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1 ATTEMPT ALL FIVE (5) QUESTIONS IN THE EXAMINATION PAPER QUESTION 1 Omicron Technologies made a before-tax profit of $50 million this year. The firm has no debt and 10 million shares outstanding, with a current market price of $45 per share. Its unlevered cost of capital is 10%. Omicron's board is meeting to decide whether to pay out the entire $50 million as a dividend or to use it to repurchase shares of the firm's stock in the open market. (a) If Omicron uses the entire $50 million to pay a dividend today, what is Omicron’s ex- dividend price of the shares in a perfect capital market with no taxes? Before tax profit/Cost of capital = $50 million/0.1 = $500 million Market value = Enterprise value + Cash = $500 million + $50 million = $550 million Market value = $550 - $50 = $500 million = $500 million/10 million shares = $50.00 per share (1 mark) (b) If Omicron instead chooses to use the entire $50 million to repurchase shares, what is the number of shares outstanding following the repurchase? What is the price of the shares, in a perfect capital market with no taxes, once the repurchase is complete? $50 million/$45 = $50,000,000/$45 = 1,111,111.111 shares Shares outstanding = Initial shares outstanding - Repurchased shares = 10,000,000 - 1,111,111 = 8,888,889 shares Market value of omicron/Shares Outstanding = $550 million/8,888,889 shares = $61.87 per share (c) Suppose that Omicron’s board decides to pay a dividend today. Now assume that Omicron pays corporate taxes of 30%. The marginal tax rate for shareholders is 35%. What is the after-tax dividend and effective tax rate for shareholders: (i) Under a classical tax system? EFB343TOA2.222

2 Cash x (1 - Corporate tax rate) x (1 - Shareholder tax rate) = $50 million x (1 - 0.30) x (1 - 0.35) = $22.75 million $50 (1 - Tax rate) = $22.75 Tax rate =1 - ($22.75/$50) = 1 - 0.455 = 0.545 or 54.5% (2 marks) (ii) Under an imputation system (assuming that the dividend is 70% franked)? (3 marks) he after-tax dividend = Shareholders dividend - (Shareholder tax - Franking credit) = $35 - ($12.5 - $10.5) = $33 million $50 (1 - Tax rate) = $33 Tax rate =1 - ($33/$50) = 1 - 0.66 = 0.34 or 34% [Total for Question 1: 8 marks] EFB343TOA2.222

3 QUESTION 2 HNH Corporation is evaluating a new project with an expected life of 4 years. The project requires an investment in a new plant. HNH can either borrow the money to buy the plant or lease the plant from its manufacturer. The details of each alternative are shown as follows: Purchase : The purchase price of the plant is $800,000 and is expected to have a salvage value of $50,000 after 4 years. The plant qualifies for 25% reducing balance depreciation if owned. Lease : The lease involves four annual payments in arears of $150,000 payable at the end of each year, and a residual payment of $30,000 payable at the end of the lease term, i.e., at the end of year 4. The company tax rate is 30%. The borrowing rate is 8% per annum. Calculate the NPV of leasing and advise the company as to whether it should purchase or lease the plant. [Total for Question 2: 8 marks] T 30% kd 8% Depreciation 25% SV $50,000 RV $30,000 SV-R= $20,000 (sv-r)*t= $6000 [BV - SV] = 50000- 3125= 46875 (bv-sv)*t= 4219 After-tax cost of debt is kd 8%(1-0.30)= 6% NPV = $248531 The final decision= lease (add value) EFB343TOA2.222

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4 QUESTION 3 Alpha Ltd and Omega Ltd are identical in all aspects except their capital structures. Alpha Ltd is 100% equity financed. It has 1 million shares outstanding and an unlevered cost of equity of 12%. Alpha’s current before interest and after tax cash earnings are $180,000, which are expected to grow at a constant rate of 3% per year indefinitely. Omega Ltd has 500,000 shares outstanding and $60,000 in debt in its capital structure at an interest rate of 7% p.a. Omega expects to maintain this level of debt permanently. Assume Miller and Modigliani (MM) perfect capital markets with no taxes and that firms and individuals can borrow and lend at the same 7% rate as Omega. (a) What is the WACC for Omega Ltd? WACC = (E/V) x Re + (D/V) x Rd x (1-Tc) WACC = (1,000,000/1,000,000) x 12% + (60,000/1,000,000) x 7% x (1-0) WACC = 12% + 0.42% WACC = 12.42% (1 mark) (b) According to MM Proposition 1, what is the stock price for Omega Ltd? (3 marks) P0 = D1/(1+r) + P1/(1+r)^2 P0 = 60,000/(1+7%) + 1,200,000/(1+7%)^2 P0 = $1,104576.72 (c) Suppose the equity of Omega Ltd was valued at $1 million. show how you could make a riskless arbitrage profit if you wanted a 10% ownership stake of the firm. Give a full explanation of the transactions needed and the amount of profit to be made. Suppose the equity of Omega Ltd was valued at $1 million. To make a riskless arbitrage profit, the investor would need to borrow $100,000 at the same 7% interest rate as the firm and then use this money to purchase 10% of the firm's equity. This would result in the investor owning 10% of the firm for a total cost of $110,000. The investor would then be able to sell their stake in the firm for $1.2 million, resulting in a riskless profit of $90,000. (4 marks) [Total for Question 3: 8 marks] EFB343TOA2.222

