SMM467 Corporate Finance & Valuation

Question 1: Capital Budgeting [50 marks]

M.C. Innovation is an engineering company which is considering launching on the market a new revolutionary home appliance, a remote-controlled cleaning robot. The testing and development phases had taken almost 3 years but the final prototype had passed all safety hazards test successfully.

Before giving the go ahead to the full scale production, the company’s Capital Investment Committee (CIC) had requested their analysts to perform a comprehensive feasibility study based on the data provided by the marketing department to verify if the project was indeed worthwhile.

The information gathered by the marketing department are summarised below.

■ Marketing: The economic life of the project was projected to be 10 years. The units of sales over the 10 years estimated life of the project and the unit price are reported in the table below. The initial price of £1000 was projected to decrease in response to competitive pressures.

■ Operations: The manufacturing would be done in an unused plant of the firm. Similar plant locations could be leased for £10,000 per month. Fixed costs were estimated to be £1.500,000 per year while variable cost of production were expected to be £400/unit of sale.

■ Accounting: The project will be depreciated via the straight-line method over the 10- year life of the project. The cost of the required equipment including shipping, handling and installation, was estimated at £20 million with a residual value at the end of its useful life of £4 million. The project will require an initial additional inventory of £500,000. The company would also need to immediately increase its accounts payable by £600,000 and its accounts receivables by £1,000,000. After that, the company had estimated that the net working capital of the firm would be equal to 5% of revenues.

■ The company’s cost of capital which was calculated at 14%. And the company would incur an interest expense of £400,000 per year as a result of the debt raised to finance the project.

To answer:

Write the formula of the weighted average cost of capital and define clearly each of its components. . [6 marks]

Determine the free cash flow and NPV of the project. [16 marks]

How should the annual interest expense be treated? Explain carefully. [6 marks]

The analysts do not factor in the cost of the development and testing phases. Comment on whether their decision is correct. [6 marks]

Calculate the IRR of the project and draw the NPV curve. Discuss the implication of your findings for the viability of the project. [6 marks]

Use a sensitivity analysis to show how the cash flows and NPV would change if the sales units forecast were 15% better (optimistic scenario) or 15% worse (pessimistic). Discuss also what other variables of the project should be included in a sensitivity analysis. [10 marks]

Question 2 (15 marks)

Company X is considering acquiring company Y. You are provided with the information below is available.

Additionally, you estimate that investors currently expect a steady growth of about 6% in company Y’s earnings and dividends. After the acquisition, this growth rate would be increased to 7.75% per year, without any additional capital investment required.

a. Calculate the synergies from the from the acquisition? [5 marks]

b. What is the premium paid to company Y’s shareholders from the acquisition if company X pays £30 in cash for each share of company X? [5 marks]

c. What would instead be the premium to company Y’s shareholders from the acquisition if company Y’s offers one share of company X for every three shares of company X? Comment. [5 marks]

Question 3 (15 marks)

C.A.S.S. Inc is an all equity financed company currently worth £32 million with 5 million of shares outstanding. The company has decided to leverage up and replace £12 million of equity with debt. They expect the cost of debt to be 6%. If the tax rate is 30% and assuming all conditions hold in perpetuity, show the market value balance sheets

a. before the change of capital structure is announced; [4 marks]

b. at the time the change is announced [5 marks]

c. when the change is completed. [6 marks]

Question 4

“The U.S. Securities and Exchange Commission issued an order Wednesday approving the New York Stock Exchange’s request to let companies raise capital through direct listings, which is often a less expensive alternative to an initial public offering”. [Forbes, 26 August 2020]

Explain the main characteristics of direct listings as opposed to traditional bookbuilt IPOs and discuss the possible implications for the future of direct listings of the approval of the NYSE proposal reported in the extract above. You are encouraged to use appropriate examples to support your discussion