Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Appendix A Solutions to self-assessment activities 685
15.7
■ Purpose – an OL is undertaken in order to perform a specific job over a short period of time, whereas
an FL is usually contracted over a term which matches the expected working life of an asset.
■ Termination – an OL can be easily terminated whereas cancellation penalties on an FL are prohibitive.
■ Obsolescence risk – with an OL, this is borne by the lessor, while the lessee bears the risk with an FL.
■ Cost – OLs are generally more expensive than FLs for the same period.
15.8 (i)
(ii) The full 9%, as the firm cannot use the tax break.
9% 31 10% 4 8.1%
CHAPTER 16
16.1 The events of 9/11 have made people more fearful for the future, and less inclined to invest. Equity would
look safer for firms as it carries no interest obligations, although as the authorities used interest rate reduc-
tions to support their economies, this might encourage more borrowing, e.g. as firms re-finance existing
loans at more favourable rates. So, on balance, probably a shift towards fixed interest financing to lock in
historically low interest rates, certainly for as long as it takes fragile equity markets to recover.
16.2 The statement is nonsense. Reserves reflect financing of past investment, i.e. they represent funds already
invested. The speaker is probably confused between reserves and ‘cash reserves’, common parlance for
‘cash balances’.
16.3 Pre-issue, a shareholder holds in shares plus in cash, totalling Post-issue, this
value is spread over 7 shares so the
16.4 In a ‘2-for-1’ split:
■ the number of shares doubles, i.e. two new shares for each old one.
■ both capital and assets are unchanged – no further cash is raised.
■ the market value of the whole equity is unchanged but the value per share is halved.
16.5 grows to over 10 years, i.e.
Inverting, From the present value tables,
16.6 (a)
(b) Yield to maturity is the interest rate that satisfies:
The solution is 5.35%.
16.7 The warrant gives the right to buy something worth for – its value is thus The one-for-four terms
are irrelevant to the value per warrant. Someone holding 400 shares would have 100 warrants valued at
etc.
16.8 Logic might suggest the following:
A SAL generates cash which raises assets, but as the lease is long-term it must be capitalised. It will thus
appear (remain as) as a fixed asset, but is offset by the corresponding PV of rental commitments, shown as
long-term debt. Overall, it leaves net assets unchanged but, initially, it increases the calculated gearing ratio
unless and until the cash generated is used to repay existing debt.
However, the reality is rather different, especially for property assets, which are usually classified as
operating leases as the lessor retains the risks and rewards of ownership. Hence, most rented properties do
not appear on the tenant’s balance sheets. The balance sheet effect is largely cosmetic (‘smoke and mirrors’),
except that it does increase liquidity.
1100 £32 £300,
£3.£5£8
£110 1£8.3 3-year annuity factor2 1£100 3-year discount factor2.
Flat yield interest>market price 1£8.30>£1102 7.5%
g 7.2%.1>11 g2
10
1£50>£1002 0.5000.
£5011 g2
10
£100.£100£50
TERP £33.50>7 £4.79.16 12
£33.50.£3.5016 £52 £30
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686 Appendix A Solutions to self-assessment activities
17.1 Earnings in year of which 60%, i.e.
,
are retained. Returns on new
Next year’s
17.2 Divicut invests in year 1 to return in year 2.
The NPV of this is vs. or vs. thus a negative NPV of because the
return on reinvested earnings (8%) falls short of the required 10%.
17.3 Paying out dividends rather than investing in worthwhile projects otherwise inaccessible to shareholders
reduces the PV of their future income below what it could have been, i.e. there is an opportunity cost
imposed on them.
17.4 Projects A, B and C are all attractive, but C appears unavailable as it would lead to exceeding the budget.
However, if C is divisible, the firm should undertake A, B and 3/7 of C; otherwise, it should pay a divi-
dend of
17.5 Gordon confuses the risk of the dividends with the risk of the underlying cash flows resulting from new
investment. If risk (and any increase in it) is suitably allowed for in the discount rate used to deflate future
cash flows, then to discount the more distant future dividend flow would entail double-counting for risk.
(If the firm moves into a low risk area, the future dividends could even have lower risk than near-in-time
dividends.)
