Semester 1 2020 Past Exam paper (Question+ Answer) PDF

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Semester 1 2020 Past Exam paper (Question+ Answer)...

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The University of Melbourne Department of Finance Final Exam FNCE20005 CORPORATE FINANCIAL DECISION MAKING Semester ONE, 2020 Exam Duration: Three (3) Hours writing time 30 minutes for uploading answers Instructions to Candidates 1.

This is an OPEN BOOK examination.

2.

There is NO reading time.

3.

Once commenced, you MUST answer all the questions and upload the answers within three and half (3.5) hours. You can submit and re-submit answers within three and half (3.5) hours. The exam will be closed for submission at 15:00 PM AEST on Monday 22/06/2020.

4.

This examination contains TWO SECTIONS for a total of 100 marks. Marks Total Questions Required Section A 40 10 Attempt ALL questions 60 7 Attempt ALL questions Section B Total 100 17 Attempt ALL questions

5.

For answering questions in Section A: a. You MUST state “True” or “False” for each of the 10 questions, followed by your detailed explanation and/or calculation. b. Your explanation should be NO more than 100 words c. An incorrect or missing reason/explanation means NO MARKS. d. All answers MUST BE HANDWRITTEN, typed answers will be awarded ZERO marks. e. You can answer the questions using your preferred way, such as writing on pages or on digital devices. f. You are allowed to upload pages with answers to multiple questions on them. For example, if you answer questions A1, A2 and A3 on the same page, you are allowed to upload the same page for each of the questions A1, A2 and A3. g. You MUST make sure the uploaded page contains the complete answer to the relevant question. h. You MUST write a question number in front of your answer. i. You are not required to name the uploaded file.

6.

For answering questions in Section B: a. In order to get marks, you need to show your workings along with the final answer. b. All answers MUST BE HANDWRITTEN, typed answers will be awarded ZERO marks. c. You can answer questions using your preferred way, such as writing on pages or on digital devices. d. You MUST upload answers to each question individually. e. Answer to each question MUST start on a new page. f. You are not required to name the uploaded file.

7.

Please scan your answers using a scanner or a mobile device. Detailed instructions about scanning on mobile devices are available under Module “Final Exam Information” in Canvas. All submitted answers MUST BE LEGIBLE, as illegible (unreadable) answers will be awarded ZERO marks.

8.

Collusion between students is absolutely forbidden and will result in very serious consequences.

9.

The discussion board in CANVAS will be available during the exam period, subject coordinators and the tutor-in-charge will be there assisting in resolving issues related to exam contents. You can ONLY refer to the QUESTION NUMBER, you may not copy and post the question, also please make sure that the issue is clearly stated.

10.

Once you have commenced the exam, you must complete it within the time constraint. Please contact: 13MELB (+61 3 9035 5511) for assistance during the exam if you are experiencing technical difficulties. They will be able to contact your examiner during the duration of the examination. Do not contact your lecturer during the examination period.

2

Section A. A1. An increase in the price of the underlying asset always increases the intrinsic value of a call option and results in a higher total value of the option. • • •

False When the option is out of the money, the increase in share price only increases its time value, hence make the call more valuable. When the option is in the money, the increase in share price also increases its intrinsic value resulting in higher total value.

A2. Alibaba Group shares were listed on NASDAQ on September 18th, 2014. As the subscription price was $68 and the first day closing price - $93.89 - was higher than the subscription price, it entitled Alibaba to receive additional capital from NASDAQ. • •

False Transactions on listing day occurred in the secondary market with no involvement of Alibaba.

A3. Empirical evidence on the wealth effects of initial public offerings demonstrate that in the long run investors in US IPOs are, on average, much better off investing in the IPO firms (rather than in other similar non-IPO firms) because they earn positive returns. • •

False Even though IPO firms earn 21.9% return over three years, when compared to other similar firms they earn -7.1% return over 3 years

A4. IBM Inc, a large U.S. company, announced on June 1, 2015, that it would pay a cash dividend of $3.00 per share on July 15. Assume that dividend income for all IBM investors is taxed at 30%, and capital gains for all these investors are taxed at 35%. If the ex-dividend date was June 26, we would expect IBM’s stock price on June 26 to drop by more than $3.00. Do not consider other factors. • • •

True Using the dividend drop-off ratio formula, drop-off = (1-0.30)/(1-0.35) = 1.076 Hence the share price will drop more than $3.00

A5. One implication of the pecking order theory of capital structure is that debt should only be used as a last resort to finance projects as issuing new debt can lower a company’s overall debt rating and therefore increase its cost of capital. • • •

False Pecking order theory suggests that companies use debt as the second source of financing after the company is unable/unwilling to use internal funds to finance projects. It does not imply anything about changes in company’s overall debt rating.

