Tutorial Sets Bfc2140 2018 S1

Department of Banking and Finance

TUTORIAL QUESTIONS BFC2140 CORPORATE FINANCE 1 SEMESTER ONE, 2018

Chief Examiner: Emma Zhang

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BFC2140 CORPORATE FINANCE I TUTORIAL SET 01 (TEACHING WEEK ONE) INTRODUCTION AND REVIEW These questions should be attempted BEFORE your tutorial! IMPORTANT: The questions that we encounter within the tutorial set throughout the semester are an indication of the standard that you will face in the final examination. Tutors will grade on a randomly selected basis a sample of students work based on the level of preparation (satisfactory/unsatisfactory) (satisfactory/unsatisfactory) and participation during the weekly tutorials. Please note that attendance itself is not considered participation

Warm up 1-1

Sam, age 4, has just inherited $100,000 from his Great-Aunt. Great-Aunt. In his Aunt’s will it is stipulated that the funds are required to be invested in ordinary shares for a period of no less than 20 years before these investments maybe realised. As financial advisor for the family you are required to assist with investing these funds. What is your recommendation from the three options provided? Please justify this decision in two or three brief sentences. In addition, once you have made the investment decision once the money is invested, what are your greatest concerns? Option A) to stake the entire inheritance on one stock (any stock). Option B) to choose 2 companies in the same industry. Option C) to invest roughly equal amounts in each of the top 10 largest companies.

Question One A) B)

What is a Corporation’s key objective? List and discuss the three key decisions facing corporate financial managers.

Question Two Note that in BFC2140 we assume that all assets are depreciated to zero from purchase price. For example, when a scrap or residual value exists, we DO NOT subtract this from the initial cost of the asset when estimating depreciation

Consider a $1000 asset (i.e., a vacuum cleaner) deemed to have a 5 year life for depreciation purposes. Assume this asset has zero scrap value.

A) B)

Use straight line depreciation Use 33% diminishing value. 2

What would be annual depreciation expense be in each of 1) and 2)? Question Three You are considering two identical firms, one levered (has debt) and the other not. The ratio of market debt to market equity is 1.5 for the levered firm. What proportion of the levered firm is financed with debt? How much of the unlevered firm is financed with debt? Hint: Remember that Assets = Liabilities + Equity

Question Four Here is some information about Company XYZ: Short-Term Debt Long-Term Debt Total Debt

$5,000,000 $10,000,000 $15,000,000

Common Equity Preferred Equity Additional Paid In Capital Retained Earnings Total Shareholders' Equity

$500,000 $250,000 $6,000,000 $3,250,000 $10,000,000

Using the debt-to-equity formula and the information above, calculate that Company XYZ's debt-to-equity ratio.

Additional problem from prescribed Text Chapter 1 (Page 22-24): Problems 2, 8, 10, 14, 15. SOLUTIONS TO THESE PROBLEMS ARE AVAILABLE ON MOODLE. THE PURPOSE OF THE ADDITIONAL PROBLEMS IS TO PROVIDE YOU WITH ADDITIONAL PRACTICE. IF YOU NEED ASSISTANCE WITH THESE PROBLEMS PLEASE ATTEND A HELP SESSION. INFORMATION ABOUT HELP SESSIONS IS AVAILABLE ON MOODLE.

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BFC2140 CORPORATE FINANCE I

These questions should be attempted BEFORE your tutorial! IMPORTANT: The questions that we encounter within the tutorial set throughout the semester are an indication of the standard that you will face in the final examination. Tutors will grade on a randomly selected basis a sample of students work based on the level of preparation (satisfactory/unsatisfactory) and participation during the weekly tutorials. Please note that attendance itself is not considered participation

Warm up 2-1.

If you invested $200,000 today in an investment returning 6% p.a. with interest compounding 6 monthly, how much would that investment have grown to at the end of 10 years?

2-2.

A bank is quoting an interest rate of 8% p.a. compounding monthly. What is the effective annual interest rate?

2-3.

Fancy Nancy has to borrow funds at 10 percent to purchase a necklace. She has a contract to sell the necklace for $70,000. Payment is to be received in two years’ time. The necklace cost $60,000 today and could be sold for this amount. Nancy likes this arrangement as she does not have to give up the necklace for two years and by then fashions will possibly have changed. What is the borrowing rate at which she would break even?

Find the missing values in the following table.

2,250 9,310 (iii) (iv) 265 360

30 16 5 15 3 9

12 9 4 20 (v) (vi)

(i) (ii) 14,451 550,164 307 761

At 6 percent interest, how long does it take to A) double your money? B) quadruple it? 4

A) You are offered an investment that requires you to put up $3,000 today in exchange for $10,000 15 years from now. What is the annual rate of return on this investment? B) A bank offers you an interest rate of 8 percent, compounded quarterly. Which one will you choose (taking the above investment opportunity or investing at this bank)?

