I need a solution for question 2 in the attached document please.

Page 1 of 6 THE UNIVERSITY OF THE WEST INDIES ST. AUGUSTINE EXAMINATIONS OF APRIL 2014 Code and Name of Course: INTF 6004 Duration: 7 Corporate Finance 3 Hours Date and Time: INSTRUCTION TO CANDIDATES: This paper has thirteen (13) pages and six (6) questions Candidates are required to Question 1 and any three (3) of the remaining questions. Each question carries twenty-five (25) marks. Use of silent programmable calculators is allowed. The University of the West Indies Course Code: INTF 6004 April 2014 DO NOT WRITE OR TYPE ON THE BACK OF THIS SHEET: USE ONE SIDE ONLY INSTRUCTIONS: Each page must be signed by the Examiners and where applicable, the University Examiner and/or the External Examiner. Where the examination does not require a University Examiner, the form must be signed by the First and Second Examiners. Completed forms should be handed to the Senior Assistant Registrar (Examinations). The EXTERNAL EXAMINER is requested to sign the question paper and return it with comments, if any (on a separate sheet), to the Senior Assistant Registrar (Examinations). ......................................... First Examiner ............................................. University Examiner ......................................... Second Examiner .............................................. External Examiner (where applicable) Date: 2014/...../..... Date: 2014/...../..... Page 2 of 6 Question 1 Question 2 Avco is a manufacturer of custom packaging products. Avco pays a corporate tax rate of 40%. Avco's current market value balance sheet, with the associated cost of capital for boith its equity and debt is shown in the table below; Avco's Current Market Value Balance Sheet ($ million) and cost of capital Assets Liabilities Cost of Capital Cash 20 Debt 320 Debt 6% Assets 600 Equity 300 Equity 10% Total 620 Total 620 Suppose Avco is considering the acquisition of another firm in its industry that specializes in custom packing. The acquisition is expected to increase Avco's free cash flow by $3.8 million the first year, and this contribution is expected to grow at a rate of 3% per year from then on. Avco has negotiated a purchase price of $80 million. After the transaction, Avco will adjust its capital structure to maintain its current debt-equity ratio. Required: (a) If the acquisition has similar risk to the rest of Avco, what is the value of this deal? (6 marks) (b) Suppose Avco proceeds with the acquisition described above. How much debt must Avco use to finance the acquisition and still maintain in debt-to-value ratio? How much of the acquisition cost must be financed with equity? (6 marks) (c) Assume that the acquisition will be initially financed by $50 million in new debt. Compute the value of the acquisition using the Adjusted Present Value (APV) method, assuming Avco will maintain a constant debt-equity ratio for the acquisition. (7 marks) The University of the West Indies Course Code: INTF 6004 April 2014 DO NOT WRITE OR TYPE ON THE BACK OF THIS SHEET: USE ONE SIDE ONLY INSTRUCTIONS: Each page must be signed by the Examiners and where applicable, the University Examiner and/or the External Examiner. Where the examination does not require a University Examiner, the form must be signed by the First and Second Examiners. Completed forms should be handed to the Senior Assistant Registrar (Examinations). The EXTERNAL EXAMINER is requested to sign the question paper and return it with comments, if any (on a separate sheet), to the Senior Assistant Registrar (Examinations). ......................................... First Examiner ............................................. University Examiner ......................................... Second Examiner .............................................. External Examiner (where applicable) Date: 2014/...../..... Date: 2014/...../..... Page 3 of 6 (d) Assume that the acquisition will initially be financed by $50 million in new debt. What is the value of the acquisition using the Flows to Equity (FTE) method? (6 marks) Question 3 The Tiger Golf Company currently produces and sells two types of steel shaft golf clubs. The board of directors wants you to consider the introduction of a new line of titanium bubble woods with graphite shafts. These titanium clubs will sell for $750 per set and have a variable cost of $390 per set. The company has spent $150,000 for a marketing study that determined the company will sell 55,000 sets of titanium clubs per year for seven years. The