THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES. Suggested Answers

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THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES Suggested Answers Level : Professional Subject : Corporate Financial Management Diet : December 2006 The suggested answers are published for the

1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES Suggested Answers Level : Professional Subject : Corporate Financial Management Diet : December 2006 The suggested answers are published for the purpose of assisting students in their understanding of what may be expected from a good candidate in the time allowed for each paper. They are in no way exhaustive nor model answer to the questions. They do not reflect the opinion of HKICS. 1

2 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES CORPROATE FINANCIAL MANAGEMENT DECEMBER 2006 Suggested Answers SECTION A 1.(a) Suppose the market interest rate declines to some interest rate r that is below 8%. Annual interest saving if refinancing at market interest rate r = $250 x (0.08 r) PV of all interest saving = [$250 x (0.08 r)]/r Refinancing cost = 250 x 0.12 tax savings = 250 x x 0.12 x 0.35 = 250 x 0.12 x (1 0.35) Set [$250 x (0.08 r)]/r = 250 x 0.12 x (1 0.35) r = 7.42% Hence, refinancing is a wise option if the market interest rate falls below 7.42%. 1.(b) A private placement is cheaper than an IPO because firms can avoid the cost of preparing costly registration documents (such as a prospectus) and fulfilling more stringent disclosure requirements. A private placement is more cost effective if the amount of capital raised is too small to justify the cost of an IPO. A private placement is also a way to solicit long-term strategic investors. The downside of private placements is their liquidity. Since the new shares are not traded in the stock exchange (or at least there is a lock up period), this greatly impairs the share s liquidity and reduces the price investors are willing to pay. Another problem with private placements is they are not suitable for large scale offerings since it is difficult to find enough buyers. 1.(c) Suppose the trader has one US dollar, Return from US dollar investment = US$ 1 (1+ ½ x 0.10) = US$ 1.05 Covered return from yen investment = US$ (1/150)(1+ ½ x 0.06)(170) = US$

3 Hence the trader should borrow yen, sell yen in the spot market for US dollars, invest in US dollars, and sell US dollars in the forward market for yen. The profit is US$ per US$. 1.(d) Two answers are possible; one exact and the other approximate. Exact answer S = RMB/US$ be the exchange rate. S e /S = (1+INF CHN )/(1+INF US ) = 1.032/1.03 S e /S = (S e S)/S = Hence, the RMB should depreciate by %. Approximate answer (S e S)/S = INF CHN - INF US (S e S)/S = = Hence, the RMB should depreciate by 0.2%. 1.(e) ROE = EAT/Owners equity A higher degree of financial leverage affects the ROE in two ways. (i) Financial cost effect: EAT since interest expenses ROE (ii) Financial structure effect: OE since debt capital replaces some equity capital ROE ROE either increases or decreases. 1.(f) Asset beta of Burger King = 0.65/(1+(0.5)(0.6)) = 0.5 Market beta of Cheapy = 0.5 [1+ (1-0.4)(1/1)] = (g) (i) Investors in venture capitalists firms are long-term investors. Hence, they do not need to have the flexibility to transfer ownership. (ii) There is little need for venture capitalists to raise new capital in the future. The aim of venture capitalists firms is to get the start-ups ready for listing or for sale at that time new capital can be raised. Venture capitalists firms themselves have no interest in raising further capital for the start-ups. They only want to put in enough seed money to get the firm going. (iii) Limited partnership is relatively inexpensive to form and subject to less regulations. (iv) Limited partnership is not subject to double taxation like corporation. 3

4 1.(h) ADRs are negotiable certificates issued by investment banks as evidence of ownership of the underlying US stocks that the bank holds in trust. ADRs are issued in the US by a US bank which certifies that a specific number of foreign shares have been deposited with an overseas branch of the bank. ADRs are denominated in US dollars and pay dividends in US dollars. ADRs can be created in one of two ways: Nonsponsored ADRs (typically traded OTC) One or more banks or brokerage firms can assemble a large block of the shares of a US firm and issue ADRs without the participation of this firm. Sponsored ADRs (can be traded OTC or on an exchange) This is a more common setup where the US firm seeking to have its stock traded in the US arranging for a particular depositary bank to issue its ADRs. 1. (i) Operating Lease Finance Lease Term Short-term Long-term Who s responsible Lessor Lessee for insurance, taxes, and upkeeping? Cancellable By the lessee on Not cancellable short-notice without penalty Reporting Not on balance sheet On balance sheet 1. (j) Spin off the company distributes shares in a subsidiary to the existing parent company s shareholders. Sell off this is the sale of part of a firm, generally for cash, to a third party Motivations for divestiture: Because the subsidiary is worth more to buyer than when operated by current owner. To settle antitrust issues. Because the subsidiary s value can be increased if it is operated independently. To change strategic direction. To shed money losers. To raise cash in times of financial distress. 4

