FINANCE 351 Advanced Financial Management
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FINANCE 351
SEMESTER TWO 2020
FINANCE
Advanced Financial Management
QUESTION 1 [6 marks]
Two years ago KK Restaurant purchased a grill for $50,000. The owner Kevin Koo has learned that a new grill is available that will cook twice as fast as the existing grill. This new grill can be purchased for $80,000 and would be fully depreciated straight line over 8 years, after which it would have no salvage value. Kevin expects that the new grill will produce EBITDA of $50,000 per year for the next eight years (Year 1 to 8) while the existing grill produces EBITDA of only $35,000 per year. The current grill is being fully depreciated straight line over its useful life of 10 years after which it will have no salvage value. All other operating expenses are identical for both grills. The existing grill can be sold to another restaurant now for $30,000. KK Restaurant’s tax rate is 30%.
Assume all cash flows are incurred at the end of each year.
What is the incremental cash flow that KK Restaurant will incur next year (Year 1) if they elect to upgrade to the new grill today (Year 0)?
QUESTION 2 [20 marks]
(a) Assume that you are an importer of Salmon into Japan from New Zealand. You have agreed to make a payment in US dollars, and you are scheduled to pay $255,000 in 90 days after you receive the Salmon. You face the following exchange rates and interest rates:
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Spot exchange rate: |
¥106.35/$ |
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90-day forward exchange rate: |
¥106.02/$ |
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90-day dollar interest rate: |
3.25% p.a. |
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90-day yen interest rate: |
1.94% p.a. |
Explain two ways to hedge the risk by referring to the contracts and rates listed in the table above (no calculations needed). (10 marks)
(b) If volatility in foreign exchange markets increases, what do you think happens to the bid– ask spread provided by a foreign currency trader? Write no more than four sentences to justify your answer. (5 marks)
(c) How would one embed political risk insurance in a capital budgeting analysis? Please describe necessary adjustments to cash flows, discount rates and necessary assumptions. Write no more than four sentences to justify your answer. (5 marks)
QUESTION 3 [ 18 marks]
Natasha’s Stores is a retail firm. In the last year (year 0), the Stores reported $100 million in revenues, $20 million in earnings before interest, tax, depreciation and amortisation (EBITDA). Operating working capital was −$10 million during the last year.
(a) What are your projected free cash flows to the firm in Year 1 and Year 2? Please use the following assumptions for Year 1 and Year 2:
• Sales will grow at 12% p.a.
• EBITDA margin remains the same as in year 0
• The capital expenditure will be 5% of revenue
• Beginning balance of net fixed assets was $50 million, and depreciation and amortisation is 10% of the beginning net fixed assets
• Operating working capital as a percent of revenues remains unchanged
• Company’s marginal tax rate is 30%
You are required to fill in all boxes in the table on the following page. At the end of each row, you must show an example of the workings for one-year’s result. ( 10 marks)
Historical Projected Projected
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Year 0 |
Year 1 |
Year 2 |
Workings |
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Sales EBIT D&A EBITDA EBITDA% |
100
20 |
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Free Cash Flow to Firm:
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Net Fixed Assets
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Beginning Addition (CAPEX) Subtraction (D&A) Ending |
50 |
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(b) Now, disregard your answers to the previous question. Use the following projected cash flows to the firm for year 1 to 3. Your manager would like you to find the per share value of Natasha’s Stores. The valuation date is the last day of year 0. You have the following information (Note: you do not have to use all of these assumptions). Please assume that all cash flows occur in the middle of each year. Please fill in your final answer and intermediate results in the table below. All boxes need to be filled in. Show example workings for one-year’s result as required.
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After-tax WACC |
8% |
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Cost of equity |
10% |
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Short-term borrowing (market value) |
$ 2 million |
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Long-term borrowing (market value) |
$ 6 million |
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Cash and cash equivalent |
$ 10 million |
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Number of shares outstanding |
8,000,000 |
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Free cash flow to firm (projection) |
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Year 1 |
$ 12 million |
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Year 2 |
$ 14 million |
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Year 3 |
$ 15 million |
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Constant annual growth rate (of free cash flows) from year 4 onwards |
3% |
(8 marks)
Year 0
Year 1
Projected
Year 2
Projected
Year 3
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Free cash flows $ million Terminal value Discount period Discount rate Discount factor |
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Enterprise value Net debt Equity value Per share value ($) |
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QUESTION 4 [8 marks]
(a) Refer to the option theory to draw the payoff diagram to equity holders and that to the debt holders. (4 marks)
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Payoff to equity holders |
Payoff to debt holders |
(b) Use option theory to explain why certain type of news would increase a firm’s share price
but decrease the firm’s bond price. Write two or three sentences to justify your answer. (4 marks)
QUESTION 5 [16 marks]
Lehman Industries (LVI) is currently an all-equity firm. It expects to generate earnings before interest and taxes (EBIT) of $10 million over the next year. Currently, LVI has 10 million shares outstanding, and its stock is trading for a price of $7.50 per share. LVI is considering changing its capital structure by borrowing $15 million at an interest rate of 8% and using the proceeds to repurchase 2 million shares at $7.50 per share. Assume that the capital markets are perfect (for example, no taxes, securities are fairly priced and information is symmetric).
(a) What are the expected earnings per share for a stock in LVI before and after the change in leverage, respectively? (4 marks)
(b) Assume that LVI’s EBIT is not expected to grow in the future and that all earnings are paid as dividends. Use MM propositions I and II to show that the increase in expected earnings per share will not lead to an increase in the share price. (8 marks)
(c) Are LVI’s shareholders better off or worse off when LVI increases its leverage? Explain your reasoning in one or two sentences. (4 marks)
QUESTION 6 [14 marks]
Sweden has a classical corporate tax system with a double taxation of dividends, with corporate tax and dividend taxation, as the United States. In 2006, Sweden cut the tax rate on dividend income from 30% to 20%, while corporate tax rate stays at 28%. Jed is the sole owner, manager and the only employee of Arendelle Corp. He can choose between receiving a salary or a dividend as an income from running Arendelle Corp. He paid himself SEK 550,000 in salary in 2005 and salary is a tax deductible expense for companies in Sweden. After the tax reform, Jed still paid a gross (before-tax) amount of SEK 550,000 to himself but part of the payment is in dividend. Assume that he paid himself SEK 490,700 as salary, with the remainder paid as dividend.
(a) Refer to the table below for personal income tax rates in Sweden to calculate the change in Jed’s after-tax income after the cut in dividend tax.
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(8 marks)
(b) How would this tax reform have affected dividend payout ratios in Sweden? Write no more than four sentences to justify your answer. (6 marks)
QUESTION 7 [9 marks]
The number of initial public offerings (IPOs) in the United States has experienced a sharp decline since peaking in the late 1980s and early 1990s. Please briefly describe three factors that contribute to the decline in numbers of firms raising funds through IPOs. Briefly explain in one or two sentences for each factor listed.
2022-11-08