Name:______
Final Exam – Spring 2002
MBAC 6060
Corporate Finance
Let the fun begin. You have 2 hours and 45 minutes to complete the attached case. Read the case carefully and directly answer the questions raised below. Also, provide any further comments you feel important for the situation at hand. You may find the following useful:
Which can be rearranged to find:
(1) For the two alternatives considered (concerning the amount of debt financing) how much debt financing would you suggest for the project? What additional information would you request if you were to further examine this question? Be sure you explain why you provide the answers you do for each of these questions.
What I am looking for here is anything you have to say about why you might choose a given level of debt or a particular debt to value ratio. There is very little in the case to go on (an important decision based on limited information, get used to it) except for a rough notion of a reasonable interest coverage ratio, i.e. can you make the interest payments with any reliability or an amount of collateral. From Exhibit 1 we can see how much debt the company currently has in its capital structure relative to either depreciation (as a proxy for collateralizeable assets) or sales (as a proxy for its ability to cover the interest payments). Either way I chose $1 Million in debt as a reasonable target but one might argue for much less. Further you might note that our valuation methods will provide a higher estimate of value the more debt you use. This is only because the valuation methods take explicit account only of the tax benefit of debt and do not capture the costs of debt financing. The added information you would request might look at things to help you predict the expected costs of debt capital for this project. Things like the variability of the cash flows to the existing competitors etc.
(2) Using your suggested amount of debt, for each option, choose one of the valuation methods suggested in the case and evaluate the NPV of the project. Be sure to explain why you are doing what you do. Note: you are being asked to perform two different valuations here.
For this you want to recognize that the APV should be used when you choose to use a given amount of debt and the WACC when you choose to keep the debt ratio constant. For the calculations themselves see the spreadsheet.
(3) Explain what risk factors you see relative to this project and to the forecasts provided by management.
Here we want to assess the optimistic (to me) projections of a growth rate based on personal service in a project that eliminates (almost) the impact of any notion of personal service. The other issue is competition and the ease of building websites as well as the eventual possibility that movies are rented off a TV screen and fed into your TV via your high-speed internet connection in digital form. Or anything else you might come up with.