BUSI2156-E1

The University of Nottingham Ningbo China

BUSINESS SCHOOL

A LEVEL 2 MODULE, SPRING SEMESTER 2020-2021

CORPORATE FINANCE

Time allowed Three HOURS

__________________________________________________________________________

Candidates may complete the front cover of their answer book and sign their desk card but
must NOT write anything else until the start of the examination period is announced

Answer a total of FOUR Questions only:

ONE question from Section A and THREE (any three) from Section B.
All questions carry equal marks

Only silent, self contained calculators with a Single-Line Display or Dual-Line Display are
permitted in this examination.

Dictionaries are not allowed with one exception. Those whose first language is not English
may use a standard translation dictionary to translate between that language and English
provided that neither language is the subject of this examination. Subject specific
translation dictionaries are not permitted.

No electronic devices capable of storing and retrieving text, including electronic dictionaries,
may be used.

DO NOT turn examination paper over until instructed to do so

ADDITIONAL MATERIAL: None.

INFORMATION FOR INVIGILATORS: The exam papers are to be collected at the end of
the exam.

BUSI2156-E1 Turn Over

 2 BUSI2156-E1

Section A

Note 1. For questions requiring calculation, answers without appropriate reasonings

or supporting calculation or will get ZERO.

Note 2. Keep only TWO digits in all calculation steps.

The current information for firm ABC is as follows:

 Market value of debt: 3000 million

 Number of shares issued: 100 million
 Current stock price: $60 per share 6000m
 Current Beta: 1.5
 Current WACC: 15%
 The expected annual growth rate of the firm is 4%.
 Marginal tax rate: 40%

The firm is considering a major change in its capital structure. You are CFO of ABC and now
you have three options:
1000 2000
Option A: Issue $1000 million 7000
in new stock and repurchase 1/3 of its outstanding debt. The
firm’s credit rating will be AAA in this case, and the associated interest rate will be 10%.
DIE 217
Option B: Issue $20005000
million in new debt to buy back stock. The firm’s credit rating will
become A- with an associated interest rate of 12%.
DIE 514
Option C: Issue $3000 million in new debt to buy back stock. The firm’s credit rating will be
CCC and the associated interest rate is 16%.
DIE 613 2
Note 1: The current interest on T-Bill is 7.5% and the interest on T-Bonds is 8%.

Note 2: Return on the market portfolio is 16.5%

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a). Estimate betas for the firm under options A, B, and C, respectively. [20 Marks]

b). What would be the weighted average cost of capital for the firm under each option?
b A CoE 8 1.35 116.5 8 1 19.481 BCoE 8 2.01 116.58 1 25.085
[30 Marks]
台iIii ii iii 会 6 i 16.48 品之
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c). What would be the value of the firm under each option? 15.15
[30 Marks]

d). What role (if any) would the variability in the firm’s income play in your decision of
whether or not to issue additional debts? And why? [20 Marks]

C CoE 8 2.53 116.51 8 29.505 c Current FU 30006000 9000m wAu 15

coD 16 0.6 9.6 9001
哭4
点 1 FCEF 990m
WAC 29.505 ㄨ 9.61x9 16.2351
Ai _4
7932.69m

BUSI2156-E1 B
货4
15
8878.92m

C 8088.24m
 3 BUSI2156-E1
Section B

Note 1. For questions requiring calculation, answers without appropriate reasonings

or supporting calculation or will get ZERO.

Note 2. Keep only TWO digits in all calculation steps.

Question 2

CF plc is a Nottingham-based company that focuses on publishing textbooks in the area of

corporate finance. Over the last five years, CF plc has spent £100,000 every year to hire
practitioners and researchers to publish papers in the area of fintech. The company is
considering an investment in a new textbook that reflects the recent trends in fintech. The
marketing team expects that the textbook will remain in print for two years (Year 1 and 2) at
which point its contents will become obsolete. Market research, which cost the firm £40,000,
suggests that 4,000 and 10,000 copies are expected to be sold in year 1 and 2. The textbook
200 000 5251000
will be initially priced at £50. The sale price is expected to grow at 5%/year. The launch of
the new book project is expected to increase CF plc’s sales in other products by £100,000 per
year during year 1 and 2, those incremental sales in other products would require £50,000
operating expenses per year. In order to print the new book, the company will need to
purchase a new machine that costs £200,000 this year (year 0). The depreciation is based on
the straight-line method and the machine is assumed to have 100000 no market value with the
obsolescence of the book. The corporate tax rate is 20%. A single copy of the new text book
will cost £20 to 80 produce,
000 which
2220 000is expected to increase at 10%/year. Finally, this project
requires an initial (t=0) investment in working capital of £20,000. Thereafter, working capital
is forecasted to be 10 % of sales of the new textbook in year 1 and is completely recovered
when the project ends in year 2.
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a). Given the information above, estimate the project’s free cash flows. [40 marks]

b). The equity cost of capital is 12% and the pre-tax cost of debt is 8%. The debt/equity ratio
of ICF plc is 1/2. Assume that the new textbook project has similar financing structure and
risk level of ICF plc, should the company proceed with the investment? [20 marks]

c). Explain why NPV method may generate misleading results for projects with embedded
options [20 marks]

d). Explain the decision criteria of NPV and IRR and describe the advantages of NPV over IRR
in capital budgeting. [20 marks]

a Year 0
b WACC 12 3 80 8 亏 10.13

I 5225
Npr 220 000 t
5
FI it iolo
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seratingExp 1501 507 187879.5770
Cost 180 12201
Dep'n
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BUSI2156-E1 56 204 Turn Over
Dep'n 100 100
x
 C 20 1 207
FCFF 1220 155 324 4 BUSI2156-E1
Question 3

