2024 EXAMINATIONS

PART II (SECOND AND FINAL YEAR)

ACCOUNTING AND FINANCE
AcF 302 CORPORATE FINANCE

(Duration: 2 hours plus 15 minutes reading)

Answer ALL questions from Section A.

Answer ALL questions from Section B.

Answer ONE question from Section C.

This exam is closed book

A list of important formulae is included at the end of the examination paper.

Electronic calculators with scientific and statistical functions are permitted provided
they are not programmable, do not allow graphs to be plotted and do not include a
computer algebra system (CAS).

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 Section A
Section A consists of Questions 1 to 10. Answer ALL questions in this section.

1) Suppose you want to calculate the present value of the final-year’s interest
tax shield for a project that has a life of five years. The following formula
should be used when:
𝑷𝑽 (𝑰𝑻𝑺𝟓 ) = 𝑰𝑻𝑺𝟓 ⁄(𝟏 + 𝑹𝑾𝑨𝑪𝑪 )𝟓

A) the debt associated with the interest tax shield is predetermined.

B) the debt is adjusted continuously to maintain a target leverage ratio.
C) the debt is adjusted periodically to maintain a target leverage ratio.
D) None of the above.

2) Which of the following statements is TRUE?

A) In a staged project, other things being equal, it is better to invest in

cheaper, riskier, and lengthier stages first.
B) In a staged project, other things being equal, it is better to invest in
cheaper, less risky, and lengthier stages first.
C) In a staged project, other things being equal, it is better to invest in
cheaper, less risky, and shorter stages first.
D) In a staged project, other things being equal, it is better to invest in
cheaper, riskier, and shorter stages first.

3) The assumption that the firm has a target leverage ratio means that:

A) the firm adjusts its debt to maintain a constant debt-to-equity ratio.

B) the risk of its debt and equity will change when it accepts a new project.
C) the firm’s debt level will remain constant throughout the life of a new
project.
D) the firm's cost of capital will increase when it accepts a new project.

4) Agency costs are best defined as:

A) the costs imposed on a corporation through the laws and regulations that
control corporations.
B) the costs a corporation incurs as the result of fraud.
C) the costs that arise when there are conflicts of interest between a firm's
stakeholders.
D) the costs associated with compensating managers when ownership and
control are separated in a firm.

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5) Which of the following statements is FALSE?
A) The conflict of interest between managers and investors derives from the
separation of ownership and control in a corporation.
B) Any discussion of corporate controls—the system of controls, regulations,
and incentives designed to prevent fraud—is a story of conflicts of interest
and attempts to minimize them.
C) Once control and ownership are separated, a conflict of interest arises
between the owners and the people in control of a corporation.
D) The separation of ownership and control is perhaps the most important
reason for the success of the corporate organizational form. Because any
investor can hold an ownership stake in a corporation, investors are able to
diversify and thus, with no costs, reduce their risk exposures.

6) Which of the following statements is FALSE?

A) In a direct lease, the lessor is the manufacturer (or a primary dealer) of the
asset.
B) The lease specifies any cancellation provisions, the options for renewal and
purchase, and the obligations for maintenance and related servicing costs.
C) If a firm already owns an asset it would prefer to lease, it can arrange a sale
and leaseback transaction.
D) With many leases, the lessor provides the initial capital necessary to
purchase the asset, and then receives and retains the lease payments.

7) Which of the following statements regarding poison pills is FALSE?

A) Companies with poison pills are harder to take over, and when they are
taken over, the premium that existing shareholders receive for their stock
is higher.
B) Because a poison pill increases the cost of a takeover, all else equal, a
target company must be in better shape to justify the expense of waging
a takeover battle.
C) Poison pills also increase the bargaining power of the target firm when
negotiating with the acquirer because poison pills make it difficult to
complete the takeover without the cooperation of the target board.
D) By adopting a poison pill, a company effectively entrenches its
management by making it much more difficult for shareholders to replace
bad managers, thereby potentially destroying value.

8) Which of the following statements is FALSE?

A) Because investment in permanent working capital is required so long as
the firm remains in business, it constitutes a long-term investment.
B) Because temporary working capital represents a short-term need, the firm
should finance this portion of its investment with short-term financing.
C) Temporary working capital is the difference between the lowest level of
investment in short-term assets and the permanent working capital
investment.
D) The matching principle states that short-term needs should be financed
with short-term debt and long-term needs should be financed with long-
term sources of funds.

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9) If Tesla bought The Goodyear Tire & Rubber Company, this would be an
example of a ________ merger.

A) conglomerate
B) vertical
C) horizontal
D) diagonal

10) Which of the following is NOT a direct action that can be taken by
shareholders?

A) Submitting shareholder resolutions directing the board to take specific

actions.
B) Withholding votes for the board of directors candidates.
C) Initiating a proxy contest.
D) Voting to remove the management team.

(3 marks for each question)

(Total 30 marks)

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 Section B
Answer ALL questions in this section.

