Reference no: EM131035242

Question 1 - Eli-Rose, a large pharmaceuticals manufacturer, is considering acquiring Clonatec, a private bio-technology company. Eli-Rose has hired you to estimate the value the equity of Clonatec. Clonatec's expected consolidated balance sheet at year end 2013, when the acquisition will take place, is portrayed in the following table:

Clonatec Inc. Forecasted Consolidated Balance Sheet (million of $US)

Current assets	Year-end 2013
Cash and cash investments	$21.8
Accounts receivable	$3.8
Inventories, at cost	$5.9
Other current assets	$3.2
Total current assets	$34.7
Property, Plant and Equipment (PP&E)
Leasehold improvements	$5.9
Equipment & furniture	$17.0
Total PP&E	$22.9
Accumulated Depreciation & amortization	($2.9)
Net PP&E	$20.0
Other non-operating Investments and Assets	$6.4
Total assets	$61.1
Current liabilities
Accounts payable	$2.6
Accrued liabilities (negative working capital)	$2.5
Notes payable to bank	$1.0
Current portion of long-term debt	$1.8
Total current liabilities	$7.9
Long-term debt	$5.2
Total liabilities	$13.1
Total shareholders' equity	$48.0
Total liabilities & equity	$61.1

Eli-Rose provides you with the following forecasts regarding the operations of Clonatec after the acquisition. EBIT for 2014 are expected to be US$5 million. Eli-Rose ascertains that Clonatec does not require cash to operate, but the other components of net Working Capital will increase by 10% between year-and 2013 and year-end 2014. Net PP&E is expected to increase by 20% between year-end 2013 and year-end 2014. "Other non-operating Investments and Assets" will be sold at 90% of their book value at the time of the acquisition. After 2014, Clonatec's EBIT, net Working Capital, and Net PP&E are expected to grow at 5% forever. Due to the expected volatility of Clonatec's cash flows, the optimal capital structure of the stand alone firm is close to zero net debt.

a. Calculate the Free Cash Flows that Clonatec's operations will generate in 2014 (the corporate tax rate is 35%)

b. Eli-Rose estimated a WACC of 15% based on their assumptions of Clonatec's risk and capital structure going forward. Calculate Clonatec's Enterprise Value (value of the cash flows from operations).

c. Calculate the value of Clonatec's equity.

d. Moleculor is a publicly traded close competitor of Clonatec (same size, products, markets) with a Debt to Equity ratio (at market values) of 2. What is Moleculor's equity beta if its debt has purely idiosyncratic risk? How does your answer change if Moleculor's debt has systematic risk? [5 points]

e. Management says that thanks to the size and diversified nature of the operations of Eli-Rose, the firm has substantial debt capacity to prevent the acquired Clonatec from incurring in costs of financial distress. Thanks to this, they believe that Clonatec could comfortably sustain a debt to equity ratio of 0.5 for the foreseeable future. How would your answers to parts a), b) and c) change with this new information? No calculations needed: discuss whether and in which direction you expect your calculations to change and explain why.

Question 2 - Pneus is a profitable French tyre company that is all equity financed. Its total value is currently 8 billion euros. The CEO of Pneus intends to increase the leverage of the firm to take advantage of tax shields. The firm is considering only three possible alternative levels of debt: 1 billion, 2 billion or 3 billion euros, each of them to be issued in perpetuity. The proceeds of the debt issuance will be used to retire some equity. The corporate tax rate is 30%. A consulting firm has calculated that the expected costs of financial distress is 5% of D2 (e.g. the expected distress cost of issuing 2 billion debt is 200 million euros).

a) Assume that Pneus is mostly owned by retired French actors who have tax residence in fiscal paradises and pay no personal taxes. Calculate the optimal debt level of the firm among the three proposed. What is the leverage of the firm under this level of debt? Carefully explain your calculation.

b) The French government tightens the tax rules and now the typical investor of Pneus has to pay personal taxes. In particular, the marginal tax rate on debt income is 50%, the marginal tax rate on capital gains is 20%, and the marginal tax rate on dividends is 40%. Pneus shareholders receive 50% of their returns via dividends, and the rest via capital gains. The price of securities in equilibrium adjusts to these tax changes, which implies that Pneus will internalize any tax costs borne by its shareholders. Which of the three proposed levels of debt should the firm choose?

c) What advice would you give to the firm on the optimal level of debt that it should use when it can freely choose the amount (i.e. it is not anymore necessary to stick to 1, 2 or 3 billion)? Do it both under the conditions of question a) and question b). How does the presence of personal taxes affect the optimal capital structure of the firm?

d) Carefully enumerate and briefly explain the different sources of indirect costs of financial distress explained in class.

