BF3201

ATTENTION: The Singapore Copyright Act applies to the use of this document. Nanyang Technological University Library

NANYANG TECHNOLOGICAL UNIVERSITY

SEMESTER 2 EXAMINATION 2014-2015

BF3201 Corporate Finance and Strategy

April/May 2015

Time Allowed: 2 hours

INSTRUCTIONS
1.

This paper contains FOUR(4) questions and comprises FIVE(5) pages.

2.

Answer ALL questions.

3.

The number of marks allocated is shown at the end of each question.

4.

Begin your answer to each question on a separate page of the answer book.

5.

Answers will be graded for content and appropriate presentation.

6.

This is a RESTRICTED OPEN-BOOK EXAMINATION. Students are only allowed to

bring into the examination hall ONE A4-size paper of formulas and notes.

Note: Examination questions begin from page 2.

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Question 1
SHOW ALL WORK FOR FULL CREDIT.
(a)

Firm X has 90 million shares outstanding trading at $10 a share and $100 million in
debt. Its current cost of equity is 7% and its current rating is AAA (with a default
spread of 0.5% over the riskfree rate). The current riskfree rate is 3% and the equity
risk premium is 5%.The marginal tax rate is 30%.
(i)

Estimate the current cost of capital for the firm.

(3 marks)

(ii)

(b)

(c)

If the firm moves to its optimal debt ratio, it expects to increase its firm value
by $50 million. There will be no growth in savings over time. Assume that at
the firms optimal debt ratio, its equity beta will be 1.04 and its before-tax cost
of debt will be 4%. Estimate the firms optimal debt to capital ratio.
(7 marks)

Firm Y is considering issuing bonds with attached warrants. The bonds have a 10-year
maturity and pay semiannual coupons. Each bond will have 20 warrants attached.
Each warrant will give the holder the right to purchase one share of Firm Y. The value
of each warrant is estimated at $10. A similar straight-debt issue at par would require
a 9 percent coupon rate.
(i)

What coupon rate should be set on the bonds so that the package of one bond
and 20 warrants would sell for $1,000?
(6 marks)

(ii)

Discuss briefly possible reason(s) why Firm Y would want to undertake a

bond-cum-warrant issue.
(4 marks)

Firm Z is an all-equity-financed company, with a cash balance of $10 million at the

end of 2014. For the year 2015, the firm expects to report a net income of $280
million and depreciation of $180 million. It also expects to increase its gross long
term assets and working capital by $300 million. The firm intends to maintain its
dividend payout ratio at 50% of net income. How much debt (in $ million) will the
firm have to raise if it wants to have a cash balance of $60 million at the end of 2015?
(5 marks)
(TOTAL: 25 marks)

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ATTENTION: The Singapore Copyright Act applies to the use of this document. Nanyang Technological University Library

Question 2
SHOW ALL WORK FOR FULL CREDIT.
(a)

BidCo recently proposed to acquire TargetCo by offering one new BidCo share for
every two TargetCo shares. You have obtained the following information just prior to
the announcement:
BidCo
TargetCo
Stock price
$10.00
$4.00
Net income
$60 million
$20 million
Shares outstanding
80 million
40 million
Earnings per share
$0.75
$0.50
(i)

Compute the percentage shareholding of TargetCos shareholders in the

combined firm.
(3 marks)

(ii)

Assume that there is no synergy from the merger. Based on the net income
reported just prior to the merger, what is BidCos earnings per share
immediately after the merger? Can you draw any lesson(s) from your analysis?
(5 marks)

(iii)

Now assume that the present value of synergies from the merger is estimated
at $20 million. Assume also that the stand-alone values of BidCo and
TargetCo before the merger can be represented by the respective market
capitalisations of the two companies just prior to the announcement. Estimate
the gain or loss to the shareholders of BidCo and TargetCo, respectively.
(5 marks)

(b)

Mr. Buffett vowed never to spin off any of Berkshire Hathaways subsidiaries,
defending the sprawling conglomerate he has assembled over the past 50 years.
(Financial Times, 2 March 2015)
In contrast to Berkshire Hathaways defence of its conglomerate structure, some firms
recently chose to spin off some parts of their businesses.
(i)

Briefly discuss the condition(s) under which diversification will create

shareholder value.
(6 marks)

(ii)

When would spin-offs make sense (i.e., create value) for a conglomerate?
Explain.
(6 marks)
(TOTAL: 25 marks)

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Question 3
SHOW ALL WORK FOR FULL CREDIT.
(a)

EM Limited is a company based in Country X. Its main businesses are in consumer

electronics and transportation. Its recent annual report shows the following:
Business
Consumer electronics
Transportation
Cash

Net Assets
30%
60%
10%

The estimated unlevered betas of comparable firms in consumer electronics and

transportation are 1.2 and 0.6, respectively. EM Limited has a target debt to equity
ratio of 50%. Country X has a rating of BB. The typical default spread for BB rated
bonds is 3%. The standard deviations in Country Xs equity and government bond are
30% and 20%, respectively. The U.S. treasury bond rate is 3%. The historical risk
premium in the U.S. is 6%. EM Limited has a marginal tax rate of 30%.
(i)

Estimate the cost of equity for EM Limited in U.S. dollar terms.

(7 marks)

(ii)

(b)

Critically evaluate the reasonableness of the assumptions in your calculations

in Part (i) above.
(6 marks)

Makan Place is a company that operates a food court business. It is considering

packaging its famous herbal drinks for sale at supermarkets and grocery stores. The
initial investment in production facilities to start this new business will be $1,200,000,
which can be depreciated straight line over 10 years to a salvage value of $200,000.
The new business is expected to generate revenues of $800,000 each year for the next
10 years. The EBITDA margin (EBITDA/revenues) is expected to be 25% on these
revenues. The working capital is expected to be 15% of revenues, with the investment
occurring at the start of each period, where needed. The working capital is expected to
be recovered in full in Year 10. The cost of capital for Makan Place is 10% but the
cost of capital for other firms in the packaged drinks business is 8%. The marginal tax
rate is 20%.
(i)

Estimate the net present value of the investment.

(9 marks)

(ii)

Now assume that the packaged drinks business will increase the after-tax
cashflows of the food court business by $50,000 a year for the next 10 years.
Estimate the value of this synergy.
(3 marks)
(TOTAL: 25 marks)

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Question 4
(a)

A recent study of the boards of 717 firms listed on the SGX as at end-2013 shows that
30.8% of the firms have Board Chairs who are concurrently the firms Chief
Executive Officer (CEO) and 26.2% of the firms have executive Board Chairs who
are not concurrently the firms CEO (Journal of ISCA, December 2014).
What are the arguments for and against separating the roles of Board Chair and CEO?
Do you think Lead Independent Directors can provide an effective check on Executive
Chairs? Why or why not?
(6 marks)

(b)

One of the sources of value to shareholders from a leveraged recapitalisation is wealth

transfer from bondholders.
(i)

How would bondholders protect themselves against the risk of wealth transfer?
(4 marks)

(ii)

Other than wealth transfer, discuss briefly other possible sources of value to
shareholders from a leveraged recapitalisation.
(7 marks)

(iii)

How does a leveraged recapitalisation differ from a leveraged buyout?

(4 marks)

(c)

Should a young technology firm with growth opportunities have more or less debt?
Why?
(4 marks)
(TOTAL: 25 marks)

END OF PAPER