CORPORATE FINANCE

UNIT 7. LONG-TERM FINANCIAL PLANNING

ACTIVITY 8. CASE SOLUTION

Identification data:
Marcel López Ponce.
Student name(s)
Teacher's name Dr. Guillermo Benavides Perales
Date April 23, 2021.

Instructions:
1. From the materials reviewed, solve the following cases. Perform all calculations and operations
in an Excel sheet and integrate the results in this document; you can integrate the calculations
from the Excel sheet at the end of this document, or send both files (Excel and Word) in the
Blackboard platform.

Case 1
Vista Oil & Gas, S.A.B. de C.V. owns assets that have an 80% chance of having a market value of
$100 million a year from now and a 20% chance of being worth only $70 million. The current risk-
free interest rate is 5% and the assets of this company have a cost of capital of 10%. There are two
scenarios:

a) Without debt, what is the current market value of your equity?

b) You have a debt with a face value of $70 million maturing in one year, what is the value of
equity? Argue, rely on the MM Theory
c) What is the expected return without leverage?

d) What is the lowest possible return on equity with or without leverage? Argue based on the
MM Theory.

Vista Oil & Gas, S.A.B. de C.V.

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Scenario 1 80% probability of having a market value of $100,000,000.00

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Interest: 5%
Cost of
Capital: 10%
Period (N): 1 year

Value
Present: VP= VF/( 1 -Ke[P otency])- $ 90,909,090.91

Value
Future: $100,000,000.00

Value for
the Option A: 100% VP*(1+Ke) $ 100,000,000.00
Option B: 70% D*(1+i) $73,500,000.00

Debt: $70,000,000.00

Profitability: $ 26,500,000.00 27%

Option C: 30%
70%
Debt: $70,000,000.00

VP -Debt: $ 20,909,090.91

(VP*(1+Ke)) $100,000,000.00
(VP*(1+i)) $ 95,454,545 45
Profitability: $ 4,545,454.55

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Scenario 2 20%probability of having a market value of $70,000,000.00

Interest: 5%
Cost of
Capital: 10%
Period (N): 1 year

Present Value: - VF/( 1+Ke[Power n]) $63,636,363.64

Value
Future: $70,000,000.00

Value for Option A: 100% VP*(1+Ke) $70,000,000.00

the
investor Option B: 70% D*(1+i) $73,500,000.00

Debt: $70,000,000.00

Profitability: $3,500,000.00 -5%

Option C: 0% 0
70% $70,000,000.00

(VP*(1+i)) : $66,818,181.82
Profitability: $66,818,181.82

Case 2
Proteak, S.A.B. de C.V., needs to raise 109 million Mexican pesos for a new investment project. If
the company issues one-year debt, it may have to pay an interest rate of 10%, although Proteak's
managers believe that 8% would be a fair rate given the level of risk. However, if the company issues
shares, the directors believe that the shares could be undervalued by 5%.

a) What is the cost to current shareholders of financing the project with retained earnings, debt
and equity?

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Proteak, S.A.B. of C.V

Cost of financing $ 109,000,000

Interest 10%
interest rate (risk)
% undervalued shares

Cost of financing with shareholders' retained earnings

Cost = 109,000,000

Cost of one-year debt financing

Cost of debt = debt amount * ( 1+interest rate)

Cost of debt = $ 119,900,000
Present value = Cost of the debt (1 - riskrate )
Present value = $ 111,018,519

Cost of financing with own resources

Value of shares = $ 100

Undervaluation of shares1
Present value of shares $ 95
Total shares to be sold 1.147,368
Cost of financing $ 114,736.842

Equity: $114,450,000.00
Debt: $ 119,900,000.00
Benefit
-$ 5,450,000.00
Retained:

b) Determine the financial preferences for shareholders and provide conclusions, based on
the Theory of the hierarchy of preferences.

Thanks to what was seen in the case, it was possible to make the decision of what the
company requires, which is a leverage of $114,450,000.00 on the part of the
shareholders and to attempt to

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seek a loan of $119,900,000.00 since it is mentioned in the theory that managers prefer to
make investments using retained earnings, after debts & that they will only choose to issue
shares as their last resort.

This theory defines the implications for the capital structure of companies, when they have
profits & generate enough cash to finance their investments, without issuing debt or equity,
relying on retained earnings. As a result, the profitable company has little debt. at your
structure from capital.

Companies that need to raise external capital, are the ones that will have significant debt
financing, since theory tells us that companies should almost never issue equity, but actually
several possible forces shape their capital structure & that they issue equity when debt
insolvency rates are too high.

Case 3
You are an entrepreneur of a new epidemiology business. If the research is successful, the vaccine
patent could be sold for $80 million, and if not, it will be worth nothing. To finance the research, $20
million is required as seed capital in exchange for 50% of the company's debt-free equity.

a) What is the total market value of the company without leverage, if you can borrow $10
million.
b) According to MM Theory, how much of the company's equity will you need to sell to get the
additional $10 million you need?
c) what is the value of your share of the company's equity with and without leverage?

