BUSI4567-E1

A LEVEL 4 MODULE, AUTUMN SEMESTER 2022-2023

BUSI4567 CORPORATE FINANCIAL MAMAGEMENG

Question 1

a. What is capital budgeting? Explain why it is important in financial decisions?

· Capital budgeting is a process to make investment decision on future projects

· Capital budgeting estimates future cash flows and the discount rate in order to determine whether the return from potential project meets the benchmark

· The financial manager should consider any projects that add shareholders’ value.

· However, due to limited resources, only projects generate best returns to investors can be considered.

·                                                                           10 marks

b. Discuss NPV and IRR rules in selecting projects. Explain their advantages and disadvantages in investment decision making.  18 marks

c. Comment on the below statement:

“If the NPV of a project is zero, then the return to investors is zero. So the project should be rejected.”   8 marks

d. A company is planning for a potential project with a beta of 1.2. The Treasury bill rate is 3% per annum, and the expected return on the market portfolio is 8% per annum. Assume the capital asset pricing model holds.

i. What is the risk premium on the market?

The risk premium on the market is r_m – r_f = 8% - 3% = 5%             3 marks

ii. What is the required rate of return on the project?

Required rate of return on this project:

r = r_f + β(r_m – r_f) = 3% + 1.2x(8% - 3%) = 9%           5 marks

iii. If an investment with a beta of 0.8 offers an expected return of 9.8%, does’ it have a positive NPV? Explain.

For an investment with 0.8 beta, the required rate of return is

R = rf + β(rm – rf) = 3% +0.8 x (8% - 3%) = 7%.

If this project offers an expected rate of return of 9.8%, which is greater than 7%, then its NPV will be positive because the project is expected to generate higher a rate of return than investors requires.    6 marks

Total 50 marks 

Question 2

a. Discuss the role of correlation between risky assets in portfolio construction, using diagram to illustrate.

The correlation between risky assets in portfolio construction plays a key role in achieving the best possible effect of diversifications. The lower correlations between assets, the more gain from diversification. More specifically, the lower correction between assets, the better performance for the relation between risk and returns of investment. Actually, the fundamental driving force for diversification is because the assets are not perfectly correlated, as a result, there is a room for achieving a higher rate of return at the given level of risk, or lower level of risk at a given rate of return, or both.

b. 

18 marks

c. A portfolio manager is considering three financial securities for investment. The first is a stock issued by Northern Banking Corporation, the second is a bond issued by Budweiser Beer Corporation and the third is a Treasury Bill that yields a rate of 3% per annum. The expected annual rates of return and standard deviation are as follows:

i. If you were to fully invest in a portfolio with the two risky securities to achieve a 10% expected rate of return, what must be the investment proportions of the efficient portfolio and what is the standard deviation of this portfolio? Suppose the correlation coefficient between the stock and the bond is -0.3.

According to the formula of portfolio return: 

w_Sxr_S + w_Bxr_B = r_P

w_Sxr_S + (1-w_S)xr_B = r_P è w_Sx15% + (1-w_S)x6% = 10%

(2 marks for formulas)

w_S = 4/9

w_B = 5/9

(5 marks for correct results)

Standard deviation of this portfolio:

SD=(w_S²xσ_S²+w_B²xσ_B²+2w_Sxw_Bxρ_SBxσ_Sxσ_B)=[(4/9)²x27%²+(5/9)²x12%²+ 2(4/9)x(5/9)x-0.3x27%x12%]^0.5 = 11.9%

(3 marks for correct formula and 4 marks for correct results)

2 marks for discussion of results.  12 marks

ii. Illustrate, through a diagram, how the risk free asset can help investors to get an even better efficient frontier?

The introduction of risk free asset into the portfolio construction will change efficient frontier from “curvy shape” to a straight line. This is the best efficient frontier for investors.  6 marks

iii. Illustrate and explain that the Capital Market Line offers investors the best trade-off between risk and return, even though the investors have different degrees of risk tolerance.

Marking scheme:

The capital market line provides the best trade-off between risk and returns. Investors only need to choose a mix between the two assets: the market portfolio and the risk free asset according to own risk tolerance for best investment opportunities.  10 marks

iv. Can you find an optimal portfolio which satisfies all investors with different risk attitudes? Explain why.

Following the discussion in (iii), there is no an optimal portfolio that satisfied all investors. Each investor has a portfolio optimal to their own tolerance.   4 marks

Total 50 marks

Question 3 

a. Draw a diagram to explain the MM theory of capital structure with and without taxes. Explain the cost of debt, cost of equity and the cost of capital at different debt ratios.