Question 11

Metro technologies plc is considering the acquisition of another firm in its industry.
The acquisition is expected to increase Metro’s free cash flow by £6 million the first
year, and this contribution is expected to grow at a rate of 3% per year from then on.
Metro has negotiated a purchase price of £150 million. Metro currently maintains a
debt-to-value ratio of 50%, its marginal tax rate is 40%, its cost of debt is 5%, and its
cost of equity is 9%. Metro will maintain a constant debt-equity ratio for the acquisition
and the acquisition has a similar risk to the rest of Metro.

REQUIRED:

a) What is the net present value (NPV) of this deal?

(4 marks)

b) How much debt must Metro use to finance the acquisition and still maintain
its debt-to-equity ratio?
(2 marks)

c) What is the present value of the interest tax shield provided by Metro’s
acquisition deal?
(4 marks)

d) Show that the value of the acquisition using the Flow-to-Equity method
matches the result you obtained using the WACC method in part (a).
(5 marks)

Question 12

Three years ago, you founded your own company. You invested £110,000 of your
money and received 5.5 million shares of Series A stock. Since then, your company
has been through three additional rounds of financing.

Round Share Price (£) Number of

Shares
Series B 0.80 1,100,000
Series C 2.50 700,000
Series D 7.00 500,000
REQUIRED:

a) What is the pre-money valuation for the Series D funding round?

(4 marks)

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 b) What is the post-money valuation for the Series D funding round?
(4 marks)

c) Assuming that you own only the Series A stock, what percentage of the firm
do you own after the last funding round?
(2 marks)

Question 13

Martin Manufacturing has earnings per share (EPS) of £3.00, 5 million shares
outstanding, and a share price of £32. Martin is considering buying Avco Industries,
which has earnings per share of £2.50, 2 million shares outstanding, and a share price
of £20. Martin will pay for Avco by issuing new shares. There are no expected
synergies from the transaction. Assume that Martin pays no premium to acquire
Avco.

REQUIRED:

a) Calculate Martin's price-earnings (P/E) ratio pre-merger.

(2 marks)

b) Calculate Martin’s total number of shares in the newly merged firm.

(2 marks)

c) Calculate the total earnings of the merged firm.

(3 marks)

d) Calculate the EPS of the merged firm.

(2 marks)

e) Calculate the price-earnings (P/E) ratio post-merger.

(1 mark)

(Total 35 marks)

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 Section C
Answer EITHER Question 14 OR Question 15.
Answer all parts of the chosen question.

Question 14

a) Rocket Bikes is planning to develop a new electric bike. In order for the project to
be successful, the company must develop a lightweight battery, a new deck to
accommodate the lightweight battery, an electric motor and a charger that is easy to
operate while moving in an open environment. The company estimates the following
costs, times, and probabilities of success for each component of the new bike:

Cost (in
Technology thousands) Time Probability of Success
Deck £100 1 year 0.75
Battery £250 3 years 0.25
Charger £300 1 year 0.50
Motor £350 2 years 0.50

All four risks are idiosyncratic, and the risk-free rate of interest is 5%. The company
has estimated that, if all stages are successful, they can then develop the electric
bike and start selling it. At that point in time (i.e., once all stages are completed), the
present value of all future profits from selling the bike will be £20 million.

REQUIRED:

i) If the company does the four stages in the correct order, what is the NPV of
the project?

(4 marks)

ii) If the company develops all four technologies simultaneously. What is the
NPV of the project in this case and what is the value of the option to stage the
investment?
(3 marks)

iii) Why does staging add value?

(3 marks)

b) Explain what the purpose of a take-over defense is and how do Recapitalization

and poison pill work.
(8 marks)

c) It is June 2020 and you run a chain of fast food restaurants in Manchester. Since
it’s been several months without being able to serve drinks or food to patrons because
of lockdown, your firm is experiencing extreme short term financial needs. You need

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to obtain £1,290,000 within the next 2 weeks to cover rent, utilities and salary of
employees that have been retained during the following 5 months you expect to be
affected by the lockdown.

After making some phone calls, you’ve been able to get the following offers as sources
of funding:
• Government loan of £19,000 at 0% interest rate, to be returned in 12
months.
• Bank North is offering £1,271,000 for five months at a stated annual rate of
2.75%, using inventory (beer and vintage wine) stored in a field warehouse
as collateral. The warehouse charges a £6,000 fee, payable at the end of
the five months.
• SouthBank can facilitate flexible borrowing up to £823,000 for five months
at an APR of 3.2% and a loan origination fee of 0.02%.
• WestBank offers £1,290,000 for five months at an APR of 2.75%. The bank
will require to maintain a (no-interest) compensating balance of 12% of the
face-value of the loan and will charge a 0.05% loan origination fee.

REQUIRED:

What would be the best financial strategy that would tide you over the following
5 months? Explain your proposal and show all your calculations.
(12 marks)

d) Venture capitalists usually receive convertible preferred stock when they invest in
private firms. Describe the typical features of these securities (i.e., the venture capital
financing terms).