An investment has the following cash flows. If the discount rate is 8 per cent, what is the present value of these flows? What is the net future value of these flows at t=3? YEAR

CASH FLOW

1 2 3

$300 $600 $900

Assume that it is presently July 1, 2016, and you need to raise $10,000 by July 1, 2021. You can invest money in your bank to earn an 8% return compounded annually.

A) B)

Calculate the amount of a deposit made on July 1, 2016, to give a balance of $10,000 on July 1, 2021. Independent of A), if you receive $7,500 from your father on July 1 2017, calculate the rate of return you must earn to reach the $10,000 required by July 1, 2021.

Additional problem from prescribed Text Chapter 4 (Pages 116-117): Problems 1, 2, 3, 4, 5, 6. SOLUTIONS TO THESE PROBLEMS ARE AVAILABLE ON MOODLE. THE PURPOSE OF THE ADDITIONAL PROBLEMS IS TO PROVIDE YOU WITH ADDITIONAL PRACTICE. IF YOU NEED ASSISTANCE WITH THESE PROBLEMS PLEASE ATTEND A HELP SESSION. INFORMATION ABOUT HELP SESSIONS IS AVAILABLE ON MOODLE.

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Warm up 3-1.

How much income per annum would a $600,000 lump sum provide for 20 years if it was invested at 7% per annum compounded annually. (Assume the investment is amortised over the 20 years.)

3-2.

What is the present value of a four-period annuity of $200 per year that begins two years from today if the discount rate is 9%?

3-3.

Your client is interested in buying a small company that has fairly reliable cash flows in the future. The projected cash flows are as follows:

YEAR

NET CASH INFLOW

1

$20,000

2-5

$30,000

6-infinity

$50,000

Required: What is the maximum price that your client should pay for this company if the appropriate discount rate for evaluating this type of company is 12%?

Assume that it is presently July 1, 2016, and you need to raise $10,000 by July 1, 2021. You can invest money in your bank to earn an 8% return compounded annually.

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A) B) C) D)

E)

If you decide to make equal annual payments beginning on July 1, 2017, calculate the value of each payment. Your father offers to make the payments calculated above, or to give you $7,500 on July 1, 2017, which would you select? Your father now offers to deposit $1,860 annually from July 1, 2017, calculate the annual compound rate of interest you must earn to reach your target. Your father offers you $4,000 today, if you obtain a part-time job and earn sufficient to make equal half-yearly deposits. As well, the bank agrees to compound its 8% rate of interest semiannually. Calculate the value of each deposit you must earn. Calculate the annual effective rate of the bank’s offer in part (d).

You are saving for the college education of your two children. They are two years apart in age; one will begin college 15 years from today and the other will begin 17 years from today. You estimate your children’s college expenses to be $21,000 per year per child, payable at the start of each school year. The annual interest rate is 15 percent. How much money must you deposit in an account each year to fund your children’s education? Your de posits begin one year from today. You will make your last deposit when your oldest child enters college.

Consider that you need to finance the purchase of a house. The purchase of the house is $400,000 and you will require 100% financing. The loan term is 30 years and the terms of the contract require monthly end of period payments (including interest and principle). The current variable rate offered by your bank is 7% per annum.

A) B) C) D)

What is the monthly mortgage payment? If you are selling the house 5 years after the mortgage start, how much do you still owe the bank? How much will your monthly payment increase if the interest rate is increased by 50 basis point 5 years after the mortgage start? If you can’t afford the ex tra payment, how much longer will you have to pay the mortgage at the original monthly payment?

Additional problem from prescribed Text Chapter 4 (Pages 117-120): Problems 7, 8, 10, 11, 12, 15, 24, 25, 27, 31. SOLUTIONS TO THESE PROBLEMS ARE AVAILABLE ON MOODLE. THE PURPOSE OF THE ADDITIONAL PROBLEMS IS TO PROVIDE YOU WITH ADDITIONAL PRACTICE. IF YOU NEED ASSISTANCE WITH THESE PROBLEMS PLEASE ATTEND A HELP SESSION. INFORMATION ABOUT HELP SESSIONS IS AVAILABLE ON MOODLE.

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Warm up Anjelkovic-148 is a new fragrance, guaranteed to attract the opposite sex and is the proud new invention of Bombastic Lova Lova Corporation. To obtain financing Bombastic Lova Lova Corporation has issued a bond that bears a coupon rate of 8 percent per annum and has a par value of $30,000. Interest payments are made semi-annually. The required yield to maturity is 16%. The bond matures in ten years. Calculate the price of the bond. Buyonline Ltd is expanding rapidly. Its dividend growth rate for the coming year is projected at 25 percent. This rate will decline by 5 percentage points per year until it reaches the industry average of 5 percent. Once it reaches 5 percent, it will stay there indefinitely. The most recent dividend was $0.85 per share, and the market requires a return of 16 percent on investments such as this one. What is the price per share for Buyonline?

Several years ago Pies in the Skies Ltd issued $100 bonds at par value with a yield to maturity of 8 per cent. Now, with 8 years left to maturity on the bonds, the company is experiencing difficulties to the extent that the yield to maturity on the bonds has increased to 12 per cent.

