Corporate Finance

2024

Dear Students:

I welcome you to the course “Corporate Finance” in the Spring 2024 semester.

In this folder you will find the practice questions for each topic which will be discussed in
class. These questions are different from the ones contained in your text. As I develop
the course during the semester, additional questions, exercises and cases might be
given in class.

Please bring this course folder to every session since we will be practicing and
discussing the questions attached in the folder.

Course materials (lecture slides, assignments, articles, etc) will be uploaded on learning
management system (SAKAI) so keep visiting the course site there. Also join the course
page on Facebook where you can start a discussion, post your questions, or post links
to good finance articles.

We will work hard and I hope you will enjoy and value the experience. Keep in mind that
good learning involves a little bit of frustration, particularly in the early stages of the
learning cycle.

Good Luck with the course 

Regards,
Sana Tauseef
Email: [email protected]

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 Corporate Finance
2024
Capital Market Efficiency

Q1. Suppose you are given the following information. The beta of company i, b i, is 1.1,
the risk-free rate, rRF, is 7%, and the expected market premium, rM - rRF, is 6.5%.
a. Use the Security Market Line (SML) of CAPM to find the required return for
this company.
b. Because your company is smaller than average and is more successful
than average (that is, it has a low book-to-market ratio), you think Fama-
French three-factor model might be more appropriate than the CAPM. You
estimate the additional coefficients from the Fama-French three-factor
model: The coefficient for the size effect, c i, is 0.7, and the coefficient for
the book-to-market effect, di, is -0.3. If the expected value of the size factor
is 5% and the expected value of the book-to-market factor is 4%, what is
the required return using the Fama-French three-factor model?

Q2. Analysis of 60 monthly rates of return on ITC common stock indicates a beta of
0.83 and an alpha of 1.49% per month. A month later, the market is up by 5%, and the
ITC is up by 6%. What is ITC’s abnormal return?

Q3. Geothermal Corporation has just received good news: Its earnings increased by
20% from last year’s value. Most investors are anticipating an increase of 25%. Will
Geothermal’s stock price increase or decrease when the announcement is made?

Q4. Column A in the table shows the monthly return on Sensex from September 2009
through April 2011. Columns B and C show returns on the stocks of two firms –
Reliance Industries Ltd and TCS Ltd.
Year A: Sensex B: Reliance C: TCS
Industries Ltd
Sep-09 0.09 0.10 0.18
Oct-09 -0.07 -0.12 0.01
Nov-09 0.06 0.10 0.10
Dec-09 0.03 0.03 0.09
Jan-10 -0.06 -0.04 -0.02
Feb-10 0.00 -0.07 0.03
Mar-10 0.07 0.10 0.03
Apr-10 0.00 -0.04 -0.02
May-10 -0.03 0.01 -0.03
Jun-10 0.04 0.04 0.01
Jul-10 0.01 -0.07 0.12
Aug-10 0.01 -0.09 0.00
Sep-10 0.12 0.07 0.09
Oct-10 0.00 0.11 0.14
Nov-10 -0.03 -0.10 0.02

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Dec-10 0.05 0.07 0.08
Jan-11 -0.11 -0.13 -0.01
Feb-11 -0.03 0.05 -0.04
Mar-11 0.09 0.09 0.06
Apr-11 0.00 -0.01 0.00

Both firms announced their earnings towards the end of March 2011. Calculate
the average abnormal return of the two stocks during the month of earnings
announcement.

Q5. During September 2017, Attock Petroleum Limited announced its earnings for the
year ending June 2017 (an EPS of PKR63.89 compared to an EPS of PKR46.16 for
previous year). Given the following prices and indices, was there an
announcement effect during September?
Month Price-APL Index-PSX100
Oct-16 6407.3 39893.8
Nov-16 7020.46 42622.4
Dec-16 7570.49 47807
Jan-17 7367.57 48757.7
Feb-17 7071.02 48534.2
Mar-17 7183.17 48155.9
Apr-17 7407.9 49300.9
May-17 7662.5 50591.6
Jun-17 7088.57 46565.3
Jul-17 7829.52 46010.5
Aug-17 7185.54 41207
Sep-17 7080.64 42409.3

With the below given EPS figures, comment on the announcement effect.

