ADVANCED CORPORATE FINANCE – SAMPLE PAPER

SECTION A (Answer ALL questions, Q1-Q22 each question is worth one mark, Q23-
Q28 each question is worth three marks)

1) The primary operating goal of a publicly-owned firm interested in serving its stockholders
should be to:

a) Maximise its expected total corporate income.

b) Maximise its expected EPS.
c) Minimise the chances of losses.
d) Maximise the stock price per share over the long run, which is the stock‟s intrinsic
value.
e) Maximise the stock price on a specific target date.

2) Which of the following is typically NOT a component of the cash budget?

a) Information on the credit terms for purchased materials.

b) Information on tax payments.
c) Information on the forecast of cumulative cash.
d) Information on how long it takes to collect from customers.
e) Information on depreciation expenses.

3) Which of the following statements is CORRECT? Assume that the firm is a publicly-owned
corporation.

a) If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected
returns on its assets are negatively correlated with the returns on most other firms‟ assets.
b) If a firm‟s managers want to maximize the value of the stock, they should, in theory,
concentrate on project risk as measured by the standard deviation of the project‟s
expected future cash flows.
c) If a firm evaluates all projects using the same cost of capital, then its risk will probably
decline over time.
d) Project A has a standard deviation of expected returns of 20%, while Project B‟s standard
deviation is only 10%. A‟s returns are negatively correlated with the firm‟s other assets
and with returns on most stocks in the economy, while B‟s returns are positively
correlated. Therefore, Project A is less risky to a firm and should be evaluated with a
lower cost of capital.
e) Projects with more than average risk typically have higher than average expected returns.
Therefore, to maximize a firm‟s intrinsic value, its managers should favor high beta
projects over low beta projects.

4) Laurier Inc., a household products firm, is considering production of a new detergent. In

evaluating whether to go ahead with the project, which of the following items should NOT
BE CONSIDERED EXPLICITLY when cash flows are estimated?

a) The company will produce the detergent in a vacant building that was renovated last
year. The building could be sold, leased to another company, or used in the future to
produce other Laurier products.
b) The project will utilize some equipment the company currently owns but is not now
using. A used equipment dealer has offered to buy the equipment.
c) The company has spent and expensed for tax purposes $3 million on research related
to the new detergent. These funds cannot be recovered, but the research might benefit
other projects that might be proposed in the future.
 d) The new detergent will cut into sales of the firm‟s other detergents.
e) If the project is accepted, the company must invest $2 million in working capital.
However, these funds will be recovered at the end of the project‟s life.

5) A firm is considering the purchase of an asset whose risk is greater than the firm‟s current
risk, based on all methods for assessing risk. In evaluating this asset, it would be
reasonable for the decision-maker to:

a) Increase the IRR of the asset to reflect its greater risk.

b) Increase the NPV of the asset to reflect the greater risk.
c) Reject the asset, since its acceptance would increase the firm‟s risk.
d) Ignore the risk differential if the project would amount to only a small fraction of the
firm‟s total assets.
e) Increase the cost of capital used to evaluate the project to reflect the project‟s higher
risk.

6) Which of the following statements about preferred stock securities is CORRECT?

a) From the issuing corporation‟s perspective, preferred stock is more risky than bonds.
b) From the investor‟s perspective, preferred stock is less risky than bonds.
c) Issuing preferred stock allows corporations to reduce their tax burden, since preferred
stock dividends are deductible.
d) If a preferred issue is cumulative this means that the issuing company is permitted to pay
dividends on its common stock even if it failed to pay the dividend on its preferred stock.
e) Most non-convertible preferred stock is owned by corporations.

7) Which of the following statements relating to capital budgeting techniques is CORRECT?

