Instructions to Candidates

1.   This is an OPEN BOOK examination.

2.   No formulae sheet provided.

3.   Late submissions will attract a 10% penalty of the total maximum mark for the exam for each 30    minutes immediately after the submission deadline (e.g., an exam submitted two minutes after the  deadline will lose 6 marks of an exam worth 60%). Submissions made or attempted 1 hour after the submission deadline will not be marked. Students who were prevented from submitting due to        technical difficulties will need to apply for technical consideration with supporting documentation.

4.   The final exam consists of 10 main questions with 10 marks each. Attempt ALL questions.

5.   You will need to upload answers to Gradescope.

a.   The answers must be handwritten unless otherwise stated. If you submit typed answers for questions that ask for handwritten answers, you will receive zero marks.

b.   You can use a tablet and stylus to write your answers. However, you are responsible for any related technological issues.

c.   For questions that ask you to submit your work in Excel, show numbers in Excel at the two decimal places.

d.   Start each question on a NEW PAGE and include question number and student number on the top of each answer

e.   Please note that when uploading answers to Gradescope, you need to assign specific pages to each of the question.

6.   If writing on pen and paper, please scan your answers using a scanner or a mobile device. Detailed instructions about scanning on mobile devices are available via

https://lms.unimelb.edu.au/students/student-guides/gradescope-converting-images-to-pdf. All answers submitted MUST BE LEGIBLE, illegible (unreadable) answers will be awarded ZERO marks.

7.   The Exam Support tool in CANVAS will be available from 3:00 PM AEDT on November 7th to 3:45 PM AEDT on November 7th, the subject coordinator will be there assisting in resolving issues related to exam contents. Please make sure that the issue is clearly stated.

8.   Once the Exam Support tool is closed (i.e., at 3:45 PM AEDT), students are advised to contact            13MELB. Inside Australia: 13MELB (13 6352) (13 6352 - Option 1 - Exams; from Outside Australia: +61 3 9035 5511) if they have queries on exam content.

9.   For any issues other than exam content (including those arising during the first 45 minutes of the exam), students are also recommended to contact 13MELB (13 6352 - Option 1 - Exams; from   Outside Australia: +61 3 9035 5511)

10. Collusion between students is absolutely forbidden and will result in very serious consequences.

Question 1. (10 marks)

Value Co’s auditor discovered that Value Co’s depreciation expense was understated by $150. Briefly describe within 150 words the changes that would be made to the balance sheet, income statement, and the cash flow statement if the mistake is corrected. Assume that the company tax rate is 25%. (Your     answer must be handwritten.)

Question 2. (10 marks)

(a) Briefly explain within 50 words why managers may prefer share repurchases over dividends when managers are compensated primarily by stock options. (Your answer must be handwritten.) (5 marks)

(b) Briefly explain within 50 words managers may be reluctant to reduce dividends under a stable (progressive) dividend policy. (Your answer must be handwritten.) (5 marks)

Question 3. (10 marks)

Value Co (Value) has 15 million shares outstanding, which trade at $20 per share. Value is in a liquidity crisis and issues 2 million shares at $12 per share to a group of hedge funds. What is the total loss          incurred by pre-existing shareholders as a result of this share issue?

Question 4. (10 marks)

Value Co (Value) operates under the assumptions of Modigliani and Miller. Value currently has no debt, and its earnings are expected be $200,000 and can range from a minimum of $100,000 to a maximum of $500,000. Value has 100,000 shares outstanding and its shares trade at $15 per share.

(a) Howard is Value’s CFO and Howard argues that Value would be better off by borrowing $900,000 at 10% interest to repurchase Value’s shares at $15. If Value goes with Howard’s proposal, what is the       change in Value’s ROE when Value’s earnings before interest is $100,000, $200,000, and $500,000        respectively? (Show all your work. Your answer must be handwritten.) (5 marks)

(b) Anne owns 10,000 Value shares. Anne argues that it is unnecessary for Value to borrow money to      repurchase debt since she can borrow as well, at the same interest rate. If Anne wants to have the same    ROE outcomes as Howard’s proposal, how much will Anne need to borrow, and what is the total number of shares that Anne will own? (Show all your work. Your answer must be handwritten.) (5 marks)

Question 5. (10 marks)

Gamma Co (Gamma) is considering an acquisition of Delta Co (Delta). The current financial year (year   0) is just about to conclude for both Gamma and Delta. Gamma is a publicly traded company and Delta is a private company. Gamma has 5 million shares outstanding, which trade for $15 per share. Delta has 3   million shares outstanding, but its shares do not trade on the stock market since it is private, and there is   no market price available for Delta’s shares. Since there is no market price for Delta’s shares, Gamma      decides to estimate the value of Delta using the discounted cash flow method.