Period 1Q-16 HY-16 3Q-16 FY-16 1Q-17 HY-17 3Q-17 FY-17

Cumulative 8.34 19.78 28.65 46.16 18.85 38.06 52.56 63.89
EPS

Q6. Following are the monthly total index return series of ICI. With the mean monthly
return ( R ) of 0.0373 and monthly variance (∑ (Rt −R ¿ ) ¿ ) of 0.0453. Compute the
2

autocorrelation (with 1-month lag) for the return series.

Month Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15

Return 0.1068 0.1207 0.1176 -0.1040 0.0607 -0.0229 -0.0172
Behavioral Finance: Implications for Corporate Finance
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 Corporate Finance
2024
Q1. Suppose a skillful fund manager is just 1 in every 100. A test is 99% accurate in
identifying that a fund manager is skillful. For skillful fund managers, the test is 99%
correct. Similarly, for those who are not skillful, the test correctly indicates that they are
not skillful with 99% of accuracy. If a fund manager takes the test and the result of the
test is positive, what is the probability that the fund manager is actually skillful? (Use
Bayes formula)

Q2. Assume the interest rates and stock index can either increase or decrease with
following given probabilities:
a. Probability of stock index increasing: 0.425
b. Probability of interest rate increasing when stock market has decreased:
0.825
c. Probability of interest rate increasing when stock market has increased:
0.059
Compute the probability of stock index decreasing when the interest rate has increased.

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2024
Review: FCF Valuation

1. Following are historic Balance Sheet and P&L Statements for Lucky Cement
Limited.
(PKR Millions)
2007 2008 2009 2008 2009
Cash 1,239 270 1,049 Net Sales 16,958 26,330
Trade Debt 477 720 1,267 EBITDA 4,056 8,354
Inventory 676 709 3,412 Depr. & Amort. 979 1,137
Other current assets 3,017 6,708 2,129 EBIT 3,077 7,217
Total Current 5,409 8,407 7,857 Financial charges 127 1,237
Net Fixed Assets
Assets 20,321 25,832 30,534 Other Income (643) (804)
Total Assets 25,730 34,239 38,391 Pre-tax Profit 2,307 5,176
Creditors & accruals 1,873 3,839 2,910 Taxation (371) 580
ST Borrowings 2,864 3,607 6,188 Net Profit 2,678 4,596
Current Portion: LT 1,615 242 -
Total Current
Debt NOTES:
Liabilities 6,352 7,688 9,098 1. Assume effective tax rate for Lucky
LT Debt 8,336 6,633 4,300 Cement at 15%.
Deferred Liabilities 1,688 1,263 1,742 2. Consider changes in deferred
liabilities as part of operating cash
Total Liabilities 16,376 15,584 15,140
flows.
Paid-Up 2,634 3,234 3,234 3. Lucky issued fresh equity
Share premium 990 7,343 7,343 amounting PKR6,953 million in
Un-appropriated 5,730 8,078 12,674 2008 through a Global Depository
Total Equity
Profit 9,354 18,655 23,251 Receipts (GDR) offering.

Based on above information, estimate the following cash flow items for 2008 and
2009. Company records Interest payment under Operating Cashflows.
A. Operating Cash Flows (start from NI)
B. Capital Expenditure (Capex)
C. Free Cash Flows to Firm (FCFF)
D. Free Cash Flows to Equity (FCFE)

2. PHB Company currently sells for $32.50 per share. In an attempt to determine
whether PHB is fairly priced, an analyst has assembled the following information:
 Before-tax required rate of return on PHB debt, preferred stock and common
stock are, respectively, 7.0% and 6.8% and 11%
 The company’s target capital structure is 30% debt and 15% preferred stock
and 55% common stock
 Market value of company’s debt is $145 million, and its preferred stock is
valued at $65 million

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 PHB’s FCFF for the year ended is $28 million. FCFF is expected to grow at a
constant rate of 4% for the foreseeable future.
 Tax rate is 35%
 PHB has 8 million outstanding common shares
What is PHB’s estimated value per share? Is PHB’s stock underpriced?