3. - Suppose that an entrepreneur can generate cash flows of either 330 or 480 millions. She can choose between two technologies to implement her idea: 1) a clean energy technology that produces the high cash flow with probability 1/3, and 2) a technology using standard fossil fuels, which produces the high cash flow with probability 2/3. The investment cost in the two projects is F. The clean energy project produces for the entrepreneur a personal gain in terms of job satisfaction, political connections, and access to philanthropic events that measured in monetary units is equal to 40 millions.

a) Suppose the entrepreneur can finance the project with internal cash. For which values of the investment cost, F, does the entrepreneur invest in the clean technology? For which values does she invest in the fossil fuel technology?

b) Suppose the entrepreneur has no cash and considers raising F by selling equity in her company. The entrepreneur chooses the project after the equity has been sold. What is the maximum value of the cost of investment, F, for which the entrepreneur decides to invest in the fossil fuel technology? Hint: assume that investors believe that the entrepreneur will invest in the fossil technology [5 points]

c) Why does equity financing change the investment behavior of the entrepreneur relative to your answer to part a). What kind of incentive problem does the use of equity exacerbate/ameliorate and why?

d) Suppose the entrepreneur considers raising F by issuing debt. The entrepreneur chooses the project after the debt financing has been received. Suppose that is F<330, such that debt is riskless. What is the maximum value of the cost of investment, F, for which the entrepreneur decides to invest in the fossil technology? (Hint: again assume that the investor believes that the fossil fuel project will be undertaken and see if the entrepreneur has the incentive to do so). How does the entrepreneur's behavior change relative to parts a) and b)? What kind of incentive problem does the use of debt exacerbate/ameliorate and why?

e) Now assume that F is such that debt is risky. For what values of the cost of investment does the entrepreneur choose the fossil fuel project? Explain how the use of debt financing changes the entrepreneur's investment behavior relative to part a). What incentive problem does risky debt exacerbate/ameliorate in this case?

4. You suspect that a hedge-fund manager has no skill. Instead, his strategy simply "levers" up the S&P 500, by creating a portfolio that invests - 50% in bonds and 150% in the S&P 500.

The risk-free rate is 0%, while the return on the S&P 500 over the next year can only take two values. It is either equal to 20% or to -20% . Currently the S&P 500 is equal to 100.

The fund manager is charging her clients according to a "high-water-mark" contract. In particular, if the fund experiences a positive return of x%, then the manager keeps 20% of the net return, i.e., 0.2x%. However, if the fund experiences a negative return, then the hedge-fund manager receives nothing.

An investor shares your concern, and wants to assess quantitatively how costly it would be to invest with such a non-skilled manager, assuming that the fund manager has no skill.

(a) Assume that the investor intends to invest 1 million dollars with the hedge fund. Assuming that the manager has no skill and follows the strategy that you believe he follows, what will be the dollar amount of the manager's fees if the S&P moves up? What if the S&P moves down?

(b) Using option-pricing theory compute the arbitrage-free present value of the manager's fees.

(c) What would be the arbitrage-free value of the manager's fees if instead of investing -50% in bonds and 150% in the S&P 500, he invests instead -100% in bonds and 200% in the S&P 500? Does the fund manager have an incentive to increase the leverage of her portfolio?

(d) Explain in words: If the manager simply "levers" up the index without truly adding value, how would you detect such behaviour, assuming that you had access to historical data on S&P returns and returns from the manager's portfolio? How should you adjust her compensation to remove any incentives to adjust leverage in an effort to influence fees?

