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Sample past midterm exam questions.pdf

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Boston College
MFIN 1127
Jerome Taillard

Past exam questions, MF 127 Corporate Finance, Professor Jerome Taillard Midterm 2010: Q4 Financial Statement Analysis (5 Points) Quisco Systems has 6.3 billion shares outstanding and a share price of $22. Quisco is considering developing a new networking product at a cost of $539 million. This project is NPV positive. Suppose the following: 1. Absent the expense of the new technology, Quisco will have an EPS of $0.52. 2. If Quisco develops the product, all costs would be treated as R&D expenses and would be expensed this year. There would be no revenues generated this year from this product. 3. Quisco’s tax rate is 35%, and the number of shares outstanding remains unchanged whatever they decide on the project. a. Compute what would be the impact of the development costs on Quisco’s EPS? (3 points) Impact is actually 0.055611, So new EPS is 0.4643 b. If the financial markets forecast Quisco’s EPS to be $0.52, would there be an incentive for management not to take this positive NPV project? Explain for full credit (2 points, max. 3 sentences) Yes. The markets are obsessed with firms meeting their EPS forecast. When they don’t the stock price usually gets punished. Hence management may very well take actions to avoid this outcome and not take the project this year. Q8 NPV Analysis (15 Points) On March 29, 1989 the Exxon Valdez struck the Bligh Reef in Alaska, spilling 750,000 Barrels of oil. In 1994 an Anchorage, Alaska Jury awarded $5 Billion in punitive damages against Exxon. Assume the discount rate in this problem to be r = 12%, and that today is Dec 31, 1994. Assume you are working for Exxon as a corporate finance consultant, and are presented with two alternative options: Option 1: Pay $5 Billion in punitive damages and incur no additional legal costs. Assume this would need to be paid today (Dec 31, 1994). Option 2: Spend $400 Million per year in legal costs, until the case is decided by the Supreme Court. Your legal experts tell you that they think this will take 14 years (to Dec 31, 2008). Additionally, they believe the final judgment from the Supreme Court will reduce the punitive damages to $500 million, if Exxon pursues this option. If Exxon decides to continue litigation, it has to pay an initial retainer to its lawyers of $400M that would be due today (Dec 31, 1994) and thereafter, it would by its annual fees of $400M (occurring at the end of each year for simplicity) with the final payment due to the lawyers the same time the final judgment is due on Dec 31, 2008. a. Draw the timeline for Option 2 (3 points) Annual legal costs of $400M incurred every Final punitive damages year for the next 14 years, + 1 of $500M payment at time b. What are the NPVs for the two respective legal strategies (4 points) Option 1 NPV = -$5 Billion Option 2 NPV = 1 1  Judgement NPV = −(CurrentPay ment Annuity + FinalJudgement )= C + C × 1 − N  + N r (1+ r  (1+r) 1  1  500 = − 400 −400 × 0.12  − (1+0.12) 14− (1+0.12) 14= −$3,153.58   c. Which option should Exxon pursue (it has to choose one of the two)? Justify your answer based on the NPVs from part a and b. (1 point) Option 2, has the higher NPV. Both NPVs are negative but one is less negative than the other. We can’t “not take the project”, it is the cost we need to incur. d. What would the annual legal costs need to be for Exxon to be indifferent between Option 1 and Option 2. Assume the punitive damages judgments of $5 billion (Option 1) and $500 million (Option 2) remain the same. (4 points, for full credit, write down the equation you need to solve.) Indifferent⇒ NPVOption
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