This is the intellectual property of Dr Pia Helbing. Do not disseminate without prior permission.

Corporate Finance
Seminar 3, Week 9
Dr Pia Helbing
Class Questions

1. Question

As the financial manager of an unlisted manufacturing company based in Amsterdam, you have been
asked to help prepare the firm for a potential listing on Euronext. The company is closely held with
only five shareholders, each owning 20 per cent of the company’s shares. The shareholders are all
directors of the firm and they make up the board of directors. Because of the company’s ownership
structure, there has been no previous consideration of corporate governance issues.

The share listing will result in the total directors’ shareholding falling to 20 per cent of the total. The
remaining 80 per cent will be owned by external shareholders (mainly banks and financial institutions).
However, the five directors do not wish to relinquish control of the firm.

The company is considering a proposal to relocate to London or Shanghai and seek a listing in one of
these locations as an alternative to Amsterdam.

a) Explain how the board can maintain control whilst only holding 20 per cent of the issued share
capital.
b) Explain the changes that may be required for the current board structure.

2. Question

Historically Full Charge Corporation had been a significant player in the market for battery production.
Despite strong and steady profitability in recent years, Full Charge’s share price had been relatively
stagnant at around $25 per share. Brian (CEO) felt that this was in part due to the financial policies
followed by his predecessor, which he viewed as overly conservative. Full Charge Corporation have
historically been 100% equity financed with no debt in the capital structure. Full Charge Corporation
are active in the production of a technology that will help reduce environmentally harmful emissions
and thus they benefit from a major tax break. More specifically, they pay zero corporation tax.

Brian proposed that Full Charge make a significant change to its capital structure. He proposed that
the company buy back $500m of its outstanding shares using cash raised by issuing new debt. He
estimated that the cost of this debt would be around 4% based on prevailing market yields on the debt
of firms with similar levels of credit quality.

His accounting department prepared the following basic set of pro forma financial statements for the
coming year (for the all equity-financed firm)

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 This is the intellectual property of Dr Pia Helbing. Do not disseminate without prior permission.

Income Statement
Revenue 1500
Operating Expenses 1375
Operating Profit 125
Net Income 125

Dividends 125
Shares Outstanding 62.5
Dividends Per Share 2
Balance Sheet
Current Assets 450
Fixed Assets 550
Total Assets 1000
Total Debt 0
Total Equity 1000
Total Capital 1000

Inflation was currently running at close to zero. Revenue and operating expenses were thus projected
to remain at the same amount per year indefinitely. Brian observed that the company’s equity beta
was around 0.8 whilst the market risk premium was around 5%. He estimated the current cost of
equity of the no-debt firm as 8%. On the basis of an estimated cost of debt of 4%, Brian argued that
any increase in debt would lead to a lowering of the company’s capital cost. The CFO, Amanda,
expressed some concerns about the restructuring. Firstly, she asserted that the proposed action might
boost EPS (EPS= Dividend per Share), however adding debt to the capital structure would magnify the
sensitivity of EPS to changes in operating profit. Furthermore, she expressed doubt as to whether or
not the restructuring would have a positive share price impact.

Required:

Provide some financial analysis to help support Amanda’s line of reasoning. (For ease of exposition,
assume that there are neither distress costs nor signalling value associated with capital structure
decisions).

3. Question

The current exchange rate is $1.60/$and the nominal one-year interest rate is 7.12% per year in
sterling and 5.58% in dollars. UK inflation is 4.0% per year and US inflation is 2.5%.

a) What is the one-year forward exchange rate? Explain why.

b) What is the real dollar interest rate? If it fell to 1.0% per year, would this imply a cheaper cost of
debt for (i) a borrower in dollars, and (ii) a borrower in sterling through borrowing in dollars and
exchanging into sterling? Calculate the nominal interest rate in each case, assuming for (ii) that the
spot exchange rate stays at $1.60/$.

c) Suppose that UK inflation falls to 2.0% per year and that the real rate of interest stays the same.
The US interest rate and inflation are unchanged. Explain the possible impact of this on the spot and
forward exchange rates.

