THE INTERNATIONAL UNIVERSITY (IU) – VIETNAM NATIONAL UNIVERSITY – HCMC

MIDTERM EXAMINATION

Date: from November 10, 2021, 3:15 pm to November 11, 2021, 3:15 pm

Duration: 1 day

Student ID: BAFNIU19151 Name: Võ Thị Kim Quyên

SUBJECT: CORPORATE FINANCE

School of Business Lecturer

Signature: Signature:

Full name:
Full name: Trinh Thu Nga

GENERAL INSTRUCTION(S)

1. This is an open-book, open-note examination.

2. Submit your answer file on Blackboard. Make sure that the file is successfully uploaded
before you log out. Only if you cannot submit it on Blackboard, you can send it via email:
ttnga@hcmiu.edu.vn. Blackboard or email submission must be before the due date.
3. The format of your answer file can be Word or pdf. It’s fine to have handwritten answers but
need to combine into one file.

GOOD LUCK!

1
 There are five questions.
Question 1: (20 points)
Read the article in the link below. The content is also in the Appendix of this exam.

https://www.federalreserve.gov/econres/notes/feds-notes/equity-issuance-and-retirement-by-
nonfinancial-corporations-20170616.htm

a. Were U.S. nonfinancial corporations on average issuing new equity or buying their
shares back? Provide evidence from the article.

According to the article, from 1996 to 2016, U.S. nonfinancial corporations on average retire their
shares rather than issue new equity.
Below is the graph extracting from the article

The figure shows that over the given period, the U.S. equity retirements (red line) have been
consistently greater than the gross issuance (black line) which results in negative net equity
issuance. Besides distributing earnings for sharesholders by saving their tax expenses from
dividends payout, repurchasing equity also reflects a common incentive compensation device for
existing shareholders.

b. The pattern of corporate financing is discussed in the textbook (Figure 15.2 page 487
and the discussion on page 488). Explain the reasons for this pattern of financing using
all relevant topics/theories of capital structure.

The figure 15.2 breaks down total financing in U.S. businesses into internal financing, debt
financing and financing through new equity. It is easy to recognize that internal financing
dominants as a source of financing compared to financing through debt and equity, the reason for
that is the cost of internal financing is cheaper than external financing. When using external
financing, the companies need to issue bonds, shares or borrow from the banks and they have to
pay for these costs which is much higher than the costs of internal financing such as retained
earnings.
The figure also indicates that when corporations use external finance, they tend to issue debt
rather than issue new equity. The reason can be explained by using pecking-order theory which
states that corporates should issue the safest securities first. Debt has relatively less risk compared
with equity because if financial distress is avoided, investors would receive a fixed return.
Besides, M&M Proposition I under taxes claimed that the value of firms is positively related to
leverage (ignore the financial distress and bankruptcy cost) and firms can take advantage from tax
shields which is not occurred in dividend payouts.
The negative net equity indicates corporates repurchased more stock then issued new equity
because they found it more attractive to repurchase stocks rather than payout dividends. This
trend accelerated in 2002-2007 and just declined at the beginning in 2008 which is the result of
financial crisis.

Question 2: (20 points)

A.

a. What is this type of voting called? What is the number of votes you can cast?

The type of voting is cummulative voting because there are three seats on the board of directors
need to be voted at once in a single election.
Numbers of shares holding = 50,000 + 5,000 x 1 = 55,000
Number of votes can cast = 55,000 x 3 = 165,000 votes

b. With this type of voting, suppose the company has 1 million+(100,000xA) shares outstanding
(with A defined above), how many more shares must you buy to be assured of earning a seat
on the board?

Number of shares outstanding = 1,000,000 + 100,000 x 1 = 1,100,000 shares

To be assured of earning a seat on the board, the numbers of shares needed at least is:
1
×1,100,000+1=275,001
3+1
Therefore, the numers of shares need to buy more is: 275,001 – 55,000 = 220,001 shares
B.
a. Call provision: this feature allows the issuing company to repurchase their bond at a
specified period before its maturity date at stated price. When the interest rates fall, the
bondholders may bear the risk of calling back their bonds by the issuers which results at
unfull payment of coupons and reinvestment at lower rates. Thus, these investors require
high returns on those bonds to compensate for such risks.
b. Put provision: in the reverse of call provision, put provision allows the investors to resell
 bond to the issuers at a specified period before its maturity date at par or face value. Put
provision protects the holders from potential losses from declining in value of bond
when interest rate raises or decreasing in credit rating, therefore, these bonds have lower
required rate of return compared to non-putable bonds.
c. Sinking fund: This is the fund managed by the bond trustee that company uses to
transfer their money in to repay the bonds. Bonds with sinking fund are paid on time
and less likely to default, therefore, the required return on these bonds are lower than
bonds without sinking fund.

Question 3:

a. What is the current value of the company?

