BMCF5103/HUTECH/NOV15/F-KK

BMCF5103 CORPORATE FINANCE

ANSWER SCHEME
NOVEMBER 2015

PART A
Question 1

a. Efficient capital market market in which current market prices fully reflect available
information. In such a market, it is not possible to devise trading rules that consistently
beat the market after taking risk into account.

Forms of market efficiency.

The Weak Form

Weak form efficiency All historical market information, including prices and volume, is
included in the price. It says that you cannot consistently earn excess returns by looking for
patterns in past price and volume information, such as is done by technical analysts. Evidence
suggests that markets are weak form efficient based on the trading rules that we have been able
to test.
The Semistrong and Strong Forms
Semistrong form efficiency All public information is already incorporated in the price. It says
that you cannot consistently earn excess returns using available information to do fundamental
analysis. Evidence is mixed, but suggests that it holds for widely held firms.
Strong Form Market Efficiency
Strong form efficiency All information, both public and private is already incorporated in the
price. Empirical evidence indicates that this form of efficiency does NOT hold.
[4 marks]

Implications for Corporate Finance

1. Accounting Choices, Financial Choices, and Market Efficiency
Early studies find that stock prices do not react to changes in accounting methods, such as LIFO
versus FIFO. These findings are consistent with the semistrong form EMH and suggest that
Gilding the lily by restating financial performance in a deceptively favorable light is unlikely
to increase value unless it can also decrease taxes, bankruptcy costs or agency costs. However, a
study by Sloan (1996) suggests that investors react slowly to changes in accounting accruals.
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2. The Timing Decision

Studies find that firms that issue new equity have negative abnormal returns in following years,
and firms that repurchase equity have positive abnormal returns in following years, suggesting
that managers time equity sales (repurchases) correctly. If managers use information not
publicly available to time security sales, the evidence is consistent with the strong form.
3. Speculation and Efficient Markets
If the markets are efficient, firmsshould not waste their time trying to forecast the issues of debt
and equity. Their forecasts will likey be no betterthan chance.
4. Information in Market Prices
Managers can reap many benefits by paying attention to market prices.
[12 marks]
d. The share price will increase immediately to reflect the new information. At the time of the
announcement, the price of the stock should immediately increase to reflect the positive information.
[4 marks]
[TOTAL: 20 MARKS]

Question 2

a. Financial Managers should make decisions that increase firm value, which effectively
involves three primary categories of financial decisions.

Capital budgeting process of planning and managing a firms investments in fixed assets. The key
concerns are the size, timing, and risk of future cash flows.
Capital structure mix of debt (borrowing) and equity (ownership interest) used by a firm. What are
the least expensive sources of funds? Is there an optimal mix of debt and equity? When and where
should the firm raise funds?
Working capital management managing short-term assets and liabilities. How much inventory
should the firm carry? What credit policy is best? Where will we get our short-term loans?

These broad categories, however, can be summarized with two concrete responsibilities:
i. Selecting value creating projects
ii. Making smart financing decisions

BMCF5103/HUTECH/NOV15/F-KK

[8 marks]

b.

Maximizing profit is not a suitable goal for various reasons:

i.

Profits can be increased by reducing maintenance or other costs. The effects of such
measures would not be felt in the short run but would have longer term implications. As
machines are not properly maintained, they would have to be replaced sooner, resulting in
greater overall costs in the future.

ii.

Another reason is that profits are not cash flows. As such, profits are affected by how
the accounting rules are applied. In other words, the picture of the financial health of the
firm, as conveyed by its profits, may appear to be better than what it truly is.

iii.

A crucial criticism of maximizing profit as a suitable goal is that it does not take risk
into consideration. A firm can expect higher profits if it takes on greater risk. However,
the nature of risk is that outcomes are often not what we expect, and instead of large
profits, large losses ensue.
[6 marks]

c. The current market price of BAT stock reflects, among other things, market opinion about
the quality of firm management. If the shareholder's sale price is low, this indirectly reflects
on the reputation of the managers, as well as potentially impacting their standing in the
employment market. Alternatively, if the sale price is high, this indicates that the market
believes current management is increasing firm value and therefore doing a good job.
[6 marks]
[TOTAL: 20 MARKS]

BMCF5103/HUTECH/NOV15/F-KK

PART B

Question 1
A. Summary: APV, FTE, and WACC

These three methods for calculating the value of a proposed project should
be viewed as complementary. The following table summarizes the
similarities and differences between the three methods.