5 SECTION B 2.(a) k E = ROA + (ROA kd)(d/e) At the target capital structure of 80% equity and 20% debt, D/E=0.25 and k E = 12% + (12% - 8%).25 = 13% WACC = WACC = k E E ( ) + k D D ( ) = 13% x % x 0.2 = 12% D + E D + E If the target capital structure changes to 50% equity, 50% debt, D/E = 1 and k E = 12% + (12% - 8%) 1 = 16% WACC = 16% x % x 0.5 = 12% (b) Albarval s return on assets accrues to both its shareholders and debtholders in proportion to their respective investments in the firm. Since a firm s weighted average cost of capital (WACC) is equal to the sum of the shareholders and bondholders expected returns in proportion to their respective investments in the firm, it must be equal to the expected return on the firm s assets. As the return on assets does not depend upon the way the assets are financed, the change in the target capital structure to 50% equity and 50% debt (D/E = 1), does not affect the firm s WACC that will still be 12% under the new capital structure. (c) k E L = ROA + (ROA - k D ) (1-t) (D/E) When the target debt-equity ratio is 0.25, the cost of equity is k E = 12% + (12% - 8%) (1-0.4) 0.25 = 12.6% and the weighted average cost of capital is: WACC = k E ( E D + E ) + k D (1-t)( D ) D + E = 12.6% x % (1-0.4) x 0.2 = 11.04% When the target debt-equity ratio is 1, we have: k E = 12% + (12% - 8%) (1-0.4) 1 = 14.4% WACC = 14.4%.5 + 8% (1-0.4).5 = 9.12% 5

6 (d) Although the return on assets is still not affected by changes in the capital structure, the weighted average cost of capital is affected because the interest payments are tax deductible. The 8 percent interest rate required by Albarval s debholders changes to 4.8% [8% (1-0.4)] when the corporate tax rate is 40%. Albarval s WACC decreases from 11.04% to 9.12% when the debt-equity ratio increases from 0.25 to 1 because the extra return expected by the shareholders from the interest tax shield and the lower aftertax cost of debt more than offset the higher financial risk generated by a higher level of debt. 6

7 3.(a) Sales = 10,000 x 500 = 5,000,000 Cost = 10,000 x 470 = 4,700,000 EBT = 300,000 EAT = 300,000 x (1-0.34) = 198,000 The real cost of capital is r r is calculated as follows: (1 + r r )(1 + i) = 1.15 (1 + r r )(1.04) = 1.15 r r = Thus, the NPV considering inflation is calculated as -$1,500,000 + Hence, the project should be accepted. $ = $371,986 (b) Depreciation Depreciable Annual Year % Basis Depreciation $60,000 $19, ,000 27, ,000 60,000 9,000 4,200 $60,000 Operating cash flows: Year ) Before-tax cost reduction 2) After-tax cost reduction $20,000 $20,000 $20,000 (line 1 0.6) 12,000 12,000 12,000 3) Depreciation 4) Tax savings from deprec. 19,800 27,000 9,000 (line 3 0.4) 7,920 10,800 3,600 5) Net operating CFs $19,920 $22,800 $15,600 Additional year 3 cash flows: Salvage value $20,000 Tax on salvage value (6,320)* Recovery of NWC 2,000 Total terminal year CF $15,680 *(Market value - Book value)(tax rate)=($20,000 - $4,200)(0.40) (ii) Initial investment: Cost ($60,000) Change in NWC (2,000) Total net investment = ($62,000) NPV r = 10% = -$62,000 + $19,920/ $22,800/ $(15,600+15,680)/ = -$1,

