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La Trobe University

Semester One Examination

2004




Student ID: Seat Number:



Unit Code: FIN31CFI Unit Name: Corporate Finance

Paper No: 1 Paper Name: Final Examination

Reading Time: 15 minutes Writing Time: 3 hours

Examination Date: 16/6/04 Examination Start Time: 2.00pm

No. of pages (including cover sheet): 15



ALLOWABLE MATERIALS

AND

INSTRUCTIONS TO CANDIDATES

1) Answer ALL six questions in the examination paper.

2) This paper totals 60 marks and represents 60% of the final assessment for this subject.

3) Materials provided with the examination paper include a multiple-page formula sheet and a present
value table.

4) Programmable or non-programmable calculator

5) Students from non-English speaking background can bring unmarked, non-electronic translation
dictionaries into the examination.



This paper MUST NOT BE REMOVED from the examination venue

2
Question 1.

Pacific Hydro Limited is a company listed on the Australian Stock Exchange that specialises
in the construction and operation of green or renewable energy generation plants focusing
on either wind or water-based electricity generating sources. After recent operating success
with its first wind-generating farm in Portland, the company is evaluating the establishment
of a new wind farm near the notoriously windy Victorian country town of Cobram. The
company owns a large plot of land in the area, where it is planning to construct the wind
farm. If the company decided not to go through with the project, this land could be sold now
to the local Kraft factory for $3.5 million to expand its cheese-production facilities. The
construction of the wind generators and the line network linking the farm to the national
electricity grid will cost $35 million, and an additional $2.6 million will be required at the
beginning of the project for ancillary net working capital requirements. It is assumed that this
$2.6 million working capital investment will be recovered at the end of the project. The wind
farm is estimated to have a 20-year useful life. At the end of this 20-year period, the Cobram
Council is prepared to purchase the wind farm site from the company for $2 million to build a
kite-flying adventure park, although this purchase is contingent on Pacific Hydro Limited
spending $400,000 at the end of the project on revegetation and land rejuvenation activities.
A consultancy report completed recently, costing the company $200,000, projected before-
tax and depreciation net cash flows from the sale of generated electricity from the wind farm
of $8,000,000 per year. The company can claim straight-line depreciation deductions of
$1,750,000 per year against the cost of construction of the wind farm. The company faces a
30% corporate tax rate on all earnings and estimates its required rate of return for this project
to be 14% per annum.

Required:

a) Determine the net present value (NPV) of the project and advise Pacific Hydro Limited
whether they should undertake construction and operation of the wind farm project.

b) The company is concerned about the long-range weather forecasts for the Cobram area.
Weather analysts from the company suggest that there is a 50% probability that annual
before-tax and depreciation net cash flows will remain at $8,000,000 throughout the life
of the project and a 50% probability of consistently lighter winds after the tenth year of
the project reducing before-tax and depreciation net cash flows to $4,000,000 per year
from years 11 to 20. The company has the option to abandon the project and sell the wind
farm to the Cobram Council for $25,000,000 at the end of year 10. Using net present
value analysis, determine whether the company should abandon the project at the end of
year 10 (ignore any consideration of terminal cash flows or other recovery costs in this
evaluation).



(7 +3 =10 marks)





OVER/
3
Question 2.

The appropriate dividend policy that a company chooses to adopt is a very important decision
and a decision that may have an influence on the type of shareholders that a company attracts
and its share price. From the companys perspective, its dividend policy is directly influenced
by operating performance and profitability, and also has the potential to influence the
companys investment and capital structure decision-making. The dividend policy adopted by
a company similarly influences the nature of the return received by its shareholders and the
tax implications of their personal investment activity.

