Afin708 Corporate Finance
Unit Code: |
AFIN808 and AFIN708 |
Unit Name: |
Corporate Finance |
Duration of Exam (including reading time if applicable): |
2 hours plus 10 minutes reading time |
Total No. of Questions: |
15 Multiple Choice, 8 short answer problems |
Total No. of Pages (including this cover sheet): |
19 |
GENERAL INSTRUCTIONS TO CANDIDATES:
- Candidates are required to obey all instructions provided by the Final Examination Supervisor and must refrain from communicating in any way with another student once they have entered the final examination venue.
- Candidates may not write or mark the exam materials in any way during reading time.
- Candidates may only access authorised materials during this examination. A list of authorised material is available on this cover sheet.
- If it is alleged you have breached these rules at any time during the examination, the matter may be reported to a University Discipline Committee for determination.
EXAMINATION INSTRUCTIONS:
The Examination Paper has 15 multiple choice, and 8 short answer questions totalling 70 marks.
Attempt all questions.
Part A (15 marks): Fifteen multiple choice questions. Answers to these questions must be recorded on a red-coloured General Purpose Answer Sheet which will be read by optical scanner. Use 2B lead pencils.
Please enter your student number and name on this sheet.
Part B (30 marks): Four short quantitative problems. The space left to answer these questions is the anticipated maximum space required. Show all workings. Use an ink pen.
Part C (25 marks): Four short theory questions. The space left to answer these questions is the anticipated maximum space required. Use an ink pen.
No part of this examination paper is to be taken from the examination room.
AIDS AND MATERIALS PERMITTED/NOT PERMITTED:
Dictionaries: Standard paper translation dictionaries may be used.
Calculators: Non-programmable calculators may be used. No calculators with text retrieval capacity may be used.
Other: This is a closed book exam. No text, notes or other materials are permitted.
Part A |
Part B |
Part C |
TOTAL A+B+C | |||||||||
Problem |
Multiple Choice |
1 |
2 |
3 |
4 |
TOTAL |
1 |
2 |
3 |
4 |
TOTAL | |
Value |
15 |
8 |
7 |
6 |
9 |
30 |
7 |
6 |
6 |
6 |
25 |
70 |
Mark |
PART A: Multiple Choice (15 marks)
For each question, select the answer which is most correct.
Question 1 (1 mark)
Arbitrage Pricing Theory is based on the idea that _________.
- Assets with identical risks must have the same expected rate of return.
- Securities with similar risk should sell at different prices.
- The expected returns from equally risky assets are different.
- Markets are perfectly efficient.
- Expected returns compensate for unsystematic risk as well as market risk
Question 2 (1 mark)
Watt Auto plans to raise $1.2 million in a rights offering. Under the terms of the offering, a current shareholder must submit $20 plus 4 rights to acquire one new share of stock. How many shares of stock are outstanding prior to the rights offer if shareholders are granted one right per share of stock currently owned?
- 60,000
- 120,000
- 240,000
- 300,000
- 1,200,000
Question 3 (1 mark)
Olsen & Myers Ltd has warrants outstanding that grant the holder the right to purchase three shares of stock at an exercise price of $10 per share. Olsen & Myers Ltd’s stock is currently selling for $9.80 a share. What is the minimum value of one warrant?
- -$.60
- -$.20
- $0
- $0.2
- $0.6
Question 4 (1 mark)
A convertible bond is selling for $1083. It has 10 years to maturity, a $1,000 face value, and an 8% coupon paid annually. Similar non-convertible bonds are priced to yield 8% per annum. The conversion ratio is 1 bond for 20 shares. The share currently sells for $52 per share. The component of the convertible bond’s price related to the option value is:
- $1,040
- $1,083
- $40
- $83
- $43
Question 5 (1 Mark)
Financial leverage impacts the performance of the firm by:
- Maintaining the same level of volatility of the firm's EBIT.
- Decreasing the volatility of the firm’s EBIT.
- Increasing the volatility of the firms’ revenues.
- Increasing the volatility of the firm’s net income.
- Decreasing the volatility of the firm’s net income
Question 6 (1 mark)
Gail's Dance Studio Ltd is currently an all equity firm that has 80,000 shares of stock outstanding with a market price of $42 a share. The current cost of unlevered equity is 12% per annum and the tax rate is 30%. Gail is considering adding $1 million of perpetual debt with an interest rate of 8% per annum to the company’s capital structure. The proceeds will be used to repurchase equity. What is the value of the equity after the repurchase?
- $2.46 million
- $2.66 million
- $3.36 million
- $3.66 million
- $3.86 million
Question 7 (1 mark)
Stock splits are often used to:
- Adjust the market price of a stock such that it falls within a preferred trading range.
- Decrease the excess cash held by a firm.