8 4. Several criteria can be used: (a) Extent of portfolio diversification Portfolio C is the most well diversified portfolio. - only 34% exposure to risky asset classes (IPO/Tech, small cap, venture capitial) - largest exposure to the broader market index portfolio, this ensures a reasonable degree of diversification - reasonable exposure to international equities and bonds Portfolio A Portfolio B Current portfolio Too much cash reserves No international exposure 56% exposure to high risk sectors Although has similar international exposure as C but 55% exposure to high risk sectors 50% invested in IPO/Tech 85% exposure to high risk sectors (b) Correlation with Sponsor s Business Portfolio C has the lowest exposure to IPO/Tech assets, which may be highly correlated with the plan sponsor s underlying business. (c) Risk-return trade off In terms of Sharpe ratio A ( )/19.8=0.40 B ( )/38.4=0.43 C ( )/26.7=0.42 Current portfolio ( )/55.2=0.38 C offers the second highest Sharpe ratio. (d) Minimal cash Portfolio C has minimal cash which is appropriate because given the plan s long-term horizon, liquidity is not important. Note that Portfolio B has excessive cash reserves. 8

9 5.(a) Country risk premium = 5% - 4% = 1% Cost of capital = 4% (10% - 4%) + 1%= 10.4% (b) Expected exchange rates are: Year 1: F 1 = S (1+i)/(1+i*) = x 1.04/1.12 = Year 2: F 2 = S [(1+i)/(1+i*)] 2 = x (1.04/1.12) 2 = (c) NPV = -800 x x / x / = = million (d) The cash flow adjustment method is better for a number of reasons. 1. If we assume investors can hold an international well-diversified portfolio, we do not need to adjust domestic cost of capital by adding a country risk premium. In contrast, country risk can affect a project s cash flows. 2. Managers tend to be complacent when the risk is simply reflected by an adding a premium. Estimating the effects on cash flow, however, will force managers to think thoroughly about the specific factors affecting cash flows. This helps them make plans to mitigate country risks. 3. Country risks are most likely one-sided (negative). Adjusting cash flow can best capture asymmetric risk. 9

10 6.(a) The number of new shares to be issued by First Corp to the shareholders of Biz One is 750,000 / 3 = 250,000 shares. Therefore, the total number of shares in the new First Corp will be: 1,000, ,000 = 1,250,000 shares. Since the NPV of the merger is zero, the market value of the new equity should be a simple sum of the market values of the two firms before the merger: V New First Corp. = V First Corp. + V Biz One = $15 1,000,000 + $5 $750,000 = $15,000,000 + $3,750,000 = $18,750,000 The new share price of First Corp. is: Share Price = V First Biz New / total # of shares = $18,750,000/1,250,000 shares = $15 This new share price is in line with the fact that the merger does not create any value: for the old shareholders of First Corp., the share value has stayed the same; and the shareholders of Biz One, who exchanged each three shares worth $15 (3 $5= $15) for one share of First Corp. worth $15, nothing has changed either. (b) The after-merger EPS should reflect the combined earnings of the two premerger companies and the new number of shares of First Corp. Pre-merger earnings: EAT First Corp = V First Corp / PE First Corp = ($15 1,000,000 shares) / 15 = $1,000,000 EAT Biz One = V Biz One / PE Biz One = ($5 750,000 shares) / 9 = $416,667 Using the combined new First Corp. s number of shares determined in part (a): EPS = EAT New First Corp / number of shares = $1,416,667 / 1,250,000 = $1.13 (c) P/E = $15 / $1.13 = (d) The merger described in this problem is a conglomerate merger where unrelated businesses are combined. Very often, as this problem shows, no value was created in such mergers. Even though the new firm s EPS is higher than First Corp s (or Biz One s) premerger EPS, the market has adjusted the new firm s P/E ratio downward to reflect the value neutral nature of the merger; as a result, the stock price of First Corp has remained unchanged. 10

risk free rate 7% market risk premium 4% pre-merger beta 1.3 pre-merger % debt 20% pre-merger debt r d 9% Tax rate 40%

risk free rate 7% market risk premium 4% pre-merger beta 1.3 pre-merger % debt 20% pre-merger debt r d 9% Tax rate 40% Hager s Home Repair Company, a regional hardware chain, which specializes in do-ityourself materials and equipment rentals, is cash rich because of several consecutive good years. One of the alternative