UNDERGRADUATE

Examination Paper Semester 1, June 2010

104248 CORPORATE INVESTMENT &
STRATEGY III
CORPFIN 3503
LECTURER: BRUCE ROSSER
Official Reading
Time:
10
mins
Writing Time: 180
mins
Total Duration 190
mins
Instructions to Candidate:
1. Answer ALL questions. Show all calculations
2. This is a Closed Book examination.
3. You should answer all questions in the answer book and should begin each answer on a
new page in the answer book.
4. Please allocate your time according to the percentage contribution of the questions.
5. Examination materials must NOT be removed from the examination room.
Materials:
1 Blue book
A calculator incapable of storing text is permitted
PLEASE DO NOT COMMENCE WRITING UNTIL INSTRUCTED TO DO SO
PLEASE SEE NEXT PAGE
104232 Corporate Investment & Strategy III June 2010 Examinations Page 2 of 13
PART A: MULTIPLE CHOICE QUESTIONS
Each question is worth two (2) marks. Indicate your preferred choice clearly in the
answer booklet.
1. In relation to the abnormal market returns of acquirers around announcement of an
acquisition, which of the following statements does not describe the findings of Mitchell and Lehn
(1990)?
a. Acquirer abnormal returns are negative for acquirers that subsequently become targets
themselves
b. Acquirer abnormal returns are negative for acquirers that subsequently divest the
acquired firm
c. Acquirer abnormal returns are negative for acquirers that did not subsequently become
targets
d. The more negative the abnormal return at announcement the higher the likelihood that the
acquirer will become a target.
Answer: c
2. Jones et al (2004) look at daily abnormal returns of various types of capital investment
announcements. Which of the following is true?
a. Small firms have an advantage in R&D expenditure
b. Asset expenditure and diversification are exercise investments
c. Abnormal returns for diversification increase in firm size
d. Abnormal returns for asset expenditure are less sensitive to firm size compared to
create investments
Answer: d
3. Which of the following statements is not true?
a. Non-resident shareholders are indifferent between partially-franked dividends and fully-
franked dividends
b. An imputation-adjusted after-tax cash flow is higher than a classical after-tax cash flow
c. Under imputation, personal income tax becomes a withholding tax against the tax that is paid
by corporations
d. Franking credits can pass through investment companies to be utilized by ultimate
shareholders who are individuals
Answer: c. Under imputation, corporate tax becomes a withholding tax against the tax that is paid
by shareholders
4. Which one of the following is false? Anderson et al (2000) find that:
a. Relative to focused firms, CEOs of diversified firms have higher stock ownership.
104232 Corporate Investment & Strategy III June 2010 Examinations Page 3 of 13
b. Relative to focused firms, CEOs of diversified firms have lower pay-for-performance
sensitivities.
c. Agency costs do not provide a complete explanation of the diversification discount.
d. Firms that decreased diversification were characterized by lower CEO equity ownership than
that of firms increasing diversification.
Answer: a
5. A put option and a call option have the same exercise price and maturity date. When the
options are at-the-money:
a. The call option is worth more than the put option
b. The put option is worth more than the call option
c. Both the put and call options are worth the same
d. None of the above
Answer: a. S PV(E) = C P. Given S = E, C>P
6. Which of the following statements about real options is not true?
a. The option to abandon a project even before it starts to generate profit will increase the market
value of a project
b. An executive can never capture the speculative value of the executive stock options granted
to him because the options are not tradable
c. An implicit reset provision on the exercise price will increase the value of executive stock
options
d. Exercise date and exercise cost are always fixed in valuing real options
Answer: d. Exercise date and exercise cost are rarely fixed for real options. All other statements
are true.
7. A proposed acquisition may create synergy by:
I. increasing the market power of the combined firm.
II. improving the distribution network of the acquiring firm.
III. providing the combined firm with a strategic advantage.
IV. reducing the utilization of the acquiring firm's assets.
104232 Corporate Investment & Strategy III June 2010 Examinations Page 4 of 13
a. I and III only
b. II and III only
c. I and IV only
d. I, II, and III only
e. I, II, III and IV
Answer: d. Redundant asset will not create synergy.
