# Business Finance J03 Solutions WebV.

doc
June 2003
Solutions
SECTION A (34 marks)
Question A1
(a) The after-tax cost of debt is 8% (1 - 0.40) = 4.8%
The lease cash flows incremental to this are (all figures in £’000)
YR0 YR1 YR2 YR3 YR4
Cash Price 360
Lease Payments (95) (95) (95) (95) (95)
Tax Deduction for lease 38 38 38 38 38
Tax Deduction from W.D.A. (28.8) (28.8) (28.8) (28.8) (28.8)
Incremental Cash Flows 274.2 (85.8) (85.8) (85.8) (85.8)
The tax effect of the WDA is calculated as 72 x 0.4 = 28.8
It is necessary to find out whether the IRR of these incremental cash flows is
greater or less than 4.8%
IRR is the discount rate at which NPV is zero.
Try 5%
NPV = 274.2 - |
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4 3 2
05 . 1
8 . 85
05 . 1
8 . 85
05 . 1
8 . 85
05 . 1
8 . 85
= -30.04
Try 10%
NPV = 274.2 - |
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4 3 2
1 . 1
8 . 85
1 . 1
8 . 85
1 . 1
8 . 85
1 . 1
8 . 85
= +2.23
Hence the IRR is fairly close to 10%, and the cost of leasing is substantially
greater then the cost of borrowing (4.8%). So Easyprint should borrow the cash
price and purchase the asset.
Note By interpolation, the incremental cost of leasing can be estimated as
5% +
(
¸
(

¸

+
5% x
23 . 2 04 . 30
04 . 30
= 9.65%
(b) Translation exposure arises for companies owning international subsidiaries
which draw up their accounts in a foreign currency (i.e. a currency other than the
one used for the parent company accounts).
Every year, the company will need to draw up group accounts which involve
consolidating the subsidiary accounts. The standard rules for consolidating
accounts requires that some items are converted at the current exchange rate and
some (specifically the shareholders capital and reserves at the time of acquisition)
are converted at the acquisition rate. This process gives rise to exchange rate
gains and losses. The risk associated with these gains and losses is called
translation risk.
Translation risk arises from accounting rules. Translation risk does not necessarily
affect company cash flow or the wealth of shareholders. However, it does affect
reported profit and several accounting ratios. If senior management are concerned
with cash flow and/or shareholder wealth they may decide to ignore translation
exposure. However, many companies are concerned to meet targets for reported
profit and hedging translation exposure helps them to do this. There are several
ways of hedging. One is to take out forward exchange contracts. Another is to
adopt the currency of the company’s debt to counteract translation exposure.
(c) The WACC rate is
T) - (1 k .
E D
D
k .
E D
E
d
+
+
+
e
k
e
is derived using the CAPM. In this case k
e
= 5% + (1.15 x 6.5%) = 12.475%
Market values are used for both debt and equity. So the rate is
120 50
120
+
x 12.475% +
120 50
120
+
x 5% x (1 - 0.45) = 9.615%
Using APV, we discount the Asset cash flows at a rate based on the Asset β ) (
a
β
A
β =
) 1 ( T D E
E
− +
E
β
=
) 45 . 0 1 ( 50 120
120
− +
x 1.15 =0.936
So the required return using CAPM is
5% + (0.936 x 6.5%) = 11.08%
When APV is used, the Asset cash flow should be valued at this rate and the
interest tax subsidy is valued separately. The two components are added together
to get the overall NPV of the project.
(d) Monte Carlo Simulation is a method of generating a probability distribution for
the NPV which will be generated by a project.
As inputs, the simulation requires probability distribution for all the risky
variables affecting the project and the interrelationship between the variables.
Each simulation is made by drawing a value for each risky variable, taking the
interrelationships into account. Once 100 (or more) simulations have been done
on a computer it is possible to answer questions such as ‘What is the probability
that the project will give a NPV of less than X; more than Y; within the range A
to B etc.
