BMAN30111 Two Hours Formula Sheet and Normal Distribution to be provided

UNIVERSITY OF MANCHESTER

ADVANCED CORPORATE FINANCE

14 January 2013 09:45 11:45

Answer ANY TWO questions All questions carry EQUAL marks

Slide rules and electronic calculators may be used, provided that they cannot store text

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BMAN30111

Answer ANY TWO questions All questions carry EQUAL marks

1.

a)

Siemens, one of the largest industrial conglomerates in Europe and the leading supplier of wind farms in the UK, plans to build a major wind turbine manufacturing plant in Hulls Alexandra Dock. The facility, the first offshore wind turbine plant in the UK, requires an initial investment of 80 million and working capital of 15 million in 2012. The plant will open in 2013 and will be fully depreciated on a straight-line basis over a period of 20 years. The projects EBITD is forecast to be 15 million in 2013 and to grow at an annual rate of 3% between 2014 and 2017. For simplicity, assume that after 2017, the projects free cash flows will grow at the rate of 2% per year in perpetuity. The main corporate tax rate in the UK will be reduced from the current rate of 24% to 23% in 2013. Assume that this new corporate tax rate will stay the same during the life of the project. The risk-free rate and the expected market return are 4% and 7%, respectively. The asset beta for the renewable energy sector is 1.5. All cash flows occur at the end of the year.

Required: i. Calculate the NPV of Siemens investment in the turbine manufacturing plant assuming the project is 100% financed with equity. (35% marks)

ii.

Siemens is considering two options to fund the project. The first option is to take out a loan worth 80 million at the start and then repay it at the rate of 16 million per year over the next five years, 20132017. The second is to borrow an appropriate amount of debt with a view to maintaining the companys current market leverage ratio of 20%. Assuming Siemens cost of debt is 6.5%, estimate the NPV of the investment project in each case using an appropriate valuation method. Clearly show your calculations and comment on your results. (30% marks)

b)

Explain briefly what the trade-off theory of capital structure is. Outline the theorys predictions and evaluate them with reference to the empirical literature. (35% marks)

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BMAN30111 2. a) What are the agency problems that may arise from the separation of ownership and control in the outsider system? What are the corresponding problems in the insider system? Explain your answer with reference to the international evidence. (40% of mark)

b)

Case study on WorldCom, Restoring Trust at WorldCom. i. On the basis of the case study and the discussion in class, explain the major corporate governance issues in WorldCom Inc. that possibly led to one of the biggest corporate scandals in history. (30% of mark)

ii.

Discuss Mr. Breedens areas of reform that are the most important for creating a sound governance structure within WorldCom. (30% of mark)

3.

The founders of Dacbury Ltd, Mr and Mrs Dacbury, have decided to list their company on the stock market towards the end of 2005. Post-IPO, Dacbury Ltds long-term debt was estimated at 25m (deduced from its debt level preIPO minus the amount that would be repaid to lenders from the proceeds of the equity issue). Dacbury Ltds book equity post-IPO was estimated at 100m. Hence, the post-IPO long-term debt to equity ratio was 25%. Near the time of the IPO, the risk-free interest rate was around 3% and the return on equities of average risk was forecasted to be 7% above the short-term risk free rate. The pre-tax cost of debt for this company was around 6%, while the statutory corporate tax rate was 30%. The total amount of outstanding common shares just before the IPO was 10 million. In order to have Dacbury Ltd valued, the two founders provided the underwriter with a five-year planning horizon of forecasts for earnings, working capital, capital expenditures, and net cash flows (see Table 1). Further, they expected the net cash flows to increase at an annual rate of 5% beyond 2010. In addition, a set of peer companies operating in the same food industry as Dacbury Ltd were identified and their most current projected data were collected (see Tables 2 and 3). Table 1. Projected cash flows for Dacbury Ltd (in m) 2006 2007 2008 2009 EBIT(1t) Incremental Working Capital Net Capital Expenditure Net Cash Flow
9.20 4.30 0.70 4.20 12.42 4.62 1.80 6.00 17.39 4.80 2.40 10.19 20.87 5.20 2.40 13.27

2010

13.93

*In the Net Cash Flow calculation, depreciation is added to EBIT(1t). Here, we assume that it is already included in EBIT(1t)

Question 3 continued overleaf

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BMAN30111 Question 3 continued Table 2. Projected data for peer companies (in m) Chortons Plc CandyCo Plc Black&Green Plc
Net income Long-term debt Total outstanding shares Net book value of equity Beta levered D/E ratio
40 160 40 780 0.95 0.11 25 0 10 315 0.74 0.00 20 145 20 510 1.1 0.18

Table 3. Stock price for peer companies () Chortons Plc CandyCo Plc Black&Green Plc
Stock price
38 20 40

Required: a) Based on the information provided above, calculate the share price of Dacbury Ltd:

i.