17.6 A clientèle is a set of investors whose interests the firm tries to serve via its particular dividend policy.
Investors with short time horizons are likely to include the relatively elderly or infirm, and those with
pressing needs for rapid income payments, e.g. to repay debts or to fund a daughter’s wedding.
17.7 (i)
(ii)
17.8 Share repurchases may signal that the firm has exhausted investment opportunities or has become too
risk-averse to devoting funds to R&D. They may also trigger CGT liabilities for some investors. It may also
cause embarrassment to directors if share prices subsequently fall.
17.9 A stable dividend policy gives reliability and security. Investors can plan their future income and expen-
ditures more easily. Sharp cuts in dividends, as well as causing alarm, may force investors to sell shares on
a weak market. Similarly, a sharp increase in dividends may force investors to reconfigure their portfolios,
as well as triggering a CGT liability.
50 plus 20% 60 shares.
£1,000>£20 50 shares
£300,000.
£16,£909,£893£1,000>11.12£1,080>11.12
2
£1,080£1,000
Growth rate
1£1,0902
1£1,0002
1 9% 160% 15%2
earnings 1£1,000 £902 £1,090.
£90.£6002
115% investment£600zero £1,000,
CHAPTER 17
CHAPTER 18
18.1 (i)
(ii) debt-to-debt plus
(iii) net less or as a percentage of
18.2 Both capital and income gearing are forms of financial gearing, i.e. they stem from the firm’s financial
structure. Capital gearing is obtained from the Balance Sheet and is measured by the amount of borrow-
ing in relation to owners’ equity. Income gearing can be gleaned from the P and L, and is measured by
interest cover, or its inverse, the proportion of PBIT accounted for by interest charges.
£100 m2 60%.
equity 1£60 m>cash 1£70 m £10 m2 £60 m,debt debt
equity £50 m>1£50 m £100 m2 33.3%.
debt>equity £50 m>£100 m 50%.
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Appendix A Solutions to self-assessment activities 687
18.3
Over to you!
18.4 Contribution is, of course, unaffected, but operating profit or PBIT would fall by to and
PBT would fall a further to The two multipliers become:
The combined
18.5 Scenario A:
Scenario B:
Scenario C:
18.6 With 25% gearing, share
With 50% gearing, share
It seems that shareholders’ demand for a higher return outweighs the increase in EPS as gearing increases.
18.7 Debt-to-equity ratio of 40% means that debt is 2/7 of the total long-term funds and equity is 5/7. The
WACC is thus:
18.8 (i) With 11% interest, market
(ii) With 3% interest, market
18.9 Over to you!
18.10 (a) Perpetual debt:
(b) 20 years to maturity:
18.11 Over to you again!
£2.06 m
120 year annuity of 6% £10 m T2 111.4699 £600,000 30%2
130% £10 m debt2 £3 m
value 1£100 3.5%>3%2 £116.67.
value 1£100 3.5%>11%2 £31.82
15>7 18% 2 12>7 8%2 112.9% 2.3%2 15.2%
price 130p>0.352 £0.86
price 123.3p>0.252 £0.93
EV
10.25 0%2 10.50 30%2 10.25 60% 2 30%
EV 10.25 3.3%2 10.50 23.3%2 10.25 43.3% 2 23.3%
EV 10.25 5%2 10.50 20%2 10.25 35%2 20%
multiplier 11.96 1.772 3.47
PBIT>PBT 1£550,000>£310,0002 1.77
Contribution>PBIT 1£1,080,000>
£550,0002 1.96
£310,000.£40,000
£550,000,£50,000
CHAPTER 19
19.1 Under MM assumptions, firms identical in all respects apart from capital structure (allowing for size),
should have the same value. Value is determined by the stream of operating cash flows and the degree of
business risk attaching to these, regardless of how the cash flows are ‘packaged’ or shared out between dif-
ferent classes of investor.
19.2 Arbitrage in pursuit of ‘home-made gearing’ is restricted by:
■ Taxes on capital gains.
■ Differences between the borrowing and lending rates available to all parties.
■ Different borrowing rates available to firms and private investors.
■ Restrictions on some institutions’ ability to borrow.
■ Transactions costs.
