“Paper Order or Assignment Requirements
Q1.
A)
Company X and Company Z are in the same line of business and have identical business risk. The shares in Company X are currently quoted at 3.84 each and those in Company Z at 4.30. Company X has 7.5 million shares in issue and Company Z has 3.5 million shares.
Company X is considering making a takeover offer for Company Z and believes that the takeover would enable the combined entity to make savings of 1.4 million per annum in perpetuity; these are assumed to come from economies of scale.
The risk free rate of return is 6% per annum and the market risk premium is 4% per annum. Company X has an Equity Beta of 1.4 and both companies are all Equity financed.
Required
a) Identify and explain any two possible reasons why economies of scale might arise as the result of a company taking over another company which is in the same line of business.
(4 marks)
b) Calculate (using the Capital Assets Pricing Model) the cost of capital to be used by Company X and calculate the Net Present Value of the anticipated economies of scale.
(4 marks)
The Directors of Company X are considering making a cash offer to the existing shareholders of Company Z. The basis of the offer would share the Net Present Value of the Economies of Scale in proportion to the current Market Valuation of the two companies. (This should be rounded to 2 decimal places).
c) Calculate the amount per share to be offered to the Company Z shareholders if a cash offer is made.
(4 marks)
d) Discuss the relative advantages and disadvantages of a cash offer as opposed to any one other method of financing the takeover offer from the point of view of a shareholder in Company X.
(3 marks)
B)
Company T is currently financed entirely by equity. It has an equity beta of 1.0 and has 5 million shares in issue with a market price of 12 each. The company generates a consistent cash profit of 9 million per year before interest and taxation. This annual cash profit is expected to continue in perpetuity.
Company T plans to expand by acquiring another company with identical business risk and that generates a consistent cash profit of 1.2 million per year before interest and taxation. This annual cash profit is expected to continue in perpetuity. The acquisition will cost 8 million and will be funded entirely by irredeemable borrowing at risk free rate of interest of 6% per year.
The rate of taxation on profits is 30%. There will be no operating economies of scale arising from the acquisition. Assume that Modigliani and Millers with tax view of capital structure holds.
Required
a) Calculate the following for both before the expansion and after the expansion:
1) The market value of Company T in total and split by equity and debt
2) The return on equity of Company T
3) The Weighted Average Cost of Capital (WACC) of Company T
b) Explain why there is a difference between the weighted average cost of capital (WACC) of Company T before the expansion and after the expansion.
Q2.
Company X and Company Y have each just paid their annual dividend.
Company X plans to pay an annual dividend of 0.50 per share in perpetuity commencing in one years time. Company Y plans to pay a dividend of 0.20 per share in one years time but its annual dividend will then grow by 5% per year in perpetuity. The cost of capital of both companies is 10% per year.
Required
a) Calculate the market price per share today of 1) Company X and 2) Company Y
b) Explain why market price per share today of Company X is different to that of Company Y.
Q3.
Shares in Helvetica plc have a current market price of 227p each. An investor believes that in one years time the share price will either be 261p or 193p. He believes that an increase in the share price is more likely that a fall in the share price but does not know the probability of these events. He wishes to buy a European Call option which is available today with a strike price of 234p and is exercisable in one years time. The interest rate for both borrowing and lending is 8% per annum.
Required
a) Using the Binomial Option Pricing Model and assuming that the market is pricing the Options according to the principle of risk neutrality calculate the fee that the investor would be prepared to pay to acquire a Call Option on 1 share of Helvetica Plc.
(8 marks)
b) Assuming the Put-Call parity calculate the fee you would expect to pay for a Put Option in the same asset.
(5 marks)
Q4
GreenBerg Plc is a firm which is based in the UK and its reporting currency is Sterling. The company is expecting a receipt of US$23m in 6 months. The current date is 10th January 20X5 and the receipt is due on 25th July 20X5. The current Spot rate of Exchange is $1.5435 is equal to 1.00. The current rate of Interest on US$ deposits and borrowing is equal to 4% p.a. and the equivalent rates in the UK Sterling are 5% p.a. The firm has access to all of the following options;
Forward contracts quoted by it bank
The ability to set up a money market hedge
Futures contracts quoted on the CME.
The forwards rate quoted by the bank is equal to 1.5300 for the term matching exactly the timing of the receipt.
The futures market (CME) has September delivery contracts which delivered on 15th September currently has a buy and sell price of 1.5337 which is a market efficient price.
As of 25th July 20X5 the current Spot rate of exchange between the US$ and the UK Sterling is equal to 1.6328. The rate for September Delivery has moved to 1.6302 for both buy and sell contracts.
Required;
1.Demonstrate using appropriate calculations the amount of income which the firm secure using the forward rate quoted by the bank?
(4 Marks)
2.Demonstrate the amount of income which the firm will secure using the money market hedge?
(6 Marks)
3.Demonstrate using the appropriate calculations how much income the firm will secure using the Futures Contracts?
(8 Marks)
4. Compare and contrast the different mechanisms you have calculated in terms of strengths and weaknesses risks which still exist etc. and any other relevant comments?
(10 Marks)
Formulae
SIMPLE INTEREST F = P(1 + nr)
COMPOUND INTEREST F = P(1 + r)n
ANNUITY P = A x r n
PERPETUITY P = A
r
PRESENT VALUE P = F
(1 + r)n
ESTIMATED INTERNAL RATE OF RETURN r = r1 + N1 x (r2 r1)
N1 N2
THE CAPITAL ASSET PRICING MODEL
GORDON GROWTH MODEL
AVERAGE GROWTH RATE
PUT-CALL PARITY FORMULA
FISHERS CLOSED HYPOTHESIS iA iB= A B
1 + iB 1 + B
INTEREST RATE PARITY iA iB= f0 s0
1 + iB s0
FISHERS OPEN HYPOTHESIS iA iB= et s0
1 + iB s0
PURCHASING POWER PARITY A B= et s0
1 + B s0
EXPECTATION THEORY f0 s0= et s0
s0 s0
“