A) Without calculating, explain what you expect to have happened to the price of the bond since it was issued? Why/ How do you know this? B) Calculate the price of the bond following the increase in the yield to 12%. Explain what has happened to the price since issue of the bond. C) Investors believe that Pies in the Skies Ltd can pay the promised coupon payments, but that the company will go bankrupt when the bond matures and the principal repayments become due. 8

Investors expect that they will only receive 80 percent of the face value at maturity. If an investor were to purchase the bond today, calculate the price the investor is willing to pay for this bond?

Lahey Industries has a $1,000 par value bond with an 8% coupon interest rate outstanding. The bond has 12 years remaining to its maturity date. A) B) C)

If interest is paid annually, what is the value of the bond when the YTM is 7%? Using a 10% required return, find the bond’s value when interest is paid semi annually. In which of the above cases is the bond at a discount? a premium? or at par value?

A firm issued a new series of bonds on January 1, 1992. The bonds were sold at par ($1,000), have a 12 percent coupon, and mature in thirty years. Coupon payments are made semi-annually (on June 30 and December 31). Hint: draw a timeline! A) B) C)

What was the yield to maturity of the bond on 1/1/92? Calculate the price of the bond on 1/1/97, five years later, assuming that the level of interest rates have fallen to 10 percent. If, on July 1, 2012, an investor expects the bonds to sell for $896.64. What is the expected yield to maturity on the bonds at that date?

A) Brig Company just paid a cash dividend of $0.20 per share. Investors require a 16% return from investments such as this. If the dividend is expected to grow at a steady 8% per year, what is the current value of a share? What will be the share worth in five years? B) Networks Ltd is experiencing a period of rapid growth. Earnings and dividends are expected to grow at a rate of 18% during the next two years, 15% in the third, and then at a constant rate of 6 per cent thereafter. Networks’ last dividend, which has just been paid, was $0.115. If the required return on the shares is 12%, what is the price of the share today? Additional problem from prescribed Text Chapter 6 (Pages 179-182): Problems 1, 2, 5, 6, 8, 11, 13, 14, 15, 23, 27. Chapter 7 (Pages 211-213): Problems 1, 3, 4, 6, 8, 10, 15, 16. SOLUTIONS TO THESE PROBLEMS ARE AVAILABLE ON MOODLE. THE PURPOSE OF THE ADDITIONAL PROBLEMS IS TO PROVIDE YOU WITH ADDITIONAL PRACTICE. IF YOU NEED ASSISTANCE WITH THESE PROBLEMS PLEASE ATTEND A HELP SESSION. INFORMATION ABOUT HELP SESSIONS IS AVAILABLE ON MOODLE.

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Warm up Burke Inc. is considering the purchase of Small Ltd. The acquisition would cost $190,000 but would increase Burke’s cash flows by $30,000 per year for the foreseeable future. If Burke’s cost of capital is 15%, should it go ahead with the acquisition of Small? You are a top finance graduate from Monash University. Your friend Nigel is a management graduate and therefore has little chance of finding a job outside the fast-food industry. Luckily for him, Nigel's rich uncle has left him $20 million in his will. Having been a management student, Nigel partied while you studied. In fact he took no courses in finance and thus knows nothing about investment. In a drunken stupor, late one Saturday night Nigel watched an interview with the Maharishi Yogi Berra. The Maharishi claims material wealth lies beneath the ground in Dromana. It is clear from the tone of the interview, the title of the documentary was "An interview with a crackpot," that the interviewer and the "experts" on the show think the Maharishi is insane. However, Nigel believes in the Maharishi because his management training taught him to believe in gurus (Peter Drucker, for example). Nigel decides to use his new found fortune to prove the Maharishi correct, making himself one of the richest people in Australia in the process! Nigel knows you have superior intellect (otherwise you wouldn't be in Finance) and asks you to work out the details. After some discreet investigation you find the homes and land can be purchased for $15 million. In addition the local council insist on a $4 million fee for defacing the views from the city. Finally, it costs $1 million to lease the mining equipment. You and Nigel meet with the Maharishi and after several hours of meditation the Maharishi provides you with estimated annual after-tax cash-flows. These cash-flows are provided to you below in table 5-2. Nigel thinks the cash-flows sound fantastic (compared to a career flipping burgers. Who wouldn't), you however decide to check the numbers using what you have learned in Finance. You believe the project is very risky and therefore in consultation with Westpac Bank Risk Management team decide to use a discount rate of 23%. Should Nigel invest his fortune based on the crackpot's ideas? a) Calculate the Net Present Value and the Internal Rate of Return. Would your decision change if you used a discount rate of b) 18% c) 10%. 10

Table 5-2 Projected Cash Flows

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

Projected Cash flow $1,500,000 $3,278,000 $5,000,000 $6,450,000 $2,500,000 $2,500,000 $2,500,000 $2,500,000 $2,500,000 $2,500,000

Year 11 Year 12 Year 13 Year 14 Year 15 Year 16 Year 17 Year 18 Year 19 Year 20

Projected Cash flow $2,500,000 $2,500,000 $2,500,000 $2,500,000 $2,500,000 $2,500,000 $2,500,000 $2,500,000 $2,500,000 $2,500,000

Taylor Made Inc. is considering two mutually exclusive projects. The projects’ expected net cash flows are provided in the table below.

