Question 1 (15 marks)

Moffatt Limited and Snowsill Limited have agreed to a merger whereby Snowsill shareholders will receive
one share in Moffatt for each share in Snowsill they already own, plus $0.30 in cash to be financed with
additional debt. Prior to the merger Moffatt had 100 million shares on issue and Snowsill had 200 million
shares on issue.
Prior to the merger, analysts were expecting the following financial performance for each firm as a standalone entity in forecast year 1. For both firms, the cost of equity capital is 15 per cent, the yield to maturity
on debt is 8 per cent and the corporate tax rate is 30 per cent. Ignore dividend imputation.
$ million
Sales
EBITDA
Depreciation and amortisation
EBIT
Interest expense
Pre-tax profit
Income tax expense
NPAT
Capital expenditure

Moffatt
1000.0
80.0
20.0
60.0
15.0
45.0
13.5
31.5
32.0

Snowsill
1200.0
60.0
10.0
50.0
10.0
40.0
12.0
28.0
32.0

As stand-alone entities, Moffatt had a 43 per cent debt-to-value ratio and Snowsill had a 38 per cent debt-tovalue ratio. Both firms were in a state of constant growth as stand-alone entities.
Required:
(a) In the absence of any synergies, estimate the equity value of Moffatt Limited subsequent to the
acquisition of Snowsill Limited (that is, the equity value of the combined firm). Use the free cash flow
to the firm valuation model, applied to each individual firm, as the first step in your analysis (7.5
marks).
(b) Assume that pre-tax operating costs were expect to be reduced by $20 million as a result of the merger.
Estimate the earnings per share of Moffatt Limited subsequent to the merger (that is, the earnings per
share of the combined firm) (7.5 marks)
Solution
(a) The estimated equity value of Moffatt Limited subsequent to the acquisition is $348 million.
The first stage is to estimate the firm value of each entity using the free cash flow to the firm valuation
model. The stand-alone firm value estimates are $383 million for Moffatt Limited and $306 million for
Snowsill Limited, computed according to the equation below for the case where cash flows are expected to
grow at a constant rate in perpetuity:

V=

FCFF1
WACC g

where:
FCFF is the expected free cash flow to the firm, computed as FCFF = EBIT (1 ) + Depreciation
Capital expenditure Change in working capital;
WACC is the weighted average cost of capital, computed as WACC = re

E
D
+ rd (1 ) ; and
V
V

g is the estimated growth rate.

The growth rate is not provided in the question, but we can estimate a long-term growth rate as the product
of the reinvestment rate and expected return on capital, and setting the expected return on capital equal to the
weighted average cost of capital, and also assuming that depreciation is an estimate of sustaining capital
expenditure, according to the equations below:
1

g = Reinvestment rate E (ROC )

Reinvestment rate =

Expansion capex
EBIT (1 ) + Depreciation - Sustaining capex

Computations for the individual firms are:

Moffatt Limited

Snowsill Limited

FCFF1 = EBIT1 (1 ) + Depn1 Capex1 WC

= 60.0 (1 0.30) + 20.0 32.0
= $30.0m

FCFF1 = EBIT1 (1 ) + Depn1 Capex1 WC

= 50.0 (1 0.30) + 10.0 32.0
= $13.0m

E
D
+ rd (1 )
V
V
= 0.15 0.57 + 0.08 (1 0.30 ) 0.43

WACC = re

= 11.0%

E
D
+ rd (1 )
V
V
= 0.15 0.62 + 0.08 (1 0.30 ) 0.38
= 11.4%

RR =

Expansion capex
EBIT (1 ) + Depn - Sustaining capex
32.0 20.0
=
60.0 (1 0.30 ) + 20 20
12
=
42
= 28.6%
g = RR E (ROC )
= 0.286 0.110
= 3.1%

Expansion capex
EBIT (1 ) + Depn - Sustaining capex
32.0 10.0
=
50.0 (1 0.30 ) + 20 20
22.0
=
35.0
= 62.9%
g = RR E (ROC )
= 0.629 0.114
= 7.2%

