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FN3092 Corporate finance

Important note

This commentary reflects the examination and assessment arrangements

for this course in the academic year 201213. The format and structure

of the examination may change in future years, and any such changes

will be publicised on the virtual learning environment (VLE).

references

Unless otherwise stated, all cross-references will be to the latest version

of the subject guide (2011). You should always attempt to use the most

recent edition of any Essential reading textbook, even if the commentary

and/or online reading list and/or subject guide refers to an earlier

edition. If different editions of Essential reading are listed, please check

the VLE for reading supplements if none are available, please use the

contents list and index of the new edition to find the relevant section.

General remarks

Learning outcomes

At the end of this course, and having completed the Essential reading and

activities, you should be able to:

explain how to value projects, and use the key capital budgeting

techniques (NPV and IRR)

understand the mathematics of portfolios and how risk affects the

value of the asset in equilibrium under the fundamental asset pricing

paradigms (CAPM and APT)

know how to use recent extensions of the CAPM, such as the Fama

and French three factor model, to calculate expected returns on risky

securities

explain the characteristics of derivative assets (forward, futures and

options), and how to use the main pricing techniques (binomial

methods in derivatives pricing and the BlackScholes analysis)

discuss the theoretical framework of informational efficiency in

financial markets and evaluate the related empirical evidence

understand the trade-off firms face between tax advantages of debt and

various costs of debt

understand and explain the capital structure theory, and how

information asymmetries affect it

understand and explain the relevance, facts and role of the dividend

policy

understand how corporate governance can contribute to firm value

discuss why merger and acquisition activities exist, and calculate the

related gains and losses.

1

In general, the Examiners are looking for a solid demonstration of

understanding of the above learning outcomes from candidates. Typically,

the examination questions cover a wide range of topics from the syllabus.

They are often set in such a way as to enable students to be tested on their

understanding of the concepts and techniques and their ability to apply

them in scenarios.

Candidates should read widely around each topic covered in the subject

guide. Essential and supplementary readings are important if you wish to

achieve high grades.

Typical weaknesses that Examiners have identified in this examination are as

follows:

1. Candidates answers are often too general or narrow. When they

are asked to critically assess a theory or concept, they often provide

a descriptive list of what the theory or concept is about. A critical

assessment for a theory or concept should indicate how logically it is

derived and how well it fits into the real world.

2. Candidates often regurgitate materials from the subject guide without

carefully considering what the examination question is in fact asking.

Consequently, they are giving either descriptive or irrelevant materials

in their answer.

3. Candidates often spot questions and focus narrowly on a few topics

in the hope that these topics cover enough material to pass the

examination. However, the empirical evidence shows that this tactic

often backfires badly. As corporate financial theories are often

inter-related, the examination questions will also cover materials from

different chapters in the subject guide. For example, when evaluating

a real life project, we need to know which discount rate to use and

how to identify the relevant cash flows. The choice of the appropriate

discount rate depends on how the project is funded and how risky it is.

Therefore a question on capital budgeting can easily involve materials

covered in Chapters 1, 2, 3 and 6.

Question spotting

Many candidates are disappointed to find that their examination

performance is poorer than they expected. This can be due to a number

of different reasons and the Examiners commentaries suggest ways

of addressing common problems and improving your performance.

We want to draw your attention to one particular failing question

spotting, that is, confining your examination preparation to a few

question topics which have come up in past papers for the course. This

can have very serious consequences.

We recognise that candidates may not cover all topics in the syllabus in

the same depth, but you need to be aware that Examiners are free to

set questions on any aspect of the syllabus. This means that you need

to study enough of the syllabus to enable you to answer the required

number of examination questions.

The syllabus can be found in the Course information sheet in the

section of the VLE dedicated to this course. You should read the

syllabus very carefully and ensure that you cover sufficient material in

preparation for the examination.

Examiners will vary the topics and questions from year to year and

may well set questions that have not appeared in past papers every

topic on the syllabus is a legitimate examination target. So although

past papers can be helpful in revision, you cannot assume that topics

or specific questions that have come up in past examinations will occur

again.

If you rely on a question spotting strategy, it is likely

you will find yourself in difficulties when you sit the

examination paper. We strongly advise you not to adopt

this strategy.

FN3092 Corporate finance Zone A

Important note

This commentary reflects the examination and assessment arrangements

for this course in the academic year 201213. The format and structure

of the examination may change in future years, and any such changes

will be publicised on the virtual learning environment (VLE).

references

Unless otherwise stated, all cross-references will be to the latest version

of the subject guide (2011). You should always attempt to use the most

recent edition of any Essential reading textbook, even if the commentary

and/or online reading list and/or subject guide refers to an earlier

edition. If different editions of Essential reading are listed, please check

the VLE for reading supplements if none are available, please use the

contents list and index of the new edition to find the relevant section.

Candidates should answer FOUR of the following EIGHT questions: ONE

from Section A, ONE from Section B and TWO further questions from

either section. All questions carry equal marks.

A list of formulas is given at the end of the paper.

A calculator may be used when answering questions on this paper and

it must comply in all respects with the specification given with your

Admission Notice. The make and type of machine must be clearly stated

on the front cover of the answer book.

Section A

Answer one question from this section and not more than a further

two questions. (You are reminded that four questions in total are to be

attempted with at least one from Section B.)

Question 1

a. Briefly explain the concept of risk shifting and what implications it has for

optimal capital structure.

(9 marks)

Reading for this question

Subject guide, Chapter 8, pp.11223.

Approaching the question

When a firm has a large amount of debt outstanding, it is optimal for

equity holders to take on too much risk, even if that risk is a negative

NPV proposition. Note that higher risk increases the probability of both

the upside and the downside. This is because increasing the probability of

the downside does not hurt equity very much they have limited liability

and their worst case scenario is zero. On the other hand, increasing the

probability of the upside helps equity holders because they receive the

residual after all payments to debt, which are fixed.

Since it is the CEOs job to represent equity holders, she will take on too

much risk. This means the firm will not be acting optimally (taking the

highest NPV projects), and will therefore be valued below maximum.

Ex-ante this actually hurts the equity holders.

b. Personal taxes result in the Modigliani and Miller 1st proposition being

violated. Briefly explain why.

(8 marks)

Reading for this question

Subject guide, Chapter 6, pp.9199.

Approaching the question

Since different payouts are taxed in different ways, it is optimal for the

firm to structure its financing so as to minimise the tax liability. Therefore

capital structure is not irrelevant and M&M1 is violated.

