Busi97318 Corporate Finance Tutorial 7: MSC Finance and Accounting

BUSI97318
Corporate Finance
Tutorial 7
MSc Finance and Accounting
Adrian Lam
y.lam16@imperial.ac.uk
Imperial College London
December 3, 2019
Logistics Conceptual Wrap-up
Plan for Today
1 Coursework 3: Solutions
Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 1 / 47

Question 1: Question
Question 1
You have become the new CEO of Lam Li & Associates (the last CEO
didnt know what he was doing). The last CEO did some thinking on
borrowing, but left you with no advice on dividend policy. You want to
know what happens to your stock price as a result of returning money to
investors. You know the following:
i) You are planning to declare a dividend of $0.40, on which investors face

a tax rate of 35%;
ii) Investors pay a capital gains tax of 35%, which can be deferred to
future years;
iii) Investors have an opportunity cost of 8.5% in evaluating future cash
flows.

Question 1(a): Question and Solution
Question 1(a)
If the price of one share of LL&A (before the ex-dividend date) is $27,
assuming the average investor defers taxes for 4 years, what will the price
be right after the ex-dividend day?
How are stock price around the ex-dividend date and the
amount dividend related?
The difference should reflect differences in tax rates for dividends and
for capital gains
With cum-dividend price (Pcum ), ex-dividend price (Pex ), divident tax
rate (td ) and capital gains tax rate (tg ), the relationship can be
expressed by
Pcum − Pex 1 − td
=
D 1 − tg

Question 1(a): Solution

How should we take into account that investors defer taxes for
4 years?
Compute the effective capital gains tax (tg∗ )
tg 35%
tg∗ = =
(1 + r )T (1 + 8.5%)4
= 25.2550999%
What is the ex-dividend price?
=
D 1 − tg
1 − td
Pex = Pcum − D ×
1 − tg
1 − 0.35
= 27 − 0.4 ×
1 − 0.33876314
= $26.65215018
Question 1(b): Question and Solution
Question 1(b)
Assume now that the majority of your investors are corporations who face
a capital gains tax of 35% and a 42.5% ordinary tax on income (including
dividends). Also assume now that, instead of being able to defer taxes,
investors are allowed to exempt 65% of the dividends they receive from
taxes. If the shares are selling at $27 each, how much will the stock price
drop by by the end of the ex-dividend day?
What is the effective dividend tax rate now?
td∗ = Taxable Dividend × tdstated = (1 − 65%) × 42.5%

= 14.875%

Question 1(c): Question and Solution
Question 1(c)
Explain intuitively why the price of the stock changes on the ex-dividend
day.
What does the price fall on ex-dividend day?

Shareholders who buy the stock after the ex-dividend day are not
entitled to the dividend payment
Why the change in stock price does not equal the dividend
amount?
The price change incorporates the differences between the dividend tax
rate and capital gains tax rate across shareholders

What is the drop in stock price on ex-dividend day (∆P)?
1 − td∗ 1 − 14.975%
∆P = 0.4 × = 0.4 ×
1 − tg 1 − 35%
= $0.523846154

Question 2(a): Question
Question 2
DelCash Inc., a discount retailer, has declared and paid a dividend of $500
million this year. You notice, looking over their financial statements, that
they have net income of $2 billion for this year, and that the cash balance
for the firm increased by $250 million.
(a) If the non-cash working capital was unchanged over the year, and the
firm finances 30% of its net capital expenditures from debt, estimate the
net capital expenditures that DelCash had during the year.

What is the amount of FCFE?

FCFE is the amount of cash left in business after non-equity
claimholders have been paid and all necessary reinvements
FCFE = Dividend + ∆Cash = 500 + 250

= $750M
What is the formula to calculate FCFE?

Simplified version with constant debt ratio
FCFE = Net Income + Reinvestment from Equity

 
D 
= Net Income − (1 − ) CapEx − Dep +∆WC 

FV | {z }
Net CapEx
= 2000 − (1 − 0.3)(Net CapEx + 0)

What is the amount of net capital expenditures?

Combining the two equations,
$750M = 2000 − 0.7 × Net CapEx

Net CapEx = $1785.714286M

Question 2(b): Question
Question 2(b)
At the start of the ex-dividend day, DelCashs stock was trading at $25. By
the end of the day, the stock was trading at $23.20. If the typical
stockholder in DelCash paid 40% on dividend income and 20% on capital
gains taxes which can be deferred for 5 years at an opportunity cost of 8%,
estimate the number of shares outstanding in the firm.