(5 marks)

(Total 35 marks)

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Question 15
a) Assume you are the owner of a chain of restaurants and are considering opening a
new restaurant in a recently opened mall in London. If you do not sign the lease on the
restaurant today, someone else will, so you will not have the opportunity to open a
restaurant in the mall later. There is a clause in the lease that allows you to break the
lease at no cost in three years’ time. The initial costs to set up the restaurant will be
£350,000. Including the lease payments, the new restaurant will cost £8,000 per month
to operate. If traffic in the new mall is low, you expect to generate £6,000 per month in
revenue in perpetuity. If, however, the mall becomes an attraction, you expect to
generate £14,000 per month in revenue in perpetuity. There is a 50% probability that
the new mall will become an attraction. The cost of capital for the business is constant
at 0.5% per month.
REQUIRED:

i) Considering the option to break the lease and abandon the restaurant in
three years’ time, what is the NPV of this investment opportunity?
(6 marks)

ii) What is the value of the option to abandon the restaurant?

(4 marks)

b) You are the CFO of a national supermarket chain that is considering the purchase
of a new vacuum packaging machine costing a total of £6.5 million. This machine will
qualify for accelerated depreciation: 32% can be expensed immediately, followed by
20%, 19.2%, 11.52%, 11.52% and 5.76% over the next five years. However,
because of the company’s substantial tax loss carry forwards, you estimate its
marginal tax rate to be only 12% over the next five years. Since the company will get
very little tax benefit from the depreciation expense, you are also considering leasing
the packaging machine instead. Suppose that the supermarket and the lessor face
the same 3.2% borrowing rate. Assume that the packaging machine is worthless after
five years, the lease term is five years, and a lease would qualify as a true tax lease.

REQUIRED:

i) Assuming that your company’s annual lease payments are £1.35 million,
calculate the lease-equivalent loan completing the cash flow table below (show
all your calculations, including the computation of the FCF (buy) and the FCF
(Lease).
(6 marks)

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 Year 1 2 3 4 5
Depreciation 0.2000 0.1920 0.1152 0.1152 0.0576

Buy
CAPEX
Dep. tax shield £156,000 £89,856 £44,928
FCF(Buy)

Lease
Lease Payments -£1,350,000
Income tax svgs.
FCF(Lease)

ii) What is the amount of the savings in year 0 from leasing?

(1 mark)

iii) Using the direct method, calculate the NPV of leasing (show your
calculations).
(2 marks)

iv) What should you do as CFO of this Food Company, lease or buy the tetra-
brick packaging machine?
(1 mark)

c) Explain the distinct types of directors and what an independent board is and a
captured board.
(5 marks)

d) By the end of fiscal year 2023 GIGGLE. CO. shares trade at £12.34 per share with
1 million shares outstanding. Merta. Co.’s CFO assesses that if Merta. Co. buys
GIGGLE. CO. and replaces the management team they can increase GIGGLE. CO
value by 50%. Merta. Co. is considering a levered buyout of GIGGLE. CO, offering
£18 per share. Assuming Merta. Co. manages to get control of the 50% of GIGGLE.
CO, what will be Merta. Co.’s gains from this transaction?
(5 marks)

e) Explain what a bond covenant is and provide examples. How can a bond covenant
reduce a firm’s borrowing cost?
(5 marks)

(Total 35 marks)

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 END OF PAPER

Formula Sheet

Present value of a perpetuity

𝐶
𝑃𝑉 =
𝑟

Present value of a growing perpetuity

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 𝐶1
𝑃𝑉 =
𝑟−𝑔
Present value of an annuity
𝐶 1
𝑃𝑉 = (1 − )
𝑟 (1 + 𝑟)𝑇
Present value of an annuity due
1 1
𝑃𝑉 = 𝐶 (1 + (1 − ))
𝑟 (1 + 𝑟)𝑇−1
Effective annual rate
𝑖 𝑚
𝐸𝐴𝑅 = (1 + ) −1
𝑚

Weighted Average Cost of Capital

Project-based WACC

Project-based WACC with Annual Debt Adjustment

Unlevered Cost of Capital

Cost of Equity

Debt Capacity

Adjusted Present Value

Free Cash Flow to Equity

Free Cash Flow

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𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇(1 − 𝜏𝑐 ) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑒𝑥 − Δ𝑁𝑊𝐶

Levered Value with a Constant Interest Coverage Ratio

𝑉𝐿 = (1 + 𝜏𝑐 𝑘)𝑉𝑈

Annually Adjusted Debt

Personal Taxes

Unlevered Cost of Capital (CAPM)

Black-Scholes Formula

Failure Cost Index

Leasing

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PV(Lease payments) = Price of the Asset – PV(residual value of the asset)

FCF(Buy)t = - CapExt + Depreciation tax shieldt

FCF(Lease)t= - Lease paymentst + Income tax savingst

Incremental free cash flowt = FCF (Lease – Buy)t = FCF(Lease)t – FCF(Buy)t

Lease equivalent loan = PV (FCF(Lease – Buy)1 + …+ FCF(Lease – Buy)T )

Valuation and the takeover process

Amount Paid = Target’s Pre-Bid Market Cap. + Acquisition Premium

Value Acquired = Target stand alone value + PV(Synergies)

𝑥 𝑃𝑇 𝑆
𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 = < (1 + )
𝑁𝑇 𝑃𝐴 𝑇

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