SINGAPORE INSTITUTE OF MANAGEMENT
UNIVERSITY OF LONDON
PRELIMINARY EXAM 2020
MODULE CODE
:
MODULE TITLE :
FN2191
Principles of Corporate Finance
DATE OF EXAM :
TIME OF EXAM
:
DURATION
:
3 hours
TOTAL NUMBER : 9
OF PAGES
(INCLUDING
THIS PAGE)
------------------------------------------------------------------------------------------------------INSTRUCTIONS TO CANDIDATES :Candidates should answer FOUR of the following SIX questions. All questions carry
equal marks.
A list of formulas is given at the end of the paper.
A handheld calculator may be used when answering questions on this paper and it must
comply in all respects with the specification given with your Admission Notice. The
make and type of machine must be clearly stated on the front cover of the answer book.
DO NOT TURN OVER THIS QUESTION PAPER UNTIL YOU ARE TOLD TO
DO SO.
Candidates are strongly advised to divide their time accordingly.
FN2191 Principles of Corporate Finance
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Question 1
Network Streaming Systems (NSS) Ltd is a video production company and
currently rents the building in which its production equipment is located at an
annual cost of £150,000, including all service charges.
The company is considering purchasing an alternative building in which to
undertake its video business. These alternative premises are due to be
demolished by the local council in 4 years’ time to make way for a new road. It is
known that the Council will purchase the building at that time at its book value of
£100,000. Because of the instability caused by the Council’s plans, NSS can
purchase the building at a knock-down price of £250,000. Otherwise, since the
building is located in a prime residential area, the land on which the building
stands would be worth £1.8 million. Currently the building is in a state of
disrepair, but a structural survey which has already been undertaken by NSS
costing £3,000, recommends that the building must be upgraded at a cost of
£50,000 before NSS moves in.
The annual heating and lighting expenses on the new building will be £40,000,
but NSS will save the annual rents on its current premises. The removal costs of
moving its equipment into the new building, and the cost of moving out again in
four years’ time will be £25,000 on each occasion.
NSS pays corporation tax on its profits at 30%, and the tax authorities allow NSS
to offset its corporate tax liabilities by using straight line depreciation on its fixed
assets. You may assume that NSS has sufficient taxable profits to take full
advantage of any tax shields from purchasing the building. NSS applies an
opportunity cost of capital of 10 per cent to all future cash flows. Assume all
annual cashflows occur at the end of the year to which they relate.
(a) Determine the free cash flow in each year from the investment in the new
building, explaining your treatment of costs and depreciation allowances.
(10 marks)
Structural improvements are an investment – include as CAPEX
Cost of the survey is a sunk cost – do not include.
Depreciation: straight-line from 300 to 100 à (300 - 100)/4 = 50 per year
Calculate incremental after-tax FCFs:
FCF = EBIT*(1-t) + Dep – CAPEX – ΔNWC + Salvage
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(b) What is the project NPV?
(2 marks)
Discounting after-tax FCFs at 10%, NPV = £30.47K
(c) NSS approaches you for advice on whether it should purchase the new
building, and asks for your opinion on payback, IRR, and accounting rate of
return as methods of investment appraisal. Advise NSS by comparing and
contrasting the four alternative investment criteria.
(8 marks)
Any reasonable discussion of the drawbacks of payback, ARR and IRR vs
NPV from the subject guide and/or textbook.
(d) Suppose that there is a small probability that the Council might change its
decision to build a road, allowing the owner to sell the land for residential
development. Outline how this would change your valuation of the project.
(5 marks)
If there is a chance that the land could be worth £1.8million, then this
increases the NPV of the project, since the decision to purchase the building
includes the (real) option to sell the land for residential development. In this
case, the project has a valuation with the current NPV of £30.47K with
probability of (1-p) if the Council sticks with its decision to build the road, but if
the Council changes its decision with probability of p, the value of the land
could increase to £1.8m. In this state, NSS will be able to choose whether to
sell the land for residential development or keep it as a studio in perpetuity.
