflects the risk of the target company.

As risk increases, the discount rate should increase and the value of the target should decrease. Examples of
risk measures are: variability of cash flows, industry-adjusted variability of cash flows, probability of losses
and, most importantly, beta.

Beta is defined as the covariance of the firm’s undiscounted cash flows and the market portfolio’s cash flows
scaled by the variance of the market’s cash flows (it could also be calculated using returns instead of cash flows)
𝐶𝑜𝑣 𝑈𝐶𝐹, 𝑀𝑎𝑟𝑘𝑒𝑡
𝛽
𝜎
Advantages of beta:
• Derived from portfolio theory
• Easy to calculate
• Objective measure of risk
• Systematic measure of risk
• Comparable across firms
• Widely used by market participants

Disadvantages:
• No guidance on the length of the period (i.e. number of observations) necessary to get a good
estimation
• Usually need a relatively large number of observations
• Need to define what is the proper “market portfolio”
• Assumes perfect capital markets where all unique risk is diversified away.
• Finally, note that the CAPM framework estimate includes financial synergies but provides little
guidance on operating synergies.

QUESTION 5

XYZ Co. is thinking of acquiring another company as a scale-expansion project. The target firm has a market
value debt-to-equity ratio of 1.0, an equity beta of 1.50, and EBIT of $39 million per year. XYZ Co. has a capital
structure of 60% equity and 40% debt, and if it acquires the target firm, will keep the current capital structure.
The risk free rate is 8%, the market risk premium is 8.5%, and the corporate tax rate is 34%. Assume that all
debt is risk free and that both firms are non growth firms. Answer the following 4 questions.
(1) What is the value of the target firm’s debt and equity?

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(2) What is the target firm’s unlevered beta and unlevered cost of equity?
(3) What discount rate should XYZ Co. use to calculate the NPV of this Acquisition?
(4) What is the highest price that XYZ Co. should pay for the target firm?

(1)
The total value of the target firm can be found by discounting the after-tax earnings at the
weighted average cost of capital. Then, given the debt-to-equity ratio, we can find the value of
the film's debt and film's equity. The film's cost of equity is determined from the CAPM,
rS=8%+1.5*8.5%= 20.75%. The firm's debt is risk free, thus rB = 8%. The W ACC is:
WACC = (D/(E +D)) rB(1- Tc)+ (E/(E +D)) rS
WACC = 0.5(8%)*(1-0.34) + 0.5*(20.75%) = 13.015%
The target firm's value is:
Value = 39*(1-0.34)/0.13015 = $197.77million
Thus, given D/S = 1, then D = 98.885 miliion and S = 98.885 million for the target firm.

(2)

𝛽 𝛽 1 1 𝑇  𝛽 𝛽/ 1 1 𝑇

βU =1.5/(1+(1-0.34)*0.5/0.5) = 0.9036, Then 𝑟 = 8% +0.9036*(8.5%) = 15.68%

Also note that we can find 𝑟 from MM prop. II with taxes:

rS = 𝑟 + D/E(𝑟 - rB)(l - Tc)

0.5
20.75% 𝑟 𝑟 – 8% 1 0.34  20.75% .66 8% 1.66𝑟
0.5
 𝑟 = 15.68%

(3)
The appropriate discount rate should reflect the risk of the project, or target firm in this case.
Since both XYZ and the target film are in the same line of business, the business risk of both
firms is the same. XYZ could use the unlevered cost of equity from part (2) with the APV method
and add the present value of the interest tax shield and any other financing side effects. XYZ
could also discount the target's cash flow at a WACC that reflects XYZ's capital structure. In
this approach, the equity beta reflecting XYZ's financial risk is:
.
𝛽 𝛽 1 1 𝑇 , 𝛽 0.9036  𝛽 0.9036 1 1 .34 1.3012
.

The cost of equity is:

rs = 8%+ 1.3012 (8.5%) = 19.06%
The WACCis:
WACC = 0.4(8%)(1-0.34) + 0.6(19.06%) = 13.55%
XYZ could use this rate to discount the after-tax earnings.

