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BFC3140 CORPORATE FINANCE 2

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Semester Two 2019
Examination Period

Faculty of Business and Economics

EXAM CODES: BFC3140
TITLE OF PAPER: CORPORATE FINANCE 2
EXAM DURATION: 2 hours writing time
READING TIME: 10 minutes

THIS PAPER IS FOR STUDENTS STUDYING AT: (tick where applicable)

 Caulfield  Clayton  Parkville  Peninsula
 Monash Extension  Off Campus Learning  Malaysia  Sth Africa
 Other (specify)

During an exam, you must not have in your possession any item/material that has not been
authorised for your exam. This includes books, notes, paper, electronic device/s, mobile
phone, smart watch/device, calculator, pencil case, or writing on any part of your body. Any
authorised items are listed below. Items/materials on your desk, chair, in your clothing or
otherwise on your person will be deemed to be in your possession.

No examination materials are to be removed from the room. This includes retaining,
copying, memorising or noting down content of exam material for personal use or to share
with any other person by any means following your exam.
Failure to comply with the above instructions, or attempting to cheat or cheating in an exam is
a discipline offence under Part 7 of the Monash University (Council) Regulations.

AUTHORISED MATERIALS

OPEN BOOK  YES  NO

CALCULATORS  YES  NO
(If YES, only a HP 10bII+ calculator is permitted, except at Malaysia and Sth Africa campuses where an
'approved for use' Faculty label is permitted)

SPECIFICALLY PERMITTED ITEMS  YES  NO
if yes, items permitted are:


Candidates must complete this section if required to write answers within this paper

STUDENT ID: __ __ __ __ __ __ __ __ DESK NUMBER: __ __ __ __ __

BFC3140 CORPORATE FINANCE 2

Page 2 of 11

Instructions to Students



This paper consists of six (6) compulsory questions, two (2) formula sheets and one (1) page
of the normal distribution table.

The examination is out of one hundred (100) marks.

There is a hurdle requirement in this unit. Students must attain a mark of at least 50% to pass.

Students must attempt to answer ALL questions.


BFC3140 CORPORATE FINANCE 2

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Question 1

(a) Describe and explain what agency costs of leverage are? What are the possible methods to
reduce these costs?
(6 marks)
(b) Long Foot Ltd. is considering a project with the following net cash flows:

Year 0 1 2 3 4 5
Cash Flow ($ Million) -700 100 200 300 200 150

The company’s market value of equity is $1,200 million, while its market value of debt is $800
million. Long Foot maintains a constant debt-equity ratio. The equity cost of capital (rE) is
10% and the debt cost of capital (rD) is 6%. The company pays 40% tax on its income.

i. What is the levered value of this project?
(6 marks)
ii. What is the present value of the tax shield?
(6 marks)
(Total = 18 marks)

(a)
Agency costs
 Too much debt can motivate managers and equity holders to take excessive risks or under-
invest in a firm.
 When FCF are high, too little leverage may encourage wasteful spending.
 Shareholders will not have an incentive to decrease leverage by buying back debt, even if it
will increase the value of the firm.
Methods
 Issuing short term debt. Agency costs are highest for long-term debt and smallest for short-
term debt.
 Debt Covenants. Conditions of making a loan in which creditors place restrictions on actions
that a firm can take

(b)
i.
WE = [1,200/(1,200+800)] = 60%
WD = (1 - WE) = (1 – 60%) = 40%
WACC = (0.10 * 0.60) + (0.06 * 0.40)(1-0.40) = 7.44%
10.763$78.10409.15089.24126.17308.93
)0744.1(
150
)0744.1(
200
)0744.1(
300
)0744.1(
200
)0744.1(
100
5432