Assume that the project being considered has normal cash flows, with one outflow followed
by a series of inflows.

a) A project‟s MIRR is always greater than its regular IRR.

b) A project‟s MIRR is always less than its regular IRR.
c) If a project‟s IRR is greater than its WACC, then the MIRR will be less than the IRR.
d) If a project‟s IRR is greater than its WACC, then the MIRR will be greater than the IRR.
e) To find a project‟s MIRR, we compound cash inflows at the IRR and then discount the
terminal value at the WACC.

8) Clueless Corporation never considers abandonment options or growth options when

estimating its optimal capital budget. What impact does this policy have on the
company‟s optimal capital budget?

a) Its estimated capital budget is too small because it fails to consider abandonment and
growth options.
b) Its estimated capital budget is too large because it fails to consider abandonment and
growth options.
c) Failing to consider abandonment options makes the optimal capital budget too large,
but failing to consider growth options makes the optimal capital budget too small, so
it is unclear what the impact is on the overall capital budget.
d) Failing to consider abandonment options makes the optimal capital budget too small,
but failing to consider growth options makes the optimal capital budget too large, so it
is unclear what the impact is on the overall capital budget.
e) Neither abandonment nor growth options should have an effect on the company‟s
optimal capital budget.
9) Which of the following statements about warrants and convertibles is NOT CORRECT?

a) Both warrants and convertibles are types of option securities.

b) One primary difference between warrants and convertibles is that warrants bring in
additional funds when exercised, while convertibles do not.
c) The coupon rate on convertible debt is lower than the coupon rate on similar straight debt
because convertibles are less risky.
d) The value of a warrant depends on its exercise price, its term, and the underlying stock
price.
e) Warrants usually can be detached and traded separately from their associated debt.

10) Which of the following statements relating to business structure is CORRECT?

a) One disadvantage of operating as a corporation rather than as a partnership is that

corporate shareholders are exposed to more personal liability than partners.
b) Relative to sole proprietorships, corporations generally face fewer regulations, and they
also find it easier to raise capital.
c) Bondholders should generally be more willing than stockholders to have managers
invest in risky projects with high potential returns as opposed to safer projects with
lower expected returns.
d) Stockholders should generally be more willing than bondholders to have managers
invest in risky projects with high potential returns as opposed to safer projects with
lower expected returns.
e) There is no good reason to expect its stockholders and bondholders to react differently
to the types of assets that a firm invests in.

11) Which of the following statements associated with capital structure is CORRECT?

a) If corporate tax rates were decreased while other things were held constant, and if the
Modigliani-Miller tradeoff theory of capital structure were correct, this would tend to
cause corporations to decrease their use of debt.
b) An increase in the personal tax rate would not affect firms‟ capital structure decisions.
c) “Business risk” is differentiated from “financial risk” by the fact that financial risk
reflects only the use of debt, while business risk reflects both the use of debt and such
factors as sales and cost variability, and operating leverage.
d) The optimal capital structure is the one that simultaneously
(1) maximizes the price of the firm‟s stock, (2) minimizes its WACC, and (3)
maximizes its EPS.
e) If changes in the bankruptcy code make bankruptcy less costly to corporations, then
this would likely reduce the debt ratio of the average corporation.

12) Which of the following statements relating to dividend policy is CORRECT?

a) If a firm follows the residual dividend policy, then a sudden increase in the number of
profitable projects is likely to reduce the firm‟s dividend payout.
b) The clientele effect can explain why many firms change their dividend policies so often.
c) One advantage of adopting the residual dividend policy is that this policy makes it easier
for corporations to develop a specific and well-identified dividend clientele.
d) New-stock dividend reinvestment plans are similar to stock dividends because they both
increase the number of shares outstanding but don‟t change the firm‟s total amount of
book equity.
e) Investors who receive stock dividends must pay taxes on the value of the new shares in
the year the stock dividends are received.
13) Which of the following statements relating to mergers is CORRECT?

a) A conglomerate merger occurs when a firm combines with another firm in the same
industry.
b) Regulations in the United States prohibit acquiring firms from using common stock to
purchase another firm.
c) Defensive mergers are designed to make a company less vulnerable to a takeover.
d) If a company that produces military equipment merges with a company that manages a
chain of motels, this is an example of a horizontal merger.
e) Acquiring firms send a signal that their stock is undervalued if they choose to use stock to
pay for the acquisition.