Required:

a) Describe the three common types of dividend policies that companies normally
discriminate between, and outline the reasoning behind a company choosing to adopt
each of the three types of dividend policies.


b) The information in the table below relates to the identification of dividend policy choice
for the two leading companies from the media industry in Australia, News Corporation
Limited and Publishing and Broadcasting Limited. News Corporation Limited is the
largest listed company in Australia and is involved in newspaper, book and magazine
publishing, television broadcasting and film production and distribution. Over 90% of
News Corporations revenue and profits are derived from their operations in the United
States, Europe or Asia, mainly through their ownership of Twentieth Century Fox Studios
in the United States and Sky Broadcasting in the United Kingdom. Publishing and
Broadcasting Limited, on the other hand, has predominantly Australian television and
publishing operations through it ownership of the Nine Television Network, Australian
Consolidated Press and gaming interests through its ownership of the Crown Casino
complex in Melbourne. Both companies also have 25% ownership interests in the Foxtel
pay-television business.

2001 2002 2003 2004 Forecast
News Corporation Limited
Earnings per share $0.230 -$0.029 $0.336 $0.417
Dividends per share $0.030 $0.030 $0.030 $0.030
Dividend pay-out ratio 13.04% -103.45% 8.93% 7.19%
Franking percentage 25.00% 0.00% 0.00% 0.00%
Publishing and Broadcasting Limited
Earnings per share $0.471 $0.406 $0.501 $0.689
Dividends per share $0.200 $0.210 $0.250 $0.330
Dividend pay-out ratio 42.46% 51.72% 49.90% 47.90%
Franking percentage 100.00% 100.00% 100.00% 100.00%






CONTINUED/
OVER/
4
Required:

Identify the specific type of dividend policy that appears to be adopted by News
Corporation Limited and Publishing and Broadcasting Limited respectively and suggest
the likely reason(s) for the adoption of these dividend policies. Include consideration of
the dividend distribution preferences of shareholders and the existence of the dividend
imputation tax system in Australia






(5 +5 =10 marks)



































OVER/
5
Question 3.

On Wednesday 28
th
April, 2004 Publishing and Broadcasting Limited (PBL) announced a full
takeover bid for all of the remaining outstanding ordinary shares of Burswood Limited (BIR)
at a cash offer price of $1.40 per share. Publishing and Broadcasting Limited and Burswood
Limiteds closing share prices on the Australian Stock Exchange on the day prior to the
takeover offer announcement were $11.98 and $1.26 respectively. At the time of the offer,
Publishing and Broadcasting Limited owned 15.60% of the total issued shares of Burswood
Limited, which were acquired from two major investors in 2003, resulting in the need to only
acquire the remaining 84.40% of outstanding Burswood Limited shares. Burswood Limited
owns and operates the Burswood Casino and Hotel Complex in Perth. Publishing and
Broadcasting Limited has made this takeover bid to expand its current casino and gaming
activities, and expects to gain synergies from this acquisition through combined advertising
expense reductions, the ability to attract increasing patronage from the high-roller market by
being able to offer package deals involving both the Crown and Burswood Casino complexes
and higher average returns from an expanded total gaming pool. Other relevant financial
information for the two companies as at 28
th
April 2004 is provided below:

Publishing and Broadcasting
Limited

Burswood Limited
Earnings per share (EPS) $0.576 $0.025
Dividends per share (DPS) $0.250 $0.018
Market capitalisation $7,929,861,500 $610,917,680
Number of total issued shares 661,925,000 484,855,300
Sales Revenue $2,676,777,000 $332,450,000
Earnings after tax $500,203,000 $21,711,000

Management of Publishing and Broadcasting Limited expect that the after-tax earnings
benefits from combining the two gaming operations will amount to $16,000,000 per year into
perpetuity. Publishing and Broadcasting Limited has a 14.00% weighted average cost of
capital and faces a 30% marginal tax rate.


Required:

a) Outline the likely reasons why Publishing and Broadcasting Limited has made a cash
offer to acquire Burswood Limited rather than using its shares as the means of payment.

b) Based on the above information, determine the gains to the shareholders of both
Publishing and Broadcasting Limited and Burswood Limited, assuming that the takeover
is successfully completed.







CONTINUED/
OVER/
6
c) In response to opposition from a number of major institutional investors who would
prefer to receive PBL shares rather than cash consideration in the takeover, Publishing
and Broadcasting Limited has announced an alternative offer of one of its shares for every
8 Burswood Limited shares. Calculate the NPV of the takeover under this share exchange
offer, assuming that it is completed, and determine the gains to both companies if shares
are used as the method of payment.






