CMA JANUARY 2023 EXAMINATION

ADVANCED LEVEL I
Sub: EF343. CORPORATE FINANCIAL STRATEGY & FINANCIAL MARKET

Model Solution

Solution of the Question 1:

1(c)

(i) E(RA) = 0.175 or 17.5%

E(RB) = 0.055 or 5.5%

E(RC) = 0.005 or 0.5%

(ii) SD (RA) = 0.2586

SD (RB) = 0.115

SD (RC) = 0.0456

(iii) CORR (RA, RB) = - 0.1639

CORR (RA, RC) = - .01098

CORR (RB, RC) = 0.2441

(iv) Stocks A and B should give you the biggest diversification benefit because their correlation is the
lowest.

(d)E(RF) =1.125% [Solve the equation,14.05 = RF+ 2.2 (7 – RF)]

Solution of the Question 2:

(a)
(b) (i) The number of shares after the acquisition will be the current number of shares
outstanding for the acquiring firm, plus the number of new shares created for the acquisition,
which is:
Number of shares after acquisition = 30,000,000 + 11,000,000
Number of shares after acquisition = 41,000,000

And the share price will be the value of the combined company divided by the shares
outstanding, which will be:
New stock price = £540,000,000 / 41,000,000
New stock price = £13.17

(ii) Let  equal the fraction of ownership for the target shareholders in the new firm. We can
set the percentage of ownership in the new firm equal to the value of the cash offer, so:

(£540,000,000) = £159,000,000
 = .2944, or 29.44%
So, the shareholders of the target firm would be equally as well off if they received 29.44
percent of the stock in the new company as if they received the cash offer. The ownership
percentage of the target firm shareholders in the new firm can be expressed as:

Ownership = New shares issued / (New shares issued + Current shares of

acquiring firm)
.2944 = New shares issued / (New shares issued + 30,000,000)
New shares issued = 12,519,685

To find the exchange ratio, we divide the new shares issued to the shareholders of the target
firm by the existing number of shares in the target firm, so:

Exchange ratio = New shares / Existing shares in target firm

Exchange ratio = 12,519,685 / 18,000,000
Exchange ratio = .6955

An exchange ratio of .6955 shares of the merged company for each share of the target
company owned would make the value of the stock offer equivalent to the value of the cash
offer.

(c) According to M&M Proposition I with taxes, the increase in the value of the company will
be the present value of the interest tax shield. Since the loan will be repaid in equal
installments, we need to find the loan interest and the interest tax shield each year. The loan
schedule will be:

Year Loan Balance Interest Tax Shield

0 $2,600,000.00
1 1,300,000.00 $208,000 $72,800
2 0 104,000 36,400

So, the increase in the value of the company is:

Value increase = $72,800 / 1.08 + $36,400 / (1.08)2
Value increase = $98,614.54

(d) (i) Before the announcement of the stock repurchase plan, the market value of the
outstanding debt is $3,100,000.

Using the debt–equity ratio, we can find that the value of the outstanding equity must be:
Debt–equity ratio = B / S
.35 = $3,100,000 / S
S = $8,857,143

The value of a levered firm is equal to the sum of the market value of the firm’s debt and the
market value of the firm’s equity, so:
VL = B + S
VL = $3,100,000 + 8,857,143
VL = $11,957,143

According to MM Proposition I without taxes, changes in a firm’s capital structure have no

effect on the overall value of the firm. Therefore, the value of the firm will not change after
the announcement of the stock repurchase plan.

