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Finance

ADVANCED CORPORATE FINANCE

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ADVANCED CORPORATE FINANCE

QUESTIONS 1

Accommodate plc is a hospitality company that owns a chain of hotels in the UK. The company is considering the acquisition of several fitness centers to expand its operations. The Finance Director has been asked to evaluate the project.

The investment would cost £20 million, which would be payable immediately. The investment is expected to generate pre-tax earnings of £1.2 million for the first year, £2.3 million for the second year, and £2million for each year after that.

The investment will be financed by 30% equity and 70% debt, which is in line with Accommodates existing capital structure. Due to a government initiative, some of the debt will be raised by a subsidized loan, however, the details are yet to be determined.

Accommodates current weighted average cost of capital (WACC) is 9%, and their pre-tax cost of debt is equal to the risk-free rate of 2%. The expected market return is currently 6%.

The Finance Director of Accommodate plc has obtained the equity and debt betas and the gearing ratio of a proxy company, for the purposes of project appraisal, these are: –

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EquityDebtGearing ratio
betabeta(debt: equity)
1.201:2

Active plc

  1. Calculate the risk-adjusted WACC for accommodate plc using Active plc as a proxy company.

Calculating the cost of equity

Ke=rf+ (rm- rf)*Be where ke stands for cost of equity, rf =free rate risk, rm= market return and Be = Beta equity

Ke= 2% + (6%-2%) * 1.2

Ke= 6.0%

Cost of debt (post tax)

Kd= cost of debt (pre-tax)* (1-T)

2%* (1- 0.2)

Kd= 0.6%

Therefore the risk-adjustment WACC is 5.4%

  1. Calculate the NPV for the project, using the risk-adjusted WACC as the cost of capital. Suggest whether the project should be accepted.
  2. PN=FV/ (1+r) n
  3. WHERE
  4. pn =present value
  5. fv=future value
  6. r=interest rate
  7. n=periods

£1.2m/(1+0.54)1=2.61

£2.3m/(1+0.54)2=10.86

£2m/(1+0.54)3=20.09

Total NPV= £33.56m

Since it gives profit at the end of the third year, then the project should be accepted.

  1. c) 1 Benefits of using WACC

It is easy and simple to use, and it doesn’t have too many complications when doing the calculation, the only thing needed is to apply the weight of each source finance with its cost and aggregate.

All of the projects can use a single hurdle rate, and it saves a lot of time since it uses an individual hurdle rate in all the projects, if it has no change in the proposed capital structure and same risk, then WACC of the current can be applied.

Prompt decision making, since new projects can be used with a single rate, making a decision can be so faster, hence allowing time for grabbing new opportunities as they come.

2) Limitation of using the WACC

Maintenance of the capital structure might be difficult, “No change in capital structure “assumption might not prevail all the time, new projects are given the same capital structure.

It has a tendency of rejecting good projects and accepting the bad ones, the assumption that no change in the risk profile of new projects again has its inbuilt drawbacks, the term risk is a long term, and a more significant list of factors can affect it. For that reason, such assumptions are unrealistic.

The cost capital of the current market cannot be enquired easily. Knowing the cost of the present day is very difficult; the equity is considered in WACC. Cost of debt. Interest keeps always changing in the market, depending on the economic changes. The preferred expected dividend also keeps changing with market sentiments.

QUESTION TWO

Cum dividend price is £255m

Regular future annual dividends £105

Current market value = £ 150m

Dividend price

£150-£105=£45 million

Number of purchase share

P=D1/r-g

105/0.3-0.06=£438m

Number of outstanding shares

105/6=18

Dividends in the future

£105m

 

 

 

 

 

 

  1. d) Stable dividend policy, this is where the dividends paid out is fixed.

Advantages of stable dividend Policy

It an indication that the company is operating under normal conditions

It helps to create confidence within the investors

Market value shares are stabilized

For those investors who depend on dividends as a source of their daily expenses, this helps them a lot.

Disadvantages of stable dividend policy

Earnings through it are not sure.

Business operation is always unsuccessful.

Lack of liquid resources.

 

2) It is using a regular type of dividend; the dividends are paid to the shareholders each year; in case of any abnormal profit, it will not be shared with the shareholders but retained to the company as earnings. And in case of loss, dividends will still be paid to shareholders under the policy.

Advantages of Regular dividend Policy

It helps the company avoid giving shareholders false hope, whereby, if profits drop, the same thing goes to dividends.

Disadvantages of Regular Policy

It might force a company to go external equity market if the need arises due to many best projects.

If there’s a declaration of too many extras in a row, they will expect of extra dividends all time by the investors.

 

QUESTION THREE

Net Asset Valuation

This is the method used to evaluate the value of assets, where adjustments are made to balance the company’s historical balance sheets. That helps in the presentation of each liability and asset, and this is examples taken to normalize the adjustment, fixed asset adjustment for them to fit their specific market values. It helps to reflect any liabilities that have never been recorded, for example, judgments.

Example

Skywave Company had the following figures at the end of 31st December

Total tangible assets £ 222.7 million

Total assets £3.2 million

Total liabilities £66.5 million

 

Total assets values= Total assets-Total liabilities-total liabilities

222.7-3.3-66.5=£152.9 Million

 

 

P/E ratio Valuation.

Price to earnings ratio is where the company measures the current share price, to its per sharing, it’s also known us earning multiple. It’s used to determine the company’s relative share value in apples to apple comparison; it can be used to compare the historical record against the company, and also the market aggregate and overtime.

Example P/E = price per share/Earnings per share

Price stock= £29.52

EPS=£1.56

P/E= £29.52/£1.56 OR £18.92

Free Cashflow Valuation

This is the intrinsic value of the company is the same as the present value of free cash flow. The net cash flow left over for distribution to stockholders and debt-holders in each period.

Example

Dominic has 1 million shares outstanding, KPK project has a value of £30 million, and 13% of its required return on equity and perpetual growth of KPK is 5.5%.what is the intrinsic of the KPK.

Totak EV = £30 million/13%-5.5%= £400 million

Per share

IVPS=£400 million/1 million=£40 million

 

QUESTION 4

Premium price

C=StN(D1)-Ke-rtN(D2 )

£38m-£ 47-3 = £103.8 million

Limitation of Black Scholes

Volatility and the risk-free rate of return is assumed over the option duration

Costless and continuous is assumed, and liquidity risk is ignored and brokerage charges.

The stock price is assumed, and the lognormal is followed.

Dividend pay-out is assumed, and its impact is also ignored.

Nonearly exercise is assumed too.

  1. c) Difference between a call and a put option

There are unlimited gains in call option since price rise cannot be capped while the input option we have a limited benefit since the price can fall steadily but will stop at zero.

Difference between a European and US option

Options might be exercised at any time before the expiry of option in American style while in European major broad-based indices, and this includes P500 and S.

Difference between the long and the short position

When we say an investor has a great place, it means he has bought and owns the shares of the stock, and in another way, when we say short position, it means the investors owe those stocks to someone.

Asset-Backing Method

This is where the valuation is done based on the company’s assets, and it is also valued using real internal of the assets of the company.

Example

Solution.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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