(3 +3 +4 =10 marks)



































OVER/

7
Question 4.

Debt Advantage Limited has an annual operating income of $20 million. The market value of
the companys ordinary shares is $80 million and the market value of its long-term debt is
$40 million. This debt is assumed to be permanent and has a cost of 8% per annum. Using an
approach which is consistent with the Modigliani and Miller (M&M) theory of capital
structure, determine the following:

Required:

a) Assuming that Debt Advantage Limited is exempted from paying corporate taxes:

i) What are the cost of equity and the overall cost of capital for the firm?

ii) If Debt Advantage Limited changes its capital structure by issuing an additional
$20 million in permanent debt at 8% per annum, what are the new values of equity
and the overall firm, and what are the new cost of equity and overall cost of
capital for the company?

b) Assuming that Debt Advantage Limited is now required to pay corporate taxes at a tax
rate of 30%:

i) What is the value of the firm with its original $40 million in debt?

ii) What are the respective values for the cost of equity and the overall cost of capital
for the company?

c) Outline the optimal capital structure choice for Debt Advantage Limited under both
situations a) and b).





(5 +4 +1 =10 marks)













OVER/

8
Question 5.

Orica Limited is a leading manufacturer of industrial and speciality chemicals, agricultural
chemicals and fertilisers, commercial explosives and mining chemicals and paint and other
consumer hardware products. The companys recent corporate focus and strategic initiatives
have centred on expanding the companys explosives and mining services businesses, with a
particular emphasis on international expansion and acquisition activity. This has resulted in
the current situation where the explosives and mining services division now accounts for
almost 50% of its total annual revenue and approximately 40% of the companys total
revenues and profits are generated from operations located outside of Australia. Operating
and financial performance information is provided for Orica Limited below as at their
respective 30
th
September year-ends:

2000 2001 2002 2003
Earnings per share (EPS) $0.536 $0.394 $0.867 $0.959
Dividends per share (DPS) $0.350 $0.160 $0.440 $0.520
Cash flow per share $0.110 $0.840 $1.230 $1.780
Capital spending per share $1.180 $0.920 $0.360 $0.420
Dividend pay-out ratio 65.30% 40.61% 50.75% 54.22%
Dividend franking percentage 32.00% 100.00% 34.00% 21.10%
Debt to total capital ratio 32.10% 41.20% 31.30% 35.70%

The company offers a dividend reinvestment plan to its shareholders, whereby shareholders
can receive equivalent franking benefits and re-invest their dividend income back into
additional shares of the company. In addition to this facility, the company also announced on
6
th
November 2002 the initiation of an on-market share buy-back program of unlimited
duration, with the aim of repurchasing up to 5% of the companys issued share capital. This
buy-back program was suspended briefly in early 2003, however, it has since been re-
activated and is still currently on-going, at the companys discretion.


Required:

a) Using the information provided above, outline the likely motivating factors for Orica
Limited announcing the share buy-back program in November 2002.

b) Explain how the existence of the dividend re-investment plan provided by Orica Limited
to shareholders may be inconsistent with the share buy-back program that they currently
have outstanding, and explain which of these two capital management initiatives would
be more attractive to the companys Australian-resident shareholders.








CONTINUED/
OVER/
9
c) The share price for Orica Limited increased from $10.38 on the previous day to close at
$10.78 on the day of the announcement of the initiation of share buy-back program.
Briefly explain the likely reasons for this price increase.






(4 +3 +3 =10 marks)






































OVER/

10
Question 6.

Capital structure change and modification is an important ongoing decision which companies
and their managements have to make. Choosing between different sources of financing,
including debt and equity finance, can have major implications, not only on the companys
cost of capital and market value, but also on the companys perceived level of risk and
investor confidence. Various theories have been put forward regarding how companies
should go about making their capital structure decisions, with some models supporting the
existence of a particular optimal mix of financing sources, whereas alternative theories
suggest that there may not be one optimal capital structure for any or all firms.



