FIN31CFI finalexam-2004

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La Trobe University

Semester One Examination

2004

Student ID: Seat Number:

Unit Code: FIN31CFI Unit Name: Corporate Finance

Paper No: 1 Paper Name: Final Examination

Reading Time: 15 minutes Writing Time: 3 hours

Examination Date: 16/6/04 Examination Start Time: 2.00pm

No. of pages (including cover sheet): 15

ALLOWABLE MATERIALS

AND

INSTRUCTIONS TO CANDIDATES

1) Answer ALL six questions in the examination paper.

2) This paper totals 60 marks and represents 60% of the final assessment for this subject.

3) Materials provided with the examination paper include a multiple-page formula sheet and a presentvalue table.

4) Programmable or non-programmable calculator

5) Students from non-English speaking background can bring unmarked, non-electronic translationdictionaries into the examination.

This paper MUST NOT BE REMOVED from the examination venue


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Question 1.

Pacific Hydro Limited is a company listed on the Australian Stock Exchange that specialisesin the construction and operation of green or renewable energy generation plants focusingon either wind or water-based electricity generating sources. After recent operating success

with its first wind-generating farm in Portland, the company is evaluating the establishmentof a new wind farm near the notoriously windy Victorian country town of Cobram. Thecompany owns a large plot of land in the area, where it is planning to construct the windfarm. If the company decided not to go through with the project, this land could be sold nowto the local Kraft factory for $3.5 million to expand its cheese-production facilities. Theconstruction of the wind generators and the line network linking the farm to the nationalelectricity grid will cost $35 million, and an additional $2.6 million will be required at the

beginning of the project for ancillary net working capital requirements. It is assumed that this$2.6 million working capital investment will be recovered at the end of the project. The windfarm is estimated to have a 20-year useful life. At the end of this 20-year period, the CobramCouncil is prepared to purchase the wind farm site from the company for $2 million to build a

kite-flying adventure park, although this purchase is contingent on Pacific Hydro Limitedspending $400,000 at the end of the project on revegetation and land rejuvenation activities.A consultancy report completed recently, costing the company $200,000, projected before-tax and depreciation net cash flows from the sale of generated electricity from the wind farmof $8,000,000 per year. The company can claim straight-line depreciation deductions of$1,750,000 per year against the cost of construction of the wind farm. The company faces a30% corporate tax rate on all earnings and estimates its required rate of return for this projectto be 14% per annum.

Required:

a) Determine the net present value (NPV) of the project and advise Pacific Hydro Limitedwhether they should undertake construction and operation of the wind farm project.

b) The company is concerned about the long-range weather forecasts for the Cobram area.Weather analysts from the company suggest that there is a 50% probability that annual

before-tax and depreciation net cash flows will remain at $8,000,000 throughout the lifeof the project and a 50% probability of consistently lighter winds after the tenth year ofthe project reducing before-tax and depreciation net cash flows to $4,000,000 per yearfrom years 11 to 20. The company has the option to abandon the project and sell the windfarm to the Cobram Council for $25,000,000 at the end of year 10. Using net present

value analysis, determine whether the company should abandon the project at the end ofyear 10 (ignore any consideration of terminal cash flows or other recovery costs in thisevaluation).

(7 + 3 = 10 marks)

OVER/


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Question 2.

The appropriate dividend policy that a company chooses to adopt is a very important decisionand a decision that may have an influence on the type of shareholders that a company attractsand its share price. From the companys perspective, its dividend policy is directly influenced

by operating performance and profitability, and also has the potential to influence thecompanys investment and capital structure decision-making. The dividend policy adopted bya company similarly influences the nature of the return received by its shareholders and thetax implications of their personal investment activity.

Required:

a) Describe the three common types of dividend policies that companies normallydiscriminate between, and outline the reasoning behind a company choosing to adopteach of the three types of dividend policies.

b) The information in the table below relates to the identification of dividend policy choicefor the two leading companies from the media industry in Australia, News CorporationLimited and Publishing and Broadcasting Limited. News Corporation Limited is thelargest listed company in Australia and is involved in newspaper, book and magazine

publishing, television broadcasting and film production and distribution. Over 90% ofNews Corporations revenue and profits are derived from their operations in the UnitedStates, Europe or Asia, mainly through their ownership of Twentieth Century Fox Studiosin the United States and Sky Broadcasting in the United Kingdom. Publishing andBroadcasting Limited, on the other hand, has predominantly Australian television and

publishing operations through it ownership of the Nine Television Network, AustralianConsolidated Press and gaming interests through its ownership of the Crown Casinocomplex in Melbourne. Both companies also have 25% ownership interests in the Foxtel

pay-television business.