In particular, personal taxes on equity payouts are typically lower than on

debt payouts. Equity payouts are either capital gains (share repurchases)

or dividends; debt payouts are interest. Capital gains are taxed at the

capital gains tax rate while interest is taxed at the personal tax rate,

which is typically higher than capital gains. Depending on the tax regime,

dividends are taxed at the same rate as interest, or lower. Thus, overall,

if we just consider personal taxes (and other frictions), equity is cheaper

than debt and firms should issue as much equity as possible.

c. Briefly explain the Modigliani and Miller 1st proposition and discuss some

of the other reasons (not including (a) and (b)) which may cause it to be

violated.

(8 marks)

Reading for this question

Subject guide, Chapter 6, pp.9199.

Approaching the question

M&M1 says that capital structure is irrelevant if certain conditions hold.

This means that it does not matter how the firm finances its investment

the value for the shareholders will be unchanged. This is because financial

decisions do not affect value, they only determine how this value is split

among the different stakeholders.

Among the other reasons that M&M1 can be violated:

corporate taxes make debt cheaper (implies more debt in the capital

structure)

high amounts of debt leading to debt overhang and underinvestment

(implies less debt in the capital structure)

high amounts of outside equity leading to too little effort by managers

(implies more debt in the capital structure)

asymmetric information leading to only bad firms issuing risky

securities and good firms underinvesting in positive NPV projects,

this is referred to as pecking order (implies more debt in the capital

structure)

asymmetric information leading to good firms signalling with certain

types of securities, for example a firm can signal with debt, because

debt is risky and costly (implies more debt in the capital structure),

or a firm can signal with dividends because they are costly from a tax

perspective (implies less debt in the capital structure).

5

Question 2

a. Explain pecking order theory. According to pecking order theory, how do

bad firms tend to finance investment? How do good firms tend to finance

investment?

(9 marks)

Reading for this question

Subject guide, Chapter 8, pp.11223.

Approaching the question

If the market does not know which firms are good and which firms are

bad, it will value all firms as average. A good firm that is valued as average

does not want to issue equity because its equity is undervalued it will be

giving up too large a fraction of its equity for too little of a cash infusion.

On the other hand, bad firms dont mind since their equity is over valued.

If a firm has a new, NPV>0 project which requires financing, if it knows

it is a good firm (so that it is undervalued), and if it has no option but to

finance it by equity, it may choose to not finance this project at all. This

is because the cost of giving away too many shares is higher than the

benefit of the project. This problem is more severe if the NPV is small

relative to the value of the firm, and if the firm is more undervalued. This

problem can even occur with risky debt, because it is priced in a similar

way to equity. However, if the firm has cash, it is not worried about outside

valuations and will finance all positive NPV projects.

The pecking order theory states that in the presence of asymmetric

information, firms will finance investment with the most informationally

insensitive securities, such as cash or safe debt, and then move up the

pecking order to risky debt and equity if they have no choice.

b. A recent research study found that firms run by CEOs who have family

problems (such as a seriously sick child) tend to underperform. You are aware

that your cousin, who is married to the CEO of NORNE LLC, is likely to file

for divorce. As a result you expect NORNEs stock price to fall and you short

it. Which kind of efficiency must be violated for your expectations to be

correct? Explain your reasoning.

(7 marks)

Approaching the question

Note that a CEOs family problems are typically private information,

therefore this gives us no evidence that either the weak form or the

semi-strong form efficiency are violated. However, if you expect to profit

from this trade, you must believe that this market is not strong-form

efficient in that private information about the CEOs personal life is not yet

incorporated into prices.

c. Suppose that starting next year you will receive a cash flow D, which will

grow at a rate g per year. The appropriate discount rate is r. Derive the

Gordon Growth Model for the present value of this cash flow.

(9 marks)

Approaching the question

The cash flow pattern is:

0, D, D(1 + g), D(1 + g)2

The discount factor is:

1, 1/(1 + r), 1/(1 + r)2, 1/(1 + r)3

Let X = (1 + g)/(1 + r). Then the NPV can be written as:

= (1 + X + X2 + X3 +) * D/(1 + r)

Note that (1 + X + X2 + X3+) = 1/(1 X) so that:

NPV = D/[(1 + r) * (1 X)] plugging in the definition of X we get:

NPV = D/(r g)

Question 3

a. How does the price of a European put option change if the time to maturity

rises? If the price of the underlying rises? If the volatility of the underlying

rises? If the exercise price rises? Explain.

(9 marks)

Reading for this question

Subject guide, Chapter 4, pp.5570.

Approaching the question

If the volatility rises, the put option price rises. This is because with

options, the downside is limited (by zero) and the upside can be very high

(unlimited for call options). Increased volatility increases the probability of

both.

A rise in time to maturity has exactly the same effect as volatility there is

now more time for the underlying to reach very low or very high prices.

If the price rises, the put option price falls. This is because a put entitles

you to sell at a particular fixed price. If the actual price is now higher, the

option to sell at a fixed (relatively low) price is less valuable.

If the strike price rises, the put option price rises. This is because a put

option entitles the owner to sell the underlying for the exercise (strike)

price. Selling at a higher price is good.

b. What are the differences between the NPV and IRR approaches to project

evaluation? Is one of the approaches superior to the other?

(8 marks)

Reading for this question

Subject guide, Chapter 1, pp.1023.

Approaching the question

The NPV approach calculates the present value of all future cash flows

using some specified discount rate.

NPV = C1/R + C2/R2 + C3/R3 +

It then suggests investing any time the NPV is positive.

The IRR approach computes that discount rate which would make the

present value exactly zero.

0 = C1/IRR + C2/IRR2 + C3/IRR3 +

It then suggests investing any time the IRR is higher than the appropriate

discount rate.

Note that for standard projects IRR and NPV give exactly the same answer

since R>IRR implies that the discounted present value is above zero.

However, for non standard projects, they may give different answers. In

particular, when we must only choose one project out of many, when the

borrowing rate is different from the lending rate, when the discount rate is

changing through time, when cash flows are often changing from positive

to negative. See the textbook for detailed explanations of how each of

these can lead to different answers between NPV and IRR.

If we are able to properly estimate cash flows, growth rates, and discount

rates the NPV approach is superior. The NPV approach says to invest

whenever a project is increasing firm value anything else would be

wrong! However, in the real world we may not always perfectly estimate

cash flows, growth rates, and discount rates. For this reason, IRR may

work better in practice even though NPV is theoretically better.

c. Describe the stylized facts about dividend payments which were listed in

Linter (1958).

(8 marks)

Reading for this question

Subject guide, Chapter 9, pp.12734.

Approaching the question

Managers seem to have a target dividend pay-out level. This is

determined as a proportion of long-run (sustainable) earnings of the

firm. Thus if there is a large temporary shock to earnings today, this

does not mean there will be a large change in dividends.

Managers seem to be more concerned with changes in dividends than

the actual level of dividends.

Managers prefer not to make changes that may be reversed. As a result,

dividends are relatively smooth and do not change often.

Linterns numerical model for dividends was dDIV(t) = L * (a * EPS(t)

DIV(t 1)) thus dividends adjust to earnings changes slowly.

