Question 1 - Working Capital Management
Firm ABC is considering a project that requires an initial investment of 500K$ and generates total annual sales of 200K$ in the first year. Sales will grow in perpetuity at an annual rate g. Production costs are constant and equal to 101% of sales, bills are paid with a 3-month delay and clients pay cash immediately. The project does not generate inventories. No taxes are paid and no minimum cash balance is required every year. The appropriate annual discount rate for the project is 10%.
1. Compute the annual break-even sales growth rate (hint: use the monthly formula but now the time horizon is one year instead of one month).
2. Compute the cash flows of the project in the first year and in the following years, if g is equal to the break-even sales growth rate.
3. What is the NPV of the project if g is equal to the break-even sales growth rate? Would you implement this project?
4. What is the growth rate of the cash flows every year as a function of g?
5. What should be the minimum sales growth rate such that the project is implemented?
6. If clients could pay with a one-month delay, would that affect the minimum sales growth rate below which the project will not be implemented? In what direction? (no computations needed)
7. Can a project with a negative gross margin (production costs higher than 100%) have a positive NPV? Explain.
Question 2 - Cost of capital and capital structure
Tea&Juices, a foreign producer of soft drinks, is considering expanding its activities to Canada. To evaluate the profitability of the business, the management has decided to use as benchmarks two other foreign producers of soft drinks who have already entered the Canadian market:
• Fruit Juices has 2.9 million shares outstanding, trading on the TSX Venture exchange at $11.45 per share. The company pays no dividends and has issued bonds, whose nominal value is $14 million, at an average yield of 8.6%. The current average yield for similar bonds is 8.6%. Its equity beta is estimated at 1.9.
• Soft Drinks Canada has an equity beta of 2.4, an average bond yield of 9.7%, and uses an equal amount of debt and equity in its capital structure. The current average yield for similar bonds is 9.3%.
To start operating, Tea&Juices will open a Canadian subsidiary firm funded with a $25 million equity investment from the parent firm, coupled with a $10 million bond offering paying a 5.9% coupon rate.
The Canadian market risk premium is 5.2% and the appropriate risk free rate is 1.5%. Assume there are no distress or transaction costs, and that all companies operate in a tax-free regime.
1. What would be the cost of capital for Tea&Juices' expansion plan, using Fruit Juices as a benchmark?
2. What would be the cost of capital for Tea&Juices' expansion plan, using Soft Drinks Canada as a benchmark?
3. What does this intuitively suggest about Fruit Juices and Soft Drinks Canada?
4. What kinds of factors might contribute to the difference observed in part (3)?
Now assume that, everything else equal, Fruit Juices and Soft Drinks Canada pay an average corporate tax rate of 25%. Tea&Juices expects to pay a similar tax rate.
5. What would be the cost of capital for Tea&Juices' expansion plan, using Fruit Juices as a benchmark?
6. What would be the cost of capital for Tea&Juices' expansion plan, using Soft Drinks Canada as a benchmark?
Question 3 - Mergers and Acquisitions
Firm T has attracted the attention of Firm A because of its poor operating performance. Firm A believes that the way Firm T is managed is inefficient and that replacing the current management team would increase the cash flow of T by $25,000 every year up to perpetuity.
Firm T has 50,000 shares outstanding and is not listed. Firm A has 250,000 shares outstanding that are currently trading at $40/share. Firm A already owns a 1% stake in Firm T. Firm T has two other shareholders, ABC and DEF. Both of them hold a 49.5% stake in Firm T. To change the management team, Firm A needs to get control of Firm T (i.e., at least 50% of shares).
Firm A hires Levan Brothers, a prestigious investment bank, to get advice on the transaction. Levan Brothers estimates that the value of one share of Firm T under the current management team is $15 per share. They also advise Firm A to pay a premium for the acquisition of T and to offer ABC and DEF $17 in cash for every share of Firm T. Fees charged by Levan Brothers to Firm A are $6,000. Assume that there are no taxes and markets are perfectly efficient. The appropriate annual discount rate is 10%.
1. Compute the maximum price per share that Firm A is willing to pay to acquire 99% of Firm T via an all-cash offer.
2. Compute ABC's gains if he accepts the all-cash offer of $17/share.
3. ABC believes that DEF will accept the offer and tender his shares. What is the optimal strategy for ABC: accept the offer or decline the offer? Show your answer.
4. What will happen if DEF also believes that ABC will tender his shares? What is the minimum share price Firm A should offer to ABC and/or DEF to avoid that?
5. Compute the gains per share for Firm A if an all-cash offer to acquire 99% of Firm T is made at a price of $20.
6. Under the assumption that ABC always believes that DEF will accept the cash offer (and vice versa), what is the likelihood that the inefficient management team is replaced some day? Explain.