14) Which of the following statements about the cost of capital is CORRECT?

a) A change in a company‟s target capital structure cannot affect its WACC.

b) WACC calculations should be based on the before-tax costs of all the individual capital
components.
c) If a company‟s tax rate increases, then, all else equal, its weighted average cost of capital
will decrease.
d) Flotation costs associated with issuing new common stock normally lead to a decrease in
the WACC.
e) An increase in the risk-free rate will normally lower the marginal costs of both debt and
equity financing.

15) Which of the following attributes is likely to encourage a firm to increase the amount of
debt in its capital structure?

a) Its sales become less stable over time.

b) Bankruptcy costs have increased.
c) Management believes that the firm‟s stock is overvalued.
d) Its degree of operating leverage is increasing.
e) Its corporate tax rate increases.

16) Which of the following statements relating to working capital management is CORRECT?

a) Permanent current assets are current assets that the firm holds in special storage for
display and marketing purposes.
b) Temporary current assets are those current assets that are kept on hand when sales are at
their low point, but this term is relevant only for firms whose sales fluctuate on a seasonal
basis.
c) Maturity matching is generally considered to be a “moderate” financing policy.
d) An aggressive current asset financing policy is one that uses lot of long-term debt and a
minimum amount of short-term debt.
e) Financially sound firms typically do not use any trade credit - this type of financing is
typically used only by firms that are so weak that they cannot obtain financing from any
other source.

17) Which of the following statements about merger motives is CORRECT?

a) A firm acquiring another firm in a horizontal merger will not have its required return
affected because the two firms will have similar betas.
b) Financial theory says that the choice of how to pay for a merger is irrelevant because,
despite affecting the firm‟s capital structure, it will not affect the firm‟s overall required
return.
 c) The basic rationale for any financial merger is synergy and thus, development of pro-
forma cash flows is the single most important part of the analysis.
d) In most mergers, the benefits of synergy and the price premium the acquirer pays over
market price are summed and then divided equally between the shareholders of the
acquiring and target firms.
e) The primary rationale for any operating merger is synergy, but it is also possible that
mergers can include aspects of both operating and financial mergers.

18) Which of the following statements about dividend policy is CORRECT?

a) Firms with a large number of investment opportunities and a relatively small amount of
cash tend to have above average dividend payout ratios.
b) One advantage of the residual dividend policy is that it leads to a stable dividend payout,
which investors like.
c) An increase in the stock price when a company decreases its dividend is consistent with
signaling theory.
d) If the “clientele effect” is correct, then for a company whose earnings fluctuate, a policy
of paying a constant percentage of net income will probably maximize the stock price.
e) Stock repurchases make the most sense at times when a company believes that its stock is
undervalued.

19) Which of the following statements relating to current asset financing alternatives for firms is
CORRECT:

a) A maturity-matching policy would involve firms financing temporary current assets with
long-term financing sources, such as debenture loans.
b) Short-term interest rates are traditionally more stable than long-term interest rates.
c) Short-term interest rates are normally more expensive than long-term interest rates.
d) Short-term debt is more risky than long-term debt due to refinancing uncertainty and
repayment requirements during downturn or recession periods.
e) To maximise profitability, highly seasonal businesses should use more long-term debt
than the average firm.