(ii) The expected return on a firm’s equity is the ratio of annual earnings to the market value
of the firm’s equity, or return on equity. Before the restructuring, the company was expected
to pay interest in the amount of:
Interest payment = .067($3,100,000)

CMA January 2023 Examination, EF343 [Page 2 of 4]

 Interest payment = $207,700
The return on equity, which is equal to RS, will be:
ROE = RS = ($1,075,000 – 207,700) / $8,857,143
RS = .0979, or 9.79%

(iii) According to Modigliani-Miller Proposition II with no taxes:

RS = R0 + (B/S)(R0 – RB)
.0979 = R0 + (.35)(R0 – .067)
R0 = .0899, or 8.99%
This problem can also be solved in the following way:
R0 = Earnings before interest / VU

According to Modigliani-Miller Proposition I, in a world with no taxes, the value of a levered

firm equals the value of an otherwise-identical unlevered firm. Since the value of the
company as a levered firm is $11,957,143 (= $3,100,000 + 8,857,143) and since the firm
pays no taxes, the value of the company as an unlevered firm is also $11,957,143. So:
R0 = $1,075,000 / $11,957,143
R0 = .0899, or 8.99%

(iv) In part c, we calculated the cost of an all-equity firm. We can use Modigliani-Miller
Proposition II with no taxes again to find the cost of equity for the firm with the new leverage
ratio. The cost of equity under the stock repurchase plan will be:
RS = R0 + (B/S)(R0 – RB)
RS = .0899 + (.50)(.0899 – .067)
RS = .1014, or 10.14%

Solution of the Question 3:

(c) The forward price of an asset with no carrying costs or convenience value is:

Forward price = S0(1 + R)

Since you will receive the bond’s face value of $1,000 in 11 years and the 11 year spot
interest rate is currently 7 percent, the current price of the bond is:

Current bond price = $1,000 / (1.07)11

Current bond price = $475.09

Since the forward contract defers delivery of the bond for one year, the appropriate interest
rate to use in the forward pricing equation is the one-year spot interest rate of 5 percent:

Forward price = $475.09(1.05)

Forward price = $498.85

(d) (i) Since the firm has a 100 percent payout policy, the entire net income, $85,000 will be
paid as a dividend. The current value of the firm is the discounted value one year
from now, plus the current income, which is:
Value = $85,000 + $1,725,000 / 1.12
Value = $1,625,178.57

(ii) The current stock price is the value of the firm, divided by the shares outstanding, which
is:
Stock price = $1,625,178.57 / 25,000
Stock price = $65.01

CMA January 2023 Examination, EF343 [Page 3 of 4]

Since the company has a 100 percent payout policy, the current dividend per share will be
the company’s net income, divided by the shares outstanding, or:
Current dividend = $85,000 / 25,000
Current dividend = $3.40

The stock price will fall by the value of the dividend to:
Ex-dividend stock price = $65.01 – 3.40
Ex-dividend stock price = $61.61

(iii) According to MM, it cannot be true that the low dividend is depressing the price. Since
dividend policy is irrelevant, the level of the dividend should not matter. Any funds not
distributed as dividends add to the value of the firm, hence the stock price. These directors
merely want to change the timing of the dividends (more now, less in the future). As the
calculations below indicate, the value of the firm is unchanged by their proposal. Therefore,
the share price will be unchanged.

To show this, consider what would happen if the dividend were increased to
$4.60. Since only the existing shareholders will get the dividend, the required
dollar amount to pay the dividends is:

Total dividends = $4.60(25,000)

Total dividends = $115,000

To fund this dividend payment, the company must raise:

Dollars raised = Required funds – Net income

Dollars raised = $115,000 – 85,000
Dollars raised = $30,000

This money can only be raised with the sale of new equity to maintain the all-
equity financing. Since those new shareholders must also earn 12 percent,
their share of the firm one year from now is:

New shareholder value in one year = $30,000(1.12)

New shareholder value in one year = $33,600

This means that the old shareholders' interest falls to:

Old shareholder value in one year = $1,725,000 – 33,600

Old shareholder value in one year = $1,691,400

Under this scenario, the current value of the firm is:

Value = $115,000 + $1,691,400 / 1.12

Value = $1,625,178.57

Since the firm value is the same as in part a, the change in dividend policy had no effect.

END OF QUESTION

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