A6. When managers are conducting net present value analysis of a project, they must also conduct real option analysis when there is high likelihood of new information arriving during the life of the project. • • •

False. Real option analysis is important if there is high uncertainty about the project’s future cash flow; And there is room for managerial flexibility.

3

A7. Black Ltd. has agreed to acquire White Ltd. using a scheme of arrangement. White Ltd. held an extraordinary general meeting to vote on the proposal and the meeting was attended by 431 of its shareholders who collectively owned 41 million shares. The proposal was approved by 233 of the attending shareholders who also owned 32.8 million shares in the company. As a result, Black Ltd. can automatically gain full control of White Ltd. • • •

False Although 75% of voting shares and 50% by number at the meeting approved the takeover; The proposal must still be approved by court.

A8. When compared with the Multiples method of valuation, the discounted cash flow (DCF) method allows the analyst to directly assess the effects of operational improvements and other synergistic efficiencies that may be implemented on a company and hence on its value. • •

True In a DCF set-up, the analyst can easily modify input variables such as growth (from year to year), reduction in costs, increase in operational efficiency (margins) etc. and compute the change in value of the target in the future.

A9. Existing shareholders are always worse off in an equity carve-out because part ownership of the parent’s subsidiary is sold to new (outside) investors. • • • •

False Instead of having 100% ownership of the asset, now the parent firm has the majority ownership (typically 80%) in the subsidiary and the cash from selling part of subsidiary’s shares. Total value of the parent firm may be higher because of the restructuring. Shareholders are not worse off because their ownership in the parent firm is not affected, and they still benefit from the subsidiary because of the parent’s ownership in the carved-out subsidiary.

A10. As exposure to higher risk is typically compensated by higher return, risk management by firms is pointless as the expected return will be close to the risk-free rate if all firm risks are eliminated. • • •

False Risk management is not to reduce all risks. Instead, it is to reduce risks the firm is not willing to be exposed to, ideally remove bad outcomes. Some desirable reasons for reducing risk can be to increase firm value via lower tax payment, lower bankruptcy cost, avoiding underinvestment problem, etc. etc.

4

Question B1 New Shoes Company is considering a plan to manufacture shoes made from composite materials. The required machinery to manufacture the shoes will cost $750,000. The machinery is expected to have a useful life of 3 years. Fixed costs associated with the project are estimated to be $70,000 per year. The variable cost is estimated to be $24 per pair of shoes and they are expected to sell for $42 per pair. The company has also estimated that it will sell around 40,000 pairs per year and its required rate of return is 12%. The board of directors, however, is concerned about future market conditions. As the company’s CFO, you have been asked by the board to answer the following question before they decide to proceed with the project – How bad can the sales price or variable cost get before the project NPV is zero? Conduct the appropriate analysis, as demonstrated in this subject’s lectures, to answer the question posed by the board. Additionally, what (if any) are limitations of your analysis? What, if any, method(s) can be used to address these limitations? [ 6+2 = 8 marks]

Solution: Sales price NPV = –$750 000 - $70 000 [

1

1− (1.12)3 0.12

] + [SP-$24] 40 000 [

1

1− (1.12)3 0.12

]=0

1. SP = $33.56 2. Compared with most likely (or expected) case, sale price decreases by 20% for NPV to equal zero

Variable cost NPV = –$750 000 - $70 000 [

1−

1 (1.12)3

0.12

] + [$42-$VC] 40,000 [

1−

1 (1.12)3

0.12

]=0

VC = 32.44; VC increases by (32.44-24)/24 = 35%. 1. VC = $32.44 2. Compared with most likely (or expected) case, variable cost increases by 35% for NPV to equal zero

Limitation: Break even analysis assumes that only one variable changes at a time. To address the limitation: Using simulation technique to allow for change of multiple variables.

5

Question B2 Tasty Pies is expanding its business and wants to open a new facility to make frozen pies, which requires a new automated pie maker. One such pie maker can be purchased for $300,000. Alternatively, it can be leased for $52,000 per year for seven years and lease rentals need to be paid annually in advance. The management informs you that the new pie maker can be fully depreciated to zero using the straight-line method over four years and that its scrap/residual value is expected to be $5,000 at the end of the lease. Tasty Pies has estimated that the appropriate after-tax opportunity cost of capital of the expansion is 19% per annum, and the net present value of the expansion is expected to $10,000.

