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Msf 507 Advanced Corporate Finance Evening Weekend Question Paper
Msf 507 Advanced Corporate Finance Evening Weekend
Course:Masters Of Science In Finance
Institution: Kca University question papers
Exam Year:2014
UNIVERSITY EXAMINATIONS: 2013/2014
EXAMINATION FOR THE MASTERS OF SCIENCE (MSC) FINANCE AND
INVESTMENT/ACCOUNTING/ECONOMICS
MSF 507 ADVANCED CORPORATE FINANCE EVENING WEEKEND
DATE: AUGUST, 2014
TIME: 3 HOURS
INSTRUCTIONS: Answer Question One and Any Other Three Questions
QUESTION ONE (31 MARKS)
a)
Despite Modigliani and Miller’s (MM) argument that dividends are irrelevant, dividend
payments have tended to smoothen over the years rather than take the expected random pattern.
Explain three theories which support dividend payments
b)
[10 Marks]
The fundamental theorem set forth by Modigliani and Miller is that, given complete and perfect
capital markets, it does not make any difference how one splits up the stream of operating cash
flows. The percentage of debt or equity does not change the total value of the cash stream
provided by the productive investments of the firm. Therefore, so long as there are no cost of
bankruptcy it should not make difference whether debt is risk free or risky
Required
Using Rubinstein [1973] mean variance framework provide a proof that risky debt and risky
equity have no impact on the value of the firm
c)
[10 Marks]
Using the simple binomial trees, calculate the value of a call option with the following
characteristics:
Underlying asset current value = 1,000
Option exercise price = 1,250.
Per-period dividends =10% of asset value
1
Up movement per period = 1.5, d=1/u.
Risk-free rate =10%
Time to expiration= 2years.
Number of time periods per year=1
[11 Marks]
QUESTION TWO (23 MARKS)
a)
The value of a mineral extraction project depends on the inventory in the ground (12,000 tons),
the price in the spot market (currently Ksh.20 per ton), the cost of capital (12%), the risk-free
rate (5% per year), the rate of extraction (4,000 tons per year), and the extraction cost (Ksh.22
per ton). Additionally, there is a 50-50 chance the price can go up by 50% or down by 331/3% in
a year. The cost of opening up is Ksh.20,000, while the cost of shutting down is Ksh.30,000.
Should the mine start open or closed, and what is the optimal rule for shutting it down? What is
its value? How does the answer change if the price of the mineral is currently Ksh.26?
[12 Marks]
b)
What potential reasons may explain the contradictory empirical results involving stock returns
and leverage?
c)
[5 Marks]
What are the differences between the trade-off and pecking order theories of Capital
structure?
[6 Marks]
QUESTION THREE (23 MARKS)
Consider firm A as an unlevered firm and firm B as a levered firm with target debt-to-equity ratio
(B/S)*=1. Both firms have exactly the same perpetual net operating income, NOI= 200, before taxes.
The before-tax cost of debt, kb, is the same as the risk-free rate. The corporate rate =.5. Given the
following market parameters:
E (Rm) =.12,
a)
s2m=.0144, Rf =.06, ßB =1, ßc=1.8,
Find the cost of capital and value for each firm. (Ignore any effect from personal income taxes)
[5 Marks]
b)
Evaluate the following four projects to determine their acceptance (or rejection) by firms A and
B. What do the results of this evaluation tell you about leverage in a world with corporate taxes
but no personal taxes? (Note: rjm is the correlation between the unlevered free cash flows of
each project and the market.)
2
Project j
Cost j
sj
E(NOIJ)
Rjm Correlation of j with
(After-tax)
the market
1 110 8 0.10 0.6
2 125 12 0.11 0.7
3 85 9 0.12 0.8
4 170 20 0.20 0.9
[10 Marks]
c)
What are the main firm-specific determinants of corporate capital structure?
[8 Marks]
QUESTION FOUR (23 MARKS)
Pilot Electric Company John Kamau, the financial analyst for Pilot Electric Company, is responsible
for preliminary analysis of the company’s investment projects. He is trying to evaluate two large
projects that management has decided to consider as a single joint project, because it is felt that the
geographical diversification the joint project provides would be advantageous.
Pilot Electric was founded in the early 1930s and has operated profitably ever since. Growing at
about the same rate as the population in its service areas, the company has usually been able to forecast
its revenues with a great deal of accuracy. The stable pattern in revenues and a favorable regulatory
environment have caused most investors to view Pilot as an investment of very low risk.
Kamau is concerned because one of the two projects uses a new technology that will be very
profitable, assuming that the demand is high in a booming economy, but will do poorly in a
recessionary economy. However, the expected cash flows of the two projects, supplied by the
engineering department, are identical. The expected after-tax cash flows on operating income for the
joint project are given in the Table below. Both projects are exactly the same size, so the cash flow for
one is simply half the joint cash flow.
