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Monash University
Semester One Examination 2013 with Solutions
Faculty of Business and Economics
Department of Accounting and Finance
Please note that the unit code changed to BFC2140 later.

EXAM CODES: AFC2140


TITLE OF PAPER: Corporate Finance
EXAM DURATION: 3 hours
READING TIME: 10 minutes

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Caulfield Gippsland Sunway Open Learning

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This paper consists of eight (8) questions printed on a total of ten (10) pages.
Students must attempt to answer ALL questions.

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Question 1

(a) Briefly describe three forms of business orgnaisation: a sole trader; a partnership;
and companies.

A sole trader is a business owned by one person.


A partnership consists of two or more owners joined together legally to manage a
business.
Companies are legal entities able to do business in its own right.

(3 marks)

(b) Between the bond holder (buyer) and the bond issuer (seller) which party is
borrowing money and which party is lending money?

The bond holder (buyer) is the lender and the bond issuer (seller) is the borrower.
(2 marks)

(c) Explain why there is an inverse relationship between interest rates (YTM) and bond
prices.

As the YTM increases beyond the coupon rate of a bond, the bond price falls as it is no
longer as attractive an investment to other bonds of the same type that are newly
issued at a higher coupon as set by the higher YTM. So the only rationale for an
investor to buy the more poorly performing bond would be if its price fell by a
discount till the coupon paid on it represents a yield that matches higher YTM.

Conversely, if YTM decreases below the coupon rate, the bond price rises as it
becomes a more attractive investment to other bonds of the same type that are newly
issued at a lower coupon as set by the lower YTM. So investors would be willing to
pay a premium price for this bond till the coupon represents a yield on a higher price
that matches the lower YTM.

(4 marks)

(d) Should the credit rating of a bond be upgraded, what is the likely effect upon the
required rate of return of the bond? Explain why such an effect occurs.

An upgrade in credit rating represents a reduction in the default risk of the bond.
This will lower the required rate of return on the bond as investors would require
less compensation for lower default risk.

(3 marks)
(Total = 12 marks)

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Question 2

You are given the following share information. Assume that dividends will be paid to
perpetuity and do not grow over time.

Market Price ($) EPS ($) Dividend ($) Discount Rate (%)
Share A 500 25 20 5
Share B 0.2 0.05 0.02 12
Share C 30 15 10 15
Share D 10 4 2 8

Required:

(a) Rank the shares from cheapest to most expensive based on P/E valuation. Which is
the cheapest and which is most expensive share?

P/E P/E Valuation


Share A 500/25 = 20 Most expensive
Share B 0.2/0.05 = 4 2nd most expensive
Share C 30/15 = 2 Cheapest
Share D 10/4 = 2.5 2nd Cheapest
(4 marks) (2 marks)

(b) For each share, would your recommendation be to buy or sell based on dividend
discount model (DDM)? Provide an explanation for each recommendation you make.

Fundamental
Recommendation
Value
Share A 20/0.05 = 400 Sell, overpriced 500>400
Share B 0.02/0.12 = 0.17 Sell, overpriced 0.2>0.17
Share C 12/0.15 = 66.67 Buy, under priced 66.67>30
Share D 2/0.08 = 25 Buy, under priced 25>10
(4 marks) (2 marks)

(Total= 12 marks)

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Question 3

(a) What is the capital budgeting process? Why is the capital budgeting decision
considered the most important decision made by a companys management?

Capital budgeting is the process by which management decides which


projects and productive assets the company should invest in. (1 marks)

Capital budgeting decisions are considered the most important decisions


made by management because
o Capital expenditures involve large amounts of money. (0.5 mark)
o Capital expenditure decisions are critical for achieving the
companys strategic plans. (0.5 mark)
o Capital expenditure decisions define a companys line of business
over the long term. (0.5 mark)
o Capital expenditure decisions determine the companys profitability
for years to come. (0.5 mark)

(3 marks)

(b) Why is net present value (NPV) method for capital budgeting decisions considered
to be superior to alternative methods?
The net present value (NPV) method leads to better investment decisions
than other techniques because the NPV method does the following:
o NPV uses the discounted cash flow valuation approach, which
accounts for the time value of money (1 mark)
o NPV provides a direct measure of how much a capital project is
expected to increase the dollar value of the company. (1 mark)
o NPV is consistent with the top management goal of maximizing
shareholders wealth. (1 mark)

(3 marks)

(c) What is the payback period method? What are its advantages? What are its
disadvantages?