marketing study also determined that the company will lose sales of 12,000 sets of its high-priced steel shaft clubs. The high-priced steel shaft clubs sell at $1,100 and have variable costs of $620. The company will also increase sales of its cheap steel shaft clubs by 15,000 sets. The cheap steel shaft clubs sell for $400 and have variable costs of $210 per set. The fixed costs each year will be $8,100,000. The company has spent $1,000,000 on research and development for the new titanium clubs. The plant and equipment required to produce the titanium clubs will cost $18,900,000 and will be depreciated on a straight-line basis. The introduction of the new line of titanium clubs will also require an increase in net working capital of $1,400,000 that will be returned at the end of the project. The tax rate is 40 percent, and the cost of capital is 14 percent. Required: Determine whether the Tiger Golf Company should introduce the new line of titanium clubs by conducting a capital budgeting analysis. Please use the following methods in your analysis: the payback period, discounted payback and net present value. (25 Marks) The University of the West Indies Course Code: INTF 6004 April 2014 DO NOT WRITE OR TYPE ON THE BACK OF THIS SHEET: USE ONE SIDE ONLY INSTRUCTIONS: Each page must be signed by the Examiners and where applicable, the University Examiner and/or the External Examiner. Where the examination does not require a University Examiner, the form must be signed by the First and Second Examiners. Completed forms should be handed to the Senior Assistant Registrar (Examinations). The EXTERNAL EXAMINER is requested to sign the question paper and return it with comments, if any (on a separate sheet), to the Senior Assistant Registrar (Examinations). ......................................... First Examiner ............................................. University Examiner ......................................... Second Examiner .............................................. External Examiner (where applicable) Date: 2014/...../..... Date: 2014/...../..... Page 4 of 6 Question 4 (a) The Holyoke Corporation has 120,000 shares outstanding with a current market price of $8.10 per share. The company needs to raise an additional $36,000 to finance new expenditures, and has decided on a rights issue. The issue will allow current stockholders to purchase one additional share for 20 rights at a subscription price of $6 per share. Required: (i) Calculate the ex-rights price that would make a new stockholder indifferent between buying shares at the old stock price and exercising the rights or buying the shares ex-rights. (5 marks) (ii) If the ex-rights price were set at $7.90, would you as a potential new stockholder choose to buy shares ex-rights or buy shares at the old price and exercise your rights? (5 marks) (iii) Suppose that the company was also considering structuring the rights issue to allow for an additional share to be purchased for 10 rights at a subscription price of $3. Prove that a stockholder with 100 shares would be indifferent between purchasing either a new share for 10 rights at $3 or purchasing a new share for 20 rights at $6. (7 marks) (b) Mitsi Inventory Systems, Inc., has announced a rights offer. The company has announced that it will take four rights to buy a new share in the offering at a subscription price of $30. At the close of business the day before the ex-rights day, the company's stock sells at $60 per share. The next morning you notice that the stock sells for $54 per share and the rights for $5 each. Required: Are the stock and/or rights correctly priced on the ex-rights day? Describe a transaction in which you could use these prices to create an immediate profit. (8 marks) The University of the West Indies Course Code: INTF 6004 April 2014 DO NOT WRITE OR TYPE ON THE BACK OF THIS SHEET: USE ONE SIDE ONLY INSTRUCTIONS: Each page must be signed by the Examiners and where applicable, the University Examiner and/or the External Examiner. Where the examination does not require a University Examiner, the form must be signed by the First and Second Examiners. Completed forms should be handed to the Senior Assistant Registrar (Examinations). The EXTERNAL EXAMINER is requested to sign the question paper and return it with comments, if any (on a separate sheet), to the Senior Assistant Registrar (Examinations). ......................................... First Examiner ............................................. University Examiner ......................................... Second