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FINM 3401 Corporate Finance Semester Two Final Examinations, 2013




Question;FINM3401 Corporate FinanceQuestion 1 (15 marks)(a)(b)When publicly traded firms announce an equity issue, their stock price falls 3percent on the announcement. A recent article in the Financial Times explained thatone of the reasons why the stock price falls is the markets response to dilution.Equity issues increase the number of shares in the firm so the earning per share aswell as the value per share must fall. Do you think that this is a reasonablestatement? Explain. (5)Winston Salem has paid a steady and consistent dividend over many years. Theirdividend is paid quarterly and was $0.75 per share in the second quarter of the year.It was announced and paid in July. On October 1st, after the market closed, WinstonSalem announced that their quarterly dividend would rise to $1.25 per share. Thedividend change was unexpected. Winston Salem stock went ex-dividend onOctober 10th. The stock price closed on October 9th at $97.00 and opened onOctober 10 at $95.75. How did the markets expectation of future cash flows changewhen the stock went ex-dividend? Explain. (5)(c)When a company announces an acquisition of a company in the same industry thereis typically very little change in its share price. However, if all else was the samebut the company announced that it was acquiring a company in a different industrythe share market reaction is usually negative. Why might the share market have thisreaction? (5)Question 2 (15 marks)You are considering the purchase of a vacant lot, upon which you will build an apartmentbuilding. The price of the lot is $100,000 and you have obtained a commitment from a localbuilder, good for one year, to construct an apartment on the lot for $400,000 in construction costs.There are two possible states of the world, each occurring with equal probability. In the goodstate, demand for housing will be high and the perpetual after-tax cashflow (after all operating andmaintenance expenses) generated by the apartment will be $100,000/year. In the bad state,demand will be low and the perpetual cashflow will be only $50,000/year. The level of demand isthe same in all years (demand is revealed at the end of the first year). Use a discount rate of 10%in all calculations. Assume that revenues begin one year after construction costs are incurred.Further assume that the value of the lot in its next-best use (i.e. without an apartment building onit) is $50,000.A)Suppose that in order to obtain financing to buy the vacant lot, you must construct theapartment building immediately. What is the NPV of the project? (5)B)Suppose that the financing constraint described in part A does not exist. Further supposethat, since you are not the only interested buyer, the seller has decided to auction the vacantlot. What is the maximum amount you would bid? Give an intuition for your answer. (5)C)Suppose that instead of $100,00 or $50,000, after-tax cashflows are either $150,000 (in thegood state) or $0 (in the bad state), again with equal probability. Expected cashflows arestill $75,000. Would you bid a lower or higher amount for the land? Assume that all otherrevenues and costs are the same. Please provide an intuitive answer. (5)Question 3 (20 marks)General Mills is a food company which produces cereals, dessert mixes, and TV dinners. Theyjust refinanced all of their outstanding debt by issuing $4.5 billion in debt. The debt is rated A byS&P and has a maturity of ten years. General Mills has 300 million shares outstanding and thecurrent stock price is $50/share. The current one year government bond rate is 2.3% and thecurrent ten year risk free rate is 2.3% (this is the expected return from rolling over T-bills for thenext 10 years, or the ten year Treasury bonds rate minus the risk premium). The market riskpremium is 8.5%.(a)The debt issue is a zero coupon bond with a face value of $6.5B which is due at maturity.What is the promised rate of return on the bond? Explain completely. (5)(b)Based upon the debt rating, assume the market is estimating a 10% probability that GeneralMills will not make the promised payment at maturity. The market believes bondholderswill retrieve their initial $4.5 billion should the firm default at maturity but that none of theaccrued interest will be paid. Since the bonds may default at maturity, they are risky.Describe the default risk associated with these bonds. Explain completely. Hint: If you holdthe bonds until maturity what is your expected return? (5)Page 6 of 17Semester Two Final Examinations, 2013(c)FINM3401 Corporate FinanceAn examination of the equity returns of General Mills reveals an equity of 0.8. What isthe cost of capital for the assets of General Mills? Explain completely. (5)(d)Laura Smith, the CFO of the dessert mix division, is evaluating an expansionopportunity and needs to determine the correct cost of capital for projects in herdivision. The cash flows of the dessert division have low total variability, but are themost pro-cyclical of the three divisions. In other words, on average, they see thelargest percentage increase in operating cash flow when the economy is expandingand the largest percentage decline in recessions. What can we say about