1. MM theory without taxes:

2. MM theory with tax:

5 marks for each diagram (or 10 marks for one diagram illustrating both MM with and without tax). 4 marks more for clear explanation to each theory; 2 more marks for citations of the literature.   22 marks 

b. South Ocean Development Corporation (SODC) starts life with all-equity financing and a cost of equity of 14 percent. Suppose it refinances to the following market-value capital structure:

ZD pays taxes at a marginal rate of Tc = 30 percent. Assume MM’s theory with tax holds.

i. Use MM’s proposition 2 to calculate the new cost of equity.

According to MM theory 1963, the risk of equity will increase with additional debt.

r_E’ = r_A + (1-T_c)x(r_A – r_D)xD/E = 14% + (1-0.35)x(14% - 9.5%)x45/55

=16.39%

(correct formula 2 marks, correct answer 4 marks, 1 mark for discussion)  6 marks

ii. Calculate ZD’s after-tax weighted-average cost of capital.

WACC = r_Dx(1-T_c) x D/A+r_ExD/A = 9.5x(1-0.35)x.45 + 16.39x.55 = 11.79%  6 marks 

c. Here are the book value and market value balance sheets of the United Printing Company (UP) after a $40 million debt finance:

Assume that MM’s theory holds with taxes. There is no growth, and the debt of $40 millions is expected to be permanent. Assume a 30 percent corporate tax rate.

i. How much of the firm’s value is accounted for by the debt-generated tax shield?

There is $40 million debt, according to MM with tax, which generates 40x30% = $12 million value from tax shield.  5 marks

ii. What was the original value of the company before the debt finance?

E + D +TcxD = 160

D = 40

T_cxD = 30%x40 = 12

So E = 160 – 40 – 12 = $108 million   5 marks

iii. Who benefited from the decision of debt finance and by how much?

The shareholders will benefit from the debt finance by $12 million.   6 marks

Total 50 marks

Question 4

The Company South Light has $8 million cash for dividends. There are 4 million shares outstanding on the market. Currently, the stock price of the company is $10 per share.

a. If the board decides to pay the dividends in cash, what will the stock price be on the ex-dividend day? Discuss the impact of the cash dividends to shareholders’ wealth. Assume no taxes.

The earning per share of the company = $8 million / 4 million shares = $2 per share.

If the company pays all earning as cash dividends, then on the ex-dividend day, the stock price will reduce by $2 to $8.  5 marks 

b. If the board decides to use the cash to repurchase the company’s stock from the market. Assume no taxes.

i. How many stocks can be repurchased with the cash?

With $8 million in cash, the company can purchase $8,000,000/$10 = 800,000 shares.  5 marks 

ii. What will the stock price be before and after the stock repurchase and why?

The stock price before and after the stock repurchase will stay the same (4 marks) on a market without friction and information asymmetry (2 marks). This is because dividend policy is a financial decision, as argued by MM (1961) theory, which cannot generate positive NPV to shareholders (2 marks).          8 marks 

iii. Explain why the popularity of stock repurchases has been growing faster than the cash dividends as a method for companies to distribute cash to their stockholders.

When the markets are not perfect, stock repurchase sometime matters to stock value:

· Flexibility. Firms view dividends as a commitment to shareholders and hesitant to reduce an existing dividend. Repurchases do not represent a similar commitment.

· Stock repurchase allows investors to decide if they want the current cash flow and associated tax consequences

· Stock repurchase has a significant tax advantage over a cash dividend (as most time the tax on cash dividends is higher then the tax on capital gain.)

· Share repurchase can offset to dilution and leads to an increase in earnings per share. But the increase in earnings per share will not affect the value of the share.

Information asymmetry. The second explanation about the impact of stock repurchase on stock value, is information asymmetry between the insiders and outside investors:

· Stock repurchases send a positive signal that management believes that the current price is undervalued.

· Tender offers send a more positive signal than open market repurchases because the company is stating a specific price

· The stock price often increases when repurchases are announced   10 marks 

c. Discuss the effects of dividend policy in the real world. 

Students should start from MM dividend irrelevance theory with the assumptions, then various theories include tax, information asymmetry, clientele effect.

For answers with key bullet points, 12 marks.

With good understanding and discussion, 18 marks.

Answers with literature of relevant theories 20-22 marks      22 marks

Total 50 marks

Question 5

a. In 2018, the PCG Company made a rights issue at $4.5 a share of one new share for every four shares held, Before the issue there were 10 million shares outstanding and the share price was $5.5.

i. What was the total amount of new money raised?