5 QUESTION 4 Currently, it is 2022 and Luther Corporation is planning to take the firm public through an IPO. Luther has no debt and 40 million shares outstanding. It is about to issue 5 million new shares for sale in the IPO. The underwriter handling Luther’s initial offering charges 7% of the gross proceeds as an underwriting fee. Luther forecasts that the 2023 cash flow from operations will be $450 million. (a) The underwriter advises Luther that the prices of other recent IPOs have been set such that the average cash flow multiple based on the 2023 forecasted cash flow from operations is 2. Assuming Luther is set at a price that implies a similar multiple, what will Luther’s IPO price per share be? How much will Luther raise from the IPO? (2 marks) Price / CF =2 Cash Flow forecasted =$450mn Value of Equity -> 2*450 = $900mn for 40mn Shares for 5mn shares company could raise - 900*5/40 = $112.5mn Underwriting fees ; 7%*112.5 = $7.875mn Net Money Raised = 112.5-7.875 = $104.625mn Per share price = 104.625/5 = $20.925 Assume that the IPO is successful and that Luther shares sell for $35 each immediately after the offering: (b) Who benefits from this price increase? Who lost, and why? (3 marks) Price before IPO = 900/40 = $20.925/share Price at which luther sells the share = $35 Money was raised at $22.5 but after the successful IPO shares of Luther are trading at $35 per share. Luther corporation could raise the money by selling at $35. Secondary markets players (who subscribed IPO @ $20.925) benefits from the IPO because they can now sell their shares at $35 (c) What is the market value of Luther after IPO? (1 mark) Market value of Luther = No of shares outstanding * price per share = 5mn*35 = $175mn total Value of luther can be found by all existing shares * price per share (d) Assume that the post-IPO value of Luther is its fair market value. Suppose Luther could have issued shares directly to investors at their fair market value, in a perfect market with no underwriting spread and no underpricing. What would the share price have been in this case, if Luther raises the same amount as in part (a)? EFB343TOA2.222

6 Without underwriting costs Luther could raise $112.5mn Price per share = 112.5mn /5mn shares = $22.5mn (2 marks) [Total for Question 4: 8 marks] EFB343TOA2.222

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7 QUESTION 5 Big Blue Banana (BBB) is a clothing retailer with a current share price of $10.00. It has no debt and 25 million shares outstanding. Now suppose that BBB announces plans to increase its leverage by borrowing $250 million and using the proceeds to repurchase shares. (a) Assuming perfect capital markets, what is the firm value for BBB after this announcement? According to MM Prop. 1, announcing plans to take on new debt does not increase or decrease share price. It'll still be $10/sh. Firm value for BBB after this announcement = $10/sh. x 25M shares outstanding= $250M worth (1 mark) (b) Suppose that BBB pays corporate taxes of 35% and that shareholders expects the change in debt to be permanent. Assume that capital markets are perfect except for the existence of corporate taxes. What is the value of BBB after this announcement? (2 marks) Firm value for BBB= $10/sh. x 25M shares outstanding= $250M worth After tax, borrowing $250M debt (1-0.35) = $162.5M Shareholders expects the change in debt to be permanent. As the capital markets are perfect except for the existence of corporate taxes, the value of BBB after this announcement is $250M- $162.5M= $87.5M $87.5M/$10=$8.75/Sh. EFB343TOA2.222

8 (c) Suppose that BBB pays corporate taxes of 35% and that shareholders expects the change in debt to be permanent. Assume that capital markets are perfect except for the existence of corporate taxes and financial distress costs. If the price of BBB's stock decreases to $8 per share following the announcement, then what is the present value of BBB's financial distress costs? (3 marks) Firm value for BBB= $10/sh. x 25M shares outstanding= $250M worth After tax, borrowing $250M debt (1-0.35) = $162.5M As the capital markets are perfect except for the existence of corporate taxes and financial distress costs. If the price of BBB's stock decreases to $8 per share following the announcement, then the present value of BBB's financial distress costs $250M-$162.5M= $87.5M $87.5M/$8=$10.94/Sh. (d) Briefly discuss the trade-off theory. What is the optimal capital structure according to the trade-off theory? (2 marks) [Total for Question 5: 8 marks] EFB343TOA2.222

9 END OF PAPER FORMULA SHEET Perfect capital market with no corporate taxes: Perfect capital market with no corporate taxes: Perfect capital market with corporate taxes: WACC = k e E V + k d ( 1 − t c ) D V Perfect capital market with corporate taxes: k e = k U + ( k U − k d ) ( 1 − t c ) D E G = t c D V = D + E Constant growth model: PV 0 = C F 1 k − g EFB343TOA2.222

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