AC3059: Consider an all-equity firm Whose only Asset is the Option to Invest in one of two Mutually Exclusive Projects: Financial management Assignment, UOL, Singapore

Learning outcomes
At the end of the course and having completed the essential reading and activities, you should be able to:

• describe how different financial markets function
• estimate the value of different financial instruments (including stocks and bonds)
• make capital budgeting decisions under both certainty and uncertainty
• apply the capital assets pricing model in practical scenarios
• discuss the capital structure theory and dividend policy of a firm
• estimate the value of derivatives and advise management how to use derivatives in risk management and capital budgeting
• describe and assess how companies manage working capital and short-term financing
• discuss the main motives and implications of mergers and acquisitions
• integrate subject matter studied on related modules and demonstrate the multi-disciplinary aspect of practical financial management problems
• use academic theory and research to question established financial theories
• be more proficient in researching materials on the internet and Online Library
• use excel for statistical analysis.

Zone A

Question 1
Consider an all-equity firm whose only asset is the option to invest in one of two mutually exclusive projects. Each project requires an investment today of £400m. Next year, project A pays £520m with a probability of 80% and £200m with a probability of 20%. Next year, project B pays £800m with a probability of 20% and £200m with a probability of 80%. After these cash flows, the firm will be shut down. There are no taxes, depreciation, or any other benefit or cost.

To implement one of these projects, the firm must raise debt financing. Note that the managers of the firm act in the interest of the equity holders and that project choice occurs after debt financing is granted, so debtholders cannot control project choice after financing. However, debtholders can rationally anticipate the actions of managers.

Assume that all cash flows are discounted at 0%.

Required:
(a) Compute the NPVs of the two projects. Which project is better?

(b) Show that the firm will be able to raise £400m today via the issue of debt by offering to invest in project A. Compute the face value of the debt required by lenders.

(c) Compute the NPVs of the two projects to the equity holders after debt financing has been granted. Which project is the best one for equity holders?

(d) Show that the firm will not be able to raise £400m today via the issue of debt if debtholders are aware that project B is available for investment too.

(e) Using your answers to previous parts of the question, briefly comment on the following statement: ‘Some firms may be excluded from debt markets, i.e. there is no interest rate at which lenders are willing to lend to them’. Which firms are most likely to be excluded?.

Question 2

Answer all parts of this question.

(a) Consider a two-period binomial setting. The current price of a stock is e80. For each of the next two periods, the stock will either move up by 10% or down by 10%. The risk-free rate per period is 5%. Assume that the stock pays no
dividend.

i. Using the risk-neutral method, price a two-period at-the-money European put.

ii. If the put option in part i. was American, would you wish to exercise early? If so, how would this affect the option’s premium?

(b) If an investor can construct a portfolio of stocks that has a long-run mean return that is reliably above the mean return of the market, is this evidence that the investor has some skill in picking stocks? Justify your answer.

Question 3
Suppose company Alpha is considering a takeover of company Beta that is deeply burdened with debt and is on the verge of bankruptcy. Alpha generates a perpetual free cash flow of US$ 10m per year and the required return on equity is 5%. In addition to the free cash flow, Alpha has US$ 50m of cash inside the company. Alpha is all-equity financed, with 10m shares. Beta has a 90% market leverage ratio and 1m shares currently traded at US$ 15 per share. The takeover will improve the value of Beta’s assets by 10%. Assume that shareholders of Alpha and Beta will equally share the gain in this takeover.

Required:

(a) What is the market value of Beta’s assets without a takeover? What is the price Does that Alpha pay for Beta’s total equity?

(b) Suppose Alpha uses cash in the corporate account to take over Beta’s existing shares. How much should Alpha pay for each share of Beta? What is the capital structure of the merged company? What is the share price of the post-takeover Alpha?

(c) Suppose Alpha issues equity to compensate Beta’s shareholders. How many shares of Alpha per one share of Beta should be issued to Beta’s shareholders? What is the ownership structure and capital structure of the merged company?