20) The Ford Motor Company is deciding whether to invest in a project today or to postpone
the decision for one year. Which of the following statements best describes the issues that
the Ford Motor Company faces when considering this investment timing option?

a) The investment timing option does not affect the expected cash flows and should
therefore have no impact on the project‟s risk.
b) The more uncertainty about the project‟s future cash flows the more likely it is that
Ford will go ahead with the project today.
c) Ford should go ahead with the project today in any case because of earlier earnings
realization for the company.
d) If the project has a positive expected NPV today, this means that its expected NPV
will be even higher if it chooses to wait a year.
e) The investment timing option will either add positive or no value to the investment,
and it will not reduce value.

21) Which of the following statements is CORRECT?

a) Higher flotation costs reduce investor returns, and that leads to a reduction in a
company‟s WACC.
 b) Because of tax effects, an increase in the risk-free rate will have a greater effect on the
after-tax cost of debt than on the cost of common stock.
c) When calculating the cost of preferred stock, companies must adjust for taxes,
because dividends paid on preferred stock are always deductible by the paying
corporation.
d) When calculating the cost of debt, a company needs to adjust for taxes, because interest
payments are deductible by the paying corporation.
e) Because interest payments are tax deductible, there is no need for a company to consider
their tax payable when calculating the cost of debt.

22) For a company whose target capital structure calls for 50% debt and 50% common equity,
which of the following statements is CORRECT?

a) The interest rate used to calculate the WACC is the average cost of all the debt the
company has outstanding and shown on its balance sheet.
b) The cost of equity is usually greater than or equal to the cost of debt.
c) The WACC should be calculated on a before-tax basis.
d) The cost of cost of equity is less than the cost of debt due to the contract commitment
of debt to payback interest for debt while the commitment is not enforced for equity.
e) The cost of retained earnings typically exceeds the cost of new common stock.

23) Assume that Kish Inc. hired you as a consultant to help estimate its cost of capital. You
have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant).
Based on the DCF approach, what is the cost of equity from retained earnings?

a) 9.29%
b) 9.68%
c) 10.08%
d) 10.50%
e) 10.92%

24) Sapp Trucking‟s balance sheet shows a total of noncallable $45 million long-term debt
with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a
market value of $50 million. The balance sheet also shows that the company has 10
million shares of common stock, and the book value of the common equity (common
stock plus retained earnings) is $65 million. The current stock price is $22.50 per share;
stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. The CFO
thinks the WACC should be based on market value weights, but the president thinks book
weights are more appropriate. What is the difference between these two WACCs?

a) 1.55%
b) 1.72%
c) 1.91%
d) 2.13%
e) 2.36%
25) Barry Company is considering a project that has the following cash flow and WACC
data. What is the project's NPV? Note that a project's projected NPV can be negative, in
which case it will be rejected.
WACC: 12.00%
Year 0 1 2 3 4 5
Cash flows -$1,100 $400 $390 $380 $370 $360

a) $250.15
b) $277.94
c) $305.73
d) $336.31
e) $369.94

26) Wilson Co. is considering two mutually exclusive projects. Both require an initial
investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax
cash inflows of $6,000 and $8,500 at the end of Years 1 and 2, respectively. In addition,
Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project
Y has an expected life of 4 years with after-tax cash inflows of $4,600 at the end of each
of the next 4 years. Each project has a WACC of 11%. What is the equivalent annual
annuity of the most profitable project?

a) $1,345.50
b) $1,346.30
c) $1,361.52
d) $1,376.74
e) $1,411.15

27) D. Paul Inc. forecasts a capital budget of $725,000. The CFO wants to maintain a target
capital structure of 45% debt and 55% equity, and she also wants to pay a dividend of
$500,000. If the company follows the residual dividend model, how much income must it
earn, and what will its dividend payout ratio be?

a) $ 898,750; 55.63%
b) $ 943,688; 58.41%
c) $ 990,872; 61.34%
d) $1,040,415; 64.40%
e) $1,092,436; 67.62%