Question 4

a. How does the empirical security market line compare to the one predicted by

the CAPM?

(7 marks)

Reading for this question

Subject guide, Chapter 2, pp.2540.

Approaching the question

The empirical line is flatter than the one predicted by theory. Stocks with

low betas tend to have higher returns than predicted by CAPM; stocks with

high betas tend to have lower returns than predicted by CAPM.

b. Discuss possible explanations for the differences between the empirical line

and the one predicted by theory.

(10 marks)

Approaching the question

This pattern may be due to mismeasurement of beta. Mismeasurement can

be due to Rolls critique, or for a host of other reasons.

If we are mismeasuring beta, then stocks we are calling high beta are

likely to have high beta but not quite as high as we are measuring (beta

is the sum of the true beta and an error). In which case, their expected

return should be lower than we would be predicting. Similar for low beta

stocks, their true beta is not as low as we are measuring. The result would

be a flatter line.

Another possible explanation is borrowing constraints. If low risk aversion

investors are unable to borrow in order to short low beta stocks and long

high beta stocks, they will just be forced to hold long positions in high

beta stocks. Thus high beta stocks will be overbought and overvalued

and have relatively low returns; low beta stocks will be underbought and

undervalued, with relatively high returns.

c. Suppose the CAPM does not hold, is this evidence of the violation of market

efficiency?

(8 marks)

Approaching the question

It is not necessarily inconsistent with market efficiency. The CAPM is

not necessarily the right model to describe all risk. Any firm with higher

loading on the true risk in the economy should have higher returns.

Multi-factor models attempt to capture the risks in the economy not

captured by the CAPM.

Section B

Answer one question from this section and not more than a further

two questions. (You are reminded that four questions in total are to be

attempted with at least one from Section A.)

Question 5

For this question assume that debt carries no tax advantage over equity. The

average return on the stock market is 8% per year, and the average risk free rate

is 2% per year.

Reading for this question

Subject guide, Chapter 2, pp.2540, Chapter 10, pp.13543.

a. Cyberdyne Systems is a robot manufacturer. It is an all equity firm whose

historic average annual return is 13%. Suppose the CAPM holds, calculate

Cyberdynes beta.

(5 marks)

Approaching the question

Beta = (R Rf)/(Rm Rf)=(0.13 0.02)/(0.08 0.02) = 1.833

b. Union Aerospace Corporation (UAC) has 1M shares of equity outstanding

with a price of $100 per share and a historic annual return of 15%, it also

has $50M of long term debt with an interest rate of 4%. Calculate UACs

weighted average cost of capital.

(6 marks)

Approaching the question

The equity value is 1M * $100 = $100M, the debt value is $50M.

Therefore the weights of equity and debt within UAC are wE = 100/(100

+ 50) = 0.67 and wD = 50/(100 + 50) = 0.33

The weighted average cost of capital is: WACC = wE * Re + wD * Rd =

0.67 * 0.139 + 0.33 * 0.04 = 13.9 per cent.

c. UAC consists of two divisions. The first division manufactures robots and

competes directly with Cyberdyne. It is very similar to Cyberdyne in terms

of its risk characteristics. The annual free cash flows (FCF) of this division

are $8M and its expected growth rate is 6% per year. UAC has a second

division which produces toy aeroplanes and its annual free cash flows (FCF)

are $6M. The expected growth rate of the toy aeroplane division is zero.

UAC is considering divesting and selling off the toy aeroplane division. Use

information from (A) and (B) to compute the fair value of this division and

the rate of return on a stand alone firm that produces toy aeroplanes.

Hint: Apply the Gordon Growth Model

(7 marks)

Since the robot division is similar to Cyberdyne, we can assume they

have the same expected rate of return of 13 per cent. Note that this is the

unlevered or the asset rate of return.

We can use 13 per cent to compute the value of the robotics division as a

stand alone: V = FCF/(r g) = 8 /(0.13 0.06) = $114.3M

9

Since UACs total value is $150M, it must be that the toy division is worth

150 114.3 = $35.7M. Its expected rate of return is 35.7 = 6/(r 0)

16.9 per cent/year

An alternative is to use the WACC from (b) to find this: WACC = wR * rR

+ wT * rT 13.9 = (114.3/150) * 13 + (35.7/150) * rT rT = 16.9

d. Suppose UAC was able to sell this division for the price you computed in (c),

and it then used all of the proceeds to repay as much of its outstanding debt

as it could. What is the value of the remaining debt? What is UACs expected

cost of equity? Briefly explain why the return on equity is different from

before.

(7 marks)

Approaching the question

UAC uses the cash from the sale to repurchase $35.7M of debt, leaving

it with $14.3M of debt; this debt still carries a 4 per cent interest rate.

The value of the capital employed (debt+equity) is $114.3M with the

weight of debt being wD = 14.3/114.3 = 0.125 and the weight of equity

being wE=100/114.3=0.875. Note that the risk of making robots has not

changed and is still the same as in (a), 13%. Again applying the formula

for the WACC: 13 = 0.125 * 4 + 0.875 * Re Re = 14.3 per cent.

If the return they got in (c) was 5.98 per cent, this should read:

The return on equity has fallen. Note that two things have happened, first

of all UAC sold one of its divisions, since this division was relatively safe

and had a low equity return, this made the remaining firm riskier. UAC has

also repurchased debt, which makes equity safer. The second effect was

stronger and the equity return decreased compared to what it was in (b).

If the return they got in (c) was 16.8 per cent, this should read:

The return on equity has fallen. Note that two things have happened; first

of all UAC sold one of its divisions, since this division was relatively risky

and had a high equity return, this made the remaining firm safer. UAC has

also repurchased debt, which makes equity safer. The second effect was

stronger and the equity return decreased compared to what it was in (b).

Question 6

There are two types of firms. Each firm has a project whose quality is known

by the firms CEO but not by outsiders (except for in (b)). Type G are good, their

project is worth $30 million. Type B are bad, their project is worth $18 million.

It is publically known that good firms are 40% of the total population of firms,

with the remainder being bad.

These firms can also finance an additional project. This new project requires an

initial investment of $20 million and next year will pay $24 million with 75%

probability or $18 million with 25% probability.

Assume risk neutrality and a discount rate of zero.

Reading for this question

Subject guide, Chapter 9, pp.12735.

Approaching the question

Students should look to approach these questions by using a combination

of basic probability theory and signalling theory outlined in the subject

guide.

10

a. What is the NPV of the project? If the market does not know which firm is of

which type and therefore values all firms equally (not including the project),

what is a firms market value?

