Heriot-Watt University Accountancy and Finance Module: Corporate Finance Tutorial topics You are advised to cover the recommended reading and self test exercises each week noted in the module outline. The following is a list of tutorial exercises to be completed by all students each week. Some of the exercises are set from the recommended textbook, Corporate Finance and Investment by Pike and Neale. Students are recommended to keep up with the reading each week to maximise the use of tutorial time. Questions relating to the exercises should be asked during the tutorials. Solutions to each week s tutorial will be made available during the tutorial. Please note: Tutorial attendance is compulsory and attendance records will be kept. Please, conduct me if you encounter any difficulties. David Kilgour (Room SBC H1)
Objectives of the firm Questions: 1. What do you understand by investment and financing decisions? Provide two examples of each. 2. The past ten years have seen a much greater emphasis on investor-related goals, such as earnings per share and shareholder wealth. Why do you think this has arisen? 3. The goal of the firm should be to create wealth for the owners. How realistic is it to adopt this single objective? What else may be considered? 4. Expanding profits, as the manager s main financial objective, may not be an appropriate corporate goal. Give an example of an action that might increase profits but at the same time reduce stock price. 5. Corporations are now required to make public the amount and form of compensation (e.g. stock options versus salary versus performance bonuses) received by their top executives. Of what use would that information be to a potential investor in the firm? 6. Identify some potential agency problems that may arise between shareholders and managers. 7. If agency problems can be mitigated by tying the manager s compensation to the fortunes of the firm, why don t firms compensate managers exclusively with shares in the firm? 8. What are the advantages & disadvantages of setting up business as (a) a sole proprietor (b) a partnership (c) a corporation 9. When a company s stock is widely held, it may not pay an individual shareholder to spend time monitoring the manager s performance and trying to replace poor management. Explain why. Do you think that a bank that has made a large loan to the company is in a different position? 2
The Time Value of Money Questions: 1. For each of the following, compute the future value: Present Value Years Interest Rate Future Value 570 15 9% 8,922 9 18% 61,133 3 12% 219,850 10 4% 2. For each of the following, compute the present value: Future Value Years Interest Rate Present Value 349 5 6% 5,227 20 2% 48,950 12 25% 612,511 7 33% 3. Solve for the unknown interest rate in each of the following: Present Value Years Interest Rate Future Value 475 4 615 7,350 7 18,350 27,175 11 65,000 93,412 19 200,000 4. You are looking into an investment that will pay you 12,000 per year for the next 10 years. If you require a 15% return, what is the most you would pay today for this investment? 5. An insurance company offers to pay 570 per month for 36 months if you pay 5,771 up front. What interest are you being offered? 6. A first-class tenor has been signed to a three-year, 5 million contract with EMI Records Ltd. The details provide for an immediate cash bonus of 500,000. The performer is to receive 1 million in salary at the end of the first year, 1.5 million the next, and 2 million at the end of the last year. Assuming a 10 percent discount rate, is this package worth 5 million? How much is it worth? 7. A firm is considering the purchase of a machine which will cost 20,000. It is estimated that annual savings of 5,000 will result from the machine s installation, 3
that the life of the machine will be five years, and that its residual value will be 1,000. Assuming the required rate of return to be 10%, what action would you recommend? 8. You would like to retire in 50 years as a millionaire. If you have 10 to invest today what annual rate of interest you need to earn to achieve your goal? 9. After carefully going over your budget you have determined you can afford to pay 28 per month for 48 months towards a new DVD player. You call up your local bank and find out that interest rate for the loan required is 1% per month. How much can you borrow? 4
Capital Investment Appraisal Questions: 1) Using a 13% discount rate find the NPV of a project with the following cash flows: Time(years) t 0 t 1 t 2 t 3 Cash flow( 000) -300 +260-200 +600 2) Bramhope Manufacturing Co. Ltd has found that, after only 2 years of using a machine for a semi-automatic process, a more advance model has arrived in the market. This advanced model will not only produce the current volume of the company s product more efficiently, but allow increased output of the product. The existing machine had cost 32,000 and was being depreciated straight-line oven a ten year period, at the end of which it would be scrapped. The market value of this machine is currently 15,000 and there is a prospective purchaser interested in acquiring it. The advanced model now available costs 123,500 fully installed. Because of its more complex mechanism, the advanced model is expected to have a useful life of only 8 years. A scrap value of 20,500 is considered reasonable. A comparison of the existing and the advance model now available shows the following: Existing machine Advanced model Capacity p.a. 230,000 units 200,000 units Selling price per unit Production costs per unit Labour Materials Fixed overheads (allocation of portion of company s total fixed overheads 0.95 0.12 0.48 0.25 0.95 0.08 0.46 0.16 The sales director is of the opinion that additional output could be sold at 95p per unit. If the advanced model were to be run at the old production level of 200,000 units per annum, the operators would be freed for a proportionate period of time for reassignment to the other operations of the company. The sales director has suggested that the advanced model should be purchased by the company to replace the existing machine. The required return is 15%. You are required to calculate: 5