2001 2002 2003 2004 Forecast

News Corporation Limited

Earnings per share $0.230 -$0.029 $0.336 $0.417

Dividends per share $0.030 $0.030 $0.030 $0.030

Dividend pay-out ratio 13.04% -103.45% 8.93% 7.19%

Franking percentage 25.00% 0.00% 0.00% 0.00%

Publishing and Broadcasting LimitedEarnings per share $0.471 $0.406 $0.501 $0.689

Dividends per share $0.200 $0.210 $0.250 $0.330

Dividend pay-out ratio 42.46% 51.72% 49.90% 47.90%

Franking percentage 100.00% 100.00% 100.00% 100.00%

CONTINUED/OVER/


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Required:

Identify the specific type of dividend policy that appears to be adopted by NewsCorporation Limited and Publishing and Broadcasting Limited respectively and suggestthe likely reason(s) for the adoption of these dividend policies. Include consideration of

the dividend distribution preferences of shareholders and the existence of the dividendimputation tax system in Australia

(5 + 5 = 10 marks)

OVER/


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Question 3.

On Wednesday 28thApril, 2004 Publishing and Broadcasting Limited (PBL) announced a fulltakeover bid for all of the remaining outstanding ordinary shares of Burswood Limited (BIR)at a cash offer price of $1.40 per share. Publishing and Broadcasting Limited and Burswood

Limiteds closing share prices on the Australian Stock Exchange on the day prior to thetakeover offer announcement were $11.98 and $1.26 respectively. At the time of the offer,Publishing and Broadcasting Limited owned 15.60% of the total issued shares of BurswoodLimited, which were acquired from two major investors in 2003, resulting in the need to onlyacquire the remaining 84.40% of outstanding Burswood Limited shares. Burswood Limitedowns and operates the Burswood Casino and Hotel Complex in Perth. Publishing andBroadcasting Limited has made this takeover bid to expand its current casino and gamingactivities, and expects to gain synergies from this acquisition through combined advertisingexpense reductions, the ability to attract increasing patronage from the high-roller market by

being able to offer package deals involving both the Crown and Burswood Casino complexesand higher average returns from an expanded total gaming pool. Other relevant financial

information for the two companies as at 28thApril 2004 is provided below:

Publishing and BroadcastingLimited Burswood Limited

Earnings per share (EPS) $0.576 $0.025

Dividends per share (DPS) $0.250 $0.018

Market capitalisation $7,929,861,500 $610,917,680

Number of total issued shares 661,925,000 484,855,300

Sales Revenue $2,676,777,000 $332,450,000

Earnings after tax $500,203,000 $21,711,000

Management of Publishing and Broadcasting Limited expect that the after-tax earningsbenefits from combining the two gaming operations will amount to $16,000,000 per year intoperpetuity. Publishing and Broadcasting Limited has a 14.00% weighted average cost ofcapital and faces a 30% marginal tax rate.

Required:

a) Outline the likely reasons why Publishing and Broadcasting Limited has made a cashoffer to acquire Burswood Limited rather than using its shares as the means of payment.

b) Based on the above information, determine the gains to the shareholders of bothPublishing and Broadcasting Limited and Burswood Limited, assuming that the takeoveris successfully completed.

CONTINUED/OVER/


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c) In response to opposition from a number of major institutional investors who wouldprefer to receive PBL shares rather than cash consideration in the takeover, Publishingand Broadcasting Limited has announced an alternative offer of one of its shares for every8 Burswood Limited shares. Calculate the NPV of the takeover under this share exchangeoffer, assuming that it is completed, and determine the gains to both companies if shares

are used as the method of payment.

(3 + 3 + 4 = 10 marks)

OVER/


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Question 5.

Orica Limited is a leading manufacturer of industrial and speciality chemicals, agriculturalchemicals and fertilisers, commercial explosives and mining chemicals and paint and otherconsumer hardware products. The companys recent corporate focus and strategic initiatives

have centred on expanding the companys explosives and mining services businesses, with aparticular emphasis on international expansion and acquisition activity. This has resulted inthe current situation where the explosives and mining services division now accounts foralmost 50% of its total annual revenue and approximately 40% of the companys totalrevenues and profits are generated from operations located outside of Australia. Operatingand financial performance information is provided for Orica Limited below as at theirrespective 30thSeptember year-ends:

2000 2001 2002 2003

Earnings per share (EPS) $0.536 $0.394 $0.867 $0.959

Dividends per share (DPS) $0.350 $0.160 $0.440 $0.520

Cash flow per share $0.110 $0.840 $1.230 $1.780

Capital spending per share $1.180 $0.920 $0.360 $0.420

Dividend pay-out ratio 65.30% 40.61% 50.75% 54.22%

Dividend franking percentage 32.00% 100.00% 34.00% 21.10%

Debt to total capital ratio 32.10% 41.20% 31.30% 35.70%

The company offers a dividend reinvestment plan to its shareholders, whereby shareholderscan receive equivalent franking benefits and re-invest their dividend income back intoadditional shares of the company. In addition to this facility, the company also announced on6th November 2002 the initiation of an on-market share buy-back program of unlimited

duration, with the aim of repurchasing up to 5% of the companys issued share capital. Thisbuy-back program was suspended briefly in early 2003, however, it has since been re-activated and is still currently on-going, at the companys discretion.