There were 10 million shares. For a one for 4 rights issue, there were 2.5 million new shares after. So total new money raised:

$4.5x2.5 million = $11.25 million   4 marks

i. What was the prospective stock price after the issue?

($4.5x2,500,000+$5.5x10,000,000)/12,500,000 = $5.3    7 marks

ii. What was the value of one right?

The value of one right = price after – offer price = $5.3 - $4.5 = $0.8   7 marks

iii. How far could the total value of the company fall before shareholders would be unwilling to take up the rights?

Shareholders would not be willing to purchase the new share when stock price decreased to equal to or lower than $4.6 per share as they could buy the company’s stock cheaper from the market.   6 marks

b. Company ABC is issuing a bond with face value of $1,000, and coupon rate of 6% per annum. The maturity of the bond is 4 years. The yield to maturity of the bond is 3% annually.

i. What is the bond price?

According to bond valuation formula:

(2 marks)

Where coupon payments = $1,000x6% = $60

P = 60/(1+0.03) + 60/(1+0.03)² + 60/(1+0.03)³ + 1060/(1+0.03)⁴ = $1111.51 (4 marks)  6 marks 

ii. If the interest rate increases, whether the bond price increases or decreases? Illustration using a diagram.

When interest rate increases, the bond price will decrease (3 marks).

(2 marks for diagram)

5 marks

c. What is leasing and what are the advantages of leasing over other means of financing?

Lease is a rental agreement that extends for a year or more and for a series of fixed payments (3 marks)

· Operating Leases - Short-term, cancelable lease (2 marks)

· Financial Leases - Long-term, noncancelable lease. (2 marks)

Advantages of leasing (6 marks for bullet points, 2 marks for good discussion):

· Short-term leases are convenient

· Cancellation options are valuable

· Maintenance is provided

· Standardization leads to low costs - Lessors are special in the area, so more efficient service or scale of economy.

· Tax shields can be used

· Leasing and financial distress - When lessee has financial distress, court will enforce the lease payments to lessor

· Avoiding the alternative minimum tax  15 marks

  Total 50 marks

Question 6

a. Describe and explain possible motives for mergers and acquisitions

· Creation of synergy

· Market power

· Economy of scale

· Vertical integration to avoid hold-up problem

· Combination of complimentary resources

· Improve efficiency

· Industry consolidation

(6 marks for key points, 2 marks for good explanation)  8 marks

b. What are main objectives of horizontal acquisitions, vertical acquisitions and conglomerate acquisitions respectively?

Horizontal

· both firms are in the same industry

· economy of scale

· market power

Vertical

· firms are in different stages of the production process

· vertical integration to avoid hold up problem

Conglomerate

· The combination of two firms that operate in unrelated business areas

· New market or products

· Risk diversification

3 marks for key points of each type of merger, 1 mark for good explanation  10 marks

c. As financial manager, you are required to value a potential merger deal between your Company Green Energy and another Company ABC Mining. You are given the below information:

You estimate that investors currently expect a steady growth of about 4 percent in ABC Mining’ earnings and dividends. Under new management this growth rate would be increased to 5 percent per year, without any additional capital investment required.

i. How much is the synergy of the acquisition?

Current stock price for Company ABC Mining and g = 4%.

$4.2 = 0.252/(r – 4%) èr = 10%

The new stock price of ABC Mining after being taken over:

P = 0.252/(10% - 5%) = $5.04

Stock price will increase by $5.04 - $4.2 = $0.84. Total market value of ABC Mining will increase by:

$0.84 x 500,000 = $420,000, this increase is the synergy of the merger, which comes from improved management efficiency.  10 marks

ii. What is the cost of the acquisition to Green Energy if Green Energy pays $4.6 in cash for each share of ABC Mining?

Cost = Cash Paid – PV_B = $4.6 ´ 500,000 – $4.2 x 500,000 = $200,000   5 marks

iii. What is the gain to Green Energy?

Gains to Green Energy = synergy – cost = $420,000 - $200,000 = $220,000  6 marks

iv. What is the gain to ABC Mining

Gain to ABC Mining = cost to Green Energy = $200,000   5 marks 

v. What will be the new stock prices when the merge deal is announced?

The stock price of Green Energy will increase by: $220,000/$8,000,000 =

The stock price of ABC Mining will increase by: $200,000/($4.2x500,000) = 9.5%   6 marks

Total 50 marks