Hello, dear friend, you can consult us at any time if you have any questions, add WeChat: THEend8_
5QQMN533 – CORPORATE FINANCE Final Examination Solutions
ANSWER
1. ALL THREE QUESTIONS IN PART 1
2. EITHER QUESTION 4 OR QUESTION 5 IN PART 2
Part 1
Question 1. (Total marks:30)
You are valuing a firm that you expect will have earnings before interest and taxes
(EBIT) of £26 million every year beginning in one year. Each year, you expect that
depreciation will equal capital spending and there will be no new required
investments in working capital. The firm has 10 million shares outstanding, uses 50%
debt financing, has a debt cost of capital of 6%, a beta of 0.8, and a tax rate of 50%.
The risk-free rate is 6%, and the market risk premium is 5%.
Requirements:
1) What is the value per share using the weighted average cost of capital (WACC)
method (please provide the working)?
(10 marks)
2) What is the value per share using the adjusted present value method (APV) method
(please provide the working)?
(10 marks)
3) What is the value per share using the flow-to-equity (FTE) method (please provide
the working)?
(10 marks)
Solution:
1)
Determine the firm’s unlevered free cash flows.
EBIT £26,000,000
– Interest 0
EBT 26,000,000
– Taxes 13,000,000
Unlevered Net Income 13,000,000
Free Cash Flow
Plus: Depreciation = Capital Spending
Less: Capital Spending = Depreciation
Less: Increases in Working Capital 0
Free Cash Flow £13,000,000
Determine the after-tax weighted-average cost of capital (WACC).
The equity cost of capital can be determined from the CAPM.
rE = rf + β(E[RMkt ] − rf )= 0.06 + 0.80(0.05) = 10%
The WACC can now be calculated as:
WACC= 0.50(0.10) + 0.50(0.06)(1 0.50) = 6.5%
Determine the firm value, equity value, and value per share using the WACC method.
Since the firm’s free cash flows are a perpetuity:
FCF=£13million/0.065=£200million
The WACC method values the firm as a whole, so the equity value is:
E = VL −D = $200 million − 0.50($200 million) = $100 million
And the value per share is $100million/10million =$10.
2 of 8
(10 marks)
2) Determine the unlevered cost of capital to use for the APV method.
The unlevered equity beta, assuming that the debt beta is approximately zero, is:
βu = [ E/( E+D )]βE + [D /( E+D)]βD ≈ [ E/(E +D )]βE = 0.50(0.80) = 0.40
So the unlevered cost of equity, which equals the unlevered cost of capital, is:
β = 0.06 + 0.40(0.05) = 8% according to the CAPM model
Determine the firm value, equity value, and value per share using the APV method.
Assuming that the present value of financial distress, agency and issuance costs are
zero:
VL = APV =Vu + PV(Interest tax shield)=
$13 million
0.08
+
$100(0.06)(0.50)
0.08
=
162.50+37.50=$200million.
The APV method values the firm as a whole, so the equity value is:
E = VL −D = $200 million − 0.50($200 million) = $100 million.
And the value per share is =
$100 million
10
= $10
(10 marks)
3) Determine the annual free cash flow to equity (FCFE) for the FTE method.
EBIT $26,000,000
– Interest (6%× $100 million) 6,000,000
EBT 20,000,000
– Taxes 10,000,000
Unlevered Net Income 10,000,000
Free Cash Flow
Plus: Depreciation = Capital Spending
Less: Capital Spending = Depreciation
Less: Increases in Working Capital 0
Plus: Net Borrowing 0
Free Cash Flow to Equity (FCFE) $10,000,000
Determine the equity value and value per share using the FTE method.
The equity value is the present value of the flows to equity, which are a perpetuity,
discounted at the levered cost of equity:
E=
$10 million
0.10
=$100million
The FTE method values the firm as a whole, so the value per share is
$100million/10million =$10.
(10 marks)
Question 2. (Total marks: 30)
You are valuing a firm that you expect will have earnings before interest and taxes
(EBIT) of £26 million every year beginning in one year. Each year, you expect that
depreciation will equal capital spending and there will be no new required
investments in working capital. The firm has 10 million shares outstanding, uses 50%
debt financing, has a debt cost of capital of 6%, a beta of 0.8, and a tax rate of 50%.
The risk-free rate is 6%, and the market risk premium is 5%.