19.3
19.4
In the ungeared firm, the overall cost of capital is simply the cost of equity, i.e. 15%. In the geared firm, the
overall cost of finance is:
15% 11 1.5%2 13.5%
k
ou
15%a1
T V
B
V
S
V
B
b 15% 31 130% £200 m>£600 m24
1£466.7 m £60 m2 £526.7 m
Value of geared firm V
u
TB £466.7 m 130% £200 m2
Value of ungeared firm
£100 m11 T2
0.15
£70 m
0.15
£466.7 m
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688 Appendix A Solutions to self-assessment activities
19.5 Beta
19.6 The APV is the value of an activity, based on its inherent worth as given by the PV of the stream of oper-
ating cash flows, adjusted for any ‘special factors’ such as tax concessions, financing costs, etc. It is thus
the ‘basic’ NPV plus the PV of non-operating factors.
19.7 In theory, the limit to a firm’s taxable capacity is where its interest charge equals the lowest possible level
of future cash flows. In reality, it is much less than this. Based on asset-backing, the theoretical limit is
where the book value of assets equals the book value of borrowings.
ungeared
1.45
31 11 30% 2
1
2
4
1.45
1.35
1.074
CHAPTER 20
20.1 Managerial motives reduce to the three Ps – power, pay and prestige, all of which are enhanced by size of
firm.
20.2 If managers are paid according to growth in EPS, a takeover that exploits synergies may enhance their
bonuses. However, if financed by debt, the value of the firm could actually fall. Takeovers that aim to
reduce risk rarely benefit shareholders for whom systematic risk is normally more relevant than total risk.
20.3 Cash is more certain, whereas the value of shares is volatile – by the time payment is made, the share value
might have fallen. Investors wishing to liquidate the shares received will incur dealing fees.
20.4 The NPV of the bid for Predator’s
Prey’s shareholders benefit by (60 per cent of gains), and those of Predator by (40 per cent),
if the bid is completed at this price.
20.5 The strategic approach to takeover analysis and execution involves the following steps:
■ Formulate corporate strategy.
■ Assess the role of acquisition candidates in achieving that strategy.
■ Screen, value and select from among possible candidates.
■ Plan for future integration and/or disposals.
■ Make informal approach.
■ Announce hostile bid if necessary.
■ Complete the deal.
■ Integrate the acquisition following a detailed resource audit.
■ Post-audit the acquisition and integration processes.
20.6 Takeovers fail to achieve the anticipated benefits due to:
■ Managerial motivation rather than shareholder orientation.
■ Inadequate evaluation of the target.
■ Over-payment for the target.
■ Failure to plan the integration process.
■ Poor integration, e.g. neglect of the human factor.
20.7 There are many motives for divestment including:
1 Dismantling conglomerates originally created by merger activity through defensive diversification
strategies.
2 A change in strategic focus. This may involve a move away from the core business to new strategic
opportunities. Alternatively, a business may decide that it is engaged in too wide a range of activities
and seek to concentrate its efforts and resources on a narrower range of core activities. Non-core activ-
ities will then be divested.
£20 m£30 m
£20 m.
shareholders 1£1,000 m £200 m £50 m2 1£1,000 £230 m2
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Appendix A Solutions to self-assessment activities 689
3 Harvesting past successes, making cash flow available for new opportunities.
4 Selling off unwanted businesses following an acquisition. This is called ‘asset-stripping’. Such sell-offs
are often planned at the time of the bid.
5 Reversing (or learning from) mistakes.
CHAPTER 21
21.1 A speculator deliberately risks losing money by taking a long or short ‘position’ in a particular currency.
A hedger tries to minimise exposure to risk. Corus is a hedger and Nintendo is a speculator. ABI were sim-
ply negligent.
21.2 Eurozone Canada
Spot
Forward points (49 – 39)
F/ward outright
21.3 ■ Transaction exposure is the risk of loss associated with short-term contractual obligations.
■ Translation exposure is the risk of loss when constructing end-of-year financial statements.
■ Economic, or Operating, or Strategic, exposure is the risk of the whole value of the firm falling due to
adverse foreign exchange rate changes affecting the PV of future cash flows.
21.4 New York price in one
London price in one
Exchange rate under
21.5 Annual interest rate differential of over This is the interest agio.
Forward rate should be Spot less forward The US$ trades at a pre-
mium of 90 points.
