Assignment#1 – 25 points Total

125.330 S1

Part A: Corporate investment decision to diversify and its impact on Firm Value (11 points)

“If shareholders can undo/redo a certain corporate decision on their own, there is no relevant value from such move by a given firm.” – The real implication of Modigliani and Miller (MM) 1958 theorem

The above principle initiated by the Founding Fathers of Corporate Finance (MM) could be applied to all corporate finance decisions.

In the context of finance, especially from your INVESTMENT (e.g. investing in Financial

Assets such as shares, bonds, ETFs, and such) COURSES, diversification has been one of the top tools in optimalising your investment portfolio as it could maintain average returns while  reducing the total risk of your portfolio investment. BUT could a firm adopt this same

principle and add value to its shareholders? The assigned article in Part A touches on this particular issue, with the focus on our New Zealand corporate landscape.

QUESTIONS/TASKS

You are working as a consultant for a listed firm in New Zealand. The company’s

management team is now considering corporate diversification, with a belief/claim that

such practice would further add value to shareholders. These executives ask you to seek

further information and provide insights that could aid their decision. Upon your search,

you came across the following article (shared on our Stream website in the ‘reading list’).    You plan to use it as your main source while also searching for other relevant literature and

information (e.g. online).

Al-Maskati, N., Bate, A.J., and Bhabra, G.S. (2015), “Diversification, corporate governance and firm value in small markets: evidence from New Zealand ”,

Accounting and Finance, Vol. 55. 627-657.

Please provide the answers to Questions 1 to 3:

1.   According to the main findings of the article, provide an executive summary on whether corporate investment decision to diversify helps or harms shareholders’ interest, in a

New Zealand context. Also provide brief explanations why and what factors to look out for.

(Tips: This is arather straightforward question. About two (or three) pages of double-spaced typewritten texts should be sufficient for the answers.) (5 points)

2.    Based on your own evaluations, provide further considerations or aspects one should also consider beyond what is mentioned in the article. Justify your points well.

(Tips: There can be two aspects. This should be not more than 1.5 double-spaced pages for EACH aspect. Backup your points with information beyond the assigned article.) (2 points)

3.    If this setting were changed to be for ‘China’ instead, how would your conclusions (e.g. from Q1) change, in your opinions?

(Tips:  This question should be not more than two double-spaced pages. Backup your points with information beyond the assigned article.) (2 points)

TOTAL   (9 points)

Part B: Advanced techniques in Investment decision - Real Option Analysis (9 points)

Chemis Pharmaceutical Incorporation (CPI) is a medium-sized pharmaceutical supplier for Australasian region. CPI has just attained a 15-year exclusive right to launch a new nasal spray which helps with clogged nose faster than any other ones available in the over-the-counter market (assumed no rivals or substitutions for a foreseeable future) called ‘Ouvertin’ . With the co-operations of the marketing/production/financial teams of CPI, the estimated average cash flows for launching ‘Ouvertin’ emerge as follows:

The product is within the same line of CPI existing business while its cost of capital is 11.5% per year. In addition, launching Ouvertin will not alter the company’s cost of capital. The launching of Ouvertin will cost $10 million at any point in time during the next fifteen years and is fixed (at $10 million). The 15-year government bond YTM is observed as 3.5% per year in the government bond market. The pharmaceutical product market is quite volatile in its nature. The six-month stock return variance on this industry’s stock portfolio in the relevant markets is estimated as 21%. For simplicity, let’s assume that the rate of decay on the product launching project is constant through time.

Questions:

1.   Should CPI should go ahead with the launching of the new product  - Ouvertin? Provide a numerical justification in the context of ‘real option analysis’. The use of Black and Scholes model in Excel (submitted separately) to justify your numbers is also required (8 points)

Note:

- Assume e = 2.718 as we always do in class and lecture note.

Part C: Applying newly emerged technique from recent research (9 points)

Memphis Tiger Company

You are working as a financial consultant for Memphis Tiger Company, a (hypothetical) publicly traded firm. Carly Santana, the CEO of the company, has been frustrated with the traditional ‘cost of capital’ calculations typically introduced in conventional finance textbook for several reasons. Ms. Santana turned to a journal that is most popular among ‘corporate finance’ practitioners called ‘Journal of Applied Corporate Finance’. It is a highly regarded journal that summarises/digests the latest development and debates in corporate finance to audiences. In a rather recent issue, she has found an article that offers a new way to calculate the cost of capital for a company called ‘EACC’ (The article will be shared on Stream website, through the reading list. It is written by Gerard Olson and Michael Pagano of Villanova University -USA). Ms. Santana is extremely excited about this and has asked you to do the following for her:

Olson, G.T., and Pagano, M.S. (2017), “The Empirical Average Cost of Capital: A New Approach to Estimating the Cost of Corporate Funds”, Journal of Applied Corporate Finance, Vol. 29. 101- 110.

QUESTIONS

1.   Calculate EACC for Memphis Tiger Company based on the data source provided (in the Excel file posted on Stream). This dataset was prepared (collected and manually keyed in) by an intern who delivered it in a rush due to work overload placed on him lately. Also provide a brief discussion on which version of ‘total capital’ should be used if the company’s stock is thinly traded in the share market.  (7 points)

Note: .

- About two weeks before the due date, Submission box will be open for you to hand in your works online, on our Stream website.

- Use Microsoft Excel application wherever possible. Submit your Excel work file along with the answers well written in a Words file.

- There is no particular setting of how many pages the report should contain. It should be complete and yet

concise (e.g. not over 20 pages of a Word file – this is the maximum, NOT the target! - Works the same as the Speed Limit ).