This year (year 0), Delta is expected to have $6 million in sales, which are expected to grow by 2% each   year. Delta’s EBIT margin has always been 40% of sales, and that is expected to continue in the future.     Delta’s depreciation and capital expenditures are expected to be 15% of sales. Delta’s working capital is   10% of sales this year, and 10% of sales in future years. The tax rate is 30%. Delta has no debt. The risk-  free rate is 4%, the market risk premium is 6%, and Delta’s beta is estimated to be 0.8. After the                acquisition, Gamma estimates that it would be able to cut costs by eliminating Delta’s sales and general    administrative expenses, which are estimated to be around 10% of sales each year. All cash flows occur at the end of the year.

(a) What is the value of Delta as a stand-alone company, and the present value of the synergies from the deal? (Show all your work. Your answer must be handwritten.) (2 marks)

(b) If Gamma pays $10 per share to acquire Delta, what is the value of the net benefit/cost to Gamma       shareholders from the acquisition? Answer based only on the information provided. (Show all your work. Your answer must be handwritten.) (2 marks)

(c) Gamma pays $10 per share to acquire Delta, but Gamma is now expected to be unable to cut any costs related to Delta’s sales and general administrative expenses. What is the value of the net benefit/cost to    Gamma shareholders from the acquisition? Answer based only on the information provided. (Show all     your work. Your answer must be handwritten.) (2 marks)

(d) If Gamma offers a Scrip bid for Delta, how many shares in Gamma would need to be offered for each share in Delta so that 70% of the gain goes to Gamma shareholders and 30% of the gain goes to Delta      shareholders? Assume that Gamma is once again able to achieve the sales and general administrative       expense reductions. Answer based only on the information provided. (Show all your work. Your answer  must be handwritten.) (4 marks)

Question 6. (10 marks)

You are the manager of Grow Co (Grow), and you live in a world where financial markets are inefficient. Grow has a net income of $20 million and has 4 million shares outstanding. Grow’s shares trade at $100  per share. For some reason, the investors in this world expect the earnings growth rate in the most recent  year to continue in perpetuity and use that growth rate to determine the appropriate price-to-earnings        ratios of firms. Assume that in this world the P/E ratio for a firm can be calculated via the formula 1/(r –  g), where r is the discount rate of the company and g is the current year’s growth rate in earnings per        share. Assume the discount rate is 15%.

Despite what the name may suggest, Grow can no longer grow its earnings organically. Knowing that the market rewards growth with high price-to-earnings ratios, you choose to artificially grow earnings by      acquiring other companies. In each of the next two years, you acquire Alpha Co (Alpha) and Beta Co      (Beta), respectively. However, Alpha and Beta also cannot grow its earnings organically.

Alpha’s net income is $5 million, and it has 5 million shares outstanding. Alpha’s shares trade at $10 per share. You acquire Alpha (in year 1) by offering 1 newly issued Grow share for 10 Alpha shares. Beta’s net income is $5 million, and it has 8 million shares outstanding. Beta’s shares trade at $5 per share. You acquire Beta (in year 2) by offering 1 newly issued Grow shares for 25 Beta shares.

(a) What is Grow’s stock price after acquiring Alpha in year 1? Answer based only on the information provided. (Show all your work. Your answer must be handwritten.) (4 marks)

(b) What is Grow’s stock price after acquiring Beta in year 2? Answer based only on the information provided. (Show all your work. Your answer must be handwritten.) (4 marks)

(c) After Grow acquires Alpha and Beta, what is Grow’s stock price if investors suddenly realize that     Grow’s growth rate is actually 0%?  (Show all your work. Your answer must be handwritten.) (2 marks)

Question 7. (10 marks)

Alpha Co (Alpha) is considering building a factory either in Chile or Iceland. Alpha cannot build in both   Chile and Iceland and needs to choose. If Alpha builds the factory in Iceland, it will cost $5 million           immediately, and $3 million each in year 1 and year 2, respectively. The factory will take 4 years to build. If there is high demand for the factory built in Iceland, it will generate $8 million per year in perpetuity. If there is low demand for the factory built in Iceland, it will generate $1 million per year in perpetuity. The probability that there will be high demand for the factory built in Iceland is 25% and the probability that   there will be low demand for the factory built in Iceland is 75%.

If Alpha builds the factory in Chile, it will cost $2 million immediately, $3 million in year 1, and will take 2 years to build. If the factory is built in Chile it is expected to generate $3 million per year in perpetuity.  The required rate of return for Alpha is 10%. Assume cash flows occur at the end of each year, except for initial cash flows, which occur immediately.