FCFF1
WACC g
30.0
=
0.110 0.031
= $383m

V=

WACC = re

RR =

FCFF1
WACC g
13.0
=
0.114 0.072
= $306m

V=

As there are no synergies the combined value of the firm subsequent to the merger will be estimated as the
sum of the individual firm values, so we have $383 million + $306 million = $690 million.
In order to estimate the equity value of the combined firm we have to subtract its debt. As a stand-alone
entity, Moffatt Limited has estimated debt of $165 million, which is its debt-to-value ratio of 0.43 multiplied
by the total value of $383 million. By the same rationale, as a stand-alone entity Snowsill Limited has total
debt of $116 million, which is its debt-to-value ratio of $0.38 multiplied by its total value of $306 million.
Hence, the aggregate debt of the two firms as stand-alone entities is $281 million (that is, $165 million +
$116 million = $281 million).
However, the acquisition will be partly funded by taking on additional debt of $60 million in order to pay
Snowsill shareholders $0.30 in cash for each of the their 200 million Snowsill shares (that is, $0.30 200
million = $60 million).
This means that the total debt of the combined entity will be $341 million, comprising $281 million of
existing debt plus $60 million of additional debt used to fund the acquisition.

As the combined firm has total value of $690 million and debt of $341 million the estimated equity value is
$348 million.
Alternative solutions
The long-term growth rate in the question is not provided. Neither is the expected return on reinvested
capital. So the solution above is derived under an assumption that the expected return on reinvested capital is
equal to the weighted average cost of capital. Alternatively, students may have imposed a growth rate on
their analysis in order to perform their computations. This is also acceptable. The table below presents a
series of alternative solutions under different assumed long-term growth rates, but with the same assumed
free cash flow to the firm and weighted average cost of capital
Growth
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%

Moffatt
274
301
335
377
431
504
605
758
1014
1532
3132

Firm value
Snowsill
114
125
138
154
175
202
239
294
379
535
910

Total
388
426
473
531
606
706
845
1052
1393
2068
4042

Moffatt
118
130
144
162
185
217
260
326
436
659
1347

Snowsill
43
47
52
59
67
77
91
112
144
203
346

Debt
Total
161
177
196
221
252
293
351
437
580
862
1692

New
60
60
60
60
60
60
60
60
60
60
60

New total
221
237
256
281
312
353
411
497
640
922
1752

Equity
Total
167
189
216
251
294
352
433
554
753
1145
2289

Another approach would have been to estimate the reinvestment rates above, and impose an estimate for the
return on capital at a premium to the estimated WACC. This is also acceptable. The table below presents
alternative solutions under this approach. Observe that the zero premium solution is the same as that
presented above. Also note that at higher premiums we do not have a solution. If the premium is, say, 7%
then E(ROC) increases to 18.0 and 18.4%, and the growth rates are 5.1 and 11.6%. For Snowsill, the growth
rate would exceed the WACC so we cant apply the constant growth discounted cash flow valuation model.
E(ROC)
Firm value
Premium Moffatt Snowsill
0%
383
306
1%
398
360
2%
413
435
3%
430
551
4%
449
751
5%
469
1180
6%
491
2747

Total
690
757
849
982
1200
1649
3238

Moffatt
165
171
178
185
193
202
211

Snowsill
116
137
165
209
285
448
1044

Debt
Total
281
308
343
394
478
650
1255

New
60
60
60
60
60
60
60

New total
341
368
403
454
538
710
1315

Equity
Total
348
390
445
527
662
939
1923

Finally, students could have imposed an assumed E(ROC) on their valuation, rather than estimating a
premium to the WACC. Under this approach we have the following results.
E(ROC)
12%
13%
14%
15%
16%
17%
18%

Moffatt
398
414
431
450
470
492
516

Firm value
Snowsill
Total
335
733
399
813
495
926
650
1100
948
1418
1751
2243
11432
11948