Tasty Pies pays tax at the rate of 30% and it can borrow funds at a before-tax rate of 11% per annum. All cash-flows have been quoted on a before-tax basis. Would you recommend that Tasty Pies buy or lease the pie maker? What is the incremental wealth associated with your decision? Show all of your work. [10 marks] Solution: Y0 Cost +300000 Lease -52,000 payments Tax saving 15600 on LP Depreciation tax savings lost Scrap value Tax on gain NCF 263600

Y1

Y2

Y3

Y4

Y5

Y6

-52,000

-52,000

-52,000

-52,000

-52,000

-52,000

15600

15600

15600

15600

15600

15600

-22500

-22500

-22500

-22500

-58900

-58900

-58900

-58900

-36400

-36400

Y7

-5000 +1500 -3500

After tax cost of borrowing = 11 (1-0.3) = 7.7% per annum

NPV lease vs. buy = +𝟐𝟔𝟑𝟔𝟎𝟎 −

𝟓𝟖𝟗𝟎𝟎 𝟎.𝟎𝟕𝟕

[𝟏 −

𝟏 ] (𝟏+𝟎.𝟎𝟕𝟕)𝟒

−

𝟑𝟔𝟒𝟎𝟎

𝟏.𝟎𝟕𝟕𝟓

−

𝟑𝟔𝟒𝟎𝟎

𝟏.𝟎𝟕𝟕𝟔

𝟑𝟓𝟎𝟎

− 𝟏.𝟎𝟕𝟕𝟕 = $𝟏𝟔, 𝟔𝟕𝟗. 𝟏𝟏

Tasty Pies should lease the pie maker. Tasty Pies is better off by $16,679.11 if it leases the pie maker instead of buying it.

6

Question B3 ABC Inc. is a publicly listed company in Australia and pays corporate tax rate at a rate of 30%. The company conducted its first off-market share buyback on April 15, 2015 and the shareholders were invited to tender their shares between $3.40 and $4.20. ABC’s volume weighted average price over the five days before the announcement was $3.98 and over the period from the announcement to the close of the buyback the market index decreased by 0.8%. ABC announced the buyback price to be $3.40 with capital component of $0.95 and the rest will be treated a fully franked dividend. The buyback was conducted under tax determination TD 2004/22. John Major, who is a resident Australian investor, bought 200 shares in ABC at $1.25 per share on July 15, 2014 and sold all his shares in the buyback. You need to answer the following questions with regards to the buyback: (a) What was the per share capital gain or loss under the buyback for John Major? (b) Assume that John’s personal tax rate is 20%. What were the total after-tax proceeds that he received after selling all his shares in the buyback? Show all your calculations. [2+4 = 6 marks]

Solution a). Deemed consideration: 3.98(1-0.008) = 3.94816 Dividend component = 3.4 – 0.95 = 2.45 Deemed capital component = 3.94816 – 2.45 = 1.49816 Capital gain = 1.49816 – 1.25 = 0.24816 b). After tax proceeds from dividend = 2.45 + 0.3 (2.45/0.7) – 0.2 (2.45/0.7) = 2.80 After tax proceeds from cap gain/loss = 0.95 - 0.2 (0.24816) = 0.900368 per share. After tax proceeds = 2.8 + 0.900368 = $3.700368 per share Total after-tax proceeds = $740.07 for 200 shares.

7

Question B4 Fish Pies Inc. (FPI) has recently announced its intention to acquire Hamburgers ‘R Us (HRU). FPI has identified potential annual gains from the acquisition of $250,000 per annum forever, with the first cash flow occurring exactly four years after the acquisition. If the acquisition were to proceed, FPI will however incur re-organization and integration costs of $300,000 per annum at the end of the first two years after the acquisition. Information about the two companies’ relevant share prices and shares outstanding is provided below: Fish Pies Inc.

