MODULE CODE : FN2191
MODULE TITLE : Principles of Corporate Finance
DATE OF EXAM : 7 March 2024
Question 1
Cinnamon, a manufacturer of industrial freezers, has recently developed a new highly energy-efficient freezer, the HC. Market research has shown that demand for the HC may be high (4,800 units per year) or low (4,250 units per year). The probability of high demand is 40%. The firm is now considering whether or not to go ahead with a project to produce and sell the HC for a period of four years.
Each HC will be sold for $1,400. The variable production costs will be $900 per HC.
Cinnamon already owns a factory that can be used for the HC project. If Cinnamon does not go ahead with the project the factory could be sold now for $0.7 million.
The project would require machinery to be bought now at a cost of $4.3 million. At the end of four years the value of the machinery will be zero. For the purposes of tax, the firm can claim depreciation (capital allowances) on the machinery at 25% per year. Assume Cinnamon will have enough taxable capacity from other projects to take advantage of any additional tax breaks from the HC project.
All cash flows are assumed to occur at the end of the year except for those that would occur now. Cinnamon's cost of capital is 16% and the tax rate is 40%.
(a) If demand for the HC is high, what is the net present value (NPV) of the project? What is the NPV if demand is low? (12 marks)
(b) Calculate the probability of high demand at which the expected value of the NPV is zero. Should the firm undertake the project? Explain. (4 marks)
(c) Cinnamon discovers that because of the environmentally friendly nature of the project, it can claim a 100% capital allowance for the machinery in year 1 instead of claiming 25% in each year. By how much does this change the expected NPV of the project? Should the firm undertake the project? Explain. (6 marks)
(d) Cinnamon used a market research firm to estimate the demand for the HC, at an agreed price of $100,000. Cinnamon has paid the market research firm $70,000 to date. By how much does this information change the expected NPV of the project? Explain. (3 marks)
(Total = 25 marks)
Question 2
An entrepreneur has a choice of two mutually exclusive investment projects, Project A and Project B. Each lasts for one time period and the firm has no other projects. Project A will result in a cash flow of $27 million in the good state and $10 million in the bad state. Each outcome is equally likely. Project B will result in a cash of $34 million in the good state and zero in the bad state. Each outcome is equally likely. Assume the entrepreneur is able to choose which project to undertake after the finance has been raised.
Each project requires an initial investment of $6 million. Assume risk-neutrality and a discount rate of zero.
Assume for parts (a) and (b) that the investment is financed by debt, and that lenders are unaware of the existence of Project B at the time of financing.
(a) If Project A is chosen, what is the expected value of the firm and the payoffs to the debtholders and the entrepreneur? (3 marks)
(b) If Project B is chosen, what is the expected value of the firm and the payoffs to the debtholders and the entrepreneur? Which is the better project? Which one will the entrepreneur choose? (4 marks)
(c) Assume the debtholders are fully aware of the firm's possible investment choices. They decide to use a bond covenant to stipulate that the face value of the debt will be $9.2 million if the entrepreneur decides to take on the riskier project. Which project does the entrepreneur choose now? Is this different from your answer in part (b)? Why/why not? (5 marks)
(d) Suppose the entrepreneur chooses instead to finance the project with outside equity. Which project will be chosen? What fraction of the project's payoff will the outside equityholders ask for? What is the payoff to the entrepreneur and the expected value of the firm? (5 marks)
(e) Explain the risk-shifting (asset substitution) agency problem identified by Jensen and Meckling (1976), with reference to your results in parts (a) to (d). Is the solution to use as much outside equity as possible? Explain. (8 marks)
(Total = 25 marks)
Question 3
The firm Ragnar has announced an initial public offering of shares (IPO). The shares are being offered in the IPO at a price of $6 each. All potential investors know that at this price the share is either undervalued by $0.50 (probability 60%) or overvalued by $0.30 (probability 40%).
‘ Informed’ investors such as banks are able to distinguish whether the share is overvalued or undervalued. ‘ Uninformed’ investors are not able to do this. Demand from uninformed investors is sufficient to take up all the shares offered in the IPO. If the demand for the shares is greater than the number offered, the shares will be rationed.