The payback period is a measure of the length of time it will take for the
cash flows from a project to recover the cost of the project. (1 mark)
Decision rule is to choose the projects with short payback periods less than
or equal to hurdle period (1 mark)

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Advantages include:
o Simple to apply and easy to understand. (0.5 mark)
o Simple measure of liquidity risk because it tells management how
quickly the company will get its money back. (0.5 mark)
Disadvantages include:
o Ignores the time value of money. (0.5 mark)
o Does not take account of cash flows recovered after the payback
period. (0.5 mark)
o Biased in favor of short-lived projects. (0.5 mark)
o Arbitrarily hurdle period. (0.5 mark)

(4 marks)

(d) What is the accounting rate of return (ARR) method? Why is this method not
recommended as a capital expenditure decision-making tool?

The ARR is based on accounting numbers, such as book value and net
income, rather than cash flow data. (0.5 mark)
Based on three variants
o based on initial investment (0.5 mark)
o based on average book value (0.5 mark)
o based on initial and final book value (0.5 mark)
Decision rule for ARR is that ARR is greater than required rate of return
(0.5 mark)

It is not recommended as a capital expenditure decision tool because


o ARR does not represent a true rate of return. (0.5 mark)
o ARR does not discount a projects cash flows over time. It simply
gives us a number based on average figures from the income
statement and balance sheet. (0.5 mark)
o ARR does not have an economic rationale for establishing hurdle
rates. (0.5 mark)
o ARR does not account for the size of the projects when a choice
between two projects of different sizes must be made. (0.5 mark)
o Has variants that result in different ARRs (0.5 mark)

(5 marks)
(Total = 15 marks)

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Question 4

(a) AOI Ltd. is evaluating two mutually exclusive projects. The company needs to decide
on between two alternative technologies for producing its line of widgets. Each
technology will generate the same revenues from the sale of the widgets, but the
expenses incurred in using the different technologies vary resulting in different net
cash flows. Technology 1 has a life of 5 years, and technology 2 has a life of 3 years
before they need replacing. The firm uses a 13.8 percent discount rate for such
projects. Outlays and cash flows are shown in the table below. Using an NPV in
perpetuity approach, determine which technology the firm should select?

Year Technology 1 Technology 2


0 $(7,500,000) $(9,200,000)
1 $3,200,000 $2,500,000
2 $1,800,000 $5,000,000
3 $1,800,000 $5,000,000
4 $2,200,000
5 $2,000,000

Suggested Solution:

Technology 1:

NPV = -7,500,000+3,200,000 x (1.138)^-1 + 1,800,000 x (1.138)^2 + 1,800,000 x


(1.138)^-3 + 2,200,000 x (1.138)^-4 + 2,200,000 x (1.138)^-5
= $282,886 (2 marks for correct solution and workings)

NPV() = 282,886 x [(1.138)^5]/[(1.138)^5 1] = $594,233 (2 marks for correct


solution and workings)

Technology 2 :
NPV = -9,200,000 + 2,500,000 x (1.138) -1+ 5,000,000 x (1.138)-2 + 5,000,000 x
(1.138)-3
= $250,392 (2 marks for correct solution and workings)

NPV() = 250,392 x [(1.138)3]/[(1.138)3 1] = $778,912 (2 marks for correct


solution and workings)

Technology 2 has the higher NVP() therefore it should be selected over Technology
1. (1 marks)
(9 marks)

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(b) You have a 1993 Nissan that is expected to run for another three years, but you are
considering buying a new Hyundai before the Nissan wears out. You intend to
donate the Nissan to a nearby charity when you buy the new car. The annual
maintenance cost for the new Hyundai is estimated to be $200 per annum. You
estimate that if you were to keep the old Nissan for the next three years, the
maintenance costs for the first year would be $1,500, $1,600 for the second, and
$1,800 for the final year. The price of your favorite Hyundai model is $18,000 and it
is expected to run for 15 years. Your opportunity cost of capital is 3 percent. Ignore
tax. When should you buy the new Hyundai?