Year Outflows Inflows Interest
1 250 10 7.5
2 250 20 15.0
3 250 25 22.5
4 250 60 30.0
5-30 0 110 30.0
31-40 0 80 30.0
41 0 40 0
3
In order to better evaluate the project, Kamau applies his knowledge of modern finance theory. He
estimates that the beta of the riskier project is 0.75, whereas the beta for the less risky project is
0.4375. These betas, however, are based on the covariance between the return on after-tax operating
income and the market. Kamau vaguely recalls that any discount rate he decides to apply to the project
should consider financial risk as well as operating (or business) risk. The beta for the equity of Pilot is
0.5. The company has a ratio of debt to total assets of 50% and a marginal tax rate of 40%. Because the
bonds of Pilot are rated AAA, Kamau decides to assume that they are risk free. Finally, after
consulting his investment banker, Kamau believes that 18% is a reasonable estimate of the expected
return on the market.
The joint project, if undertaken, will represent 10% of the corporation’s assets. Pilot intends to finance
the joint project with 50% debt and 50% equity.
Kamau wants to submit a report that answers the following questions; please assist him now.
a) What is the appropriate required rate of return for the new project?
b) What is the cost of equity capital and the weighted average cost of capital for Pilot Electric
before it takes the project?
[4 Marks]
[6 Marks]
c) Should the joint project be accepted? [2 Marks]
d) What would the outcome be if the projects are considered separately? [6 Marks]
e) If the joint project is accepted, what will the firm’s new risk level be? [5 Marks]
QUESTION FIVE (23 MARKS)
a)
The XYZ Company (an all-equity firm) currently has after-tax operating cash flows of
Ksh.3.00 per share and pays out 50% of its earnings in dividends. If it expects to keep the same
payout ratio, and earn 20% on future investments forever, what will its current price per share
be? Assume that the cost of capital is 15%.
b)
[12 Marks]
It was suggested that if a firm announces its intention to increase its dividends (paid from cash),
the price of common stock increases, presumably because the higher dividend payout
represents an unambiguous signal to shareholders that anticipated cash flows from investment
are permanently higher. A higher level of cash flows is also beneficial to bondholders because
it diminishes the profitability of default. If dividends are paid from cash, what does the OPM
suggest will happen to the market of debt?
[11 Marks]
4
QUESTION SIX (23 MARKS)
The Jordan Corporation is a manufacturer of heavy-duty trucks. Because of a low internal profitability
rate and lack of favorable investment opportunities in the existing line of business, Jordan is
considering merger to achieve more favorable growth and profitability opportunities. It has made an
extensive search of a large number of corporations and has narrowed the candidates to two firms. The
Konrad Corporation is a manufacturer of materials handling equipment and is strong in research and
marketing. It has had higher internal profitability than the other firm being considered and has had
substantial investment opportunities.
The Loomis Company is a manufacturer of food and candles. It has a better profitability record than
Konrad. Data on all three firms are given in the table below. Additional information on market
parameters includes a risk-free rate of 6% and an expected return on the market, E(Rm), of 11%. Each
firm pays a 10% interest rate on its debt. The tax rate,
c,
of each is 40%. Ten years is estimated for the
duration of supernormal growth. Use the continuing value formula to estimate supernormal growth.
a) Prepare the accounting balance sheets for the three firms
[3 Marks]
b) If each company earns the before-tax r on total assets in the current year, what is the net
operating income for each economy?
[3 Marks]
Book value per Price/Earnings Number Debt ßfor Internal investment Growth
share (Ksh.) Ratio, of Shares Ratio Existing Profitability Rate, Rate,
PE (Millions) B/S Leverage Rate, r K g
Jordan 200 6 4 1 1.4 0.06 0.5 0.03
Konrad 200 15 2 1 1.2 0.12 1.5 0.18
Loomis 200 12 2 1 1.5 0.15 1.0 0.15
c)
Given the indicated price/earnings ratios, what is the market price of the common stock of each
company?
d)
[4 Marks]
What will be the immediate effects on the earnings per share of Jordan if it acquires Konrad or
Loomis at their current market prices by the exchange of stock based on the current market
prices of each of the companies?
e)
Compare Jordan’s new beta and required return on equity if it merges with Konrad with the
same parameters that would result from its merger with Loomis.
f)
[3 Marks]
Calculate the new required cost of capital for a Jordan-Konrad combination and for a Jordan-
Loomis combination, respectively.
g)
[3 Marks]
[4 Marks]
Compare the increase in value of Jordan as a result of a merger at market values with the cost
5
of acquiring either Konrad or Loomis if the combined firms have the following financial
parameters:
[3 Marks]
EBIT
r WACC K g
Jordan/Konrad 340 0.16 9.3% 1.0 0.16
Jordan/Loomis 380 0.13 10% 1.0 0.13
6
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