Initial Investment
Cash Flows
Discount Rates
PV of financing
effects

APV
All
UCF
R0

WACC
All
UCF
RWACC

FTE
Equity Portion
LCF
RS

Yes

No

No

Guideline for choosing between these models:

Use the WACC or the FTE methods if the target debt ratio will
be constant throughout the life of the project.
Use the APV method if the debt level will be constant through
out the life of the project.

[12 marks]

BMCF5103/HUTECH/NOV15/F-KK

b. NPV of all equity financed project = $1 million

PV of flotation costs including deductibility of expenses is:
-$50,000 + $10,000(.25) PVIFA 5, 10% = -$40,523
NPVLOAN= $8,000,000 - $600,000(3.7908) - $8,000,000/1.105= $758,149.42
APV = $500,000 + $758,149.42 - $40,523 = $1,217,626.42
PVIFA 5, 10% = 3.7908
[8 marks]
[TOTAL: 20 MARKS]

Question 2
a.

The three forms are merger, acquisition of stock, and acquisition of assets. A merger
has the advantage that it is legally simple and therefore low cost but it has the
disadvantage that it must be approved by the shareholders of both firms. Acquisition by
stock requires no shareholder meetings and management of the target firm can be
bypassed. However, it can be a costly form of acquisition and minority shareholders may
hold out, thereby raising the cost of the purchase. An acquisition of assets requires the
vote of the target firm's shareholders. However, it can become quite costly to transfer
title to all of the assets.
[ 6 marks]

BMCF5103/HUTECH/NOV15/F-KK

b. Often, the management of the target firm is replaced after an acquisition. If management
believes this may be the case, they may fight the takeover attempt in an effort to
maintain their current positions. In other cases, management may fight the attempt if
they feel that by doing so, they may increase the amount paid by the acquiring firm.
[4 marks]
c. Explanations for the minimal returns to the acquiring firm's stockholders.
Size differentials, competition in the takeover market, lack of achieving merger gains,
management goals other than the best interests of the shareholders, and early
announcements of corporate acquisition intent are all presented as possible explanations in
the textbook.
[6 marks]

d. Merger premium = $100m - ($50m + $40m) = $10m

[4 marks]
[TOTAL: 20 MARKS]

Question 3
a. Debt issues are simply easier and less risky to sell from an investment banks perspective.
The two main reasons are that very large amounts of debt securities can be sold to a relatively
small number of buyers, particularly large institutional buyers such as pension funds and
insurance companies, and debt securities are much easier to price.
[5 marks]

BMCF5103/HUTECH/NOV15/F-KK

b. Best efforts underwriting: The underwriter bears risk with a firm commitment because it
buys the entire issue. Conversely, the syndicate avoids this risk under a best-efforts offering
because it does not purchase the shares. Instead, it merely acts as an agent, receiving a
commission for each share sold. The syndicate is legally bound to use its best efforts to sell the
securities at the agreed-upon offering price. If the issue cannot be sold at the offering price, it is
usually withdrawn.
Dutch auction underwriting: The underwirtier does not set a fixed price for the shares to be
sold. Instead, the underwriter conducts an auction in which investors bid for shares. The offer
price is determined from the submitted bids. A Dutch auction is also known by the more
descriptive name uniform price auction.
[6 marks]

c.
i.

Set up the indifference equation as follows:

N(Old Stock Price) + Subscription Price = (N + 1) (Ex-Rights Price)
10($1.60) + $1.20 = 11(X) = > X = $1.56
[5 marks]

ii.