- Increase both the number of shares outstanding and the market price per share simultaneously.
- Increase the total equity of a firm.
- Adjust the debt-to-equity ratio such that it falls within a preferred range.
Question 8 (1 mark)
In the binomial option pricing approach, the most correct method to determine the current value of future payoffs would be to:
- Take the discounted expected value at the risk-free rate.
- Take the expected value using the probabilities.
- Take the discounted expected value using the risk-neutral probabilities and the risk free rate.
- Sum the payoffs discounted at the risk free rate.
- None of the above.
Question 9 (1 mark)
What is the value of a 9-month call with a strike price of $45 given the Black-Scholes Option Pricing Model and the following information?
Stock price $48
Exercise price $45
Time to expiration 0.75 years Risk-free rate 5% p.a.
N(d1) 0.718891
N(d2) 0.641713
- $2.03
- $4.86
- $6.69
- $8.81
- $9.27
Question 10 (1 mark)
Big Ltd has 1 million shares outstanding trading at a price of $45 per share. Big Ltd announces an offer to takeover Little Ltd by paying a cash price of $20 for each share in Little Ltd. Little Ltd has 1 million shares on issue which were trading at $16 immediately prior the takeover announcement. If the synergies from the takeover are estimated at $2,000,000, and the market knows this, what should be the price of Big Ltd’s shares immediately after the takeover announcement? (Assume the takeover will occur with certainty).
- $45.00
- $43.00
- $29.50
- $20.00
- $19.00
Question 11 (1 mark)
Which of the following is NOT a typical characteristic of infrastructure project financing arrangements?
- A special purpose entity.
- Limited or non-recourse debt.
- A large specific purpose asset.
- Off-take agreements for the output of production.
- Unlimited guarantees from the sponsor(s)
Question 12 (1 mark)
A company announces a rights issue when its shares are trading at $30. The offer allows shareholders to subscribe for one new share at $25 per share for every existing share they currently hold. Assuming everything else is constant, when a share goes ex-rights its price should:
- Decrease since the stockholder is losing an option.
- Increase since the company no longer has the right to force the stockholder to convert.
- Remain the same since an efficient market would anticipate this change.
- Move up and down depending on whether a small investor wanted to exercise his/her rights.
- None of these.
Question 13 (1 mark)
A firm is valued at $6 million and has debt of $2 million outstanding. The firm has an equity beta of 1.8 and a debt beta of .42. The beta of the overall firm is:
- 00
- 11
- 20
- 34
- Impossible to determine with the information given.
Question 14 (1 mark)
A proposed acquisition may create synergy by:
- Increasing the market power of the combined firm.
- Improving the distribution network of the acquiring firm.
Providing the combined firm with a strategic advantage. IV. Reducing the utilization of the acquiring firm's assets.
- I and III only
- II and III only
- I and IV only
- I, II and III only
- I, II, III and IV
Question 15 (1 mark)
Suppose the Barges Corporation's common shares have an expected return of 12% per annum. Assume that the risk-free rate is 5% per annum, and the market risk premium is 6% per annum. If no unsystematic influence affected Barges' return, according to the Capital Asset Pricing Model (CAPM), the beta for Barges’ shares is ______.
- 00
- 17
- 20
- 50 E. 3.00
PART B: Short Problems (30 marks) Problem 1 (8 marks)
New Utility Co is considering a $23million expansion in its wind farm operations. The project is expected to produce unlevered after-tax cash flows of $1.8 million per year in perpetuity.
The company intends to maintain its current 0.5 target debt-to-value ratio. New Utility Co’s cost of debt is 6.7% per annum and its cost of equity is 11% per annum. The new project has the same risk as the existing business and will support the same degree of leverage. New Utility Co has a tax rate of 30%.
Calculate the NPV of the project to New Utility Co. (3 marks)
Suppose instead that a competitor, Windfarm Inc., bids for the same project and proposes to finance the project with $12.5 million of perpetual debt at an interest rate of 6.7% per annum, and the rest ($11.5 million) with equity. The project offers the same business risk as the existing operations and has unlevered cash flows of $1.8million per year to Windfarm Inc. The company has the same tax rate of 30%. Calculate the NPV of the project to Windfarm Inc. (3 marks)
Is the decision to accept or reject the project the same in ‘a’ and ‘b’ above? Yes/No
Explain why or why not. (2 marks)
[Answer for Problem 1 continued]
Problem 2 (7 marks)
BPH & Co Ltd is all-equity financed and has $200,000 in excess cash. The company is deciding between paying a special cash dividend to shareholders or repurchasing shares with the cash. Current earnings per share (EPS) is $2 and the stock currently trades at $40. There are 40,000 shares outstanding.
Ignore taxes. Assume there are no signalling effects and that no other news affects the price.
