tne LONDON SCHOOL oF ECONOMICS ano POLITICAL SCIENCE mt ‘Summer 2016 examination FM422 Corporate Finance Suitable for all candidates This paper contains six questions: three in Section A and three in Section B. Answer two questions from Section A and two questions from Section B. All questions will be given equal weight (25%). Time Allowed- Reading Time: 15 minutes. You may not write in your examination answer booklet, but you may make notes on the examination paper. Writing Time: 3 hours You are supplied with No additional material You may also use: No additional material Calculators: Calculators are allowed in this examination © LSE ST 2016/FM422 Page 1 of 8Section A 1 (a) Consider the following data from CBA Inc. (in thousand dollars) 2012 2013 2014 2015 Sales Revenue 8952 11011 12883 16490 Net Income 369 398 383 291 Assets 3275 3852 4980 5870 Shareholders’ equity 1193 1392 1583.5 1729 Dividends 184.5 199 191.5 145.5 () — (®marks) Calculate CBA’s sustainable growth rate and actual growth rate of sales for 2013, 2014, and 2018. What growth management problems has CBA faced during this period? Discuss carefully. (i) (@ marks) Based on the limited information you have, what advice would you have for the management of CBA? (b) (7 marks) "When firms announce increases in quarterly dividends their stock prices jump upward whereas when firms announce decreases in quarterly dividends their stock prices jump downward.” How would you explain this phenomenon? (c) (7 marks) The PE ratio is a tool commonly used by practitioners to determine the desirability of an investment. It is the ratio of the price of a firm's shares to its earnings per share. Consider an all-equity financed firm in a frictionless economy with no depreciation, amortization, CAPEX, or changes in Net Working Capital. Denote time in years as t = 0, 1, 2... Today is t = 0. The firm has no expenses of any kind and produces in total an annual cash flow of x(t) at the end of year t, for each t = 1, 2, 3,.... For each t, x(t) can be variable. The expected cash flow, x, is the same for all t. The appropriate discount rate for the stream of cash flows x(t) is r > > 0 where rs the risk-free rate of return. There are currently N shares outstanding. At t = 0, the firm issues safe perpetual debt with market value D and uses the proceeds immediately to repurchase shares in the open market. Characterize how this leveraged recapitalization affects the expected PE ratio of the firm today. Comment on your finding. © LSE ST 2016/FM422 Page 2 of 82 Time is designated as follows: t = 0 represents today and t = 1 represents a year from today. Consider amature firm, PQR Inc., which will be closed down forever after all t = 1 cash flow has been paid out. The cash flow from PR's legacy assets at t= 1 can be either £240 million if PR is of the good type, or £120 million if it is of the bad type. All uncertainty about the type of POR will be resolved at t= 1. At t= 0, PR (regardless of its type) has access to a new project that costs £17 million at t= 0 and pays £24 milion with certainty at t= Due to the unusual preferences of its founding fathers many years ago, PQR's corporate charter precludes any form of leverage, and thus PR is all-equity financed at t = 0, and ~ if it wishes to implement this project ~ PQR’s managers must elther use internal funds (if available) or raise outside equity financing. Everybody is risk neutral, and the discount rate, throughout this problem, for all cash flows is 20%. PQR's managers maximize the wealth of existing shareholders. (a) Suppose there is symmetric information: Managers and outside markets both know that PQR is of the good type. Argue carefully that managers: i, (3 marks) Would invest in this project if PAR had £17 million of internal cash available (i.e., there is a spare £17 milion which is about to be paid out to shareholders as a special dividend at t = 0, but which can instead be invested in the project if managers decide to). li, (8 marks) Would invest in this project if PAR had no internal cash available. Show your work. (b) Suppose there is asymmetric information only about the value of legacy assets: Managers know that POR is of the good type, but outside markets believe that there is a 50% chance that PQR is of the good type and a 50% chance that POR is of the bad type. Argue carefully that managers: i. (2 marks) Would invest in this project if PAR had £17 million of internal cash available. ii, (3 marks) Would not invest in this project if PAR had no internal cash available. (6 marks) Would your answer to (b ii) have been different if managers knew that PQR is of the bad type? Taking this into account, what would the market value of equity be conditional on an equity issuance? Show your work and explain precisely (in all parts). (©) (8 marks) Retain the asymmetric information assumption of part (b). For this part of the problem, now imagine that PR is subject to corporate taxation at the rate of T. = 1/3 on its income, but that its shareholders (being institutional investors) do not pay any taxes. Reinterpret the cash flows from legacy assets above as after-tax cash flows. POR has no spare cash at t = 0. The reason is that a year ago, at t = -1, POR was targeted by an activist hedge fund. Att = -1, POR had £15 million in (aftet-corporate-tax) spare cash. The activist is well informed. Both the activist and POR’s managers already knew at t= -1 that PQR is of the good type and that at t= 0 POR would have access to a new investment project that would require £17 million to implement and would generate some risk-free cash flows at t = 1, after which POR would shut down. They differed in their assessment on what the eventual cash flows from this new investment would be, however. POR’s managers firmly believed that the (= 1 after-tax cash flow from the new investment would be £24 million. The activist firmly believed that the after-tax cash flow would be only £x million where x < 24. Att = 0, everyone simultaneously discovers the actual risk-free cash flow that will be generated by the investment project at t = 1. The activist was interested in maximizing long-term shareholder value (i.e., you can assume he does not sell his equity position in the firm until t = 1). He agitated successfully (by convincing other shareholders to join him in putting pressure on management) for the immediate disbursement (at t = -1) of £15 million to shareholders against the wishes of POR's managers. What does this tell you about what the activist must have believed x to be? Explain carefully, and derive any conclusions formally. © LSE ST 2016/FM422 Page 3 of(2) (4 marks) “For the same level of investment opportunities, the pecking order of financing choices implies a negative relationship between leverage and profitability across firms.” Is this statement true of false? Explain briefly ‘The remainder of this question is independent of part (a). A year ago, at t = -1, XYZ Inc. invested £80 million in an investment project. Today, at t = 0, XYZ's managers are faced with a strategic choice: There are two processes by which the investment project can be taken forward. One involves relatively litle risk, and is referred to as "Process S". Process S delivers returns of £150 million, £100 million, or £50 million in a year (at t= 1) with equal probability. The other process involves more risk: This alternative, referred to as “Process R’, delivers returns of £240 million with probability 1/3 or £0 with probability 2/3 in a year (at t= 1). The processes (S and R) are mutually exclusive: XYZ's managers have to choose between them. There are no additional implementation costs for either process at t= 0. After the cash flows from the project are obtained at t = 1, they are paid out, and XYZ closes down forever. There are no other projects or cash flows. The discount rate for all cash flows in this problem is 0. XYZ’s managers act in the interest of shareholders. Att =-1, when XYZ had to invest the £80 million, the firm could draw on two possible sources of finance: Retained earnings (i.e. internal financing) or external debt financing. Consider two pos: scenarios: (b) (4 marks) Suppose at t = -1 XYZ had high internal cash flows, so that the full £80 million was internally financed, and thus XYZ is an all-equity financed firm at t = 0. Which process will the managers choose at t = 0? Show your work. (©) (4 marks) Suppose at t = -1 XYZ did not have a full £80 million available inside the firm, and as a result a two-year discount (zero coupon) bond was sold to external bond markets at t= -1 with a face value of £45 million (which is payable at t = 1). This is XYZ’s only debt outstanding at t = 0. The rest of the £80 million required was internally financed. Which process will the managers choose at t = 0? Show your work. If your answer differs from (b), give clear intuition for why. (d) (6 marks) Retain the assumptions of part (c). Assume that at t= -1, at the time they purchased the bond, bondholders anticipated the strategic choice XYZ's managers would be faced with down the road at t = 0. Compute the total payoffs to bondholders and shareholders of XYZ in part (c). If managers, acting on behalf of shareholders, could have (somehow) committed at t= -1 to choose any specific process at t = 0, which process would they have committed to, and who would have been better off or worse off as a result? What friction typically prevents such commitment in the real world and why should bondholders be sceptical of the managers’ commitment? (e) (7 marks) Again, retain the assumptions of part (c). Just before the process is chosen at t= 0, a consultant approaches XYZ's managers and promises to design, for a fee, a one-year zero-coupon, non-callable, convertible bond with the same face value as XYZ's existing bond, which can be converted by bondholders at t = 1 (once final cash flows are known) into equity. The consultant claims that, if offered as a swap to XYZ's bondholders for the existing bond at t = 0, this bond would: (i) lead to no new equity being issued (i.., it is not going to be converted at t = 1), (i) lead XYZ's managers to choose process S, and (ili) be welcomed by XYZ's bondholders, who would even pay some cash to XYZ when the bonds are swapped. Could the consultant be correct? If so, compute the terms of the convertible bond (or range of convertible bonds) that he has in mind. If not, show that he cannot be correct, LSE ST 2016/FM422 Page 4 of 8Section B 4 (a) (8 marks) A manufacturer of footballs currently produces 400,000 units a year and expects output levels to remain