Requirements:
3 of 8
1) What is the value per share using the weighted average cost of capital (WACC)
method (please provide the working)?
(10 marks)
2) What is the value per share using the adjusted present value method (APV) method
(please provide the working)?
(10 marks)
3) What is the value per share using the flow-to-equity (FTE) method (please provide
the working)?
(10 marks)
Question 2. (Total marks: 30)
Case 1: The finance director of your company has decided to review working capital
policies, and has collected the following data:
£
Sales 2,000,000
Cost of sales 800,000
Purchases 850,000
Stock 197,260
Trade Debtors 328,767
Trade Creditors 174,657
There have been some problems with liquidity recently. This has caused difficulty in
paying trade creditors on time, and some suppliers are suggesting that future trade
may have to be on cash terms only. Suggestions to remedy the problem include:
a. Reducing the credit period allowed to debtors.
b. Reducing the amount of inventory held.
Case 2: KBS Clothe plc is a clothing manufacturer. At the moment it calculates the
order quantity for yarn used in the knitting of sports socks on the basis of the Economic
Order Quantity (EOQ). The company has estimated demand, order and holding costs
as below:
Annual demand 3,000 metres
Annual stockholding costs 85p per metre
Order costs per order £120
Requirements:
1) Calculate the working capital operating cycle for the working capital shown above
for case 1.
(5 marks)
2) Calculate the amount of cash required to reduce the trade creditor payment period
to 30 days for case 1.
(5 marks)
4 of 8
3) Calculate number of days’ reduction in the trade debtor collection period which
would be required in order to make the cash available to reduce the trade creditor
payment period to 30 days for case 1.
(5 marks)
4) Calculate the EOQ for yarn on the basis of the estimated demand, order and holding
costs for case 2.
(6 marks)
5) Based on your calculation in 4), explain how to improve the inventory management
of KBS Clothe plc.
(10 marks)
Solution:
1) Calculation of working capital operating cycle:
Stockholding period (197,260 / 800,000) x 365 = 90 days
Debtor days (328,767 / 2,000,000) x 365 = 60 days
150 days
Creditor days (174,657 / 850,000) x 365 = 75 days
Working capital operating cycle = 75 days
(5 marks)
2) To reduce the trade creditor payment period to 30 days would require a reduction
of 45 days.
45 days purchases represent (45/365) x 850,000 = £104,794
(5 marks)
3) £104,794 as a proportion of annual sales =
(104,794 / 2,000,000) x 365 = 19 days
(5 marks)
4) EOQ calculation:
m
H
DO
EOQ
35.920
85.0
120000,322
=
==
(6 marks)
5)
KBS Cloths Plc would require very frequent deliveries. In the absence of any changes
this would push up the cost of stock management, since the ordering cost is high. [2
marks]
Hence it would be necessary to reduce the ordering cost. [1 mark]
This could be done by increased reliance on the supplier:
• Using electronic data interface with the supplier to reduce the transaction costs
associated with ordering the yarn. Low stock levels would trigger an automated
order. [1 mark]
• Reliance on high quality materials being delivered. This eliminates the need to
check the materials for quality, allowing materials to be delivered direct to the
production floor. [1 mark]
5 of 8
• Eliminate stock holding records, since materials are effectively delivered straight
to production. [1 mark]
Such changes can only be achieved if there is a close, cooperative relationship with
the supplier. The supplier would have to be informed of the company’s production
plans, for example. [1 mark]
This implies that the number of suppliers would be reduced. Choice of supplier may
be based in some part on cost, but also very much on the long-term ability to provide
a supply which fits in with the company. [1 mark]
(10 marks)
Question 3. (Total marks: 10)
Discuss the types of leasing and reasons for the use of lease. Give examples where
appropriate. (Maximum 500 words)
(10 marks)
Solution: Please refer to Lecture 8 slides and BMA Chapter 25
Part 2
ANSWER EITHER QUESTION 4 OR QUESTION 5
Question 4. (Total marks: 30)
KBS Plc. is considering entering the specialty retail business. The initial investment to
get the retail stores launched is expected to be £5 billion, depreciable straight line
over a lifetime of 10 years to a salvage value of zero. The tax rate for KBS Plc is 40%
and the company faces an overall cost of capital of 11% for different businesses. The
cost of capital for specialty retailers is 9%.