Examiner .............................................. External Examiner (where applicable) Date: 2014/...../..... Date: 2014/...../..... Page 5 of 6 Question 5 Plant Inc., is considering making an offer to purchase Palmer Corp. Plant's vice president of finance has collected the following information: Plant Palmer Price-earnings ratio 14.5 times 10 times Shares outstanding 1,500,000 750,000 Earnings $4,200,000 $960,000 Dividends $1,050,000 $470,000 Plant also knows that securities analysts expect the earnings and dividends of Palmer to grow at a constant rate of 4 percent each year. Plant management believes that the acquisition of Palmer will provide the firm with some economies of scale that will increase this growth rate to 6 percent per year. Required: a) What is the value of Palmer to Plant? (8 marks) b) What would Plant's gain be from this acquisition? (3 marks) c) If Plant were to offer $20 in cash for each share of Palmer, what would be the NPV of the acquisition be? (3 marks) d) What is the most Plant should be willing to pay cash per share for the stock of Palmer? (3 marks) e) If Plant were to offer 225,000 of its shares in exchange for the outstanding stock of Palmer, what would the NPV be? (5 marks) f) Should the acquisition be attempted? If so, should it be as in (c) or (e)? (3 marks) The University of the West Indies Course Code: INTF 6004 April 2014 DO NOT WRITE OR TYPE ON THE BACK OF THIS SHEET: USE ONE SIDE ONLY INSTRUCTIONS: Each page must be signed by the Examiners and where applicable, the University Examiner and/or the External Examiner. Where the examination does not require a University Examiner, the form must be signed by the First and Second Examiners. Completed forms should be handed to the Senior Assistant Registrar (Examinations). The EXTERNAL EXAMINER is requested to sign the question paper and return it with comments, if any (on a separate sheet), to the Senior Assistant Registrar (Examinations). ......................................... First Examiner ............................................. University Examiner ......................................... Second Examiner .............................................. External Examiner (where applicable) Date: 2014/...../..... Date: 2014/...../..... Page 6 of 6 Question 6 (a) Nodhead College needs a new computer. It can either buy it for $250,000 or lease it from Compulease. The lease terms require Nodhead to make six annual payments (prepaid) of $62,000. Nodhead pays no tax. Compulease pays tax at 35%. Compulease can depreciate the computer for tax purposes over five years. The computer will have no residual value at the end of year 5. The interest rate is 8%. Required: (i) What is the NPV of the lease for Nodhead College? (5 marks) (ii) What is the NPV for Compulease? (5 marks) (iii) What is the overall gain from leasing? (5 marks) (b) The Safety Razor Company has a large tax-loss carry forward and does not expect to pay taxes for another 10 years. The company is therefore proposing to lease $100,000 of new machinery. The lease terms consist of eight equal lease payments prepaid annually. The lessor can write the machinery off over seven years using the tax depreciation schedules given in Table 6.4. There is no salvage value at the end of the machinery's economic life. The tax rate is 35% and the rate of interest is 10%. Required: Wilbur Occam, the president of Safety Razor, wants to know the maximum lease payment that is company should be willing to make and the minimum payment that the lessor is likely to accept. Can you help him? (10 marks) END OF QUESTION PAPER The University of the West Indies Course Code: INTF 6004 April 2014 DO NOT WRITE OR TYPE ON THE BACK OF THIS SHEET: USE ONE SIDE ONLY INSTRUCTIONS: Each page must be signed by the Examiners and where applicable, the University Examiner and/or the External Examiner. Where the examination does not require a University Examiner, the form must be signed by the First and Second Examiners. Completed forms should be handed to the Senior Assistant Registrar (Examinations). The EXTERNAL EXAMINER is requested to sign the question paper and return it with comments, if any (on a separate sheet), to the Senior Assistant Registrar (Examinations). ......................................... First Examiner ............................................. University Examiner ......................................... Second Examiner .............................................. External Examiner (where applicable) Date: 2014/...../..... Date: 2014/...../