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 (4)
The most that XYZ should pay is the price that makes NPV = O. Discounting the target finn's
cash flow at the WACC from part (3), we find:
V(to XYZ) = 39*(1- 0.34)/ 13.55% = $189.96 million

Note that with XYZ's capital structure, the value of the target film to XYZ is less than the current
market value ($197.77million) of the target firm.

QUESTION 6

Zeta Co. is just paid a dividend of $0.50. The dividend is expected to grow at a rate of 15% per year for the next
3 years as the firm goes through a period of rapid growth. After that, it is expected to grow at an average rate of
5% per year forever. The covariance between the equity return of the company and that of the market return is
0.5. The expected return of market portfolio is 10%. The variance of return on the market portfolio is 0.2. The
government Treasury bill yields 3%. What is the value of a share of ABC Co.? Assume the CAPM holds.
βZeta = cov(rZeta, rm)/var(rm) = 0.5/0.2 = 2.5

The discount rate: rZeta = rf + βZeta (rm-rf) = 3%+2.5*(10%-3%) = 20.5%

Stock price: P0=∑ 𝐷𝑖𝑣 / 1 𝑟 =0.5*1.15/1.205+0.5*1.15^2/1.205^2

+0.5*1.15^3/(1.205^2*(.205-.05))=4.31
QUESTION 7

a) A new venture can be started at an investment cost of $1000. The venture would generate an expected free
cash flow of either $300 or $50 in the first year (one year from now). The probability of the $300 cash flow
is p = 0.3. The cash flows from that year on would remain at the level attained in the first year in perpetuity.
Furthermore, assume that cash flows are uncorrelated with the market (i.e. they have β = 0). The risk free
rate is 8%. Calculate the NPV of this venture if it is started right away.

b) Consider the option of waiting 1 year before deciding whether or not to launch the venture described in part
(a) at the same initial cost of $1000. By that time, the information about the economy and the market for
the product would fully reveals the future cash flows of the venture. Nonetheless, the cost of waiting is
$41.67 (in present value). Should the investor choose to wait? If so, what is the value of the wait option?

c) Consider the case in which learning about expected future cash flows requires an actual investment in the
venture but that the investment can be staged. Assume that in the venture described in part (a), instead of
investing $1000 right away, a pilot project can be started at the cost of $100, and that an additional $900
would be required in one year in order to generate the free cash flows starting one year from now. The cost
of abandoning the project in year one would be $100. Should the investor choose the pilot project as opposed
start right away as in part (a)?

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a)
As the cash flow is uncorrelated with the market, the discount rate is the risk free rate of 8%
If the project starts right away, NPV0 = -Cost0 + PV0 of Expected Future Cash Flows
NPV0 = -1000 +( .3*300+(1-.3)*50)/8% = $562.50

b)
Suppose the wait option is taken, then if the NPV at year 1, NPV1 > 0, start the project; if NPV1 < 0, abort
the project.

1 year from now:

In the good case (300 perpetually): NPV1300 = -1000+ 300+300/8% = $3050
 start the project in the good case and NPV1300 = $3050

In the bad case (50 perpetually): NPV150 = -1000+ 50+50/8% = -$325

 abort the project in the bad case and NPV150 = 0

NPV of the project now (with waiting):

NPV0W=0.3*$3050/1.08+0.7*0 - 41.67= $805.55; As NPV0W > NPV0, the investor should take the
wait option and wait.

The gross value of the wait option is $805.55-562.50+41.67= $284.72

But to take this wait option, it costs 41.67.
So the net value of waiting in this case is $284.72-41.67=$243.05

c)
Suppose the pilot project is chosen, then if the NPV at year 1, NPV1 > 0, start the project; if NPV1 < 0,
abort the project.

1 year from now:

In the good case (300 perpetually): NPV1300 = -900+ 300+300/8% = $3050
 start the project in the good case and NPV1300 = $3150

In the bad case (50 perpetually): NPV150 = -900+ 50+50/8% = -$225

 abort the project in the bad case and NPV150 = -100 NOT “0” due to the cost of abandoning

NPV of the project with pilot project:

NPV0P=-100+0.3*3150/1.08+0.7*(-100)/1.08 = $710.19; As NPV0P > NPV0, the investor should
choose the pilot project.