Using the Discounted Cash Flow (DCF) method and taking into account that the terminal value of the company can be calculated as a growing perpetuity. Critically discuss the main limitations of the DCF approach. (35% of mark)

ii.

Given that the financial needs of Dacbury Ltd were estimated to be around 100m, and that the issuing costs were estimated to be about 6% of the total proceeds, calculate how many shares should be issued in this IPO. (10% of mark)

iii.

Using the Comparable Firms approach and, in particular, the P/E multiple, calculate the share price range of Dacbury Ltd. (15% of mark)

b)

Why do companies go public? Explain the advantages and disadvantages of going public and of being listed in the light of the international empirical evidence. (20% of mark)

c)

What are the anomalies related to the IPO process? Explain these anomalies and the theoretical explanations provided for them in the literature (20% of mark) PTO Page 4 of 7

BMAN30111 4. A publicly listed firm plans to invest in a positive NPV project. The firm has limited financial slack and must issue equity to new shareholders to cover the cash shortfall. Assume all the assumptions of Myers and Majlufs (1984) pecking order model hold. At time t=0 (i.e., the date of the new equity issue), the firms management receives private information about the quality of its assets-in-place and the NPV of the investment project. The management acts in the best interests of the passive, existing shareholders in deciding whether to issue new equity and invest in the project. The key financial information about the firm and its investment opportunity is summarised in the table below.

Firm type Probability of firm type Financial slack (in million) Assets in place (in million) Initial outlay of new project (in million) NPV of new project (in million)

High quality 0.3 10 240 100 24

Low quality 0.7 10 120 100 12

Required: a) Derive a rational expectations equilibrium (REE) in which investors rational beliefs at t=0 are consistent with the managements actions at t=0. Show your calculations in detail and comment on your results. Draw a diagram to illustrate the investment decision rule adopted by the management in the REE and show why there is underinvestment in the presence of asymmetric information. (40 marks)

b)

What would be the equilibrium outcome of the model if the firm had more financial slack, S=50? Show the steps in detail and discuss the value of financial slack in mitigating the underinvestment problem. (20 marks)

c)

Outline the predictions of the pecking order theory and evaluate them using both survey and regression evidence. Briefly compare and contrast these predictions with the market timing hypothesis. (40 marks)

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BMAN30111 5. Schloses&White PLC was a growing company, traded on the London Stock Exchange since early 2000. At the beginning of 2006, the market valued the firms assets at 500 million. The company was financed largely through (nondividend paying) equity. It also had a small amount of zero-coupon (nonconvertible) debt, which was to mature in five years with a redemption value of 120m. The firms volatility was estimated at 25% and the annual riskfree interest rate was expected to remain constant over the following five years at 5%. a) Using the BlackScholes option-pricing model, calculate: i. the value of the equity and of the (risky) debt of the company; (20% of mark) the value of limited liability for Schloses&White PLC at the beginning of 2006, clearly explaining your answer. (5% of mark)

ii.

b)

By the end of 2007 the financial crisis had occurred. Numerous companies had been severely harmed with many having never made a net profit. The market value of Schloses&White PLCs assets collapsed to 200 million, and its volatility was then estimated at 50%. The annual riskfree interest rate decreased to 3%, and it was expected to remain at 3% over the following 3 years. In addition to its existing debt (with a redemption value of 120m and a remaining time to maturity of three years), the company decided to issue further zero-coupon (nonconvertible) debt with a redemption value of 40 million and with three years to maturity. Given the new scenario: i. Calculate: the new value of equity; the new value of the total risky debt of the company; the value of the old, existing, risky debt of the company; and the value of the newly issued risky debt. Compare your results to those of part (a)(i), and discuss the differences (if any). (15% of mark) What is the value now of limited liability? previous scenario? If yes, explain why. Is it different from the (5% of mark)

ii.

iii.

Carefully explain the changes in shareholders and debtholders wealth under the new circumstances. Are these changes due to the capital structure games played between the companys shareholders and debtholders? Clearly explain your answer. (15% of mark)

Question 5 continued overleaf Page 6 of 7

BMAN30111 Question 5 continued c) Agency costs of debt. i. Explain the agency costs of debt using the OPT framework. (15% of marks) Provide examples of the main sources of this conflict. (15% of marks) iii. Outline the mechanisms that may be used to reduce agency conflicts between shareholders and debtholders. Critically discuss their advantages and disadvantages. (10% of marks)

ii.

END OF EXAMINATION

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