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Mergers and Acquisitions

Q1. Penn Corp. is analyzing the possible acquisition of Teller Company. Both firms
have no debt. Penn believes the acquisition will increase its total after-tax annual cash
flows by $2.4 million indefinitely. The current market value of Teller is $58 million, and
that of Penn is $107 million. The appropriate discount rate for the incremental cash
flows is 10%. Penn is trying to decide whether it should offer 40% of its stock or $73
million in cash to Teller’s shareholders.

a. What is the cost of each alternative?

b. What is the NPV of each alternative?
c. Which alternative should Penn choose?

Q2. The shareholders of Jolie Company have voted in favor of a buyout offer from Pitt
Corporation. Information about each firm is given here:
Jolie Pitt
P/E ratio 10.4 22
Shares outstanding 92,337 194,000
Earnings $245,000 $730,000

Jolie’s shareholders will receive one share of Pitt for every three shares they hold in
Jolie.

a. What will the EPS of Pitt be after the merger? What will the PE ratio be if
the NPV of the acquisition is zero?
b. What must Pitt feel is the value of the synergy between these two firms?
Explain how your answer can be reconciled with the decision to go ahead
with the takeover.

Q3. Fly-By-Night Couriers is analyzing the possible acquisition of Flash-in-the-Pan

Restaurants. Neither firm has debt. The forecasts of Fly-By-Night show that the
purchase would increase its annual after-tax cash flow by $450,000 indefinitely. The
current market value of Flash-in-the-Pan is $14 million. The current market value of Fly-
By-Night is $31 million. The appropriate discount rate for the incremental cash flows is
8%. Fly-By-Night is trying to decide whether it should offer 35% of its stock or $18.5
million in cash to Flash-in-the-Pan.

a. What is the synergy from the merger?

b. What is the value of Flash-in-the-Pan to Fly-By-Night?
c. What is the cost to Fly-By-Night of each alternative?

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d. What is the NPV to Fly-By-Night of each alternative?
e. Which alternative should Fly-By-Night use?

Q4. World Enterprises is determined to report earnings per share of $2.67. It therefore
acquires the Wheelrim and Axle Company. You are given the following facts:
World Enterprises Wheelrim and Axle Merged Firm
EPS $2.00 $2.50 $2.67
Price per share $40 $25 ?
P/E ratio 20 10 ?
No. of shares 100,000 200,000 ?
Total earnings $200,000 $500,000 ?
Total market value $4,000,000 $5,000,000 ?

There are no gains from merging. In exchange for Wheelrim and Axle shares, World
Enterprises issues just enough of its own shares to ensure its $2.67 EPS objective.

a. Complete the table for the merged firm

b. How many shares of World Enterprises are exchanged for each share of
Wheelrim and Axle?
c. What is the cost of the merger to World Enterprises?
d. What is the change in the total market value of the World Enterprises
shares that were outstanding before the merger?

Q5. VolWorld, a large telcom company, is evaluating the possible acquisition of Bull
Cable Company, a regional cable company. VolWorld’s analysts project the following
data for BCC (in thousands of dollars, with a December 31 year-end):

Year 2015 2016 2017 2018

Net Sales $450 518 555 600
CGS as percentage of sales 60 62 65 65
Selling & Admin Expenses (including Depreciation) 55 60 60 65
Depreciation 30 32 34 36
Interest 40 45 45 45
Capex 50 80 75 75
Change in NWC 12 15 18 20

Analysts estimate that at the end of the fourth year (2018), BCC will be worth 10 times
its fourth year’s cash flows. If the tax rate for BCC is 30 percent and the appropriate
discount rate is 10.5 percent, compute the value of BCC on January 1, 2015.