L
L
V
V


ii.
05.20)(
)(10.76305.743
) (



xshieldInteresttaPV
xShieldInterestTaPV
ShieldTaxInterestPVVV UL


Question 2

(a) Nielson Motors sold 10 million shares of stock in an SEO. The market price of Nielson's
stock at the time was $37.50. Of the 10 million shares sold, 4 million shares were primary
BFC3140 CORPORATE FINANCE 2

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shares sold by the company, and the remaining 6 million shares were sold by the venture
capital investors. Assume the underwriter charges 4% of the gross proceeds as an
underwriting fee which is shared proportionately between the primary and secondary
shares.

i. Calculate the amount of money raised by Nielson Motors in the SEO.
(4 marks)
ii. Calculate the amount of money raised by the venture capitalists in the IPO.
(4 marks)
(b) In 2005, Ben founded a company that specialises in supplying industrial packaging
materials. Initially, Ben invested $1,500,000 in the company and received 1.5 million
shares. In 2010, a venture capitalist invested in Ben’s company at a share price of $3.50
and obtained 2 million shares.

In 2013, the company needed additional funding for growth and Ben decided to take his
company public through an initial public offering (IPO) by issuing 5 million new shares.
Ben forecasts that in 2013, the net income of the company will be $8 million. The
underwriter advises Ben that the prices of other recent IPOs have been set such that the
Price/Earnings ratios is 18.0x based on 2013 earnings.

i. Estimate the IPO price per share for Ben’s company.
(4 marks)
ii. What percentage of the firm does Ben own after the IPO? What is the value of Ben’s
investment in the firm?
(4 marks)
(Total = 16 marks)
(a)
i.
There are 4 million shares issued by the company at $37.50 per share for a total gross proceeds
of 4 x 37.5 = $150 million. Of this amount the underwriter's charge is 4% or .04 x 150 = 6 million.
So the total proceeds to the company are $150 - $6 = 144 million.
ii.
There are 6 million shares issued by the company at $37.50 per share for a total gross proceeds
of 6 x 37.5 = $225 million. Of this amount the underwriter's charge is 4% or .04 x 225 = 9 million.
So the total proceeds to the company are $225 - $9 = 216 million.

(b)
i.
Price = 18 x earnings = 18 x 8 million = 144 million
Total no. of shares outstanding = 1.5 m + 2m + 5 m = 8.5 million
Price per share = 144 million/ 8.5 million = $16.94
ii.
Ben owns 1.5 million shares. Ownership = 1.5/8.5 = 17.65%
Value of Ben’s investment = 1.5 m x $16.94 = 25.41 million


Question 3

Smith Ltd. is considering an investment in a small manufacturing plant that currently
generates revenues of $3.2 million per year. The initial outlay of the investment is $4.1
million. Next year, based upon a decision on a long-term government contract, the revenues
will either increase by 40% or decrease by 30%, with equal probability, and stay at that level
BFC3140 CORPORATE FINANCE 2

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as long as the plant is still operated. Other costs amount to $2.4 million per year. There is an
option to abandon production after 3 years if the project is not going well. Assume that the
firm’s cost of capital is 14% per annum, which can be used to discount all types of cash flows.
What is the value of the option to abandon production? Show intermediate steps.
(Total = 17 marks)

If operate the plant under all circumstances,
Expected net cash flow = [0.5 x (3.2 x 1.4) + 0.5 x (3.2 x 0.70)] – 2.4 = 0.96 million

NPV of the investment without option to abandon =0.96 million/ 0.14 – 4.1 million =
2,757,142.86

NPV of the investment opportunity if revenues increase
= (3.2(1.4)-2.4)/0.14 – 4.1 million = $ 10,757,142.86

NPV of the investment if revenue decreases
= ($3.2 (0.70) - $2.4)/0.14*[1-1/1.14^3] -4.1 million = - $4,471,461.12

Equal probability of each state:

NPV with the option to abandon = 0.5 *10,757,142.86 + 0.5*(-4,471,461.12) = $3,142,840.87

Value of the option to abandon = NPV with option to abandon – NPV without the option
= $3,142,840.87 - $2,757,142.86= $385,698.01