Question 2(b): Solution
How to find the number of shares?

With total amount of dividends paid (DTotal ), dividends per share
(DPS ) and the number of shares outstanding (N),
DPS × N = DTotal
What is the amount of dividend paid?

Using the stock price/tax relationship,
=
DPS 1 − tg

Question 2(b): Solution
What is the effective capital gains tax rate (tg∗ )?
20%
tg∗ = = 0.136116639
(1 + 8%)5
What is the amount of dividend paid? (Continued)
25 − 23.2 1 − 0.4
=
DPS 1 − 0.136116639
DPS = $2.591650082
What is the number of shares outstanding?
DPS × N = DTotal
2.591650082 × N = 500
N = 192.9272796

Question 2(c)
Assume that DelCash Inc.s debt is in the form of corporate bonds. How
would you expect the bonds to react to the announcement?
Bond prices should fall because

Bond coupons become riskier
Unexpected dividend payout is essentially a transfer of wealth from
bondholders to shareholders

Question 3
RYBR Inc., an all-equity firm, has net income of £100 million currently
and expects this number to grow at 10% a year for the next three years.
The firms working capital increased by £10 million this year and is
expected to increase by the same £ amount each of the next three years.
The depreciation is £50 million and is expected to grow 8% a year for the
next three years. Finally, the firm plans to invest £60 million in capital
expenditure for each of the next three years. The firm pays 60% of its
earnings as dividends each year. RYBR has a cash balance of £50 million
today.

Question 3(a)
Assuming that the cash does not earn any interest, how much would you
expect to have as a cash balance at the end of the third year?
Using the information provided

Year t t+1 t+2 t+3
Net Income 100 110 121.00 133.10
Depreciation 50 54 58.32 62.99
CapEx 60 60 60.00 60.00
Change in WC 10 10 10.00 10.00
FCFE 80 94 109.32 126.09
Dividends – 66 72.60 79.86
Cash 50 78 114.72 160.95
Cash balance at the end of the third year is £160.95

Question
Assume that RYBR had financed 20% of its reinvestment needs with debt,
estimate the cash balance at the end of the third year.
Using the information provided

Year t t+1 t+2 t+3
Net Income 100 110 121.00 133.10
Depreciation 40 43.2 46.66 50.39
CapEx 48 48 48.00 48.00
Change in WC 8 8 8.00 8.00
FCFE 84 97.2 111.66 127.49
Dividends – 66 72.60 79.86
Cash 50 81.2 120.26 167.88
Cash balance at the end of the third year is £167.88

Question 3(c): Question
Question 3(c)
Now assume that stockholders in RYBR are primarily corporations. They
are exempt from ordinary taxes on 85% of the dividends that they receive
(Ordinary tax rate=30%), and pay capital gains on price appreciation at a
20% rate. If RYBR pays a dividend of 2 per share, how much would you
expect the stock price change to be on the ex-dividend date?
What is the change in stock price on the ex-dividend date?

∆P 1 − td
=
D 1 − tg
∆P (1 − (1 − 85%) × 30%)
=
2 1 − 20%
∆P = $ 2.3875

Question 4(a)
Lube Oil, a chain of automobile service stations, reports net income of
$100 million after depreciation of $50 million. The firm has capital
expenditures of $80 million, and the non-cash working capital increased
from $25 to $40 million.
(a) Estimate the firms FCFE, assuming that the firm is all equity financed.
What is Lube Oil’s FCFE?
FCFE = Net Income − Net CapEx − ∆WCNon Cash + ∆Debt

= $100M + $50M − $80M − ($40 − $25)
= $55M

Question 4(b)
Lube Oil paid a dividend of $20 million and bought back $25 million in
stock. Estimate how much the cash balance of the firm changed during
the year.
What is the total payout?

Total payout (Payout) is the sum of dividends (D) and share
repurchase (Buyback)
Payout = D + Buyback = $20M + $25M
= $45M
What is the cash balance (Cash) after the payout?

Cash = FCFE − Payout = $55M − $45M
= $10M

Question 4(c)
How would your answers to (a) and (b) change if you were told that Lube
Oil started the year with $120 million in debt and ended the year with
$135 million?
How will this affect FCFE?

By looking at the FCFE formula,
= $55M + ($135M − $120M)
= $70M
What is the new cash balance?