If you purchase 10 shares at the old price and exercise, your cost will be 10($1.60) + $1.2
= $17.20.
If you purchase 11 shares ex-rights, your cost is 11($1.50) = $16.50. This is the cheaper
alternative
[4 marks]

BMCF5103/HUTECH/NOV15/F-KK

Question 4

a. what are the major differences between an OTC forward contract and an exchange traded
futures contract?
Forward
Customized
Search cost use dealers
Low liquidity
Higher default risk limited to large,
creditworthy institutions
No up-front or intermediate cash flows
No Clearinghouse
Delivery normally occurs

Futures
Standard features (delivery date, size of contract,
quality of asset, etc.)
No search cost contact broker
High liquidity
Virtually no default risk
Initial margin requirements, daily marking-tomarket, margin calls
Clearinghouse that guarantees performance
Majority of contracts offset, not delivered

[8 marks]
b.
A short futures hedge involves selling a futures contract. Short hedges are used when you will be
making delivery of an asset at a future date (e.g., a farmer anticipating a harvest of wheat) and wish to
minimize the risk of a drop in price.
A long futures hedge involves buying a futures contract. Long hedges are used when you must purchase
an asset at a future date (e.g., a bakery with a demand for wheat) and wish to minimize the risk of a rise in
price.
`

c.

[6 marks]

Contract nets to you the original price. The net position is based on daily marking to the
market. The net change is $- .10, Close - Change = $2.70 -$10 = $2.60
[3 marks]

d. The firm is hurt by declining oil prices, so it should sell oil futures contracts. The firm may not
be able to create a perfect hedge because the quantity of oil it needs to hedge doesnt match
the standard contract size on crude oil futures, or perhaps the exact settlement date the
company requires isnt available on these futures. Also, the firm may produce a different
grade of crude oil than that specified for delivery in the futures contract.
[3 marks]

BMCF5103/HUTECH/NOV15/F-KK

Question 5
a.

In the home currency approach, you must forecast both the foreign cash flows and the
future expected exchange rates, convert the foreign currency cash flows into dollars, and
discount those dollar cash flows at the cost of capital for dollar-denominated investments.
In the foreign currency approach, you forecast the foreign cash flows, determine the
discount rate appropriate for cash flows denominated in the foreign currency and discount
those cash flows to the present. You then convert the NPV to dollars using the current
exchange rate. If done properly, both approaches give identical results. However, the
foreign currency approach is computationally somewhat more straightforward.
[6 marks]

b. On the plus side, a strengthened dollar makes Japanese cars less expensive in dollars, thus
increasing the automaker's export sales. In addition, American cars sold in Japan will be
relatively more expensive, thus making Japanese cars more price competitive in their
home market. On the other hand, raw materials and any other goods and services
purchased from America will be more expensive for the manufacturer, creating upward
pressure on its cost structure and squeezing profits. The net result may very well be a
tradeoff of higher sales volume versus lower per unit profits.
[5 marks]

BMCF5103/HUTECH/NOV15/F-KK

c. Exchange Rate Risk

Short-Term

Exposure

Exchange rate risk the risk of loss arising from fluctuations in exchange rates
A great deal of international business is conducted on terms that fix costs or prices, while at the
same time calling for payment or receipt of funds in the future. One way to offset the risk from
changing exchange rates and fixed terms is to hedge with a forward exchange agreement.
Another hedging tool is to use foreign exchange options. An option will allow the firm to protect
itself against adverse exchange rate movements and still benefit from favorable exchange rate
movements.

[2

Long-Term

marks]
Exposure

Long-run changes in exchange rates can be partially offset by matching foreign assets and
liabilities, inflows and outflows.

[2 marks]

Translation Exposure
U.S. based firms must translate foreign operations into dollars when calculating net income and
EPS.
Problems:
What is the appropriate exchange rate to use for translating balance sheet accounts?
How should balance sheet accounting gains and losses from foreign currency translation be
handled?
FASB 52 requires that assets and liabilities be translated at the prevailing exchange rates.
Translation gains and losses are accumulated in a special equity account and are not
recognized in earnings until the underlying assets or liabilities are sold or liquidated.
[2 marks]

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Managing Exchange Rate Risk

For large multinational firms, the net effect of fluctuating exchange rates depends on the firms
net exposure. This is probably best handled on a centralized basis to avoid duplication and
conflicting actions.
[3 marks]
[TOTAL: 20 MARKS]

QUESTION PAPER ENDS HERE

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