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Q6. VolWorld, a large telcom company, is evaluating the possible acquisition of Bull
Cable Company, a regional cable company. VolWorld’s analysts have identified three
companies, Aqua, Feron and Trace, which are comparable to BCC. The relevant data
for BCC and the comparable companies are given as under:

Valuation Variable BCC Aqua Feron Trace

Stock Price 40.5 23.5 35.25 44
Earnings per share 4.5 2.53 4.5 2.8
Sales per share 20.5 18 21.5 21
Book Value per share 17.4 16 15.25 13.5

Using the most recent takeovers of companies that are similar to BCC, the analysts
have estimated an average takeover premium of 24 percent. Compute the estimated
fair takeover price of BCC using the comparable company analysis.

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2024
International Corporate Finance

Q1. A currency trader observes that in the spot exchange market, one USD can be
exchanged for nine Mexican pesos (MXN) or for 111.23 Japanese yen (JPY). What is
the cross-exchange rate between JPY and MXN; that is, how many yen would you
receive for every peso exchanged?

Q2. Six-month T-bills have a nominal rate of 7 percent, while default-free Japanese
bonds that mature in six months have a nominal rate of 5.5 percent. In the spot market,
one JPY equals 0.009 USD. If interest rate parity holds, what is the six-month forward
exchange rate?

Q3. A television set costs $500 in the US. The same set costs 550 euros in France. If
purchasing power parity holds, what is the spot rate between the euro and the dollar?

Q4. Suppose the exchange rate between USD and Swiss franc (CHF) was SFr1.6 = $1,
and the exchange rate between USD and GBP was £1 = $1.50. What was the
exchange rate between francs and pounds?

Q5. Assume that interest rate parity holds and that 90-day risk-free securities yield 5
percent in the US and 5.3 percent in Germany. In the spot market, one euro equals 0.80
dollar.

a. Is the 90-day forward rate trading at a premium or discount relative to the

spot rate?
b. What is the 90-day forward rate?

Q6. Assume that interest rate parity holds. In both the spot market and the 90-day
forward market 1 JPY equals 0.0086 USD. The 90-day risk-free securities yield 4.6% in
Japan. What is the yield on 90-day risk-free securities in the US?

Q7. In the spot market 7.8 pesos can be exchanged for 1 USD. A compact disc costs
$15 in the US. If the absolute purchasing power parity holds, what should be the price of
the same disc in Mexico?

Q8. You are estimating the cash flows of a store that XYZ Limited plans to open in
Germany. The expected cash flows have been projected in Deutsche marks (DEM) for
this store and are summarized as follows.

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Year Cash Flow (DEM)

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0 (15,000)
1 1,350
2 1,485
3 1,634
4 1,797
5 1,977
6 2,174
7 2,392
8 2,631
9 2,894
10 3,183

The current exchange rate is $0.65 per DEM, and the interest rate in the US is 5%; it is
4% in Germany. (You can assume that these are the spot-rates for 1- to 10- year
bonds).

a. Estimate the expected Cash flows in USD

b. Assume that XYZ Limited uses a cost of capital of 12% for US stores.
Would you adjust this for the Germany store? Why or why not?
c. Calculate the NPV of the store in USD
d. Calculate the NPV of the store in DEM

Q9. Assume that Wal-Mart is considering opening a store in Argentina. Argentina is

rated BB-, and its dollar-based bonds are traded at a default spread of 3% over the US
Treasury bond rate of 6.5%. The Argentine equity market is 1.8 times more volatile than
the Argentine long-term bond market. Wal-Mart has a beta of 0.9 and a tax rate of 35%;
the market risk premium in the US is 5.5%. The firm intends to borrow in Argentine at a
local rate of 12% (in pesos) and maintain a debt ratio of 25% for Argentine projects. You
can assume that the inflation rate in the US is 3% whereas it is 9% in Argentina.

