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theory of corporate finance
Questions and Answers of
Theory Of Corporate Finance
=+(b) Calculate the Present Value (PV) as of year 4, of the net cash flows for the six years from year 5 to year 10, and insert the figure into the cash flow forecast you prepared in problem 10.1.
=+(a) Use your answers to problems 10.2 and 10.3 to calculate the WACC of the company.
=+Problem 10.3 Name two alternative approaches to calculating ROOT’s cost of equity and use both of them to calculate its cost of equity. Assume that the company’s actual cost of equity is the
=+(b) Calculate the company’s gearing ratio [shown as a percentage] as defined by debt divided by (debt plus equity), based on market values.10.5 Problems 229
=+Problem 10.1 Set out the year-by-year cash flow forecast for the first four years of the project (years 0–4) if Root goes ahead with the project. If you make any assumptions, please state them.
=+(c) How stable is the beta coefficient?
=+(b) What is the risk-free rate? Is the rate on T-bills appropriate? Should we use the yield on government bonds?
=+(a) What is the right figure for the MRP? Is it between 7 and 8 per cent? Some say it is less. Others say it depends on location.
=+b. For each company, calculate the forward and historic price to earnings ratio and comment on the results.
=+a. How many outstanding shares does each company have?
=+Problem 9.4 The following information is from Yahoo finance as of August 2021:Company Coca-Cola PepsiCo Earnings per share (based on most recent earnings) $1.87 $5.92 Earnings per share (based on
=+c. How else might Peverill try to value Middlesex Mouldings?
=+b. What is the maximum price that Peverill should offer for Middlesex? Assume a discount rate of 10 per cent and a five-year time horizon for the acquisition.
=+can be increased by a further £4 million a year; but only if £10 million is invested at once and a further £3 million invested at the end of each year for the next four years(until and including
=+Problem 9.3 Peverill Plastics plc is considering making a bid for control of MiddlesexMouldings Ltd. The company’s directors have taken a five-year view.Middlesex’s predicted cash flow for the
=+a. ratio of debt to (debt plus equity) based on book values.b. interest coverc. earnings per share after the acquisition with Beach Products Inc’s present position. Assume a tax rate of 30 per
=+2. issuing $50 million 12 per cent loan stock.For each of the alternative methods of financing the acquisition, calculate and compare the:
=+group’s current profit before interest and tax (PBIT) is $25 million a year, which is expected to rise by $10 million a year (to $35 million a year) as a result of the acquisition.Beach Products
=+Problem 9.2 Beach Products Inc is planning a major acquisition costing $50 million.The company’s present capital consists of 100 million 50¢ issued ordinary shares,$40 million retained earnings
=+b. using a horizon period of 15 years?
=+year. Surplus Snapdragon assets to be sold immediately after the acquisition (without significantly affecting profits) are expected to realize £1 million net.If the appropriate after-tax discount
=+economies of scale can add a further £2 million a year after tax under their ownership. The move to acquire Snapdragon requires an immediate capital investment of£5 million (which is stated net
=+Problem 9.1 Hollyhock plc is proposing to acquire all the equity capital of Snapdragon Ltd. Future cash inflows for Snapdragon as a separate company are estimated at £4 million a year after tax.
=+iv. Show how the investor can maintain the same level of net disposable funds next year as they have had in the past by selling some of their holdings. How much dividend will they be receiving from
=+iii. Assuming the firm undertakes the project, what would be its annual dividends starting in year 2?References 201
=+to invest in equipment that costs £1 million. The project is expected to generate an annual net cash flow of £70,000 a year forever, starting in two years’ time (end of year 2), at which time
=+b. Company X which is now an all-equity firm, is considering investing next year in a new project of the same risk profile as its existing projects. The idea is to retain next year’s profits of
=+ii. Show how the investor can maintain the same stream of income and percentage of holdings in the firm’s equity as they had before the change in the capital structure, by taking a personal loan
=+a. The company is considering raising £8 million in new shares and using the proceeds to pay off the debt.i. Show that the WACC of the company remains the same when it becomes an all-equity firm.
=+ The debt bears an annual coupon rate of 5 per cent, and the company’s dividend policy is to pay out all earnings after interest, as dividends. The weighted average cost of capital (WACC) of
=+Problem 8.5 (Challenging!) In a perfect capital market, without taxes or transaction costs, lives a person who holds 1 per cent of the shares of company X which earns£1 million in profit before
=+b. Calculate the level of earnings before interest and tax (EBIT) at which EPS under the two financing alternatives will be the same.
=+iii. Debt ratio. i.e., Debt to (Debt plus Equity), using the market value of equity and the book value of debt (assuming the book value of debt is similar to its market value).