(a) payback period (b) NPV (c) what recommendations would you make to the sales director? What other considerations are relevant? (Pike & Neale, Chapter 6, exercise 4) 3) A firm is considering an investment in a new manufacturing plant. The site already is owned by the company, but existing buildings would need to be demolished. Which of the following should be treated as incremental cash flows? (a) The market value of the site (b) The market value of the existing buildings (c) Demolition costs and site clearance (d) The cost of a new access road put in last year (e) Lost cash flows on other projects due to the executive time spent on the new facility (f) Future depreciation of the new plant. 4) Highflyer plc has two possible projects to consider. It cannot do both - they are mutually exclusive. The cash flows are: Year Project A Project B 0 (420,000) (100,000) 1 150,000 75,000 2 150,000 75,000 3 150,000 0 4 150,000 0 Highflyer s cost of capital is 12%. Assume unlimited funds. These are the only cash flows associated with the projects. a) Calculate the net present value (NPV) for each project. b) Calculate the internal rate of return (IRR) for each project. c) Compare and explain the results in (a) and (b) and indicate which project the company should undertake and why. 6
5). The directors of Mylo Ltd are currently considering two mutually exclusive investment projects. Both projects are concerned with the purchase of new plant. The following data is available for each project. Project 1 Project 2 Cost (immediate outlay) 100,000 60,000 Expected annual net profit (loss): Year: 1 29,000 18,000 Year: 2 (1,000) (2,000) Year: 3 2,000 4,000 Residual value (Year 3) 7,000 6,000 Mylo Ltd employs the straight-line method of depreciation for all fixed assets when calculating net profit. The company has an estimated cost of capital of 10%. Neither project would increase the working capital of the company. The company has sufficient funds to meet all capital expenditure requirements. Required: a) Calculate for each project: i) the net present value ii) the approximate internal rate of return iii) the profitability index iv) the payback period b) State which, if either, of the projects should be accepted by the directors of Mylo, based on the methods you have used. 6). A proposed overseas expansion has the following cash flows: Year Project A 000 0 (100) 1 50 2 40 3 40 4 15 a) Calculate the payback, the discounted payback, and the NPV at a required rate of return of 15 percent. b) What are the main objections to the use of payback? Why does it remain a very popular method? 7
Sources of finance and financial planning 1. In an interview with J.P.Morgan for the post of Corporate Finance trainee, you are asked to discuss the advantages and disadvantages of: (a) issuing ordinary shares as a source of long-term finance, and (b) issuing a domestic coupon paying corporate bond as a source of long-term finance. 2. Last Tuesday, the Laura Ashley ordinary shares with a par value of 10p, were priced at. (see FT General retailers). If the Laura Ashley corporation intends to raise 5 million from a new issue of ordinary shares, how many new shares will enter the market? 3. On 16/1/2000, a 91-day deep discount bond with a face value of 100 sells at 87.75. What is the annual yield promised? 4. What are the main advantages and disadvantages of Eurobonds as an international source of finance? 5. Cambridge Castings Ltd is planning to undertake a major expansion and modernise its manufacturing plant, thereby improving productivity costs. The company s existing capital base is fairly evenly divided between equity and debt and it is clear that the capital investment programme can only partly be funded through profit retention. The suggestion has been made that the additional finance could be raised through a preference share issue. You are required to evaluate this source of finance for the company with equity or debt: a) from the company s point of view; b) from the viewpoint of the investors. 6. Preference shares of financially strong firms sometimes sell at lower yields than bonds of those firms. For weaker firms, preference shares have ahigher yield. What might explain this pattern? 7. Why might a bond agreement limit the amount of assets that the firm can lease? 8