a. Estimate the cost of equity and capital in dollar terms for the Argentine
store
b. Estimate the cost of equity and capital in peso terms for the Argentine
store

Q10. Lakonishok Equipment has an investment opportunity in Europe. The project costs
€14 million and is expected to produce cash flows of €2.1 million in year 1, €3.4 million
in year 2, and €4.3 million in year 3. The current spot exchange rate is $1.28/€; the
current risk-free rate in the US is 4.8%, compared to that in Europe of 4.1%. The

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appropriate discount rate for the project is estimated to be 13%, the US cost of capital
for the company. In addition, the subsidiary can be sold at the end of three years for an
estimated €9.6 million. What is the NPV of the project?

Q11. Suppose the spot rate for Canadian dollar (CAD) is 1.06 CAD and the six-month
forward rate is 1.11 CAD.

a. Which is worth more, USD or CAD?

b. Assuming absolute PPP holds, what is the cost in the US of an Elkhead
beer if the price in Canada is 2.50 CAD? Why might the beer sell at a
different price in the US?
c. Is the USD selling at a premium or a discount relative to the CAD?
d. Which currency is expected to appreciate?
e. Which country do you think has higher interest rates – the US or Canada?
Explain.

Q12. The treasurer of a major US firm has $30 million to invest for three months. The
interest rate in the US is 0.37% per month. The interest in the UK is 0.51% per month.
The spot rate is £0.55, and the three-month forward rate is £0.56. Ignoring transaction
costs, in which country would the treasurer want to invest the company’s funds? Why?

Q13. Suppose the spot and six-month forward rates on the Norwegian krone (NOK) are
Kr 5.15 and Kr 5.22, respectively. The annual risk-free rate in the US is 3.8%, and the
annual risk-free rate in Norway is 5.7%.

a. Is there an arbitrage opportunity here? Is so, how would you exploit it?
b. What must the six-month forward rate be to prevent arbitrage?

Q14. The spot rate for British pounds is $1.76. The U.S. risk-free rate is 5.1%, and the
U.K. risk-free rate is 6.2%, both are compounded annually. One-year forward contracts
are currently quoted at a rate of $1.75. Assume the trader’s domestic currency is U.S.
dollars. Identify a strategy in which the trader can earn a profit at no risk by
engaging in a forward contract, regardless of his view of pound’s likely
movement.

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The Financing Process

Q1. You need to choose between making a public offering and arranging a private
placement. In each case the issue involves $10 million face value of 10-year debt. You
have the following data for each:
 A public issue: The interest rate on the debt would be 8.5%, and the debt would
be issued at face value. The underwriting spread would be 1.5%, and other
expenses would be $80,000.
 A private placement: The interest rate would be 9%, but the total issuing cost
would be $30,000.

a. What is the difference in the proceeds to the company net of expenses?

b. Other things equal, which is the better deal?
c. What other factors beyond the interest rate and issue costs would you
wish to consider before deciding between the two offers?

Q2. Associated Breweries is planning to market alcohol-free beer. To finance the

venture, it proposes to make a right issue at $10 of one new share for each two shares
held. (The company currently has outstanding 100,000 shares priced at $40 per share).
Assuming that the new money is invested to earn a fair return, give values for the
following:
a. Number of new shares
b. Amount of new investment
c. Total value of company after issue
d. Total number of shares after issue
e. Stock price after issue
f. Price of the right to buy one new share

Q3. Here is the recent financial data on Pisa Construction, Inc.