steady in the future. It currently buys valves for the balls from an outside supplier at a price of $1 per valve. The plant manager believes that it would be cheaper to make these valves rather than buy them. Direct in-house production costs are estimated to be only $0.60 per valve. The Necessary machinery would require an upfront investment of $300,000 and would be obsolete after ten years, This investment could be depreciated to zero for tax purposes using a ten-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $60,000 right away but argues that this sum can be ignored since it is recoverable at the end of the ten years. Expected proceeds from scrapping the machinery after ten years are $30,000. ifthe company pays tax at a rate of 30% and the appropriate discount rate is 10%, what is the net present value of the decision to produce the valves in-house instead of purchasing them from the supplier? State clearly any additional assumptions you need to make and show all your work. (b) (7 marks) "Valuation by Comparables" is a widely used valuation method. What are its strengths and weaknesses? Discuss carefully. (c) (10 marks) Golden Fall, Inc., develops and runs senior living facilities throughout the United States. Golden Fall is a private company, so its stock is not traded in the market. It is entirely equity-financed, with no plans to borrow in the future. Francine Liu, Golden Fall's CFO, has been examining a proposal to build a new senior centre outside of Boston. Liu has correctly concluded that the project will have a positive NPV only if the applicable discount rate is below 13.0%. Her project manager has argued that, because current risk- free interest rates are 3.95% for all maturities, the appropriate discount rate cannot be above 13.0%. Liu is not sure whether her project manager is correct. She has gathered information about two of Golden Fall's publicly-traded competitors, which is shown below. The two competitors’ leverage ratios have been stable in recent years. Senior Living Inc. _ Assisted Living Services Inc. Total Stockholder Equity* $1,100,000,000 $273,000,000 Total Debt" $2,680,000,000 $105,000,000 Long-term Assets* $3,161,000,000 $159,000,000 Cash and Marketable Securities* $30,000,000 $5,000,000 Shares Outstanding 120,000,000 11,000,000 Price per Share $14.50 $34.00 Return on Equity (last 12 months) 2.03% 5.48% Net Income Margin 11% 6.15% Beta of Equity 3.69 41 * From most recent financial statements. Lu has called a few of her contacts in the investment banking community and has determined that 6% is the current consensus opinion on the market risk premium. Assume that the CAPM holds. Based on the information that Liu has collected, can she reasonably conclude that the Boston opportunity is a positive NPV project? Show all your work and clearly state any additional assum make. © LSE ST 2016/FM422 Page 5 of 85 (a) Divanos Corp.’s equity has a market capitalization of $200 million. The firm has a debt-to-equity ratio of 1/3, which it is planning to maintain perpetually, and no excess cash. Its equity cost of capital is 14%, and its debt cost of capital is 8%. Divanos faces a corporate tax rate of 30%. Divanos's free cash flows are expected to be $8 million a year from today, and its free cash flows are expected to grow at a constant rate into the indefinite future. For this question, assume that the only frictions in financial markets are the corporate tax benefits of debt. (i) @ marks) Determine Divanos's after-tax weighted-average cost of capital (WACC). Show all your work. (ii) (@ marks) What constant expected future growth rate of the FCF is consistent with the total firm value of Divanos? Show all your work. (ii) (3 marks) What is the total value of the tax savings from debt? In other words, what is the present value of Divanos's interest tax shields? Show all your work. (b) (6 marks) From time to time, governments permit firms to depreciate some capital assets faster than usually allowed. Should a firm that maximizes shareholder value take advantage of this opportunity? Explain your answer. (c) Tungsten Inc. is a producer of light bulbs. Last year, it produced 800 million traditional incandescent light bulbs at a cost of 45 cents per bulb. Unfortunately, because of increasingly tough regulations against incandescent light bulbs (which are energy inefficient), sales of these bulbs have been disappointing. Tungsten sold only 680 milion of last year’s production, leaving 120 million bulbs in inventory. Consequently, Tungsten discontinued the production of incandescent bulbs as of the start of this year. Fortunately, Tungsten has introduced a successful line of modern, energy-efficient light bulbs. These energy-efficient bulbs are selling briskly. As a result, Tungsten has very little inventory of them and does not expect to build up inventory in the coming years. The energy-efficient bulbs are more expensive to produce, at a cost of 80 cents per bulb, but Tungsten is able to sell them at a wholesale price of 115 cents. Because of favourable payment terms with its suppliers and customers, accounts payable and accounts receivable associated with the energy-efficient bulbs tend to off-set each other. Originally, Tungsten was planning on selling the leftover incandescent bulbs to Walmart and