28) Carlson Inc. is evaluating a project in India that would require a $6.2 million investment
today (t = 0). The after-tax cash flows would depend on whether India imposes a new
property tax. There is a 50-50 chance that the tax will pass, in which case the project will
produce after-tax cash flows of $1,350,000 at the end of each of the next 5 years. If the
tax doesn't pass, the after-tax cash flows will be $2,000,000 for 5 years. The project has a
WACC of 12.0%. The firm would have the option to abandon the project 1 year from
now, and if it is abandoned, the firm would receive the expected $1.35 million cash flow
at t = 1 and would also sell the property for $4.75 million at t = 1. If the project is
abandoned, the company would receive no further cash inflows from it. What is the value
(in thousands) of this abandonment option?

a) $104
b) $115
c) $128
d) $141
e) $155
SECTION B

Question 1.

Super Snacks Inc. is considering the development of a new range of potato chips. The potato
chips will be sold in a variety of flavours and will be marketed to young children. In evaluating
the proposed project, the company has collected the following information:
 The company estimates that the project will last for four years.
 The company will need to purchase new machinery that has an up-front cost of $300 million
(incurred at t = 0). At the end of the project (t = 4), the machinery has an estimated salvage
value of $50 million.
 The machinery will be depreciated on a 4-year straight-line basis.
 Production of the new range of potato chips will take place in a recently-vacated facility that
the company owns. The facility is empty and Super Snacks Inc. does not intend to lease the
facility.
 The project will require a $60 million increase in inventory at the beginning of the project (t =
0), and the company expects that its accounts payable will also rise by $10 million at the
beginning of the project. There will be no further changes in net operating working capital
until the completion of the project at the end of year t = 4, when the net operating working
capital investment will be completely recovered.
 The company estimates that sales of the new range of potato chips will be $210 million in
each of the next four years.
 The operating costs of the production facility, excluding depreciation charges, are expected to
be $100 million each year.
 The company‟s tax rate is 40%.
 The estimated after-tax weighted average cost of capital (WACC) for the project is 10%.

Required:

a) Calculate the initial cost, annual cash inflows, and the terminal cash flow for the project, and
use these cash flows to determine the project‟s net present value (NPV). Based on this
analysis, should Super Snacks Inc. undertake the project?

For the remainder of this question assume, independent of your answer in part a) above, that
Super Snacks Inc. has commenced the project at time t = 0. Since the commencement of the
project, the Food and Drug Administration (FDA) has announced an inquiry into childhood
obesity in the United States, with one suggested policy outcome being the introduction of a „fat
tax‟ on producers of junk-food products. The findings of this inquiry are expected to be released
at the end of the second year of the project (t = 2), and Super Snacks Inc. would abandon the
project at this point in time if the FDA decided to introduce this „fat tax‟ policy. If the project is
abandoned at the end of year 2, the company expects to be able to sell the machinery for $230
million, however, they would only be able to recover 80% of the initial net operating working
capital investment. The company thinks that there is a 60% probability that the FDA will decide
to introduce the tax at the end of year 2, and a 40% probability that the tax will not be introduced
(in which case the firm would continued with the project as outlined above until the end of year
4).

b) Based on this information, determine the expected NPV of the project (at t = 0) and from this,
the associated value of the abandonment option.
Question 2.

a) A consistent finding in the empirical literature is that the post-merger performance of

acquiring firms is significantly lower if they fund the acquisition of target firms using their
own common stock compared to when cash is used as the method of merger payment.
Outline possible reasons that may explain this empirical finding, and discuss how it may
relate to the signaling theory explanation for capital structure determination.

b) Gekko Enterprises is considering an acquisition of Teldar Paper Company. Teldar Paper

Company has a capital structure of 50% debt and 50% equity, with a current book value of
$10 million in assets. Teldar Paper Company‟s beta is 1.36 and is not likely to be altered as a
result of the proposed merger. Gekko Enterprises‟ pre-merger beta is 1.02, and both it and
Teldar Paper Company face a 40% tax rate. Gekko Enterprises' capital structure is 40% debt
and 60% equity, and it has $24 million in total assets. The net cash flows from Teldar Paper
Company available to Gekko Enterprises‟ stockholders in the merger are estimated to be $4.0
million at the end of the current year, with these net cash flows expected to grow at a rate of
2.40% per annum into perpetuity. Additionally, new debt issued by the merged (combined)
firm would yield 10% before-tax, and the cost of equity for the merged firm is estimated at
12.59%. Currently, the risk-free rate is 6.00% and the market risk premium is 5.88%.