8. ABC and XYZ are all-equity firms. ABC has 1,750 shares outstanding at a market price of $20
a share. XYZ has 2,500 shares outstanding at a price of $28 a share. XYZ is acquiring ABC for
$36,000 in cash. The incremental value of the acquisition is $3,000. What is the net present value
of acquiring ABC to XYZ?
a. $1,000
b. $2,000
c. $3,000
d. $4,000
e. $5,000
Answer: b. NPV = (1,750 $20) + $3,000 - $36,000 = $2,000
9. Bruce Corporation wants to maintain its current dividend policy, which is a payout ratio of
40%. The firm does not want to increase its equity financing but is willing to maintain its current
debt-equity ratio. Given these requirements, the maximum rate at which Bruce can grow is equal
to:
a. 60% of the internal rate of growth
b. 60% of the sustainable rate of growth
c. 40% of the internal rate of growth
d. The internal rate of growth
e. The sustainable rate of growth
104232 Corporate Investment & Strategy III June 2010 Examinations Page 5 of 13
Answer: e. SGR measures how much the firm can grow by using internal financing and issuing only
enough debt to maintain a constant debt ratio, without issuing new equity.
10. Which one of the following statements about economic value added (EVA) is correct?
a. The value of EVA cannot be lower than 0 as it is an option to the company.
b. Financial ratios such as ROA and ROE are less preferred to EVA in performance
measurement because EVA focuses on cost of employed capital.
c. EVA aids capital budgeting as it uses projections of future cash flows.
d. EVA is an alternative to NPV in project evaluation.
e. None of the above.
Answer: b. Not c, EVA uses earnings rather than cash flows.
11. Which one of the following is false? Morck et al (1988) argue that:
a. Managers owning 25% or more of outstanding equity are owner-managers.
b. As equity ownership increases to 5% managers behave like shareholders.
c. Managers owning between 5% and 25% of outstanding equity become entrenched because
their voting rights confer effective control.
d. Managers owning 25% or more of outstanding equity are entrenched because they have a
virtual majority of voting rights.
Answer: d
12. Options are granted to top corporate executives because:
a. Executive pay is at risk and linked to firm performance
b. Executives will make better business decisions in line with benefiting the shareholders
c. Options are tax-efficient and taxed only when they are exercised
d. All of the above
Answer: d
13. To obtain the same payoff as a put option, an investor can:
a. Sell a stock, buy a call and lend present value of exercise price
b. Buy a stock, sell a call and lend present value of exercise price
c. Sell a stock, sell a call and borrow present value of exercise price
d. Buy a stock, buy a call and borrow present value of exercise price
Answer: a. P = C + PV(E) S
14. Shareholders in a leveraged firm might wish to accept a negative net present value project if:
104232 Corporate Investment & Strategy III June 2010 Examinations Page 6 of 13
a. It lowers the variance of the returns on the firm's assets
b. It diversifies the cash flows of the firm
c. It increases the standard deviation of the returns on the firm's assets
d. It decreases the risk that a firm will default on its debt
Answer: c. Equity is viewed as a call option. A higher standard deviation will increase the value of
call option.
15. The External Funds Needed (EFN) equation does not measure the:
a. Additional asset requirements given a change in sales
b. Additional total liabilities raised given the change in sales
c. Rate of return to shareholders given the change in sales
d. Net income expected to be earned given the change in sales
e. None of the above
Answer: c.
( ) d PM EFN
,
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.
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1 sales Projected Sales
Sales
s liabilitie s Spontaneou
Sales
Sales
Assets
104232 Corporate Investment & Strategy III June 2010 Examinations Page 7 of 13
PART B
This part is made up of short-answer questions. You must answer ALL FIVE (5)
questions. Show all calculations.
QUESTION 1
ABC Inc. has a P/E ratio of 21 and maintains a dividend payout ratio of 30 percent. The stock price of
ABC Inc. on January 1 is $24. What would the value of stock be if the dividend payout ratio were 50
percent?
(12 marks)
Answer:
Using the dividend growth model, the price of a stock can be written as
P = D/(k g), or
P = E*PO/(k g),
where PO is the dividend payout ratio.
Rearranging:
P/E = PO/(k g)
Substituting values:
21 = .3/(k g)
1/(k g) = 21/0.3 = 70
From P = E*PO/(k g) and substituting P = $24, PO = 30%, 1/(k g) = 70, we obtain
24 = E*.3*70
E = 8/7
If the dividend payout were 50%, then
P = E*PO/(k g)
P = (8/7)*.5*70 = $40
Check: P * newPO/oldPO = 24 *50/30 = $40
QUESTION 2
Wet for the Summer Inc manufactures filters for swimming pools. The company is deciding whether to
implement a new technology in its pool filters. One year from now the company will know whether the
new technology is accepted in the market. If demand for the new filters is high, the PV of cash flows in
one year will be $18.6m. Conversely, if demand is low, the value of the cash flows in one year will be
$9m.
