Corporate finance

This final assessment includes 5 questions and is worth 70% of your overall mark for FI3004

Answer THREE questions. ONE question from Section A and TWO questions from Section B.

All questions carry equal marks.

All questions should be answered in essay/paragraph style. Bullet points answers are not acceptable.

The deadline for the assessment is Wednesday 2nd December 2020, 12 noon. Submission should be made online via the course MyAberdeen webpage.

Marks are awarded for method of calculation, not only for the correct answer.

SECTION A – ANSWER ANY ONE QUESTION
QUESTION 1
a) Consider two risky common stocks issued by two companies X and Y. The correlation between two stocks is 0.943. The probability distributions of the returns are given by the table below.
State of Economy Probability R(X) R(Y)
Growth 65% 8.0% 18.0%
Stagnation 25% 6.5% 8.0%
Recession 10% 0.0% -5.0%

A 3-month Treasury Bill with AAA credit rating offers a yield of 1.5% per annum. The market index of all shares in the UK has an expected return of 8.0% with standard deviation 3.5%.
a.1) Calculate the expected return, standard deviation of X and Y, and the covariance between X and Y.
15 marks
a.2) Suppose that all risky assets in the market are correctly priced (no mispricing), Calculate the beta coefficients of X and Y.
10 marks
a.3) An investor wants to invest 35% of her initial wealth in X and 65% in Y. What is her portfolio’s expected return, standard deviation and beta?
15 marks
a.4) Calculate the expected return of a portfolio P’ on the CML which has the same total risk as that of the portfolio in a.3). What are the proportions of risk free asset and the market portfolio included in P’?
10 marks
b) Read the article “Best practices in estimating the cost of capital: an update” by Brotherson et al (2013) and discuss the difficulties encountered by practitioners in estimating weighted average cost of capital. Full text of the article is available on FI3004’s Aberdeen page. Your discussion should not exceed 1,000 words. 50 marks
(Total: 100 marks)
QUESTION 2
a) You are given the following data about ABC corporation, a multi-sector company:
• The company’s estimated beta is 1.3
• The market risk premium: 15%
• There are 12 million common shares outstanding. The market value per share is $45
• Yield on a risk-free short-term government bond is 1.2%
• The company has two outstanding bond issues as follows:
o Issue 1: face value is $1000. Its current market price is 93.2% of par value. There are 250,000 bonds outstanding. The remaining maturity is 4 years. Coupon annual rate is 6% per annum. Coupon payment frequency is semi-annual.
o Issue 2: par value is $1000. The bond market price is 107.3%. The bond expires in 10 years. There are 60,000 bonds outstanding. Coupon annual rate is 7%. Coupon payment frequency is annual.
• The company doesn’t issue preferred stocks.
• Corporate tax rate is 25%

a.1) Estimate the weighted average cost of capital (WACC) for this company.
30 marks
a.2) Explain why applying WACC to every project might lead managers to misleading investment decisions.
20 marks

b) Read the article “Best practices in estimating the cost of capital: an update” by Brotherson et al (2013) and discuss the difficulties encountered by practitioners in estimating weighted average cost of capital. Full text of the article is available on FI3004’s MyAberdeen page. Your discussion should not exceed 1,000 words.
50 marks
(Total: 100 marks)

SECTION B – ANSWER ANY TWO QUESTIONS
QUESTION 3
The modern theory of capital structure began with the celebrated paper of Modigliani and Miller (1958). Since then, many economists have followed the path they mapped. Discuss, compare and contrast the competing theories of capital structure with reference to both theoretical and empirical literature.
100 marks
QUESTION 4
Companies often need external money to maintain their operations and invest in future growth. There are two types of capital that can be raised: debt and equity. Equity financing refers to funds generated by the sale of shares. The main benefit of equity financing is that funds need not be repaid.
a) Compare and contrast the different ways that companies can raise equity finance in an IPO. Your discussion should include examples of companies who have used the different IPO listing mechanisms.
15 marks

b) Compare and contrast the different ways that companies can raise equity finance in an SEO. Your discussion should include examples of companies who have used the different SEO listing mechanisms.
15 marks

c) Are pre-emption rights valuable? Discuss.
15 marks

d) Discuss the differing UK and US position on rights issues.
10 marks

e) With reference to relevant theoretical and empirical literature, identify and discuss the reasons that have been put forward to explain the preference for non-underwritten offerings over rights issues.
25 marks

f) DGW Plc is looking to raise £36m to fund the purchase of it’s competitor, DL Plc. DGW Plc has 40m shares in issues, and the current market value of shares is £120 per share. The directors of DGW Plc have decided on a 1 for 4 rights issue.
20 marks
i. Calculate the ex-rights price
ii. Calculate the value of the right.
iii. Show that shareholder wealth is unaffected regardless of whether rights are taken up or not.
(Total: 100 marks)

QUESTION 5
Mergers and acquisitions are transactions in which the ownership of companies, other business organisations, or their operating units are transferred or consolidated with other entities.
a) With reference to relevant theoretical and empirical literature, identity and discuss the various reasons proposed for mergers.
20 marks

b) Review the merger process.
50 marks
c) The defensive strategies a company employs to thwart a hostile takeover can have a significant impact on its shareholders, including sometimes a decline in shareholder value. Outline the strategies that companies who are subject to a hostile takeover can potentially take to thwart an unwanted takeover bid.
30 marks
(Total: 100 marks)

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