Mid Term Exam

FIN413 – Practice Midterm Exam
Fall 2012

Boris Nikolov

William E. Simon Graduate School of Business Administration
University of Rochester

Name ______________________________

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Please do not open exam until instructed to do so

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Exam is 2 hours

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This is a closed book exam

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One page of personal notes allowed

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Please do not sit in adjacent seats

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Please write only in the space provided for each question

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You need a pocket calculator

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Good luck!

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GRADE SHEET
INSTRUCTOR USE ONLY

Question 1: _____________
Question 2: _____________
Question 3: _____________
Question 4: _____________

Total number of points: _____________

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Problem 1
“The way I see it,” says the CFO of Milk Em Dry, Inc., “if I buy half of the 10,000 outstanding common shares with the proceeds from the sale of debt, I can increase earnings per share. After all, I can borrow at 10% and I am currently earning 20% on my al l-equity-financed firm. I estimate the beta of the borrowed money at 0.40 and the beta of my equity before borrowing at
1.20. The price-earnings ratio (P/E) of the common shares is 5 on operating income of $25,000; and I expect to continue to generate that amount of operating income after the debt financing.
Seems to me this will be a good deal for shareholders, and they are the one’s I’m working for. In fact, it would be dumb not to go into debt.”
Your job is to help this CFO determine whether to borrow or not. Assume perfect capital markets with no taxes. Also, to make life easier assume all cash flows are perpetuities. Determine the
EPS, the return on equity, and the value of the firm under the two scenarios. How do you interpret the results?

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Problem 2
Midcap Corporation (MC) will cease to operate in one year. The firm is currently all-equity financed, and has 10 million shares outstanding. In one year, MC’s projects will generate earnings before interest and taxes of