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VF: $80.000.000.00
Cost of capital: 50%
Leverage: $20.000.000.00
Denda: $ 10.000.000.00

VP: VF/(1+Ke) $53,333,333.33

Enterprise Vu=UAII*UAII
Value: (1-te)/Ro $37,333,333.33

Cost of Capita:
Tax on revenues: 50%

30%

Case A: VF-VP Without the amount

Utility: $26.666.666.67 $10.000.000.00
borrowed, with With the leverage
Utility: $16.666.666.67
amount borrowed with leverage
Case B:
Without the amount
$10.000.000.00
$ 6.666.666.67 borrowed, with With the leverage
-$ 3,333,333.33 amount borrowed with leverage

Case C:
$53.333,333.33 Unlevered shareholders' equity
VF/(1+Ke) (VF/1+KE)-
Leverage
$33,333,333.33 Equity with leverage

Case 4
Success Corporation has $140 million in equity and $60 million in debt and is forecasting $28 million
in net income for this year. Today, it pays a dividend of 25% of its net income. The company is
currently analyzing a possible change in its profit distribution policy: an increase in dividends to 35%
of net income.

a) Determine how this change will affect the company's internal and sustainable growth rates?
By increasing dividends, we will have a reduction in the withholding tax rate. This in turn will
have an impact on the company's sustainable growth rate.

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b) What is the difference between the internal growth rate and the sustainable growth rate?
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The internal growth rate refers to the percentage of resources available to the company without
the need to increase capital or debt in order to finance its expansion. On the other hand, the
sustainable growth rate refers to the percentage by which the organization can increase its
revenues without incurring debt or soliciting additional investment from shareholders.
In this particular case, these rates are as follows:

Growth rate Growth rate

% benef. net
Internal Sustainable
25% 10.5% 15.0%
35% 9.1% 13.0%

c) If the company grows faster than its sustainable growth rate, does this growth reduce the value
of the company?

The company may grow faster, slower or only at the sustainable growth rate. Although rapid
growth might seem like a positive indicator, a growth rate that exceeds the sustainable growth
rate means that the company does not have sufficient cash balance available to meet the
company's needs, according to its growth rate. If the sustainable growth rate you calculate is
higher than the return on equity, it means that the company is not performing as well as it
could.
Although a high real growth rate is not by default negative, it means that the company will
have to finance the increase in operations by issuing new equity instruments, acquiring new
debt, reducing dividends or increasing profit margins. Most owners prefer not to manage more
loans or issue more equity during the early years and may need to slow the company's growth
to the speed of the sustainable growth rate.

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So if the company grows faster than its sustainable growth it will lose value
as it will have higher debt liabilities to finance its increased costs.
to be able to sustain its operation.
Success Corporation
% benef. Cree rate. Cree rate.
Net Internal Sustainable
25% 10.5% 15.0%
Shareholders' equity 140,000, 000 35% 9.1% 13.0%
Debt 60,000,000
Initial assets 200,000,000
Benefit 28,000,000
% dividend old 25%
% dividend new 35%

ROA = Net income / initial assets

RO A = =28,000,000/200,000,000
ROA = 14%

ROE = Net Profit / Initial Shareholders' Equity

ROE= =28,000,000 / 140,000,000
ROE= 20%

Old retention rate = (1 - distribution of beneficiaries)

Old retention rate = 0.75
New retention rate = 0.65

Old internal Cree rate = ROA * retention ratio

Believe rate , old intema = 10.5%
New cree rate , intema = 9.1%

Cree rate , old sustainable = ROE * retentionrate

Cree rate , old sustainable 15.0%
New cree rate . Sustainable = 13.0%

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Conclusion:

As a final conclusion of the present unit & activity on this last case analysis, it is that we understood
the utmost importance that financial planning imparts, since it was understood that it is an extremely
indispensable tool that helps us to guarantee the business achievements that allow us to be anticipated
& show us future problems, generating a balance of the company's position & establishing which
direction to take & follow.

It also provides a framework for determining the financial impact & effects of various corrective
actions. helping us to guarantee the achievement of the objectives as well as their importance, since it
allows us to anticipate & show us the problems that may arise in the future, taking stock of where the
company is & establishing a clear direction to follow.

Defining an adequate financial planning provides us with the business benefit of facilitating the
economic resources that are managed through methodical evaluations & the best financial and
investment decisions are made based on current profitability & expected returns. This is how
organizations are prepared with their respective financial alternatives to support them.

That is why this initiative is necessary to constantly monitor the financial planning in order to control
management and implement improvements or changes if necessary to achieve the objectives & goals
set by the organization.

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Bibliographic references:

• Harford, J. Berk, J. and Harford, J. (2010). Fundamentals of corporate finance. [Book

online]. Retrieved April 19, 2021 from: https://elibro.net/es/ereader/uvm/53847

• Mature, J. (2015). International financial management. [Online book]. Retrieved

on April 19, 2021 at: https://elibro.net/es/ereader/uvm/40028

• Pacheco, C. (2015). Budgeting: a managerial approach. [Online book]. Retrieved on

April 19, 2021 at: https://elibro.net/es/ereader/uvm/116416

• ¨Without author's name¨. (2015, June 18). https://actualicese.com [Home].

Retrieved April 20, 2021 at: https://actualicese.com/planeacion-financiera-a- largo-plazo-que-

es-y-para-que-serves/