IF3108 Corporate Finance 2019
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IF3108 Corporate Finance
Question 1
Zip.com is a producer of storage hardware. The company currently has no debt. Its cost of capital is 10% and is expected to produce EBIT of $10m at the end of the year, which will be growing at 3% per year in perpetuity. Capital expenditures are expected to be $2m at the end of the year, also growing at 3% per year in perpetuity. Depreciation is expected to equal capital expenditures. Net working capital, currently at $1m, will need to grow to $2m at the end of the year and grow at 3% per year in perpetuity. The corporate tax rate is 30%.
a. What is the Free Cash Flow of the firm at the end of the year?
b. What is the Enterprise Value as of now?
At the beginning of the year, the Chief Financial Officer of Zip.com decides that is can raise leverage to D/V=0.2 without any increase in financial distress. The proceeds of the debt issue will be used to buy back equity. The expected cost of debt is 5%, which is also the risk free rate:
c. What is the new Weighted Average Cost of Capital?
d. What is the new Enterprise Value?
Question 2
Safe & Co., a producer of wallets, has currently a conservative capital structure with D/V=0.1. Its estimated beta of equity is 1.2. Its expected Free Cash Flow at the end of the year is £50m and is expected to grow at 4% per year in perpetuity. This year the company decides to undertake a recapitalisation: to increase its leverage to D/V=0.3, a level at which it still expects to face no costs of financial distress, and to use the proceeds to buy back shares. The cost of debt is expected to stay at 3% and so is the risk free rate. The market risk premium is 6%. The corporate tax rate is 30% and there are 100 million shares outstanding.
a. What is the Weighted Average Cost of Capital before the recapitalisation?
b. What is the share price before the recapitalisation (assuming nobody expected it to happen)?
c. What is the new Weighted Average Cost of Capital after the recapitalisation?
d. What happens to the share price at the announcement of the recapitalisation?
Question 3
Divide Inc is considering how to pay out £6m of cash, which was just raised through a debt issue. The value of equity after the cash is paid to shareholders is £100m. There are 10m shares outstanding. Assume that there are no personal taxes and the corporate tax rate is
30%.
a. Suppose the cash is paid out as dividends. What are the cum-dividend and the ex-dividend prices?
b. Suppose that the cash is paid through an open market share repurchase. What are the number of shares bought back and the stock price after the repurchase is complete?
c. Suppose the cash is paid in a tender offer at £12 per share. What are the number of shares repurchased and the stock price after the repurchase is complete?
d. What is the ranking between options a, b and c from shareholders' perspective?
Question 4
Underform PLC operates a well in the North Sea. They have £10m of cash and expect to extract the last gallons of oil at the end of the year generating FCF of £40m. They do not expect to have any other source of income and do not expect to recover anything from the liquidation of their equipment. They are highly levered and their debt is due at the end of the year: they must pay a total of £55m inclusive of interests. The CEO learns about the opportunity to invest in an oil well in Greenland: the investment requires £10m and produces no return with probability 85% and £50m with probability 15%. Assume that the discount rate is 0% and there are not corporate taxes.
a. What is the market value of debt and equity if the firm does not invest in Greenland
b. What is the market value of debt and equity if the firm does invest in Greenland?
c. What is the right decision and what will the CEO (who acts in the interest of its shareholders) do?
d. Suppose the creditors swap their debt for 90% of the equity. How would your answer to question c change? Should they do it?
Question 5
Gems Ltd is considering to purchase the rights to operate a diamond mine in South Africa for 2 years. The asking price of the rights is £0.5m. Operating the mine will cost £10m per year in variable costs (to be paid at the end of the year). The mine (if operating) is expected to produce 10,000 carats of diamond at the end of the year. The price of diamonds now is £1,000 per carat and is expected to increase by 30% or fall by 10% per year with equal probability. The risk free rate is 0% per year and is expected to stay constant.
a. What is the risk neutral probability for investing in diamond production?
b. What are the expected profits of operating the mine in each year? Consider separately the expected profit from operating the mine (i) in the first period, (ii) in the second period when the price of diamond is high, and (iii) in the second period when the price of diamond is low.
c. What is the NPV of operating the mine without any flexibility?
d. How (and by how much) can flexibility help increase the NPV?
2021-12-26