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4. Question

You are a shareholder of Smart Tech, a company that is planning to raise new equity. The stock is
trading at $15 per share, and there are 1 million shares outstanding. The firm issues 500,000 rights to
buy additional shares at $10 per share to its existing shareholders.

a) What is the expected stock price after the rights are exercised?
b) If the rights are traded, what is the price per right?
c) As a shareholder, would you be concerned about the dilution effect lowering your stock price?
Why or why not?
5. Question

Assume that Small Tech has net income of $1mn and that the earnings will increase in proportion with
the additional capital raised.

a) Estimate the earning per share that Small Tech will have after the rights issue described in the
last problem.
b) Assume that Small Tech could have raised the capital by issuing 333,333 shares at the
prevailing market price of $15 per share (thus raising the same amount of equity as was raised
in the rights issue) to the public. Estimate the earnings per share that Small Tech would have
had with this alternative.
c) As a shareholder, are you concerned about the fact that the rights issue results in lower
earnings per share than the general subscription offering (described in b)

6. Question

Cracker Barrel, which operates restaurants and gift stores, is re-examining its policy of paying minimal
dividends. Cracker Barrel reported net income of $66mn; it had capital expenditures of $150mn in
that year and claimed depreciation of only $50mn. The working capital in 2021 was $43mn on sales of
$783mn. Looking forward, Cracker Barrel expects the following:

 Net income is expected to grow 17% a year for the next five years.
 During the five years, capital expenditures are expected to grow 10% a year, and depreciation
is expected to grow 15% a year.
 The working capital as a percentage of revenues is expected to remain at 2021 levels, and
revenues are expected to grow 10% a year during the period.
a) Estimate how much cash Cracker Barrel would have available to pay out to its shareholders
over the next five years.
b) How would your answer change if the firm plans to increase its leverage by borrowing 25% of
its net capital expenditure and working capital needs?
c) Assume that Cracker Barrel wants to continue with its policy of not paying dividends. You are
the CEO of Cracker Barrel and have been confronted by dissident shareholders, demanding to
know why you are not payout out your FCFE (from previous estimation) to your shareholders.
How would you defend your decision? How receptive will shareholders be to your defence?
Would it make any difference that Cracker Barrel has earned a return of equity 25% over the
previous five years and that its beta is only 1.2?

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 This is the intellectual property of Dr Pia Helbing. Do not disseminate without prior permission.

7. Question

MVP, a manufacturing firm with no debt outstanding and a market value of $100mn, is considering
borrowing $40mn and buying back stock. Assuming that the interest rate on the debt Is 9% and that
the firm faces a tax rate of 35%, answer the following questions:

a) Estimate the annual interest tax savings each year from debt.
b) Estimate the PV of interest tax savings, assuming that the debt change is permanent.
c) Estimate the PV of interest tax savings, assuming that the debt will be taken on for 10 years
only.
d) What will happen to the PV of interest tax savings if interest rates drop tomorrow to 7% but
the debt itself is fixed rate debt?

8. Question

You have been asked to calculate the debt ratio for a firm that has the following components to its
financing mix:

 The firm has 1 mn shares outstanding, trading at $50 per share

Estimate the debt ratio for this firm.

9. Question

Discuss issues a financial analyst can encounter when calculating free cash flows (FCF). Explain how
dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE.
In your answer use theories and examples where appropriate.

10. Question

Drawing on relevant academic literature and recent corporate practice, discuss why firms rely heavily
on internal funds. In your essay, discuss the advantages and disadvantages of relying on internal funds.
Explain what different theories on the capital structure would argue. Finally, outline its implications
for a company’s capital structure across the life cycle of a firm and external factors.

11. Question

In recent years, top managers have been given large packages of options, giving them the right to buy
stock in the firm at a fixed price. Will these compensation schemes make managers more responsive
to shareholders? Why or why not? Are lenders to the firm affected by these compensation schemes?