21.6 Langer’s assets are now worth If all prices inflate at 7% in Australia, Langer’s
assets will appreciate to in one year. The AUD vs. GBP exchange rate should
become At this rate, the sterling value of these
This is the level to which they would have appreciated had they been located in Britain and experi-
enced 2% UK inflation i.e.
21.7 Leading is advancing outflows in a strong currency and advancing inflows in a weak one. Lagging is
delaying inflows in a strong currency and delaying outflows in a weak one.
21.8 There is no point exercising an option ‘at the money’. The purchaser simply loses the premium.
21.9 Clearly, both firms make a major proportion of their sales in the USA, and hence suffer significant euro/
dollar exposure (VW) and sterling/dollar exposure (Hanson). However, the big difference is that whereas
VW exports to the USA, with its costs mainly denominated in euros, Hanson has a US operating base where
its US$ costs provide a natural hedge against US$ revenues. Moreover, Hanson has more flexibility in its
pricing on the US market, and thus its US profits are likely to be less severely damaged by sterling appre-
ciation. The result is that dollar depreciation damages its profits and cash flow in parent country currency
(sterling) far less than for VW. VW was also experiencing major cash outflows with its investment pro-
gramme, as was Hanson, but Hanson could fund a great deal of this with its US$ cash flow.
Faced with far more severe exposure and far greater pressure on parent currency cash flow, VW was far
more likely to cut dividends in order to preserve cash. Expressed in different terms, Hanson’s problem was
more of a translation exposure problem, while VW’s problem was more of a transaction problem, with
more profound consequences for parent company profits and cash flow.
£36.3611.022 £37.1 m.
£37.1.
assets 1A4107 m>2.884212.75 1.07>1.022 A$2.884 per£1.
A$100 m 11.072 A$107 m
1A$100 m>2.752 £36.36 m.
agio 1£1.4455 99.375%2 $1.4365.
3 months 0.625%.2.5% 2.5%>4
PPP 1$1.53>£1.042 $1.47 per £1
year £1.0011.042 £1.04
year $1.5011.022 $1.53
2.2568 2.25891.4421 1.4430
15
17
2.2617 2.26281.4406 1.4413
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690 Appendix A Solutions to self-assessment activities
CHAPTER 22
22.1 Broadly, an MNC is a firm whose activities span national borders, but the term usually applies to firms that
invest in foreign locations. A global firm both trades and invests abroad.
22.2 Licensing tends to have very low variable costs. Its fixed costs depend on the degree of supervision applied
to the overseas operator (the agency costs). Fixed costs are probably higher than for exporting but lower
than for FDI.
22.3 FDI differs from domestic investment for many reasons:
■ Exposure to FX risk.
■ Likelihood of inflation abroad occurring at rates different from home inflation.
■ Risk of political intervention, leading to blocked funds, etc.
■ Access to concessionary finance and grants.
■ Overspill effects on existing operations.
22.4 Beta of project
Adjusted for correlation
Required return 5% + 0.7 [11% – 5%] 5% + 4.2% 9.2%
22.5 The firm will pay tax only in the US, i.e. which is allowable in full against
UK tax liability.
22.6
Total exposure US$120m
22.7 The net exposure could be reduced by:
■ Producing more output in the US and shipping direct to South America.
■ Sourcing more US$-denominated inputs to support UK production.
■ Borrowing in US$.
22.8 ■ Source materials and services from local suppliers.
■ Employ locals in key management posts.
■ Invest in training programmes for locals.
■ Invest in sports and health facilities, open to the wider population.
■ Sponsor local cultural events.
■ Undertake joint ventures with local firms.
■ Reinvestment rather than repatriation of profits.
■ Use local sources of finance.
US$100 m
Exposure in South America
US$20 mExposure of US operations US$150 m 30 m2
1US$100 m 30%2 US$30 m,
11.75 0.42 0.7
11.4 1.252 1.75
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Solutions to selected questions
Appendix B
CHAPTER 1
1 The goal of maximising owners’ wealth is the normally accepted economic objective for resource allocation
decisions. Rather than concentrate on the organisation, it evaluates investments from the viewpoint of the
organisation’s owners – usually shareholders. Any investment that increases their stock of wealth (the pres-
ent value of future cash flows) is economically acceptable.