(3 marks)

Approaching the question

20 +.75 * 24 + .25 * 18 = 2.5

Avg firm: 0.4 * 30 + 0.6 * 18 = 22.8

b. Suppose the outside market knows each firms type. What is the payoff

to each firms original owners if they do not invest in this project? What

is the payoff to each firms original owners if each firm finances the new

project with equity. What fraction of equity must each type of firm offer to

outsiders? Which firms finance the project and which do not?

(5 marks)

Approaching the question

If the firms do not invest in this project the payoffs of each firm are just

their original values: 30 for G, 18 for B.

If a firm finances the project with equity then the cost of the project must

equal the expected payoff for outside investors, which is a fraction of the

firms total value promised to them. Let that fraction be .

For G: (30 + .75 * 24 + .25 * 18)= 52.5= 20 = 38.1 per cent.

The payoff to the original owners is (1 ) * 52.5 = 32.5 > 30 so they

finance the project.

For B: (18 + .75 * 24 + .25 * 18)= 40.5 = 20 = 49.4 per cent.

The payoff to the original owners is (1 ) * 40.5 = 20.5 > 18 so they

finance the project.

Approaching the question

c. Now consider a world of asymmetric information where the CEO knows her

own firm type but the outside market does not. Suppose outside investors

believe that all firms finance these projects with equity. What fraction of

equity will outside equity investors ask for? What will be the total value of

firm G? What will be the total value of firm B?

(6 marks)

The outside market does not know which firm is which so asks for fraction

that is the same for both firms. The market assumes it is getting an

average firm.

[0.4 * (30 + .75 * 24 + .25 * 18) + 0.6 * (18 + .75 * 24 + .25 * 18)]= 20

(0.4 * 52.5 + 0.6 * 40.5)= 45.3 = 20 = 44.2 per cent

Approaching the question

d. Compute the benefit to the original shareholders of each firm from following

the strategy in (c) and compare it to the strategy of not investing in this

project. What will each type do? Thus, what will the market believe about

firms who raise equity?

(6 marks)

G and invest: (1 0.442) * (30 + .75 * 24 + .25 * 18) = 29.3

G and not invest: 30 Good does not invest

B and invest: (1 0.442) * (18 + .75 * 24 + .25 * 18) = 22.6

B and not invest: 18 Bad invests, good does not

Approaching the question

e. If the market reacts rationally to the assumed strategies in (d), what does

the market assume about any firm that raises equity? What fraction of equity

does the market ask for? What is the market value of any firm that raises

equity? How does it compare to the original stock price in (a)?

(5 marks)

11

Only bad firms raise equity, since the market is aware of this, the problem

of the bad firm becomes identical to (b). In particular = 49.4 per cent

and the firms value is 20.5, which is below 22.8 in (a). Thus bad firms

tend to raise equity and their value drops.

Question 7

Hotel California, a lovely place along the 101 Highway, last underwent an

upgrade in 1969. As a result of its dilapidated conditions it has plenty of extra

rooms. It is considering a major renovation.

The construction costs of the renovation are estimated to be $1 million, payable

at the end of construction. If the construction starts today, it will last one year.

During the renovation, the hotel will be closed to guests (however assume that

all of the hotels expenses, such as paying staff, are unchanged due to long term

contracts).

Hotel Californias capacity is 40 rooms and, on average, 60% of the rooms are

vacant on any single day. The daily profit per occupied room is $90.

The corporate tax rate is 20%, the appropriate discount rate is 9%, and

renovation can be depreciated at 33.3% per year.

Reading for this question

Subject guide, Chapter 1, pp. 1023.

Approaching the question

Students should practise NPV calculation questions to enable them to get

comfortable in aligning the cash flows, as well as the inputs.

a. Compute the average profit per occupied room a year. Then compute the

average profit for the hotel as a whole. Assume 365 days per year. (4 marks)

Approaching the question

Occupied room: 365 90 = $32,850

Hotel: $32,850 * (40 * 0.4) = $525,600 where 0.4 = 1 0.6 is the

occupancy rate.

b. Suppose Hotel California decides to begin renovation today. Assume that

after renovation, the vacancy rate will fall to 25%. Suppose that the hotel

will be sold exactly 3 years after the renovation is complete. Ignore the sales

price and everything that happens after the sale and compute the NPV of

renovation for cash flows from now until the sale (excluding the sale). Do

not forget depreciation and corporate taxes. Assume that Hotel California

has enough taxable profit to take advantage of any additional tax breaks

due to this construction. Assume no additional capital expenditures are made

between the end of renovation and the sale of the hotel.

(14 marks)

Approaching the question

Note that in the table below, everything is done in excess of what would

happen if the hotel did not undergo renovation.

Rooms in excess of no

renovation

Pre-tax profit in excess of

no renovation

Capital expenditures

Depreciation

12

2013

2014

2015

2016

32.85

32.85

32.85

32.85

16

14

14

14

525.6

459.9

459.9

459.9

333.3

333.3

333.3

1000

Taxable income

525.6

126.6

126.6

126.6

Tax

105.1

25.3

25.3

25.3

After-tax income

420.5

434.6

434.6

434.6

1420.5

434.6

434.6

434.6

0.917

0.842

0.772

0.708

PV

1303.2

365.8

335.6

307.9

NPV

294.0

FCF

Discount multiple

c. Explain how you would calculate the price at which the hotel is sold and how

you would use this number to augment the NPV calculation.

(7 marks)

Approaching the question

The sales price of the hotel is the present value of all future cash flows

after the sale.

To augment the NPV calculation you have to add the sales price but

subtract what the sales price would have been if the renovation was not

done. No marks for this part if they do not mention this.

There are several ways to compute the sales price. One would be to

assume a constant growth rate and discount rate and then plug the

FCF into the Gordon Growth Model: V = FCF/(r g). How to get FCF?

Could use the FCF for the last year: 434.6; however, this assumes that:

(i) no additional capital expenditures are made; (ii) there is no need to

account for additional depreciation; and (iii) includes the tax-shields

from depreciating the original investment, which should run out after

2015. The third assumption is clearly problematic, but the first two are

not unreasonable assumptions since it was specified that $90 is profit

per room (which may include costs of replacing depreciation). However,

a better answer would specifically say something about subtracting off

additional depreciation, and replacing depreciated capital with capital

expenditures.

Question 8

You currently have $50,000 in cash. You have access to a project which requires

an initial investment of $50,000. One year from now this project will pay either

$40,000 with probability 50% or $100,000 with probability 50%. After this, there

are no further cash flows.

Assume risk neutrality and an annual discount rate of 10%. This is also the risk

free rate.

Reading for this question

Subject guide, Chapter 6, pp. 8999.

Approaching the question

Students should look to approach these questions by using a combination

of basic probability theory and capital structure theory outlined in the

subject guide.

a. What is the NPV of this project?

(4 marks)

NPV = 50 + (0.5 * 40 + 0.5 * 100)/1.1 = $13,636

Note that the cash you have is irrelevant for this calculation.

