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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.

TITLE OF PAPER: Corporate Finance

EXAM DURATION: 3 hours

READING TIME: 10 minutes

THIS PAPER IS FOR STUDENTS STUDYING AT: (office use only - tick where applicable)

Caulfield Gippsland Sunway Open Learning

During an exam, you must not have in your possession, a book, notes, paper, calculator, pencil case,

mobile phone or any other material/item which has not been authorised for the exam or specifically

permitted as noted below. Any material or item on your desk, chair or person will be deemed to be in

your possession. You are reminded that possession of unauthorised materials in an exam is a

disciplinable offence under Monash Statute 4.1.

AUTHORISED MATERIALS

CALCULATORS YES NO

(If YES, only calculators with an 'approved for use' Faculty label are permitted)

if yes, items permitted are:

This paper consists of eight (8) questions printed on a total of ten (10) pages.

Students must attempt to answer ALL questions.

PLEASE CHECK THE PAPER BEFORE COMMENCING. THIS IS A FINAL PAPER. THIS EXAMINATION

PAPER MUST BE INSERTED INTO THE ANSWER BOOK AT THE COMPLETION OF THE PAPER. NO

EXAMINATION PAPERS SHOULD BE REMOVED FROM THE EXAMINATION ROOM

AFC2140 Page 1 of 17

OFFICE USE ONLY

Question 1

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

and companies.

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)

OFFICE USE ONLY

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?

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)

OFFICE USE ONLY

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?

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

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)

OFFICE USE ONLY

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)

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)

OFFICE USE ONLY

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?

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:

(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)

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)

solution and workings)

Technology 2 has the higher NVP() therefore it should be selected over Technology

1. (1 marks)

(9 marks)

OFFICE USE ONLY

(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:

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)

OFFICE USE ONLY

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:

= $9,319,218.75 =>

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

(4 marks)

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:

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.

Good 0.35 0.20 0.30

OK 0.50 0.10 0.10

Poor 0.15 -0.20 -0.30

Solution:

0.15(0.20 0.09)(0.3 0.10) 0.0251

(2 marks)

OFFICE USE ONLY

(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]

OFFICE USE ONLY

Question 6

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:

(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)

OFFICE USE ONLY

(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:

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]

OFFICE USE ONLY

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.

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?

(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:

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

0.126 = (1-0.3) 0.09 (250/ [250 + 750]) + ke (750/ [250 + 750])

ke = 0.147, or 14.7%

(3 mark)

OFFICE USE ONLY

(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.

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)

OFFICE USE ONLY

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)

OFFICE USE ONLY

(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.

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

OFFICE USE ONLY

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

OFFICE USE ONLY

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

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

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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