Singapore Management University

FNCE201 Corporate Finance

Term 1 2019/20
Practice Questions 8 (Payout 2)

1. Iota Industries is an all-equity firm with 50 million shares outstanding. Iota has $200
million in cash and expects future free cash flows of $75 million per year. Management
plans to use the cash to expand the firm’s operations, which in turn will increase
future free cash flows by 12%. Iota’s cost of capital is 10% and assume that capital
markets are perfect.

(a) What is the value of Iota if they use the $200 million to expand?

Solution:

75(1.12)
Value = = $840 million
0.1

(b) What is the value of Iota if they do not use the $200 million to expand and hold
the cash instead?

Solution:
75
Value = + 200= $950 million
0.1

(c) What is the price per share of Iota if they use the $200 million to expand?

Solution:

75(1.12) 840
Value = = $840 million, Price per share = = $16.80
0.1 50

(d) What is the price per share of Iota if they decide not to use the $200 million to
expand and hold the cash instead?

Solution:
75 950
Value = + 200= $950 million, Price per share = = $19.00
0.1 50
(e) What is the NPV of Iota’s expansion project?

Solution:
(84 − 75)
NPV = −200 + = −$110 million
0.1

(f) A member of Iota’s board of directors suggests that Iota’s stock price would be
higher if they used the $200 million to repurchase shares instead of funding the
expansion. If you were advising the board, what course of action would you
recommend, expansion or repurchase? Which provides the higher stock price?

Solution:

Value with expansion:

75(1.12)
Value = = $840 million
0.1
840
Price per share = = $16.80
50
Value with repurchase:
Since capital markets are perfect, the stock price with the repurchase will be
the same as the stock price before the repurchase takes place:
75
Value = + 200= $950 million
0.1
950
Price per share = = $19.00
50
Another way to show that the expansion is a bad idea is to calculate the
NPV of the project:
(84 − 75)(1.12)
NPV = −200 + = −$110 million
0.1
You should recommend that they use the cash for a share repurchase.

(g) Suppose that Iota is able to invest the $200 million in excess cash into a project
that will increase future free cash flows by 30%. If you were advising the board,
what course of action would you recommend: investing the $200 million in an
expansion project that will raise future free cash flows by 30% or use the $200
million to repurchase shares? Which option results in a higher stock price?

Solution:

Value with expansion:

75(1.30)
Value = = $975 million
0.10
840
Price per share = = $19.50
50

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 Value with repurchase.
Since capital markets are perfect, the stock price with the repurchase will be
the same as the stock price before the repurchase takes place):
75
Value = + 200= $950 million
0.1
950
Price per share = = $19.00
50
Another way to show that the expansion is a bad idea is to calculate the
NPV of the project:
(97.5 − 75)
NPV = −200 + =$25 million
0.1
You should recommend that they invest in the expansion project that offers
the 30% increase in FCF.

2. Berkshire Hathaway’s A shares are trading at $120,000. What split ratio would it
need to bring its stock price down to $50?

Solution:
$120,000 per old share/$50 per new share = 2400 new shares/old share. A 2400:1
split would be required.

3. AMC Corporation currently has an enterprise value of $400 million and $100 million
in excess cash. The firm has 10 million shares outstanding and no debt. Suppose
AMC uses its excess cash to repurchase shares. After the share repurchase, news
will come out that will change AMC’s enterprise value to either $600 million or $200
million.

(a) What is AMC’s share price prior to the share repurchase?

Solution:
Since Enterprise Value (EV) = Equity + Debt – Cash
Equity = EV + Cash = $500 million.
Share price=($500 million)/(10 million shares)=$50 per share.

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(b) What is AMC’s share price after the repurchase if its enterprise value goes up?
What is AMC’s share price after the repurchase if its enterprise value declines?

Solution:
AMC repurchases $100 million/($50 per share)=2 million shares.
With 8 million remaining shares outstanding, its share price if its EV goes
up to $600 million is $600/8=$75 per share. And if EV goes down to $200
million, its share price is $200/8=$25 per share.

(c) Suppose AMC waits until after the news comes out to do the share repurchase.
What is AMC’s share price after the repurchase if its enterprise value goes up?
What is AMC’s share price after the repurchase if its enterprise value declines?

Solution:
If EV rises to $600 million prior to repurchase, given its $100 million in
cash and 10 million shares outstanding, AMC’s share price will rise to
(600+100)/10=$70 per share.
If EV falls to $200 million: Share price=(200+100)/10=$30 per share. The
share price after the repurchase will be also be $70 or $30, since the share
repurchase itself does not change the stock price.