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QUESTION 8

Compare the following approaches to valuation that were discussed in class:

1) Discounted Cash Flow;
2) Real Options;
3) Relative Valuation.
Refer to class notes and discussions.

QUESTION 9

Use the data for the three separate firms in the table below to answer the following questions. Answer each
question independently of all other questions. You must show your step by step derivation to receive full credits.

Data for What Not, Inc. (in millions)

What-Not, Inc. If-Not, Inc. Why-Not, Inc.
Earnings per share $4 $2 $2
Price per share $64 $28 $12
Price-earnings ratio 16 14 6
Number of shares 200,000 100,000 100,000
Total earnings $800,000 $200,000 $200,000
Total market value $12,800,000 $2,800,000 $1,200,000
Book Value (in millions of dollars, valued at fair market prices):

NWC $1.1 $0.4 $0.3

FA 2.8 1.0 0.8
D 2.0 0.7 0.3
E 1.9 0.7 0.8

a) What are the cost and net present value of the combination of What-Not, Inc., and If-Not, Inc., if, as a result
of the merger, the economies expected are $400,000 and What-Not, Inc. plans to pay $3 million in cash for
If-Not, Inc.?

b) If What-Not acquires If-Not for $3 million in cash, how will the shareholders of each make out on the deal?

c) If What-Not Inc., merges with Why-Not, Inc., there are no economic gains from the merger, and $1.2 million
in stock is paid for Why-Not. Demonstrate the bootstrapping effect of the merger and fill in the blanks in
the following table.

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 What-Not, Inc.
(Postmerger)
1. Earnings per share
2. Price per share
3. Price-earnings ratio
4. Number of shares
5. Total earnings
6. Total market value
7. Current earnings per
dollar invested in stock

d) Calculate the apparent and true costs of the merger between What-Not, Inc. and If-Not, Inc., assuming
expected economies of $400,000 and the shareholders of If-Not receive one share of What-Not for every
two shares they hold.

e) Show the results of accounting for the merger between What-Not, Inc. and If-Not, Inc., using both pooling
of assets and a purchase of assets methods, where If-Not is acquired for $3 million.

a)
Cost = Cash – PVIF-Not = $3,000,000 - $2,800,000 = $200,000
NPV = gain – cost = [PVW + I – (PVW + PVI)] – (cash- PVI)
= [(12.8 + 2.8 + 0.4) – (12.8 +2.8)] – (3.0 – 2.8) = 16 – 15.6 – 0.2
= 0.4 - 0.2 = 0.200 = $200,000
b)
Net gain to acquiring firm = average gain to combination - gain captured by acquired firm
What’s gain = $400,000 - $200,000 (If’s gain) = $200,000
What’s gain:
NPV = wealth with merger – wealth without merger
= (PVW+I – cash outlay) - PVW
= [(12.8 + 2.8 + 0.4) – 3)] – 12.8 = 16 - 3 – 12.8 = 13 – 12.8 = $200,000

c)

What-Not, Inc.
(Postmerger)
1. Earnings per share $4.57

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 2. Price per share $64
3. Price-earnings ratio 14
4. Number of shares 218,750
5. Total earnings $1,000,000
6. Total market value $14,000,000
7. Current earnings per $0.0714
dollar invested in stock
Number of shares used to buy Why-Not = value of Why- Not / market price per share of What-Not
= $1,200,000 / $64 = 18,750 shares
Total shares outstanding after merger = 200,000 + 18,750 = 218,750

d)

Apparent cost = (number of shares x market price per share) – PVI

= (50,000 x $64) – 2.8 = 3.2 – 2.8 = $400,000
True cost:
X = new shares issued to acquired firms stockholders/(outstanding shares of acquiring firm
+ new shares) = 50,000/(200,000 + 50,000) = 50,000/250,000= 0.2
True cost = (X) (PVW+I) – PVI = (0.2 x 16.0) – 2.8 = 0.4 = $400,000

e)

