SMM125 Corporate Finance/SMM471 Finance 2: Advanced Corporate Finance

Section A

Answer TWO of the following questions (30 lines maximum each):

Question 1

“Acquisitions can also be a form of financial engineering . . . Say Acme has 100m shares, earnings of $10m (earnings per share of 10 cents) and a share price of $2 (a price-earnings ratio of 20). Grotco has the same earnings and number of shares but its share price is just $1 (a price-earnings ratio of 10). If Acme makes an all-share bid valuing Grotco at $1.20, it will need to issue 60m new shares. The combined group will have $20m of earnings, 160m shares and earnings per share of 12.5 cents. With the help of nothing more than maths, Acme’s earnings per share will have jumped by 25%. The “brilliance” of Acme’s managers may well be rewarded with an even higher share price and a better rating, allowing it to make further deals.” (Come together: Don’t just sit there, bid for something, The Economist, February 23, 2013) Write a brief letter to The Economist, explaining why, according to sound financial economics, Acme’s share price may well not increase, in spite of the increase in earnings per share. 18 marks

Question 2

Meat Ltd is a company operating in the food processing industry. After unlevering the equity beta of its main competitors you estimate that the asset beta in Meat’s core business is 0.53. The company’s management is now considering acquiring a chain of vegan restaurants called Veggie, to diversify in the restaurant sector, for which you have estimated an asset beta equal to 0.96. You are advising Meat’s CFO team on the valuation of the acquisition target. The CFO insists that the discount rate they recently estimated to value a new meat processing factory can be used in the WACC valuation of Veggie. Do you agree with them? How would your valuation be affected if you followed their advice? 18 marks

Question 3

Modigliani and Miller proposition that a firm’s value is not affected by capital structure depends – among others – on the assumption that business risk does not depend on leverage. However, in real world companies, a firm’s leverage may substantially affect managers’ incentives when they select real investment projects. Based on this mechanism, provide up to two reasons why high leverage may cause an increase in a firm’s business risk. 18 marks

Question 4

Discuss two key factors explaining why Amazon has a negative cash cycle and how they relate to Amazon’s competitive position with respect to customers and/or suppliers. 18 marks

Section B

Answer ONE of the two questions in this Section:

Question 5

ABC has earnings per share of $3. It has 10 million shares outstanding and is trading at $24 per share. ABC is thinking of buying TZ, which has earnings per share of $1.5, 3 million shares outstanding, and a price per share of $10. ABC will pay for TZ by issuing new shares: it offers an exchange ratio equal to 0.417. Expected synergies from the transaction are equal to $10 million. Assume that, once announced, the acquisition will be completed with certainty: all market participants are informed of this on the announcement day. Financial markets are perfect.

(a) (10 marks) What will earnings per share be after the merger? Is the acquisition a positive NPV investment for ABC shareholders? Comment.

(b) (8 marks) What is the percentage premium (at current prices) offered to the target shareholders? Are the target shareholders benefiting from the deal and if so, by how much? Explain.

(c) (5 marks) Assume now that ABC makes a mixed cash plus stock offer: in case of a merger, each TZ share receives $3 plus 0.28 ABC shares. Is the acquisition a positive NPV investment for ABC?

(d) (5 marks) In the cash plus stock offer of question

(c), what is the actual premium gained by the target shareholders? Is this offer better for them than the stock-only offer of 0.417 ABC shares per target share? 28 marks

Question 6

DiD is a publicly traded software developer that has just hired a new CFO. In March 2021, the company has $20 million in debt, and it has 4 million shares trading at $45 per share. The firm faces a marginal tax rate of 35%. The CFO is convinced that the company still has unexploited tax shields and should lever up its capital structure permanently. The proceeds of any new debt issuance will be used to repurchase stock. The following table summarises the estimated probabilities of default for HT at different levels of debt:

You have been hired by DiD to help the CFO determine the optimal size of the levered recap. After analysing its business, you have estimated the direct and indirect default costs for HT to be 10% of the firm’s unlevered assets’ value.

a. (10 marks) Estimate the optimal debt level for the firm relying on the Trade Off Theory. Present in a table the tax shields, default costs and market value of the firm associated with each debt level.

b. (8 marks) The firm follows your advice and announces a leveraged recapitalisation to implement the optimal debt level you have determined. Assuming efficient markets, at which price will the firm be able to repurchase the stock? What will the market value balance sheet be after the recap announcement?

c. (5 marks) After estimating the optimal level of debt, you realise you should also take into account the fact that the company is fast growing and has many investment opportunities. How would this change your advice on optimal capital structure?

d. (5 marks) Assume that at the optimal level of debt identified anwering question (a), it is βE = 1, βD = 0.2. Would equity holders benefit from an investment project requiring initial investment I = $30 million, with NPV equal to $3 million? Explain. 28 marks

Section C

Answer the following question:

In March 2021, Kilburn Liquors (KL) manufactures alcoholic beverages that it sells to public venues in the UK. The company pays a corporate tax rate of 19%; it is unlevered, and has βU = 0.67, in line with other companies in the industry. KL considers investing £60 million to buy new equipment and start producing alcohol-based hand sanitisers. The management expects to take advantage of steady sales of hand sanitisers for the next 3 years, but intends to close the project after 2024, when its alcoholic beverages business will have fully recovered.

Ms Sarah Brown (the CFO) has negotiated a £40 million bank loan dedicated to fund this investment: the company will pay a 6.5% yearly interest on the loan for 3 years and reimburse the whole capital at the end of the project life. The remaining £20 million will be funded with equity. Ms Brown expects no working capital requirements, and predicts that the equipment will be obsolete after 3 years. She is trying to complete the following table to project free cash flows and interest payments on the loan (all figures in millions):

Ms Brown wants to value the project using the APV method.

(a) (6 marks) Estimate the unlevered cost of capital for the investment project. The risk free rate is 1%, the market risk premium 5%. Motivate all assumptions.

(b) (12 marks) Estimate the present value of tax shields and the Adjusted Present Value of the project, assuming that all the interest tax shields generated by any loan funding the project are “allocated” to the project. Should Kilburn Liquor invest in the hand sanitiser project? Explain what assumptions you make.

(c) (8 marks) Assume now that the government announces an increase in the corporate tax rate to 25% that will affect the company in 2023 and 2024. How does your valuation of the project change? Explain.

(d) (10 marks) Taking into account the information on the tax rise announced by the government, would you advice Kilburn Liquor’s treasurer to alter the way the project is funded? Motivate your answer including calculations. 36 marks