Hamburgers ‘R Us

Share price

$2.70

$5.50

Number of shares outstanding

15,000,000

1,200,000

FPI has also decided to make a cash bid for all outstanding shares of HRU and offers $6.40 per share to HRU shareholders. The appropriate opportunity cost of capital is 12% per annum. (a) Assuming the acquisition occurred immediately, calculate the gain from the acquisition. (b) Assuming the acquisition occurred immediately, calculate the total wealth impact for shareholders of Hamburgers ‘R Us. (c) Assuming the acquisition occurred immediately, calculate the total wealth impact of the proposed acquisition for shareholders of Fish Pies Inc. (d) The chairman of FPI’s board has been meeting with board members from HRU to discuss the proposed acquisition. After a couple of meetings, he makes the following statement: “I have had very friendly and cordial meetings with HRU. We have jointly determined that after accounting for all re-organization costs etc. the present value of total gains to be generated is $6,500,000. Given the co-operation offered by HRU, I have now decided not to proceed with a cash offer but to make a share offer instead. I need the answers to these TWO questions: i. What is the maximum exchange ratio that can be offered to HRU? ii. If we split the gains as 70% and 30% between FPI and HRU respectively, what is the appropriate stock exchange ratio to complete the acquisition under this arrangement. Assuming the bid were to proceed immediately, conduct all relevant analysis to provide the answer to the Chairman’s questions. [2+1+2+7 = 12 marks]

Solution a)

𝟐𝟓𝟎𝟎𝟎𝟎

𝑮𝒂𝒊𝒏 = (

𝟎.𝟏𝟐

∗

𝟏

𝟏.𝟏𝟐𝟑

𝟑𝟎𝟎𝟎𝟎𝟎

)−(

𝟏.𝟏𝟐

+

𝟑𝟎𝟎𝟎𝟎𝟎 𝟏.𝟏𝟐𝟐

) = $𝟗𝟕𝟓 ，𝟖𝟔𝟎

b) Premium paid is (6.4-5.5=$0.9) per share so total wealth impact for HRU shareholders is, 1,200,000 x $0.9 = $1.08 million 8

c) NPV = Gain - net cost Net cost = $7.68M – $6.6M = $1,080,000 NPV = 975,8760 - 1,080,000=$-104,140 = total wealth impact for FPI shareholders. d) Part i) Maximum net cost = $6.5 = b (40.5+6.6+6.5) - 6.6 =>b=0.244403 Initially there were 15m shares in FPI. After the bod, there will be 15m+X shares where X = the number of shares issued to HRU shareholders

X / [15m + X] = 0.244403 => X = 4.851852m There were 1.2 million HRU shares, therefore the exchange ratio is 4.04321 FPI shares for 1 HRU share.

Part ii) The gain of $6.5m is split 70/30 between FPI and HRU FPI = $4.55m; HRU = $1.95m Net cost to FPI = 1.95 = b (40.5 + 6.6 + 6.5) – 6.6 => b=0.159515 Initially there were 15,000,000 shares in FPI. After the bid, there will be 15m + X shares where X = the number of shares issued to HRU shareholders. X / [15m + X] = 0.159515 => X = 2.846838m There were 1.2 million HRU shares, therefore the exchange ratio is 2.372365 FPI shares for 1 HRU share.

9

Question B5 ABC Inc. is proposing to acquire XYZ Inc. by offering one share of ABC for every three shares of XYZ. Both companies are listed on the stock exchange and the table below provides some financial information about the two companies: ABC Inc.

XYZ Inc.

Current stock price

$120

$25

Number of shares outstanding

300,000

200,000

Earnings per year ($)

$2.5 million

$900,000

An independent analyst has looked at the terms and possible outcomes from the deal. He conducts further independent analysis of what will happen if the merger goes through and concludes the following: •

The EPS of the combined entity will increase to $12.20 per share and the P/E ratio will change to 9.90.

Using the information about the 2 companies as provided above, and the analyst’s estimates of the combined entity’s EPS and P/E ratio, determine if there is any value created from the transaction? If yes, estimate the value (in $ terms) created by the proposed transaction. Show all workings. [6 marks]

Solution: 1 ABC shares for every 3 XYZ shares ➔total of 200,000 / 3 = 66,667 ABC shares issues ➔total of 366,667 ABC shares after the acquisition Share price of combined entity after acquisition = 12.2 * 9.9 = $120.78 Total Market Value of the combined entity after acquisition = $120.78 * 366,667 = $44,286,040 Market value of ABC before acquisition = $120 * 300,000 = $36 million Market value of XYZ before acquisition = $25 * 200,000 = $5 million Synergy = $44,286,040 – ($36 million + $5 million) = $3,286,040 The value created from the transaction is $3,286,040.

10

Question B6 Amusement Inc. is evaluating an investment opportunity in regional Darwin that is currently being promoted by Commonwealth government. The project has a 10-year life and requires initial investment of $4.5 million and a rehabilitation cost of $1.5 million at the end of the project life. If the net cash flow at the end of the first year is $1.5 million (project is successful), the net cash flows will be $2.5 million...