Assume that KBS Plc. expects to stay in the retail business for only ten years. Revenues
are expected to be £4 billion each year for the next ten years.
Requirements:
(Please be explicit about the discount rate that you are using to compute your
answers in each part)
1) If KBS Plc. expects the EBITDA margin (EBITDA as a percent of sales) at the stores
will be 20%. Assuming no changes in working capital, please make the decision on
this investment project using the NPV method?
(8 marks)
2) Given the 20% EBITDA margin, what is the Profit Index for this investment project?
(4 marks)
3) What is the IRR for this investment project (using trial-and-error), assuming the
20% EBITDA margin?
(10 marks)
6 of 8
4) If the EBITDA margin turns out to be 30%, What is the payback period and
discounted payback period for the investment project?
(8 marks)
(Total: 30 marks)
Indicative Answer
1)
Initial investment = -£5,000.00
Annual cash flow
Revenue £4,000.00 1. Did not treat depreciation correctly: -2 mark
EBITDA £800.00 2. Forgot to take taxes: -2 mark
- DA £500.00 3. Wrong discount rate (9%): -2 mark
EBIT £300.00 4. Math errors: -2 mark
- Taxes £120.00
After-tax EBIT £180.00
+ DA £500.00
After-tax Cash flow £680.00
NPV = -£635.99 (8 marks)
2) PI =0.87
(give 1 mark for the
correct formula of PI) (4 marks)
3) IRR=6.02% 6.0205% 10 marks
4)
Initial investment = -£5,000.00
Annual cash flow
Revenue £4,000.00
EBITDA £1,200.00
- DA £500.00
EBIT £700.00
- Taxes £280.00
After-tax EBIT £420.00
+ DA £500.00
After-tax Cash flow £920.00
(5 out of 8 marks)
PP=5000/920= 5.43 years (1 out of 8 mark)
DPP = 7.8 years (2 out of 8 marks)
7 of 8
Question 5. (Total marks: 30)
KBS International Corp is a company that operates in two businesses, steel and
technology, and in two countries, the US and the UK. The table below summarises the
revenues by business and by country (in millions):
US UK Total
Steel $800 $300 $1,100
Technology $600 $400 $1,000
Total $1,400 $700 $2,100
You have estimated unlevered betas of 0.90 for steel and 1.20 for technology and
equity risk premiums of 6% for the US and 7% for the UK. The US Treasury bond rate
is 3% and the UK-denominated bond rate is 4%. KBS International Corp has 315 million
shares, trading at $10 per share, no debt outstanding and no cash balance. The
corporate marginal tax rate is 40%. Assume that KBS International Corp can hedge
against foreign exchange risk.
1) Based on the information provided, estimate the cost of capital for KBS
International Corp.
(15 marks)
2) Now assume that KBS International Corp plans to borrow $1.2 billion at 5% (pre-
tax) to invest in its technology business in the UK. Estimate the cost of capital for
the company after the debt issue and expansion.
(15 marks)
(Total: 30 marks)
Solution
1)
• For the US segment:
The unlevered beta for Clarus in the US segment:
(800/1,400) * 0.9+ (600/1,400) *1.2 = 1.03
As Clarus is all equity-financed, its unlevered beta = levered beta. Its cost of equity
(US segment): 3% + 1.03*6% = 9.18%
• For the UK segment:
The unlevered beta for Clarus in the UK segment:
(300/700) * 0.9+ (400/700) *1.2 = 1.07
The cost of equity (UK segment) = 4% + 1.07*7% = 11.49%
Cost of equity = cost of capital = (1,400/2,100) *9.18%+ (700/2,100) *11.49% = 9.95%
(15 marks)
2)
Market value of Equity: 315m*$10 = $3.15 billion
8 of 8
If we weight the total market value by revenues, this implies that $1.05 billion
shareholder value comes from the UK segment and the other $2.1 billion comes
from the US segment.
Levered beta in UK: 1.07*1 + (1.2/1.05)*(1-40%)) = 1.8
The cost of equity (UK segment) = 4% + 1.8*7% = 16.6%
The cost of capital (UK segment) = 16.6% * (1.05)/(1.05 + 1.2) + 5%*(1.2)/(1.05 +
1.2)*(1-40%) = 9.35%
Cost of equity = cost of capital = (1,400/2,100) *9.18%+ (700/2,100) *9.35% = 9.24%
(15 marks)