Tutorial Questions

Question 1

Leverged lease vs other finance leases? What is the aim? What is the role of the parties?

Answer 1

Lessor: Finances only a proportion of the cost of the asset and borrows the remainder from one or more lenders.
Lessee: Acquires use of the asset for making regular lease payments
Broker: Organise and manage lease in return for a fixed percentage of the purchase price of the
asset.

Aim: Maximise the value of the tax savings associated with ownership of the leased asset. .

Question 2

Business risk, Financial Risk, Default Risk. Distinguish them.

Answer 2

Business Risk: Shareholders. K0. Risk inherent in a company’s operations (Depend largely on the industry)

Financial Risk: Shareholders. (K0-KD)(D/V). Additional risk exposed due to a company’s use of debt,

Default Risk: Debtholders. A borrower may fail to make the repayments that are due to lenders

(Note: Any borrowing by a company will cause financial risk, even if the risk that the borrower may default is zero)

Question 3

Would companies in same industry have similar D/E ratio? Reasons.

Answer 3

D/E similar in same industry is due to similar business risk. However, intra-industry have different D/E ratio suggest that other factors other than risk is important.

Eg: Cash inflows > pay debt. Profitable company = Lower D/E ratio than Less Profitable Company (Same industry though)

Question 4

When evaluating a new project, management requires an estimate of the project’s own cost of capital.

The WACC formula only gives a cost of capital applicable to the company as a whole and is therefore inappropriate for this purpose. Comment.

Answer 4

Marginal cost of capital = Specific investment and depends on the features (Risk and period of commitment)

WACC = risk and duration of its ‘average’ investments.

Using WACC = Ensure risk and duration are same as ‘average investments’

While the
WACC does have important limitations, it is a valid approach that is appropriate for estimating the
marginal cost of capital.

Question 5

Maintain portfolio: Need for external finance minimized because c.f. from old mine can use to fund new ones.

Also, c.f. can be smoothed by adjusting plans to fit new ones (e.g. if there are delays in bringing new mines to production, old mine life can be extended by mining not-economic old ones)

Shareholder views?

Answer 5

Maintain portfolio: Good because avoids the costs inherent
in labour redundancy and rehiring programs

However, Shareholders are interested
in the amount and timing of the company’s net cash flows, but are unlikely to benefit from mining lowgrade ore simply to smooth its cash flows (Negative NPV = Decrease shareholder wealth)

Employee and Managers: Benefit
SH: No benefits

Question 6

Are dividends are taxed at a lower rate than capital gains?

Answer 6

Depends on 3 Factors:
1.) Dividends are franked or unfranked,
2.) Capital gains before or after 12 months, 
3.) Investors are
residents or non-residents

Franked Dividends: Most will be taxed less than capital gains. Unfranked Dividends: Taxed at the same rate as short-term capital gains, while long-term capital gains will be
taxed at much lower rates.

> Resident investors will prefer that companies pay dividends only to the extent they can be franked

> Non-resident investors do not benefit directly from the dividend imputation system, (Prefer capital gains to dividends, even if
dividends were franked) This suggests a preference for low-dividend payout companies

Question 7

Likelihood of dividend payout ratio: Imputation tax system only allow 50% franked

Answer 7

Fall

Question 8

Likelihood of dividend payout ratio: Personal income (not CG) tax increased

Answer 8

Fall

Question 9

Likelihood of dividend payout ratio: No CG tax

Answer 9

Retention of profits would become more attractive and dividend payout ratios should fall

Question 10

Likelihood of dividend payout ratio: Interest Rates increase

Answer 10

Profits would be expected to fall, but dividends are likely to be maintained so that payout
ratios would increase

Question 11

Likelihood of dividend payout ratio: Company profitability increase

Answer 11

Dividends are likely to be increased, but the rate of increase would generally be lower than the rate of increase in profits. Therefore, dividend payout ratios would fall.

