Solutions theory exam 2017 for Corporate Finance PDF

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Solutions part 1

Your friend is looking to launch a new hotel chain, Roxy Inc., designed to serve the traveling needs of the budget-minded millennial traveler. To launch Roxy Inc., she is expected to invest $500 million this year (year=0). The hotel chain is expected to generate free cash flows of $27 million per year, starting in year 1. Thereafter, these free cash-flows are expected to grow at 3 percent per year in perpetuity. For simplicity, assume these cashflows are received at the end of each year. Your friend knows you’ve been taking this class, so she asked you to assess the potential value of the new hotel chain. To help you, she gives you the following reports for a handful of publicly-traded firms, as well as the expected returns on the government bond (Treasury), and the risk premium on the value-weighted market portfolio:

Company Dropbox Ikea Intercontinental Hotels Group 10-year Treasury rate Expected Market Risk Premium

Market Value of Equity 900 1,000 7,500

Market Value of Debt 150 100 2,500

Equity Beta 2 2.3 1.6

2.0% 5.0%

Assume throughout that the CAPM holds for all assets, and that the debt of Dropbox, Ikea, and Intercontinental Hotel Group is risk-free. None of these firms hold (excess) cash assets. Exercise 1. If Roxy Inc. were to be 100% equity financed, what would be a reasonable estimate of the expected return on Roxy’s equity? What is Roxy’s WACC? The expected return on equity is: _8%__

Roxy’s WACC is: __8%__

Show your work/Explain your answer: 1. Find the right comparable: Intercontinental Hotel Groups (1 point) 2. Compute the Unlevered Beta of the comparable: (2 points) 2.5 7.5  0  1.2 ⇒   1.2  1.6    10 10 3. Use CAPM to find the return to equity: (1 point)   2%  1.2  5%  8% 4. Realize this is also ROXY’s WACC (1 point)

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Exercise 2. What is the value of Roxy Inc.? Is the project worth pursuing? The estimated value of Roxy Inc. is: __$540m______________ The estimated gain to your friend from investing in Roxy’s Inc. is: __$40m____  The investment is worth pursuing.

 The investment is not worth pursuing.

Show your work/Explain your answer: 1. We have a WACC of 8% and the growth rate is 3%: (3 points) $27  $540 󰇛0󰇜  8%  3% This is the value of ROXY Inc. If they write the NPV, substract -2. 2. To evaluate the project, we subtract the initial cost: NPV = $540m - $500m = $40m (2 points)

Exercise 3. (a) Assume that the new hotel chain is financed instead with a debt-to-value ratio of 25%, and that this leverage ratio is not expected to change over time. What is Roxy’s WACC? What is its cost of equity? What is the value of Roxy? In this part (a), assume that the debt issued is riskfree and that there are no frictions in financial markets (no taxes, bankruptcy costs, etc). Roxy’s WACC with leverage is: _8%______ Roxy’s return on equity: __10%____ The value of Roxy Inc. is now: _$540m_____ 

The investment is worth pursuing.

 The investment is not worth pursuing.

Show your work/Explain your answer: By MM, the WACC and the value of Roxy remain unchanged (1 point) Roxy’s return to equity, using the fact that return to debt is the risk-free rate, is obtained from solving (2 points)         ⇒     󰇛   󰇜         %  󰇛%  %󰇜  %  2

Exercise 4. After you complete your analysis in part (a), you learn that Roxy does actually pay a corporate tax of 35%. Describe the effect of corporate taxes on (i) Roxy’s WACC and (ii) Roxy’s expected value. Roxy’s WACC is: _7.825%_

Roxy’s value is: _$559.6m___

Briefly explain your answer: The return on equity remains unchanged, so we just have to compute the post-tax WACC (1 point):      󰇛1  󰇜     0.75  10%  0.25  2%  󰇛1  0.35󰇜  7.825%

  

To compute the new Value of Roxy we use the growing perpetuity again using the after-tax WACC (1 point): $27  $559.6 󰇛 󰆒 󰇜  7.825%  3%

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