BUSI4567-E1
A LEVEL 4 MODULE, AUTUMN SEMESTER 2023-2024
BUSI4567 CORPORATE FINANCIAL MAMAGEMENG
Question 1
a. The students should firstly define the concepts of the NPV, IRR and Payback rules, then discuss the advantages and disadvantages of them. They need further justify the NPV is superior rule in maximising firm value. 10 marks
b. it is acceptable to take a project with zero NPV as the actual return to investors are from the required rate of return, through positive NPV increases the market value of the firm. 10 marks
c. As it will lead to the rejection/acceptance of the projects – a wrong rate will either accept a wrong project or reject a right project. 8 marks
d. It depends on whether the project is riskier or safer than the company’s overall risk. The cost of the capital of the project will be higher when it is riskier than the company’s existing business. Lower when it is safer than company. 6 marks
e. Darby Mining Corporation’s assets consist of three projects. The Project one’s asset is £10 million, project two £20 million and project three £30 million. The Betas of three projects are 1.5, 1.2 and 0.7 respectively. The risk free rate is 2%, market premium is 3%. Assume the CAPM holds.
i. What are the required rates of return on each of the projects?
According to the CAPM, ri = rf + bi (rm – rf)
Then:
rA = rf + βA (rm – rf) = 2% + 1.5 x 3% = 6.5%
rB = rf + βB (rm – rf) = 2% + 1.2 x 3% = 5.6%
rC = rf + βC (rm – rf) = 2% + 0.7 x 3% = 4.1% 7 marks
ii. What is the required rate of return on the whole company?
The total asset of the company = 10 + 20 + 30 = £60 million
r = 6.5x10/60 + 5.6 x 20/60 + 4.1x30/60 = 5% 4 marks
iii. Justify whether the below statement is true or not?
The company cost of capital is the correct discount rate for all projects. Because the high risks of some projects are offset by the low risk of other projects.
Not true – each project should use own discount rate due to various levels of risks. 5 marks
Total 50 marks
Question 2
a. What are the yield spreads between bonds? How credit ratings affect the yields of the bonds and yield spreads between bonds? Illustrate when necessary. 12 marks
b. You are required to price a treasury bond with a coupon rate 7% paid annually. The par value of the bond is $1,000. The maturity of the bond is 3 years.
i. State the principles of bond valuation.
Students need to realise the bond price should be the intrinsic value of the bond, (2 mark), which is the present value of the expected cash flows from the bond. (2 mark) 8 marks
ii. What is the price of the bond when YTM is 9% annually?
Coupon payments at 7% coupon rate = face value x rC = $1,000 x 7% = $70
6 marks
iii. What is the price of the bond when YTM is 5% annually?
Coupon payments at 7% coupon rate = face value x rC = $1,000 x 7% = $70
4 marks
iv.
Use a diagram to illustrate the relation between bond price and interest rate. 4 marks
v. Explain that at which situation a bond is priced at a discount, premium or at par value?
Holding coupon rate and maturity constant, higher interest rate, lower bond price: (1 marks)
When coupon rate > r, market price P0 > par value B (1 marks)
When coupon rate < r, market price P0 < par value B (1 marks)
When coupon rate = r, market price P0 = par value B (1 marks) 4 marks
c. A company is to raise 100 million debt capital for 3 years from bond markets. The corporate bond offers an annual coupon rate of 5%. The coupon payments are to be paid semi-annually. How many bonds with face value of $1,000 should be issued in order to meet the capital need? Ignore the commission fees for issuing the bond and taxes. The yield to maturity for this bond is 10% annually.
Question 3
a. Discuss Modigliani & Miller’s capital structure theory and optimal capital structure under 1) the no- taxes case; 2) the tax without bankruptcy costs case and 3) the tax with bankruptcy costs case.
Students need to define and discuss MM theories in cases 1, 2, 3. Using diagrams to help.
Good marks are offered to answers showing clear understanding of the issue and logic presented in good manner. 20 marks
b. XYZ Company has long-term debt of £233 million and book value of shareholders’ equity of £292 million. The debt has been financed at an annual interest rate of 7%. The estimate beta of the stock is currently 1.5 and the expected annual return on the market is 9%. The annual Treasury bill rate is 3%. There are 8.5 million shares outstanding, and the shares are trading at £42. The tax rate is 35%.
Assume the unit of measurement is in £,000
i. Calculate the weighted-average cost of capital (WACC) of XYZ.
Market value of Shareholders’ equity = 8,500 X 42=£357,000
Long-term debt 233,000
Shareholders’ equity 357,000
Total £590,000
D/V=233,000/590,000=0.39
E/V=357,000/590,000 =0.61
10 marks
ii. If long-term debt increases 283,000-233,000=£50,000
The corporate tax rate is 35%, so firm value increases by:
0.35 ´ £50,000 = £17,500
The market value of the firm is now: 590,000 + 17,500 = 607,500
The market value of shareholders’ equity is now:
607,500-283,000=324,500
New capital structure
Long-term debt 283,000
Shareholders’ equity 324,500
Total £607,500
D/V=283,000/607500=0. 47
E/V=324,500/607500=0.53
D/E =283,000/324,500=0.87
c. Students should explain the pecking order theory and the logic of the theory. Good marks for answers showing clear understanding and presentation is well constructed. 12 marks
Question 4
a. Explain MM Theory of Dividend Irrelevance (1961) and discuss the considerations of payout policies in real world.