YEAR 0 1 2 3 4 5

PROJECT 1 ($300,000) (387,000) (193,000) 100,000 600,000 1,270,000

PROJECT 2 ($599,000) 234,000 234,000 234,000 234,000 234,000

Required A) Sketch the NPV profiles for projects A and B. Be careful to ensure that you label all axes, lines and points carefully. B) If you were told that each project’s cost of capital is 10%, which project should be selected? You are required to calculate the NPV for each project to receive full credit. C) Calculate the crossover rate exactly. Explain in one or two sentences the importance of the cross over rate. Specifically, in your answer, detail the range for cost of capital that project 1 would be preferable to project 2?

State clearly if you would accept the following independent projects? Assume the opportunity cost of capital is 12% for each project and that the cash flows generated for each project are conventional. If you decide to undertake an investment in a project explain why? If you decide not to undertake investment in a project explain why not?

(i) (ii) (iii) (iv)

“Project alpha” has a small, but negative, NPV. “Project beta” has a very small positive NPV when discounted at 10%. “Project gamma” has a cost of capital that exceeds its rate of return. “Project delta” has a zero NPV when discounted at 14%.

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Define and explain the Payback Method, the Net Present Value Method, and the Internal Rate of Return Method. In your discussion state the criteria for accepting or rejecting an investment under each rule. You should also discuss the strengths and weaknesses associated with the use of each alternative method. Additional problem from prescribed Text Chapter 8 (Pages 251-254): Problems 1, 2, 3, 4, 5, 6, 7, 11, 12, 17, 18, 24, 26.

SOLUTIONS TO THESE PROBLEMS ARE AVAILABLE ON MOODLE. THE PURPOSE OF THE ADDITIONAL PROBLEMS IS TO PROVIDE YOU WITH ADDITIONAL PRACTICE. IF YOU NEED ASSISTANCE WITH THESE PROBLEMS PLEASE ATTEND A HELP SESSION. INFORMATION ABOUT HELP SESSIONS IS AVAILABLE ON MOODLE.

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Warm up 6-1.

Mr Burns the President of the Springvale Electrical Company is sick and tired of falling cash flows and as a result decreasing NPV. The company itself is responsible for making electrical components, but of late has been suffering from decreasing output as the result of one particularly lazy employee. The financial director, Mr Burns son, George, has come up with an idea of how to overcome this problem. "It's easy, the guy sits around all day stuffing his face with food and sleeping, it's no wonder output has fallen substantially. All we have to do to get things rolling again is to replace him with a new fully automated machine."

This replacement would mean the need for one less employee, "That lazy ……., Homer" generating salary and benefit savings. The following day the director carries out a feasibility study and the following data is presented to the President. 

  

It would cost $60,000 to purchase the new automated machine and it would be expected to have a life expectancy of 20 years. Annual maintenance would be $8,000. The replaced employee's salary is $25,500. The machine will be depreciated on a straight-line basis over 20 years to a zero salvage value. 13

 

The firm's marginal tax rate is 30 percent. The firm's current cost of capital is estimated to be 15%.

On the basis of the net present value criterion, should the automated machine be purchased and the lazy operator fired? Confirm that your answer is correct by calculating the Internal Rate of Return. Does your answer make sense? Comment.

Billy was asked to choose between the following mutually exclusive projects: Year 0 1 2 3 4

Project S ($100,000) 60,000 60,000

Project L ($100,000) 33,500 33,500 33,500 33,500

The projects provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future. Both projects have a 10 percent cost of capital. A) B)

What is each project’s initial NPV without replication? Repeat the analysis assuming now replication takes place. Hint: Use the equivalent annual annuity approach and lowest common multiple methods introduced in class.

International Foods (IFC) currently processes seafood with a unit it purchased several years ago. The unit, which originally cost $500,000, currently has a book value of $250,000. IFC is considering replacing the existing unit with a newer, more efficient one. The new unit will cost $700,000 and will also require an initial increase in net working capital of $40,000. Additionally, in order to make the new unit operational shipping and installation costs will require a further $50,000 investment. The new unit will be depreciated on a straight-line basis over 5 years to a zero balance. The new unit will have a salvage value of $75,000 at the end of the projects life in 5 years. The existing unit is being depreciated at a rate of $50,000 per year. IFC can sell the existing machine today for $275,000. Assume IFC’s tax rate is 30 percent. If IFC purchases the new unit, annual revenues are expected to increase by $100,000 in annuity (due to increased capacity), and annual operating costs (exclusive of depreciation) are expected to decrease by $20,000 in annuity. IFC estimates that in addition it will need to make ongoing contributions to net working capital in years 1, 2, 3 and 4 in the amount of $10,000. Accumulated net working capital will be recovered at the end of 5 years. IFC has a company cost of capital that can be used for discounting purposes of 12%. In addition the company has to borrow $100,000 to fund the new project. The loan is interest only requiring monthly payments at an interest rate of 18% per annum. Repayment of the principal will occur after the sale of the new unit. Advise whether the company should replace the unit or not? [use an incremental analysis approach to solve this cash flow analysis]. We will also teach you an alternative approach to that of the incremental analysis. The approach you will be taught in tutorials will allow you to arrive at the same answer but will evaluate the two decisions; (1) the decision to keep the old machine; and (2) the replacement decision; in isolation.

