# CORPORATE FINANCIAL MANAGEMENT (code IB9EM0)

UNIVERSITY OF WARWICK

MSc Accounting and Finance/MSc Finance and Economics

Mock Final Exam 2020

CORPORATE FINANCIAL MANAGEMENT (code IB9EM0)

Instructions

Time allowed: 3 hours plus 15 minutes reading time during which notes may be made ( on the question paper only) but NO ANSWER MAY BE BEGUN.

Solve the following THREE problems, which have several sub-parts (including some theoretical questions). The weight of the individual sub-parts is indicated in parentheses. Each problem carries equal weight (33%).

Read carefully the instructions on the answer book and make sure that the particulars required are entered on each answer book.

Please turn over

1

Ms James is working for Old Balance. At the end of 2019, she must decide whether to proceed with the project of launching a new sport footwear, dubbed Advance project. The project has a life of three years and the wholesale price of the Advance trainer is $110. The overall market for this type of shoes is 4 million pairs sold in 2020, growing year-onyear at 10% in 2021 and 12% in 2022. The expected market share of Advance is 15 %. Costs of goods sold is 40% of revenues. Sales, general, and administrative expenses are 10% of the revenues. Advertising and promotion will be respectively $4 million, $5 million, and $6 million in 2020, 2021, and 2022. Inventory together with accounts receivable would increase by $15 million and accounts payable would increase by $10 million immediately. All these accounts would be recovered at the end of the project.

Advance will be made in an existing facility, which has an overhead cost of $2 million and would be used for another project if Advance does not go forward. The project requires new equipment costing $12 million, fully depreciated over 5 years using the straight-line method. The market value of equipment at the end of 2022 is estimated $6 million. The technology for the new product costs $60 million and is fully depreciated immediately. The incremental debt for this project entails an interest payment of $1.2 million in the first year, and of $1 million and $1.1 million in 2021 and 2022, respectively. Rebook, a traded company, is in the same segment of Advance and the beta of its stock is 0.75. Rebook has no debt outstanding, but has cash holdings in a proportion of 25% of overall market value of the firm. The cost of debt for Advance is 5% and the marginal tax rate for the project is 30%. The risk-free rate is 4% and the market risk premium is 6%. [*Make your assumptions if you need*.]

- What are the revenues and the EBIT in each of the following three years?

[6 marks]

- What is the expected net cash flow from the sale of equipment at the end of 2022 ?

[3 marks]

- Calculate the incremental free cash flow of the project at the end of each year.

[5 marks]

d) What is the interest tax shield in each year? | [5 marks] |

e) Calculate the unlevered cost of capital for Advance. | [4 marks] |

f) Should Ms James decide to launch Advance? | [4 marks] |

- g) The cost of unlevered asset,
*r*, is typically estimated from comparable firms, the debt and equity securities of which are traded in the financial market. Formulate a theory relating_{U}*r*to the cost of equity,_{U }*r*, and to the cost of debt,_{E}*r*, of these comparable firms. What is the effect on_{D}*r*of agency and distress costs in these firms? [6 marks]_{U }

[Total marks: 33]

2

Arab Oil Co (AOC) is going to be floated for a whopping $1.5 trillion valuation and a financial analyst is considering such a valuation in relation of the company position in the market vis-a`-vis the current price of crude oil and its evolution in the next two years:

- $80

$70

$55

The company’s baseline production is 0.5 billion (bl) barrels per year (b/y), which can be increased to 0.75 bl b/y if AOC’s oil market share is above 30%, and can be halved to 0.25 bl b/y if the share is below 10%. AOC has the highest quality (i.e., cheapest to extract–$7 per barrel at the baseline production–) oil reserves, which makes it the likely last producer should the oil price decline if more ecological sources of energy are adopted. Therefore, the analyst reckons the market share, currently at 20%, will be above 30% if the price is below $50, and will drop below 10% if the price is higher than $72, because also low quality producers (like Canada, Brazil, Venezuela, and US shale oil) will be on the market at that price. The extraction cost becomes $10 per barrel if production is 0.75 bl b/y and $3 if production is 0.25 bl b/y.

The simple question is: can the $1.5 trillion valuation be justified? For this purpose, the risk-free rate is constant at 2%; in each year the production is sold at the price observed at the beginning of the year (e.g., first year’s production is sold at $60); no change of production is made after *t *= 2 and the value at that date is the present value of the perpetuity at the optimal cash flow.

- a) What is the risk-neutral probability in each of the nodes of the binomial tree above?[4 marks]

b) Would AOC reduce production if the price is above $72? And would they increase production if the price is below $50? [6 marks] c) What is the value of AOC today if, regardless of the evolution of the market, the company could stick to the baseline production plan? [6 marks]

- d) What is the value of the company today under the optimal production plan? [6 marks]

e) What is the value of the option to scale production down when oil price is high? And what is the value of the option to scale production up if the price is low?

[6 marks]

- f) What are the assumptions on which real options valuation is based? [5 marks]

[Total marks: 33]

3

Consider an economy with two dates, *t *= 0*,*1, and with risk-free rate of 3%. At *t *= 1 the economy can be either good or bad, with equal actual probability, and the stock market index can have a return of 15% or 0% in the good and bad state, respectively. At *t *= 1 MBS, Inc., can invest *I *in a project with value at that date of

*.*

Assume MBS cannot raise external financing and can only use the cash flow from the current assets to finance the project. However, MBS can hedge such a cash flow, so that it is equal to the average cash flow.

- a) Calculate the risk-neutral probability of the economy. [3 marks]

b) Calculate the first-best level of investment at *t *= 1, which maximizes MBS’s value absent/ignoring the financing constraints of the firm. [5 marks]

Assume the cash flow from the assets is $1000 and $600 in the good and bad state, respectively.

- c) Calculate the value of the firm at
*t*= 0 if MBS does not hedge. [4 marks]

d) Assume that MBS hedges the cash flow. What is the cost of hedging [*in other words, how much can you invest*]? What is the value created by hedging? Does it make sense to hedge? [6 marks]

Assume the cash flow is $1400 and $1200 in the good and bad state, respectively.

- e) Calculate the value of the firm at
*t*= 0 if MBS does not hedge. marks] - f) Assume that MBS hedges the cash flow. What is the cost of hedging? What is the value created by hedging? Does it make sense to hedge? [6 marks]

g) Define the function *P*(*w*) = max* _{I }f*(

*I*) −

*I*−

*C*(

*e*), subject to

*e*=

*I*−

*w*, where

*w*is the cash flow at

*t*= 1,

*f*(

*I*) the value from investment

*I*,

*e*is the financing gap, and

*C*

(*e*) the external financing cost. Froot, Scharfstein and Stein (1993) predict that hedging is optimal if *P*(*w*) is concave. Can you explain why? marks]

[Total marks: 33]

END OF PAPER