=+One is a 1 for 10 rights issue at 150p. The other is to borrow £30 million at 8 per cent a year for 10 years (Ignore transaction costs.) Annual operating profit (EBIT)is currently £54 million.
=+million (with an average interest rate of 10 per cent a year) and shareholders’ funds 200 8 Capital Structure and Dividend Policy of £180 million. Andover is considering two alternative ways to
=+Problem 8.4 Andover Equipment plc needs to raise £30 million of new capital to finance a major expansion which is expected to increase operating profit by £6.0 million a year. The company
=+b. At what level of current operating profit would earnings per share be the same under the alternative financing proposals?
=+profit by e50 million a year. Two alternatives are being considered:1. Issue 120 million new ordinary shares at e2.50 each (compared with the current market price of e3.00); or 2. Borrow e300
=+Problem 8.3 Travis Gmbh has an operating profit of e150 million. Currently debt interest payable is e20 million a year, the corporate tax rate stands at 40 per cent and there are 600 million
=+both pay out all profits after tax as dividends to equity holders. Borg has a debt ratio of 5 per cent, McEnroe of 20 per cent. In each case the rate of debt interest is 15 per cent a year. Assume
=+Problem 8.2 Borg Inc and McEnroe Inc, two companies in the same industry, are of similar size but have different levels of gearing. In Year 1 each company made an operating profit of $90 million,
=+b. At what level of Return on Capital Employed will the Return on Equity for the two companies be the same?
=+a. Calculate the after-tax Return on Equity (PAT divided by equity) and the interest cover (EBIT divided by interest payable) for Laurel and Hardy for Year 1 and Year 2.
=+30 per cent. In Year 1, the Return on Capital Employed (EBIT divided by (debt plus equity)) for each company is 25 per cent; in Year 2 it is only 7.5 per cent.
=+Problem 8.1 Laurel plc and Hardy plc are similar companies except for their financial gearing. Each company’s capital employed (debt plus equity) is £120 million and each pays out all profit
=+Problem 7.4 DE Inc has book values of debt and equity of $200m and $400m, respectively. Assume the market value of debt is the same as the book value. The cost of debt is 6.0 per cent, and the cost
=+c. BC has a WACC of 12.0 per cent. The cost of debt is 5.0 per cent. The debt/equity weights are 30/70. What is the cost of equity capital?
=+b. ZA has a WACC of 12.0 per cent. The cost of debt is 6.0 per cent and the cost of equity is 15.0 per cent. What are the weights of debt and equity, respectively?
=+Problem 7.3a. XY plc has equity with a market value of £60 million and debt with a market value of £20 million. The cost of equity capital is 12.0 per cent and the cost of debt is 6.0 per cent.
=+e. UVW GmbH expects to pay a dividend at the end of this year of 12.0¢ per share.The current share price is 240¢. The cost of equity capital is twice the expected growth rate in dividends. Using
=+d. RST has a cost of equity capital of 14.4 per cent. The current dividend yield (based on next year’s dividend) is 10.0 per cent. What is the (constant) annual growth rate expected in future?
=+c. PLQ Inc paid a dividend of 6.0¢ per share last year. The current dividend yield(based on next year’s dividend) is 5.0 per cent and dividends are expected to grow in line with earnings at 8.0
=+dividend of only 4.0p per share this year-end. The prospects for the industry look gloomy, and the risk premium applicable to the company has increased, so that the cost of equity capital is now
=+b. MD Enterprises plc has run into trouble. The company’s policy is to pay out a constant proportion of its earnings in dividends each year; but earnings per share are now expected to grow by
=+Problem 7.2a. MD Enterprises plc expects to pay a net dividend at the end of this year of 6.0p per share; and the market expects the dividend to increase by 5 per cent a year.The company’s cost
=+e. MNO plc has a beta of 0.75. The risk-free rate of return is 4.0 per cent and the cost of equity capital is 10.0 per cent. How much does the cost of equity increase if the beta doubles?170 7 Cost
=+d. JKL Inc has a beta of 0.8, and a cost of equity capital of 8.8 per cent. The risk-free rate of return is 4.0 per cent. What is the market risk premium?
=+c. GHI plc has a cost of equity capital of 16.5 per cent. If the market risk premium is 8.0 per cent and the risk-free rate of return is 4.5 per cent, what is GHI’s beta?
