This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON

AC3059 ZA (279 0059)

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social Sciences, the Diplomas in Economics and Social Sciences and Access Route

Financial Management

Thursday, 10 May 2012 : 10.00am to 1.00pm

Candidates should answer FOUR of the following NINE questions: TWO from Section A, ONE from Section B and ONE further question from either section. All questions carry equal marks. Workings should be submitted for all questions requiring calculations. Any necessary assumptions introduced in answering a question are to be stated. Extracts from compound interest tables are given at the end of Section A of this paper. 8-column accounting paper is provided at the end of this question paper. If used, it must be detached and fastened securely inside the answer book. A calculator may be used when answering questions on this paper and it must comply in all respects with the specification given with your Admission Notice. The make and type of machine must be clearly stated on the front cover of the answer book.

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SECTION A Answer TWO questions from this section and not more than one further question. (You are reminded that four questions in total are to be attempted with at least one from Section B.) 1. Dreyers Grand Ice Cream Holdings Inc. is a publicly-held US company that has two primary businesses: ice cream manufacturing and ice cream distribution. Dreyers assets have a total market value of $180m of which 70% are manufacturing assets and 30% are distribution assets. The beta for manufacturing assets is 0.47. Dreyers equity beta is 0.75. Dreyers only liability is $20m of longterm debt with a beta of 0.3. The current share price is $22.86 and there are 7m shares outstanding. Required: (a) (b) What is Dreyers overall asset beta? (6 marks)

Dreyers is considering selling the distribution assets and investing the proceeds in short-term government bonds. If Dreyers goes through with this, would the firms equity beta increase, decrease, or stay the same? (4 marks) Redden Microbatch Ice Cream Inc., a privately held firm, markets and sells super premium ice cream. Unlike Dreyers, Redden Microbatch does not manufacture its own ice cream. Redden Microbatch will go through an IPO this week. If you were to value Redden Microbatch, explain which discount rate you would use in order to calculate the present value of future free cash flows to all claimholders. Assume that the market risk premium is 8.4%. (6 marks) Redden Microbatch has a capital structure consisting of 25% debt and 75% of equity. Its debt has a beta of 0.35. If you were to value Redden Microbatchs equity, explain which discount rate you would use in order to calculate the present value of dividends? (6 marks) During the road show for institutional investors, the founders of Redden Microbatch indicated that the companys hurdle rate was 25%. How does this particular information influence your opinion of the company? (3 marks)

(c)

(d)

(e)

2.

Consider a strategic (i.e. value-enhancing) merger/takeover between two firms A and B. Firm A has 100,000 shares outstanding priced at $2 each, and firm B 200,000 shares priced at $1 each. If a merger takes place, the new firm could make cost savings in production and marketing of $4,000 each year indefinitely. The cost of capital is 10%. Required: (a) Suppose firm A proposes a bid for firm Bs shares worth $1.2 each, and also suppose the bid is going to be accepted for sure by all of Bs shareholders. Work out the price-response to the bid announcement by a rational market which takes the announcement as a complete surprise. Do you think firm A is overpaying for firm Bs shares? Explain your answer. (8 marks) Suppose now that the two firms have agreed to a merger where each share in firm A will be converted into 2 shares in the merged firm, and each share in firm B will be converted into 1 share in the merged firm. Work out the price-response to the announcement of the merger, making similar assumptions as in (a). (9 marks) What mechanisms do companies adopt in an effort to prevent takeovers? Given that the targets shareholders typically benefit from a takeover, can these takeover defences ever be justified? (8 marks)

(b)

(c)

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3.