You are an uninformed investor with $12,000 to invest. If rationing occurs you will only be able to buy 800 of Ragnar's IPO shares.
(a) By what percentage is the IPO underpriced/overpriced? (3 marks)
(b) What would be your expected profit if you were able to buy 2,000 of the IPO shares? Do you expect to be able to do this? Why/why not? (5 marks)
(c) As an uninformed investor, what is your expected profit from participating in the IPO? (5 marks)
(d) What would your expected profit be if the undervaluation is only $0.20 per share instead of $0.50, and everything else unchanged? What is the underpricing percentage now? (5 marks)
(e) Explain what is meant by the “winner's curse” in the context of IPOs, with reference to your answers for the previous parts of the question. Briefly discuss one other possible reason for the empirically observed underpricing of IPOs. (7 marks)
(Total = 25 marks)
Question 4
Dean plc is considering a takeover of Grange plc. Both companies are entirely equity financed. Information about Dean and Grange is shown below. Both companies have just paid a dividend and the next dividend payments are expected one year from now.
|
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Dean
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Grange
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Dividends per share (most recent)
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£0.750
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£0.380
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Number of shares
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10 million
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3 million
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Share price
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£23
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£10
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The dividends per share of Grange have been growing at a rate of 4% per year for the past few years. Following the takeover, it is believed that Grange's dividend per share will grow at a rate of 5.5% per year.
(a) Use the Dividend Growth model to estimate Grange's cost of equity (the required rate of return of Grange's shareholders). (3 marks)
(b) Assume that Grange's cost of equity does not change as a result of the takeover. What is the value of Grange's share after acquisition? What is the synergy gain of the acquisition? (4 marks)
(c) What is the premium paid by Dean if it pays $12.50 in cash for each Grange share? What is the gain for Dean's shareholders? What proportion of the synergy gain does this represent? (4 marks)
(d) What is the premium paid by Dean if it offers four of its own shares for every nine shares of Grange? What is the gain for Dean's shareholders? Should Dean acquire Grange using cash or a share offer? (6 marks)
(e) Discuss the advantages and disadvantages of each acquisition method to both Dean and Grange. (8 marks)
(Total = 25 marks)
Question 5
The firm Kappa has just decided to undertake a major new project. As a result, the value of the firm in one year's time will be either $120 million (probability 0.25), $250 million (probability 0.5) or $360 million (probability 0.25).
The firm is financed entirely by equity and has 10 million shares. All investors are risk-neutral, the risk-free rate is 4% and there are no taxes or other market imperfections.
(a) What is the value of the company and its share price? (4 marks)
Kappa decides to issue debt with face value $146 million due in one year and use the proceeds to repurchase shares now. Assume now that bankruptcy costs will be 15% of the value of the firm's assets in the event of default on debt repayment.
(b) What is the value of the debt now? What is its yield? (5 marks)
(c) What is the expected value of the firm and the price per share? How many shares will be repurchased? (5 marks)
(d) Assume Kappa decides instead to issue debt with face value $100 million due in one year and repurchase shares with the proceeds. What is the firm's value now? Why? What is its share price? (5 marks)
(e) Explain how the presence of corporate taxes would influence Kappa's restructuring decision. (6 marks)
(Total = 25 marks)
Question 6
A firm is considering a new project that would require an investment of $11 million today and would result in a certain cash flow of $14 million in one year.
Cash flows from the firm's existing projects next year are expected to be $60 million if the economy is in a good state and $20 million if it is bad. The probability of the good state is 70%.
The firm has existing debt with face value $45 million due in one year. To finance the new project it can issue new debt which will have a lower priority for payment in the event of bankruptcy.
Assume that investors are risk neutral and the appropriate discount rate is zero.
(a) What are the values of the firm's equity and debt without the new project? (3 marks)
(b) If the new project is undertaken, what will be the value of the firm's original debt? (4 marks)
(c) What payoff will the new lenders require in the good state of the economy? (5 marks)
(d) What will be the value of the firm's equity with the new project? (6 marks)
(e) Explain what is meant by debt overhang and briefly suggest how this problem might be reduced. Illustrate your answer with reference to your results in the previous parts of the question. (7 marks)
(Total = 25 marks)