Question 12

Likelihood of dividend payout ratio: Increase cost of shares issues

Answer 12

The higher costs of raising capital by issuing shares would make retention of profits more
attractive. Therefore, dividend payout ratios would be expected to fall.

Question 13

Some companies have investment opportunities well in excess of the earnings available to finance them but they still insist on paying dividends. Why?

Answer 13

Managers are reluctant to reduce dividends.

Possible reasons are the
existence of dividend clienteles, the adverse information content of a reduction in dividends, and
the desire to transfer tax credits to shareholders as quickly as possible

Question 14

The imputation system encourages payment of high dividends. Companies that do so may be left short of cash. Comment on this statement,

Answer 14

The problem of running short of cash can be overcome by introducing a dividend reinvestment
plan. In this way, the twin objectives of distributing franking credits to resident shareholders and retaining cash in the company are achieved

Question 15

Weaknesses of sensitivity analysis.

Answer 15

(a) frequently, it is difficult to specify precisely the relationship between a particular variable and net present value;
(b) estimates of variables are not independent over time in that an unexpected change in a variable. In one period may have implications for the reliability of estimates of other variables in that period and that variable in later periods; and
(c) it can be difficult to specify the distribution of values that a variable might take – which is
implicitly what is required for an analyst to arrive at their “optimistic” and “pessimistic”
values.

Question 16

“Break-even analysis provides a simple and logical decision tool for managers. All they have to do is concentrate their attention on the variable for which the smallest percentage change in value will yield NPV equal to zero”. Do you agree with this statement? Provide reasons.

Answer 16

Having determined the change necessary to induce a zero net present value, the next question the manager must ask is “which change is most likely to occur?”

It is a mistake to simply concentrate on
the variable that requires the smallest change to induce a zero net present value, as this change might be much less likely than a larger change by another variable that also induces a zero net present value.

Question 17

Explain what Dixit and Pindyck (1995) mean when they say managers should require more than just positive NPV from a project.

Answer 17

The point is made in reference to the fact that by exercising the decision to invest, the manager is “killing”the time-value associated with the option.

Hence, the net present value of immediate commencement of the project needs to also compensate the manager for the loss of the option / flexibility to invest at a later date.

HIGHER HURDLE RATE

Question 18

Explain how the notion of real options may explain why we observe that exporters are slow to cease supplying overseas markets following adverse changes in exchange rates

Answer 18

By removing yourself from a market, you are giving up the option to continue operations if economic circumstances change. It could have meant the irreversible loss of tangible and intangible assets that you used to build your operation in that export market if you decide to withdraw too early from that
export market.

Question 19

What type of option is an option to expand operations? In what situation might an option to expand operations be rationally exercised early?

Answer 19

A call option gives the holder the right but not the obligation to buy an asset at a predetermined exercise price on or before a specified date. The option to expand gives the firm the right but not the obligation
to expand the project (buy expected incremental cash flows) at a later date at a specified price (cost of
expansion).

You may exercise an option to expand early if you believed that by not exercising you were
missing out on some cash flows associated with the project. This is analogous to exercising a call option
early on a dividend-paying stock.

Question 20

There is no reason for on acquiring company to prefer a cosh bid to a shore exchange or vice versa. Discuss this statement.

Answer 20

The statement is false.

Cash: Net cost is fixed, in the
sense that it depends only on the amount of the cash consideration and on the value of the target as an independent entity.
Share exchange bid: Net cost depends on the gain associated with the takeover and on the distribution of the gain between the two companies’ shareholders.
This means that the net cost depends on the price of the acquiring company’s shares after the bid has been announced.

Other factors that may be important include:
Availability of Cash
Dilution of ownership
Effect on Capital Structure

Question 21

What are the benefits and costs associated with having the Australian Competition and Consumer Commission (ACCC) involved with the market for corporate control? Give an example of where the ACCC has not permitted an acquisition to proceed and outline its reasons for doing so.

Answer 21

Cost: Hinder the efficient allocation of resources by allowing firms
that are underutilising (or wasting) resources to continue to operate, rather than be acquired by firms that are better able to utilise the assets in place.