Stock price $40 Market value of firm $400,000
Number of 10,000 EPS $4
shares
Book net worth $500,000 Return on Investment 8%

Pisa has not performed spectacularly to date. However, it wishes to issue new shares to
obtain $80,000 to finance expansion into a promising market. Pisa’s financial advisers
think a stock issue is a poor choice because, among other reasons, “sale of stock at a
price below book value per share can only depress the stock price and decrease
shareholders’ wealth.” To prove the point they construct the following example:

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“Suppose 2,000 new shares are issued at $40 and the proceeds are invested. (Neglect
issue costs.) Suppose return on investment does not change. Then

Book net worth = $580,000

Total earnings = 0.08(580,000) = $46,400
EPS = 46,400/12,000 = $3.87

Thus, EPS declines, book value per share declines, and share price will decline
proportionately to $38.70.” Evaluate this argument with particular attention to the
assumptions implicit in the numerical example.

Q4. Office Helpers is a private firm that manufactures and sells office supplies. The firm
has limited capital and is estimated to have a value of $80 million with the capital
constraints. A venture capitalist is willing to contribute $20 million to the firm in
exchange for 30% of the value of the firm. With this additional capital, the firm will be
worth $120 million.

a. Should the firm accept the venture capital?

b. At what percentage of firm value would you (as the owner of the private
firm) break even on the venture capital financing?

Q5. You are a venture capitalist and have been approached by Cirrus Electronics, a
private firm. The firm has no debt outstanding and does not have earnings now but is
expected to be earning $15 million in four years, when you also expect it to go public.
The average price-earnings ratio of other firms in this business is 50.

a. Estimate the exit value of Cirrus Electronics

b. If your target rate of return is 35%, estimate the discounted terminal value
of Cirrus Electronics
c. If you are contributing $75 million of venture capital to Cirrus Electronics,
at the minimum, what % of the firm value would you demand in return?

Q6. Sunshine Media has just completed an IPO in which 50 million shares of the 125
million shares outstanding were issued at an offering price of $22 per share. On the
offering date, the stock price zoomed to $40 per share. Who gains from this increase
in the price? Who loses, and how much?

Q7. You are the owner of a small and successful firm with an estimated market value of
$50 million. You are considering going public.

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a. What are the considerations you would have in choosing an investment
banker?
b. You want to raise $20 million in new financing, which you plan to reinvest
back in the firm. (The estimated market value of $50 million assumes that
this $20 million is reinvested.) What proportion of the firm would you have
to sell in the IPO to raise $20 million?
c. How would your answer to (b) change if the investment banker plans to
underprice your offering by 10%?
d. If you wanted your stock to trade in the $20-$25 range, how many shares
would you have to create? How many shares would you have to issue?

Q8. You have been asked for advice on a rights offering by a firm with 10 million shares
outstanding, trading at $50 per share. The firm needs to raise $100 million in new
equity. Assuming that the rights subscription price is $25, answer the following
questions:

a. How many rights would be needed to buy one share at subscription price?
b. Assuming all rights are subscribed to, what will the ex-rights price be?
c. Estimate the value per right
d. If the price of a right were different (higher or lower) than the value
estimated in (c), how would you exploit the difference?

Q9. Security Brokers Inc. specializes in underwriting new issues by small firms. On a
recent offering of Beedles Inc., the terms were as follows:
Price to public = $5 per share
No. of shares = 3 million
Proceeds to Beedles = $14 million

The out-of-pocket expenses incurred by Security Brokers in the design and distribution
of the issue were $300,000. What profit or loss would Security Brokers incur if the issue
were sold to the public at a price of:
a. $5 per share
b. $6 per share
c. $4 per share

Q10. The Beranek Company, whose stock price is now $25, needs to raise $20 million
in common stock. Underwriters have informed the firm’s management that they must
price the new issue to the public for $22 per share because of signaling effects. The
underwriters’ compensation will be 5% of the issue price, so Beranek will net $20.90 per
share. The firm will also incur expenses in the amount of $150,000.

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How many shares must the firm sell to net $20 million after underwriting and
floatation costs?