Solution:

NPV of cost of the new car is:

NPV(Hyundai)= -18,000 + 200*(((1.03)15-1) / ((1.03)15*0.03)) = 20,387.59 (2 marks)

EAC of the new car is:

EAC(Hyundai) = 20,387.59*0.03*((1.03)15) / ((1.03)15-1) = 1,707.8 (2 marks)

Decision: Because the EAC for the new Hyundai is greater than the current annual
maintenance costs for the old Nissan (i.e. $1,707.80 > $1,500 and >$1,600), then you
should continue with the old car for another two years before replacing it. (2 marks)

(6 marks)

(Total = 15 marks)

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Question 5

(a) John is watching an old game show on rerun television called Lets Make a Deal in
which you have to choose a prize behind one of two curtains. One of the curtains will
yield a gag prize worth $150, and the other will give a car worth $7,200. The game
show has placed a subliminal message on the curtain containing the gag prize, which
makes the probability of choosing the gag prize equal to 75 per cent. What is the
expected value of the selection, and what is the standard deviation of that selection?

Solution:

E(prize) =0 .75($150) + (0.25) ($7,200) = $1,912.50

2prize = 0.75($150 $1,912.50)2 + (0.25) ($7,200 $1,912.50)2


= $9,319,218.75 =>
prize = ($9,319,218.75)1/2 = $3,052.74
(4 marks)

(b) The distribution of grades in an introductory finance class is normally distributed,


with an expected grade of 80. If the standard deviation of grades is 8, in what range
would you expect 90 per cent of the grades to fall?

Solution:

95% is 1.96 standard deviations from the mean


Lower bound: 80 1.96(8) = 64.32
Upper bound: 80 + 1.96(8) = 95.68
Range: 64.32 to 95.68
(3 marks)

(c) Given the returns and probabilities for the three possible states listed here, calculate
the covariance between the returns of Share A and Share B. For convenience,
assume that the expected returns of Share A and Share B are 9 per cent and 10 per
cent, respectively.

Probability Return(A) Return(B)


Good 0.35 0.20 0.30
OK 0.50 0.10 0.10
Poor 0.15 -0.20 -0.30

Solution:

Cov( R A , RB ) AB 0.35(0.2 0.09)(0.3 0.10) 0.5(0.1 0.09)(0.1 0.10)


0.15(0.20 0.09)(0.3 0.10) 0.0251
(2 marks)

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(d) Describe how investing in more than one asset can reduce risk through
diversification.

An investor can reduce the risk of his or her investments by investing in two or
more assets whose values do not always move in the same direction at the
same time. This is because the movements in the values of the different
investments will partially cancel each other out.

(2 marks)

(e) Describe the Capital Asset Pricing Model (CAPM) and what it tells us.

The CAPM is a model that describes the relation between systematic risk and
the expected return. The model tells us that the expected return on an asset
with no systematic risk equals the risk-free rate. As systematic risk increases,
the expected return increases linearly with beta. The CAPM is written as E(R i)
= Rrf + i(E(Rm) Rrf).
(3 marks)

[Total = 14 marks]

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Question 6

(a) What is the weighted average cost of capital?

The weighted average cost of capital (WACC) is the weighted average of the
costs to the different sources of capital used to fund a company, The WACC is
often used as an estimate of the cost of financing a new project given the
companys current mix of debt and equity.
(2 marks)

(b) Capital Ltd has a capital structure that is financed, based on current market values,
with 50 per cent debt, 10 per cent preference shares, and 40 per cent ordinary
shares. If the return offered to the investors for each of those sources is 8 per cent,
10 per cent, and 15 per cent for debt, preference shares, and ordinary shares,
respectively, then what is Capitals after-tax WACC? Assume that the companys
corporate tax rate is 30 per cent.

Solution:

WACC xdebt k debt (1 t ) x ps k ps xcs k cs =

WACC = 0.5x0.08x(1-0.3)+0.1x0.10+0.4x0.15=0.098 or 9.8%


(2 marks)

(c) A company financed totally with ordinary equity is evaluating two distinct projects.
The first project has a large amount of non-systematic risk and a small amount of
systematic risk. The second project has a small amount of non-systematic risk and a
large amount of systematic risk. Which project, if taken, will have a tendency to
increase the companys cost of capital?

Markets adjust the cost of capital according to the level of systematic risk in a
project. Therefore, the project with the greatest level of systematic risk will have the
greatest positive impact on the cost of capital for the company, even if it has the
lowest level of nonsystematic risk.

