THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS

Size: px

Start display at page:

Download "THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS"

Sabrina James
6 years ago
Views:

1 THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination CORPORATE FINANCIAL MANAGEMENT PILOT PAPER Marking Scheme 1

2 Section A Question 1 (a) Cost of capital for RE: WACC = R + β E( R ) R ) = 5% + 0.8(10%) = 13% F V ( M F Since the project is in another line of business and has different risk from that of the firm s operation, the firm-wide WACC is not relevant for evaluating the project. (3 marks) The pure play approach is used to determine the business risk of CK Communications Inc., which is the same as that of the project. S B β V = βs + βb( 1 T ) = (60%)(1.80) = 1.08 (4 marks) B + S B + S Cost of capital for the project: WACC = R + β E( R ) R ) = 5% (10%) = 15.08% (3 marks) F V ( M F Note: No marks (out of 7 marks) should be awarded if the firm-wide WACC of RE is used to evaluate the project. NWC = 10% +10% -5% = 15% (of sales) t=0 t=1 t=2 t=3 T=4 Sales NWC Changes in NWC NWC related CFs An improvement in inventory utilisation will require less investment in inventory and therefore reduces cash outflow. (1 mark) 2

3 (c) t=0 t=1 t=2 t=3 T=4 Sales COGS Depreciation EBIT Taxes (20%) Net Income Depreciation Erosion Opportunity Costs (Warehouse) Initial Investment NWC related CFs CF from project NPV = $2.175 million Accept the project. (10 marks) (d) The conventional NPV analysis assumes a passive role for managers, that is, it ignores the managerial flexibility or real option. The firm has an expansion option at the end of the project and the option is valuable. Therefore, even if the project has a negative NPV, its value can still be positive: Value of project = NPV + value of real option When there is debt outstanding, shareholders may take a negative NPV project, as long as the project increases the risk of the firm and hurts the bondholders even more. Since B < V = S + B and V = NPV, in order that S = V B > 0, we have V > B. Thus, NPV is the condition. 3

4 Section B Question 1 (a) Super-normal growth (Excel solution): PV Factor PV 0 r S 10% Div 0 1 g 1 20% Div 1 =Div0(1+g1) Div 2 =Div1(1+g1) Div 3 =Div2(1+g1) Div 4 =Div3(1+g1) g 2 5% Div 5 =Div4(1+g2) =Div5/(rS P 4 g2) P 0 = $34.74 Bond price = (30)(PVIFA 4%,10 ) + $1,000(PVIF 4%,10 ) = $ Firm value: V=B+S = *10, *500,000 = $ million (12 marks) Agency costs of debt arise from the conflict between shareholders (agents) and bondholders (principals). In particular, shareholders have the incentive to increase asset risk to take advantage of bondholders (risk-shifting problem). Since bonds are fixed-income securities, as the risk of assets increases, the market value of the bonds decreases. A zero-npv project will not change the firm value. Thus, a decrease in B implies an increase in S. Alternatively, equity can be viewed as a call option on firm s assets (V). As the risk of assets (volatility) increases, the call option value (S) also increases. Thus, shareholders benefit, at the expense of bondholders. (8 marks) 4

5 Question 2 (a) We can use interest rate parity and the unbiased forward rate. F t = S 0 [1 + (R E R US )] t and F t = E[S t ] E[S t ] = (1/1.25)[1 + (.06.08)] t E[S t ] = 0.8(.98) t So, the cash flows each year in US dollar terms will be: t Euros E[St] US Discount factor PV NPV= Using the international Fisher effect to find the required return in euros, we get: R Euro = (1+R US )[1+ (.06.08)] - 1 R Euro = 9.76% (15 marks) NPV = (PVIFA 9.76%,5 ) NPV = Euro M Converting the NPV to dollars at the spot rate, we get the NPV in US dollars as: NPV = ($1.25) = $