Morningtea Plc has just released their annual financial statement. In financial year 2017,
Morningtea treats operating lease payment as one of the operating expenses items. It has
conventional debt of £300 million on its balance sheet with an average maturity of 5 years
and the pre-tax cost of debt is 10%. In 2017, Morningtea has generated (in its financial
statement) a revenue of 600 million and an operating income of 200 million, after taking into
account its operating lease payment at 100 mil. Morningtea Plc also has a book value of
equity of 500 million and cash and marketable securities of 50 million. Morningtea Plc paid 12
million interest in 2017. In the notes of its financial statement, the future planned operating
lease expenses are stated as follows:

Year Commitment(£ mil)

2018 110
2019 121
2020 133.1
2021 80
2022 80

The current market value of the firm’s shares outstanding quoted from Bloomberg terminal is
472.7 mil. After running a regression of Morningtea Plc’s past five years’ excess return
against market risk premium, you obtain an estimated market beta of 1.8 for Morningtea Plc.
Assuming the expected market portfolio annual return is 8% and the UK GILT annual rate at
1.5%. The marginal tax rate is paid at 20%. Please use a straight line method to account for
the depreciation and answer the followings questions:

For the purpose of DCF valuation, you make a few adjustments to the 2017 financial
statement of Morningtea Plc.

a). What is the estimated asset value of the operating leases? [6 points]

b). What is the adjusted operating income? [6 points]

c). What is the adjusted revenue to capital ratio based on market value in year 2017? [6
points]

d). Based on CAPM model, what is the cost of equity? [6 points]

e). What is the adjusted debt to equity ratio based on market value? [6 points]

f). Based on the market value of equity and debt, what is cost of capital of Morningtea Plc
that should be employed to discount its future Free cash flow from firm? [8 points]

g). Based on the market value of equity and debt, what is the hurdle rate of IRR estimation
for a full equity-financed project with equivalent risk of AfternoonT Plc? [8 points]

h). Based on the market value of equity and debt, what is discount rate that should be used
to discount future Free cash flow to equity for Morningtea Plc? [8 points]

BUSI2156-E1
 5 BUSI2156-E1
i). Explain the underlying reason of making operating lease adjustment before deriving FCFF
of Morningtea Plc. [16 points]

j). Explain how R&D expenses should be treated to value a firm/project and explain the
underlying reasons. [30 points]

Question 4

a). Explain and prove the MM propositions of capital structure without tax [30 Marks]

b). Explain MM propositions of capital structure with corporate tax [10 Marks]

c). Illustrate the costs and benefits of using corporate debt and explain their implications to
the usage of debt capital [35 Marks]

d). Explain the role of information asymmetry in corporate financing decisions and discuss the
implications of pecking order theorem [25 Marks]

Question 5

a). Please describe the potential conflicts between shareholders and bondholders. How
bondholders can protect their interests in the firm? [30 Marks]

b). Please describe the potential conflicts between shareholders and corporate managers.
What are the mechanisms that can be used to solve the conflict? [30 Marks]

c). The ESG (Environmental, social and governance) investing helps to solve the conflicts
between which parties? [40 Marks]

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Question 6

a). Compare and contrast the quantitative methods that can be used to determine optimal
debt capital structure.

[40 Marks]
1850m
b). Nottingham North, a railroad company, had debt outstanding of £985 million and 40
million shares trading at £46.25 per share today. It earned £203 million in earnings before
interest and taxes and faced a marginal tax rate of 36.56%. The EBIT
firm was interested in
estimating its optimal leverage using the adjusted present value approach. The following
table summarizes the estimated bond rating with probabilities of default at each level of debt
from 0% to 90%. The direct and indirect cost of bankruptcy together is estimated to be 25%
of the firm value. Estimate the optimal ratio of the firm based on levered firm value.

Debt Bond Prob. of

ratio(%) rating default (%) Tax benefit BKcost
0 AAA 0.28
10
20
AAA
A-
0.28
1.41
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30 BB 12.20
40 B- 32.50
50 CCC 46.61
60 CC 65.00
70 C 80.00
80 C 80.00
90 D 100.00
5 [30 Marks]

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c). Discuss the advantage and disadvantage of an immediate shift to optimal debt ratio for a
firm.

[20 Marks]

d). Explain the guiding principle of debt design.

[10 Marks]

BUSI2156-E1