Cash = FCFE − Payout = $70M − $45M
= $25M
Question 4(d): Question and Solution
Question 4(d)
Now assume that Lube Oil has a return on equity of 5% and a cost of
equity of 10%. As a stockholder in Lube Oil, would you want the firm to
change its dividend policy? Why or why not?
What would investors prefer?

Prefer Lube Oil to change its financing policy by increasing payout
Why?
Since the return on equity is lower than the cost of equity, it reflects
that managers are making poor project choices
How could Lube Oil change its financing policy?
Lower its capital expenditures, which currently stands at 80% of its net
income

Question 5
Neebom Corporation, a manufacturer of toys, has asked for your advice on
dividend policy. Neebom had a net income of $150 million in 2015 and
reported depreciation of $20 million. Its balance sheets for 2014 and 2015
are below (in millions):
Assets Liabilities and Equity

2016 2017 2016 2017
Net Fixed Assets $750 $800 Current Liabilities $50 $60
Cash $50 $100 Debt $200 $240
Non-cash Current Assets $100 $120 Equity $650 $720

Question 5(a)
Estimate how much Neebom paid out as dividends during 2015.
What do we know about the uses of FCFE?

FCFE is either paid out or retained in cash
FCFE = ∆Cash + Payout
What is the FCFE?

= 150 − (800 − 750) − ((120 − 60) − (100 − 50))
+ (240 − 200)
= $130M

What is the amount paid out?
FCFE = ∆Cash + Payout

FCFE = (100 − 50) + Payout
Payout = 130 − (100 − 50)
= $80M

Question 5(b)
Estimate how much capital expenditure Neebom had in 2015.
What is CapEx?
∆Net Fixed Assets = CapEx − Dep

CapEx = (800 − 750) + 20
= $70M


Question 5(c)
Now assume that you have been given the following information on next
years projections for Neebom Corporation: Net Income, depreciation and
non-cash working capital are expected to increase 10% from 2015 levels.
The firm has four projects that it is considering for next year:
Project EBIT Investment Beta

A $6.67M $30M 1.2
B $3.33M $20M 1
C $4.17M $20M 1.1
D $8.33M $35M 2
Assume that the firm plans to finance these projects at a debt to capital
ratio of 25%, and that the cost of debt is 8%. Also suppose that the
corporate tax rate is 40% and that the long-term Treasury bond rate is 7%.
Estimate how much Neebom can afford to pay out next year as dividends.
Question 5(c): Solution
What is the return on invested capital for project i (RoCi )?
(1 − t)EBITi
RoCi =
Investmenti
What is the expected return on each project and the
corresponding cost of capital?
Project Return Cost of Capital
A 13.34% 12.39%
B 9.99% 11.4%
C 12.51% 11.895%
D 14.28% 16.35%

Which projects should we accept?

Projects A and C, since return on equity is greater than cost of equity
CapEx for 2017
CapEx2017 = InvestmentA + InvestmentC = 30 + 20

= $50M

What is the amount of potential dividends?

Since FCFE is a measure of potential dividends and Neebom plans to
finance these projects at a 60% debt ratio,
D
FCFE = Net Income − (Net Investment + ∆WCNon Cash ) × (1 − )
FV
= (150 × 1.1) − ((50 − 20 × 1.1)) × (1 − 0.25)
− ((120 − 60) × (1.1 − 1)) × (1 − 0.25)
= $139.5M

Question 6
Netsoft is a company that manufactures networking software. In the
current year, the firm reported operating earnings before interest and taxes
of $200 million (note that operating earnings does not include interest
income), and these earnings are expected to grow 4% a year in perpetuity.
In addition, the firm has a cash balance of $250 million. The unlevered
beta for other networking software firms is 1.33. If Netsoft has a debt ratio
of 15%, a tax rate of 40%, a return on capital of 10% on operating assets,
and a cost of debt of 10%, estimate the value of the firm. (The risk-free
rate is 6%, and you can assume a market risk premium of 5.5%.)

Question 6: Solution
What is the required return on Netsoft’s operating assets (rE )?
If we lever it up using the beta from comparable firms

0.15
rE = 6% + 1.33 × 1 + (1 − 0.4) × × 5.5%
1 − 0.15
= 14.0895294%
What is the weighted average cost of capital for Netsoft’s
operating assets (rC )?
rC = 0.85 × 14.0895294% + 0.15 × (1 − 0.4) × 10%
= 12.8761%
What is the reinvestment rate (γ)?
g = RoC × γ
4% = 10% × γ
γ = 40%
Question 6: Solution
What is the value of Netsoft’s operating assets?