Required:

a) Using the information provided above, outline the likely motivating factors for OricaLimited announcing the share buy-back program in November 2002.

b) Explain how the existence of the dividend re-investment plan provided by Orica Limitedto shareholders may be inconsistent with the share buy-back program that they currentlyhave outstanding, and explain which of these two capital management initiatives would

be more attractive to the companys Australian-resident shareholders.

CONTINUED/OVER/


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c) The share price for Orica Limited increased from $10.38 on the previous day to close at$10.78 on the day of the announcement of the initiation of share buy-back program.Briefly explain the likely reasons for this price increase.

(4 + 3 + 3 = 10 marks)

OVER/


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Question 6.

Capital structure change and modification is an important ongoing decision which companiesand their managements have to make. Choosing between different sources of financing,including debt and equity finance, can have major implications, not only on the companys

cost of capital and market value, but also on the companys perceived level of risk andinvestor confidence. Various theories have been put forward regarding how companiesshould go about making their capital structure decisions, with some models supporting theexistence of a particular optimal mix of financing sources, whereas alternative theoriessuggest that there may not be one optimal capital structure for any or all firms.

Required:

a) Anecdotal evidence suggests that companies within particular industries typically havesimilar capital structures or target debt-to-equity ratio levels. Outline the likely reasonsexplaining this general finding that similar firms tend to have similar capital structures,and the factors which are likely to determine whether an industry sector is characterised

by a high or low debt-to-equity ratio. Use examples where appropriate.

b) A classical taxation system favours the use of corporate debt, but the introduction of thedividend imputation system has removed this advantage. Discuss this statement, withreference to company valuation and the relative use of corporate or personal borrowing.Use examples or equations where appropriate.

(5 + 5 = 10 marks)

OVER/


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Formula Sheet for the Corporate Finance (FIN31CFI) Final Examination Paper

Time Value of Money

Present value of an ordinary annuity:

%),(

)1/(11rt

t

PVIFACPVORr

rCPV =

+=

where:C = equal annuity amountr = interest or discount ratet = number of periods of the annuityPVIFA(t , r%) = annuity discount factor for t periods at r%, from the present value of anordinary annuity table

Present value of an ordinary perpetuity:

r

CPV =

where:C = the annual perpetuity amount

Present value of a growing perpetuity:

gr

CPV

=

where:C = cash flow in year 1r = interest rate or required rate of returng = long-term growth rate in cash flows

Capital Investment Decision-Making

Net present value (NPV) method:

CostInvestmentInitialflowscashprojectfutureofvaluePresentNPV =

Annual cash flows from an investment project (Short-cut method):

)()1( CC tonDepreciatitprofitNetflowcashAnnual +=

OVER/


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Initial project cost:

Asset purchase or construction cost+ Installation and set-up costs+ Increase in net working capital requirements

+ Opportunity costs- Salvage value from disposal of old asset (if relevant)

Tax gain (loss) on disposal of old asset (if relevant)

Terminal Cash Flow from an Investment:

Salvage value from disposal of the asset

Tax loss (gain) on disposal of asset+ Recovery of net working capital- Completion expenses

NPV of Abandonment decision:

flowscashfutureofvaluePresentvaluetAbandonmenNPV =

Cost of Capital Estimation

After-tax weighted average cost of capital (WACC):

))(/())(/()1)()(/( EPCD RVERVPtRVDWACC ++=

where:D = the market value of debtP = the market value of preference sharesE = the market value of equityV = the market value of the firm (V = D + P + E)tC= the applicable corporate tax rateRD= the before-tax cost of debtRP= the after-tax cost of preference sharesRE= the after-tax cost of equity

OVER/


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Capital Structure Determination

Without Corporate Taxes

Value of the firm (V):

AR

EBITVOREDV =+=

where:RA= overall cost of capital for the firm

Overall cost of capital (RA):

V

EBITRORRVDRVER ADEA =+= //

Cost of equity capital (RE):

E

incomeNetRorEDRRRR EDAAE =+= )/()(

where:Net income = EBIT - Interest

With Corporate Taxes

Value of the levered firm (VL):

)( CUL tDVV += where:VU= the value of an unlevered firmD = the market value of debttC= the corporate tax rate

Value of the unlevered firm (VU):

U

UR

TaxEBITV

)( =

where:RU= the cost of equity for the unlevered firm

Cost of equity capital (RE):

E

tInterestEBITRORtEDRRRR CECDUUE

)1)(()1()/()(

=+=

OVER/


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Overall cost of capital (RA):

equationWACCUsingORV

tEBITR CA

)1( =

Mergers, Acquisitions and Takeovers

Gain from a takeover (V):

)( BAAB VVVV += where:VAB= the value of the merged firmVA= the value independently of the bidding firm

VB= the value independently on the target firm

Value of firm B to firm A: (VB*):

BB VVV +=*

NPV of a takeover:

takeovertheofAFirmtoCostVNPV B =*

Proportional ownership from a share exchange takeover ():

ABCompanyinsharesissuedTotal

BCompanytoissuedShares=

END/

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FIN31CFI finalexam-2004