Question 4

(a) Provide and explain two reasons why acquirers tend to pay so large a premium and end
up capturing so little from the synergies.
(4 marks)
(b) Explain why the M&A market serves as an external corporate governance mechanism.
Then discuss how poison pills and staggered boards can prevent this market from
functioning.
(6 marks)
(c) Explain the role of the board of directors in corporate governance.
(6 marks)
(d) Explain how the controlling shareholders use pyramid structures to transfer wealth from
minority shareholders to themselves.
(4 marks)
(Total = 20 marks)

(a)
The Free Rider Problem: Often times the target firm is poorly managed, resulting in a low share
price. If the corporate raider can take control of the firm and replace management, the value of
the firm (and the raider’s wealth) will increase. The only way to persuade shareholders to tender
their shares is to offer them the post-acquisition value, which removes any profit opportunity for
the corporate raider
Competition: Once an acquirer starts bidding on a target company and it becomes clear that a
significant gain exists, other potential acquirers may submit their own bids. The result is
effectively an auction in which the target is sold to the highest bidder.

BFC3140 CORPORATE FINANCE 2

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(b)
M&A improves governance because managers know that if they do not maximize shareholder
value, then a raider might step in and improve firm value by replacing existing management.
Poison pills: It is a rights offering that gives the target shareholders the right to buy shares in
either the target or an acquirer at a deeply discounted price. Because target shareholders can
purchase shares at less than the market price, existing shareholders of the acquirer effectively
subsidise their purchases, making the takeover so expensive for the acquiring shareholders that
they choose to pass on the deal.
Staggered boards: In many public companies, a board of directors whose three-year terms are
staggered so that only one-third of the directors are up for election each year. Also known as
Classified Board - A bidder’s candidate would have to win a proxy fight two years in a row before
the bidder had a majority presence on the target board.

(c)
The board of directors is the primary internal control mechanism and the first line of defence
against the mismanagement of corporate resources. The boards are expected to mitigate the
agency conflict between shareholders and managers and ultimately prevent corporate fraud.
The boards are empowered to hire and fire managers, set compensation policies, approve major
financial decisions and decide the direction of corporate strategy.

(d)
Pyramid Structure is a way for an investor to control a corporation without owning 50% of the
equity. The investor first creates a company in which he has a controlling interest. This company
then owns a controlling interest in another company. The investor controls both companies, but
may own as little as 25% of the second company. The controlling shareholder could move profits
(and hence dividends) away from companies in which he has relatively less cash flow rights
toward firms in which he has relatively more cash flow rights (“up the pyramid”).


Question 5

Farmville Industries is a major agricultural firm and is concerned about the possibility of
drought impacting corn production. In the event of a drought, Farmville Industries anticipates
a loss of $75 million. The likelihood of a drought is 10% per year and the beta associated with
such a loss is 0.4. The risk-free interest rate is 5% and the expected return on the market is
10%.

(a) What is the actuarially fair insurance premium?
(8 marks)
(b) In an event of such a loss, Farmville Industries would face a distress cost of $10 million
and issuance cost of $2 million. What is the NPV of purchasing insurance for Farmville
Industries?
(6 marks)
(Total = 14 marks)

(a)
BFC3140 CORPORATE FINANCE 2

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(b)

NPV = 0.1 ×
12
1.07
= $1.12

Question 6

Luther Industries, a U.S. Corporation, is considering a new project located in Great Britain. The
expected free cash flows from the project are detailed below:

Year Free Cash Flow (£ millions)
0 -30
1 10
2 14
3 28

You know that the spot exchange rate is S = 1.8862/£. In addition, the risk-free interest rates
on dollars and pounds are 4.4% and 5.6%, respectively. Assume that these markets are
internationally integrated and the uncertainty in the free cash flow is not correlated with
uncertainty in the exchange rate. You have determined that the dollar Weighted Average Cost
of Capital (WACC) for these cash flows is 11.2%.