other discount retailers. This plan called for selling 60 million bulbs each year for the next two years at a wholesale price of 50 cents per bulb However, Tungsten is now considering an advertising campaign to stimulate demand for the incandescent bulbs. The campaign has a one-time up-front cost (payable today) of $10 million and would both accelerate the sale of these bulbs as well as increase their price. The table below shows the projected sales and pricing of incandescent bulbs if the campaign is undertaken: 7 __Year1 Year 2 Incandescent bulbs sold 100 million 20 million Wholesale price per bulb __G0.cents_85 cents Tungsten estimates that for every five incandescent light bulbs it sells in the next two years, one fewer of its energy-efficient bulbs is sold. These lost sales occur whenever the incandescent bulbs are actually sold. Tungsten’s tax rate for incremental profits is 30%, and the discount rate applicable to the marketing campaign is 10% per year. (i) (6 marks) Determine the incremental net income (i.e., after-tax operating profit) attributable to the advertising campaign. Show all your work and clearly state any assumptions you need to make (li) (4 marks) Determine the net present value of undertaking the advertising campaign. Show all your work and clearly state any assumptions you need to make. © LSE ST 2016/FM422 Page 6 of 86 (a) Greenback Technologies (GTC) is a privately held developer of Intemet security systems. As part of your business development strategy, in mid-2016 you initiate discussions with GTC’s founder about the possibility of acquiring the business at the end of 2016. You are trying to value GTC using a discounted Free Cash Flow (FCF) approach. (i) (4 marks) To estimate GTC’s cost of capital, you download the following data on its closest publicly-traded competitor: Debt outstanding (book value) $400 million Number of shares of common stock 80 million Stock price per share $15.00 Book value of equity per share $6.00 Beta of equity 1.20 Beta of debt 0.0 Expected return of value-weighted market portfotio 10.0% Risk-free rate (all maturities 4.0% Assume that the CAPM holds, that the competitor has no excess cash on its balance sheet, and that. its capital structure has been stable in recent years. What is your estimate of the cost of capital that should be used to discount GTC’s future cash flows? State clearly any additional assumptions you need to make. (ii) (5 marks) Suppose you forecast Free Cash Flows for GTC of $45 million in 2017 and of $50 million in 2018. You expect its FCF to grow at a rate of 5% per year after 2018. You also just learned that GTC has excess cash of $110 million and debt with a market value of $30 million, and you expect both cash and debt levels to stay constant going forward. GTC has 50 million shares outstanding and pays taxes at a rate of 30%. What is your estimate of GTC’'s equity value per share at the end of 2016? Show all your work (b) (7 marks) In recent years, many successful and fast-growing start-up companies have decided to postpone their IPO and to instead raise funds repeatedly from private equity investors while remaining unlisted. What are the likely reasons for this decision? Discuss carefully. (c) Frameworks Inc. is a national chain offering picture framing services. Frameworks is an all-equity firm with no net debt on its balance sheet, an equity beta of 1.8, a stock price of $20 per share, and 10 million shares outstanding. Frameworks’ FCF for the next 12 months is expected to be $22 million, and its FCF is expected to grow at a rate of 1% per year in perpetuity. The table below summarizes the data on the firm as of the close of trade on May 10, 2016: Frameworks Inc. (FRMS) _ Equity market capitalization 200m Stock price (close) $20 Number of shares outstanding 10m Unlevered FCF (expected) $22m Growth rate of FCF (expected) 1% Book value of equity $131.6m Corporate tax rate 30% Beta of equity i 18 ‘After the close of trading on May 10, 2016, Frameworks announces a recapitalization: it will issue debt such that its new debt-to-equity ratio will be 1/3. It plans to maintain this debl-to-equity ratio forever. The entire proceeds from the debt issue will be used to buy back equity. The newly issued debt will have an expected return of 5% per year. The risk-free rate is 3% at all maturities. © LSE ST 2016/FM422 Page 7 of 8Assume that this recapitalization is a complete surprise to the market, and that the firm's equity market valuation at the close of trade on May 10, 2016, was based on the expeclation that Frameworks would always be an all-equity firm. Assume further that there are no costs or benefits associated with the recapitalization besides the corporate interest tax shields associated with the debt. Also assume that there is no security mispricing and that the market prices Frameworks’ equity correctly based on the information described above. (i) (5 marks) How does Frameworks’ equity market capitalization change when the recapitalization plan is announced? Show all your work. (ii) (4 marks) What is Frameworks’ equity beta after the recapitalization? To answer this question, assume that the CAPM holds for all assets, and that the expected return on the market portfolio is 8% per year. Show all your work. © LSE ST 2016/FM422 Page 8 of 8