 5 - Fixed Income

Suppose that a pension fund has committed to pay 100 million to retirees at the end of year 10 and another 100 million at the end of year 11. The yield curve is flat and all bonds currently have a yield to maturity of 5%.

(a) How much money does the pension fund need to raise from the prospective retirees today in the form of premiums ?

(b) What is the Macaulay Duration of the Pension fund's liabilities?

(c) Suppose that you can invest in a 5 year zero coupon bond and in a 15 year zero coupon bond. Suppose also that you are uncertain about the level of interest rates going forward. Specifically, you believe that after 3 years all yields could decrease to 4% (permanently) or they could increase to 6% (permanently). What dollar amounts would you invest in each of the two bonds to ensure that you can meet your obligation to the retirees in 10 and 11 years, irrespective of whether the yield curve experiences an upward or downward parallel shift?

(d) Immediately after raising the amount of funds implied by 5a, but before investing it, you become convinced that all yields will increase after 3 years to 6% and will stay there permanently. Suppose that you can invest in the 5-year or the 15-year zero coupon bond, or you can leave the money in a bank account where it will be earning the prevailing 1-year yield each year. However, you cannot short any of the two bonds, nor can you borrow. Assume that your objective is to maximize the net worth (i.e. present value of assets minus present value of liabilities) in year 10. (That way you can give some extra money to the retirees)., How would you invest the money now? How large would be the net worth of the fund in year 10, assuming you are right and you follow the optimal policy?

 6 - Asset and liability management

 Suppose that a bank has assets and liabilities. Its only assets consist of a mortgage pool that delivers 50 x (1.04) at the end of the first year and 50 x (1.04)² at the end of the second year. The bank's liabilities are short-term deposits with face value of 100 that require the bank to pay a floating interest rate. That interest rate is xl% for the first year (to be paid at the end of the first year) and x2% for the second year (to be paid at the end of the second year). The bank also needs to repay its liabilities of 100 at the end of year two. In summary, here are the bank's cash flows

	Year 1	Year 2
Mortgage payments	50 x (1.04)	50 x (1.04)2
Paymrnts to deposits	-x1 x 100	-100 (1+x2)

Finally, you may assume throughout that the bank can invest any cash in its vault at the prevailing one-year rates, i.e. xl% for year one and x2% for year 2. Currently the bank has zero cash in its vault.

The yield curve (i.e. the yield to maturity for zero coupon bonds of different maturities) is currently at 4% for all maturities.

(a) Assuming that interest rates remain at x₁ = x₂ = 4% throughout, show that the bank is solvent, i.e. track the bank's cash-flows and show that the bank will be able to meet its obligations to the deposit-holders in both years one and two.

(b) Show that the bank would be insolvent at the end of year 2, if in the next instant the yield curve experiences a permanent, parallel shift to 5% (so that in particular x₁ = x₂ = 5%). Compute the shortfall at the end of year 2.

(c) Suppose that the yield curve is currently flat at 4%, and that the bank can purchase or issue two zero coupon bonds. The first zero coupon bond matures in one year. The second zero coupon bond matures in 3 years. Create a portfolio of these two zero-coupon bonds that has the same value and Macaulay duration as the bank's mortgages.

(d) Suppose that you are called today to consult with the bank's management. They are afraid that the yield curve may experience a parallel, permanent shift over the next instant. Suppose that currently (i.e. while the yield curve is at 4%), the bank can issue the one- and three-year zero coupon bonds in part c.) of the exercise. It can invest the funds that it raises from the issuance of these bonds (along with any other cash in its vault) at going market rates (i.e. xi% for the first year, and x2% for the second year). It can also repurchase the bonds at a later time at their going price.

Can you describe a duration-matching strategy that involves issuing the two zero-coupon bonds of part c.), so that the bank can approximately meet its obligations in years one and two, no matter what parallel, permanent shift the yield curve experiences over the next instant? After describing your strategy, give a table detailing the cash flows of the bank, if it follows the strategy that you constructed, and the yield curve experiences a permanent, parallel shift to x₁ = x₂ = 5%, as described in part b) of the exercise. (Hint: Because duration only produces an approximate hedge, you may round the net position of the bank at the end of year two to the second decimal place.1)