ECON366 - KONSTANTINOS KANELLOPOULOS



INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.

COURSE: MBA-680-50-F12 Corporate Financial Theory

SEMESTER: I, 2012

Revision for the Final Exam

(with results)

Konstantinos Kanellopoulos

12th December 2012

PART I EXERCISES FROM CHAPTERS 18-19-26-27-33

Exercise 1 – Chapter 18

“I was amazed to find that the announcement of a stock issue drives down the value of the issuing firm by 30%, on average, of the proceeds of the issue. That issue cost dwarfs the underwriter’s speed and the administrative costs of the issue. It makes common stock issues prohibitively expensive”.

a) You are contemplating a $100 million stock issue. On past evidence, you anticipate that announcement of this issue will drive down stock price by 3% and that the market value of your firm will fall by 30% of the amount to be raised. On the other hand, additional equity funds are necessary to fund an investment project that you believe has a positive NPV of $40 million. Should you proceed with the issue?

b) Is the fall in market value on announcement of a stock issue an issue cost in the same sense as an underwriter’s spread? Respond to the quote that begins this question.

Use your answer to (a) as a numerical example to explain your response to (b).

Solution Other things equal, the announcement of a new stock issue to fund an investment project with an NPV of $40 million should increase equity value by $40 million (less issue costs). But, based on past evidence, management expects equity value to fall by $30 million. There may be several reasons for the discrepancy:

i) Investors may have already discounted the proposed investment. (However, this alone would not explain a fall in equity value.)

ii) Investors may not be aware of the project at all, but they may believe instead that cash is required because of, say, low levels of operating cash flow.

iii) Investors may believe that the firm’s decision to issue equity rather than debt signals management’s belief that the stock is overvalued.

If the stock is indeed overvalued, the stock issue merely brings forward a stock price decline that will occur eventually anyway. Therefore, the fall in value is not an issue cost in the same sense as the underwriter’s spread. If the stock is not overvalued, management needs to consider whether it could release some information to convince investors that its stock is correctly valued, or whether it could finance the project by an issue of debt.

Exercise 2 – Chapter 18

Compute the present value of interest tax shields generated by these three debt issues. Consider corporate taxes only. The marginal tax rate is Tc = .35.

c) A $1,000, one year loan at 8%.

d) A five-year loan of $1,000 at 8%. Assume no principal is repaid until maturity.

e) A $1,000 perpetuity at 7%.

Solutuion a. [pic]

b. [pic]

c. PV(tax shield) = TC D = $350

Exercise 3 – Chapter 18

Ronald Masulis has analyzed the stock price impact of exchange offers of debt for equity or vice versa. In an exchange offer, the firm offers to trade freshly issued securities for seasoned securities in the hands of investors. Thus, a firm that wanted to move to a higher debt ratio could offer to trade new debt for outstanding shares. A firm that wanted to move to a more conservative capital structure could offer to trade new shares for outstanding debt securities.

Masulis found that debt for equity exchanges were good news (stock price increased on announcement) and equity for debt exchanges were bad news.

f) Are these results consistent with the trade-off theory of capital structure?

g) Are the results consistent with the evidence that investors regard announcements of (i) stock issues as bad news, (ii) stock repurchases as good news, and (iii) debt issues as no news, or at most trifling disappointments?

h) How could Masulis’s results be explained?

Solution

a. Masulis’ results are consistent with the view that debt is always preferable because of its tax advantage, but are not consistent with the ‘tradeoff’ theory, which holds that management strikes a balance between the tax advantage of debt and the costs of possible financial distress. In the tradeoff theory, exchange offers would be undertaken to move the firm’s debt level toward the optimum. That ought to be good news, if anything, regardless of whether leverage is increased or decreased.

b. The results are consistent with the evidence regarding the announcement effects on security issues and repurchases.

c. One explanation is that the exchange offers signal management’s assessment of the firm’s prospects. Management would only be willing to take on more debt if they were quite confident about future cash flow, for example, and would want to decrease debt if they were concerned about the firm’s ability to meet debt payments in the future.

