FINE 342: Midterm Examination
Thomas J. Rivera
Issued: Monday, April 26, 2021, 9:00am EST
Due: Thursday, April 29, 2021, 9:00am EST
Introductory message
The purpose of this exam is to provide you with an opportunity to demonstrate what
you have learned so far this semester. Because of the challenging situation imposed by
COVID-19, Desautels Faculty of Management wants to ensure that you are fully aware of
the special measures we are taking to ensure the exam is fair and that you have enough
time to complete it. Please read the complete cover page and sign the academic integrity
honour code before beginning your exam.
General information
Course name and #: FINE 342
Type of exam: Take-home
Date and time of exam release: Monday, April 26, 2021, 9:00am EST
Deadline for exam submission: Thursday, April 29, 2021, 9:00am EST
Method of submission: 3 documents via mycourses→assignments→final:
1.) Single pdf file with typed or scanned solutions
2.) Single Excel supplementary file for Question 6 only.
3.) Signed copy of the honor code on page 4.
Terms and Conditions
a) Referring to the course material is permitted.
b) Online searching of subject material/related exam questions is not permitted (it won’t
help you anyway!).
c) Communicating with classmates regarding any aspect of the exam or course
once you begin is not permitted.
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FINE 342
d) Posting or sharing exam content with anyone, including exam questions,
your questions, or your answers is not permitted.
e) I reserve the right to use a plagiarism checker or any other software to compare exam
copies and check for signs of cheating.
Exam time period and submission
a) You may submit more than once in the assignments section of mycourses, but only the
last submission will be graded.
b) Late submissions will be penalized by 1 point per minute late unless the
delay is justified and approved by the BCOM office.
Questions that arise during the exam time period
If you find an exam question to be ambiguous or unclear, email your concerns to the
instructor at the address shown above in the General Information section. Your instructor
will try to review questions periodically during the exam period, but there is no guarantee
of response. It is important, therefore, that you still answer questions to the best of your
ability. The instructor will refuse to answer any questions related to the content of the
course during the exam period.
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FINE 342
INSTRUCTIONS
1. The McGill University Code of conduct applies. Any violation of the code of conduct
will be dealt with severely.
2. This is an open book exam.
3. All work you want to be graded should be included in the single pdf file or single
excel file (only for question 6) submitted in the assignments tool on mycourses and
clearly indicated.
4. Your solutions should consist of 6 sections (one for each exercise) with a clear
label at the start. All answers to subquestions (e.g. 1.2, 3.1, etc.) must also
be labeled and in order, any answer without a label or not in order will not be
graded. Any solution material that does not appear directly in the appropriate
section will not be graded (i.e. you are NOT allowed to include an appendix or
any figures, notes, etc. that are not directly integrated into the solution section).
I do not need you to reproduce the exam questions with your solution, just a blank
sheet of paper (or typed document) that is correctly labeled with the section and
question numbers.
5. Solutions that are unnecessarily long (e.g. rambling) will be penalized so please be
concise. Similarly, if one part of the solution contradicts another part (e.g. making
one correct statement but following it with an incorrect statement that contradicts
it) this will also be penalized.
6. Write clearly. Any illegible answers will immediately receive a score of zero.
7. The exam must be submitted before 12pm (Montreal Time), Saturday, February
27, 2021. 100% typed submissions will receive a 5 point bonus. Unapproved late
submissions will be penalized by 1 point per minute late.
8. This exam counts for 50% of your final grade. There are 100 points in total.
9. To receive full marks for questions 1-5 you must show all work and computa-
tions used in the pdf file. I will not accept work done in excel except for Question
6.
10. For question 6, you must clearly demonstrate and label any calculations in the sub-
mitted excel file that you reference in your answer. Messy excel files with calculations
in hard to find cells or cells that are not clearly labeled will be penalized.
11. Submissions without the following signed honor code are not considered complete
and therefore the late rule applies until the signed honor code is submitted.
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Academic integrity
McGill University values academic integrity. Therefore, all students must understand
the meaning and consequences of cheating, plagiarism and other academic offences under
the Code of Student Conduct and Disciplinary Procedures” (see www.mcgill.ca/students/srr/honest/
for more information). (Approved by Senate on 29 January 2003).
Please sign the following honour code and upload it to mycourses→assignments
→ midterm:
Student Name:
Student Number:
“I have neither given nor received unauthorized aid on this quiz/exam and I fully under-
stand the instructions and the repercussions for not following them.”
Signature:
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FINE 342
* represents a more difficult problem.
1 Payout Policy/Capital Structure (15 pts)
Consider a firm F that generates a single cash-flow in one year which depends on the state
of the economy:
-Boom (probability 1/2) 5m
-Recession (probability 1/2) 1m
-F has 2,000 bonds outstanding with face value $1,000 and a 6% coupon, one year matu-
rity.
-There are no taxes, and the risk free rate is 3%
-F has 1m cash at the beginning of year 1.
