FIN 70104 FINANCING THE CORPORATION
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SEPTEMBER SEMESTER 2021
FINANCING THE CORPORATION
FIN 70104
Question 1 (MLO 1)
The basic assumption in finance is that the interests of the firm’s financial managers and its shareholders are perfectly aligned, and that financial decisions are in the shareholders’ interest. But perfect alignment is implausible in theory and impossible in practice.
The free cash flow hypothesis advanced by Michael Jensen states that managers endowed with free cash flow will invest it in negative net present value (NPV) projects rather than pay it out to shareholders. Jensen defines free cash flow as cash flow left after the firm has invested in all available positive NPV projects.
The free cash flow hypothesis posits that cash flow increases the agency costs of firms with poor investment opportunities. It assumes that management values investments in operations more than investments in financial assets. This may be because management perquisites increase with investments in operations even when these investments have a negative NPV. So, once management has exhausted positive NPV projects, it proceeds to invest in negative NPV projects rather than pay out funds to shareholders.
a. Evaluate the implications on modern firms when the interests of the principal and the agent are not aligned. (12 marks)
b. Appraise the role of capital structure and pay-out policy for dealing with shareholder-manager conflicts based on Jensen’s FCF hypothesis (13 marks)
[25 marks]
Question 2 (MLO1)
You own a small manufacturing plant that currently generates revenues of RM 2 million per year. Next year, based upon a decision on a long-term government contract, your revenues will either increase by 20% or decrease by 25%, with equal probability, and stay at that level as long as you operate the plant. Other costs run RM 1.6 million per year. You can sell the plant at any time to a large conglomerate for RM 5 million and your cost of capital is 10%.
a. Estimate the value of your plant if you are awarded the government contract and your sales increase by 20%. (6 marks)
b. Calculate the value of your plant if you are not awarded the government contract and your sales decrease by 25% (10 marks)
c. Derive the estimated value of your plant without the embedded option to sell the plant (3 marks)
d. Derive the estimated value of your plant with the embedded option to sell the plant (3 marks)
e. Deduce the value of the option to sell the plant. (3 marks)
[25 marks]
Question 3 (MLO 1)
NOBODY would have guessed that the daily trading volume record on Bursa Malaysia would be broken this year. When the Covid- 19 crisis hit, most people were focused on the gloom and doom from the fallout of the pandemic. Bursa Malaysia’s trading volume and trading value hit a record 9.3 billion units and RM9.4bil on May 29. It is also not a one-day affair. There were 44 days when volumes were 50% to 100% higher than the average of Bursa Malaysia’s trading volume and values of 2.7 billion units and RM2.4bil respectively in the last two years. To be fair, it is not just a Malaysian phenomenon, a few other markets, for example those in the United States and Hong Kong also experienced similar surges in trading volumes.
The “star” contributors to the surge in trading volume are not the usual big local institutions. It is also not contributed by strong inflows from global foreign institutional funds. There is no foreign “hot money” this time. In fact, foreign institutions have been selling Malaysian stocks since two years ago and remained very much absent this time around. Retail investors were big contributors to the high trading volumes this year. Retail participation reached a high of 40% last month.
There were many prognosis from the “experts” who tried to explain this including “Malaysian retail investors have limited funds to invest in the stock market, retail investors don’t understand the stock market, they only buy speculative and penny stocks and Malaysian retail investors buy unit trusts instead of stocks so you should count unit trusts as part of retail participation.” So, what is the combined “fire power” of retail investors in Malaysia? How much money do they have? Unlike institutional funds, retail investors have no such restriction, they buy what they want and is only limited by how much money they have. Excluding disposal income used for household expenditure, if you add the total amount of money that individuals have in their savings accounts in the banks, the amount of money invested in unit trusts and the ownership of stocks by individuals is close to RM1.6 trillion. Another factor is leveraging. Retail investors can borrow money to buy stocks. Most, if not all local institutions cannot borrow money for investments. Another commonly accepted perception about retail investors is they only buy speculative and penny stocks. This perception has also been debunked by the recent behaviour of the retail investors – there is a pandemic coming, so buy gloves stocks. In addition, it is a well- known fact that Malaysian glove companies are global leaders in the manufacturing of gloves. There is no need for a 20-page research report to come to this simple decision to buy glove stocks. Glove stocks are definitely not penny stocks. Bursa Malaysia is still about 15% below its recent high of 1,887 points achieved in 2018. Whether the market will undergo a major correction soon, we now have a different perspective of the retail investors. They are not a dying breed with no resources and only buy penny stocks. There is still a lot of work to be done in terms of investors education and digitalisation of the industry but retail participation should be nurtured and individual investors should be allowed to participate in wealth creation through the stock market.
You are trading in a market in which you know there are a few highly skilled traders who are better informed than you are. There are no transaction costs. Each day you randomly choose five stocks to buy and five stocks to sell (by, perhaps, throwing darts at a dartboard).
a. Over the long run will your strategy outperform, underperform, or have the same return as a buy and hold strategy of investing in the market portfolio? (12 marks)
b. Would your answer to part (a) change if all traders in the market were equally well informed and were equally skilled? (13 marks)
[25 marks]
Question 4 (MLO 1)
Stock market booms and merger waves are both driven by increases in optimism in financial markets. This is driven by managerial discretion and overvaluation that claim that merger waves are driven by market optimism. Empirical support for the managerial theory is provided by evidence that the amounts of assets acquired increase as optimism in financial markets increases and that the returns to acquiring companies are inversely related to market optimism at the time ofmergers.
Since the Covid- 19 outbreak, rubber glove makers stocks have by far been the clear outperformers on Bursa Malaysia. The market rallies were largely fuelled by global shortages of rubber gloves. Shares of rubber glove makers were chased by institutional investors and retailers, as they were seen as beneficiaries of the pandemic amid strong sales and severe undersupply.
A beneficiary of the bull run has been Super Glove Berhad which now has accumulated large cash reserves and would like to expand into another promising area, financial technology. Super Glove Berhad has earnings per share of RM 4.00. It has 1 million shares outstanding, each of which has a price of RM 40.00. The management is thinking of buying Hyper Fintech, which has earnings per share of RM 2.00, 1 million shares outstanding, and a price per share of RM 25.00. The management will pay for Hyper Fintech by issuing new shares. Super Glove and Hyper Fintech are in totally different industries. There are no expected synergies from the transaction.
a. Diversification is good for shareholders. Rationalise whether should managers acquire firms in different industries to diversify a company? (5 marks)
b. Evaluate the acquisition of Hyper Fintech by Super Glove in terms of impact to respective shareholders’ wealth. (5 marks)
c. Compute the earnings per share of Super Glove Berhad after the merger if it pays no premium to acquire Hyper Fintech. (5 marks)
d. Rationalise the change in earnings per share and its impact on shareholders. (10 marks)
[25 marks]
2022-12-12