Exercise 4 – Chapter 18

The Salad Oil Storage (SOS) Company has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the ropes yet. Explain:

a) Why SOS stockholders could lose by investing in a positive-NPV project financed by an equity issue.

b) Why SOS stockholders could gain by investing in a negative-NPV project financed by cash.

c) Why SOS stockholders could gain from paying out a large cash dividend.

Solution

a. SOS stockholders could lose if they invest in the positive NPV project and then SOS becomes bankrupt. Under these conditions, the benefits of the project accrue to the bondholders.

b. If the new project is sufficiently risky, then, even though it has a negative NPV, it might increase stockholder wealth by more than the money invested. This is a result of the fact that, for a very risky investment, undertaken by a firm with a significant risk of default, stockholders benefit if a more favorable outcome is actually realized, while the cost of unfavorable outcomes is borne by bondholders.

c. Again, think of the extreme case: Suppose SOS pays out all of its assets as one lump-sum dividend. Stockholders get all of the assets, and the bondholders are left with nothing.

Exercise 5 – Chapter 19

Calculate the weighted average cost of capital (WACC) for Federated Junkyards of America, using the following information:

i) Debt: $75,000,000 book value outstanding. The debt is trading at 90% of book value. The yield to maturity is 9%.

j) Equity: 2,500,000 shares selling at $42 per share. Assume the expected rate of return on Federated’s stock is 18%.

k) Taxes: Federated’s marginal tax rate is Tc = .35.

Solution

Market values of debt and equity are D =0 .9*75 = $67.5 million and E= 42* 2.5 =$105 million. D/V= .39.

WACC=.09*(1-0.35)*.39+0.18*0.61=0.1325, or 13.25%. The key assumptions: stable capital structure (D/V constant); Federated will pay taxes at 35% marginal rate in all relevant future years; use WACC as discount rate for projects with same risk as average of firm’s assets.

Exercise 6 – Chapter 19

The WACC formula seems to imply that debt is “cheaper” than equity – that is, that a firm with more debt could use a lower discount rate. Does this make sense? Explain briefly.

Solution

Debt is tax deductible – Initially it is good to use some debt in the capital structure. But there is a point where the advantages of using debt are counterbalanced by their disadvantages, especially when there is a case of a high debt ratio.

Exercise 7 – Chapter 19

The Bunsen Chemical Company is currently at its target debt ratio of 40%. It is contemplating a $1 million expansion of its existing business. This expansion is expected to produce a cash inflow of $130,000 a year in perpetuity.

The company is uncertain whether to undertake this expansion and how to finance it. The two options are a $1 million issue of common stock or a $1 million issue of 20-year debt. The flotation costs of a stock issue would be around 5% of the amount raised, and the flotation costs of a debt issue would be around 1½ %.

Bunsen’s financial manager, Miss Polly Ethylene, estimates that the required on the company’s equity is 14%, but she argues that flotation costs increase the cost of new equity to 19%. On this basis, the project does not appear viable.

On the other hand, she points out that the company can raise new debt on a 7% yield, which would make the cost of new debt 8½ %. She therefore recommends that Bunsen should go ahead with the project and finance it with an issue of long-term debt. Is Miss Ethylene right? How would you evaluate the project?

Solution

Note the following:

• The costs of debt and equity are not 8.5% and 19%, respectively. These figures assume the issue costs are paid every year, not just at issue.

• The fact that Bunsen can finance the entire cost of the project with debt is irrelevant. The cost of capital does not depend on the immediate source of funds; what matters is the project’s contribution to the firm’s overall borrowing power.

• The project is expected to support debt in perpetuity. The fact that the first debt issue is for only 20 years is irrelevant.

Assume the project has the same business risk as the firm’s other assets. Because it is a perpetuity, we can use the firm’s weighted-average cost of capital. If we ignore issue costs:

WACC = [rD ( (1 – TC) ( (D/V)] + [rE ( (E/V)]

WACC = [0.07 ( (1 – 0.35) ( 0.4] + [0.14 ( 0.6] = 0.1022 = 10.22%

Using this discount rate:

[pic]

The issue costs are:

|Stock issue: |0.050 ( $1,000,000 = $50,000 |

|Bond issue: |0.015 ( $1,000,000 = $15,000 |

Debt is clearly less expensive. Project NPV net of issue costs is reduced to:

($272,016 – $15,000) = $257,016. However, if debt is used, the firm’s debt ratio will be above the target ratio, and more equity will have to be raised later. If debt financing can be obtained using retaining earnings, then there are no other issue costs to consider. If stock will be issued to regain the target debt ratio, an additional issue cost is incurred.

