FN2 - ADVANCED CORPORATE FINANCEEXAM REVIEWHANDOUT IIIADVANCED CORPORATE FINANCE“MORE RECENT” EXAM REVIEW QUESTIONS – HANDOUT III SUMMARY OF QUESTIONSQUESTION SOURCE PARTICULARS MARKS101 December 2006 EAR calculations;debt v. commonshares182 June 2006 Capital structure;M&M perfect world3 June 2006 Currency hedge17options4 March 2006 Dividend policy 155 March 2007 Bond refinancing 14Question 1 (December 2006)10 marksTwo years ago, John Green and Jack Bean, graduates of a university software engineering program, founded Safe Networks Co. (SN) to commercialize their software products developed for any organization to protect its computer network from hackers’ attacks. SN is an all-equity company financed with John and Jack’s own savings and savings from their families and friends. The business has been very successful.Now John and Jack are exploring financing initiatives to expand their operation. The amount of working capital required is $1 million. The following banks have offered to lend money to SN:• Bank A offers a term loan at an interest rate of 6.5%, compounded daily.• Bank B offers a simple interest term loan at an interest rate of 5.5%, with a compensating balance of 10% and interest payments made quarterly.• Bank C offers a discount interest term loan at a 6.5% interest rate, compounded monthly.• Bank D offers a discount interest term loan with a 6% annual interest rate and a compensating balance of 5%.Required:Write a memo to John and Jack to address the following:• One advantage and one disadvantage of issuing new common shares• One advantage and one disadvantage of introducing debt into SN’s capital structure • The effective annual interest rate for each loan proposal• Your recommendation of which offer John and Jack should accept and whySolution to Question 1Date: December 31, 2006To: John GreenJack BeanFrom: Jill Jones, CGA StudentRe: Financing AlternativesMany businesses start small with personal savings as the main source of financing. As business expands and financing need increases, owners should explore other financing alternatives. One possibility is to issue new common shares. There are advantages and disadvantages of issuing new common shares.Advantages:• Equity is a permanent source of capital, which reduces the risk to the issuer• Common-share financing improves the firm’s debt-to-equity ratioDisadvantages:• Issuing new common shares dilutes the control of current shareholders• Cost of equity may be higher than debt as new shareholders expect a higher return on their investmentAnother possibility is to introduce debt into the capital structure.The advantage of debt is that the firm may save some income taxes because the interest expense is tax deductible and using debt is using financial leverage.The disadvantage is that using debt introduces financial risk into the firm because there are required periodic cash payments (interest and principal).The effective annual interest rate for each loan proposal can be calculated as:Bank A:Bank B:Bank C:Bank D:You should choose Bank B since the effective annual interest rate on that loan is the lowest, at 6.25%.Question 2 (June 2006) 18 marksDEF Corp. is currently an all-equity firm. It needs to raise $2.5 million in additional funds. After raising the funds, it expects earnings before interest and taxes (EBIT) to be $600,000. The firm’s unlevered cost of equity, k U, is 12%, and its before-tax cost of debt, k B, is 8%.Required:a. If there are no corporate taxes, in a perfect Modigliani and Miller (M&M) world, what is the value of DEF if it issues common shares to raise the needed funds? Alternatively, what is the firm’s new cost of equity and the value of the firm if it issues debt to raise the needed funds? What is its opportunity cost of capital? What is the fundamental determinant of the value of the firm in the M&M no-tax case?b. Now assume that the corporate tax rate is 35%.i) What is the all-equity value of DEF?ii) What is DEF’s value if $2.5 million in debt is issued? What is the new k E? What is the new opportunity cost of capital?iii) Assume the debt is now $4 million. What is DEF’s value? What is the new k E? What is the new opportunity cost of capital?c. Based on your answers to parts a) and b), what role do debt financing and corporate tax play in a firm’s capital structure decision? What other factors does a firm need to consider?Solution to Question 2a. In a no-tax M&M perfect world, after raising the fund by issuing common shares,The current common equity is $5,000,000 – $2,500,000 = $2,500,000.If $2.5 million is to be raised by issuing debt,b. In an M&M world with corporate tax:c. In a no-tax M&M perfect world, a firm’s capital structure decision is irrelevant. Regardless of how much debt a firm uses, the firm’s value remains unchanged. Only a firm’s investment decision can change a firm’s value. With corporate tax, a firm can use debt to increase its own value. The more debt, the