6 Question 3 (a) V U = [(EBIT)(1-T C )] / r 0 = [($40)(1-0.2)] / 0.15 = $ Based on MM Proposition I: V L = V U + T C B = $ (0.20)($100) = $ S= $ $100 = $ Based on MM Proposition II with corporate taxes: r S = r 0 + (B/S)(r 0 r B )(1 T C ) = ($100 / $133.33)( )(1 0.2) = 19.20% When the firm announces its plan for recapitalisation, in an efficient market the stock price adjusts to the news right away. Thus, Repurchase price = V L / #Shares outstanding = /20 = $11.67 #shares repurchased = B/Repurchase price = 100/11.67 = 8.57 million #shares remaining = = million A firm s optimal financial leverage depends on the trade-off between tax shield and costs of financial distress. The latter depends on asset characteristics: shipping firms have more tangible and general-purpose assets, whereas pharmaceutical firms have more intangible assets and R&D, etc. Therefore, shipping firms have lower costs of financial distress than that of pharmaceutical firms at the same level of leverage. (4 marks) Free cash flow is defined as the cash flow after taking up all positive NPV projects. Debt financing can reduce the free cash flow problem: scheduled interest and debt repayments are contractual obligations. Debt forces the firm to pay out cash. (4 marks) 6

7 Question 4 (a) CAPM r s = 5% + 1.5(12%-5%) = 15.50%. (3 marks) r B = YTM = 10%. Bond price = (40)(PVIFA 5%,20 ) + $1,000(PVIF 5%,20 ) = $ (1 mark) Use market values to estimate the weights, since target values are not available. Market value of equity = S = $10(10 million) = $100 million. Market value of debt = B = $875.38(60,000) = $52.52 million. w S = 100/( ) = 65.56%. w B = 52.52/( ) = 34.44%. (3 marks) WACC = w B r B (1 - T) + w S r S = (10%)(1 -.40) (15.50%) = 12.23%. (3 marks) There are two conditions for using firm-wide WACC to evaluate a project: (1) the risk of the project is the same as that of the firm; (2) the project is financed with the same capital structure. For the proposed project, the firm-wide WACC over-estimates the hurdle rate. Using the firm-wide WACC would therefore under-allocate funds to the less risky project. (Illustrate with SML). Describe pure play approach 7

8 Question 5 (a) Cost of equity for Sunny Toys, based on the DDM: D0 (1 + g) r S = + g P 0 = 1.60*(1+6%)/90 + 6% = 14.48% Gain from the merger: 1.60(1 + 8%) Gain = PV AB ( PVA + PVB ) = [ 20](600000) 14.48% 8% = $4,000,000 Cash offer: Cost = Cash paid - PV B = (25 20)(600000) = $3,000,000 NPV of merger = Gain cost = $1,000,000 (Accept) Share offer: Plastic Products Inc. needs to offer 600,000/3 = 200,000 new shares to acquire Sunny Toys. So the fraction of new shares is N = 200,000/(1,000, ,000) = 16.67% Cost = N PV AB PV B = (16.67%)(90*1,000,000+20*600,000+4,000,000) 20*600,000 = $5,666,667 NPV of merger = Gain cost = 4,000,000 5,666,667 = -$1,666,667 (Reject) (12 marks) Asymmetric information exists between insiders (managers) and outside investors. Since the cost of the share offer depends on the post-merger valuation, the share offer signals that the merger gain is either small or uncertain. Also, the share offer signals that acquiring firm s stock is overvalued. All these may explain the observed negative market reaction. If cash is offered, the cost of merger is not affected by the merger gain, whereas if shares are offered, the cost depends on the merger gain. Therefore, the share offering mitigates the effect of overvaluation of the target firm, because the target firm s (Sunny Toys ) shareholders share the gain (as well as its uncertainty). (8 marks) 8

THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS

THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND ADMINISTRATORS International Qualifying Scheme Examination CORPORATE FINANCIAL MANAGEMENT PILOT PAPER Time allowed