Benefit: Acquirer has fewer incentives to
operate efficiently, given that it already has substantial market power that is undiminished by the threat of competition (If there is no ACCC)

Question 22

Takeover activity tends to vary significantly over time. Outline the factors that may explain this variation

Answer 22

1. ) Share Prices. Reflects optimist outlook for investments..
2. ) Economic shocks that affect particular industries, and are often followed by industry re-structuring.
3. ) Other factors such as changes in legislative controls and foreign investment regulations may also be relevant.

Question 23

Company can reduce risk via. takeover. Do you agree with this statement? Is
it a justifiable reason for a takeover?

Answer 23

A company can reduce its total risk by a takeover, but the systematic risk of the combined company will simply be an average of the systematic risks of the two individual companies.

In general,
investors can diversify easily in their own portfolios by purchasing the shares of companies that operate in different industries. Therefore, a takeover by a company does not offer any risk reduction benefits that were not previously available to investors.

However, there may be cases where diversification by a (typically private or family-controlled) company is of value, because
there are barriers that prevent its shareholders diversifying directly.

Question 24

A company with accumulated tax losses is necessarily a valuable takeover proposition. Discuss this statement.

Answer 24

A takeover of a company with accumulated losses can be valuable, provided that the acquiring company can use the tax losses (2 Tests)

However, it should be noted that for Australian-owned companies, the benefits associated with reducing company tax by using accumulated tax losses (or by using other means) are likely to be small under the imputation tax system.

Question 25

What are some of the reasons for corporate restructuring?

Answer 25

AT SMNC (AT So Many New Cars)

Question 26

What do the following forms of corporate restructuring mean: divestiture, spin-off, equity carve-out,
and leveraged buyout? What is the empirical evidence with respect to the value creation of these forms
of restructuring?

Answer 26

(a) DIVESTITURES: The sale of assets (segment of the business) to a third party. It can be through a trade sale or through an IPO. They are “voluntary” decisions by management and the expectation
is that it is a positive net present value strategy. Empirical evidence appears to suggest that the market views it favourably.

(b) SPIN-OFFS: Usually a subsidiary is established as a separate listed entity. All the shares owned by the parent are distributed pro-rata to their shareholders. For companies with multiple lines of business it will mitigate cross-subsidization concerns. Empirical evidence appears to show a
significant positive response to announcements of spin-offs.

(c) EQUITY CARVE-OUTS: IPO of part of a parent company assets and operations. A minority stake is sold in the new company to the public. The funds received are retained by the company. The empirical evidence seems to suggest a small positive announcement period return and
benchmark returns in the 3-year post period.

(d) LBO: When a small group of investors purchase a company by using a high proportion of debt If these investors are institutional, it is a leveraged buyout (LBO). The public company is de-listed
from the exchange (goes private).

Question 27

What are the central differences between a spin-off and an equity carve-out?

Answer 27

Spin-Off: 100% of shares in the new entity are held by shareholders and no shares are retained by the parent company. Also, all the shares are distributed pro-rata to the existing shareholders of the parent company.

ECO: Only a minority portion of the new entity is own by shareholders with the
rest being retained by the parent company. Also, the parcel of shares issued and owned by the shareholders in the new entity is sold directly into the markets for cash that is received by the parent. There is no pro-rata distribution of shares.

Question 28

Why factors might companies consider in electing whether to engage in a spin-off or an equity carve-out?

Answer 28

Equity carve-outs maybe used in situations in which the parent company have more difficulty in obtaining financing from conventional sources such as debt and new stock issues. Carve-out permits the parent company to get capital to pursue their investment and/or acquisition program.

Other possible reasons are that they are used to showcase the subsidiaries to prospective future buyers as part of a two-stage process. By not selling off 100% of the shares, it permits the parent to
benefit from the potential upside when the market realizes the true value of the subsidiary in the
second stage of the selling process.