A careful estimate of the issue costs attributable to this project would require a comparison of Bunsen’s financial plan ‘with’ as compared to ‘without’ this project.

Exercise 8 – Chapter 27

Blades plc would like to speculate on the anticipated movement of the bahlt currency against the British pound. Blades plc expects that the bahlt currency would move from a current level of 0.0147 British pounds to the level of 0.0133 British pounds within the next 30 days. The following interbank lending and borrowing rates exist:

|Currency |Lending rate |Borrowing rate |

|British pounds |8.1% |8.2% |

|Thai bahlt |14.8% |15.4% |

Assume that Blades plc has a borrowing capacity of either 7 million British Sterling or the bahlt equivalent of this amount, depending on which currency it wants to borrow. How could Blades plc capitalize on its expectations without using deposited funds? Estimate the speculative profits (in pounds) that could be generated from this strategy.

|Solution | |

|Depreciation of the Baht from £0.0147 to £0.0133 | |

| | |

|1. Borrow Thai baht (£7,000,000/0.0147) |476,190,476 |

| | |

|2. Convert the Thai baht to pounds 476,190,476 baht× £0.0147). |7,000,000 |

| | |

|3. Lend the pounds at 8.10% annualized, which represents a 0.68% return over | |

| the 30-day period [computed as 8.10% × (30/360)]. After 30 days, Blades | |

| would receive (£7,000,000 × (1 + .0068)) |7,047,600.00 |

| | |

|4. Use the proceeds of the dollar loan repayment (on Day 30) to repay the | |

| baht borrowed. The annual interest on the baht borrowed is 15.40%, or 1.28% | |

| over the 30-day period [computed as 15.40% × (30/360)]. The total baht | |

| amount necessary to repay the loan is therefore (476,190,476 × (1 + .0128)) |482,285,714 |

| | |

|5. Number of pounds necessary to repay baht loan (482,285,714 baht× £0.0133) |6,414,400 |

| | |

|6. Speculative profit (£7,047,600 – £6,414,400) |£633,200 |

Chapter 26 – Multiple choice questions

1. Suppose you borrow $95.24 for one year at 5% and invest $95.24 for two years at 7%. For the time period beginning one year from today, you have: (approximately) 

a. Borrowed at 7%

b. Invested at 7%

c. Borrowed at 9%

d. Invested at 9%

 +95.24(1.05) (-100; 95.24(1.07)(1.07) (+109.04; i.e. (Invest at 9%)

2. Firm A is paying a fixed $700,000 in interest payments, while Firm B is paying LIBOR plus 50 basis points on $10,000,000 loans. The current LIBOR rate is 6.25%. Firm A and B have agreed to swap interest payments, how much will be paid to which Firm this year? 

a. A pays $750,000 to Firm B

b. B pays 25,000 to Firm A

c. B pays $50,000 to Firm A

d. A pays $25,000 to Firm B

Floating rate = 6.75%; Interest cost = $675,000; Fixed rate = 7.0%; Interest cost = $700,000; A pays $25,000 to B

3. First National Bank has made a 5-year, $100 million fixed-rate loan at 10%. Annual interest payments are $10 million, and all principal will be repaid in year 5. The bank wants to swap the fixed interest payment into floating-rate payments. If the bank could borrow at a fixed rate of 8% for 5 years, what is the notional principal of the swap? 

a. $80 million

b. $100 million

c. $125 million

d. $180 million

10/0.08 = 125

4. Third National Bank has made 10-year, $25 million fixed-rate loan at 12%. Annual interest payments are $3 million, and all principal will be repaid in year 10. The bank wants to swap the fixed interest payments into floating-rate payments. If the bank could borrow at a fixed rate of 10% for 10 years, what is the notional principal of the swap? 

a. $40 million

b. $20 million

c. $25 million

d. $30 million

3/0.1 = 30

Chapter 27 – Multiple choice questions

1. If a Big Mac costs C$3.00in Canada and $2.31 in the USA, according to purchasing power parity, what is the implied exchange rate in C$/US$? 