Question 4 - Capital Structure
Firm ABC is financed with equity (market value $400 million) and perpetual debt (market value $1,000 million). The firm has decided that the current level of leverage is not optimal and wants to reach a debt-equity ratio of 0.6. In order to achieve this goal, Firm ABC plans to issue equity and repay some of the existing debt. Assume that the firm operates in a Modigliani and Miller world (i.e., markets are efficient, no transaction costs, no financial distress costs, etc.) but has a tax rate of 30%.
1. Determine the amount of debt the Firm ABC needs to repay to reach the target debt-equity ratio, and the value of debt and equity after the restructuring.
2. Assume that there are 20 million shares outstanding before the restructuring. Determine how many shares Firm ABC must issue to repay the debt needed to reach the target debt- equity ratio.
3. Solve part (1) assuming that Firm ABC's debt is not perpetual but consists of 10-years bonds with a 10% annual coupon rate and a nominal value of $1,000 million. Debt market value is still $1,000 million.
4. Assume now that Firm ABC operates in a tax-free regime. Market value of debt and equity is still $1,000 million and $400 million, respectively. Determine the amount of debt the Firm ABC needs to repay to reach the target debt-equity ratio of 0.6, and the value of debt and equity after the restructuring. Consider both the case in which debt is perpetual and the case in which debt consists of 10-year bonds (see part 3).
Question 5 - Dividends Policy
Firm A is all equity with 100M shares outstanding. The firm has $150M in cash and expects future free cash flows of $65M/year. The management plans to use the cash available to expand the firm's operations. The expansion will increase future free cash flows by 12%. Assume that the appropriate annual discount rate for the firm is 10%.
1. Compute the current share price of Firm A.
2. Compute the share price of Firm A if the company decides to use the cash available for a share repurchase at no premium. Show your answer.
3. Compute the share price of Firm A if the company decides to expand its operations.
4. Comment on the results obtained in parts (2) and (3).
5. Firm A believes that its shares are underpriced and that the true value is $10. The management expects that new information will come out soon and investors will revise their opinions and agree on a $10 share value for Firm A. If Firm A plans to use the $150M cash for a share repurchase, should it wait until the new information comes out or not? Show your answer.
Question 6 - Firm Evaluation/WACC/Project Evaluation
PART A - Trading Multiples
Firm A is listed and operates in the same industry as firm B that is not listed. The current stock price of A is $22.3. Firm A and Firm B have 41,000,000 and 3,000,000 shares, respectively. A private equity fund would like to acquire 100% of Firm B.
|
in M$
|
A
|
B
|
|
P&L Key figures
Sales
|
1535.0
|
321.0
|
|
EBIT
|
138.2
|
12.8
|
|
Net Inc.
|
69.1
|
5.1
|
|
Balance Sheet Key figures
|
|
|
|
Cash & equivalents
|
41.0
|
2.0
|
|
Accounts Receivables
|
223.0
|
12.0
|
|
Stocks
|
411.0
|
23.0
|
|
Fixed Assets
|
601.0
|
35.3
|
|
Common Equity
|
655.0
|
41.0
|
|
Debt
|
210.0
|
19.3
|
|
Accounts Payables
|
411.0
|
12.0
|
1. Calculate the following trading multiples for firm A: VF /Sales, VF/EBIT, and P/E ratio (VF stands for firm value).
2. Estimate a valuation range for the share price of Firm B.
3. Briefly explain why the sales multiple leads to a very different pricing estimate. Therefore, what range for the share price of B would you recommend?
PART B - WACC/Project Evaluation
Firm A pays a 30% tax rate on income and its financial structure is as follows:
- 21.6 million common shares trading at $5.00 that currently pay an annual dividend of $0.30. The dividend is expected to grow at a 5% rate each year.
- 1.8 million preferred shares, paying a $1.00 annual dividend, with a current market price of $9.80/share.
- Two bond issues, both yielding 6% to maturity and making semi-annual interest payments. The first has a $10,000,000 par value, 8 years left to maturity, and an annual coupon rate of 8%; the second has a $15,000,000 par value, 14 years left to maturity, and pays a 10% annual coupon.
Compute:
1. The market value weights of common shares (S), preferred shares (P) and debt (D).
2. The weighted average cost of capital for Firm A.
Firm A has currently $9 million in marketable securities available for immediate investment and is considering the following projects, which have the same average risk as the overall firm:
|
Project
|
Initial Cost
|
IRR
|
|
1
|
$11,500,000
|
11%
|
|
2
|
$2,800,000
|
28%
|
|
3
|
$6,300,000
|
9%
|
|
4
|
$7,200,000
|
13%
|
The firm can issue up to $8 million in new debt with a 6% annual coupon rate for a net after tax fee equal to 2% of total proceeds and new preferred shares for a net after tax fee equal to 4% of proceeds. The management is unwilling both to adjust the firm's capital structure and to endure the costs associated with a common share issuance.
3. Compute the weighted average cost of capital that the company should use to evaluate the new projects.
4. Which projects should be undertaken if the company uses IRR as ranking criteria?