Question 4
Silkroad is a family business and wholesaler, importing silk fabric from Far Eastern countries, and selling on to specialist curtain and upholstery retailers. During the year ended 31 December 2018, the business entered into a new contract with local branches of a national retail chain. The business also expanded its warehouse and automated its office processes in the year.

Summarised financial statements for 2018 and 2017 for the business are as follows:

Required:
(a) Calculate the following ratios for Silkroad for the financial years ended 31 December 2018 and 2017:
i. Return on Equity
ii. Return on Capital Employed
iii. Net profit Margin
iv. Gross Profit Margin

v. Administrative Expenses as a Percentage of Revenue
vi. Distribution Costs as a Percentage of Revenue
vii. Asset Turnover
viii. Leverage.

(b) Using both the summarised financial statements and the ratios from part (a), produce a report that provides an analysis of the financial performance of Silkroad for the year ended 31 December 2018 in comparison with the previous year.

Question 5
The Running for Life Centre is considering replacing its treadmills and is faced with a choice between two models: the Track model costing £800 per machine and the Pro model costing £1,400 per machine. The Pro model is sturdier and the cost of maintenance per machine is £50 per year. The Track model is less robust and requires more maintenance costing £75 per machine per year. The Track model is also less durable. The Running for Life Centre estimates that it would need to replace the Track machines after 3 years of use and that it would need to buy 30 machines to ensure that enough are working at any particular time.

The Pro model would last 4 years and only 25 machines would be needed. All other revenue and costs for the Running for Life Centre would remain the same. The required discount rate for this project is 10%.

Required:
(a) On the basis of the information provided, which machine should the Running for Life Centre buy? Explain.

(b) What other information would you consider before making a decision?

Question 6
Answer all parts of this question.

(a) The stock of DRAM PLC is currently selling for £20 per share. Earnings per share in the coming year are expected to be £3.50. The company, whose capital structure consists solely of equity, has a policy of paying out 25% of its earnings each year in dividends. The remaining part is retained and invested in projects that earn a 5% internal rate of return per year. This situation is expected to continue indefinitely.

i. Show that the growth rate g in earnings that is consistent with a pay-out ratio PYT and return on equity ROE is g = (1 − P Y T ) × ROE.

ii. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth Dividend Discount Model, what rate of return do DRAM’s investors require?

iii. By how much would DRAM’s stock price change if all its earnings were paid as dividends and nothing were reinvested?

(b) Clearstream has made the decision to invest in a new project with a high positive NPV. Before the investment decision has been announced to the public, a director of Clearstream however buys shares under an assumed name and makes an enormous profit by selling them just after the new investment is eventually disclosed to the world but before the project generates any cash flow. What do these facts tell us about the efficiency of this stock market?

Question 7
Give your views and reasons as to whether or not the London or New York stock markets will ever become completely ‘semi-strong efficient as defined by the efficient market hypothesis

Zone B

Question 1
The Fitness Centre is considering replacing its treadmills and is faced with a choice between two models: the Track1 model costing £900 per machine and the ProFitness model costing £1,400 per machine. The ProFitness model is sturdier and the cost of maintenance per machine is £50 per year. The Track1 model is less robust and requires more maintenance costing £70 per machine per year. The Track1 model is also less durable. The Fitness Centre estimates that it would need to replace the Track1 machines after 3 years of use and that it would need to buy 30 machines to ensure that enough are working at any particular time. The ProFitness model would last 4 years and only 25 machines would be needed. All other revenue and costs for the Fitness Centre would remain the same. The required discount rate for this project is 10%.

Required:
(a) On the basis of the information provided, which machine should the Fitness Does Centre buy? Explain.

(b) What other information would you consider before making a decision?

Question 2
Rally is an all-equity firm with assets worth $25 billion and 10 billion shares outstanding. Rally plans to borrow $10 billion and use these funds to repurchase shares. The firm’s corporate tax rate is 35%, and Rally plans to keep its outstanding debt equal to $10 billion permanently.

Required:
(a) Without the increase in leverage, what would Rally’s share price be?

(b) Suppose Rally offers $2.75 per share to repurchase its shares. Would
Do shareholders sell for this price?