The value of the project today under these assumptions is $12.8m, and the risk-free rate is 8%.
Suppose that in one year, if demand for the new technology is low, the company can sell the
technology for $10.4m.
What is the value of the option to abandon?
(12 marks)
Answer:
In one year, the company will abandon the technology if the demand is low since the value of
abandonment is higher than the value of continuing operations. Since the company is selling the
technology in this case, the option is a put option. The value of the put option in one year if demand is
low will be:
Value of put with low demand = $10,400,000 9,000,000
Value of put with low demand = $1,400,000
104232 Corporate Investment & Strategy III June 2010 Examinations Page 8 of 13
Of course, if demand is high, the company will not sell the technology, so the put will expire worthless.
We can value the put with the binomial model. In one year, the percentage gain on the project if the
demand is high will be:
Percentage increase with high demand = ($18,600,000 12,800,000) / $12,800,000
Percentage increase with high demand = .4531 or 45.31%
And the percentage decrease in the value of the technology with low demand is:
Percentage decrease with high demand = ($9,000,000 12,800,000) / $12,800,000
Percentage decrease with high demand = .2969 or 29.69%
Now we can find the risk-neutral probability of a rise in the value of the technology as:
Risk-free rate = (ProbabilityRise)(ReturnRise) + (1 ProbabilityRise)(ReturnFall)
0.08= (ProbabilityRise)(0.4531) + (1 ProbabilityRise)(.2969)
ProbabilityRise = 0.5025
So, a probability of a fall is:
ProbabilityFall = 1 ProbabilityRise
ProbabilityFall = 1 0.5025
ProbabilityFall = 0.4975
Using these risk-neutral probabilities, we can determine the expected payoff of the real option at
expiration. With high demand, the option is worthless since the technology will not be sold, and the
value of the technology with low demand is the $1.2 million we calculated previously. So, the value of
the option to abandon is:
Value of option to abandon = [(.5025)(0) + (.4975)($1,400,000)] / (1 + .08)
Value of option to abandon = $644,907
QUESTION 3
Consider the following pre-merger information about a bidding firm (firm B) and a target firm (firm T).
Assume that both firms have no outstanding debt.
Firm B Firm T
Shares outstanding 3,600 1,800
Price per share $42 $28
Firm B has estimated that the value of the synergistic benefits from acquiring firm T is $8,700.
The merger can be undertaken by a cash offer $32 per share or a stock offer with an exchange ratio of
3:5 (3 shares of B for every 5 shares of T)
Required:
a. Are the shareholders of firm T better off with the cash offer or the stock offer?
b. Suppose firm T is agreeable to a merger by an exchange of stock with exchange ratio 3:5, what
will be the price per share of the merged firm?
c. At what exchange ratio of B shares to T shares would the shareholders in T be indifferent
between the two offers?
(18 marks)
104232 Corporate Investment & Strategy III June 2010 Examinations Page 9 of 13
Answer: (Note to markers: do not penalise carry-forward errors)
a. The cash offer is better for the target firm shareholders since they receive $32 per share. In the
share offer, the target firms shareholders will receive:
Equity offer value = (3/5)($32) = $19.20 per share
[3m]
b. The number of new shares will be the number of shares of the target times the exchange ratio,
so:
New shares created = 1,800(3/5) = 1,080 new shares
The value of the merged firm will be the market value of the acquirer plus the market value of the
target plus the synergy benefits, so:
VBT = 3,600($42) + 1,800($28) + 8,700 = $210,300
The price per share of the merged firm will be the value of the merged firm divided by the total
shares of the new firm, which is:
P = $210,300/(3,600 + 1,080) = $44.94
[8m]
c. From part b, we know the value of the merged firms assets will be $210,300. The number of
shares in the new firm will be:
Shares in new firm = 3,600 + 1,800x
that is, the number of shares outstanding in the bidding firm, plus the number of shares
outstanding in the target firm, times the exchange ratio. This means the post merger share price
will be:
P = $210,300/(3,600 + 1,800x) (1)
To make the target firms shareholders indifferent, they must receive the same wealth, so:
1,800(x)P = 1,800($32) (2)
This equation shows that the new offer is the shares outstanding in the target company times the
exchange ratio times the new stock price. The value under the cash offer is the shares
outstanding times the cash offer price. Solving this equation for P, we find:
P = $32 / x (2A)
Combining equations (1) and (2A), we find:
$210,300/(3,600 + 1,800x) = $32 / x
x = 0.7544
[There is a simpler solution that requires an economic understanding of the merger terms. If the
target firms shareholders are indifferent, the bidding firms shareholders are indifferent as well.