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Question 2
Tinpot Resources (TR), an all-equity firm, is considering purchasing the rights to
operate an iron ore mine in the Pilbara region of Western Australia. Acquiring the
rights will cost $50,000 today (time 0) but will also oblige TR to pay substantial
environmental rehabilitation costs of $250,000 when the mine is shut down in 3
years’ time. While in operation, the mine is expected to produce 20,000 tonnes of
iron ore per year, with extraction costs running at $93 per tonne.
Although TR knows it can sell iron ore in the market for $100 per tonne in the first
year, it faces considerable uncertainty regarding the future iron ore price, which
is equally likely to rise by 10% or fall by 15% in each of the subsequent two
years.
There are no taxes or any other costs. Unless otherwise stated, assume any
cash flows occur at the end of each year. Use a discount rate of 20% for all cash
flows. Show your calculations.
a) Draw a binomial tree depicting the possible market prices of iron ore during
the mine’s operating life. Remember, the price in year 1 is known with
certainty. What is the expected market price of iron ore in years 2 and 3?
(4 marks)
Binomial tree of iron ore price per tonne (u = 1.1, d = 0.85):
E(P2) = 0.5*110 + 0.5*85 = $97.50
E(P3) = 0.25*121 + 0.5*93.5 + 0.25*72.25 = $95.0625
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b) Calculate the NPV of the project. Should TR purchase the rights?
(6 marks)
NPV = -50000 + 140,000/(1.2) + 90000/(1.2^2) – 208750/(1.2^3) = $8,362.27
Project’s NPV is positive, so TR should purchase rights to operate the mine.
c) Explain why using the IRR rule is likely to result in an incorrect decision when
evaluating this project (do not attempt to calculate the IRR). Be specific.
(4 marks)
The project has non-normal cashflows. Specifically, FCFs change sign more
than once (FCF is negative at t=0 and t=3), which can result in multiple IRRs.
Better answers will go on to describe/explain how multiple IRRs can produce
incorrect decisions.
Now assume that TR has the ability to temporarily halt extraction operations if
iron ore prices move adversely. However, by doing so, it cannot avoid paying the
environmental rehabilitation costs at the end of the mine’s life.
d) When will TR choose to exercise this option? Explain fully.
(4 marks)
TR’s operating profit per tonne at each node:
By halting extraction when operating profit is negative, TR can minimise its
losses. This will occur if iron ore prices fall at t=2 and fall again at t=3 (shown
in red in the tree above). Note that even though total FCF is negative in the
middle node at t=3, TR should continue operations at this node since FCF
would be even more negative if production were halted.
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e) Determine the value of the abandonment option and comment on the source
of the option value.
(7 marks)
Operating profit per tonne with temporary abandonment:
Et=1(operating profit) = 7*20000 = 140,000
Et=2(operating profit) = 0.5*(17*20000) = 170,000
Et=3(operating profit) = 0.25*(28*20000) + 0.5*(0.5*20000) = 145,000
NPV(with abandonment) = -50000 + 140000/(1.2) + 170000/(1.2^2) 105000/(1.2^3) = $123,958.33
Abandonment option value:
Option value = NPV(with option) - NPV(without option)
= 123,958.33 – 8,362.27
= $115,596.06
Alternatively, the value of the abandonment option can be calculated directly.
Temporary abandonment allows TR to:
•
•
•
Avoid an operating loss of 8*20000 = 160,000 at t = 2, which occurs with
50% probability
Avoid an operating loss of 20.75*20000 = 415,000 at t = 3, which occurs
with 25% probability
Abandonment option value is the expected PV of losses avoided:
(0.5*160,000)/(1.2^2) + (0.25*415,000)/(1.2^3) = $115,596.06
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Question 3
Canada Moose (CM), a manufacturer of high-end winter apparel, is keen to
expand its offerings by introducing a new range of coats made from the fur of
baby seals. This project is expected to require an initial investment of $800
million. However, a concerted campaign by animal rights activists has seen the
company’s sourcing practices draw the ire of legislators. The company is eagerly
awaiting the results of a key regulatory ruling that will have a material impact on
the value of its existing business and future investment.