In practice, many of the assumptions underlying this goal do not always hold (e.g. shareholders are only
interested in maximising the market value of their shareholdings). In addition, owners are often far
removed from managerial decision-making, where capital investment takes place. Accordingly, it is com-
mon to find that more easily measurable criteria are used, such as profitability and growth goals. There are
also non-economic considerations, such as employee welfare and managerial satisfaction, which can be
important for some decisions.
CHAPTER 2
2 (c) (i) For the cash offer
On Day 1, the total value of each firm is:
A:
B:
Company B is making an offer of for Company A which is apparently worth only million – this will
reduce the market value of B by million to million or per share. Against this, the
anticipated savings would raise B’s value to or per share (assuming the
market accepts this assessment).
1 Semi-strong form efficiency
Under semi-strong form efficiency, the market prices will only react when the information about the bid
enters the public domain. The advent of new information will produce the following share prices:
Share price
AB
Day 2 No new information £2.00 £3.00
Day 4 Takeover bid announced. B appears to be paying £6 m
for assets worth £4 m £3.00 £2.67
Day 10 Information available which revises the market
value of B £3.00 £3.20
2 Strong – form efficiency
If the market is strong – form efficient, all information is reflected in the share price even if it is not pub-
licly available information. This will mean that on Day 2, when the management of B decides to offer
£3.00
£3.201£16 m £3.2 m2 £19.2 m
£16 million>6 £2.67£16£2
£4£6 m
£3 6 m shares
£18 m
£2 2 m shares £4 m
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692 Appendix B Solutions to selected questions
for A, the share prices will then react to reflect the full impact of the bid on both shares, perhaps via leak-
age of information by an informed insider. This will produce the following share prices:
Share price
AB
Day 2 Full impact of decision to bid and make savings reflected in £3.00 £3.20
share price
Day 4 Public announcement of bid, i.e. information of which the market £3.00 £3.20
is aware and therefore has no new information content
Day 10 Public announcement of savings to be derived from bid, i.e. further £3.00 £3.20
information of which the market is aware and therefore has no
new information content
(ii) For the share exchange
Prior to the bid, the combined value of the two companies is If a share-for-share
exchange were made on a one-for-one basis, the value per share of the expanded company would become
until further information about prospective savings emerged. Under semi-strong form
efficiency, this will not happen until Day 10, but will leak out on to the market immediately under strong form
efficiency. Spread over the whole 8 m shares, the savings are worth per share.
The sequence of share price movements is thus:
Level of efficiency
Semi-strong Strong
ABAB
Day 2 £2 £3 £3.15 £3.15
Day 4 £2.75 £2.75 £3.15 £3.15
Day 10 £3.15 £3.15 £3.15 £3.15
Notice that the ultimate share price under the share exchange is lower than for the cash offer. This is because
the benefits of the merger are spread out over a larger number of shares post-bid. In effect, the shareholders
of B will have released part of the benefit they expect to receive from the bid to the former shareholders of A.
£3.2 m>8 m £0.4
£22 m>8 m £2.75 m,
1£4 m £18 m2 £22 m.
CHAPTER 3
1 Accounting profit is the excess of income over expenditure. Income and expenses relate to a specific period
(e.g. the sales and costs for the month of January) based on accounting conventions such as depreciation. Cash
flow is the cash receipts and payments from all operations including capital investment.
2 Using the table in Appendix D, the annuity factor for ten years and is 4.1925:
3 Savings:
Residual value:
Less: initial cost:
NPV
The NPV is negative. Recommend the project is rejected.
4 (a) The firm should invest
(b) Market rate of i.e. 25%
(c) Average return on
(d) Present value of an investment of
NPV £4,000 £2,000 £2,000.
£2,000 £5,000>1.25 £4,000.
investment 1£5,000>£2,0002 100 250%.
interest £10,000>£80,000 1.25,
£6,000 £4,000 £2,000.
£14252
1£20,0002
£19,575
£621£1,000 0.62092
£18,954£500,000 3.7908
PV £100 4.1925 £419.25
i 20%
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Appendix B Solutions to selected questions 693
(e) Value of firm after
(f) If a dividend of is paid now, a further will be invested on the capital market (there being no
internal projects offering a better return). This will give cash next year of from
external investment plus from internal investment, a total dividend of
Students should be aware of the assumptions for the two-period investment model:
(i) Only the present and subsequent periods are considered.