The Company Cost of Capital Questions 1) Project GO has an initial cost of 7,500 and the firm s risk-free interest rate is 10%. If certainty equivalents and net cash flows (NCF) for the project are as below, should the project be accepted? Year Certainty equivalents Net Cash flows ( ) 1 0.75 6,000 2 0.70 7,000 3 0.65 5,000 4 0.60 5,000 5 0.55 3,500 6 0.50 3,500 7 0.10 2,100 2) Company X has a beta value of 1.3, the risk free rate of return is 8% and the historic risk premium for shares over the risk free rate of return has been 9%. Calculate the return expected on shares in X assuming CAPM applies. 3) Arlington plc is correctly valued by the market at 6 per share, having recently paid a dividend of 40p per share, and has recently achieved dividend growth of 21.3% per annum. Projecting this past growth into the future what the shareholders required rate of return would be? 4) Burgundy plc is expected to have an operating profit of 1.5m this year. It is financed through a bond and ordinary shares. The bond was issued five years ago at a par value of 100 (total funds raised 5m). It carries an annual coupon of 10%, is due to be redeemed in four years and is currently trading at 105. The company s shares have a market value of 4m, the return on risk-free government securities is 8% and the risk premium for an average-risk share has been 7.9% for the past eight decades. Burgundy s shares have a lower than average risk and its historic beta as measured by the co-movement of its shares and the market index correctly reflects the risk adjustment necessary to the average risk premium - this is 0.85. The corporate tax is 31%. Burgundy is expected to produce profits of 600,000 from its assets of 5m. Required: a) Calculate the cost of debt capital b) Calculate the cost of equity capital c) Calculate the weighted average cost of capital. 5) Lancelot plc is a diversified company with three operating divisions - Nperth, South and West. The operating characteristics of North are 50% more risky than South, while West is 25% less risky than South. In terms of financial valuation, South is thought a market value twice that of North, which has the same market value as West. Lancelot is all-equity financed with a Beta of 1.06. The overall return on the FT All share Index is 25%, and the risk free rate is 10%. Recently, South has been underperforming and Lancelot s management plan to sell it and use 9
the entire proceeds to purchase East Ltd, an unquoted company. East is all-equity financed and Lancelot s financial strategists reckon that while East is operating in broadly similar markets and industries as South, East has a revenue sensitivity of 1.4 times that of South, and an operating gearing ratio of 1.6 compared to the current operating gearing of South of 2.0. Assume that there are special benefits from the disinvestment and acquisition. You may ignore taxation. Required: 1. Calculate the asset Betas for the North, South and West divisions of Lancelot. 2. Calculate the asset Beta for East. 3. Calculate the asset Beta for Lancelot after the disinvestment and acquisition. 4. What discount rate should be applied to any new investment projects in East division? 5. Indicate the problems in obtaining a tailor-made project discount rate such that calculated in (4). Capital Structure Questions 1) Best plc. has estimated the cost of debt and equity for various financial gearing levels: Proportion of debt Required rate of return VD V + V Debt (%) Equity (%) D E 0.80 9.0 35.0 0.70 7.5 28.0 0.60 6.8 21.0 0.50 6.4 17.0 0.40 6.1 14.5 0.30 6.0 13.5 0.20 6.0 13.2 0.10 6.0 13.1 0.00 6.0 13.0 Required: Find the company s optimal capital structure. 10
2) The most recent annual accounts for Hassle plc show the following: Profit and Loss Account for year ended 31 December 1998 m Operating income 32.77 Debt interest 2.00 Taxable profit 30.77 Corporation Tax @ 35% 10.77 Profit after tax available for ordinary s/hs 20.00 Dividends 5.00 Retained earnings 15.00 Balance Sheet as at 31 December 1998 m m Capital employed: Fixed assets (net) 100 Net current assets 20 120 Financed by: Ordinary shares 60 Reserves 40 Long-term debt 20 120 Notes 1. Ordinary shares are denominated in 25p units. The present market price is 50p. 2. The long-term debt comprises a Secured Loan Stock redeemable in 2004 with an annual coupon rate of 10%. The current market price of this stock is 80. The stock pays coupons annually. Hassle is contemplating a new capital investment project, which requires an outlay of 10m (this can be financed internally), and promises a perpetual annual cash flow (before tax) of 6.15m. The directors of Hassle are in disagreement about the appropriate discount rate to apply to these cash flows when appraising the project. One group, led by Mr Bother, argues that there is sufficient information in the annual accounts to support a cost of capital calculation. The opposing party, led by Mr Aggro, argues that a more sophisticated approach is required, utilising the Beta coefficient for Hassle (estimated by London Business School at 1.20). Required: a) Discuss, with supporting calculations, how the annual accounts may be used by the Bother group to compute the weighted average cost of capital. b) Explain the drawbacks with the various approaches, which you suggest in (a). c) Explain how the Capital Asset Pricing Model may assist in the estimation of Hassle s cost of capital. 11