Given the uncertainty, the company is unable to secure additional debt financing
(it has $200 million of outstanding debt on its balance sheet) and must raise the
required $800 million by issuing outside equity. The following table details the
outcomes depending on whether the regulatory ruling is harsh (State 1) or soft
(State 2), as well as the market’s assessment of the probability of each state. All
dollar values are in millions.
Probability
Assets in place
Investment cost
NPV (Fur seal project)
Debt
State 1
50%
600
800
50
200
State 2
50%
1200
800
150
200
When answering this question, state any additional assumptions you may need
to make. Show your calculations.
a) If CM’s managers must issue equity without knowing whether the ruling will
be harsh or soft, what percentage of the firm’s equity must original equity
holders give up in exchange for the capital?
(5 marks)
Since the decision to issue equity does not convey any information about the true
state, outside investors will value CM based on expectations. The expected value
of CM’s equity post-issue is 1600. In exchange for $800m cash, new
shareholders will demand an $800m equity stake, or 800/1600 = 50% of the postissue equity.
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b) If there was no debt in CM’s capital structure, would this raise or lower the
percent of equity demanded by outside investors in (a)? Explain briefly.
Assume all other numbers remain unchanged.
(4 marks)
If CM had no debt, new investors would demand a smaller percentage stake
since the expected value of equity post-issue would be 1800, not 1600. New
investors would require (800/1800) = 44.44% of the post-issue equity.
For the remainder of this question, assume the company has $200 million of debt
in its capital structure (i.e. as per the table above).
c) Now assume that management knows the true state of the world before the
decision to issue and invest is made. If management is maximising the wealth
of old shareholders and can sell equity at the terms described in (a), do they
have an incentive to use their inside information when deciding whether to
issue equity and invest? Explain.
(5 marks)
To determine whether to issue and invest, managers will examine the impact
of this decision on the wealth of existing shareholders. If managers can issue
equity on the terms determined in (a), old shareholders will retain a 50%
stake in the post-issue equity, versus a 100% stake in the existing equity if
managers do nothing (i.e. don’t issue and invest). Old shareholders’ wealth in
each state under each scenario is shown in the table below:
Since original shareholders’ wealth is higher in State 2 if managers do
nothing, managers will choose not to issue and invest in State 2. The
opposite is true in State 1.
Old shareholders are worse off under the decision to issue and invest in State
2 because the firm would be selling underpriced shares (the market believes
the firm’s post-issue equity is worth 1600 when it’s actually worth 1950). New
shareholders would contribute 800m cash but receive a stake worth 0.5*1950
= $975m. The negative NPV of financing (800 - 975 = -175m) would outweigh
the positive NPV of the project (150m). Similar, but opposite reasoning
applies in State 1.
d) If management knows the true state and announces their intention to issue
and invest, what percentage of the firm’s equity must original equity holders
give up in order to raise the $800 million? (Assume the market believes the
managers know the true state even though the state has not been announced
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to the market.)
(4 marks)
If management announces its intention to issue and invest, the market will
infer that the true state is State 1 and consequently revise down its post-issue
equity valuation of CM to $1250m. Old investors will now have to give up
(800/1250) = 64% of their equity stake to raise the cash. As the value of the
stake retained by old investors in State 1 ($450m = 0.36*1250) would still be
higher than if the firm did not issue and invest ($400m), the equity issuance
would proceed on these new terms.
e) Let X be the NPV of the project in State 2. Assume all other numbers in the
table above remain unchanged. How large does X have to be in order for your
conclusion in (c) to change? Explain this result intuitively. Hint: note that
changing X will also alter the issuance terms agreed in (a).
(7 marks)
If investors do not know the true state, they will value the firm based on
expectations. The expected value of post-issue equity is E = 0.5*1250 +
0.5*(1800 + X) = 1,525 + 0.5X
In exchange for 800m cash, outside investors will demand a fraction α of the
post-issue equity such that the value of their stake is 800m in expectation:
800 = α*(1525 + 0.5X)
Under these terms, managers will always choose to issue and invest in State
1 (they are selling overpriced shares). However, they will only issue in State 2
if the post-issue value of old shareholders’ wealth is greater than doing
nothing (i.e. 1,000), so we need:
(1 - α)(1800 + X) > 1000
Solving for X, we get X > 180.996 ≈ 181. That is, when the NPV of the project
in State 2 is greater than $181m, CM will opt to issue equity and invest in
State 2.