Monte Carlo Simulation is useful because:
(a) The average of the NPVs generated by simulation can differ from the single
NPV number calculated by using the expected value of each variable.
(b) A project which makes a substantial loss can have an adverse effect on the
whole company, preventing it from realising profitable investment plans.
Simulation enables this risk to be taken into account.
Question A2
(a)
(i) The cost of buying the land is not a sunk cost. The land could presumably
be sold if it was not needed by Tintin. We take the land cost as 0.5 x
380,000 = 190,000.
(ii) The total cost of the new building is 800,000 + 190,000 = 990,000. When
the building is sold at the end of four years the expected receipts are
990,000 x 1.05
4
= 1,203,351. The gain in value will be taxable.
(iii) Since the equipment will be fully depreciated at the end of year 4, the
£30,000 at scrap value will be taxable.
(iv) The reduction in working capital generates an immediate non-taxable cash
flow of £100,000. This is offset by £100,000 less cash flow from the
liquidation of all working capital in 4 years time.
(v) The incremental revenues are taxable
The incremental tax is calculated as
Immediate 1yr 2yr 3yr 4yr
Cash receipt 60,000 60,000 60,000 60,000
Scrap value of
Equipment 30,000
Gain on property 213,315
Writing down
Allowance (40,000) (40,000) (40,000) (40,000) (40,000)
Incremental taxable
Income (40,000) 20,000 20,000 20,000 263,351
Incremental tax 12,000 (6,000) (6,000) (6,000) (79,005)
So the incremented cash flows from the project are
Immediate 1yr 2yr 3yr 4yr
Land + Building (990,000) 1,203,351
Equipment (200,000) 30,000
Working Capital 100,000 (100,000)
Net Cash Receipts 60,000 60,000 60,000 60,000
Incremental Tax 12,000 (6,000) (6,000) (6,000) (79,005)
Incremental after-
tax Cash Flows
(1,078,000) 54,000 54,000 54,000 1,114,346
NPV = ( ) |
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4 3 2 1
08 . 1
346 , 114 , 1
08 . 1
000 , 54
08 . 1
000 , 54
08 . 1
000 , 54
000 , 078 , 1
= (119,759)
(b) The present values of all relevant costs over a single life-cycle are as follows
Van A: 16,000 + |
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4 2
08 . 1
000 , 2
08 . 1
800
= 15,216
Van B: 20,000 + |
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6 3
08 . 1
000 , 3
08 . 1
1500
= 19,300
The annuity factor for 4 years (Van A’s life cycle) at 8% is 3.312.
So the Equivalent Annual Cost of Van A is |
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312 . 3
216 , 15
= 4,594
The annuity factor for 6 years (Van B’s life cycle) is 4.623.
So the Equivalent Annual Cost of Van B is |
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623 . 4
300 , 19
= 4,175
So the annual cost of Van B is lower than the annual cost of Van A and Van B should
be chosen.
(c) A ‘decision tree’ looks at an investment project not as a single decision but as a
sequence of decisions that will be taken over time in response to the changing
business environment. There will be a sequence of decisions: development X in
environment, new decisions; etc.
If the probabilities of different developments in the business environment are
known, and the financial outcomes of the subsequent decisions that a company
might take, then a ‘decision-tree’ can be ‘solved’ to give the optimal decision at
each stage of the process.
Decision-tree analysis is therefore very useful to a manager who expects his
company’s investments to develop through a multi-stage decision process over a
substantial period of time.
SECTION B (33 marks)
Question B1
a) Consider the corporate objective that we must Max V subject to maximising P.
Zero NPV projects desirable. Payback, IRR and PI all emphasise “investment”
efficiency i.e. low outlay (etc) for given NPV. For a given NPV the greater the
investment input the better. Either the market systematically undervalues the
positive NPV potential of companies, or after an initial price adjustment at
flotation the expectation of achieving share price growth (abnormal) is an illusion.