13

b. Suppose you decide to finance this project with your own cash. How much

money do you expect to have one year from now?

(6 marks)

Approaching the question

0.5 * 40 + 0.5 * 100 = $70,000

Note that this question was posed in terms of payoff one year from now;

however, if they do everything in terms of present values that is fine too.

c. You have found investors who will fund the full cost of the project through

equity. You will invest your cash at the risk free rate. What is the share of

equity they will ask for? How much money do you expect to have one year

from now?

(6 marks)

Approaching the question

Let be the fraction of equity promised to outsiders. It must be that:

50 = * (0.5 * 40 + 0.5 * 100)/1.1 = * 63.64 = 78.57 per cent.

Your payoff: (1 ) * (0.5 * 40 + 0.5 * 100) = 15

In addition you will have 50 * 1.1 = 55 from investing your cash.

In total you have 15 + 55=$70,000.

Note that this question was posed in terms of payoff one year from now;

however, if they do everything in terms of present values that is fine too.

d. You have found investors who will give you a loan for the full cost of the

project. You will invest your cash at the risk free rate. Assume in case of

default, these investors can claim all of the projects cash flows, but cannot

claim the cash you have invested outside of the project. What is the face

value of the loan and the interest rate? How much money do you expect to

have one year from now?

(6 marks)

Approaching the question

Loan calculation:

50 = (0.5 * 40 + 0.5 * F)/1.1 F=70 Interest rate = 40 per cent

Your payoff: 0.5 * 0 + 0.5 * (100 F) = 15

In addition you will have 50 * 1.1 = 55 from investing your cash.

In total you have 15 + 55 = $70,000.

Note that this question was posed in terms of payoff one year from now;

however, if they do everything in terms of present values that is fine too.

e. In light of your numerical answers above, discuss Modigliani and Millers 1st

proposition.

(3 marks)

Approaching the question

Note that in (b),(c) and (d) the payoff was always the same. Furthermore,

if you were to discount it to year 0 (divide by 1.1) and subtract the value

of your cash ($50,000), they are all equal to the NPV in (a). This is exactly

the point of M&M1, financing method (capital structure) is irrelevant. The

payoff to the firms owner will be the same regardless of which capital

structure is chosen, as long as the conditions stipulated by M&M hold

(which they do in this question).

14

C = S[N(d1)] X[N(d2)]e-rt

d1 =

ln ( S / X )

1

+ t

2

and

d 2 = d1 t

E(Ri) = Rf + i E (Rm) Rf

Modigliani and Miller

Proposition I (no tax): VL = VU

Proposition II (no tax): Re = Ra + (Ra Rd) D

E

Proposition I (with corporate tax): VL = VU + Tc D

Proposition II (with corporate tax): Re = Ra + (Ra Rd) (1 Tc) D

E

Miller (1977)

(1 Tc )(1 Te )

VL = VU + 1

D

1 Td

15

FN3092 Corporate finance Zone B

Important note

This commentary reflects the examination and assessment arrangements

for this course in the academic year 201213. The format and structure

of the examination may change in future years, and any such changes

will be publicised on the virtual learning environment (VLE).

references

Unless otherwise stated, all cross-references will be to the latest version

of the subject guide (2011). You should always attempt to use the most

recent edition of any Essential reading textbook, even if the commentary

and/or online reading list and/or subject guide refers to an earlier

edition. If different editions of Essential reading are listed, please check

the VLE for reading supplements if none are available, please use the

contents list and index of the new edition to find the relevant section.

Candidates should answer FOUR of the following EIGHT questions: ONE

from Section A, ONE from Section B and TWO further questions from

either section. All questions carry equal marks.

A list of formulas is given at the end of the paper.

A calculator may be used when answering questions on this paper and

it must comply in all respects with the specification given with your

Admission Notice. The make and type of machine must be clearly stated

on the front cover of the answer book.

Section A

Answer one question from this section and not more than a further

two questions. (You are reminded that four questions in total are to be

attempted with at least one from Section B.)

Reading for this question

Subject guide, Chapter 5, pp.7389/Chapter 2, pp.2540.

Approaching the question

Question 1

a. Discuss evidence on anomalies such as size, book-to-market, and return

predictability.

(9 marks)

Approaching the question

Size: small firms tend to have higher returns than large firms.

Book-to-Market: value firms (firms with high Book/Market ratio) tend to

have higher returns than Growth firms (low Book/Market ratio).

At longer horizons stock returns are predictable by variables like P/E, say.

16

b. Are these anomalies consistent with the CAPM? How does Rolls critique

relate to this?

(8 marks)

Approaching the question

For anomalies such as these to be consistent with CAPM, the firms with

higher returns need to have higher betas. This does not seem to be the

case for small and value firms, at least not enough to explain the return

differences.

However, to compute a beta we need to have the markets return. In

practice, a beta is typically computed relative to some equity index. Rolls

critique is that the typical equity index is not necessarily equal to the true

market return. In which case, beta is mismeasured so we cannot confirm

that the CAPM fails.

c. Are these anomalies consistent with market efficiency?

(8 marks)

These are not necessarily inconsistent with market efficiency. The CAPM

is not necessarily the right model to describe all risk. Any firm with higher

loading on the true risk in the economy should have higher returns. It

may be that small and value firms are indeed such firms. Multi-factor

models attempt to capture the risks in the economy not captured by the

CAPM.

Question 2

a. Corporate taxes result in the Modigliani and Miller 1st proposition being

violated. Briefly explain why.

(8 marks)

Reading for this question

Subject guide, Chapter 6, pp. 8999 and Chapter 9, pp.12733.

Approaching the question

Since different payouts are taxed in different ways, it is optimal for the

firm to structure its financing so as to minimise the tax liability. Therefore

capital structure is not irrelevant and M&M1 is violated.

In particular, at the corporate level any payments to creditors are not

taxed, while all other profit (which is eventually paid out to equity) is

taxed at the corporate tax rate. Therefore debt is cheaper than equity and

if we consider corporate taxes only, firms should issue as much debt as

possible.

b. Asymmetric information result in the Modigliani and Miller 1st proposition

being violated. Briefly explain why.

(9 marks)

Approaching the question

The answer can be either about pecking order theory, or signalling with

debt, or signalling with dividends.

Pecking order theory: When the market does not know firm type, good

firms may choose to not issue risky securities because good firms are

undervalued and will have to give away too much to the outside investors.

If they can, they will issue safer securities (this is the pecking order)

because safe security payoffs have less dependence on firm type. Or they

will finance investment with internal cash. However, if they cannot issue

safe securities, they will not use external financing at all, and therefore

will pass up positive NPV projects.

17

Signalling: When the market does not know firm type, good firms will

want to signal to the market that they are good. This is so that they can

get a better price for issuing securities. The signal must be more costly

for bad firms than for good firms; otherwise, bad firms would replicate

the signal and the market still would not be able to tell good from bad.