Explanation: When the project’s NPV in State 2 is above 181, the NPV is ‘too
good’ for old investors to pass up even if that means issuing underpriced
equity. If the project NPV in State 2 is 181, then the NPV of financing (-181)
exactly offsets the positive NPV of the project, so that old shareholder wealth
remains $1,000 whether the firm invests in the project or not. If project NPV >
181, old shareholders are better off investing.
Implication: If X > 181, managers will now issue equity and invest in both
states. Hence, the decision to issue will not signal any information to market.
Therefore, the equilibrium issuance terms will be set as in (a) (i.e. by
expectations).
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Question 4
Consider an all-equity firm whose only asset is the option of investing in one of
two mutually exclusive projects. Each project requires an investment today of
£400 million. Next year, project A pays £520 million with probability 80% and
£200 million with probability 20%. Next year, project B pays £600 million with
probability 20% and £200 million with probability 80%. After these cash flows, the
firm will be shut down. There are no taxes, depreciation, or any other benefits or
costs.
To implement one of these projects, the firm must raise debt financing. Note that
the managers of the firm act in the interest of the equityholders and that project
choice occurs after debt financing is granted, so debtholders cannot control
project choice after financing. However, debtholders can rationally anticipate the
actions of managers.
When answering this question, state any additional assumptions you may need
to make. Show your calculations.
For parts (a) and (b), assume all cash-flows are discounted at 0%.
(a) Compute the NPVs of the two projects. Which project is better?
(4 marks)
The NPVs are as follows:
NPV(A) = 0.8(520) + 0.2(200) - 400 = 56
NPV(B) = 0.2(600) + 0.8(200) - 400= -120.
NPV(A) > 0 > NPV(B) à A is better
(b) Show that the firm will be able to raise £400 million today via the issue of
debt. Compute the terms of the debt (i.e. the face value) required by lenders.
(5 marks)
At a discount rate of 0%, debtholders will be willing to lend 400 today, only if
they expect cash flows of 400 next year. Suppose that debtors believed that
the firm would adopt project A (the higher and positive NPV project). Then, in
order to receive an expected cash flow of 400 in one year, they would set a
face value of F, where 0.8(F) + 0.2(200) = 400, thus F = 450.
We need to verify that with debt outstanding with a face value of 450, equity
holders would actually choose project A (otherwise debtholders may not be
satisfied with a face value of 450). Cash flows to equity holders when F = 450
are as follows:
From project A: 0.8(520 - 450) = 56 > From project B: 0.2(600 - 450) = 30.
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So, indeed, equity holders will choose project A and debt financing will
proceed on these terms (i.e. F = 450).
For parts (c) and (d) assume, instead, that all cash flows are discounted at 12%.
(c) Recompute the NPVs of the two projects. Which project is better? (4 marks)
Now, with the higher discount rate, the NPVs are as follows:
NPV(A) = (0.8(520)+0.2(200))/1.12 - 400 = 7.1.
NPV(B) = (0.2(600)+0.8(200))/1.12 - 400= - 150.
A is (still) better.
(d) Show that the firm will not be able to raise £400 million today via the issue of
debt. Explain why this is so. Be precise: show your steps and explain your
reasoning.
(7 marks)
A discount rate of 12% means that debtholders will be willing to put up 400
today, only if they expect cash flows of 400*1.12 = 448 next year. Suppose
debtholders believe the firm would adopt project A. Then, in order to receive
an expected cash-flow of 448 in one year, they would set a face value of F,
where 0.8(F) + 0.2(200) = 448, thus F = 510.