(a) Should Alpha build the factory in Chile or in Iceland? Explain. Answer based only on the information provided. (Show all your work. Your answer must be handwritten.) (5 marks)

(b) Iceland is looking to attract investments and offers Alpha an option to sell the factory to the                government of Iceland at a price of $20 million, 6 years after the initial investment. If Alpha chooses the option to sell the factory to the government, it will not receive the cash flows generated from the factory  in that year. Should Alpha choose to build the factory in Chile or in Iceland, after considering the option? Answer based only on the information provided. (Show all your work. Your answer must be                     handwritten.) (5 marks)

Question 8. (10 marks)

Calculate the expected IRR on the following leveraged buyout. The target firm can be bought at 7 times  EBITDA (LTM) and is expected to be sold at 8 times EBITDA (LTM) after 7 years. The buyout will be financed with 60% debt. The interest on the debt is 12% and the principal will be repaid using cash         available for debt repayment in each year. If any debt is left at the end of year 7, it will be fully paid off  before the equityholders can be paid. The interest on the debt will be calculated on the ending balance of the previous year’s debt.

The current financial year (year 0) is about to conclude for the target firm. This year (year 0), the target     firm had sales of $150 million. Sales for the target firm are expected to grow by 5% until year 3, after       which sales growth will become 1% in perpetuity. The EBITDA margin for the target firm is expected to  stay the same at 40%. The target firm’s existing net plant, property, and equipment is $45 million and will be depreciated to zero in 3 years, using the straight-line method. The target firm will spend 15% of its       revenues for each year as capital expenditures. The capital expenditures will be depreciated to zero in 3    years, using the straight-line method. The target firm’s capital expenditures for any particular year are       made at the start of that year. The target firm requires working capital of 30% of sales. Taxes are 20%.      The target firm owns no cash right after the buyout. All cash flows occur at the end of the year, except for capital expenditures. (Show your work in Excel. In Excel, show numbers at the two decimal places.          Copy-paste your Excel work to your answer document as an image.) (10 marks)

Question 9. (10 marks)

You are asked to project Value Co (Value)’s free cash flows (to the firm) over the next 10 years. Value’s sales this year (year 0) was $240 and its cost of goods sold was $120. Value’s sales are expected to be      $250 next year which will increase by 10% each year thereafter. Value’s cost of goods sold is expected to stay constant at 50% of sales. Value’s EBIT margin is expected to stay constant at 40%. Value’s existing net plant, property, and equipment is $100 and will be depreciated to zero in 8 years, using the straight-    line method. Value will spend 20% of its revenues for each year as capital expenditures. The capital         expenditures will be depreciated to zero in 8 years, using the straight-line method. Value’s capital             expenditures for any particular year are made at the start of that year. Value’s working capital consists of accounts receivables, inventories, and accounts payables. Value’s current (year 0) accounts receivables is $30, inventory is $10, and accounts payable is $25. Value’s days sales outstanding, days inventory held,  and days payable outstanding is expected to remain constant in the future. The days sales outstanding,      days inventory held, and days payable outstanding of a particular year are calculated based only on that    year’s account receivables, inventories, account payables, sales and cost of goods sold. Value’s company tax rate is 30%.

(a) What is Value’s expected after-tax EBIT for the next 10 years? Answer based only on the information provided. (Show your work in Excel. In Excel, show numbers at the two decimal places. Copy-paste your Excel work to your answer document as an image.) (1 mark)

(b) What is Value’s expected capital expenditures and depreciation for the next 10 years? Answer based  only on the information provided. (Show your work in Excel. In Excel, show numbers at the two decimal places. Copy-paste your Excel work to your answer document as an image.) (4 marks)

(c) What is Value’s expected increase in net working capital for the next 10 years? Answer based only on the information provided. (Show your work in Excel. In Excel, show numbers at the two decimal places. Copy-paste your Excel work to your answer document as an image.) (4 marks)

(d) What is Value’s expected free cash flow (to the firm) for the next 10 years? Answer based only on the information provided. (Show your work in Excel. In Excel, show numbers at the two decimal places.       Copy-paste your Excel work to your answer document as an image.) (1 mark)

Question 10. (10 marks)

(a) Value Co (Value) has $200 million in debt, with a before-tax cost of debt of 8%. Value has 15 million shares outstanding, with a market price of $20 per share. Value’s cost of equity can be estimated using the CAPM model and data from comparable firms. Alpha Co (Alpha) and Beta Co (Beta) are equally              comparable to Value. Alpha has a levered beta of 1.5 and a debt-to-equity ratio of 100%. Beta has a          levered beta of 0.8 and a debt-to-equity ratio of 20%. The risk-free rate is 4% and the market risk              premium is 7%. What is Value’s WACC? (Show your work in Excel. In Excel, show numbers at the two  decimal places. Copy-paste your Excel work to your answer document as an image.) (3 marks)

(b) Assume that the information provided about Value in (a) holds here as well. The following are    selected items from Value’s financial statements from the past three years. The dollar amounts in the financial statements are in millions. Today is the last day of year 100.

Depreciation

% SDl?s

Capital Expenditures

% SDl?s

15.00

LS%

15.00

LS%

17.40

LS%

17.40

LS%

19.84

LS%

19.84

LS%