1. Initial Balance Sheets What-Not, Inc. If-Not, Inc.

NWC $1.1 $2.0 D NWC $0.4 $0.7 D
FA 2.8 1.9 E FA 1.0 0.7 E
$3.9 $3.9 $1.4 $1.4
2. Pooling of Interest What-Not, Inc. Purchase of Assets If-Not, Inc.
NWC $1.5 $2.7 D NWC $1.5 $2.7 D
FA 3.8 2.6 E FA 3.8
$5.3 $5.3 Good Will 2.3 4.9 E
$7.6 $7.6

QUESTION 10

Company X has an equity beta of 1 and 50% debt in its capital structure. The company has risk-free debt
which costs 5% before taxes, and the expected rate of return on the market portfolio is 11%. Company X
is considering the acquisition of a new project which is expected to yield 25% on after-tax operating cash
flows. Company Y which is in the same product line (and risk class) as the project being considered, has
an equity beta of 2.0 and has 20% debt in its capital structure. If Company X finances the new project with

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50% debt, should it be accepted or rejected? Assume that the corporate tax rate, tc, for both companies is
50%. Assume also perfect capital markets and ignore personal taxes and flotation costs.

Note: The systematic risk of an unlevered company, U, and the systematic risk of the equity of a levered
company, L, are related by
D
 L  BU [1  (1  tc ) ]
E
if the companies are identical apart from capital structure. D and E denote the value of debt and equity of
the levered firm.
For Company Y:
βL = βU[1 + (1 – tc)D/E] → 2.0 = βU (1 + (1- 0.5)*0.2/0.8) → βU = 2 / 1.125 = 1.78

For Company X:
βL = 1.78*(1+(1-0.5)*0.5/0.5) = 2.67
Denote: rs = equity return required for the project for Company X
rs = rf + βL [Rm – rf] = .05 + 2.67*(.11 - .05) = 21.02%

WACC = (B / S + B)rB (1 – tc)+ (S /S+B)rs = .2102*(0.50) + .05*(0.50)*(1-0.50) = 11.76%

Where rB = rf = 5%

Therefore, Company X should accept the project because 25% > 11.76%

QUESTION 11

1. Consider firm B as an unlevered firm and firm C as a levered firm with target debt-to-equity ratio
(B/S) =1. Both firms have the same expected perpetual net operating income, EBIT = 180, before
taxes. But the two firms are not identical in terms of riskiness. The before-tax cost of debt, rb, is
the same as the risk-free rate. The corporate tax rate = .5. Given the following market parameters,

E(Rm) = .12 2m = .0144 Rf = .06 B = 1 c = 1.5

a) Find the cost of capital and value of each firm

b) Evaluate the following four projects to determine their acceptance (or rejection) by firms B
and C. What do the results of this evaluation tell you about leverage in a world with corporate taxes
but no personal taxes? (Note ρjm is the correlation between the unlevered free cash flows of each
project and the market).

Projectj Costj EBITj σj ρjm

(after tax)
1 100 9 .10 .6

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 2 120 11 .11 .7
3 80 9 .12 .8
4 150 18 .20 .9

a) The cost of capital, WACC, is given by

WACC = (1 – tc) rb + rs
rs can be found by the equation of the security market line, rs = rf + [E(Rm) – rf ]
For firm B: rs = .06 + (1)*(.12 - .06) = .12, therefore WACCB = .12 because B is an all-equity firm.
For firm C: rs = .06 + (1.5)*(.12 - .06) = .15

B/S = 1  B = S, therefore B/(B + S) = 0.5

Use: WACC = (1 – tc) rb + rs for firm C

(1 – tc)rb = rf(1 – tc) = .06*(.5) = .03, then WACCC = .5*(.03) + .5*(.15) = .09

The value of firm B: VU = EBIT(1 – tc ) / r0= 180*(1 -.5)/ .12= 750

For the value of firm C: VL = EBIT(1 – tc) / WACCC = 180*(1 -.5)/.09 = 1000

b)
For Project 1:
Uj = cov(E(Rj), E(Rm)) / var(Rm) = ρjmjm / m2= (.6)*(.10)*(.12)/(.0144)= .5

The required rate of return given 100% equity financing of Project 1 is

E(Rj) = Rf + j[E(Rm) – Rf ] = .06 + (.12 - .06)*.5 = .09, this is also the WACC for firm B.

