CORPORATE FINANCE Mid-term examination (D &E) Prof TT Ram Mohan Time: 90 utes; Total marks: 50 (please return the question paper along with the answer book) 1. Pure Drinks is in the business of packaged fruit juices. It already produces and sells orange, apple and pineapple juices. It intends to increase its range of juices. The company engaged a well-known marketing consultant to conduct a market survey to find the scope for guava juice. The market survey indicated tremendous scope for guava juice, and that the company could sell 900,000 sachets of guava juice each year. ‘The Rs.5 million cost of the survey has not been yet paid in cash. The survey has also shown that for one Llitre sachet of guava juice, consumers are not Prepared to pay more than Rs.65 as of today. The management accounting department of the company has estimated that the variable cost per sachet would be Rs.15, which includes material cost of Rs.6.50, labour cost of Rs.3.50 and overhead cost of Rs.5.00. These costs are also as of today. At a capacity of one million sachets, the fixed overhead cost per sachet is estimated at Rs.6.75. The fixed overhead costs are allocations of the corporate general and administrative costs. Because of the project, the corporate marketing expenses and some administrative cost are likely to increase by Rs.0.50 million per year in real terms. The management accountant feels that the profitability of the project would be affected by inflation. He expects 4 per cent annual inflation to apply to the product price, corporate marketing expenses and administrative costs. Further, he estimates that the price increases in variable overhead cost and labour cost would be 5 per cent per annum and in material cost 3 per cent per annum. The expected price increases (or inflation rate) would apply to revenues and costs in a given year. The company is implementing a computer-based inventory control system that is likely to decrease the project's working capital by about 4 per cent of sales. In the absence of the new inventory control system the working capital ratio is expected to be 30 per cent of sales. The working capital investment precedes sales by one year. The company is considering using its existing building for processing the guava juice. The building was fully depreciated for tax purposes and was not in use so far. But a few months ago it received an offer of Rs.100 million (net of taxes) for the purchase of the building from a computer company. If the company does not sell the building immediately, its value is likely to appreciate by Rs.100 milion (net of taxes) after five year, The processing facility for guava juice would cost Rs.200 million. It is expected to have an economic life of five years. The estimated savage value of the processing equipment is Rs.100 million. The company uses straight-line depreciation method for tax purpose and tax is applicable on the profit or loss from the sale of the assets at the corporate income tax rate of 35 per cent. The discount rate for the project is 13%. Should the company go ahead with the project? Please show the calculations.(14 marks) 2. Bucholz Brands is considering the development of a new ketchup product. The ketchup will be sold in a variety of different colors and will be marketed to youngchildren. in evaluating the proposed project, the company has collected the following, information: ‘* The company estimates that the project will last for four years. The company will need to purchase new machinery that has an up-front cost of $300 millon (incurred at t= 0}. Att =4, the machinery has an estimated salvage value of $50 million. The machinery will be depreciated on a 4-year straight-line bi Production on the new ketchup product will take place in a recently vacated facility that the company owns. The facility is empty and Buchole is not in a position to lease the facility. The project will require a $60 million increase in inventory at t = 0. The company expects that its accounts payable will rise by $10 million at t= 0. After t= 0, there will be no changes in net operating working capital, until t = 4 when the project is completed, and the net operating working capital is completely recovered. + The company estimates that sales of the new ketchup will be $200 million each of the next four years. + The operating costs, excluding depreciation, are expected to be $100 million each year, ‘+ The company's tax rate is 40 percent. ‘+ The project’s WACC or discounting rate is 10 percent. If Buchole goes ahead with the project, they will have the option to pursue a second stage project at t = 4. This second-stage project will involve a full line of multi-colored condiments. This second stage project cannot be undertaken, unless the first-stage project (the new ketchup product) is undertaken today. The company estimates today, that if they want to go ahead with the second stage project that this will require a significant expenditure at t = 4. However, the company does not have to decide whether to pursue the second stage project or to spend any funds on the second stage project until t=4. Currently, the company’s analysts estimate that there is a 25 percent chance that demand will be high and the second stage will have an estimated NPV (at t = 4) of $40 million, and there is a 75 percent chance that demand will be weak and the second stage will have an estimated NPV (at t = 4) of -$75 million. Furthermore, the analysts believe that, by the fourth year (at t = 4), consumer preferences and demands for the second stage project will be known with certainty. Assume that all cash flows are discounted at the cost of capital (10 percent). Given the existence of the second stage, what should be the minimum NPV of the first stage for the company to proceed with the first stage? Please show the calculations. (11 marks) Assume an economy with perfect capital markets. In this setting, indicate what's wrong with the following arguments: {) The more debt a firm issues, the higher the interest rate it must pay. This is an important reason why firms should operate at conservative debt levels, given a mixture of debt and equity. (i) Moderate Borrowing doesn''t significantly affect the probability of financial distress. Consequentiy, moderate borrowing doesn’t increase the rate of return demanded by borrowers. (ii) Asthe firm borrows more and the debt becomes risky, both stock and bond holders demand higher rates of return. Thus, by reducing the debt to equity ratio, we can « reduce both the cost of debt and the cost of equity, increasing firm value. (6 marks)4, Here are the book and market value balance sheets of ABC company. Assume an economy with corporate taxes, but no other market imperfections of any kind. (9 marks) [Book Market | Net working capital 20” | Debt 40 | Net working capital 20 | Debt 40 Long-termassets 80 | Equity 60 | Long-termassets 140 | Equity 120 700 T00 160 ‘Te0 There is no growth and the Rs 40 of debt is expected to be permanent. Assume a 40 percent corporate tax rate. (a) What proportion of the firm’s value is accounted for by the debt-generated tax shield? (b) How much better off will ABC's shareholders be if the firm borrows $20 more and uses it to repurchase stock? (c} Now suppose that parliament passes a law which eliminates the deductibility of interest for tax purposes after a grace period of 5 years. What will be the new value of the firm, other things equal? (Assume an 8 percent borrowing rate) For (c), assume debt level as in (b) i.e. Debt value = 40+20 = 60 5. Vintage Cola Company's equity currently trades at Rs15 per share. The company proposes to introduce a new product, which requires an investment of Rs 2 million, and an NPV of Rs1 million. Due to information asymmetry about its new product, management fears that any new equity issued can be priced only at Rsi5 per share. The firm has currently 200,000 shares outstanding. {a) Compute the share price that would prevail (after any information asymmetry about the new product is resolved) if management is able to implement the project with internal financing. (b) Ifinstead, management were forced to implement the project by selling new equity priced at $15 per share, what share price would prevail after the information asymmetry about the project is resolved? (c}_ Under situation (b) above, was management right to undertake the project. (10 marks)