Two such signals are debt and dividends. Debt (as in Ross 1977) is costly

because it increases the probability of the firm going bankrupt (for this

to work the model also needs either bankruptcy costs, or disutility from

bankruptcy for manager). Dividends (as in Bhattacharya 1979) are costly

because they are taxed at a higher rate than other types of payouts.

c. Briefly explain the Modigliani and Miller 1st proposition and discuss some

of the other reasons (not including (a) and (b)) which may cause it to be

violated.

(8 marks)

Approaching the question

M&M1 says that capital structure is irrelevant if certain conditions hold.

This means that it does not matter how the firm finances its investment

the value for the shareholders will be unchanged. This is because financial

decisions to not affect value, they only determine how this value is split

among the different stakeholders.

Among the other reasons that M&M1 can be violated:

Personal taxes make equity cheaper (implies less debt in the capital

structure)

High amounts of debt leading to debt overhang and underinvestment

(implies less debt in the capital structure)

High amounts of debt leading to risk shifting; that is, managers take on

too much risk because upside is unlimited and downside has limited

liability (implies less debt in the capital structure)

High amounts of outside equity leading to too little effort by managers

(implies more debt in the capital structure).

Question 3

a. Explain debt overhang. Describe situations in which debt overhang is most

severe. What are some possible solutions to the debt overhang problem?

(9 marks)

Reading for this question

Subject guide, Chapter 8, pp.11124.

Approaching the question

When a firm has too much debt; that is, when the firm is close to

bankruptcy but not yet in default, it may bypass positive NPV projects. The

reason is that there is a high probability that the firm will default, in which

case creditors will receive all benefit from the new investment. Thus, in

expectation, equity holders receive only a fraction of the benefit from

investing (whenever the firm does not default), but pay the full cost. The

reason they pay the full cost is that if the firm did not invest, it could use

the cash to pay them a cash dividend.

Debt overhang is most severe for firms with high expectations of default,

and with low (but positive) NPV projects. Note that if the project has a

very high NPV, then the equity holders will want to take it because the

fraction they receive in expectation is still higher than the cost.

One possible solution is renegotiation. Since the firm is bypassing positive

NPV projects, in theory everyone could benefit if they could somehow

18

take the project and split the NPV between equity and debt holders.

Negotiation can involve a reduction of interest payments, or a deferral of

interest payments.

Another possible solution is issuance of new debt. However, this can only

work if the new debt is more senior than existing debt. Thus new creditors

know they are likely to be paid back and do not charge too high interest

rates. However, this is typically forbidden in the covenants of the existing

debt. If the firm files for bankruptcy, then issuing senior debt is allowed.

b. How does clientele theory explain the existence of dividends?

(9 marks)

In most tax regimes dividends are taxed at a higher rate than capital

gains. Thus, if a firm chooses to issue equity, it would seem that it is best

to pay out equity investors with capital gains (repurchases) rather than

dividends.

However, not all investors are the same. There are some investors that are

in high tax brackets. Indeed, for them, dividends are a tax disadvantage

and they prefer to be paid through capital gains. However, there are other

investors who are tax exempt, or in low tax brackets. For them dividends

are no worse, and may be even better than capital gains. In order to attract

as many investors as possible to the market, some firms will choose to

cater to each of these types of investors. Indeed, empirically it is true that

low tax investors have portfolios that are tilted toward dividend paying

stocks.

c. Suppose you notice that subsequent stock returns are higher after warm and

sunny mornings; stock returns are lower after cold and rainy mornings. Is

this market efficient? Which forms of efficiency are violated according to this

observation.

(7 marks)

Approaching the question

This market is is not semi-strong form efficient because morning weather

is public information on which anyone can trade. Thus semi-strong-form

efficiency is violated, and strong-form efficiency is violated as well. We are

given no evidence that weak-form efficiency is violated.

Question 4

a. How does the price of a European call option change if the volatility of the

underlying rises? If the price of the underlying rises? If the interest rate

rises? If the strike price rises? Explain.

(9 marks)

Reading for this question

Subject guide, Chapter 4, pp.5571.

Approaching the question

If the volatility rises, the call option price rises. This is because with

options, the downside is limited (by zero) and the upside is unlimited.

Increased volatility increases the probability of both.

If the price rises, the call option price rises. This is because a call entitles

the owner to buy at a particular fixed price. If the actual price is now

higher, the option to buy at a fixed (relatively low) price is more valuable.

If the risk free rate rises the call option value rises. This is because it

decreases the present value of the exercise price.

If the strike price rises, the call option price falls. This is because a call

option entitles the owner to buy the underlying for the exercise (strike)

price. Buying at a higher price is bad.

19

b. Describe the NPV and IRR approaches to project evaluation. When do they

agree? Give an example of when they disagree.

(8 marks)

Reading for this question

Subject guide, Chapter 1, pp. 1023.

Approaching the question

The NPV approach calculates the present value of all future cash flows

using some specified discount rate.

NPV = C1/R + C2/R2 + C3/R3 + .

It then suggests investing any time the NPV is positive.

The IRR approach computes that discount rate which would make the

present value exactly zero.

0 = C1/IRR + C2/IRR2 + C3/IRR3 + .

It then suggests investing any time the IRR is higher than the appropriate

discount rate.

Note that for standard projects IRR and NPV give exactly the same answer

since R>IRR implies that the discounted present value is above zero.

However, for non standard projects, they may give different answers. In

particular, when we must only choose one project out of many, when the

borrowing rate is different from the lending rate, when the discount rate is

changing through time, when cash flows are often changing from positive

to negative. See the textbook for detailed explanations of how each of

these can lead to different answers between NPV and IRR.

If we are able to properly estimate cash flows, growth rates, and discount

rates the NPV approach is superior. The NPV approach says to invest

whenever a project is increasing firm value anything else would be

wrong! However, in the real world we may not always perfectly estimate

cash flows, growth rates, and discount rates. For this reason, IRR may

work better in practice even though NPV is theoretically better.

c. Do takeovers typically increase the value of the target? Do they tend

to increase the value of the acquirer? Briefly discuss the theory and the

empirical evidence.

(8 marks)

Reading for this question

Subject guide, Chapter 10, pp.13544.

Approaching the question

Grossman and Hart (1980) suggest that it is impossible (or at least

very difficult) for takeovers to occur due to the free-rider problem. The

shareholders of the target firm will refuse to sell for anything less than the

acquirers maximum valuation of the target. Thus the acquirer has nothing

to gain.

There are certain mechanisms which may make takeovers easier; for

example, if the acquirer is able to purchase many shares in secret, before

the market realises there is a takeover bid. However, even in this case, the

acquirer is likely to pay more than the target is worth.