That is, the offer is a zero sum game. Using the new stock price produced by the cash deal, we
find:
NPV added to firm B = 1,800*28 +8,700-1,800*32=1,500
Share price for B after merger=( 3,600*42 +1,500)/3,600=42.42
Exchange ratio = $32/$42.42 = 0.7544]
[7m]
104232 Corporate Investment & Strategy III June 2010 Examinations Page 10 of 13
QUESTION 4
Firm XYZ wants to invest in a bottling plant with required investment $8,000. The expected operating
cash flow before taxes is $1,200 annually in perpetuity. The target debt/equity ratio is 0.25 and the
required return on debt is 10%. The required return on equity is 12%, and the company tax rate is
30%. Assume debtholders provide $5,000 of debt capital, paying $500 interest.

Compute the NPV of this project using the Operating Income Method, once with = 0.8 and again
with = 1. Explain why your answers differ.
(16 marks)
Answer:
Target D/E= 0.25 D/A=1/5=20% E/A=4/5=80%
Operating Income Method
Gamma
0.8 1
Adjusted after-
company tax CF = 1200*(1-0.30) + 0.8*(1200)*0.30 1128.00
Required r (%)
= 10*(1-((1-.8)*.30))*.2 + 12*.8 11.48
NPV = -8000 + 1128/.1148 1825.78
Adjusted after-
company tax CF = 1200*(1-0.30) + 1.0*(1200)*0.30 1200
Required r (%)
= 10*(1-((1-1)*.30))*.2 + 12*.8 11.6
NPV = -8000 + 1200/.116 2344.8
[13m]
The project is less valuable when gamma = .8 because the adjusted after-company tax cash flow is
lower: the value of the franking or tax credit is only 80% of the value when gamma = 1. Although the
discount rate is lower when gamma =.8 (due to the tax shield of debt having less value), the reduction
is not enough to offset the impact of the lower CF.
[3m]
QUESTION 5
Yermack (1996) finds an inverse association between board size and firm value and also documents a
range of supporting regularities. Discuss his findings.
(12 marks)
Answer:
Yermack documents strong evidence that large boards are associated with lower Tobins Q ratios and
lower performance (eg, ROA). Tobins Q is the market value of a firms assets divided by their
replacement cost. Also, abnormal stock returns are positive (negative) when decreases (increases) in
board size are announced.
The effect is strongest when boards grow from small to medium; large boards beyond 7 or 8 people
are dysfunctional, possibly owing to productivity losses as work groups grow large. Directors fees are
also noted increasing with board size while directors stock ownership is decreasing in firm size,
implying a possible agency problem.
104232 Corporate Investment & Strategy III June 2010 Examinations Page 11 of 13
The inverse relation is robust with respect to several variables, including firm size, board composition,
growth opportunities, diversification and different governance structures (can discuss). Fractional
equity ownership of outside directors is in fact negatively related to Q.
Board size is found to remain stable over time despite fluctuations in firm performance.
CEO performance incentives provided by the board through compensation and the threat of dismissal
operate less strongly as board size increases.
END OF EXAMINATION
104232 Corporate Investment & Strategy III June 2010 Examinations Page 12 of 13
Selected Formulae
multiplier Equity over asset turn Total margin Profit ROE
( ) d PM EFN
,
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1 sales Projected Sales
Sales
s liabilitie s Spontaneou
Sales
Sales
Assets
b
b
SGR

ROE 1
ROE
EVA = Earnings after tax (WACC Total Capital)
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annuity PV
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1 annuity growing PV
EPS
NPVGO 1
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(general form only)
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credit Franking
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c BT c BT
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V
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104232 Corporate Investment & Strategy III June 2010 Examinations Page 13 of 13
issued shares New shares Old
issued shares New
+