Q11. A company is trying to estimate its debt ratio. It has 1 million shares
outstanding, trading at $50 per share and it had $250 million in straight debt
outstanding (with a market interest rate of 9 percent). It also has two other securities
outstanding:
a. It has 200,000 warrants outstanding, conferring on its holders the right to buy
stock in the company at $65 per share. The warrants are trading at $12 each.
b. It also has 10,000 convertible bonds outstanding, trading at par, with a
coupon rate of 6 percent and 10 years to maturity.
Estimate the debt ratio in market value terms.

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Leasing

Q1. Reynolds Construction needs a piece of equipment that costs $200. Reynolds
either can lease the equipment or borrow $200 from a local bank and buy it. If the
equipment is leased, the lease would not have to be capitalized. Reynold’s balance
sheet prior to the acquisition of the equipment is as follows:

Current Assets $300 Debt $400

Net Fixed Assets $500 Equity $400
Total Assets $800 Total Claims $800

a. (1) What is Reynolds’ current debt ratio?

(2) What would be the company’s debt ratio if it purchased the equipment?
(3) What would the debt ratio be if it the equipment were leased?
b. Would the company’s financial risk be different under the leasing and
purchasing alternatives?

Q2. Assume that Reynolds’ tax rate is 40% and the equipment’s depreciation would be
$100 per year. If the company leased the asset on a 2-year lease, the payment would
be $110 at the beginning of each year. If Reynolds’ borrowed and bought, the bank
would charge 10% interest. Should Reynolds’ lease or buy the equipment?

Q3. Big Sky Mining Company must install $1.5 million of new machinery in its Nevada
mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the
machinery. Assume that the following facts apply:
 The machinery falls in the MACRS 3-year class
 Estimated maintenance expenses are $75,000 per year, payable at the
beginning of each year
 The firm’s tax rate is 40%
 The loan would have an interest rate of 15%
 The lease terms call for $400,000 payments at the end of each of the next 4
years.
 Under either case, Big Sky must pay for insurance, property taxes, and
maintenance.
 Assume that Big Sky Mining will continue to use the machine beyond the
expiration of the lease and must purchase it at an estimated residual value of
$250,000 at the end of the 4th year.
Compute the incremental after-tax cash flows from leasing the asset instead of
buying. Which alternative is better?

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Q4. Sadik Industries must install $1 million of new machinery in its Texas plant. It can
obtain a bank loan for 100% of the required amount. Alternatively, a Texas investment
banking firm that represents a group of investors believes that it can arrange for a lease
financing plan. Assume that these facts apply:

 The machinery falls in the MACRS 3-year class

 Estimated maintenance expenses are $50,000 per year
 The firm’s tax rate is 34%
 If the money is borrowed, the loan would have an interest rate of 14%, amortized
in 3 equal installments at the end of each year
 The tentative lease terms call for $320,000 payments at the end of each of the
next 3 years.
 Under the proposed lease terms, the lessee must pay for insurance, property
taxes, and maintenance.
 Sadik must use the equipment if it is to continue in business, so it will almost
certainly want to acquire the property at the end of the lease. If it does, then
under the lease terms it can purchase the equipment at its fair market value at
that time, the best estimate of which is $200,000, but it could be much higher or
lower under certain circumstances.
To assist management in making the proper lease-versus-buy decision, you are asked
to answer the following questions:
a. If the lease can be arranged, should the firm lease or borrow and buy the
equipment? (Hint: In this situation, the firm plans to use the asset beyond the
lease term. Thus, the residual value becomes a cost to leasing in Year 3. Also,
there is no Year 3 residual value tax consequence, as the firm cannot
immediately deduct the Year 3 purchase price from taxable income)

Q5. Nodhead College needs a new computer. It can either buy it for $250,000 or lease it
from Compulease. The lease terms require Nodhead to make six annual payments
(prepaid) of $62,000. Nodhead pays no tax. Compulease pays tax at 35%. Compulease
can depreciate the computer for tax purposes over 5 years. The computer will have no
residual value at the end of Year 5. The interest rate is 8%.

a. What is the NPV of the lease for Nodhead?

b. What is the NPV for Compulease?
c. What is the overall gain from leasing?