a. 1.2987

b. 0.725

c. 1.3276

d. None of the above

C$/US$ = 3/2.31 = 1.2987

 

2. The Mexican economy is predicted to average double digit inflation over the next two years of 10% per annum. The inflation forecast for the US is 4% per annum. If the current exchange rate is $0.091/peso, what will be the exchange rate two years from now? 

a. $0.0831

b. $0.08134

c. $0.1018

d. None of the above

E(Spot) = (0.091)[(1.04/1.10)^2] = $0.08134/peso

3. Currency risk exposure can be categorized as: 

a. Transactions exposure

b. Economic exposure

c. Translation exposure

d. All of the above

The correct answer is D.

4. XJ Company from the USA is evaluating a proposal to build a new plant in the United Kingdom. The expected cash flows in pounds are as follows: Year 0, -50; Year 1, 25; Year 2, 35; Year 3, 40. The discount rate in BP is 14% and the discount rate in the US$ is 12%. The spot rate is US$1.99/BP. Calculate the NPV of the project in BP: 

a. +28.69

b. +25.86

c. +42.67

d. None of the above

 NPV = -50 + (25/1.14) + (35/1.14^2) + (40/1.14^3) = 25.86

5. XJ Company from the USA is evaluating a proposal to build a new plant in the United Kingdom. The expected cash flows in pounds are as follows: Year 0, -50; Year 1, 25; Year 2, 35; Year 3, 40. The discount rate in BP is 14% and the discount rate in the US$ is 12%. The spot rate is US$1.99/BP. Calculate the NPV in US$: 

a. +25.86

b. +28.69

c. +51.46

d. None of the above

(25.86)(1.99) = 51.46

6. Assume that international capital markets are competitive and that the real interest rates are the same. The one-year interest rate is approximately 9% in the USA and 5% in Switzerland. If the expected inflation rate is 6% in the USA, what is the expected inflation rate in Switzerland? (Approximately) 

a. 16%

b. 10%

c. 2.1%

d. None of the above

Real interest rate = [1.09/1.06] - 1 = 2.83%; Inflation rate = [1.05/1.0283] - 1 = 2.1%

Chapter 33 – Multiple choice questions

1. Which of the following statement(s) is(are) true about company financing in the U.S.A.? I) The U.S.A. has a large amount of bank loans outstanding II) The U.S.A. has a large stock market III) The U.S.A. has a large bond market 

a. I only

b. II only

c. I,II and III

d. II and III only

C is correct.

2. Individual investors in the U.S.A. can play an important part in corporate governance because: I) A large fraction of households' portfolio is held directly in equity securities II) A large fraction of households' portfolio is held in pension funds III) A large fraction of households' portfolio is held directly in bank deposits 

a. I only

b. II only

c. III only

d. II and III only

A is correct.

3. Large firms in Germany have: I) The board of directors II) The supervisory board III) The management board 

a. I only

b. II only

c. III only

d. II and III only

D is correct.

4. The banking system in Germany is: 

a. Nationally chartered banking system

b. Dual banking system

c. Universal banking system

d. State chartered system

C is correct.

5. A firm whose only asset is controlling blocks of shares in other firms is called: 

a. A conglomerate

b. A holding company

c. A pyramid

d. Dual-class company

B is correct

6. Large business combinations in Japan are normally carried out through reciprocal ownership of common stock. These networks, or keiretsu, involve a large number of diversified companies centered around a large bank, industrial firm, or trading firm. One of the main benefits of this structure is argued to be: 

a. The monopolistic control of economic segments

b. The reduction of financial distress costs

c. Large scale diversification that cannot be done by individual shareholders

d. Greater efficiency in management because the management skills are homogeneous even for

B is correct

7. The idea that a corporation's financial goal is to "maximize stockholder value" is more prevalent in: I) the U.S.A II) the U.K. III) France IV) Japan 

a. I and II only

b. II and III only

c. III and IV only

d. II and IV only

A is correct

8. The following are sources of financing for corporations: I) Households II) Financial institutions III) Other corporations 

a. I only

b. II only

c. III only

d. I, II, and III

D is correct

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