-F’s cost of debt is 4% regardless of the payout policy they choose.
F can distribute at the beginning of year 1 either 70% of its cash or 30% of its cash. The
cash retained by the firm is invested at the risk free rate.
Stockholders invest the dividend they receive at the beginning of year 1 at the risk free
rate as well.
1.1 (5 pts) Which of the two payout policies maximize stockholder payoffs at the end of year 1?
1.2 (5 pts) Anticipating that the firm will choose to payout 70% of its cash at the start of year
1, the market value of the firm’s bonds is 1.5m, calculate the expected bankruptcy
costs on the firm’s assets.
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1.3* (5 pts) Suppose instead that the market value of the bonds are 2m regardless of the payout
policy chosen. The required return on the firm’s assets is 10%, and the required
return on equity if the firm had zero cash is 12%. Which of the two payout policies
will the firm’s shareholders optimally undertake and why?
2 Agency Costs (15 points)
F generates a single cash-flow in one year. This cash-flow depends on the strategy chosen
by the management:
- The safe strategy yields a certain cash-flow of $3,500,
- The risky strategy yields a high cash-flow of $15,000 with probability 0.2, and a low
cash-flow of $625 with probability 0.8.
F has 3 stocks outstanding and one bond with a $2,000 face value, a 5% annual coupon
and a one-year maturity. All agents are risk neutral and the risk free rate is 5%.
2.1 (3pts) If the bond is non-convertible, which strategy does the management choose and why?
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2.2 (7pts) If the bond is convertible with a conversion ratio of 4, which strategy does the
management choose and why? In what cases do the bondholders convert in what
cases do they not convert (they can see the cashflow before converting)?
2.3* (5pts) Suppose the bond has not been issued yet and that both projects cost 2,000. The
firm wants to issue the same convertible bond as in 2.2 but must include one of the
following covenants to the bond:
-Covenant A: restricts the firm to only invest in the safe asset.
-Covenant B: restricts the firm to only invest in the risky asset.
Assuming the creditors pay market value for the bonds, which covenant will the firm
include and why?
3 Agency Costs/Bank Regulation (15 pts)
Suppose that you are a bank regulator who knows that there are two types of bank’s under
your jurisdiction, high quality (H) and low quality (L), who differ in their ability to screen
loan applications for credit worthy borrowers. Using past data you estimate that roughly
70% of banks are high quality and 30% are low quality. High quality bank’s generate a
cashflow per loan of 100k with probability .8 and 0 with probability .2. A low quality
bank on the other hand generates a cashflow per loan of 100k with probability .5 and 0
with probability .5.
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FINE 342
These banks primarily make small loans to local businesses which creates a social benefit
of 4% per dollar lent (i.e. if the bank lends $10 then the social benefit is 4%*$10). When
a bank fails though, it generates a social cost of 15% per dollar of losses to the banks
creditors (i.e. if creditors lose $10 then the social costs is 15%*$10).
As a regulator you must choose a “capital requirement”, dictating how much the banks
can borrow to make loans, in order to maximize the expected social value. Each loan costs
$50k and generates the returns described above. Additionally, the bank’s start with $50k
of their own money to invest. You, as the regulator, are debating whether to let the banks
borrow money to issue 0, 1, or 2 additional loans. We assume the bank’s find it optimal
to issue as many loans as possible but can only raise additional funds by borrowing. This
means banks will always make at least 1 loan with their initial $50k and will make an
additional 0, 1, or 2 loans with borrowed money depending on how much the regulator
allows them to borrow. All loans generate the same cash flow (e.g. if the H-type makes
3 loans then with prob .8 each loan generates a cashflow of 100k and with .2 each loan
generates a cash flow of 0. Similarly, if the L-type makes 3 loans then each loan generates
a cash flow of 100k with prob .5 and each loan generates a cashflow of 0 with probability
.5).
3.1 (9pts) Assume the regulator knows which banks are H-type and which are L-type. What
is the expected social value (i.e. social benefit minus expected social cost) if the
regulator allows the H-type bank to borrow 0, $50k, or $100k to make additional
loans? What bout the L-type bank? How much will the regulator optimally allow
the H-type and L-type bank’s to borrow? (remember all bank always makes at least
1 loan, so they will either make 1, 2, or 3 loans depending on whether the regulator
allows them to borrow 0, $50k, or $100k. Also note that the social cost only applies
to borrowed money lost in default, not the bank’s initial $50k, and the social benefit
applies to money lent, not the realized cashflow).
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3.2 (3pts) Suppose instead that the regulator cannot tell which bank is H-type and which is
L-type. How much will the regulator optimally allow the bank’s to borrow? What
is the expected social value of this optimal policy?
3.3 (3pts) The regulator is deciding whether to invest in a “stress testing” technology that will
allow them to distinguish H-type banks from L-type banks. How much would the
regulator be willing to pay for this technology?
