Disclaimer:  This practice midterm exam roughly resembles what the upcoming exam will look like in terms of its format.  It has been designed to reflect mainly the materials that are related to our course.  However, this does not mean the practice exam will show exactly the same length, difficulty, emphases, and weights on topics we have covered so far for the upcoming exam.

Instructions:

1. Please write your student ID (not your name) and circle your section in the space above.

2. The exam is closed-book and closed-notes.

3. You are allowed (i) one basic calculator with logarithm and exponential functions, and (ii) one 8.5” by 11” crib sheet with notes written on both sides.  But you may not use any other electronic devices (including phone, smart watch, laptop, tablet, etc.) during the exam.

4. You have one hour and twenty minutes (90 minutes) to work on the exam.  There are 100 total points; points per question are indicated next to the question.  Verify that your exam book consists of 10 pages (including this cover page).

5. Please round percentages and values up to four (4) decimal places.

6. Your grade will be based only on work in this exam book.  Whenever possible, show your work.  You will not get full credit for most of your answers unless you do so.  Similarly, partial credit can only be given based upon what you actually write down during the exam.

7. If you need additional space, please continue on the back of the page and indicate clearly that you are doing so.  It is important to avoid mistakes, especially ones that lead to glaringly wrong answers.  Double-check your work carefully.

8. Whenever in doubt, please try to state your reasoning as clearly as possible and, in particular, explain any additional assumptions you may have used for obtaining your answers.

9. Read questions and instructions carefully, allocate your time wisely, and all the best of luck!

I. Cost of Capital (20 points)

Open Seasme! (OPSM) is a large e-commerce company that provides a variety of consumer and business services via web portals.  It just went public with a recent IPO.  As a valuation consultant hired by the company, you need to estimate OPSM’s weighted average cost of capital (WACC).  OPSM has 10,000 shares outstanding, and its current market price is $40 per share.  The company also has $200,000 debt outstanding, selling at 95% of its par value with a yield of 3.1%.  Its current excess cash balance is at $350,000.  You know OPSM plans to keep its debt-to-value ratio constant at the current level.  Further you know that the risk-free rate is 2.8%, and the equity market risk premium is 5.5%.  However, because the company has only been listed on the stock exchange for a short time, you do not have an accurate assessment of its equity beta.  Thus, you have found BABA, a comparable firm in the same industry, and estimated the following data for BABA:

Suppose that BABA will keep its level of debt constant in dollar amount (i.e., permanent debt) regardless of how the market value of its equity changes.  Both companies have an effective corporate tax rate of 35%.  Compute OPSM’s WACC.