(ii) Investors are wealth-maximisers.
(iii) All decision-relevant information is known with certainty.
(iv) Investment projects are entirely independent of each other and are divisible.
(v) No capital markets.
(vi) The firm is owner-managed.
£6,250.£5,000
£1,000 1.25 £1,250
£1,000£3,000
investment £6,000 £2,000 £8,000.
CHAPTER 4
3 Free cash flow (£) Revenue less bad debts less operating costs + depreciation less replacement investment
less tax (allowing for relief on bad debts)
(a) valued @ 10% as a perpetuity:
(b) valued over 10 years:
V ten year annuity factor 10%)
4 Free cash flow per or 50p
(i)
(ii)
(iii)
(iv) Present value of dividends over years 1–3:
Year 1 Dividend 26.88p, as per part (ii) PV @ 12% £0.239
Year 2 Dividend 26.88p (1.075) 28.89p PV @ 12% £0.230
Year 3 Dividend 28.89p (1.075) 31.05p PV @ 12% £0.221
PV of dividends beyond year 3:
Share
5 (i)
(ii)
(iii)
(iv)
(v) b g>R 12%>10%2 20%
£0.20
£0.65
10.6 16%2 9.6%
£0.37955
price Total PV £4.005
1£4.657 0.71182 £3.315
31.05p 11.052
112% 5% 2
13-year PV factor2
P
o
50% 50p 11 310% 50% 42
12% 310% 50% 4
26.25p
0.07
£3.75
P
o
50% 50p 11 315% 50% 42
12% 315% 50% 4
26.88p
0.045
£5.97
P
o
1£0.5>0.122 £4.17
share 1£5 m>10 m2 £0.50
1£131,500 6.14462 £808,015 m, or £0.405 per share 140.5p2.
1£131,500
i.e. 1£1.315 m>2 m2 £0.6575 per share 165.75p2
V 1£131,500>0.12 £1.315 million
£131,500
1490,000 300,000 50,000 50,000 60,000 1,5002
150,0002 160,000 30.3 50% 2% 500,00042
10.98 500,0002 1300,000
2 150,0002
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694 Appendix B Solutions to selected questions
CHAPTER 5
1 Microtic Ltd
Project A (£) Project B (£)
1 Payback period
Outlay/annual flow 1,616/500 556/200
3.2 Years 2.8 Years
2 Net present value (15%)
Annual cash flow five years £500 3.352 1,676,000 200 3.352 670,400
Scrap value £301 0.497 149,600 56 0.497 27,800
Outlay (1,616,000) (556,000)
NPV 209,600 142,200
3 Internal rate of return
(use trial and error to obtain NPV of zero) try 20% try 25%
Annual cash flow 500 2,991 1,495,500 200 2,689 537,800
Scrap value 301 0.402 121,000 56 0.328 18,400
Outlay (1,616,000) (556,000)
NPV 500 200
4 Accounting rate of return
Average profit before depreciation 500,000 200,000
Depreciation (1616 301)/5 (263,000) (556 56)/5 (100,000)
237,000 100,000
Average capital employed (1616 301)/2 958,500 (556 56)/2 306,000
Rate 24.7% 32.7%
Investment advice
All appraisal methods apart from the NPV approach recommend acceptance of Project B. This is because it
generates a higher return for every invested. The question is, however, which of the two projects creates
most wealth for the owners. Clearly, the much larger Project A has the higher NPV. Unless the firm is experi-
encing severe capital rationing problems, Project A should be accepted.
2 Mace Ltd (£000)
Fraction Required
Project NPV per £ outlay Ranking accepted capital (£) NPV (£)
1 1.6/60 0.027 4 0 – –
2 1.3/30 0.043 3 1/3 10 0.43
3 8.3/40 0.207 1 1 40 8.3
4 0 0.9
5 7.9/50 0.158 2 1 50 7.9
100 17.53
£1
(vi)
As and
(vii) 15%
R
g
b
0.105
0.7
15%
b 0.7,
g 10.5%,
k
e
11D
1
>P
o
2 g2 1£0.054>£0.602 8% 17%
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