Moffatt
171
178
185
193
202
211
222

Snowsill
127
152
188
247
360
666
4344

Debt
Total
298
330
373
440
562
877
4566

New
60
60
60
60
60
60
60

New total
358
390
433
500
622
937
4626

Equity
Total
375
424
492
599
796
1306
7322

With respect to the estimation of the firms debt as a stand-alone entity, there is also an alternative
computation. Students are given the yield-to-maturity on debt and the expected interest expense in year one.
They may estimate the value of debt as the interest expense divided by the yield to maturity. For Moffatt
Limited the estimated debt value will be $188 million, computed as $15.0 million 0.08 = $188 million. For
Snowsill Limited the estimated debt value will be $125 million, computed as $10.0 million 0.08 = $125
3

million. Hence, the total estimated debt for the two firms as stand-alone entities will be $313 million,
making the total debt of the combined firm $373 million once the $60 million of additional debt is included.
With firm value of $690 million and total debt of $373 million, the estimated equity value is $317 million.
A final alternative solution would have been to estimate the debt figures as interest expense dividend by
yield to maturity, and then estimate firm value with reference to the given debt-to-value ratios. For Moffatt
Limited, the estimated debt is $188 million and the debt-to-value ratio is 43%. Hence the firm value of
Moffatt as a stand-alone entity is $436 million (that is $188 million 0.43 = $436 million). For Snowsill
Limited, the estimated debt is $125 million and the debt-to-value ratio is 38%. Hence, the firm value of
Snowsill as a stand-alone entity is $329 million (that is, $125 million 0.38 = $329 million). In aggregate
we have firm value of $765 million (that is $436 million + $329 million = $765 million). From this we can
subtract total debt of $373 million (which is the sum of $188 million, $125 million and the additional $60
million of debt taken on) to arrive at an estimated equity value of $392 million.
(b) The estimated earnings per share of Moffatt Limited subsequent to the acquisition is $0.23.
Ultimately we need to estimate earnings per share as the ratio of net profit after tax (NPAT) to the number of
shares on issue in the combined firm.
First, NPAT of $70.1 million is computed as follows:
NPAT of Moffatt as a stand-alone entity
NPAT of Snowsill as a stand-alone entity
Combined NPAT stand-alone
+ NPAT increase from synergies
After-tax interest expense from new debt
= Combined firm NPAT

$31.5
$28.0
$59.5
$14.0
$3.4
$70.1

[pre-tax cost reductions of $20 (1 0.30) = $14.0]

[$60m 0.08 (1 0.30) = $3.4]

Second, shares on issue reach 300m because Moffatt Limited issues an additional 200 million shares to
Snowsill Limited shareholders (that is, Snowsill Limited shareholders receive a share in Moffatt Limited for
each of the 200 million shares they already own). Combined with the 100 million shares already on issue the
total number of shares on issue is 300 million.
Hence, earnings per share is estimated as $70.1 million 300 million shares = $0.23.

Question 2 (15 marks)

Slater and Gordon Limited (SGH), a law firm, was listed on the Australian Stock Exchange on 21 May
2007. It raised $35 million by issuing 35 million shares at $1.00 per share. The total number of shares on
issue was 108 million. At the end of the first says trade its share price was $1.40 per share.
Its closing price on 22 September 2009, 2.34 years after listing, was $1.66. At this time, the most recent
reported earnings per share and dividends per share were $0.148 and $0.042, respectively. For the next two
years, analysts are forecasting earnings per share of $0.166 and $0.168. They are also forecasting dividends
per share of $0.05 and $0.04 for the corresponding years. Dividends are fully franked and the corporate tax
rate is 30 per cent. At the end of year two, analysts expect the dividend payout ratio to remain constant at the
year two level, and that any reinvested earnings will earn a return of 20 per cent.
Assume that the market values imputation credits attached to dividends at 20 cents in the dollar (that is, your
estimate of phi or is 0.20). Also assume that equity investors require a total expected return of 18 per cent
as compensation for the risk exposure of SGH.
Required:
(a) At the current price of $1.66 and current analyst expectations would you recommend investors buy or
sell SGH? Document the reasons for your recommendation (7.5 Marks).
(b) In the period since SGH has been listed, total returns on the Australian sharemarket have been minus 30
per cent. Comment upon the performance of SGH shares during this time with reference to the historical
evidence on the long-run performance of initial public offerings (7.5 marks).
Solution
(a) The present value of expected dividends is $1.38. This is substantially below the current price of
$1.66 so investors should sell the stock.
The stock can be valued as the present value of expected dividends according to the equation below:

Equity _ value _ per _ share =

t =1

t =1

% Franked
Dt 1 +
1

(1 + re )t

% Franked
% Franked D2 (1 + g ) 1 +
Dt 1 +
1

1
+
(1 + re )t
(re g ) (1 + re )2

0.30
0.30
0.30

1.00 0.20 0.040 1 +

1.00 0.20 0.040 1.152 1 +
1.00 0.20
0.050 1 +

1
0
.
30
1
0
.
30
1
0
.
30

=
1.18
1.182
(0.180 0.152) (1.18)2
0.050 1.086 0.040 1.086
0.050 1.086
+
+
(0.18 0.15) 1.392
1.180
1.392
0.054 0.043 0.054
1
=
+
+

1.18 1.392 0.030 1.392

1.812
= 0.046 + 0.031 +
1.392
= 0.046 + 0.031 + 1.301
= $1.38

where:
Dt is the expected dividend per share in year t (given as $0.05 and $0.04, respectively);
re is the required return to equity holders (given as 18%);
is the corporate tax rate (given as 0.30);
or phi is the estimated value of an imputation credit attached to a dividend (given as 0.20);
%Franked is the proportion of dividends which have franking credits attached (given as 100%); and
g is the estimated perpetual growth rate.
5

In turn, the long-term growth rate (g = 15.2%) is estimated as the product of the reinvestment rate for equity
and the expected return on reinvested earnings, computed as follows:

g = Reinvestment rate E (ROE )

= (1 Dividend payout ratio ) E (ROE )

Dividends per share

E (ROE )
= 1
Earnings per share

0.040
= 1
0.20
0.168
= (1 0.238) 0.20
= 0.762 0.20
= 15.2%
(b) The performance of Slater and Gordon shares since listing, which includes capital gains of 18.6%
since listing (7.6% per year) compared to total returns of 30.0% on the broader market (14.1% per
year) is contrary to the historical long-run average performance of IPOs. Capital gains are computed
as $1.66 $1.40 1 = 0.186 and the annualised capital gains are computed as 1.186(1/2.34) 1 = 0.076.
IPOs on average earn lower returns than the broader market subsequent to the first day of trade.
The performance differential of Slater and Gordon is even greater if dividend yield is considered. We know
that at least one dividend of $0.042 has been paid, which implies that the total return of Slater and Gordon
subsequent to the first day of trade is at least 21.6% (8.7% per year), computed as $1.702 $1.40 1 =
0.216 and 1.216(1/2.34) 1 = 0.087.
According to the evidence presented in Ritter and Welch (2002) over three years the average US IPO
underperformed the broader market by 23%. However, once IPOs are appropriately benchmarked against
firms with similar market capitalisation and book-to-market equity characteristics, this underperformance
diminished to around 5%. More recent evidence from Chung, Chang and Lim (2009) shows that the longrun underperformance of IPOs is concentrated amongst firms with both low-quality underwriters and which
make accounting choices which inflate earnings prior to the IPO.

Question 3 (15 marks)

The table below summarises the most recent financial statement and equity market pricing for two
Australian retailers Harvey Norman (which specialises in furniture and electrical sales) and Nick Scali (a
furniture seller). Items are in $ million unless otherwise specified and the corporate tax rate is 30 per cent.