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Additional problem from prescribed Text Chapter 8 (Pages 254-255): Problems 28, 29. Chapter 9 (Pages 284-286): Problems 1, 2, 3, 7, 13, 22. SOLUTIONS TO THESE PROBLEMS ARE AVAILABLE ON MOODLE. THE PURPOSE OF THE ADDITIONAL PROBLEMS IS TO PROVIDE YOU WITH ADDITIONAL PRACTICE. IF YOU NEED ASSISTANCE WITH THESE PROBLEMS PLEASE ATTEND A HELP SESSION. INFORMATION ABOUT HELP SESSIONS IS AVAILABLE ON MOODLE.


IMPORTANT: Tutors will be working through the marking guide for your In-Semester test. It is critical that you attend this tutorial as otherwise you will miss out on very important feedback at the mid point of the unit. Also note that you will still be assessed on tutorial participation.

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IMPORTANT: The mid semester test will be handed back to students in their allocated tutorial in teaching week 8. It is absolutely imperative that you attend this class. Tutors will be handing back the test paper for viewing. If you have concerns with how your paper has been graded you should raise these concerns and make an appointment with your tutor for further discussion in their consultation sessions. Your test paper will be collected at the end of class and you will not be permitted to take the paper home. We maintain copies of the test for record keeping purposes.


Warm up 8-1. 8-2.

Define net working capital, and discuss the importance of working capital management. What are some of the trade-offs required in the management of working capital accounts?

Given the aggregate balance sheet and income statement for Sifty Sasha's Burbon Exporters, calculate the cash conversion cycle.

Income Statement Sales COGS

3,635 Inventory 3,257 A/R A/P

Balance Sheet Start 2015 390 403 249

End 2015 420 432 272

Listed below are three different transactions that Sifty Sasha Burbon exporters might make. Indicate how each transaction would affect each of the following (a) Cash, (b) Working Capital Your responses should be: Increase, Decrease or No change.

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Transaction Cash (i) Your company makes a sale of inventory for cash at cost. (ii) Your company takes delivery of $1,000 worth of inventory on 30 days credit. (iii) Your company arranges for $1,000,000 worth of short term debt to be refinanced with debt of 4 years maturity. (iv) Your Company donates $40,000 to charity.

Net Working Capital

The credit terms for each of three suppliers are shown in the following table.

Supplier A B C

Credit terms 1/10 net 55 2/10 net 30 2/20 net 60

Required A) Determine the approximate cost of giving up the cash discount from each supplier. Assume a 360 day year. B) Assuming your firm needs short-term financing, recommend whether it would be better to give up the cash discount or take the discount and borrow from a bank at 15% annual interest. Evaluate each supplier separately using your findings in a. C) What impact, if any, would the fact that your firm could stretch its accounts payable (net period only) by 20 days from supplier C have on your answer in (b) relative to this supplier?

What effect will the following events have on the cash conversion cycle? A) B) C) D)

Higher financing rates induce the firm to reduce its level of inventory. The firm obtains a new line of credit that enables it to avoid stretching payables to its suppliers. The firm factors its accounts receivable. A recession occurs, and the firm’s customers increasingly stretch their payables

Additional problem from prescribed Text Chapter 19 (Pages 593-594): Problems 1, 2, 3, 4, 5, 6, 7, 8. SOLUTIONS TO THESE PROBLEMS ARE AVAILABLE ON MOODLE. THE PURPOSE OF THE ADDITIONAL PROBLEMS IS TO PROVIDE YOU WITH ADDITIONAL PRACTICE. IF YOU NEED ASSISTANCE WITH THESE PROBLEMS PLEASE ATTEND A HELP SESSION. INFORMATION ABOUT HELP SESSIONS IS AVAILABLE ON MOODLE.

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Which of the following is a reason why incremental earnings may be differ ent from incremental cash flows? (a) Changes in accounts receivable reflects non-cash sales present in incremental earnings that are not incremental cash flows. (b) Depreciation is a cash expense, but does not appear in incremental earnings. (c) Capital expenditures appear on the income statement. However, as these costs are depreciated over time, they should not be present in incremental cash flows. (d) Firms pay taxes based on incremental cash flows, not incremental earnings. (e) After-tax salvage is not important to incremental cash flows, but does factor into revenues on the income statement.