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FINE 342
4 Excel Exercise (55 points)
Excel Instructions: For this question I want all work to be clearly explained in the pdf
solutions. Important components to include in the pdf are how the cash flows are derived
and discounted for all adjustments, making it clear the discount rates you are using and
the time period. Please be explicit: e.g. I want to see ”I discount year X cashflows at a
rate 1
(1.10%)3
” not ”I discount year X cashflows at the rate of .7513”. Further, I want you
to copy and paste the excel cells with your actual calculations and reference that in the
pdf document where you explain what you are doing.1 Failure to include this information
in the pdf file and/or copy pasting results that are not identical to what I will find in the
Excel file will result in a penalty.2
Excel Sheet Formatting Instructions: Please format the cells you will be using in
Excel to include three decimal points and to use commas as 1000 separator (drag and
highlight cells you will use, right click, choose Format Cells→Number, Fill in Decimal
places: 3, and click the box “Use 1000 separator”).
Webticks is a young private firm that provides a streaming service platform to which it
charges an annual subscription fee of $15 per user. Data reveals an expected user base of
10m in 2019. Due to the lockdowns from the pandemic and general uncertainty, Webticks’
user base is expected to drop by 15% for 2020. Yet, given the high demand for streaming
(due to stay at home orders) Webticks is expected to be able to boost its market share
during the pandemic resulting in an expected increase in users by 45% in 2021 (from the
2020 level). Analysts’ best forecast predicts that, due to the ease of stay at home orders
at the end of 2021, Webticks’ users would decline in 2022 by 10% of the 2021 level and
then continue growing at the pre-pandemic rate of 3% starting in 2023 (i.e. this growth
rate does not apply to 2022).
The annual operating cost per user of Webticks’ operations depends on the number of
users and the year and is summarized by the following table:
# of Users 2019-2023 2024+
0-8,000,000 $16 per user $8 per user
>8,000,000 $8 per user $8 per user
As can be seen, Webticks faces a higher cost per user in the final ”start-up” years of
1You can screen shot a selected part of your screen by pressing and holding shift+command+4 on
mac or shift+windows+s on windows and then drag the cursor to create a box around the part you want
to screenshot and letting go of the cursor. You can then save this image and insert it into your word
document (which you will convert to pdf after).
2If you choose not to type your exam you can leave out the copy paste of excel results. I strongly
suggest that all students type the exam to avoid being penalized by the curve.
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FINE 342
2019-2023, but only for the first 8m users.3 This represents the fixed cost of buying the
content that Webticks streams. Starting in 2024 Webticks will own this content outright
and therefore faces cost per user of $8 independent of the number of users. The net capital
expenditure for this purchase of content has already been accounted for prior to 2019 (i.e.
we can ignore it) but the purchase is still being accounted for via D&A according to the
straight line method at 2m per year with the last year being 2019.
Additional Capex from 2019 onward is equal to additional D&A (i.e. not including the
2m D&A in 2019). Additionally, change in NWC is equal to zero as the business requires
very little working capital. Webticks is all equity, the required return on Webticks’ assets
is 20%, and the corporate tax rate is 30%.
5.1 Scenario 1: (30pts) Give the most accurate possible valuation of Webtixs at the
start of 2019 given the above forecasts using the APV method.
5.2 Scenario 2: (10pts) Suppose instead that at the start of 2019 you did not know
about the coronavirus outbreak and its potential to disrupt markets. In that case, you
simply assumed the company will have 10m users in 2019 and that they are growing at the
pre-pandemic rate of 3% after 2019 (all other data is the same). Compare the valuation
under this scenario to that of Scenario 1.
5.3 Scenario 3 (hard, 15pts) Suppose that the user base for Webtixs is the same as in
Scenario 2 but that Webtixs has 25m outstanding debt at the start of 2019 with an interest
rate of 5%, linearly amortized over the next 5 years. In order to understand the required
return on Webtixs equity you use data from Netflix from 2016-2019 when it was in a com-
parable growth phase (see the attached excel file). Assume Netflix had the same leverage
over this sample period as Webtixs starts with in 2019. The annual risk free rate in 2019 is
expected to be 2.8% and the annual market return is expected to be 15.3%. Finally, we as-
sume that the cost of debt for Webtixs remains constant at 4% over the lifetime of the loan.
Give the most accurate possible valuation of Webtixs using the FTE method. You cannot
use any estimates for the value of equity when using this approach but you can use ap-
propriate estimates for leverage (hint: you will need this to correctly proceed). Was your
estimate of leverage accurate? (note that this exercise is labeled hard for a reason and that
you MUST use the FTE approach, without using any of the prior calculations of value.
You can of course use the same initial calculations as in Scenario 2 so you don’t have to
repeat the same work. Also note that not all of the exercise is hard so there is potential
for partial credit.).
3E.g. if Webticks has 10m users in 2022 then its total operating cost is 8m ∗ 16 + 2m ∗ 8, while if it
has 10m users in 2024 then its total operating costs is 10m ∗ 8.
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