Calculate the Earnings per Share (EPS) and the Price-to-Earnings ratio after the dividend, assuming the special cash dividend is paid. Assume no other news affects the price. (2 marks)
Calculate the Earnings per Share (EPS) and the Price-to-Earnings ratio after the dividend, assuming instead that the stock repurchase occurs. (2 marks)
Comment on why BPH may prefer to repurchase shares with the $200,000 rather than pay a special cash dividend. (3 marks)
Problem 3 (6 marks)
The Blank Button Company Ltd is considering the purchase of a new machine for $30,000. The machine is expected to save the firm $12,500 per year in operating costs over a 5 year period. The machine can be depreciated on a straight-line basis to a zero salvage value over its life.
Alternatively, the company can lease the machine for $6,500 per year for 5 years, with the first payment due in 1 year. The company's tax rate is 34%, and its cost of debt is 10% per annum. All cash flows are assumed to occur at the end of the relevant year.
Calculate the NPV of the lease versus the purchase decision and indicate whether Blank Button Company Ltd will prefer to lease or buy. (3 marks)
Calculate the reservation payment of the lessee (the maximum lease payment it can make). (3 marks)
Problem 4 (9 marks)
Puddle Ltd is considering investing $50 million in a garbage recycling technology. The cost will be the same whether you invest now or in 1 year from now. The sales from commercialising the new technology depends on the success of government legislation which will be known in exactly one year’s time. There is an 80% chance the market for the technology will be strong and produce a perpetual free cash flow of $10 million per year; there is a 20% chance it will produce no free cash flow. All yearly cash flows would commence one year after making the investment and are assumed to be received at the end of each year. The cost of capital is fixed at 10% per annum (effective annual rate).
Draw a fully labelled decision tree which shows the choices Puddle Ltd faces regarding the investment. (Indicate timings, decision-nodes, information-nodes, probability of each outcome) (3 marks)
Calculate the value of the technology if Puddle Ltd invests today (i.e. doesn’t wait).
Should Puddle Ltd invest today or wait one year to invest? Answer this by calculating the value, today, of waiting one year in order to learn of the market size before deciding to invest.
[Problem 4 answer continued]
PART C: Short Questions (25 marks) Question 1 (7 marks)
In the context of capital structure decisions, describe the free cash flow hypothesis and the effect of increasing debt according to this hypothesis. (4 marks)
Evidence from industry and corporate practices, suggests companies have a target debtto-equity ratio. Indicate three factors which have been shown to influence the target debt-toequity (D/E) ratio and describe their influence on observed target D/E ratios. (3 marks)
Question 2 (6 marks)
Private Equity finance usually involves a limited partnership structure.
Describe the roles and financial contributions of the limited partners and the general partners. (4 marks)
Describe two characteristics of Private Equity that are likely to reduce agency issues between Limited Partners and General Partners. (2 marks)
Question 3 (6 marks)
Explain the rationale behind the statement: ‘Equity is a call option on the levered firm’s assets’. (4 marks)
In a) above, describe when a shareholder would allow the call option to expire. (2 marks)
Question 4 (6 marks)
The evidence on Initial Public Offering (IPO) sales is varied, but there are three themes widely observed; under-pricing, underperformance, and the common reasons for going public. Describe the three common themes.
Underpricing: (2 marks)
Underperformance: (2 marks)
Reasons for going public (2 marks)
Useful Formulas
Present Value: |
Beta of a Security |
NPV= PV-Cost | |
Perpetuity: |
Equilibrium Asset Pricing |
No growth: Constant Growth: |
CAPM: k-factor model: |
Annuity: |
Value of the Firm: |
No growth: Constant growth: |
MMI (No taxes): MMI (With Taxes): |
Measures of Risk for Individual Assets: |
Leverage and the Cost of Equity: |
n ^{2 }[r_{i }E(r)^{2 }Pr_{i }] i1 |
Before tax: After tax: |
Returns: |
Weighted Average cost of capital: |
No taxes:
Free Cash Flow (unlevered) |
Adjusted Present Value |
Portfolio of Two Assets: |
Equity Beta: |
Expected Portfolio Return: Portfolio Variance: Portfolio Beta: |
No taxes: With Corp Taxes: |
Options: |
Binomial Option Pricing: |
Black-Scholes formula: Put-Call Parity (dividend paying share): |
Risk-Neutral Probability of increase in S: Call option price (risk-neutral method): Delta: Call Option Price (replicating portfolio): |
Rights |
Merger |
Ex-rights share value = Value of total equity after issue /No. shares on issue after rights issue Value of the right = Price cum-rights - Price ex-rights OR, where n is the number of shares needed to be entitled to subscribe for 1 new share |
Cumulative Normal Distribution Table