In 2016, Project Soothsayer is expected to produce incremental earnings (after taxes and depreciation) of $19.2 million. The expected depreciation charge in that fiscal year is $2.6 million. Expected capital expenditures total $9.0 million and after tax salvage is expected to be $3.2 million. The project’s net working capital needs (in millions of dollars) from 2015 through 2016 are given in the table below:

Year Net working capital

2015 $1.00

2016 $5.60

2017 $5.00 18

What are the expected cash flows from the project in 2016?

A firm expects a project to have the following incremental Income Statement (all values in millions of dollars): Fiscal year 2015 2016 2017 Revenues $56.70 $69.60 $61.80 Costs -34.8 -42.7 -37.9 Depreciation -1.9 -1.9 -1.9 EBIT 20 25 22 The project’s incremental pro-forma balance sheet is expected to contain the following working capital items at the end of those fiscal years (all values in millions of dollars): Assets Liabilities Fiscal year 2015 Inventories $2.80 Accounts payable $2.00 Accounts receivable 1.3 Fiscal year 2016 Inventories 3.5 Accounts payable Accounts receivable 1.6

2.5

Fiscal year 2017 Inventories 3.1 Accounts payable Accounts receivable 1.4

2.2

In 2016, expected incremental capital expenditures total $2.9 million and incremental after tax salvage is expected to be $5.0 million. The tax rate for the project is 30%. What are the expected incremental cash flows from the project in 2016?

Wernham-Mifflin is considering launching a new line of pentagonal-shaped paper. You have the following information: Revenues due to the sale of the new product are expected to be $90 million annually. Total paper production costs will increase from the current level of $22 million annually to $63 million annually after the product launch. Top sales agent Michael Scarn will be reassigned from other projects to sell the new product line. Sales of those other products are expected to decline by $12 million annually. The project will make use of an existing paper mill, built last year at a cost of $38 million. The mill is being depreciated using prime cost over a useful life of 16 years. Wernham-Mifflin currently pays taxes at a marginal rate of 26%. Total annual incremental cash flows for the project are expected to remain constant for the next 16 years. After this period, the project’s total incremental cash flows will decline at a rate of 5% annually and will be received in perpetuity.  





 

What is the present value of the project if the annual project discount rate is 6.0%?

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These questions should be attempted BEFORE your tutorial!

IMPORTANT: The questions that we encounter within the tutorial set throughout the semester are an indication of the standard that you will face in the final examination. Tutors will grade on a randomly selected basis a sample of students work based on the level of preparation (satisfactory/unsatisfactory) and participation during the weekly tutorials. Please note that attendance itself is not considered participation

Warm up 9-1.

Explain the relation between risk and return.

9-2.

Describe the two components of a total holding period return, and calculate this return for an asset.

9-3.

Determining Portfolio Weights: What are the portfolio weights for a portfolio that has 135 shares of Stock A that sell for $47 per share and 105 shares of Stock B that sell for $41 per share?

9-4.

Portfolio Expected Return: You own a portfolio that is 25 percent invested in Stock A, 40 percent in Stock B, and 35 percent in Stock C. The expected returns on these three stocks are 11 percent, 17 percent, and 14 percent, respectively. What is the expected return on this portfolio?

Question One A) Total risk can be decomposed into systematic risk and unsystematic risk. Explain each component of risk, and how each is affected by increasing the number of securities in the portfolio. B) The table gives information on two risky assets A and B: Asset A B

Expected return (%) 12.5 16

Standard deviation of return (%) 40 45

Correlations A B 1.00 0.20 0.20 1.00

There is also a risk free asset F whose expected return is 8%. (i) (ii)

Portfolio 1 consists of 40 per cent asset A and 60 per cent Asset B. Calculate its expected return and standard deviation. Portfolio 2 consists of 40 per cent Asset A and 60 per cent in the risk free asset. Calculate its expected return and standard deviation. Compare your answers to (i) and comment. 20

Question Two Mr. Henry can invest in Highbull stock and Slowbear stock. His projection of the returns on these two stocks is as follows: State of Economy

Probability of State Occurring

Recession Normal Boom

Return on Highbull Stock (%)

0.25 0.60 0.15

Return on Slowbear Stock (%)

-0.02 0.092 0.154

0.05 0.062 0.074

Required: A) Calculate the expected return on each stock. B) Calculate the standard deviation of returns on each stock. C) Calculate the covariance and correlation between returns on the two stocks. D) Create an equally weighted portfolio and calculate the expected return and standard deviation for this portfolio. Question Three The following table provides a sample of the last six monthly percentage price changes for two market indexes. You are encouraged to make use of the statistical functionality available with your calculator when answering this question. Month 1 2 3 4 5 6

Nikkei 0.08 0.15 -0.12 0.11 0.09 -0.06

Russell_2000 0.12 0.09 -0.07 0.13 0.04 -0.14

Required: A) The expected monthly rate of return and standard deviation for each series B) The covariance between the rates of return for Nikkei – Russell_2000 The correlation coefficient for Nikkei-Russell_2000 C) Question Four You have been provided the following annual return data about 4 shares over a sample period 2011-2015. YEAR 2011 2012 2013 2014 2015