The empirical evidence is consistent with the theory. The value of the

20

target firm typically rises during the sale. However, the evidence on the

acquirer and the total value is mixed. The gain to the acquirer may even

be negative, and the net gain may be negative as well.

Other studies look at operating performance of mergers, rather than

market values. Here the evidence too, is mixed. Some studies find

improvements in operating performance (namely, higher return on assets,

profit) but others find no improvement.

Section B

Answer one question from this section and not more than a further

two questions. (You are reminded that four questions in total are to be

attempted with at least one from Section A.)

Question 5

There are two types of firms. Each firm has a project whose quality is known

by the firms CEO but not by outsiders (except for in (b)). Type G are good, their

project is worth $40 million. Type B are bad, their project is worth $25 million.

It is publically known that good firms are 30% of the total population of firms,

with the remainder being bad.

These firms can also finance an additional project. This new project requires an

initial investment of $17 million and next year will pay $21 million with 50%

probability or $15 million with 50% probability.

Assume risk neutrality and a discount rate of zero.

Reading for this question

Subject guide, Chapter 9, pp.12735.

Approaching the question

Students should look to approach these questions by using a combination

of basic probability theory and signalling theory outlined in the subject

guide.

a. What is the NPV of the project? If the market does not know which firm is of

which type and therefore values all firms equally (not including the project),

what is a firms market value?

(3 marks)

Approaching the question

17 + .5 * 21 + .5 * 15 = 1

Avg firm: 0.3 * 40 + 0.7 * 25 = 29.5

b. Suppose the outside market knows each firms type. What is the payoff

to each firms original owners if they do not invest in this project? What

is the payoff to each firms original owners if each firm finances the new

project with equity? What fraction of equity must each type of firm offer to

outsiders? Which firms finance the project and which do not?

(5 marks)

Approaching the question

If the firms do not invest in this project the payoffs of each firm are just

their original values: 40 for G, 25 for B.

If a firm finances the project with equity then the cost of the project must

equal the expected payoff for outside investors, which is a fraction of the

firms total value promised to them. Let that fraction be .

For G: (40 + .5 * 21 + .5 * 15)= 58= 17 = 29.3 per cent. The

payoff to the original owners is (1 ) * 57 = 41 > 40 so they finance the

project.

21

payoff to the original owners is (1 ) * 43 = 26 > 25 so they finance the

project.

c. Now consider a world of asymmetric information where the CEO knows her

own firm type but the outside market does not. Suppose outside investors

believe that all firms finance these projects with equity. What fraction of

equity will outside equity investors ask for? What will be the total value of

firm G? What will be the total value of firm B?

(6 marks)

Approaching the question

The outside market does not know which firm is which so asks for fraction

that is the same for both firms. The market assumes it is getting an

average firm.

[0.3 * (40 + .5 * 21 + .5 * 15) + 0.7 * (25 + .5 * 21 + .5 * 15)]= 17

(0.3 * 58 + 0.7 * 43)= 47.5 = 17 = 35.8 per cent

d. Compute the benefit to the original shareholders of each firm from following

the strategy in (c) and compare it to the strategy of not investing in this

project. What will each type do? What will the market believe about firms

who raise equity?

(6 marks)

Approaching the question

G and invest: (1 0.358) * (40 + .5 * 21 + .5 * 15) = 37.2

G and not invest: 30 Good does not invest

B and invest: (1 0.358) * (25 + .5 * 21 + .5 * 15) = 27.6

B and not invest: 25 Bad invests, good does not

e. If the market reacts rationally to the assumed strategies in (d), what does

the market assume about any firm that raises equity? What fraction of equity

does the market ask for? What is the market value of any firm that raises

equity. How does it compare to the original stock price in (a)?

(5 marks)

Approaching the question

Only bad firms raise equity, since the market is aware of this, the problem

of the bad firm becomes identical to (b). In particular = 39.5 per cent

and the firm value is 26, which is below 29.5 in (a). Thus bad firms tend

to raise equity and their value drops.

Question 6

Hotel California, a lovely place along the 101 Highway, last underwent an

upgrade in 1969. As a result of its dilapidated conditions it has plenty of extra

rooms. It is considering a major renovation.

The construction costs of the renovation are estimated to be $900,000, payable

at the end of construction. If the construction starts today, it will last one year.

During the renovation, the hotel will be closed to guests (however assume that

all of the hotels expenses, such as paying staff, are unchanged due to long term

contracts).

Hotel Californias capacity is 25 rooms and, on average, 50% of the rooms are

vacant on any single day. The daily profit per occupied room is $80.

The corporate tax rate is 25%, the appropriate discount rate is 10%, and

renovation can be depreciated at 33.3% per year.

Reading for this question

Subject guide, Chapter 1, pp.1023.

Approaching the question

22

comfortable in aligning the cash flows, as well as the inputs.

a. Compute the average profit per occupied room a year. Then compute the

average profit for the hotel as a whole. Assume 365 days per year. (4 marks)

Approaching the question

Occupied room: 365 80= $29,200

Hotel: $29,200 * (25 * 0.5) = $365,000 where 0.5 = 1 0.5 is the

occupancy rate.

b. Suppose Hotel California decides to begin renovation today. Assume that

after renovation, the vacancy rate will fall to 20%. Suppose that the hotel

will be sold exactly 3 years after the renovation is complete. Ignore the sales

price and everything that happens after the sale and compute the NPV of

renovation for cash flows from now until the sale (excluding the sale). Do

not forget depreciation and corporate taxes. Assume that Hotel California

has enough taxable profit to take advantage of any additional tax breaks

due to this construction. Assume no additional capital expenditures are made

between the end of renovation and the sale of the hotel.

(14 marks)

Approaching the question

Note that in the table below, everything is done in excess of what would

happen if the hotel did not undergo renovation.

2013

2014

2015

2016

29.2

29.2

29.2

29.2

Rooms in excess of no

renovation

12.5

7.5

7.5

7.5

renovation

365

219

219

219

Capital expenditures

900

Depreciation

300

300

300

365

81

81

81

91.25

20.25

20.25

20.25

273.75

239.25

239.25

239.25

1173.75

239.25

239.25

239.25

0.909

0.826

0.751

0.683

PV

1067.05

197.73

197.73

197.73

NPV

526.16

Taxable income

Tax

After-tax income

FCF

Discount multiple

c. Explain how you would calculate the price at which the hotel is sold and how

you would use this number to augment the NPV calculation.

(7 marks)

Approaching the question

The sales price of the hotel is the present value of all future cash flows

after the sale.

To augment the NPV calculation you have to add the sales price but

subtract what the sales price would have been if the renovation was not

done. No marks for this part if they do not mention this.