=+Problem 7.1a. ABC plc has a beta of 1.2. If the risk-free rate of return is 2.5 per cent and the market risk premium is 6.0 per cent, what is ABC’s cost of equity capital?b. DEF Inc has a beta of
=+b. Also calculate the position of two holders of 2000 ordinary shares. The first, Olivia Knox, plans to take up the rights to which she is entitled; while the second, Colin Berry, proposes to sell
=+Problem 6.4 Nancy King plc has 240 million ordinary shares already in issue, with a current market price of 330p per share. The company plans to raise an extra £180 million of equity capital by
=+b. Show the investor’s profit/loss on the deal if the shares end up at $330 per share.148 6 Ordinary Share Capital
=+Problem 6.3 An investor believes that the share price of company Y is overvalued at $300 and is going to drop in price. As she does not hold the stock, the investor decided to short sell 20 shares
=+Problem 6.2 An investor buys 100 shares of company X at $20 per share. The company pays a dividend of $2 per share. By the end of the year, the shares of company X are trading at $25 per share.a.
=+b. Explain the importance of market capitalization and the difference between market capitalization and free-float market capitalization.
=+Problem 6.1a. Identify three components of the Dow Jones Industrial Average (DJIA) and find the market capitalization of each.
=+(ii) What is the current yield on the bond?
=+(i) What is the current market price of the bond?
=+(b) The bond now has 2 years to maturity, the next interest payment is due in one year, and the yield to maturity stands at 3 per cent.
=+Problem 5.4 Some years ago, a company issued a 20-year bond with face value of£100 and coupon rate of 5 per cent, paid annually.(a) The bond now has 3 years to maturity, the next interest payment
=+(b) What would be the price of the bond after 5 years, if the yield to maturity at that time stood at 1.5 per cent?
=+Problem 5.3 You bought a 10-year zero-coupon bond with a face value of $1000, for $853.(a) What is the yield to maturity on the bond?
=+(b) What will the price of the bond be if the interest rate is:(i) 5 per cent(ii) 3 per cent?References 127
=+Problem 5.2 The Arcadian government’s irredeemable bond is considered risk-free.It pays an annual coupon of 4 per cent on 100 par value, and the next interest payment is due in one year’s
=+(c) What happens if the interest rate rises to 15 per cent?
=+(b) What happens to the value if the interest rate falls to 10 per cent a year?
=+Problem 5.1(a) What is the value of a perpetuity of 600p (£6) a year if the interest rate is 12 per cent and the first payment is due in one year’s time?
=+ Is there adequate depth of management?
=+ How good is the management, especially financial management and management control?
=+• What sort of business is it? Profitable? Risky? Stable?
=+ If their financial position were to get much worse, would they continue to provide regular accurate up-to-date reports?
=+ What about their character: would a possible default really concern them?
=+• Is the borrower both honest and competent? What is their track record?
=+ How low, at worst, could their second-hand value be, if the whole industry is in a downturn?
=+• In a crisis, how quickly could the borrower sell-off fixed assets?
=+• How quickly could the borrower liquidate current assets if need be, to pay loan interest or to repay principal?
=+• To what extent could the company reduce planned spending at lower levels of output?
=+• How far might the borrower’s profits and cash inflows fall in a downturn?
=+Why should a European fashion house consider establishing operations in the United States, given the foreign exchange risks to which this activity exposes the firm?
=+(b) Officine Générale is now considering entering the US market by opening an actual store and an office in New York.
=+Show the cash flows involved under a forward hedge and under a hedge strategy that involves purchasing options.
=+$1.21/e. Put and Call options on euro, with an exercise price of $1.22/e are selling for $0.03/e and $0.01/e, respectively.(a) Explain how Bloomingdale’s can hedge the foreign exchange risk to
=+Problem 4.3 Bloomingdale’s Inc., an American luxury department store, has just signed a contract to buy e500,000 worth of top brands from Officine Générale, a French fashion house. According to
=+Calculate the NPV of the proposed project under the alternative scenario and its IRR.
=+Problem 4.2 While Centric Brands Group is quite optimistic about the project, it decided to consider an alternative scenario where the economy recovers and demand for office space in New York gets
=+(b) Conduct a sensitivity analysis to determine by how much each of the following variables would have to change in order for the company’s management to change its mind about going ahead with
=+(a) Calculate the NPV of the proposed project, and comment upon its viability.
=+b) Conduct a sensitivity analysis to determine by how much each of the following variables would have to change before the company would change its mind about going ahead with the new product:1.
=+the first year (year 1), reducing by 10 per cent in each year of the project’s life.1 Depreciation—an expense allowable for tax—is to be charged on the equipment using the straight-line basis
=+The Hair Factory company is considering the production of a new product with a life expectancy of 4 years. This is a new hair treatment oil which is expected to fetch a price of $12.50 per unit and
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