The value of Netsoft’s operating assets (EV) should be equal to the
present value of the after-tax income stream it generates
(1 − t) × EBIT × (1 + g ) × (1 − γ)
EV =
rC − g
(1 − 0.4) × 200 × (1 − 0.4)
=
12.5161% − 4%
= $843.6137493M
What is the firm value of Netsoft (FV )?
FV = EV + Cash = 843.6137493 + 250

= $1093.613749M

Question 7(a)
Gemco Jewelers earned $5 million in after-tax operating income in the
most recent year. The firm also had capital expenditures of $4 million and
depreciation of $2 million during the year, and the non-cash working
capital at the end of the year was $10 million.
(a) Assuming that the firms operating income will grow 20% next year,
and that all other items (capital expenditures, depreciation, and non-cash
working capital) will grow at the same rate, estimate the FCFF next year.

What is the FCFF for next year?
FCFF = (1 − t) × EBIT − Net Investment − ∆WCNon Cash

= 5 × (1 + 20%) − (4 − 2) × (1 + 20%) − 10 × (1 + 20% − 1)
= $1.6M

Question 7(b)
If the firm can grow at 20% for the next five years, estimate the present
value of the FCFF over that period. Assume a cost of capital of 12%.
What is the present value of the FCFF over the next five years
(PVFCFF
1,5 )?
Using the growing annuity formula,
" T #
FCFFt=1 1+g
PVFCFF
1,5 = × 1−
r −g 1+r
" 5 #
1.6 1 + 20%
= × 1−
12% − 20% 1 + 12%
= $8.238791872M

Question 7(c)
After year 5, the growth rate will drop to 5% forever. In year 6, the firms
capital expenditures will be $6.53M, and operating income, non-cash
working capital and depreciation will be 5% higher than in year 5. In
addition, the cost of capital will decline to 10%. Estimate the terminal
value of the firm at the end of year five.

Year 1 2 3 4 5 6
EBIT(1-t) 6.00 7.20 8.64 10.37 12.44 13.06
CapEx 4.80 5.76 6.91 8.29 9.95 6.53
Dep 2.40 2.88 3.46 4.15 4.98 5.23
WC 12.00 14.40 17.28 20.74 24.88 26.13
∆ WC 2.00 2.40 2.88 3.46 4.15 1.24
FCFF 1.60 1.92 2.30 2.76 3.32 10.51
FCFF )?
What is the terminal value (PV6,∞
FCFF FCFFt=6 10.514992

PV6,∞ = 0 0
=
rC − g 10% − 5%
= $210.29984M

Question 7(d): Question and Solution
Question 7(d)
Estimate the current value of the operating assets of the firm.
What is the current value of the operating assets (EV)?
EV = PVFCFF FCFF
1,5 + PV6,∞
210.29984
= 8.238791872 +
(1 + 12%)5
= $127.5685688M

Question 8
Lockheed, one of the largest defense contractors in the United States, reported
EBITDA of $1,290 million in a recent financial year, prior to interest expenses of
$215 million and depreciation charges of $400 million. Capital expenditures
amounted to $450 million during the year, and working capital was 7% of revenues
(which were $13,500 million). The firm had debt outstanding of $3.068 billion (in
book value terms), trading at a market value of $3.2 billion, and yielding a pretax
interest rate of 8%. There were 62 million shares outstanding, trading at $64 per
share, and the most recent beta is 1.10. The tax rate for the firm is 40%. (The
Treasury bond rate is 7%.) The firm expects revenues, earnings, capital
expenditures, and depreciation to grow at 9.5% a year for the next five years, after
which the growth rate is expected to drop to 4%. (Even though this is unrealistic,
assume that capital spending will offset depreciation in the stable-growth period.)
The company also plans to lower its debt/equity ratio to 50% for the steady state
(which will result in the pretax interest rate dropping to 7.5%).

