ADVANCED CORPORATE FINANCE EXAM

Transcription

1 ADVANCED CORPORATE FINANCE EXAM 9 January 2018 LAST NAME: FIRST NAME: STUDENT NUMBER: 1. This is an individual, closed-book exam; any attempt to cheat will be penalized by the immediate cancellation of the exam. 2. The exam duration is 3 hours sharp. 3. One error is penalized only once. In case you estimate that a piece of data is missing or ambiguous, state clearly your hypothesis in your answer and go ahead with solving the question. Whenever needed, write down the formula used. 4. Your answers to the qualitative questions (where no calculation is required) should not be long, but precise. 5. All answers should be rounded off and displayed with 2 decimal places. 6. All types of classical calculators are authorized. The use of a computer, smartphone and/or computer-like calculator is not authorized. Students are requested to use their own calculator and may not borrow from or share a calculator with another candidate during the exam. 7. Answer all questions in a thorough, clear and readable manner. Any ambiguous or unreadable answer plays against you. 8. Check that your questionnaire contains 16 pages. 9. Good luck! Part Total Maximum Your result 1/15

2 Part 1. Financial Analysis and Company Valuation Anderlecht, the Belgian football club, has been up for sale for a couple of weeks now. In December 2017, it was the Flemish well-known entrepreneur Marc Coucke who took control of the club. Reportedly, he paid 80 million for a 70% equity stake. Some observers estimate he overpaid, others think he got a bargain. Most of these observers know a lot about football, but nothing about finance. We all know football can be an erratic sport, but you learned something about finance and valuation so you are required to do some basic analysis. Luckily some of the basic data are provided and some other football clubs are listed on the stock market. The average company tax rate is 25%. The company invested 7 million in fixed assets in We assume that the working capital requirement has been constant in the past. BALANCE SHEET (31 December 2017, all numbers are listed in millions of ) ASSETS LIABILITIES Fixed Assets Equity Current Assets Long-term Debt Accounts Receivables Inventories Current Liabilities Cash Accounts Payables Other Current Assets Other non-financial shortterm Debt TOTAL ASSETS TOTAL LIABILITIES INCOME STATEMENT (31 December, all numbers are listed in millions of ) Sales Depreciation & write-offs of fixed assets Other costs Net interest charges Profit before taxes Taxes Profit after taxes ) Based on balance sheet information, do you have any comments about the price paid by Marc Coucke? 2/15

3 2) Calculate the working capital requirement, the net working capital and the net liquid balance of Anderlecht in How do you interpret the results? What is the link between these numbers? Explain. 3) Calculate the unlevered free cash flows of Anderlecht in Let s now have a look at the wider industry. You gathered some information about the football industry and the market in general: Average beta equity: 1.65 Average Debt/Equity ratio (based on market values): 1 Average Tax rate: 25% Risk-free interest rate: 0.5% Expected return of the market portfolio: 10.21% 4) Assuming that the debt of Anderlecht is riskless and that the ratio D/E (in market values) is equivalent to its book value, calculate the equity cost of capital of Anderlecht (before the deal with Marc Coucke). Please comments all your results and be specific about any hypothesis you made. 5) Finally, let s have a look at Marc Coucke s deal. Assuming that Marc Coucke wants to change the capital structure of Anderlecht to be equivalent to the rest of the sector, what is the wacc to be used to calculate the value of Anderlecht? 6) Assuming a constant perpetual growth of FCFs equal to 4%, what is the market value of equity? What is your final conclusion about the price paid by Marc Coucke? Part 2. Callable Debt Bitcoin (BTC) has been at the center of the cryptocurrency craze as its value has risen more than 12-fold in Together with other cryptocurrencies like the Ripple (XRP), the Litecoin (LTC), the Ethereum (ETH) or the TRON (TRX), it is puzzling financial markets and investors who are wondering what to do. Economists and market commentators seem to be unanimous about the fact we are witnessing a new financial bubble set to burst. However, even if nobody can agree on what is going on, something is going on All around the world, central banks are studying various options among which the creation of their own virtual currency. In this context, as a young graduate, you have been hired by the National Bank of Belgium to work on a secret cryptocurrency project, the Manneken Peace Coin or MPC. The goal is to issue the first crypto sovereign debt with a calming impact on the market. Taking into account the current volatility of existing cryptocurrencies, no doubt interest rates linked to a crypto bond will show similar volatility. Therefore, the National Bank decided that its first crypto sovereign bond would be a callable bond with the following features: 3/15