(2 marks)

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(d) You know that the return of Momentum Cyclicals ordinary shares reacts to
macroeconomic information 1.6 more times than the return of the market. If the
risk-free rate of return is 4 per cent and the market risk premium is 6 per cent, what
is Momentum Cyclicals cost of ordinary equity capital?

Solution:

We know that the beta for Momentum Cyclicals is 1.6, and we can use the
remaining information in the CAPM as follows:


E(Rcs ) = Rrf + E(Rm ) - Rrf
= 0.04 + 1.6(0.06) = 0.136 = 13.6
(2 marks)

(e) In your analysis of the cost of capital for an ordinary share, you calculate a cost of
capital using a dividend discount model that is much lower than the calculation for
the cost of capital using the CAPM model. Explain a possible source for the
discrepancy.

Solution:

Comparing the two formulas for the two methods, we have:

D
E(Rcs ) = Rrf + E(Rm ) - Rrf and k cs 1 g
Pcs
Given these two sources of information, we see that the only variable that we
are not able to get directly from the market is the growth rate in dividends
(note that future dividends are also a function of this growth rate), which is an
estimate. Since our dividend discount method provided a lower cost of capital
than the CAPM, it seems likely that we estimated the growth rate lower than
what the aggregate market has assumed. Of course, this assumes that the
market is efficiently pricing the share. If the market price is incorrect, then
this might lead to a difference.
(3 marks)

[Total = 11 marks]

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Question 7

(a) Under Modigliani and Millers Proposition 1, where all three of the assumptions
remain in effect, explain how the value of the company changes due to changes in
the proportion of debt and equity utilised by the company.

Under Modigliani and Millers Proposition 1, the value of the company is


independent of the proportion of debt and equity utilised by the company.

(2 marks)

(b) The weighted average cost of capital for a company, assuming all three Modigliani
and Miller assumptions hold, is 10 per cent. What is the current cost of equity capital
for the company if the cost of debt for the company is 8 per cent, given that the
company is financed by 80 per cent debt?

Using the formula given in the text:

kcs = iAssets + (VDebt /Vcs) x (iAssets iDebt)

ics = 0.10 + (0.8 / 0.2) x (0.10 0.08) = 0.18, or 18%


(2 marks)

(c) Blackwood Resources has a WACC of 12.6 per cent, and it is subject to a 30 per cent
corporate tax rate. Blackwood has $250 million of debt outstanding at an interest
rate of 9 per cent and $750 million of equity (market value) outstanding. What is the
expected return of the equity given this capital structure?

Solution:

Using the WACC formula when tax is included:


WACC = (1-tc) kd x (D/V) + ke (E/V)

We can solve for the missing variable:


0.126 = (1-0.3) 0.09 (250/ [250 + 750]) + ke (750/ [250 + 750])
ke = 0.147, or 14.7%
(3 mark)

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(d) Discuss how the legal costs of financial distress may increase with the
probability that a company will fall become insolvent, even if the company has not
reached the point of insolvency.

If a company is anticipating insolvency to a greater extent, then it will increase


its legal efforts to protect the company from creditors when and if the
company reaches that point. Therefore, the legal costs of insolvency will
increase with financial leverage even if the company has not yet declared
insolvency.

(2 marks)

(e) Albatross Ltd is currently valued at $900 million, but management wants to
completely pay off its perpetual debt of $300 million. Albatross is subject to a 30 per
cent corporate tax rate. If Albatross pays off its debt, what will be the total value of
its equity?

Albatross will be worth $900 million less the present value of the tax shield on
its current debt. The present value of the tax shield is
$300,000,000 x .3 = $90,000,000
Therefore, Albatross will be worth $810 million after the recapitalisation, and
since it will be an all-equity company, that will be the value of the equity.

(2 marks)

(Total = 11 marks)

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Question 8

(a) Dividend policy and company value: Explain how the repurchase new securities
by a company can produce useful information about the issuing company. Why does
this information make the shares of the company more valuable, even if this
information is confirmation of existing information about the company?