The benefit of the firm’s positive NPV potential accrues to the founder
shareholders as a reward for entrepreneurial behaviour. Increasing share price is
not the goal. Maximising the value of the firm subject to maximising the share
price is the goal.
b) Both metrics are trademarked by US consultants Stern-Stewart. MVA is the value
that has been created by a company over its entire life from all the capital invested
in it.
Market Value Added (MVA) is MVA = Market value – Capital where Market
value = Current value of debt, preference shares and ordinary shares and Capital =
All the cash raised from finance providers and retained from earnings to finance
new investment in the business, since the company was founded.
Problems- Estimating the amount of cash invested. When was the value created?
Is the rate of return high enough? Inflation distorts MVA. MVA is an absolute
measure. Economic Value Added (EVA) is the profit after deducting operating
expenses and a charge for opportunity cost of capital. Uses two methods –
performance spread or capital charge method. Need WACC.
Drawbacks- 1 The balance sheet does not reflect invested capital 2 Manipulation
and arbitrariness 3 High economic profit and negative NPV can go together 4
Difficult to allocate revenues, costs and capital to business units, products, etc.
The comparison should include the following points: MVA is based on market
value and therefore incorporates growth opportunities as well as earnings. EVA is
based on earnings and tells us the value created in a single period. EVA is a
backward looking historic measure of what value has been created whilst MVA is
more forward-looking as it incorporates growth opportunities. Both use capital
invested which is adjusted by Stern Stewart (up to 164 adjustments may be
included but usually 5 to 15). MVA equals future discounted EVA. If the market
is efficient then MVA incorporates all current information available about the
company.
Question B2
a) An option is the right, but not the obligation, to take an action in the future.
Options allow us to limit losses from bad outcomes and increase the payoff from
positive outcomes. A financial option gives the owner the right to buy or sell a
security at a specified price on a specified future date. It will be exercised only if
the price of the security on that date exceeds or is less, respectively, than the
specified price. A real option is one where many strategic investments create
subsequent opportunities that may be taken and so the investment opportunity can
be viewed as a stream of cash flows plus a set of options. Real options extend
financial option theory to options on real, non-financial assets.
b)
From Black-Scholes:
P
s
- Stock Price or Underlying asset price
N(d
1
) - Cumulative normal density function of (d
1
)
S - Cost of investment or exercise price
N(d
2
) - Cumulative normal density function of (d
2
)
r - discount rate
t - time to maturity of option (as % of year) or time to expiry
OR
From Dixit and Pindyck: Irreversibility, Uncertainty, The ability to delay
OR
From Kester: Time, Project risk, Interest rates, Exclusiveness, Industry rivalry
c)
Present Value £500,000 Estimated Selling Price £450,000
Maturity (years) 1 Interest 6%
Future Value (high) £625,000 Future Value (low) £400,000
p(Rise) 0.25 p(Fall) -0.20
(625,000-500,000) (400,000-500,000)
500,000 500,000
P(r) 0.578 (3 dec. pl.) 1 – p(r) 0.422 (3 dec. pl.)
Derived from p(r) x 0.25 + p(f) x -0.20 = 6%
Option Value if Rise £0 Option Value if Fall £50,000
Abandonment Option = p(r)*0 + [1 – p(r)]*50,000
= £21,100 (21,111)
Discounted = £19,905 (19,916)
£500,000 + 19,905 = £519,905
d) An Abandonment Option
Put option value (graphic) given a \$85 exercise price. Note: no figures required in the
Put option
value
Share Price
e) Companies invest early because:
–Competitors may have the same option
–NPV is high
–Level of risk is low
–Level of interest rates is low
–Industry rivalry is intense
80 85
\$5
SECTION C (33 marks)
Question C1
A good candidate will explain what is meant by a hostile takeover bid.
Good candidates will discuss many of the following issues.
“The basic objective of making acquisitions is identical to any other investment
associated with a company’s overall strategy, namely, to develop a value-creating
sustainable competitive advantage”, Rappaport (1986). Thus M&A are an Investment
decision hence the motive should and could be shareholder wealth maximisation
(SWM). However, there are other reasons and managerial motives are generally not
SWM. This results from the principal-agent problem.