the cost ofcapital that should be used in the dessert mix division? Explain completely. (5)Question 4 (15 marks)Joe Bourne the CEO of Lucas Wind Farms (LWF) encouraged by the incoming administrationsposition on renewable energy sources, hopes to buy easement access for transmission lines inWestern Australia as it has the best wind in Australia. To fend off potential competitors, LWFneeds to raise a significant amount of capital today and Mr. Bourne is considering issuingpreferred equity. He owns 23% of the one million shares outstanding. The firm has no debt.The market is projected to be worth up to $1B a year in revenues. Like bonds, preferred equityalso has a specified liquidation value (like the face value) and a dividend rate (like the couponrate). The security recommended by his bankers: Turbo Charged Preferred (TCP) has two parts.First, it is preferred equity which can be converted into 25 shares of LWP stock in three years(2015). The liquidation value for the TCP is $1000 and the dividend rate is zero. In addition, eachTCP has 25 warrants attached to it. Each warrant gives the owner the right to purchase anadditional share of LWF for a fixed price in three years. To exercise the warrants, the owner mustpay the fixed price to the firm and would receive a share of stock in return. LWF plans to sell20,000 TCPs for a price of $1000 each. If LWF issued ordinary preferred (i.e. no conversionfeatures), the dividend rate would have to be 7% for it to sell for par ($1000). The current risk freerate is 5%.(a)What is the conversion price of the convertible preferred at maturity? Explain. Note thatwhen you convert the preferred equity into common equity, you do not give up thewarrants. (3)(b)If the strike price for the warrants attached to the TCP is $40, what is the implied value of asingle warrant? Explain. (7)(c)Describe the circumstances under which the owner of the TCP would choose to convert thepreferred equity into common equity, but not exercise the warrants which are attached to it.Explain. Assume you have no inside information and the TCP can be bought or sold for themarket price. (5)FORMULASPV(Annuity):C111 r NrPV CN1 1 g1r g 1 rEffective Tax Advantage of Debt:Assets = ASSET1Asset 1Asset 2+ ASSET2Total AssetsTotal AssetsC E S N d 1 X 1 r fTPE S N d1 X 1 r f N d 2N d 2Sln (r f 0.5 2) TXd1TTd 2 d1 TQuestion 1 (a)No. The article in the Financial Times is correct in that the number of shares increaseswhen a firm issues equity, however, so do the firm's assets. So, there is no dilution effectwhen you issue new equity. The reason why the stock price may fall is more likely due toasymmetric information. Manager' who maximize the wealth of current shareholders willbe more likely to issue equity when the equity is overvalued than when it is undervalued.Since the market can figure this out, equity issues will be a signal to the market that theequity is overvalued and the stock price will consequently fall.Question 1 (b)The ex-dividend day does not convey information to the market. The dividend payment(125 cents) was already known to the market. The market learned the dividend paymenton the 1st of October when the dividend was announced. Investors purchasing the stockon the 10th will not receive the dividend. Investors purchasing the stock on the 9th willreceive the dividend and thus are willing to pay $1.25 more for the stock.The stock price thus falls by the dividend between the 9th (the cum-dividend day) and the10th (the ex-dividend day). The fact that the stock price fell by exactly the amount of thedividend is consistent with the market making no changes in its expectation of futurecashflows to equity holders (dividends).Question 1 (c)Evidence is that the more the two companies have in common, the more successful theacquisition. This is because there is more chance for the acquirer to apply its competitiveadvantages (core competencies) to the target. Companies in the same industry have morein common.A company in a different industry is more likely to have unexpected problems andproblems that the acquiring company is not skilled to solve.Question 2(a)Expected cashflows are $750,000 in perpetuity. If you must build immediately, youwill incur an immediate cash outflow of $500,000, $100,000 to buy the land and$400,000 to construct the building. Therefore, the NPV of the project is:Expected cashflow in perpetuity Total costs = $250,000(b)You have two options. First, you could buy the land and start constructionimmediately. Your maximum bid would be the one that makes the NPV of thisapproach equal to zero:- Construction Costs + (Expected cashflow in perpetuity / required rate of return)=$350,000Your second option is to buy the land and wait one year before commencingconstruction. After one year, you will be able to observe the level of demand andyou can decide whether or not to build the apartment building. If demand turns outto be low, the NPV after one year will be positive and you will choose to build:NPV (conditional on low demand) = $100,000-Construction Costs + (Cashflow if bad / required rate of return) =-$400,000 + ($50,000/0.1) = $100,000 > 0If demand turns out to be high, the NPV after one year will be positive and you willeither build the apartment or sell the project:NPV (conditional on high demand) = $600,000-Construction Costs + (Cashflow if bad / required rate of return) =-$400,000 + ($100,000/0.1) = $600,000The total NPV of the project if you wait isNPV (waiting) = (100,000*.5+600,000*.5)/1.1=318,181The value of the project is lower if you wait a year and learn about the level ofdemand (318,181<350,000). Thus, the maximum bid is 350,000. The intuition ofthis result is that information about future demand is not valuable at all in this case.No matter what demand is, you will have a positive NPV, so you would not changeyour decision, based on future information. Therefore, the option has zero value.