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 Corporate Finance
2024
Options-Basics and Pricing

The following option prices were observed for a stock on April 1 of a particular year.
Ignore the dividends on the stock. The stock is priced at $165.125 and the volatility of
the stock is 0.21. The expirations are July 1, August 1 and October 1. The risk free rate
is 5% per annum for all maturities. Consider all options are European. Use the
information to answer Q1 till Q3.

Calls Puts
Strike July August October July August October
155 10.5 11.75 14 0.1875 1.25 2.75
160 7 8.125 11.125 0.75 2.75 4.5
165 2.6875 5.25 8.75 2.375 4.75 6.75
170 0.8125 3.25 6 5.75 7.5 9

Q1. Which of the July call and put options are in-the-money and which are out-of-
money?

Q2. Calculate the time value and intrinsic value for October 170 call and put.

Q3. Check the August 155 options for the boundary conditions and suggest the
arbitrage.

Q4. Calculate the price of a 3-month European put option on a non-dividend paying
stock with a strike price of $50, the risk free interest rate is 10% per annum and the
volatility is 30% per annum.

Q5. What difference does it make to your calculations in Q4 if a dividend of $1.50 is

expected in 2 months?

Q6. What is the price of a European call option on a non-dividend-paying stock when
the stock price is $52, the strike price is $50, the risk free interest rate is 12% per
annum, the volatility is 30% per annum and the time to maturity is 3 months?

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 Corporate Finance
2024
Options Applications in Corporate Finance

1. Company Z is examining a new project. It expects to sell 7,500 units per year at
$68 cash flow a piece for the next 10 years. The relevant discount rate is 14
percent and the initial investment required is $2.3 million.

a. What is the base-case NPV?

b. After the first year, the project can be dismantled and sold for $1.5
million. If the expected sales are revised based on first year’s
performance, when would it make sense to abandon the project? In
other words, at what level of expected sales would it make sense to
abandon the project?
c. Suppose you think it is likely that the expected sales will be revised
upwards to 9,500 units if the first year is a success and revised
downward to 4,000 units if the first year is not a success. If success and
failure are equally likely, what is the NPV of the project? What is the
value of abandonment option?
d. Suppose the scale of project can be doubled in one year in the sense
that twice as many units can be produced and sold. Naturally,
expansion would be desirable only if the project is a success.
Abandonment is still an option if the project is a failure. What is the
value of expansion option?

2. XYZ Corporation has $500 million in zero coupon debt outstanding due in five
years. The firm had earnings before interest and taxes of $40 million in most
recent year (tax rate is 40 percent). Earnings are expected to increase
perpetually at 5 percent per year. And the firm pays no dividend. Firm had a cost
of equity of 12 percent and a cost of capital of 10 percent. The annualized
standard deviation in firm values of comparable firms is 12.5 percent. Five-year
bond rate is 5 percent.
a. Estimate the value of firm using DCF model.
b. Estimate the value of equity, using options pricing model. Estimate
the value of debt and appropriate interest rate on debt.

3. You have been approached by a real estate conglomerate with a deal: you can
buy 100,000 square feet of space in a mall at $50/square foot. Over the next ten
years, you can expect to make an after-tax cash inflow of $500,000 a year. At the

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 Corporate Finance
2024
end of 10 years, you expect to be able to sell the space back at $5 million to
other investors.
a. From a standard capital budgeting analysis, would you take this
project if your discount rate were 15 percent?
b. Assume that as an inducement, the promoters offer to give you the
option of buying another 100,000 square feet at today’s price
anytime over the next five years. The five-year bond rate is 6 percent,
and the prices per square foot for the last six years have been as
follows:

Year Price/Square Foot ($)

-6 20
-5 30
-4 55
-3 70
-2 55
-1 50

What is the value of this option?

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