The main motives are:
• Synergies - Market power, Economies of scale, Internalisation of transactions,
Entry to new markets and industries, Tax advantages
• Bargain hunting – Undervalued shares, Poor management.
• Managerial objectives - Empire building, Status, Power, Job security
(diversify, minimise costs or avoid takeovers)
! Remuneration: Growth of company (large company = large salary
and/or high EPS means large bonus (Bootstrap game - increase EPS by
acquiring low PE firms in share exchange offers).
! Hubris (Roll, 1986): Thrill of the chase; Arrogance; Animal spirit;
Ego; Underused talents and skills.
! Survival
! Diversification
! Free cash flow (Jensen, 1986)
! Short-termism: Finally the problem of short-term myopia and
inefficient takeovers may lead to: Pressure to perform; Markets don’t
reward long-term investment; Companies with high R&D undervalued;
Become takeover targets; No empirical evidence support theory.
Question C2
a)
i. Treat all shareholders the same
ii. Information available equally
iii. Proceed only after due consideration
iv. No relevant information withheld
v. Documents and adverts must be prepared to the highest possible standards
vii. No action without shareholder approval after offer is received
viii. Proper exercise of corporate control
ix. Directors must act on behalf of all shareholders regardless of personal
shareholdings
x. If control obtained a general offer is required
b)
i. Pre-bid – This stage involves the development of the acquisition
strategy. The exploration of the logic behind the way in which value
will be created by the merger or acquisition and the acquisition criteria.
Then the search begins for potential targets which are screened (again
using a set of criteria) and the final selection of target or targets
identified. This stage concludes with the evaluation of the target in
terms of strategic fit to justify the acquisition.
ii. Bidding stage – In this stage of the process, the target has been chosen
and bidding management must determine a bidding strategy. The target
is then valued using an appropriate valuation model (e.g. PER, Tobin’s
Q, etc) and a bid price for the target determined. Finally during this
stage the negotiations are undertaken, finance must be arranged and the
deal closed. Good candidates will discuss hostile -v- negotiated
takeover.
iii. Post-bid – The final stage involves the evaluation of the organisational
and cultural fit of the merging companies. The integration strategy
must be decided upon. The strategy, organisation and culture of the
merging companies must be matched.

a currency other than the one used for the parent company accounts). Translation risk arises from accounting rules. it does affect reported profit and several accounting ratios. If senior management are concerned with cash flow and/or shareholder wealth they may decide to ignore translation exposure.615% 50 + 120 50 + 120 Using APV.08% When APV is used.k e + D+E D+E ke is derived using the CAPM.15 =0. we discount the Asset cash flows at a rate based on the Asset β ( β a ) βA = E βE E + D(1 − T ) 120 x 1. the Asset cash flow should be valued at this rate and the interest tax subsidy is valued separately. The two components are added together to get the overall NPV of the project.0.Business Finance J03 Solutions WebV. Every year.e.45) = So the required return using CAPM is 5% + (0. Another is to adopt the currency of the company’s debt to counteract translation exposure. This process gives rise to exchange rate gains and losses. many companies are concerned to meet targets for reported profit and hedging translation exposure helps them to do this.45) = 9.T) .936 x 6. However.5%) = 11. The risk associated with these gains and losses is called translation risk. The standard rules for consolidating accounts requires that some items are converted at the current exchange rate and some (specifically the shareholders capital and reserves at the time of acquisition) are converted at the acquisition rate. One is to take out forward exchange contracts.doc (b) Translation exposure arises for companies owning international subsidiaries which draw up their accounts in a foreign currency (i.15 x 6. In this case ke = 5% + (1. There are several ways of hedging. (c) The WACC rate is E D . However.475% Market values are used for both debt and equity. . the company will need to draw up group accounts which involve consolidating the subsidiary accounts. k d (1 .936 120 + 50(1 − 0. So the rate is 120 120 x 12.5%) = 12. Translation risk does not necessarily affect company cash flow or the wealth of shareholders.475% + x 5% x (1 .