Question 8(a)
Estimate the value of the entire firm.
What is the current market value of equity (VE ) and firm value
(FV)?
VE = 62 × 64
= $3.968B
FV = 3.2 + 3.968
= $7.168B
What is the current cost of capital (rC ,t=0 )?
3.968 3.2
rC ,t=0 = × (7% + 1.1 × 5.5%) + × (1 − 0.4) × 8%
7.168 7.168
= 9.3669643%
What is the current unlevered beta (βU,t=0 ), steady state cost

of equity (rE ,t>5 ) and steady state cost of capital (rC ,t>5 )?
1
βU,t=0 = 1.1 × 3.2

1 + (1 − t) × 3.968
= 0.741304348
rE ,t>5 = 7% + 0.741304348 × (1 + (1 − 0.4) × 0.5) × 5.5%
= 12.3003261%
1 0.5
rC ,t>5 = × 12.3003261% + × (1 − 0.4) × 7.5%
1 + 0.5 1 + 0.5
= 9.7002174%

What is EBIT?
EBIT = EBITDA − (Depreciation + Amortisation)
What are the FCFFs in the following years?
Year t t+1 t+2 t+3 t+4 t+5 t+6* t+6**

Rev 13,500.00 14,782.50 16,186.84 17,724.59 19,408.42 21,252.22 22,102.31 22,102.31
EBITDA 1,290.00 1,412.55 1,546.74 1,693.68 1,854.58 2,030.77 2,112.00 2,112.00
EBIT(1-t) 534.00 584.73 640.28 701.11 767.71 840.64 825.15 874.27
CapEx 450.00 492.75 539.56 590.82 646.95 708.41 736.74 654.88
Dep 400.00 438.00 479.61 525.17 575.06 629.70 736.74 654.88
WC 945.00 1,034.78 1,133.08 1,240.72 1,358.59 1,487.66 1,547.16 1,547.16
∆ WC 0.00 89.78 98.30 107.64 117.87 129.07 59.51 59.51
FCFF 484.00 440.21 482.02 527.82 577.96 632.87 765.65 814.76
PV 402.50 402.99 403.48 403.97 404.46 8,454.73 8,997.10
* New CapEx determined by CapEx

** New CapEx determined by Dep

What is the value of the firm?
EV = PVFCFF FCFF
1,5 + PV6,∞
= $10472.14258M (t+6*) or $11014.51341M (t+6**)

Question 8(b)
Estimate the value of the equity in the firm and the value per share. Are
Lockheed shares selling close to their fundamental value?
What is the fundamental value of equity (VE ,Fun. )?

Assuming there is no cash,
VE ,Fun. = EV − VD
= EV − 3200
= $7272.142577M (t+6*) or $7814.513414M (t+6**)

What is the value per share (PFun. )?
VE ,Fun.
PFun. =
NShares Outstanding
= $117.2926222 (t+6*) or $126.0405389 (t+6**)
Are Lockheed shares selling close to their fundmental value?

No, Lockheed is massively underpriced relative to the fundamental
value calculated here
One possible reason is that we have assumed a 4% perpetual growth
rate without net investment

Wrap-up
Questions, Comments and Feedback

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BUSI97318

MSc Finance and Accounting

Imperial College London

Plan for Today

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 1 / 47

i) You are planning to declare a dividend of $0.40, on which investors face

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 2 / 47

Question 1(a): Question and Solution

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 3 / 47

Question 1(a): Solution

Question 1(b): Question and Solution

What is the effective dividend tax rate now?

td∗ = Taxable Dividend × tdstated = (1 − 65%) × 42.5%

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 5 / 47

Question 1(c): Question and Solution

What does the price fall on ex-dividend day?

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 6 / 47

Question 1(c): Question and Solution

What is the drop in stock price on ex-dividend day (∆P)?

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 7 / 47

Question 2(a): Question

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 8 / 47

Question 2(a): Question

What is the amount of FCFE?

FCFE = Dividend + ∆Cash = 500 + 250

What is the formula to calculate FCFE?

FCFE = Net Income + Reinvestment from Equity

= 2000 − (1 − 0.3)(Net CapEx + 0)

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 9 / 47

Question 2(a): Solution

What is the amount of net capital expenditures?

$750M = 2000 − 0.7 × Net CapEx

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 10 / 47

Question 2(b): Question

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 11 / 47

Question 2(b): Solution

How to find the number of shares?

What is the amount of dividend paid?

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 12 / 47

Question 2(b): Solution

What is the effective capital gains tax rate (tg∗ )?

What is the number of shares outstanding?

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 13 / 47

Question 2(c): Question and Solution

Bond prices should fall because

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 14 / 47

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 15 / 47

Question 3(a): Question and Solution

Using the information provided

Cash balance at the end of the third year is £160.95

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 16 / 47

Question 3(b): Question and Solution

Using the information provided

Cash balance at the end of the third year is £167.88

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 17 / 47

Question 3(c): Question

What is the change in stock price on the ex-dividend date?

Adrian Lam (Imperial College) Tutorial 7 December 3, 2019 18 / 47