3) Demonstrate how the process of home-made gearing would operate in an Modigliani & Miller (MM) world so as to equalise the values of the following two firms. The companies are identical in every respect except their capital structures. Geared Ungeared Expected earnings 100 100 Debt finance (nominal) 200 - Interest rate 5% - Market value of equity 900 950 Market value of company 1,100 950 Assume that the market value of the geared debt is equal to the nominal value, and the investor holds 10% of Geared s equity. 4) Gypco expects a stream of earnings (before interest and taxes) of 10,000 every year forever. Gypco can borrow at 7%. Suppose Gypco currently has no debt and its cost of equity is 17%. If the corporate tax rate is 35%, what is the value of the firm? What will be its value, if Gypco borrows 15,000 and uses the proceeds to repurchase stock? 5) Indicate what is wrong with the following arguments on capital structure: (a). As the firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return. Thus by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off. (b). Moderate borrowing does not significantly affect the probability of financial distress or bankruptcy. Consequently, moderate borrowing will not increase the expected rate of return demanded by stockholders. (c). The more debt the firm issues, the higher the interest rate it must pay. That is one important reason why firms should operate at conservative debt levels. 12
Dividend Policy 1. In 1999 Reebok International paid a regular quarterly dividend of $0.075 a share. (a) Connect each of the following dates to the correct term: May 7, 1999 June 6, 1999 June 7, 1999 June 11, 1999 July2, 1999 Record date Payment date Ex-dividend date Last with-dividend date Declaration date (b) On one of these dates the share price is likely to fall by about the value of the dividend. Why? (c) The share price in early January 1999 was $27. What was the prospective dividend yield? (d) The earnings per share for 1999 were forecast at around $1.90. What was the percentage payout rate? 2. In 1974 Consolidated Edison announced that it would omit its regular 45 cents per share cash quarterly dividend. It cited losses due to increased oil prices following the OPEC oil embargo. The share price fell by about 30% in one day, from about $18 a share to $12 a share. Why would omission of $0.45 per share dividend result in a share price drop of $6 a share? 3. Galahad plc, a quoted manufacturer of textiles, has followed a policy in recent years of paying out a steadily increasing dividend per share as shown below: Year Earnings per Dividend Share (net) Cover 1986 11.8p 5.0p 2.4 1987 12.5p 5.5p 2.3 1988 14.6p 6.0p 2.4 1989 13.5p 6.5p 2.1 1990 16.0p 7.3p 2.2 Galahad has only just made the 1990 dividend payment, and so the shares are quoted ex-dividend. The main board, which is responsible for strategic planning decisions, is considering a major change in strategy whereby greater financing will be provided by internal funds, involving a cut in the 1991 dividend to 5p (net) per 13
share. The investment projects thus funded will increase the growth rate of Galahad s earnings and dividends to 14%. Some operating managers, however, feel that the new growth rate is unlikely to exceed 12%. Galahad s shareholders seek an overall return of 16%. Required: a) Calculate the market price per share for Galahad, prior to the change in policy, using the Dividend Growth Model. b) Assess the likely impact on Galahad s share price of the proposed policy change. c) Determine the break-even growth rate. d) Discuss the possible reaction of Galahad s shareholders and of the capital market in general to this proposed dividend cut in the light of Galahad s past dividend policy. 4. Vale plc has the following profit-after-tax history and dividend per share history: Year Profit after tax Dividend per ( ) share 1988 10,800,000 5.400 1987 8,900,000 4.920 1986 6,300,000 4.480 1985 5,500,000 4.083 1984 3,500,000 3.710 1983 2,600,000 3.380 In 1987 the number of issued ordinary shares was increased by 30%. In 1986 a rights issue doubled the number of shares. In 1988 there were 100 million ordinary shares in issue with a total market value of 190m. Vale is quoted on the Alternative Investment Market. Vale s directors are committed to shareholder wealth maximisation. Required: (a) The risk-free return on government securities is currently 6.5%, the risk premium for shares above the risk-free rate of return has been 7.9% per annum and Vale is in a risk class of shares which suggests that the average risk premium of 7.9 should be adjusted by a factor of 0.9. The company s profits after tax per share are expected to continue their historic growth path, and dividends will remain at the same proportion of earnings as in 1988. Use the Dividend Growth Model and state whether Vale s shares are a good buying opportunity for a stock market investor. 5. It is well documented that stock prices tend to rise when firms announce increases in their dividend payouts. How, then, can it be said that dividend policy is irrelevant? 14
Working Capital management Questions 1. (a) What is the difference between cash management and liquidity management? (b) Is it possible for a firm to have too much cash? Why would shareholders care if a firm accumulates large amounts of cash? (c) What does the Economic Order Quantity (EOQ) model determine for the firm? 6. Almondvale Manufacturing starts each period with 10,000 golf clubs in stock. This stock is depleted each month and reordered. If the carrying cost per golf club is 1, and the fixed order cost is 5, is Almondvale following an economically advisable strategy? 7. In each of the following pairings, indicate which firm would probably have a longer credit period and explain your reasoning. (a) Firm A sells a miracle cure for baldness; Firm B sells toupees. (b) Firm A specialises in products for landlords; Firm B specialises in products for renters. (c) Firm A sells to customers with an inventory turnover of 10 times; Firm B sells to customers with an inventory turnover of 20 times. (d) Firm A sells fresh fruit; Firm B sells canned fruit. (e) Firm A sells and installs carpeting; Firm B sells rugs. END OF TUTORIAL QUESTIONS 15