Corporate Finance Practice Exam answers

Question 1b (5 Marks)
Briefly explain why private equity has an advantage, versus publicly owned firms, in creating value.

Public firms suffer from agency problems and a separation of management from ownership. This tension may
cause managers to look out for their own interests at the expense of owner's interests. Private equity firms
offer owners much more control over the managers of the company. As such, the managers work more
effectively to maximize owner value. The popularity of private equity has also been linked to the costs and
distractions of public ownership, including the costs of dealing with Sarbanes-Oxley and other legal and
regulatory requirements.

Question 1b (10 Marks)

Firm A Firm B Firm AB (after merger of A and B)
Price per share $120 $8
Total earnings $600 $400
Share outstanding 100 60
Total value $12,000 $480 $13,000

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Firm A has proposed to acquire Firm B at a price of $12 per share for Firm B's stock.

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i) Calculate the gain from the merger. (2 marks)

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ii) Calculate the NPV of the merger. (2 marks)
iii) What will be the post-merger price per share for Firm A's stock if Firm A pays in cash? (2 marks)

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iv) What will earnings per share be for Firm A after the merger assuming that cash is used in the
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acquisition? (2 marks)
v) Calculate the post-merger P/E ratio assuming cash is used in the acquisition. (2 marks)

i) 13,000 - 12,000 - 480 = 520 (2 Marks)

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ii) NPV = Gain - cost; (13000 - 12480) - ((12)(60) - 480) = 280 (2 Marks)
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iii) P = (12,000 + 280)/100 = 122.80 (2 Marks)

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iv) EPS = (600 + 400)/100 = $10.00 (2 Marks)

v) P/E ratio = 122.8/10 = 12.28 (2 Marks)

Question 2a (7 marks)
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Catfood Corporation is financed entirely by common stock. The company employed a new finance manager
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and he decided to repurchase 30% of the stock. He would be using debt at a fixed rate of 6% to achieve this.
Calculate the expected return on its common stock after refinancing if it is currently priced to offer a return
of 15%?
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Re = Ra + (Ra – Rd)(D/E) (page 434 of textbook)

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= 0.15 + (0.15 - 0.06)(0.3/0.7)

= .1885 or 18.85%

Question 2b (8 marks)
MyToys Company decided to issue 500,000 new shares through a rights issue at a subscription price of
$17/share. If there are 1,000,000 shares outstanding at $43/share before the new issue, calculate the value
of each right.

Stock price after issue: ($43M + 0.5*17)/1.5M = $34.33

Method 1 (Price before rights – Price after issue)
(43 -34.33) = 8.67
Method 2
(Price before rights – Price to buy 1 right) / (N + 1)
(43 – 17) / 3 = 26 / 3 = 8.67
Method 3
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 (Price after rights - price to buy 1 right) / N
(34.33 – 17) / 2 = 17.33 / 2 = 8.67

Question 3 (5 marks)
Briefly explain the difference between leveraged buyouts and leveraged restructurings.

The financial characteristics of LBOs and leveraged restructurings are similar. The three main characteristics
of LBOs are: high debt, incentives to managers, and private ownership. Leveraged restructurings share the
first two characteristics but continue to operate as public companies.

Question 4 (15 marks)

Zamba Limited is intending to expand its business by investing in a new patent. This new investment, costing
$50 million, will result in a net after tax cash flow of $12M for the next 10 years. Due to the recent credit
downgrade on the company from A to BB, the expected long term cost of debt would increase. As a result,
management is uncertain if they should still proceed with the investment. A similar BB rated 10 year bond is
currently selling for $908.72 per $1000 bond with a coupon rate of 9% paid semi-annually.
Using the financial information below, ignoring taxes, show evidence of whether to go ahead with the
investment or not.

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Price per share $50

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Beta of the company 0.8

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Book value per share rs e $25
Number of shares of common stock 10,000
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Share returns of the coy of the past four years 10%, 30%, 20%, 20%
Market return for the past four years 5%, 15%, 25%, 15%
Risk-free rate 5%
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Long term debt outstanding $300,000

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Expected rate of return on stock (r equity) 15%

Cost of equity
RM = (5 + 15 + 25 + 15)/4 = 15%
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Re = 5 + (0.80)(15 - 5) = 13%.
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Cost of Debt
N = 20
PMT = $45;
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FV = $1000;
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PV = -$908.72;
YTM = 5.25*(2) = 10.5% per annum

Asset position
Total equity = 50 * 10,000 = 500,000
Total debt = 300,000

Company’s cost of capital =

 300,000   500,000 
r   0.105    0.13
 300,000  500,000   300,000  500,000 
=12.06%

Investment assessment
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 PMT = $12M
PV = -$50M
N = 10
R = 12.06%
NPV = $17.64M

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