Required:

a) Anecdotal evidence suggests that companies within particular industries typically have
similar capital structures or target debt-to-equity ratio levels. Outline the likely reasons
explaining this general finding that similar firms tend to have similar capital structures,
and the factors which are likely to determine whether an industry sector is characterised
by a high or low debt-to-equity ratio. Use examples where appropriate.

b) A classical taxation system favours the use of corporate debt, but the introduction of the
dividend imputation system has removed this advantage. Discuss this statement, with
reference to company valuation and the relative use of corporate or personal borrowing.
Use examples or equations where appropriate.





(5 +5 =10 marks)

















OVER/

11
Formula Sheet for the Corporate Finance (FIN31CFI) Final Examination Paper

Time Value of Money

Present value of an ordinary annuity:

%) , (
) 1 /( 1 1
r t
t
PVIFA C PV OR
r
r
C PV =

+
=

where:
C =equal annuity amount
r =interest or discount rate
t =number of periods of the annuity
PVIFA
(t , r%)
=annuity discount factor for t periods at r%, from the present value of an
ordinary annuity table

Present value of an ordinary perpetuity:
r
C
PV =

where:
C =the annual perpetuity amount

Present value of a growing perpetuity:
g r
C
PV

=

where:
C =cash flow in year 1
r =interest rate or required rate of return
g =long-term growth rate in cash flows


Capital Investment Decision-Making

Net present value (NPV) method:

Cost Investment Initial flows cash project future of value Present NPV =

Annual cash flows from an investment project (Short-cut method):

) ( ) 1 (
C C
t on Depreciati t profit Net flow cash Annual + =




OVER/

12
Initial project cost:

Asset purchase or construction cost
+Installation and set-up costs
+Increase in net working capital requirements
+Opportunity costs
- Salvage value from disposal of old asset (if relevant)
Tax gain (loss) on disposal of old asset (if relevant)

Terminal Cash Flow from an Investment:

Salvage value from disposal of the asset
Tax loss (gain) on disposal of asset
+Recovery of net working capital
- Completion expenses


NPV of Abandonment decision:

flows cash future of value Present value t Abandonmen NPV =


Cost of Capital Estimation

After-tax weighted average cost of capital (WACC):

) )( / ( ) )( / ( ) 1 )( )( / (
E P C D
R V E R V P t R V D WACC + + =

where:
D =the market value of debt
P =the market value of preference shares
E =the market value of equity
V =the market value of the firm (V =D +P +E)
t
C
=the applicable corporate tax rate
R
D
=the before-tax cost of debt
R
P
=the after-tax cost of preference shares
R
E
=the after-tax cost of equity











OVER/
13
Capital Structure Determination

Without Corporate Taxes

Value of the firm (V):

A
R
EBIT
V OR E D V = + =
where:
R
A
=overall cost of capital for the firm

Overall cost of capital (R
A
):

V
EBIT
R OR R V D R V E R
A D E A
= + = / /


Cost of equity capital (R
E
):

E
income Net
R or E D R R R R
E D A A E
= + = ) / ( ) (

where:
Net income =EBIT - Interest

With Corporate Taxes

Value of the levered firm (V
L
):

) (
C U L
t D V V + =

where:
V
U
=the value of an unlevered firm
D =the market value of debt
t
C
=the corporate tax rate

Value of the unlevered firm (V
U
):

U
U
R
Tax EBIT
V
) (
=

where:
R
U
=the cost of equity for the unlevered firm

Cost of equity capital (R
E
):

E
t Interest EBIT
R OR t E D R R R R
C
E C D U U E
) 1 )( (
) 1 ( ) / ( ) (

= + =


OVER/
14
Overall cost of capital (R
A
):

equation WACC Using OR
V
t EBIT
R
C
A
) 1 (
=



Mergers, Acquisitions and Takeovers

Gain from a takeover (V):

) (
B A AB
V V V V + =

where:
V
AB
=the value of the merged firm
V
A
=the value independently of the bidding firm
V
B
=the value independently on the target firm

Value of firm B to firm A: (V
B
*
):

B B
V V V + =
*


NPV of a takeover:

takeover the of A Firm to Cost V NPV
B
=
*


Proportional ownership from a share exchange takeover ():

AB Company in shares issued Total
B Company to issued Shares
=















END/