With debt outstanding with face value of 510, will equity holders actually
choose project A? Cash flows to equity holders when F = 510 are:
From project A: 0.8(520 - 510) = 8 < From project B: 0.2(600 - 510) = 18.
That is, equity holders will not choose project A under these terms. But, then,
debtholders will anticipate this and ask for a higher face value (since F = 510
was based on the assumption that the firm picked project A). Assuming that
they will at least get paid in full in the 20% state for project B, they will set F
such that: 0.2(F) + 0.8(200) = 448, which gives F = 1440, which is obviously
not feasible.
Thus, there is no debt contract that would give debtholders their required
return, and no financing will be put into place.
(e) Use your answers to parts (b) and (d) to comment briefly on the following
statement: "In times of financial stress, when lenders are impatient and the
discount rate is high, credit markets may fail. Some firms may be excluded
from debt markets, i.e. there is no interest rate at which lenders are willing to
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lend to them." Speculate on which types of firms, based on this problem, are
most likely to be rationed (i.e. excluded) from debt markets.
(5 marks)
The underlying problem is that highly indebted firms will be inclined to
increase risks (asset substitution). When the discount rate is high, lenders are
not willing to lend unless they are compensated highly for making loans,
which means that, all else equal, they will demand a higher face value for
their debt. But such higher face value demands imply that the firms that they
lend to will be even more likely to increase risks, which leads lenders to ask
for even higher face values, a destructive spiral. Sometimes, this can lead to
a situation in which a firm cannot borrow at all – at no interest rate will lenders
lend to them. Which firms are most likely to face such an outcome?
Precisely the firms that have most access to asset substitution opportunities –
small, risky, firms which many potential projects, including pretty risky ones.
These firms will suffer the most in times when loanable funds are expensive.
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Question 5
Midlife Crisis Inc. (MCI) has two assets: £1,600 in cash and an investment
project. The cash is invested in the risk-free asset which earns 5% per year. The
project requires an investment of £800 today and generates an expected cash
flow of £1,600 one year from now. This opportunity recurs perpetually each year.
Thus, for example, one year from now MCI can again invest £800 and generate
£1,600 one year subsequent to that investment. MCI has 800 shares
outstanding. The market equity risk premium is 5% per year, and the investment
project has a CAPM beta of 1. Assume a Modigliani and Miller world.
When answering this question, state any additional assumptions you may need
to make. Show your calculations.
(a) Should MCI invest in the project? Explain.
(5 marks)
Yes. Using the CAPM, the project has a cost of capital of 0.05 + 1*0.05 =
10%. At this discount rate, the project has positive NPV and should be taken
each year. Specifically, NPV = -800 + 800/0.1 = 7200
(b) Suppose MCI’s CFO decides to pursue the project. What is the value of MCI?
(5 marks)
After investing, MCI’s value is the sum of the PV of the investment project
(8000 = 800/0.1) and the remaining cash (800). Value = 8000 + 800 = 8800.
(c) Suppose MCI’s CFO decides to take the project and always pay out all free
cash flow as a dividend. What is MCI’s cum-dividend price expected to be
one year from now?
(4 marks)
The CFO’s dividend policy is $1/share (800 FCF / 800 shares). Thus, the
expected cum-dividend price one year from now has claim to the $1 dividend
that is about to be paid as well as claim to a perpetual expected payment of
$1. Thus, Price = 1 + 1/0.1 = $11
(d) MCI’s investment banker suggests that MCI instead pays out the £1,600 in
cash as a dividend today, reverting to the CFO’s proposed dividend policy
described in part (c) in one year. In order to continue to invest in the project,
MCI must raise equity immediately after the dividend is paid to raise the cash
needed for the project. How many shares must be issued to new
shareholders?
(4 marks)
Since MCI is paying out all its cash, it will need to raise 800 to fund
investment. As new shareholders will be contributing 800 of a firm that is
worth 8000 post-issue, they will demand 10% of the firm’s shares. As there
are currently 800 shares outstanding, N/(800+N) = 0.1 where N is the number
of new shares issued. Thus N = 89.
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(e) Describe both the dollar amount and timing of the expected dividend stream
to old shareholders under the investment banker’s proposal. Has old
shareholder wealth changed?