higher a firm’s total value, the lower its cost of capital (WACC). But debt financing increases a firm’s cost of equity and reduces its equity value. This is financial risk. Other factors a firm needs to consider are personal taxes, bankruptcy costs, business risk, and agency costs.Question 3 (June 2006) 17 marksABC Corp., a Canadian firm, has an account payable with a British firm coming due in 6 months. The payable requires ABC to pay £200,000 (British pounds). ABC’s founder and CEO, Jean Sawyer, has asked you to advise her on the various alternatives for dealing with the exchange risk inherent in this payable. She wishes to know the expected Canadian dollar cost of 1) a forward hedge, 2) borrowing on the money market, 3) an option hedge, and 4) remaining unhedged.The following information is available. The spot rate today is C$2.48 = £1. The current 6-month forward rate is C$2.47 = £1. The premium for a 6-month option with an exercise price of C$2.45 = £1 is C$0.05 per British pound. Interest rates in the two countries are as follows:Great Britain Canada6-month deposit rate 4.5% 4%6-month borrowing rate 5.5% 5%Required:Write a brief report to advise Jean on the following:Which of the four alternatives do you recommend? Be clear on which position to take — buy or sell (with an option hedge, also specify a call, or a put). Support your recommendation with calculations and a discussion of the advantages and also specify disadvantages of each alternative.Solution to Question 3MEMODATE: June 10, 2006TO: Jean Sawyer, CEOFROM: Antonio Bing, CGASUBJECT: Alternatives for Exchange RiskThe expected Canadian dollar cost of each hedging alternative is as follows:1) Forward hedge: You would buy a forward contract. Though you don’t need to pay for the contract right now, 6 months later you will have to pay the Canadian dollar cost of the forward hedge, which is:£200,000 (C$2.47 / £1) = C$494,0002) Money market hedge: For this alternative, you would borrow Canadian dollars and convert these dollars into British pounds at today’s spot rate. Then you would deposit these pounds in a British bank to earn interest. Because your deposit earns interest in British pounds, the amount of British pounds you would need today is:To get this amount of British pounds at today’s spot rate, you would need to borrow: £195,599 (C$2.48 / £1) = C$485,085.52Since you borrowed this amount of Canadian dollars, you would have to pay interest. The Canadian dollar cost of this alternative is:C$485,085.52 (1 + 5% × 6/12) = C$497,212.663) Option hedge: You would purchase a call on pounds. The maximum Canadian dollar cost of this alternative is:£200,000 (C$2.45 + C$0.05) = C$500,000One benefit unique to a purchase call option hedge is you retain the potential to reduce your cost if the exchange rate moves in your favour, that is, if the Canadian dollar appreciates against British pounds in this case. You may pay fewer Canadian dollars to get the same amount of pounds. $500,000 is the maximum cost to you.4) Remaining unhedged: The Canadian dollar cost of this alternative cannot be determined now, as it depends on the spot exchange rate 6 months later, which is unpredictable. In general, the Canadian dollar cost of remaining unhedged is:£200,000 (Spot rate 6 months later)Recommendation:I would recommend the option hedge alternative. Although remaining unhedged allows you to benefit from a lower value of pounds, it is more risky because it is equally likely that the British pound will strengthen against the Canadian dollar. Both forward and money market hedges eliminate the risk of a strong pound but they also eliminate your opportunity to benefit from a weak pound. An option hedge provides you with both protection against a weaker Canadian dollar and potential to benefit from a stronger Canadian dollar.Question 4 (March 2006) 15 MarksIn 2004, ABC Corp. paid dividends totalling $3.6 million on net income of $10.8 million. The year 2004 was a typical year, and for the past 10 years, earnings have grown at a constant annual rate of 10%. However, in 2005, earnings are expected to increase to $14.4 million because of an exceptionally profitable new product line being introduced, and the firm expects to have profitable investment opportunities of $8.4 million. After 2005, the company will likely return to its previous 10% growth rate.ABC’s target capital structure is 40% debt and 60% equity.Required:a. Calculate ABC’s total dividends for 2005 if it follows each of the following policies:i) Its 2005 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.ii) It continues the 2004 dividend payout ratio.iii) It uses a pure residual dividend policy (40% of the $8.4 million investment is financed with debt and 60% with common equity).iv) It employs a regular-dividend-plus-extra policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual policy. Also calculate the extra dividend for 2005.b. Which of the