In order to compute the cost of equity given that Firm C uses 50% debt financing, we need to estimate
the levered L for the project then use the CAPM.
L = U [1 + (1 – tc)B/S] = 0.5*(1 + (1 - 0.5)*1)= .75

using the CAPM to compute the cost of the levered equity in firm C, we have
Rs = Rf + L [E(Rm) – Rf ] = 0.06 +(0.75)*(0.12 - 0.06) = .105

The required rate of return for debt financing on project 1 is Rf(1 – tC) = .03
The expected return for project 1 is E(Rj) = EBITj / costj = 9/100 = .09

Therefore, for firm B (all-equity), the required return on project 1 is equal to the expected return (.09),
and the project is marginally acceptable. For firm C, the total required return on project 1 is:
WACC = .03(.5) + .105(.5) = .0675

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 The expected return, .09 is higher than the required return, and the project is profitable.

Similar calculations for projects 2, 3, and 4 are summarized in the following two tables. In a world
with corporate, but no personal taxes, a leveraged firm will always have a lower required rate of return
on projects than an unleveraged firm. This is because the differential tax structure in effect subsidizes
debt. There is a gain from leverage. Project 2 is rejected by firm B, the unlevered firm, but accepted
by firm C with 50% leverage.

PROJECT EVALUATION FOR FIRM B (ALL – EQUITY)

Required Rate on Expected Rate of

Equity Financing Return on Project
Projectj U j
(=WACC) =(EBITj/COSTj) Decision
________________________________________________________________________
1 .5 .09 .09 Marginally Acceptable
2 .6416 .0985 .0916 Reject
3 .8 .108 .1125 Accept
4 1.5 .15 .12 Reject

PROJECT EVALUATION FOR FIRM C (LEVERED: B/B+S = 0.50)

Required Rate on Expected Rate of

Equity Financing Return on Project
Projectj Uj
(=WACC) =(EBITj/COSTj) Decision
_____________________________________________________________________
1 .75 .0675 .09 Accept
2 .9624 .0739 .0916 Accept
3 1.2 .0810 .1125 Accept
4 2.25 .1125 .12 Accept

QUESTION 12

Explain the “real options” approach to valuation of project investments, and the claim that the “naïve” NPV
rule which ignores the value of such options leads to adverse investment decisions. In your discussion compare
two alternative situations, one where uncertainty involves probability distributions which are independently and
identically distributed (i.i.d) over time, and another where there is substantial resolution of uncertainty over
time.

PLEASE REFER TO LECTURE NOTES (handout) ON REAL OPTIONS.

If the underlying distributions are iid then the naïve NPV rule would be optimal. If the process is not iid

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 then the naïve NPV rule has to be modified to take into account future options.

QUESTION 13

a) It is said that the equity holders of a levered firm can be thought of as holding a call option on the
firm’s assets. Explain what is meant by this statement.

b) Can the equity be also considered as a put option? Explain.

a)
Levered Equity is a Call Option. The underlying asset comprises the assets of the firm. The strike
price is the promised payment on the bond.

If at the maturity of their debt, the assets of the firm are greater in value than the debt, the
shareholders have an in-the-money call, they will pay the bondholders, and “call in” the assets of the
firm.

If at the maturity of the debt the shareholders have an out-of-the-money call, they will not pay the
bondholders (i.e., the shareholders will declare bankruptcy), and let the call expire.

b)
Levered Equity can be viewed as a Put Option. The underlying asset comprises the assets of the firm.
The strike price is the promised payment on bond.

If at the maturity of their debt, the assets of the firm are less in value than the debt, shareholders have
an in-the-money put. They will put the firm to the bondholders.

If at the maturity of the debt the shareholders have an out-of-the-money put, they will not exercise the
option (i.e., NOT declare bankruptcy) and let the put expire.

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