Share A 10% 7% 11% 9% 18%

Share B 12% 12% 11% 9% 10%

Share C 7% -12% 32% 15% -13%

Share D -3% -11% 22% 2% -1%

Required: A) Compute the expected return for each share? B) Compute the risk measure for each share? C) Identify which security you would suggest investing funds in if you had to select only one? Explain your decision. 21

Additional problem from prescribed Text Chapter 11 (Pages 348-350): Problems 1, 4, 7, 8. SOLUTIONS TO THESE PROBLEMS ARE AVAILABLE ON MOODLE. THE PURPOSE OF THE ADDITIONAL PROBLEMS IS TO PROVIDE YOU WITH ADDITIONAL PRACTICE. IF YOU NEED ASSISTANCE WITH THESE PROBLEMS PLEASE ATTEND A HELP SESSION. INFORMATION ABOUT HELP SESSIONS IS AVAILABLE ON MOODLE.

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BFC2140 CORPORATE FINANCE I TUTORIAL SET 11 (TEACHING WEEK ELEVEN) COST OF CAPITAL These questions should be attempted BEFORE your tutorial! IMPORTANT: The questions that we encounter within the tutorial set throughout the semester are an indication of the standard that you will face in the final examination. Tutors will grade on a randomly selected basis a sample of students work based on the level of preparation (satisfactory/unsatisfactory) and participation during the weekly tutorials. Please note that attendance itself is not considered participation

Warm up: 12-1. Explain what the weighted average cost of capital for a company is and why it is often used as a discount rate to evaluate projects. 12-2. How do taxes affect the cost of debt? 12-3. Calculating Cost of Equity: The Dybvig Corporation’s common stock has a beta of 1.21. If the risk-free rate is 3.5 percent and the expected return on the market is 11 percent, what is Dybvig’s cost of equity capital? 12-4. Calculating WACC:

Mullineaux Corporation has a target capital structure of 70 percent common stock and 30 percent debt. Its cost of equity is 13 percent, and the cost of debt is 6 percent. The relevant tax rate is 35 percent. What is Mullineaux’s WACC?

Problems: Question One Gayle’s Cricket Farm issued a 30-year, 6 percent semiannual bond 8 years ago. The bond currently sells for 96 percent of its face value. The company’s tax rate is 35 percent.

Required A) What is the pretax cost of debt? B) What is the aftertax cost of debt? C) Which is more relevant, the pretax or the aftertax cost of debt? Why? Question Two Rooster Inc has 9 million shares of common stock outstanding. The current share price is $52 and the book value per share is $4. Rooster also has two bond issues outstanding. The first bond issue has a face value of 23

$80 million, has an 8 percent coupon and sells for 104 percent of par. The second issue has a face value of $50 million, has a 7.5 percent coupon, and sells for 102 percent of par. The first issue matures in 10 years, the second in 6 years. Ignore tax. Required A) What are Rooster’s capital structure weights on a book value basis? B) What are Rooster’s capital structure weights on a market value basis? C) Which are more relevant, the book or market value weights? Why?

Question Three In Question 2) suppose the most recent dividend paid was $3.10 and the dividend growth rate is 7 percent. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both bonds make semiannual payments. The tax rate is 35 percent. What is the company’s WACC?

Question Four An all-equity firm is considering the following projects: Project W X Y Z

Beta 0.40 0.95 1.06 2.20

Expected Return 9% 11% 15% 19%

Assume a risk-free rate of 6 percent and an expected return on the market equal to 13 percent. The company has a 13 percent cost of capital. A) Making use of the security market line (depict grpahically) identify which projects should be accepted? B) Which projects will be incorrectly accepted and which projects will be incorrectly rejected if the fir m’s overall cost of capital is adopted as a hurdle rate? C) What assumption is made in the above problem with regards to the risk of the projects?

Question Five Goetzmann Industries stock has a beta of 1.20. The company has just paid a dividend of $0.80, and the dividends are expected to grow at 5 percent. The expected return on the market is 13 percent, and the Treasury bill rate is currently 6 percent. The most recent stock price for Goetzmann is $53.00. A) Calculate the cost of equity using the DCF method. B) Calculate the cost of equity using the SML method. C) Why do you think your estimates in (A) and (B) are so different?

Question Six Och, Inc., is considering a project that will result in initial after-tax cash savings of $3.5 million at the end of the first year, and these savings will grow at a rate of 4 percent per year indefinitely. The firm has a target debt-equity ratio of 0.55, a cost of equity of 13 percent, and an after-tax cost of debt of 5.5 percent. The costsaving proposal is somewhat riskier than the usual projects the firm undertakes; management uses the subjective approach and applies an adjustment factor of +2 percent to the cost of capital for such risky projects. Under what circumstances should Och take on the project?

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Additional problem from prescribed Text Chapter 13 (Pages 408-409): Problems 1, 2, 3, 5, 7, 8, 11, 15, 17, 18, 19. SOLUTIONS TO THESE PROBLEMS ARE AVAILABLE ON MOODLE. THE PURPOSE OF THE ADDITIONAL PROBLEMS IS TO PROVIDE YOU WITH ADDITIONAL PRACTICE. IF YOU NEED ASSISTANCE WITH THESE PROBLEMS PLEASE ATTEND A HELP SESSION. INFORMATION ABOUT HELP SESSIONS IS AVAILABLE ON MOODLE.