4 5% coupon crypto bond with three years to maturity (face value of 100 MPC), callable in year 2 for 100 MPC As your first assignment, you are asked the following: 7) apply a binomial interest rate tree approach to assess the value of this instrument if it would be issued today. The assumed volatility of the one year forward interest rate is 65%. One of your colleague was kind enough to start building the interest rate tree (Kalotay Williams Fabozzi, 1993 model see below) but could not finish before his vacations, you are told to resume his work and apply the model s assumptions. Today Year 1 Year 2 2,25% 2,20% 1,52% 8) What would be the computed value if the bond was also callable after 1 year for 95 MPC? 9) As bondholder of a callable instrument, what are the major risks? Provide a short explanation in each case. Part 3. Real Options Allan Spice has closely followed the market enthusiasm for electric car and is considering an investment in a mine extracting lithium, an important component of battery electrolytes and electrodes. Three investments are required before the start of the production: (1) the acquisition of a piece of land rich in lithium, (2) the acquisition and construction of the extracting site, (3) a final investment in machinery. The amount and date of investment are displayed in the table below. Amount to be invested Payment date (1) Land Acquisition 200,000 31/12/2017 (2) Site Construction 500,000 31/12/2018 (3) Machinery Acquisition 600,000 31/12/2019 4/15

5 Allan estimates that the present value (today December 31 st, 2017, just before the possible Land Acquisition) of all the future cash flows generated by the mine if it were to be opened today would be 1,200,000. However, the market price of lithium has been volatile in the past: as a result, the volatility of the 1,200,000 is around 40% per year. If all the investments are made, the mine will produce cash flows as from January 1 st, The annual risk-free interest rate is 2.5% (annually compounded). You can use a binomial tree with 1-year step to answer the following questions. 10) What is the net present value of this project? 11) What is the net present value of this project if you can sell the land either in 2018 or 2019 for 50,000? 12) How would change the value of a real option if the volatility of the underlying asset were to increase? Why? Part 4. Varia 13) Explain why the mix of assets observed in non-life insurance companies may differ from life insurance companies? 14) Illustrate the concept of agency costs using one detailed example. What is (are) the potential impact(s) on the capital structure of companies? In 2015, a certain professor of finance bought 12 initial public offerings of common stock. He held each of these for approximately one month and then sold them. The investment rule he followed was to submit a purchase order for every initial public offering of oil- and gasexploration companies. There were 22 such offerings, and he submitted a purchase order for approximately 1,000 of stock for each one. With 10 of these, no shares were allocated to this professor. With 5 of the 12 offerings that were purchased, fewer than the requested number of shares were allocated. The year 2015 was very good for oil- and gas-exploration company owners. For the 22 stocks that went public, the stock was selling on average for 80 percent above the offering price within a month. Yet, the professor looked at his performance record and found the 8,400 invested in 12 companies had grown to only 10,100, a return of only 20 percent. 15) Did he have bad luck, or should he have expected to do worse than the average initialpublic-offering investor? Explain. 16) What are the real implications of your justification to question 15)? 5/15

6 Part 1: Q1) 1 point Q2) 1 point WCR = AR+INV+Other Current assets AP-Other short term debt = 11,797 NLB =Cash= 0,390 NWC = E+LTD=WCR+NLB=12,187 Q3) 1 point EBIT = 2,011 NOPAT = 1,508 Depr.=11,656 Capex = 7 Delta WCR=0 FCF = EBIT*(1-Tc)+Depr-Capdex-Delta WCR=6,164 Q4) 1 point Be = 1,65 D/E = 1 Tc=25% Ba (with riskfree debt) (MM)= Be/(1+(1-Tc)*D/E)=0,94 Ba (with riskfree debt) (HP) = Be/(1+D/E) = 0,83 Be (with riskfree debt) (MM) = Ba(MM)*(1+(1-Tc)*D/E) = 3,10 Be (with riskfree debt) (HP)= Ba(HP)*D/E = 3,34 Re (with riskfree debt) (MM) = 30.59% using CAPM Re (with riskfree debt) (HP) = 32.93% using CAPM 6/15

7 Part 1 (continued): Q5) 1 point Be = 1,65 Re = 16,52% Rd = 0,5% Wacc= Re*E/V+Rd*(1-Tc)*D/V = 8,45% Q6) 1 point G = 4% V = 138,57 =FCF/(wacc-g) D = 46,385 E = V-LTD = 92,184 70% * E= 64,53 7/15

8 Part 2: Q7) 3 points In Kalotay-Williams-Fabozzi (1993) interest rate binomial tree, the one-year forward rate is assumed to follow a lognormal random walk. With σ, the volatility of the one-year forward rate: The following interest rate tree can be constructed: A callable bond is a bond with an embedded option that gives the right for the issuer to reimburse the face value at a predetermined price before the final maturity. The issuer will exercise that right if the present value of all future payments is higher than the said predetermined price. In this question he can only exercise in year 2. The following tree provides the price of the callable bond at each node: At each node the price is the present value of the future expected payments. In year two the minimum between the strike price (100) and the bond price has been selected. Q8) 1 point The next tree follows the same logic for the addition of a call option at a strike 95 to be exercised in year 1 8/15