(d) Suppose AMC management expects good news to come out. Based on your
answers to parts (b) and (c), if management desires to maximize AMC’s ultimate
share price, will they undertake the repurchase before or after the news comes
out? When would management undertake the repurchase if they expect bad
news to come out?

Solution:
If management expects good news to come out, they would prefer to do the
repurchase first, so that the stock price would rise to $75 rather than $70.
On the other hand, if they expect bad news to come out, they would prefer
to do the repurchase after the news comes out, for a stock price of $30 rather
than $25.

(e) Given your answer to part (d), what effect would you expect an announcement
of a share repurchase to have on the stock price? Why?

Solution:
Based on (d), we expect managers to do a share repurchase before good
news comes out and after any bad news has already come out. Therefore,
if investors believe managers are better informed about the firm’s future
prospects, and that they are timing their share repurchases accordingly, a
share repurchase announcement would lead to an increase in the stock price.

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4. Venture Corporation is deciding how much it should pay out to its stockholders. It
has $100 million in investible funds and has the following information to base its
decision upon.

• It has 100 million shares outstanding with each share selling for $15. The beta
of its stock is 1.25 and the risk-free rate is 8%. The expected return on the
market is 16%.
• Venture has $500 million of debt outstanding and the marginal interest rate on
the debt is 12%.
• The corporate tax rate is 50%.
• The equity risk premium is 5.5%.
• Venture has the following investment projects:

Project Investment Requirement($m) After-tax ROC(%)

A 15 27
B 10 20
C 25 16
D 20 14
E 30 12

Venture plans to finance all its investment needs at its current debt ratio.

Should Venture return money to its stockholders and how much should it return?

Solution:
After-tax cost of debt = 12%(1 − 0.5) = 6%
Cost of equity = 0.08 + 1.25(0.055) = 14.875%
Market value of debt = $500m.
Market value of equity = 15(100m) = $1500 m.
WACC = (500/2000)(6%) + (1500/2000)(14.875%) = 12.656%
All projects except E have W ACC > ROC. Therefore the capital needed for
investment is $70m.
However, 25% (current debt ratio =$500/$2000) of the capital needed will come
from debt issues.
Hence Venture’s FCFE = 100 − (0.75)(70) = $47.5m, which it should return to
shareholders. However, the firm should also look at estimates of future investment
needs and future cash flows.

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5. Crosslinks is faced with the decision of how much to pay out as dividends to its
stockholders. It expects to have a net income of $1,000 (after depreciation of $500),
and it has the following projects:

Project Initial Beta IRR

Investment (to equity
($m) investors) (%)
A 500 2.0 21
B 600 1.5 20
C 500 1.0 12

Crosslink’s beta is 1.5, the current risk-free rate is 6%, and the market risk premium
estimate is 5.5%. The firm plans to finance net capital expenditures (Cap Ex −
Depreciation) and working capital with a 20% debt ratio. The firm also has current
revenues of $5,000, which it expects to grow at 8%. Working capital will be main-
tained at 25% of revenues. How much should the firm return to its stockholders as a
dividend?

Solution:

Project IRR(to equity investor) Beta Cost of Equity

A 21% 2.0 0.17
B 20% 1.5 0.1425
C 12% 1 0.115

The cost of equity is computed using the CAPM.

Accept all three projects since IRR > Cost of Equity. The total capital expendi-
tures is therefore equal to $1,600.

Estimated FCFE next year is equal to:

F CF E =N I − (Capex − Depreciation + ∆N W C)(1 − δ)

= 1000 − (1600 − 500 + 100)(1 − 0.2) = $40

The firm should pay out a dividend of $40.

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6. Victon reported net income of $10 million in the most recent year, while making
$25 million in capital expenditures (depreciation was $5 million). The firm had no
working capital needs and uses no debt.

(a) Can the firm afford to pay out dividends now?

Solution:

No. Its FCFE is negative : FCFE = 10 − (25 − 5) = −$10million

(b) Assuming net income grows 40% a year and that net capital expenditures grow
10% a year, when will Victon be in a position to pay dividends?

Solution:

Current 1 2 3 4 5
Net Income $10 $14 $19.60 $27.44 $38.42 $53.78
−(Capex−Depreciation) $20 $22 $24.20 $26.62 $29.28 $32.21
=FCFE <0 <0 <0 >0 >0 >0

Victon will have positive FCFE by year 3, after which it can start paying
dividends.

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