Main Examination Period 2021 – January Examination Period ECN378 Corporate Finance Duration: 3 hours Answer TWO questions from Section A (40 marks) and ALL questions from Section B (60 marks) If you answer more questions than specified, only the first answers (up to the specified number) will be marked. Cross out any answers that you do not wish to be marked This examination paper MUST NOT be shared with anyone else. Doing so will be considered a very serious assessment offence under the Queen Mary Academic Misconduct Policy. This examination is an individual assessment and must be entirely your own work. All work will be run through the plagiarism software, Turnitin. The software will also compare your script against all other student submissions. Any evidence of plagiarism or collusion will be taken forward as academic misconduct. Calculators are permitted in this examination. Please ensure that your working is clearly shown with all steps of your calculation included in your answer document, including any formula used. When writing formulas, please note the following: • It is acceptable to use the standard alphabet rather than Greek letters. The following are recommended: m for , s for , w for , r for , d for , b for • For mathematical operators: add +, subtract -, multiply *, and divide / • Where appropriate, use an underscore to indicate a subscript, Eg r_f for rf • Use the ^ character for power, eg x^2 for x2, x^0.5 for √x • As an alternative to x^.5 you may type sqrt(x). • Use brackets as necessary. To make your answer clearer use different brackets where appropriate, eg [] {} () Examiners: Dr Thomai Filippeli © Queen Mary University of London, 2021 Page 2 ECN378 (2021) Section A. Answer TWO questions Question 1 Discuss the following argument: “If a firm issues debt that is risk free, because there is no possibility of default, the risk of the firm’s equity does not change. Therefore, risk- free debt allows the firm to get the benefit of a low debt cost of capital without raising its equity cost of capital.” [20 marks] Question 2 [20 marks] A. Explain how the growth rate of a firm can affect the optimal fraction of debt in the capital structure. [10 marks] B. Briefly discuss why firms do not always choose capital structures that fully exploit the tax advantages of debt. [10 marks] Question 3 [20 marks] A. The book value of a company’s assets usually does not equal the market value of those assets. What are the reasons for this difference? [10 marks] B. Can a firm with positive net income run out of cash? Explain. [10 marks] ECN378 (2021) Page 3 Continues on next page Section B. Answer ALL questions. Question 4 [30 marks] A. La Forme Idéal SA is a company that makes clothing. The company is considering investing in purchasing a new machine that could be used to produce petite sizes as well. The cost of the new machine is £40,000 and it will generate revenues of £90,000 per year for five years. The operating expenses needed to generate these revenues will be in total £57,000 per year. The machine is expected to sell for £1,000 at the end of its five-year life and will be depreciated on a straight–line basis over five years to zero. Corporate tax rate is 34% and the opportunity cost of capital is 12%. (i) Should the company purchase the new machine? Explain why or why not. (ii) Briefly explain why the announcement of a new investment is usually accompanied by a change in the firm’s share price. [20 marks] B. Assume ABC corporartion is considering the acquisition of another firm in its industry. The acquisition is expected to increase ABC’s free cash flow by £5 million the first year, and this contribution is expected to grow at a rate of 4% per year from then on. ABC has negotiated a purchase price of £110 million. Assume also ABC’s weighted average cost of capital is 7.5%. After the transaction, ABC will adjust its capital structure to maintain its current debt-equity ratio of 2. (i) If the acquisition has similar risk to the rest of the ABC, what is the value of this deal? (ii) Assume now that ABC proceeds with the acquisition. How much debt must the company use to finance the acquisition and still maintain its debt-to-value ratio? How much of the acquisition cost must be financed with equity? [10 marks] Page 4 ECN378 (2021) Question 5 [30 marks] A. Colt Systems will have EBIT this coming year of £15 million. It will also spend £6 million on total capital expenditures and increases in net working capital, and have £3 million in depreciation expenses. Colt is currently an all-equity firm with a corporate tax rate of 35% and a cost of capital of 10%. (i) If Colt is expected to grow by 8.5% per year, what is the market value of its equity today? (ii) If the interest rate on its debt is 8%, how much can Colt borrow now and still have nonnegative net income this coming year? (iii) Is there a tax incentive for Colt to choose a debt-to-value ratio that exceeds 50%? Explain. [15 marks] B. Consider a firm whose only asset is a plot of vacant land, and whose only liability is debt of £15 million due in one year. If left vacant, the land will be worth £10 million in one year. Alternatively, the firm can develop the land at an upfront cost of £20 million. The developed land will be worth £35 million in one year. Suppose the risk-free interest rate is 10%, assume all cash flows are risk-free, and assume there are no taxes. (i) If the firm chooses not to develop the land, what is the value of the firm’s equity today? What is the value of the debt today? (ii) What is the NPV of developing the land? (iii) Suppose the firm raises £20 million from equity holders to develop the land. If the firm develops the land, what is the value of the firm’s equity today? What is the value of the firm’s debt today? (iv) Given your answer to part (iii), would equity holders be willing to provide the £20 million needed to develop the land? Discuss your answer. [15 marks] End of Paper
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