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BFC2140 CORPORATE FINANCE I TUTORIAL SET 12 (TEACHING WEEK TWELVE) CAPITAL STRUCTURE These questions should be attempted BEFORE your exam! IMPORTANT: The questions that we encounter within the tutorial set throughout the semester are an indication of the standard that you will face in the final examination. Tutors will grade on a randomly selected basis a sample of students work based on the level of preparation (satisfactory/unsatisfactory) and participation during the weekly tutorials. Please note that attendance itself is not considered participation

Question One Absent tax effects, why can’t we change the cost of capital of the firm by using more debt financing and less equity financing?

Question Two Explain what is wrong with the following argument: ‘If a firm issues debt that is risk free because there is no possibility of default, the risk of the firm’s equity does not change. Therefore, risk -free debt allows the firm to get the benefit of a low cost of capital of debt without raising its cost of capital of equity.’

Question Three Telfast expects perpetual earnings before interest and taxes of $2 million per year. The firm’s pre-tax cost of debt is 15% per annum and its annual interest expense is $100,000. Company analysts estimate that the unlevered cost of Telfast’s equity is 20%. The company tax rate is 30%. What is the value of the firm?

Question Four Levered Inc. and Unlevered Inc. are identical in every way except their capital structures. Each company expects to earn $96 million before interest per year in perpetuity, with each company distributing all its earnings as d ividends. Levered’s perpetual debt has a market value of $275 million and costs 8% per annum. Levered has 4.5 million shares outstanding currently worth $100 per share. Unlevered has no debt and 10 million shares outstanding, currently worth $80 per share. Neither firm pays taxes. Is Lever’s stock a better buy than Unlevered’s stock?

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Additional problem from prescribed Text Chapter 16 (Pages 495-497): Problems 1, 2, 3, 10. SOLUTIONS TO THESE PROBLEMS ARE AVAILABLE ON MOODLE. THE PURPOSE OF THE ADDITIONAL PROBLEMS IS TO PROVIDE YOU WITH ADDITIONAL PRACTICE. IF YOU NEED ASSISTANCE WITH THESE PROBLEMS PLEASE ATTEND A HELP SESSION. INFORMATION ABOUT HELP SESSIONS IS AVAILABLE ON MOODLE.

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BFC2140 CORPORATE FINANCE I TUTORIAL SET 13 (SWOT VAC – SELF STUDY) MARKET EFFICIENCY AND PAY OUT POLICY IMPORTANT: There is no tutorial arrangement during the week of SWOT VAC. This set of tutorial questions are related to the last lecture topic of the unit: Market efficiency and payout policy. This topic is EXAMINABLE. Students are highly encouraged to attempt the questions at your own before referring to the solutions.

Part 1: Market Efficiency 1. Efficient Market Hypothesis: Define the three forms of market efficiency. 2. Efficient Market Hypothesis: Which of the following statements are true about the efficient market hypothesis? a. It implies perfect forecasting ability. b. It implies that prices reflect all available information. c. It implies an irrational market. d. It implies that prices do not fluctuate. e. It results from keen competition among investors. 3. Semistrong Efficiency: If a market is Semistrong form efficient, is it also weak form efficient? Explain. 4. Efficient Market Hypothesis: For each of the following scenarios, discuss whether profit opportunities exist from trading in the stock of the firm under the conditions that (1) the market is not weak form efficient, (2) the market is weak form but not semistrong form efficient, (3) the market is semistrong form but not strong form efficient, and (4) the market is strong form efficient. a. The stock price has risen steadily each day for the past 30 days. b. You observe that the senior management of a company has been buying a lot of the company’s stock on the open market over the past week.

Part 2: Dividend Policy 1. Dividend policy and company value: You have just encountered two identical companies with identical investment opportunities, as well as the ability to fund these opportunities. You have found that one of the companies has just announced an introductory dividend policy, whereas the other has continued with a no-dividend policy. Which of the two companies is worth more? Explain.

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2. Share buyback (repurchase): Explain what a share buy-back is and how companies buy back their shares. 3. Dividend policy: Discuss the benefits and costs associated with dividend payments, and compare the relative advantages and disadvantages of dividends and share buy-backs. 4. Dividend policy and company value: Is it possible for a company to retain its shareholders using its dividend policy? Explain your answer. Your answer should also include a definition/discussion of imputation tax system.

5. Dividend and Stock Price Last month, Central Virginia Power Company, which had been having trouble with cost overruns on a nuclear power plant that it has been building, announced that it was “temporarily suspending dividend payments due to the cash flow crunch associated with its investment program.” The company’s stock price dropped from $28.5 to $25 when this announcement was made. How would you interpret this change in the stock price? (That is, what would you say caused it?)

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Tutorial Sets Bfc2140 2018 S1

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