(c) Suppose Rally offers $3.00 per share, and shareholders tender their shares at this price. What will Rally’s share price be after the repurchase?

(d) What is the lowest price Rally can offer and have shareholders tender their
shares? What will its stock price be after the share repurchase in that case?

Question 3
The stock of DRAM PLC is currently selling for £20 per share. Earnings per share in the coming year are expected to be £3.50. The company, whose capital structure consists solely of equity, has a policy of paying out 25% of its earnings each year in dividends. The remaining part is retained and invested in projects that earn a 5% internal rate of return per year. This situation is expected to continue indefinitely.

(a) Show that the growth rate g in earnings that is consistent with a payout ratio PYT and return on equity ROE is g = (1 − P Y T ) × ROE.

(b) Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth Dividend Discount Model, what rate of return do DRAM’s investors require? Explain.

(c) By how much would DRAM’s stock price change if all its earnings were paid as dividends and nothing was reinvested? Explain.

(d) If the company were to increase its dividend payout ratio to 40%, what would happen to its stock price?

Question 4
The following financial information relates to the financial position and performance of Eagle Plc, a UK-domiciled financial investment group, for the year to 31 July 2018 and 2017.

Required:
(a) Calculate (to two decimal points) the following ratios for Eagle plc for both 2018 and 2017:
i. Return On Equity
ii. Return On Capital Employed
iii. Net Margin
iv. Current Ratio
v. Fixed Asset Turnover

vi. Current Asset Turnover
vii. Leverage
viii. Price/Earnings Ratio.
(b) Using your answers to part (a), evaluate the financial performance and position of Eagle plc, focusing on the concerns of shareholders, managers and debtholders.

Question 5
Suppose you are the sole owner of company Taurus plc. The market value of your company is £100m and there are 20m shares outstanding. Now you are thinking about acquiring the target company Gemini with a stand-alone market value of £50m with 25m shares outstanding. Assume first that the present value of the synergies generated by combining the two companies is £20m

Required:
(a) Suppose you issue new shares to pay Gemini’s shareholders so that the net cost of the acquisition to Taurus is nil, meaning the shareholders of Gemini break even. How many shares do you need to issue? How many shares do you need to pay for each share in Gemini? Assume from now on instead that the present value of the synergies generated by combining the two companies is −£10m as opposed to £20m.

(b) Redo part (a) with the new present value of synergies. Would you choose to acquire the company Gemini? Discuss your findings in comparison with those reported in part (a). Assume now that you hold only 2m shares in Taurus but have control rights in the company (meaning that you can decide on Taurus’ acquisition of Gemini). In addition, assume that you also have 15m shares in Gemini.

(c) What is the value of your portfolio without any acquisition?

(d) Suppose you have the opportunity to have company Taurus acquire the company Gemini by offering 1 newly created share of Taurus for two shares of Gemini. What is the post-merger share price after the acquisition? What is your payoff? Do you proceed with the proposed merger?

(e) Based on your findings in (c) and (d), discuss how ownership structure (especially ownership in the target company) affects acquirers’ tendency to take over targets with negative synergy.

Question 6
Consider a company that has $10m to invest into one of three projects with the following cash-flows generated next year in the good and bad states of nature, with p denoting the probability of a given state obtaining for any project.

Required:
(a) Assume that the firm is purely equity financed. How does the firm rank the three projects?

(b) Suppose the firm carries debt maturing in the next year with a face value of $10m. How do equity holders rank the three projects? How do debtholders rank the three projects?

(c) Rank the three projects again if the face value of debt is $1m.

(d) What is the risk-shifting problem? Comparing your findings in parts (a) and
(b), briefly discuss the relation between risk shifting and the face value of debt.

(e) How does the debt overhang problem differ from the risk-shifting problem

Question 7
‘The senior managers and the Board of Directors do not need to worry about the dividend policy of their organizations, since it is not relevant to firms’ value.’ Evaluate this statement with references to two schools of thought regarding dividend policy.

Question 8
Give your views and reasons as to whether or not the London or Hong Kong stock markets will ever become completely ‘semi-strong efficient as defined by the efficient market hypothesis.