9 Part 2 (continued): Q9) 1 point Reinvestment risk Price compression risk 9/15

10 Part 3: Q10) 2.5 points Volatility= 40% U=exp(40%)=1.49 D=1/u=0.67 p=(1+rf-d)/(u-d)=43.17% Possible values of the project at maturity are given by the binomial tree: The amount of investment is subtracted to the value at each step if the result is positive. Otherwise the investment is not made (in which case its value is null) For example: = Max((43.17%* ( %)* )/(1+rf);0) The NPV is therefore Volatility = 50% (Version B) Volatility= 50% U=exp(50%)=1.65 D=1/u=0.60 p=(1+rf-d)/(u-d)=40.15% Possible values of the project at maturity are given by the binomial tree: 10/15

11 Part 3 (continued): The amount of investment is subtracted to the value at each step if the result is positive. Otherwise the investment is not made (in which case its value is null) For example: = Max((40.15%* ( %)* )/(1+rf);0) The NPV is therefore Q11) 1 point Volatility=40% (version B) Volatility=50% (version B) We just add a put option: we are allowed to sell the land for It is an exit strategy: whenever the value of the project is null we can sell the land. With this extra option the NPV is now Q12)1.5 point An increase in the volatility of the underlying asset will increase the u factor, decrease the d factor. It will also have an impact on the risk neutral probabilities: p will decrease. An increase in the volatility will increase the value of the project because while we enjoy a better upside potential, we are protected against the higher downside potential. 11/15

12 Part 4: 13) (1,5 points) two main differences : Duration: longer-term business (in general) for life activities => longer-term assets (e.g. longterm bonds). Asset-liability management is key! Matching durations Liquidity: more liquid assets for non-life because the amount to be paid in case of insured event (e.g. car accident) is more unpredictable. The payment to non-life customers is also usually faster (for life business, it takes longer due to the dead s will, notary, ) 14) (1,5 points) Agency costs = Costs associated with potential conflict shareholders debtholders in case of high debt ratio. examples (to be developed): milking the property, Incentive to take large risks or Incentive toward underinvestment impact: lower company's value => debt ratio is then decreased (and not maximum if only the tax shield is taken into account) 15) & 16) (2 points) example of a winner's curse lower return was expected as he invested in all IPOs. He is an uninformed investor. Due to the rationing, he has more stocks when it is overvalued. Impact: to attract uninformed investors, companies need to undervalue stock price for IPOs 12/15

13 Formula Sheet 1. Discounting and Portfolio Theory Constant perpetuity PV = C / r Growing perpetuity PV = C /( r g) 1 T Constant annuity PV = ( C / r)[1 1/(1 + r) ] Growing annuity PV = C1 /( r g) 1 ((1 g) /(1 r))t + + Expected Return for N assets = R P N i=1 Xi R i N i=1 N j=1 Variance for N assets σ P 2 = X i X j σ ij 2. Capital Asset Pricing Model CAPM equation R i = r f + β i (R M r f ) Definition of beta β i = Cov(R i,r M ) σ M 2 3. Capital Structure and Weighted Average Cost of Capital Unlevered Free-cash Flows Levered Free-cash Flows Weighted average cost of capital FCF u = EBIT(1 T c ) + Dep CAPEX WCR FCF l = FCF u int + int T c + D WACC = r E E/V + r D (1 T C ) D/V MM1958 (no taxes) Required return to equityholders MM II Weighted average cost of capital r E = r A + (r A r D ) D/E WACC = r A = r E E/V + r D D/V With Taxes - Constant debt Required return to equityholders (MM II) r E = r A + (r A r D ) (1 T C ) D/E Weighted average cost of capital WACC = r A (1 T C D V ) With Taxes Debt proportional to value L = D/V (Harris-Pringle) Required return to equityholders r E = r A + (r A r D ) D/E 13/15

14 Weighted average cost of capital WACC = r A r D T C L With Taxes Debt proportional to value L = D/V (Miles-Ezzel) Required return to equityholders Beta Equity Weighted average cost of capital 4. Options Put-Call Parity r E = r A + (r A r D (1 + T C ( r A r D ))) 1+r D β A (1 + D E ) (1+r D (1 T C L) 1+r D ) WACC = r A r D T C L 1+r A 1+r D S + P = C + PV(K) L 1 L Black and Scholes formula (non-dividend paying stock) C = SN(d 1 ) PV(K)N(d 2 ) d 1 = ln( S PV(K) ) σ T d 2 = d 1 σ T + 0.5σ T Risk-neutral probability of up p = (1+r f t d) with simple interest rate (u d) Gross returns in up and down states: u = e σ t d = 1 u Binomial interest rate tree r1,h = r1,l*e 2σ 5. Risky debt valuation Merton model Beta equity D = Risk-free debt Put option D = F (1 p) (F V d) 1+r f 1+r f β A Delta equity V/E 14/15

15 N(x) & N(-x)=1-N(x) /15