Financial Management Assignments and Exercises

Assignment Section A

1. The Fitness Centre is considering replacing its treadmills and is faced with a choice between two models: the Track1 model costing £900 per machine and the ProFitness model costing £1,400 per machine. The ProFitness model is sturdier and the cost of maintenance per machine is £50 per year. The Track1 model is less robust and requires more maintenance costing £70 per machine per year. The Track1 model is also less durable. The Fitness Centre estimates that it would need to replace the Track1 machines after 3 years of use and that it would need to buy 30 machines to ensure that enough are working at any particular time. The ProFitness model would last 4 years and only 25 machines would be needed. All other revenue and costs for the Fitness Centre would remain the same. The required discount rate for this project is 10%. 

Required:

a) On the basis of the information provided, which machine should the Fitness Centre buy? Explain.

b) What other information would you consider before taking a decision? 

2. Rally is an all-equity firm with assets worth $25 billion and 10 billion shares outstanding. Rally plans to borrow $10 billion and use these funds to repurchase shares. The firm’s corporate tax rate is 35%, and Rally plans to keep its outstanding debt equal to $10 billion permanently.

Required:

a) Without the increase in leverage, what would Rally’s share price be?

b) Suppose Rally offers $2.75 per share to repurchase its shares. Would shareholders sell for this price?

c) Suppose Rally offers $3.00 per share, and shareholders tender their shares at this price. What will Rally’s share price be after the repurchase? 

d) What is the lowest price Rally can offer and have shareholders tender their shares? What will its stock price be after the share repurchase in that case?

3. The stock of DRAM PLC is currently selling for £20 per share. Earnings per share in the coming year are expected to be £3.50. The company, whose capital structure consists solely of equity, has a policy of paying out 25% of its earnings each year in dividends. The remaining part is retained and invested in projects that earn a 5% internal rate of return per year. This situation is expected to continue indefinitely.

a) Show that the growth rate g in earnings that is consistent with a payout ratio PYT and return on equity ROE is g = (1 – PYT)*ROE. 

Section A Question 1

b) Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth Dividend Discount Model, what rate of return do DRAM’s investors require? Explain.

c) By how much would DRAM’s stock price change if all its earnings were paid as dividends and nothing was reinvested? Explain. 

d) If the company were to increase its dividend payout ratio to 40%, what would happen to its stock price? 

4. Suppose you are the sole owner of company Taurus plc. The market value of your company is £100m and there are 20m shares outstanding. Now you are thinking about acquiring the target company Gemini with a stand-alone market value of £50m with 25m shares outstanding.

Assume first that the present value of the synergies generated by combining the two companies is £20m. 

Required:

a) Suppose you issue new shares to pay Gemini’s shareholders so that the net cost of the acquisition to Taurus is nil, meaning the shareholders of Gemini break even. How many shares do you need to issue? How many shares do you need to pay for each share in Gemini?

Assume from now on instead that the present value of the synergies generated by combining the two companies is -£10m as opposed to £20m.

b) Redo part 1) with the new present value of synergies. Would you choose to acquire company Gemini? Discuss your findings in comparison with those reported in part 1). 

Assume now that you hold only 2m shares in Taurus but have control rights in the company (meaning that you can decide on Taurus’ acquisition of Gemini). In addition, assume that you also have 15m shares in Gemini.

c) What is the value of your portfolio without any acquisition?

d) Suppose you have the opportunity to have company Taurus acquire company Gemini by offering 1 newly created share of Taurus for two shares of Gemini. What is the post-merger share price after the acquisition? What is your payoff? Do you proceed with the proposed merger? 

e) Based on your findings in 3) and 4), discuss how ownership structure (especially ownership in the target company) affects acquirers’ tendency to take over targets with negative synergy. 

5.Consider a company which has $10m to invest into one of three projects with the following cash-flows generated next year in the good and bad states of nature, with p denoting the probability of a given state obtaining for any project:

For simplicity, there is no time discount. 

a) Assume that the firm is purely equity financed. How does the firm rank the three projects? 

b) Suppose the firm carries debt maturing in the next year with face value $10m. How do equity holders rank the three projects? How do debt holders rank the three projects? 

c) Rank the three projects again if the face value of debt is $1m. 

d) What is the risk shifting problem? Comparing your findings in parts 1) and 2), briefly discuss the relation between risk shifting and the face value of debt. 

e) How does the debt overhang problem differ from the risk shifting problem?

6. ‘The senior managers and the Board of Directors do not need to worry about the dividend policy of their organizations, since it is not relevant to firms’ value.’ Evaluate this statement with references to two schools of thought regarding dividend policy. 

7. Give your views and reasons as to whether or not the London or Hong-Kong stock markets will ever become completely ‘semi-strong’ efficient as defined by the efficient market hypothesis.