(3 marks)
Old shareholders have sold off 10% of the firm. Therefore, old shareholders
will receive 1600 immediately and are expected to receive 800*0.9 = 720 in
each subsequent year. The value of old shareholder wealth is equal to 1600 +
720/0.1 = 8800 which, as expected under Modigliani and Miller, is the same
as in part (b)
(f) If MCI no longer operates in a Modigliani-Miller world, dividend policy may no
longer be irrelevant. Carefully discuss the various ways MCI's dividend policy
may affect their valuation.
(4 marks)
Both the subject guide and the textbook discussed several ways in which
dividend policy might be relevant to firm value. Some of those ways include:
1) the importance of dividends as a signal to markets concerning firm
prospects, 2) optimising investors after-tax payout if dividends face differential
taxation to repurchases, 3) agency costs associated with dividend payouts.
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Question 6
Byder plc is considering a possible acquisition of Targetty plc. You have been
asked to evaluate the merits of the proposed merger. Here are the data on the
two companies before the acquisition.
Targetty
Byder
1,000m
5,000m
P/E ratio
10
2
Expected EPS
0.5
3
Shares outstanding
Byder has valued the synergies from the merger as being £2,500m.
(a) If Byder wishes to finance the acquisition with shares in the merged firm, what
is the maximum number of shares it would be willing to offer to Targetty's
shareholders?
(7 marks)
Value Byder: (2*3)*5000m = £30,000m
Value Targetty: (10*0.5)*1000m = £5,000m
Value Synergies: £2,500m
Merged firm value: £37,500m
For Byder not to lose, the post-merger share price must be above £6 (its premerger share price), which implies a maximum of 6250m shares,
(37500/6250 = 6) or 1,250m extra shares.
So, the maximum number of new shares that can be offered is 1,250m shares
for the 1,000m Targetty shares or 1.25 shares of the bidder per target share.
(b) What would be the consequences of such a bid on expected earnings per
share of Byder if we assume that the synergies will lead to an increase in
expected earnings of £200m in the first year? Does the effect on earnings per
share of the merged firm affect the merits of the transaction?
(5 marks)
New EPS = [500 (Targetty) + 15,000 (Byder) + 200 (Synergies)]/6,250= 2.512
This is a decline in EPS compared to Byder’s current level. However, this
should not affect the decision making process of the bidder. If the deal can be
done for less than 1,250 new shares, the bidder creates shareholder value
(i.e. the merger is positive NPV for Byder shareholders).
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(c) Instead of the share exchange, Byder has sufficient surplus cash on its
balance sheet to finance the acquisition with a cash offer. Alternatively, Byder
could return the cash to its shareholders before making the bid, and continue
with the share exchange. How would you advise Byder to decide between the
share offer and returning the cash to shareholders versus using the cash to
make the acquisition?
(7 marks)
Value of cash offer that gives zero NPV for the merger is £5,000m + £2,500m
= £7,500m. So the firm has £7,500m surplus cash on its balance sheet. In a
MM world the two alternatives are the same, and the firm should be indifferent
between them. When MM is violated, many factors may play a role: the
answer should involve a reasonable discussion of these factors, such as
share mispricing, control, taxes, and optimal capital structure considerations.
(d) Independently of the specific example above, discuss the validity of risk
diversification as a motivation for companies engaging in merger and
acquisition activity.
(6 marks)
In general, diversification is not a valid motivation for M&A activity. A full
answer should involve a reasonable to discussion of the potential benefits of
a diversifying acquisition versus drawbacks, as discussed in the subject guide
and the textbook.
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LIST OF FORMULAS
Capital Asset Pricing Model (CAPM)
Modigliani and Miller
Proposition I (no tax): VL = VU
Proposition II (no tax): Re = Ra + (Ra - Rd)(D/E)
Proposition I (with corporate tax): VL = VU + TcD
Proposition II (with corporate tax): Re = Ra + (Ra - Rd )(1 - Tc )(D/E)
Miller (1977)
END OF PAPER
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