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Case Western Reserve University 2025 midterm 440, Exams of Finance

One of the midterm from Krish's finance modeling class, very helpful and much detials inside.

Typology: Exams

2024/2025

Uploaded on 04/22/2025

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440
Problem Set 3
1. There are two firms in a market – firm A and firm B. Insiders of firm A know that the
present value of future Free Cash Flows (FCFs) is $200 million. Insiders of firm B know
that the present value of future FCFs is $100 million. The outside investors perceive the
present value of future FCFs for both firms to be $100 million. If firm A does nothing to
signal its true value then there is nothing that changes the perception of the investors.
Both firms can invest in a project that requires an investment of $10 million that will
generate a present value of cash flows of $20 million, which is common knowledge. The
$10 million investment has to be funded by new equity from outside investors. One
action firm A could take to signal that its value is higher than what outside investors think
(and lower its cost of equity) is to pay an unexpected special dividend financed by a debt
issue such that firm B finds it sub-optimal to mimic this action. The cost associated with
the special dividend in terms of the opportunity cost, cost of making dividend payments,
and cost of the debt issue can be represented by C, where C is a function of the amount of
special dividend paid. Let C = 0.2*amount of special dividend. What is the lowest
amount of special dividend that can correctly signal that a firm that takes this action was
worth $200 million (before this action) and not $100 million as initially estimated by the
outside investors?
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Problem Set 3

  1. There are two firms in a market – firm A and firm B. Insiders of firm A know that the present value of future Free Cash Flows (FCFs) is $200 million. Insiders of firm B know that the present value of future FCFs is $100 million. The outside investors perceive the present value of future FCFs for both firms to be $100 million. If firm A does nothing to signal its true value then there is nothing that changes the perception of the investors. Both firms can invest in a project that requires an investment of $10 million that will generate a present value of cash flows of $20 million, which is common knowledge. The $10 million investment has to be funded by new equity from outside investors. One action firm A could take to signal that its value is higher than what outside investors think (and lower its cost of equity) is to pay an unexpected special dividend financed by a debt issue such that firm B finds it sub-optimal to mimic this action. The cost associated with the special dividend in terms of the opportunity cost, cost of making dividend payments, and cost of the debt issue can be represented by C, where C is a function of the amount of special dividend paid. Let C = 0.2*amount of special dividend. What is the lowest amount of special dividend that can correctly signal that a firm that takes this action was worth $200 million (before this action) and not $100 million as initially estimated by the outside investors?
  1. A firm’s manager makes the dividend payout decisions. The amount of investment made from out of the firm’s after-tax cash flow determines its intrinsic value, which is the manager’s estimate of the present value of its future cash flows. The amount of dividend paid out from out of after-tax cash flow determines the firm’s current market price, which is the estimate of the outside investors of the present value of its future cash flows. The after-tax cash flow for the firm is $ 25 million. Using a simple model, assume that the manager’s estimate of future cash flows is $10.5 million, $11 million and $10 million per year forever if the investment is $22.5 million, $20 million and $17.5 million respectively. The outside investors’ estimate of future cash flows is $7.5 million, $11 million and $12.5 million per year forever if the dividend is $2. million, $5 million and $7.5 million respectively. Assume that the rate used by both the insiders and the outsiders to discount all future cash flows is 10%. All the manager cares about is the value of all his shareholding. What would be the manager’s payout decision if he holds 10,000 shares in all and (a) plans to sell 5000 very soon and hold 5000 (b) plan to sell 7000 very soon and hold 3000 (c) plans to hold all shares? Comment in each case whether his decision is the optimal one in the sense of maximizing the firm’s intrinsic value.