(c)If the variance of the cashflows increased, the option becomes valuable. Therefore,information becomes valuable and the "option" is valuable. In this case, the value ofthe project becomes higher if you wait a year and learn about the level of demand.You would be willing to bid $522k for the land.Question 3A) The price of the debt is $4.5B today and the promised payment in ten years is $6.5B.Thus the promised rate on the debt is 3.75%.PBond = 4.5 B =6.5 B(1 + r promised)10r promised = 3.75%B) We already know that the default risk on the General Mills bonds is positive (thedefault probability is 10%). In addition, we can show that the default risk iscompletely idiosyncratic. To know whether default risk is systematic or idiosyncraticwe have to be able to compare the or expected return of the General Mills bonds(which do default) to the or expected return of ten year government bonds (which donot default). The annualized expected return on the General Mills bond over the 10years is 3.4%. If you purchase the bond for $4.5B, you will receive a cash flow ofeither $6.5B with a 90% probability or $4.5B with a 10% probability. The expectedcash flow is therefore $6.3B. The implied expected return is thus 3.4%.P Bond = 4.5 =0.1 (4.5) + 0.9 (6.5)10(1 + rD)=6.3(1 + r D)10r D = 3.4%Alternatively, you could have calculated the return if the bond defaults (0) and if itdoes not default (the promised return of 3.75%) and taken a weighted average ofthese returns.rD = 0.1 (0) + 0.9 (3.7) = 3.4C) The cost of capital for General Mills assets is a weighted average of the firms cost ofdebt and its cost of equity where the weights are the fraction of the firms asset whichare financed with debt and equity. Since we know that the asset is 0.8, the cost ofequity capital, or the expected return on equity, is 9.1%r E = r risk free + E E[ r market return - r risk free ]= 2.3 + 0.8 (8.5) = 9.1%The cost of capital for General Mills is therefore 7.8%r Assets = r DebtEquityDebt+ r EquityDebt + EquityDebt + Equity4,50015,000= 3.4+ 9.14,500 + 15,0004,500 + 15,000= 7.8%D) Since the dessert division is the most pro-cyclical, its cash flows have more systematicrisk than do the other divisions. If its is greater than the of the other divisions,then its must be greater than the average of the firm. Its cost of capital mustaccordingly be greater than the cost of capital of the entire firm. Therefore, thediscount rate should be higher than 7.8%.To know precisely what the cost of capitalfor the dessert division is we could look at competitors that only operate in the dessertmix industry and calculate their asset. Alternatively, if we knew the discount ratesappropriate for the other divisions of General Mills and the value of each of thedivisions, then we could determine the correct cost of capital for the dessert mixdivision.Question 4(a)At maturity, the equity will pay the liquidation value (1000) if it is not converted or25 shares if it is converted. Thus the conversion price is $40/share. Since thewarrants are kept independent of whether the preferred is converted, we can ignorethem for this calculation.(b)The price of the entire security is $1000. This consists of the straight preferred (likea straight bond) plus the conversion features. The TCP can be viewed as a straightpreferred (with a zero dividend rate) plus 50 warrants. The strike price for all 50warrants is $40 each. The only difference between the warrants is the strike price onthe first 25 are paid for by relinquishing the preferred equity (value $1000) and thestrike price on the next 25 warrants (these are ones that are attached) must be paidfor in cash. The value of the two are thus equal. Since the TCP is worth $1000 andthe straight preferred portion of the TCP is worth $816, this implies the 50 warrantsare worth $184. A single warrant is therefore worth $2.54 (184/50).V TCP = V Zero rate preferred + 50 Warrants(X = 40)1000=+ 50 Warrants(X = 40) = 1000(1 + 0.07) 2= 816 + 50 Warrants(X = 40) = 1000Warrant(X = 40) = 3.68(c)The conversion value on the convertible equity is $40 per share. Thus if the marketprice of stock higher than $40 in two years, the owner of the TCP will convert hispreferred into common stock. Since the strike price on the attached warrants, thedecision rule for exercising the warrants is the same as for converting the preferred.If the owner does one, they will do the other. It is true that conversion of thewarrants requires cash, but this should be easy to secure given the certain nature ofthe payoff to the warrants. If you dont have the cash, you can always sell thewarrants to someone with the cash and they will convert.


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