(a) Calculate the pound present value of the project.
(6 marks)
(b) What is the dollar present value of the project?
(3 marks)
(c) Describe the two common methods that firms can use to reduce their taxes on foreign
projects.
(6 marks)
(Total = 15 marks)



(a)
£
*r =
1 r£
1 r$


(1 + $
*r ) - 1 =
1.056
1.044
(1.112) - 1= 12.48%
NPV£ = -30 +
10
1.12481
+
14
1.12482
+
28
1.12483
= £9.63 million

(b)
NPV$ = NPV£ × S = £9.63 × 1.8862/£ = $18.16 million

(c)
BFC3140 CORPORATE FINANCE 2

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Pooling Multiple Foreign Projects: Multinational corporations may use any excess tax credits
generated in high-tax foreign countries to offset their net home tax liabilities on earnings in low-
tax foreign countries
Deferring Repatriation of Earnings: A tax liability is not incurred until the profits are brought
back home if the foreign operation is set up as a separately incorporated subsidiary (rather than
as a foreign branch). If a company chooses not to repatriate, it effectively reinvests those
earnings abroad and defers its home tax liability

END OF EXAMINATION

BFC3140 CORPORATE FINANCE 2

Page 9 of 11

= 11 + 22 + ⋯ + = ∑

[] = ∑ []



(, ) = [( − [])( − [])]

( , ) =
1
− 1
∑ (, − ̅)(, − ̅)



(, ) =
(, )
() ()


() = 1
2(1) + 2
2(2)
+ 212(1, 2)

() = ∑ ∑ (, )



() = ∑ ()(, )



[] = + ([] − )

[] = ()

ℎ =
[] −
()



=
() ( , )
()
=
(, )
()


[] = ≡ +
× ([] − )

[] = = + ([] − )

− = + ( − ) +

[] = + ([] − ) +

= ∑



=
1
0
+

= −

=

+
+

+


− = =

+
+

+


= =

+
+

+
(1 − )

= −

+


= +


( − )

+ () + () = +

() = − ()

= ∆ + (1 + )

= ∆ + (1 + )

∆ =
−
−


=
− ∆
1 +


= ∆ +

= ()[1 − (2)] − [1 − (1)]





BFC3140 CORPORATE FINANCE 2

Page 10 of 11


= × (1) − () × (2)

1 =
ln (

()
)
√
+
√
2


=

1 +


2 = 1 − √

= − ()

0 =
1
−


0 =




0 =


(1 −
1
(1 + )
)

=
1 +
1 +


=
1 + $
∗
1 +
∗

1 + £
∗ =


(1 + $
∗)

£
∗ =
1 + £
1 + $
(1 + $
∗) − 1

= (1 − ) + − − ∆

= +
∗ = 1 −
(1 − )(1 − )
(1 − )


= + ∗

0
=
1
1 +
+
2
(1 + )2
+
3
(1 + )3
+ ⋯

= ×



=
+1 + +1

1 +

= = + ( ℎ)

= × −1 = − −1
= − (1 − )( )
+ ( )
ℎ <


(1 +


)








BFC3140 CORPORATE FINANCE 2

Page 11 of 11

Table for  xN when 0x .
x 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224

0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621

1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441

1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817

2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.2 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952

2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3.0 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990

3.1 0.9990 0.9991 0.9991 0.9991 0.9992 0.9992 0.9992 0.9992 0.9993 0.9993
3.2 0.9993 0.9993 0.9994 0.9994 0.9994 0.9994 0.9994 0.9995 0.9995 0.9995
3.3 0.9995 0.9995 0.9995 0.9996 0.9996 0.9996 0.9996 0.9996 0.9996 0.9997
3.4 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9998
3.5 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998

3.6 0.9998 0.9998 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.7 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.8 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.9 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
4.0 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000






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