As inputs.Business Finance J03 Solutions WebV. Once 100 (or more) simulations have been done on a computer it is possible to answer questions such as ‘What is the probability that the project will give a NPV of less than X. Simulation enables this risk to be taken into account. Each simulation is made by drawing a value for each risky variable. Monte Carlo Simulation is useful because: (a) The average of the NPVs generated by simulation can differ from the single NPV number calculated by using the expected value of each variable. within the range A to B etc. preventing it from realising profitable investment plans. the simulation requires probability distribution for all the risky variables affecting the project and the interrelationship between the variables. more than Y. . (b) A project which makes a substantial loss can have an adverse effect on the whole company. taking the interrelationships into account.doc (d) Monte Carlo Simulation is a method of generating a probability distribution for the NPV which will be generated by a project.

000 (6.5 x 380.000) 20.000) (40.054 = 1.000 (6.351 30. This is offset by £100.000 60.000) 54.000 (6.000) (990.005) 1. The total cost of the new building is 800.000) 54.000 (6.351. The land could presumably be sold if it was not needed by Tintin.000) (40.351 (79.000 4yr 60.315 (40.346 .000) 263.000. When the building is sold at the end of four years the expected receipts are 990. the £30.000) (200.000 (79.doc Question A2 (a) (i) The cost of buying the land is not a sunk cost.000) (40.203.000 (100.Business Finance J03 Solutions WebV.000 60.078.000 3yr 4yr 1.000 = 190. The gain in value will be taxable.000 + 190.000 (1. Since the equipment will be fully depreciated at the end of year 4.000 (6.000.000) 54.000 = 990.000 213.005) So the incremented cash flows from the project are Immediate 1yr 2yr Land + Building Equipment Working Capital Net Cash Receipts Incremental Tax Incremental aftertax Cash Flows 12.000 3yr 60.000) 60.000 (6.114.000) (40.000 at scrap value will be taxable. The incremental revenues are taxable The incremental tax is calculated as 1yr Immediate Cash receipt Scrap value of Equipment Gain on property Writing down Allowance Incremental taxable Income Incremental tax (40.000) 20. The reduction in working capital generates an immediate non-taxable cash flow of £100.000 less cash flow from the liquidation of all working capital in 4 years time.000 60. We take the land cost as 0.000 30.000 60.000) 100.000 x 1.000) 12.000.203.000 (ii) (iii) (iv) (v) 2yr 60.000) 20.

216 − 2  4   1. .175  4.312. etc.08   1.000  = 19.594  3.114.08   1500   3. development Y in the business environment.216  So the Equivalent Annual Cost of Van A is   = 4. Decision-tree analysis is therefore very useful to a manager who expects his company’s investments to develop through a multi-stage decision process over a substantial period of time. new decision.  19.08   1.Business Finance J03 Solutions WebV.08  The annuity factor for 4 years (Van A’s life cycle) at 8% is 3.000 ) +  + + +  1  2  3  4  1.  15.759) (b) The present values of all relevant costs over a single life-cycle are as follows  800   2.300  So the Equivalent Annual Cost of Van B is   = 4.000   1.000   54. (c) A ‘decision tree’ looks at an investment project not as a single decision but as a sequence of decisions that will be taken over time in response to the changing business environment.000   54.623. new decisions.000 +  − 3 6   1.000 +  = 15. If the probabilities of different developments in the business environment are known.623  So the annual cost of Van B is lower than the annual cost of Van A and Van B should be chosen.08   1. and the financial outcomes of the subsequent decisions that a company might take.300 Van B: 20.08   1. There will be a sequence of decisions: development X in the business environment.078.000  Van A: 16. then a ‘decision-tree’ can be ‘solved’ to give the optimal decision at each stage of the process.doc  54.08  = (119.346  NPV = (1.312  The annuity factor for 6 years (Van B’s life cycle) is 4.08   1.