*Input data:
EBIT = 31,000 + 200 x 1 = $31,200

R0 =14 %

Corporate tax rate: 26% + 1% =27%

The present value of the unlevered firm is the present of EBIT x (1-T c ¿

EBIT x ( 1−T c ) 31,200 × ( 1−0.27 )

V U= = =$ 162,685.71
R0 0.14

b. Suppose the company can borrow at 7%. What will the value of the company be if it takes on
debt equal to 30 percent of its unlevered value?

B = 0.3 x 162,685.71=$48,805.71

According to M&M Proposition I with corporate tax:

V L=V U +T c B = 162,685.71+0.27 × 48,805.71=$ 175,863.25

c. What will the value of the company be if it takes on debt equal to 30 percent of its
levered value?

V L=V U +T C B

V L=V U +T c × 0.3 V L

V L=162,685.71+0.27 × 0.3 V L
V L=$ 177,024.71

Question 4: (20 points)

*Input data:

Sales revenue = 18,000,000 + 100,000 = $18,100,000

Corporate tax = 26% +1 % = 27%

a. If the company were financed entirely by equity, how much would it be worth?

EBIT = Sales – Variable costs = 18,100,000 – 0.65x 18,100,000 = $6,335,000

EBIT ×(1−T c ) 6,335,000×(1−0.27)

Value of unlevered firm: V U = = =$ 38,537,916.67
R0 0.12

b. What is the required return on the company’s levered equity?

According to M&M Proposition II with corporate tax:

B
R S=R0 + ( 1−T c ) ( R0−R B )
S

R S=0.12+0.4 ×(1−0.27) ( 0.12−0.08 )

 R S=0.13168

Therefore, the required return on equity of levered firm is 13.168%

c. Use the weighted average cost of capital (WACC) approach to calculate the value of the
company. What is the value of the company’s equity? What is the value of the company’s
debt?

B S
WACC= × RB × ( 1−T c ) + × RS
B+ S B+S

0.4 1
WACC= ×0.08 × ( 1−.27 ) + ×0.13168=0.110743=11.0743 %
0.4 +1 0.4+1

EBIT × ( 1−T c ) 6,335,000 × ( 1−.27 )

Value of the company: V L= = = $41,759,298.56
WACC 0.110743

S 1
Value of the company’s equity = ×V L= ×41,759,298.56 = $29,828,070.4
S +B 0.4 +1
 Value of the company’s debt = 41,759,298.56 - 29,828,070.4 = $11,931,228.16

d. Use the flow to equity (FTE) approach to calculate the value of the company’s equity (Hint:
use the value of debt calculated in part c to calculate interest expense).

Sales 18,100,000

VC -11,765,000 (0.65 x 18,100,000)

Interest -954,498.25 (11,931,228.16 x 0.08)

Income after interest 5,380,501.75

Corporate tax (27%) -1,452,735.47

Levered CF 3,927,766.28

Value of the company’s equity is the present value of Levered CF

Levered CF 3,927,766.28
V E= = =¿ $29,828,115.72
RS 0.13168

Question 5: (20 points)

a. Discuss the static trade-off theory and the pecking order theory of capital structure. What
are the main differences between these two theories? (10 points)

There are some main differences between static trade-off and pecking-order theory:

- Trade-off theory focuses on target debt-equity ratio and the firm should borrow up to the point
where tax benefit from debt is equal to the bankruptcy cost. By contrast, the pecking-order
theory does not focus on a target amount of debt, it stated that the firm prefers to use internal
financing whenever possible and issuing debt and equity come after respectively.
- With pecking-order theory, profitable firms do not need to finance externally and usually rely
on less debt. However, according to trade-off theory, the higher profit firms generate, the
higher debt they should use to capture tax benefits.
- Financial slacks are valuable for pecking-order theory as they can help the company go
through a difficult period, so they use less external financing. However, the trade-off theory
assumes that managers of firms with large free cash have more incentive to pursue wasteful
activities, therefore, firms should issue debt to limit these opportunities.
 b.

*Input data:

Beta of ASA’s equity = 1 + 0.1 x 1 = 1.1

Corporate tax = 26% + 1% = 27%

*ASA’s cost of equity capital:

R S=R F + β × ( R M −R F )

R S=0.05+1.1 ×0.08=0.138=13.8 %

According to M&M proposition II with tax:

*ASA’s cost of capital if all equity

B
R S=R0 + ( 1−T c ) ( R0−R B )
S
0.25
0.138=R0 + × ( 1−0.27 ) × ( R0 −0.09 )
0.75

By solving the equation, we get R0 =0.128606=12.8606 %

Applying the assumption that business risk of GP venture if all equity is equal to business risk of
ASA which is already in the business. Therefore, R0of these two firms are the same.

*Cost of equity capitial for GP’s smart alarm business:

B
R S=R0 + ( 1−T c ) ( R0−R B )
S

0.2
R S=0.128606+ × ( 1−0.27 ) × ( 0.128606−0.1 )
0.8

 R S=0.133827=13.3827 %

¿ RWACC for GP’s smart alarm venture:

B S
WACC= × RB ( 1−T c ) + × RS
B+ S B+ S
WACC=0.2× 0.1× ( 1−0.27 )+ 0.8× 0.133827=0.1217=12.17 %