Required:

i) What is the appropriate discount rate that Gekko Enterprises should use to discount the
equity cash flows to be received from Teldar Paper Company as a result of the merger?

ii) What is the present value of the Teldar Paper Company equity cash inflows resulting
from the merger to Gekko Enterprises?

iii) If the acquisition price that Gekko Enterprises is willing to offer for Teldar Paper
Company is 280% of Teldar Paper Company‟s current book value of assets, should
Gekko Enterprises proceed with the acquisition? What is the NPV of the acquisition for
Gekko Enterprises?
 Sample exam questions answer

Section A
1) d
2) e
3) d
4) c
5) e
6) e
7) c
8) a
9) c
10) d
11) a
12) a
13) c
14) c
15) e
16) c
17) e
18) e
19) c
20) d
21) d
22) b
23) d
24) e
25) b
26) d
27) a
28) c
Explaining of answers to questions 23-28

23. Answer: d

D0 $0.90
P0 $27.50
g 7.00%
D1 = D0 × (1 + g) $0.963
rs = D1/P0 + g 10.50%

24. Answer: e

P0 $22.50 Book value weights

Shares outstanding (millions) 10 Capital Weights Cost rates Product
bond coupon rate (not used) 7.00% Debt $45.00 40.91% 3.60% 1.47%
YTM = rd 6.00% Equity $65.00 59.09% 14.00% 8.27%
rs 14.00% Total $110.00 100.00% WACC = 9.75%
Tax rate 40%
BV debt (millions) $45.00 Market value weights
BV equity (millions) $65.00 Capital Weights Cost rates Product
MV debt (millions) $50.00 Debt $50.00 18.18% 3.60% 0.65%
MV equity (millions) = # sh × P0 =$225.00 Equity$225.00 81.82% 14.00% 11.45%
AT cost of debt = rd(1−T) 3.60% Total $275.00 100.00% WACC = 12.11%
Difference = 2.36%
25. Answer: b

WACC: 12.00%
Year 0 1 2 3 4 5
Cash flows -$1,100 $400 $390 $380 $370 $360

NPV = $277.94

26. Answer: d

WACC = 11.00%
0 1 2
Project X CFs -10,000 6,000 8,500

Project X, NPV = $2,304.20

Determine Project X Equivalent Annual Annuity (EAA):
N 2
I/YR 11.00%
PV $2,304.20
FV 0
PMT = EAAX $1,345.50

0 1 2 3 4
Project Y CFs -10,000 4,600 4,600 4,600 4,600

Project Y, NPV = $4,271.25

 Determine Project Y Determine Project X Equivalent Annual Annuity (EAA):
N 4
I/YR 11.00%
PV $4,271.25
FV 0
PMT = EAAY $1,376.74

EAA of most profitable project, Project Y = $1,376.74

27. Answer: a

Capital budget $725,000

Equity ratio 55%
Dividends paid $500,000

NI = Dividends + (Equity % × Capital budget) = $898,750

Payout = Dividends/NI = 55.63%

28. Answer: c

(Dollars in thousands)
WACC 12.0%
Initial investment $6,200
CFs, no tax $2,000
CFs, with tax $1,350
Salvage value at t = 1 $4,750

Without Abandonment
Prob. 0 1 2 3 4 5 NPV
No tax 50% -$6,200 $2,000 $2,000 $2,000 $2,000 $2,000 $1,010
New tax 50% -$6,200 $1,350 $1,350 $1,350 $1,350 $1,350 -1,334
Expected NPV -$ 162