preceding four policies would you recommend? Explain briefly.c. Suppose that investors expect ABC to pay total dividends of $9 million in 2005 and to have the dividend grow at 10% after 2005. The share’s total market value is $180 million. Calculate the firm’s cost of equity.d. In addition to cash dividends, identify other possible forms of shareholder remuneration that can be used.Solution to Question 4a.i) 2005 dividends = (1.10) (2004 dividends) = (1.10) ($3,600,000) = $3,960,000ii) 2004 payout ratio = $3,600,000 / $10,800,000 = 33 1/3%2005 dividends = (331/3%) ($14,400,000) = $4,800,000iii) Equity financing = $8,400,000 (0.6) = $5,040,0002005 dividends = Net income – Equity financing= $14,400,000 – $5,040,000= $9,360,000All of the equity financing is done with earnings as long as they are available.iv) The regular dividends would be the 2004 dividends plus a 10% growth:Regular dividends = (1.10) ($3,600,000) = $3,960,000The residual policy calls for dividends of $9,360,000. Therefore, the extra dividend would be:Extra dividend = $9,360,000 – $3,960,000 = $5,400,000.b. Policy iv), based on the regular dividend with an extra dividend, seems most logical. If implemented properly, it would lead to correct capital budgeting and correct financing decisions, and it would convey correct signals to investors.c. The cost of equity =d. Other possible forms of remuneration are stock dividends, stock splits, and share repurchases.Question 5 (March 2007) 14 marksLake Ontario Mining Co. (LOM) has a $10 million outstanding bond issue bearing a 15% coupon. The bonds were issued in 1990, and will mature in 2015 but are callable after 2006. Now LOM’s investment banker has given assurance that up to $15 million of new 8-year bonds maturing in 2015 can be sold at par. The following exhibit shows the characteristics of the outstanding bonds and of the planned bond issue.Characteristics of LOM’s Old and New Bond IssuesOld Bonds New BondsFace value $10,000,000 $10,000,000 Remaining maturity 8 years 8 yearsOverlap period 2 months 2 monthsCoupon rate 15% paid semi-annually ?% paid semi-annually Flotation costs 5% of face valueCall premium 50% of coupon rateThe financial staff at LOM notice that LOM’s close competitors are selling their new 8-year 8% coupon bonds at par. The new bonds would be issued 2 months before the old bonds are to be called. During the overlap period, proceeds from selling the new bonds will be invested in the 91-day T-bills which were issued 31 days ago but sell for 99.18% of a $1,000 face value on the market. LOM is in the 40% tax bracket.Required:a. What should the coupon rate be on the new bonds, assuming that the market is efficient? Explain briefly.b. Should LOM refinance the bond issue? Why? Show your calculations.c. From the current bondholders’ perspective, how much capital gain or loss (on the basis of a $1,000 face value) would be incurred if LOM calls the bonds?Solution to Question 5a. As the market is efficient, bonds of the same risk class yield the same rate of return. LOM should be able to sell its new 8-year bonds at a coupon rate of 8% at par because its close competitors are selling their new 8-year 8% coupon bonds at par. This 8% is also the yield to maturity on such bonds.b.The value of the call premium associated with the old issue of bonds is 0.5 × 15% ×$10M = $750,000.Flotation costs associated with the new issue of bonds are 0.05 × $10M = $500,000. These flotation costs are tax-deductible over 5 years. The value of the tax savings each of the 5 years is 0.4 × $500,000 / 5 = $40,000.The present value of these tax savings may be calculated using LOM’s after-tax cost of new debt, which is 8% (1 – 40%) = 4.8% paid semi-annually.The effective annual rate is:The present value of the future tax savings from the flotation costs is $40,000 × PVIFA (4.86%, 5) = $173,851.33.The net flotation costs are $500,000 – $173,851.33 = $326,148.67.The current T-bill rate can be calculated as follows:The net additional interest expense during the overlap period of 2 months on an after-tax basis is $10M × [(15% – 5%) × (2 / 12)](1 – 40%) = $100,000.The incremental after-tax interest savings from the refinancing is $10M [(15% – 8%) / 2] (1 – 40%) = $210,000.The semi-annual discount rate is the semi-annual after-tax cost of the new debt is 8% (1 – 40%) / 2 = 2.4%.Present value of the semi-annual after-tax interest savings is $210,000 × PVIFA (2.4%, 16) = $2,763,007.05.NPV of refinancing the old bonds = $2,763,007.05 – $750,000.00 – $326,148.67 – $100,000.00 = $1,586,858.38 > 0; therefore, LOM should refinance the old bonds.c. If LOM does not call the bonds, they would sell for:$75 × PVIFA (4%, 16) + $1,000 × PVIF (4%, 16) = $1,407.83 per $1,000 face value LOM pays the $1,000 face value + call premium (0.5 × 15% × $1,000) = $75; that is, a total of $1,075 to call a $1,000 bond. The current bondholders would lose $1,407.83 – $1,075.00 = $332.83 per $1,000 bond.。