Visual-Audio Systems (VAS) Ltd is a video production company and currently rents the building in which its production equipment is located at an annual cost of 150,000, including all service charges. The company is considering purchasing an alternative building in which to undertake its video business. These alternative premises are due to be demolished by the local council in 4 years time, to make way for a new road and it is known that the council will purchase the building at that time for 100,000. Because of the instability caused by the council's plans, VAS can purchase the building at a knock-down price of 250,000. Otherwise, since the building is located in a prime residential area, the land on which the building stands would be worth 1.8 million. Currently the building is in a state of disrepair, but a structural survey which has already been undertaken by VAS costing 3,000, recommends that the building must be upgraded at a cost of 50,000 before VAS moves in. The annual heating and lighting expenses on the new building will be 40,000, but VAS will save the annual rents on its current premises. The removal costs of moving its equipment into the new building, and the cost of moving out again in five years time will be 25,000 on each occasion. VAS pays corporation tax on its profits at 30%, and the tax authorities allows VAS to offset its corporate tax liabilities by using straight line depreciation on its fixed assets. You may assume that VAS has sufficient taxable profits to take full advantage of any tax shields from purchasing the building. VAS applies an opportunity cost of capital of 10 per cent to all future cash flows. Assume all annual cash-flows occur at the end of the year to which they relate. Required: (a) Calculate the NPV of the investment in the new building, explaining your treatment of costs and depreciation allowances. (10 marks) Estimate the IRR of this investment (use 15% discount rate as one of your guesses). (5 marks) VAS approaches you for advice on whether it should purchase the new building, and asks for your opinion on payback and accounting rate of return as methods of investment appraisal. Advise VAS by comparing and contrasting four alternative investment criteria. (5 marks) Suppose that there is a small probability that the council might change its decision to build a road, allowing the owner to sell the land for residential development. Outline how this would change your valuation of the project. (5 marks)

(b)

(c)

(d)

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4.

(a)

Explain how corporate debt and equity can be thought of as asset combinations of risk free debt and call and put options on the firms assets. p(8 marks) Suppose corporate earnings are taxed at the corporate level (tax rate tC) and that earnings distributed to investors as income on equity are taxed privately (tax rate tE) and earnings distributed to investors as income on debt are also taxed privately (tax rate tD) but such income is tax deductible at the corporate level. Explain that in this case the value of a levered firm VL is equal to the value of an unlevered firm VU plus the value of corporate debt D times a factor measuring the tax benefits of borrowing 1 (1-tC)(1-tE)/(1-tD). Given that the marginal tax rates on equity and debt are the same in the UK for most investors. What implications does the above equation have for an individual firms decision on capital structure? (10 marks) Eagle Corporation has decided to raise additional equity through a rights issue. The current market price is 60 per share and Eagle arranges the terms as a 1 for 3 offer at a subscription price of 50 per share. If we assume a 100% take up of the rights, what is the value of each right? (7 marks)

(b)

(c)

Tables Future value of 1 received today, in n years time at x% n\ x 1 2 3 4 5 10% 1.1000 1.2100 1.3310 1.4641 1.6105 20% 1.2000 1.4400 1.7280 2.0736 2.4883 30% 1.3000 1.6900 2.1970 2.8561 3.7129 Present value of 1, receivable in n years time at x% 10% 0.9091 0.8624 0.7513 0.6830 0.6209 20% 0.8333 0.6944 0.5787 0.4823 0.4019 30% 0.7692 0.5917 0.4552 0.3501 0.2693

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SECTION B Answer ONE questions from this section and not more than one further question. (You are reminded that four questions in total are to be attempted with at least two from Section A.)

5.

Critically evaluate the Capital Structure Irrelevance Theory originally proposed by Modigliani and Miller. (25 marks)

6.

The usefulness of financial ratio analysis in the evaluation of a firms performance is severely limited by a number of factors. Describe and discuss. (25 marks)

7.

Describe and discuss the relevance to the real world of the following theories of dividend policy: Modigliani and Millers irrelevance theory, the dividend clientele theory, agency cost theory, and signalling theory. (25 marks)

8.

Discuss the relevance of the cost of equity capital to investors. Describe two different methods a company might use to derive its cost of equity capital. Critically discuss the methods explaining why they may not produce the same result. (25 marks)

9.

Briefly explain how the value of a firm going through an initial public offering (IPO) could be estimated. Critically review the assumptions underlying your proposed method and discuss the quality and relevance of beta estimates in general. (25 marks)

END OF PAPER

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