When issuing new securities, the issuing company must submit to a process
that amounts to a special audit by outsiders such as investment bankers and
other experts. This additional production of information increases the level of
monitoring concerning the companys actual financial status. In a sense, it
reduces the variability in the information that the company may already have
released. If the production of this information reduces the level of risk borne
by investors, then the issue of repurchasing new securities could actually
increase the value of the securities issued by the company and, in turn, the
total value of the company.
(3 marks)

(b)Dividends: A company announces that it will make a $1.00 dividend payment fully
franked at the company tax rate of 30 per cent. Assuming all investors are subject to
a 15 percent tax rate on dividends, how much should the companys share price
drop on the ex-dividend date?

Assuming that the $1 dividend paid is fully franked, the share price will drop
by approximately $1 plus tax credit of ($1.00 x 0.3)/(1-0.3) = $1.43. Since the
personal tax rate of all investors is less than the company tax rate, they will be
able to offset the tax credit against their other taxable income.
(2 marks)

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(c) Cholla Ltd currently has 30,000 shares outstanding. Each share has a market value of
$20. If the company buys back $150,000 worth of shares, what will be the value of
each share after the repurchase? Ignore tax.

The current value of all of the shares is 30,000 $20 = $600,000.


If the company repurchases $150,000 worth of shares, then it will repurchase
$150,000 / $20 = 7,500 shares.
Therefore, the value of all of the shares not purchased will be worth $150,000
less, or $450,000, and the price of each share will be $450,000 / (30,000
7,500) = $20 per share.

It seems logical, however, that if shares were worth $20 before the repurchase,
then they should be worth $20 after the repurchase since investors should be
indifferent between selling their shares to the company and retaining shares.

(3 marks)

(d) You are the CFO of a large publicly traded company. You would like to convey
positive information about the company to the market. If you intuitively understand
(and agree with) the results from the Lintner study, then will you keep paying your
currently high dividend or will you raise that dividend by a small amount?

Although the current high level of dividends certainly suggests that the
company has the ability to sustain a high payout to investors, that high payout
does not convey any new, positive information to the market. However, by
increasing the dividend, the CFO would be telling the market that the company
will be able to support an even higher level of cash payout in the future.
Therefore, you think it would be better to increase the dividend.

(2 marks)

(Total = 10 marks)

END OF EXAMINATION

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FORMULA SHEETS

FV P(1 rt ) D
P0
FV R
PV
(1 rt ) D0 (1 g )
P0
Rg
FV PV (1 i) n
P
FV V EPS
PV E
(1 i) n
n
NCFt
j
m NPV0 1 k t
NCF0
i 1 1 t 1

m
T
1 i r r1 r2 r1 1
i* 1 T1 T 2
1 p
FV PV e jn 1.5
1 Reducing balancerate
n
P n
i n 1
P0 (1 k ) t
NPV NPV0
(1 k ) 1
t
CF 1
PV 1
1 i n
i
NPV
EAV
1
FV
CF

(1 i) n 1 1

1


i k 1 k t
CF 1
PV CF 1 EAV k NPV
i (1 i) n 1
FC
CF 1 CashFlow DOL 1
1 n
EBITDA
PV
i (1 i)
(1 i) k 1 FC D & A
Accounting DOL 1
EBIT
CF FC
PV EBITDA Break Even
i Pr ice Unit VC

F
PB FC Alternative1 FC Alternative 2
(1 i ) n COEBITDA
UnitContri bution Alternative1 UnitContri bution Alternative 2

C 1 F
PB 1 n
FC D & A
i (1 i) 1 i n EBIT Break Even
Pr ice Unit VC

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FORMULA SHEETS (CONTINUED)


n
E[ RP ] wi E ( Ri )
i 1
n
E Ri pi Ri
i 1
n
2 (Ri E[ Ri ]) 2 pi
i 1

n
XY RXi E[ RX ] RYi E[ RY ] p( RX , RY )
i 1
XY
XY
XY

p2 w12 12 w22 22 2w1w2 12 1 2

E ( Ri ) rf i [ E ( Rm ) rf ]

E ( Rit ) R ft im [ E ( Rmt ) R ft ] is E[SMB] ih E[ HML]


n
p wi i
i 1
Cov( Ri , RM )
i
M2
D
k e k o (k o k d )
E
VL VU t c D
I
KD
VD
DPS
k PS
PPS

K OS r f i [ E ( Rm ) r f ]

D1
K OS g
P0

te tC (1 )
kcompany = xDebtkDebt + xEquitykEquity
WACC xDebt k Debtpretax(1 t e ) xpsk ps xOSkOS

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