With Abandonment
Prob. 0 1 2 3 4 5 NPV
No tax 50% -$6,200 $2,000 $2,000 $2,000 $2,000 $2,000 $1,010
New tax: abandon 50% -$6,200 $1,350 $0 $0 $0 $0
$4,750
Net CFs -$6,200 $6,100 $ 0 $ 0 $ 0 $ 0 -754
Expected NPV $ 128

The value of the abandonment option is the difference between the expected value of the project
with and without the abandonment option. However, if the NPV of the project without the option
is negative, then the value of the option is simply the NPV of the project with the option (because
the project wouldn‟t be undertaken otherwise).
Option value = NPV with option – NPV w/o option = $128
SECTION B, Question 1.
a)
Initial cost

Machinery purchase cost $300 million

Increase in NOWC 50 million
$350 million

Annual net cash flow

Annual depreciation expense = $300 / 4 = $75 million

Annual NCF = ($210 - $100)(1 – 0.4) + ($75)(0.40) = $96 million

Terminal cash flow

Salvage value $50 million

Less Tax gain from disposal $20 million
Plus Recovery of NOWC $50 million
$80 million

Project NPV = -$350 + $96(3.1699) + $80(0.6830) = $8.9504 million

 Super Snacks Inc. should undertake the project as it has a positive NPV

b)
If the project is abandoned at t=2
Book value of machinery = $300 – (2  $75) = $150 million
Gain on disposal = $230 - $150 = $80 million
Tax on gain from disposal = $80(0.40) = $32 million
Recovery of NOWC = $50(0.80) = $40 million

NPV if abandoned = -$350 + $96(0.9091) + $96(0.8264) + ($230 - $32)(0.8264) +

$40(0.8264) = $13.2912 million

NPV if the project is not abandoned = $8.9504 million (from part a))

Expected NPV = (0.60)($13.2912) + (0.40)($8.9504) = $11.5549 million

Value of the abandonment option = ($13.2912 - $8.9504)(0.60) = $2.6045 million

 Can also be calculated as Expected NPV – Base NPV = $11.5549 - $8.9504 = $2.6045
million
SECTION B, Question 2.
a)
The decision of an acquiring firm to use their own common stock to fund an acquisition of a
target firm is thought to represent the following:
 Uncertainty about the gains and benefits of the acquisition and the wish to share
acquisition risks with former target firm shareholders
 Bidder firm belief that their shares are currently overvalued, which allow them to issue
fewer new shares as part of the acquisition which minimises dilution effects for existing
shareholders and transfers wealth from target firm shareholders to existing acquiring firm
shareholders
 The resulting realisation of this acquisition risk and/or acquiring firm overvaluation leads
to a post-acquisition decline in the acquiring firm‟s stock price lowering post-merger
performance outcomes

This is consistent with the signaling theory explanation for firm capital structure decisions
based on the idea that the use of equity-financing sends an over-valued „bad news‟ signal to
the market and firms would only choose to issue equity as a last resort (in line with its final
position of the financing choice pecking order), due to the negative signal that this provides
which would be expected to lower its stock price.

b)
i) The appropriate discount rate to use is the current discount rate for Teldar Paper Company,
which is reflective of the risk associated with Teldar Paper Company's cash flows. This can
be calculated as:
 RS = 0.0600 + (0.0588)(1.36) = 0.1400 (14.00%)

ii)
PV of Teldar Paper Company equity cash flows = $4.00 / (0.1400 – 0.0240) = $34.4828
million

iii)
Offer price = 2.80  $10 million = $28 million
NPV of the acquisition = $34.4828 - $28.0000 = $6.4828

As the acquisition has a positive NPV, Gekko Enterprises should proceed with acquiring
Teldar Paper Company.