ACC2022 Corporate Finance

AY2024 Trimester 1 Revision Seminar

QUESTION 1 – True/False

(a) The Binominal model or Black-Scholes model assume that investors are risk neutral
a. True
b. False.

(b) One way to see why you sometimes choose not to invest in a positive-NPV project is to think
about the decision of when to invest as a choice between two mutually exclusive projects: (1)
invest today or (2) wait
a. True
b. False

(c) A key distinction between a real option and a financial option is that real options, and the
underlying assets on which they are based, are often traded in competitive markets
a. True
b. False

(d) The value of an option generally decreases with the volatility of the stock.
a. True.
b. False.

(e) Out-of-the-money calls are riskier than in-the-money calls, and because most growth options are
likely to be out-of-the-money, the growth component of firm value is likely to be riskier than the
ongoing assets of the firm.
a. True.
b. False.

(f) Call options with strike prices above the current stock price are in-the money, as are put options
with strike prices below the current stock price.
a. True.
b. False.

(g) A financial option contract gives the writer the right (but not the obligation) to purchase or sell
an asset at a fixed price at some future date.
a. True.
b. False.

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(h) Merger activity is greater during economic contractions than during expansions
a. True.
b. False.

(i) There are two primary mechanisms by which ownership and control of a public corporation can
change: Either another corporation or group of individuals can acquire the target firm, or the
target firm can merge with another firm.
a. True.
b. False.

(j) As Modigliani and Miller made clear in their original work, capital structure matters in perfect
capital markets. Thus, if capital structure does not matter, then it must stem from a market
imperfection
a. True.
b. False.

QUESTION 2

MacBeth Ltd has $2 million of outstanding debt and 100,000 outstanding shares selling at $30 per
share. Its current borrowing rate is 8% and the financial manager thinks that the shares are priced to
offer at 15%. Given that Macbeth has an effective tax rate of 30%, what is the after-tax weighted
average cost of capital for MacBeth?

QUESTION 3

Pacific Time Inc. is considering investing in a new plant. The investment will cost Pacific, $50m.
This investment is expected to increase Pacific’s free cash flow by $2.5m the first year with a grow
rate of 2% every year thereafter. The debt to equity ratio for Pacific is currently 0.5 and Pacific
intends to maintain a constant debt-equity ratio for the investment. Pacific has a marginal tax rate of
30% and its cost of debt is 4% while its cost of equity is 7% respectively. If Pacific issues new debt
of $15m initially to fund the investment, using the APV method, what is the total value of this
investment?

QUESTION 4

Testtel Group New Project Free Cash Flows

Year 0 1 2 3
Free Cash
Flows ($100) $45 $80 $100
Given :
o Testtel’s after tax WACC is 9.75%
o Testtel’s borrowing cost is 4.25%
o The risk of the new project equals the average risk for Testtel
o Testtel’s debt-value ratio is 45% and the firm wants to hold this ratio constant.
o Testel’s effective tax rate is 30%

What is the debt capacity for Testtel’s new project in years 0,1 and 2?
What is the corresponding yearly interest tax shield?
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QUESTION 5

VPop Group’s share price is currently traded at $40. You predict that in the next two-years, VPop’s
share price will have an equal chance of going up by 10% or going down by 5%. Vpop does not pay
dividends to its shareholders. The one year risk-free rate is 4.25% and you expect that this will
remain constant. Using the binomial pricing model, what is the price (at year 0) of a two-year call
option on VPop share price with a strike price of $38?

QUESTION 6
The following table lists option prices on Rio Tinto as of 01/08/18 from NYSE.

Calls
Contract Expiry Strike Bid Ask
19/10/18 37.50 16.30 16.80
19/10/18 42.50 12.40 12.80
19/10/18 45.00 10.00 10.30
19/10/18 47.50 7.60 7.90
19/10/18 50.00 5.50 5.70
19/10/18 52.50 3.70 4.00
19/10/18 55.00 2.20 2.60
19/10/18 57.50 1.15 1.70
19/10/18 60.00 0.50 0.85
19/10/18 62.50 0.20 0.45
19/10/18 65.00 0.20 0.30
19/10/18 67.50 0.05 0.15
19/10/18 70.00 0.30 0.10
19/10/18 75.00 0.00 0.05
You have constructed a butterfly spread using three calls with strikes (42.50, 45.00, 47.50).
Create a table to show the profit function from the butterfly spread.

QUESTION 7
Arms Ltd has earnings per share of $5, 6.6 million shares outstanding, and a share price of $18.50.
Arms is considering buying Legs Ltd, which has EPS of $2.50, 3million shares outstanding and a
share price of $9. Arms will pay for Legs by issuing new shares. There are no expected synergies
from the transaction.
a) Assume that no premium will be paid by Arms, what is the total number of shares in the new
merged firm?
b) Assume that no premium will be paid by Arms, what will the EPS be for the merged firm?

QUESTION 8

SIN Ltd is considering the acquisition of SAINT Ltd. The annual expected cash flows of SIN and
SAINT are, respectively, $6.66 million per annum in perpetuity and $2.880 million per annum in
perpetuity. These cash flows are expected to be unaffected by the takeover. The systematic risk
(beta) of SIN is 1 and of SAINT is 0.8. The risk-free interest rate is 6% and the average market
return is 13%. What is the price at which SAINT represents a zero NPV investment?

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QUESTION 9

The current price of WD Industries stock is $20. In the next year the stock price will either go up by
20% or go down by 20%. WD pays no dividends. The one year risk-free rate is 5% and will remain
constant
(a) The risk neutral probability of an up state for WD industries is closest to :
a. 37.5%
b. 62.5%
c. 40.0%
d. 60.0%
e. None of the above
(b) The risk neutral probability of a down state for WD industries is closest to :
a. 37.5%
b. 62.5%
c. 40.0%
d. 60.0%
e. None of the above
(c) Using risk neutral probabilities, the calculated price of a one-year call option on WD stock with
a strike price of $20 is closest to :
a. $2.38
b. $1.43
c. $2.03
d. $2.18
e. None of the above

QUESTION 10
“Takeovers are important because they provide the only way to exploit synergies and to ensure that
managers of corporations act in the interests of shareholders”. Critically evaluate this statement.

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