Students should explain the MM theory of dividend irrelevance and the logic of the theory. Good marks for answers showing clear understanding and presentation is well constructed. 20 marks
b. US Steel Co. has been paying a regular cash dividend of $4 per share each year for over a decade. The company is paying out all its earnings as dividends and is not expected to grow. There are 100,000 shares outstanding selling for $80 per share. The company has sufficient cash on hand to pay the next annual dividend.
Suppose that Bao Steel decides to cut its cash dividend to zero and announces that it will repurchase shares instead.
i. What is the immediate stock price reaction? Ignore taxes, and assume that the repurchase conveys no information about operating profitability or business risk.
If no taxes, and repurchase conveys no information about operating profitability or business risk, then stock repurchase will not impacted on stock price. So the stock price will stay at $80. 3 marks
ii. How many shares will Bao Steel purchase?
There are 100,000 shares and $4 per share. So total earnings will be 100,000 x $4 = $400,000.
So $400,000/80 = 50,000 shares can be repurchased 5 marks
(a) The stock of Golden Eagle Corporation is currently selling for $10 per share. Earnings per share in the coming year are expected to be $1. The company has a policy of paying out 50% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 12% rate of return per year. This situation is expected to continue indefinitely.
i. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth DDM (i.e., the Gordon’s model), for what a rate of return do Golden Eagle’s investors require?
according to Gordon’s moduel:
P0 = Div1/(r – g), and g = b x ROE = 50%x12% = 6%;
Div1 = (1-b)xE1 = (1-0.5) x $1 = $0.5
r = Div1/P + g = 0.5/10 + 6% = 11% 7 marks
ii. If Golden Eagle were to cut its dividend payout ratio to 25%, what would happen to its stock price?
When b = 75, Div1 = 25%x$1 = $0.25, g = b x ROE = 0.75 x 12% = 9.%
So P0 = Div1/(r-g) = 0.25/(11%-9) = $12.5 8 marks
iii. From the above results, discuss how the financial manager could increase the firm value? 7 marks
Total 50 marks
Question 5
a. An investment of £500 will generate one of two outcomes: £400 in one year and £500 in two years OR £350 in one year and £300 in two years. Each outcome has a 50% probability. The discount rate is 15%.
i. What is the expected NPV of the investment?
Marking scheme:
First, draw a decision tree:
Year 1 Year 2
(4 marks for drawing)
The NPV of the investment = -500 + [(400/(1+15%) + 500/(1+15%)2]x0.5 +
+ [350/(1+15%) + 300/(1+15%)2]x0.5 = -500 + 628.54 = £128.54
(5 marks)
The NPV of the project is greater than zero, therefore, it is a good project (1 mark) 10 marks
ii. Assume you have an option to abandon in one year for £300. If you abandon, you keep that as the year one cash flow and give up the year two cash flow. Is the abandonment rational for either outcome? What is the NPV of the investment assuming rational abandonment and the value of the abandonment option?
Marking scheme:
When this is a real option to abandon, the new decision tree will be like:
(4 marks for drawing)
The NPV of the investment with the real option of abandonment
= -500 + [(400/(1+15%) + 500/(1+15%)2]x0.5 +
+ [(350+300)/(1+15%) ]x0.5 = -500 + 645.56 = £145.56
The value of the real option to abandonment = NPV with real option – NPV without real ption = 145.56 – 128.54 = £17.02
(5 marks)
The above results from question (i) and (ii) indicate the investment with real option is more valuable than those without. (1 mark) 8 marks
b. Describe four types of real options often encountered in investment opportunities.
Marking scheme:
· The option to expand
–the opportunity to expand and make follow-up investments.
· Time option
–the opportunity to “wait and see” and invest later when more information is received.
· The option to abandon
–the opportunity to shrink or abandon a project.
· Flexible production option
–the opportunity to vary the mix of the firm’s output or production methods. 12 marks
c. Identify the problems of the discounted cash flow (DCF) analysis for valuing a project and explain the reasons that managers might use real options analysis.
Marking scheme:
The students is expected to elaborate how “traditional” NPV through DCF analysis misses a very important issue in investment evaluations, that is, the opportunities of “wait and see” at later stage of a project. This ignorance of the opportunity underestimates the value of a project.
Good marks for clearly understanding of the issue and elaboration of the key points with concise and logic presentation. 20 marks
Total 50 marks
Question 6
(a) What is corporate governance? Why it is important for modern corporations?
Corporate governance is a system that enables shareholders to get proper rate of return according to the definition by Shleifer (1997). There are many other definitions like OECD, etc.
A sound corporate governance can minimise the agency problem. It is evident that a good corporate governance will increase the return to shareholders. 12 marks
(b) Give some examples of corporate governance mechanisms and explain how they work
Internal mechanism: corporate charter, general shareholders’ meeting, the board of directors, the board of supervision, information disclosure etc.
External mechanism: laws and regulations, unions in some countries, financial markets, publicity, history, etc. 10 marks
(c) Horizon Electronic Corporation is contemplating the acquisition of Potterton High-tech Co. The values of the two companies as separate entities are $150 million and $90 million, respectively. Horizon estimates that by combining the two companies, it will reduce marketing and administrative costs by $1,500,000 per year in perpetuity. Horizon can pay $95 million cash for Potterton. The opportunity cost of the capital is 5%.
i. What is the concept “synergy” and where the synergy comes from? 8 marks
ii. What is the synergy from the merger?
PV of the saving = $1,500,000/0.05 = $30,000,000 (We assume that the $1,500,000 saving is an after-tax figure.) 10 marks
iii. What is the cost of the cash offer?
$95 – 90 = 5 million 5 marks
iv. What is the NPV of the acquisition under the cash offer?
30 million - 5 million = $25 million 5 marks
Total 50 marks