There are several ways to compute the sales price. One would be to

assume a constant growth rate and discount rate and then plug the FCF

into the Gordon Growth Model: V = FCF/(r g). How to get FCF? Could

use the FCF for the last year: 239.25; however, this assumes that no

additional capital expenditures are made, and there is no need to account

for additional depreciation. This is not an unreasonable assumption since

23

it was specified that $80 is profit per room (which may include costs of

replacing depreciation); however, a better answer would specifically say

something about subtracting off additional depreciation, and replacing

depreciated capital with capital expenditures.

Question 7

You own a project which requires an initial investment of 1M. One year from

now this project will pay either 0.8M with probability 40% or 1.5M with

probability 60%. After this, there are no further cash flows. You have no money

to finance this project on your own.

Assume risk neutrality and an annual discount rate of 15%.

Reading for this question

Subject guide, Chapter 6, pp. 8999.

Approaching the question

Students should look to approach these questions by using a combination

of basic probability theory and capital structure theory outlined in the

subject guide.

a. What is the NPV of this project?

(4 marks)

NPV = 1 + (0.4 * 0.8 + 0.6 * 1.5)/1.15 = 0.061M

b. You have found investors who will give you a loan for the full cost of the

project. What is the face value of the loan and the interest rate? What is the

expected present value of your payoff?

(6 marks)

Approaching the question

Loan calculation:

1 = (0.4 * 0.8 + 0.6 * F)/1.15 F = 1.383 Interest rate = 38.3 per

cent

Your NPV: [0.4 * 0 + 0.6 * (1.5 F)]/1.15 = 0.061M

c. You have found investors who will fund the full cost of the project through

equity. What is the share of equity they will ask for? What is the expected

present value of your payoff?

(6 marks)

Approaching the question

Let be the fraction of equity promised to outsiders. It must be that:

1 = * (0.4 * 0.8 + 0.6 * 1.5)/1.15 = * 1.061 = 94.26 per cent.

Your NPV: (1 ) * 1.061 = 0.061

d. You have found investors who will give you a loan for half of the cost of the

project. You will finance the rest with equity. What is the face value of the

loan and the interest rate? What is the share of equity promised to the equity

investors? What is the expected present value of your payoff?

(6 marks)

Approaching the question

Loan calculation:

0.5 = (0.4 * F + 0.6 * F)/1.15 F = 0.575 Interest rate = 15 per

cent.

Let be the fraction of equity promised to outsiders. It must be that:

0.5 = * [0.4 * (0.8 F) + 0.6 * (1.5 F)]/1.15 = * 0.561 =

24

Your NPV: (1 ) * 0.561 = 0.061

e. In light of your numerical answers above, discuss Modigliani and Millers 1st

proposition.

(3 marks)

Approaching the question

Note that in (b),(c) and (d) the payoff was always the same and equal

to the NPV in (a). This is exactly the point of M&M; financing method

(capital structure) is irrelevant. The payoff to the firms owner will be

the same regardless of which capital structure is chosen, as long as the

conditions stipulated by M&M hold (which they do in this question).

Question 8

For this question assume that debt carries no tax advantage over equity. The

historic risk free rate is 3% and the historic stock market premium (in excess of

the risk free rate) is 7%.

Reading for this question

Subject guide, Chapter 2, pp.2540, Chapter 10 pp. 13543.

a. LexCorp is a private equity fund which owns several airlines. It has

outstanding long term debt with face value $120M and an interest rate of

5%. It has 50M shares outstanding, trading at $2/share. Its historic annual

equity return is 20%. It plans to sell one of its airlines, Inter-Continental

Airlines, as a stand alone all equity firm. Assuming its risk is similar to

LexCorp, what is the appropriate discount rate at which to value InterContinentals equity?

(6 marks)

Approaching the question

LexCorps equity market cap is 2 * 50 = 100. Its capital employed is

120 + 100 = 220. Its weight of equity is 100/220 = 0.45 and its weight of

debt is 120/220 = 0.55

LexCorps WACC is 0.55 * 4 + 0.45 * 20 = 11.81 per cent.

Inter-Continental has the same risk as LexCorp; furthermore, there are no

tax issues, therefore it has the same discount rate as LexCorps WACC.

b. Inter-Continental Airlines has annual free cash flows (FCF) of $2M. What is its

current value assuming no growth in cash flows? Suppose Inter-Continental

raises $10M in cash through a debt offering with an interest rate of 3%. What

is the new beta of Inter-Continental Airlines equity? What is the weighted

average cost of capital?

(7 marks)

Approaching the question

The current value is 2M/0.1181 = $16.93M. After the debt issuance it has

added $10M to its assets (and liabilities), raising the value to $26.93M.

The total value is not affected by choice of capital structure because debt

does not carry a tax advantage. Therefore the weights of equity and debt

are now 16.93/26.93 = 0.629 and 10/26.93 = 0.371. Note that the firm

has two assets, cash and airline. The presence of cash has not changed the

airlines risk; therefore its expected return is the same as before: 11.81

and its beta = (11.81 3)/7 = 1.26. Using the WACC approach:

WACC = 0.629 * 11.81 + 0.371 * 3 = 8.54.

25

Petroleum which extracts oil. Oil extracting firms typically have betas of 2.1.

What is the new beta of Inter-Continental Airlines equity?

(7 marks)

Approaching the question

First consider the asset side of the balance sheet. Inter-Continental has two

projects: airline with a beta of 1.26 (from (b)), and oil extraction, with

a beta of 2.1. The weights are 0.629 and 0.371 just as in (b); therefore

WACC = 0.629 * 1.26 + 0.371 * 2.1 = 1.57.

Now using WACC on debt and equity (liabilities side of balance sheet):

There is still outstanding debt with market value 10 and a promised return

of 3 per cent, implying beta(Debt) = (3 3)/7 = 0. Its weight is 10/26.93

= 0.371, as in (b). Applying the WACC once more: 1.57 = 0.371 * 9 +

0.629 * Beta(equity) Beta(equity) = 2.50.

d. What must Southwestern Petroleums annual free cash flows (FCF) be to

justify the sales price? Assume no cash flow growth.

(5 marks)

Approaching the question

Its beta is 2.1, implying an expected return of 2.1 * 7 = 14.7.

FCF/0.147 = 10 FCF = $1.47M.

Black-Scholes Option Pricing Formula

C = S[N(d1)] X[N(d2)]e-rt

d1 =

ln ( S / X )

1

+ t

2

and

d 2 = d1 t

E(Ri) = Rf + i E (Rm) Rf

Modigliani and Miller

Proposition I (no tax): VL = VU

Proposition II (no tax): Re = Ra + (Ra Rd) D

E

Proposition I (with corporate tax): VL = VU + Tc D

Proposition II (with corporate tax): Re = Ra + (Ra Rd) (1 Tc) D

E

Miller (1977)

(1 Tc )(1 Te )

VL = VU + 1

D

1 Td

26

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