Sales
EBITDA
EBIT
Pre-tax profit
NPAT
Dividends
Franking
Capital expenditure
Interest bearing debt
Non interest bearing liabilities
Total liabilities
Book value of equity
Market value of equity

Harvey Norman
2410.1
472.7
421.4
386.7
250.4
116.9
100%

Nick Scali
77.5
7.3
6.9
6.9
4.8
4.9
100%

240.3

1.2

585.4
1011.6
1597.0
2059.2
4409.0

0.00
13.75
13.75
18.42
96.00

Historically, the ratio of EBIT/Sales for Harvey Norman has averaged 27 per cent with a standard deviation
of 10 per cent. For Nick Scali, the ratio of EBIT/Sales has averaged 16 per cent with a standard deviation of
5 per cent.
Required:
Compare the two firms capital structures in the context of the tax benefits of debt finance, costs of financial
distress, agency costs and financial flexibility (15 marks).
Solution
Harvey Norman is the larger firm according to sales, earnings and assets, and has significantly more
leverage. It has a debt-to-value ratio of 11.7% on a market value basis, computed as $585.4m ($585.4m +
$4409.0m = 0.117, and 22.1% on a book value basis, computed as $585.4m ($585.4m + $2059.2m) =
0.221. In contrast Nick Scali has no debt. In general, larger firms have the ability to tax on relatively more
debt finance than smaller firms, and still maintain the same credit rating. It is somewhat surprising that a
firm with $2.4 million of sales and $2.6 billion of assets is only geared to 22.1% on a book value basis.
However, while Harvey Norman has the higher average EBIT margin it also has the more volatile EBIT
margin, which may explain its cautious use of debt.
The higher leverage of Harvey Norman increases value due to the tax deductibility of interest payments. In
present value terms this increased value can be estimated at $175.6 million, computed as corporate tax rate
debt = 0.30 $585.4m = $175.6m.
In terms of increasing firm value, these tax benefits need to be offset by increased costs of financial distress
and the lower financial flexibility associated with having debt in the capital structure. According to the most
recent financial statements, Harvey Norman has EBIT interest coverage of 12.1 times (interest = EBIT
pre-tax profit = $421.4m $386.7m = $34.7m; EBIT interest = $421.4m $34.7m = 12.1) so Harvey
Norman isnt close to financial distress. Hence, both businesses could take on additional debt without undue
financial distress risks. Debt also imposes discipline on management thereby mitigating some of the agency
costs of equity.
However, additional debt may impede their flexibility to make additional investments which require
additional finance in a short space of time. The taxation benefit of, say, an additional $500m of debt, $150m
in present value terms, may prevent Harvey Norman taking advantage of an acquisition opportunity with
even greater value benefits.
7

Question 4 (15 marks)

As the CEO of a major recording company you are considering whether to invest $1 million in development
of a new artist. There is a 10 per cent chance that the new artist generates sufficient success that you will
spend another $2 million on development in the following year (otherwise you will stop financing the new
artist after the first stage). There is then a further 50 per cent chance of success at the second stage. Success
at the second stage would result in an expected pre-tax income stream of $5 million in perpetuity starting
from year 3.
The expenditures of $1 million today, and the potential expenditure of $2 million in one years time are not
tax deductible and should also not be depreciated in the future.
You currently generate pre-tax profits of $6 million per year from the production and distribution of
recorded music from existing artists. This income stream is expected to continue in perpetuity. Any
expenditure on new artist development will need to come from the reinvestment of after-tax cash flows
generated by existing artists. In other words you have no external sources of capital.
The corporate tax rate is 30 per cent, any dividends are fully franked and the market values distributed
imputation credits at 50 cents in the dollar (that is, your estimate of phi or is 0.50). The cost of equity
capital is 20 per cent and there is no debt in the balance sheet.
Required:
Evaluate whether to finance the new artist by comparing equity value including and excluding the new artist
in your portfolio. A binomial tree may help to explain your answer. But the problem can be solved by either
modelling value over time in a binomial tree, or by forecasting the expected dividend payments and
discounting to time zero (15 marks).
Solution
The new artist should not be financed because the incremental value of the investment, net of the $1
million to be spent today, is $0.46 million.
One technique for answering the question is to compute the present value of expected dividends including
and excluding the new artist in the portfolio.
The value of the equity in the company with just the existing portfolio is $25.50 million, computed as
follows:

% Franked
D1 1 +
1

Equity value =
re
0.3

4.20 1 +
1 0. 5
1
0
.
3

=
0.20
4.20 1.21
=
0.20
5.10
=
0.20
= $25.50m
The dividend of $4.20 million in the equation above is equal to the net profit after tax, which in turn in the
product of the pre-tax profit of $6.00 million and (1 corporate tax rate of 30%).
If the new artist is taken on, the present value of expected dividend payments and the initial cash outflow of
$1 million is estimated at just $25.04m, computed according to the table below, with all figures being
expectations, that is, a probability-weighted average of possible outcomes:
8

Year
Existing artist NPAT
+ New artist NPAT
= Combined NPAT
Development costs
= Dividend

2
4.200
0.000
4.200
0.000
4.200
5.100

3
4.200
0.1751
4.375
0.000
4.375
5.313

Net cash flows (Dev costs in year 0; Div in years 1 and 2)

-1.000
4.857
5.100
Present value of net cash flows
-1.000
4.0483
3.5424
Net present value
25.035
1
Pre-tax profit (1 ) Probability of success at stage 1 Probability of success at stage 2
= $5 million (1 0.30) 0.10 0.50
= $0.175 million.
2
Stage 2 development expenditure Probability of success at stage 1
= $2 million 0.10
= $0.2 million.
3
$4.857m 1.20 = $4.048m.
4
$5.100m 1.20 = $3.542m
4
($5.313m 0.20) 1.202 = $26.563 1.202 = $18.446m.

5.313
18.4465

-1.000

D 1 +
% Franked
1

1
4.200
0.000
4.200
-0.2002
4.000
4.857

Alternatively, we could construct a binomial tree for the value associated with the investment in the new
artist, and work backwards through the binomial tree to time zero, and compare outcomes. The assumption
embedded throughout the solution is that the discount rate of 20% is appropriate under both portfolios, that
is, both including and excluding the new artist. This assumption does not necessarily hold in reality, but is
sufficient for the purposes of the question.
51.850 50%
37.026 10%
25.04

30.600 50%
30.600 90%

Working backwards through the binomial tree, the computations are as follows. Note that the cash receive in
the particular year is included in the value at that point in time.

Value if success at stages 1 and 2

0.3

= 4.200 (1 0.3) 1 +
1 0.5 +
1 0.3

7.700 1.214
= 4.200 1.214 +
0.200
9.350
= 5.100 +
0.200
= 5.100 + 46.750
= 51.850

(6.00 + 5.00) (1 0.30) 1 +

0.20

0.3

1 0.5
1 - 0.3

Value if success at stage1 but failure at stage 2

0.3

6.00 (1 0.30 ) 1 +
1 0.5
0.3

1 - 0.3

= 6.00 (1 0.3) 1 +
1 0.5 +
0.20
1 0.3

4.200 1.214
= 4.200 1.214 +
0.200
5.100
= 5.100 +
0.200
= 5.100 + 25.500
= 30.600
Expected value at end of year 2 if success at stage 1
= 0.50 51.850 + 0.50 30.600
= 41.225

Value at end of year 1 if success at stage 1

= Year 1 dividend value + Present value of expected value at end of year 2
0 .3

41.225
= (4.200 2.000 ) 1 +
1 0.50 +
1 0 .3
1.200
= 2.671 + 34.354
= 37.026

Value at end of year 1 if failure at stage 1

0.3

4.200 1 +
1 0.50
0.3

1 0.3

= 4.200 1 +
1 0.50 +
0.200
1 0 .3

= 30.600
Value at year 0 if investment of $1 million is made
Prob of success at stage 1 Value if successful + Prob of failure at stage 1 Value if unsuccessful
=
Investment
1 + re
= 0.10 37.026 + 0.90 30.600
1.000
1.20
31.243
=
+ 1.000
1.20
= 26.035 1.000
= 25.035

10