SECTION A. Multiple-Choice Questions (2 marks * 5 = 10 Marks)

A1

Which of the following statements is correct regarding a firm’s capital structure?

a)   If the firm is operating under a pure imputation system, there are no tax benefits associated with debt.

b)   Asset substitution refers to the case whereby when the firm is in financial distress, debt holders tend to invest in risky projects at the expense of shareholders.

c)   The expected bankruptcy costs caused resulting from too much debt are borne by debt holders only.

d)   More than one of the other statements is correct regarding a firm’s capital structure.

e)   None of the other statements is correct regarding a firm’s capital structure.

A2

Which of the following statements accurately describes difference(s) between paying special dividends and paying ordinary dividends?

(a) Special dividends can only be used to pass on imputation credits to shareholders.

(b) The payment of special dividends generally does not create an expectation by shareholders that the firm will continue to pay the same special dividend in    subsequent periods.

(c) Special dividends can only to be paid to resident investors.

(d) More than one of the other statements accurately describes difference(s) between paying special dividends and paying ordinary dividends.

(e) None of the other statements accurately describes difference(s) between paying special dividends and paying ordinary dividends.

A3

Which of the following statements is correct regarding share buybacks?

a)   An on-market share buyback is beneficial to superannuation funds and low-income earners due to the large tax benefits associated with franked dividends and capital  gains.

b)   TD 2004/22 is only relevant for off-market share buybacks.

c)   Empirical evidence suggests that share buybacks tend to be used by firms to distribute higher permanent, operating cash flows.

d)   More than one of the other statements is correct regarding share buybacks.

e)   None of the other statements is correct regarding share buybacks.

A4

Which of the following statements is correct regarding the real option to abandon a project?

a)   It is a put option with the exercise price being the salvage value of the project.

b)   It is a put option with the exercise price being the present value of future cash flows from the project.

c)   It is a put option and might be exercised early if the PV of future cash flows is sufficiently higher than the salvage value of the project.

d)   More than one of the other statements is correct regarding the real option to abandon a project.

e)   None of the other statements is correct regarding the real option to abandon a project.

A5.

Which of the following statements is correct with respect to takeover valuation methods?

a)   Terminal value, when used as part of the discounted cash flow (DCF) valuation       method, is typically calculated when the firm has matured with low growth rate and volatile future cash flows.

b)   The contingent claim valuation method is typically used to value equity as a call option in troubled firms.

c)   The discounted cash flow (DCF) valuation method is typically useful for firms with limited assets or no earnings.

d)   More than one of the other statements is correct with respect to takeover valuation methods.

e)   None of the other statements is correct with respect to takeover valuation methods.

SECTION B. True/False Questions (5 marks * 8 = 40 Marks)

•   Indicate whether each of the following 8 statements is TRUE or FALSE by selecting the appropriate answer. Provide an explanation and/or a calculation and upload them to Gradescope. Attempt ALL questions.

•   Each question is worth 5 marks for a total of 40 marks.

Answers MUST BE HANDWRITTEN and uploaded to corresponding question.

Question 1

Existing shareholders are always worse off in an equity carve-out because part ownership of the parent’s subsidiary is sold to new (outside) investors.

Question 2

Melbourne Ltd. Is a publicly listed company in Australia that pays corporate tax at rate of      30%. It is conducting an off-market share buyback under tax determination TD 2004/22. On  May 15, 2021 the company announced the buyback price to be $18.50 per share with capital  component of $6.50 and the remainder treated as a fully franked dividend. The deemed          consideration for the buyback has been determined to be $19.80 per share. Henry is an           Australian resident shareholder in Melbourne Ltd. who bought 100 shares at $14 per share on January 20, 2020. He pays tax at a marginal tax rate of 45%. When compared with selling his 100 shares on the exchange at a market price of $18.50, Henry’s after-tax proceeds are higher if he instead participates in the off-market buyback.

Question 3

The information asymmetry explanation for IPO underpricing suggests that investment banks (underwriters) typically underprice IPOs as a way to reduce their costs (due to information    asymmetry) of doing business in these markets.

Question 4

A company may engage in share buybacks due to reasons relating to signalling, financial flexibility, and employee share options.

Section C: Short Answer Questions

Question 9 (10 marks)

HPM is a mid-size iron ore mining company with operations around Australia. It has 20         million shares with current market price of $5 per share and outstanding debt with a market   value of $200 million. Its current cost of debt is 7% per annum and current equity beta is 1.5. HPM pays a statutory corporate tax at rate of 30% and shareholders on average claim 40% of the tax paid by the company. The expected market return is 11% per annum.

A typical mining lease requires HPM to rehabilitate/restore a mining site to its natural            condition after extracting has finished. As HPM has just finished extracting iron ore from      three mines around the country, it needs to spend $25 million to rehabilitate (or restore) these mining sites as per the lease agreements. HPM’s board has decided to issue $25 million in     debt to finance these rehabilitation projects. However, this new debt issue will lead to            downgrading of HPM’s debt rating from BBB (current) to B. As a result, it will also change  the firm’s cost of capital. The relevant default spreads for bonds with different ratings are      provided in the table below.

HPM’s operating activities and share price will remain unaffected by this debt issue. Given this information, conduct appropriate analysis to show the board of directors how the          company’s cost of capital will be affected. Show all workings.

Question 10 (3 + 5 + 3 + 2 = 13 marks)

Smarts Inc. is a leader in developing AI based solutions for businesses. It is currently evaluating the  opportunity to  develop  a  software  system that would utilize both blockchain  and AI technologies simultaneously. The initial investment required to develop this software is $5 million and the software will be ready in one year’s time. If the software system performs well (and results in high demand from businesses), Smarts anticipates that it will generate net cash flows of $2 million per year (starting one year from now) over the next ten years. However, if the system’s performance only leads to low demand from customers, it will generate net cash flows of $500,000 per year over the next ten years. Due to the novel nature of the software, the likelihood of demand being high is only 30% and the appropriate cost of capital for Smarts is 10% per annum.

The NT government is keen for Smarts’ development team to be based in Darwin as it would like to promote Darwin (and NT) as an IT and software hub.   It is therefore offering the company the ability to exit the operation at the end of the first year – the government will buy the entire project (code, computers etc.) for $3 million.

a.   Draw the decision tree relating to this project.

b.   Calculate the net present value for the project with the option to exit. If Smarts took the project, would it exercise the option after the commencement of the project? Why or why not? Show all workings.

c.   Using the approach discussed in the lecture, calculate the value of the real option that is being offered by the NT government? Show all workings.

d.   Suppose that everything in the above example remains the same except that the NT government is offering to buy the entire project for $2 million at the end of the first year. What is the value now of the option to exit the project at the end of the first year? Explain this result from the viewpoint of the drivers of option values.

Question 11 (3 + 3 + 6 + 3 = 15 marks)

Black Inc. (BI) has recently announced its intention to acquire White Inc. (WI). Information about the two companies’ relevant share prices and shares outstanding is provided below:

BI has  also  determined the  following  cash  flows will  occur  as  a result  of the proposed acquisition.

•    One-off integration costs of $2 million per year will be incurred at the beginning of the first two years.

•    The combined businesses will increase the net cash flows by $2.5 million per year in perpetuity , with these cash flows starting 2 years from now.

•    Elimination of duplicate back-office roles such as HR, OHS etc. will result in net savings of $3 million per year for four years, starting two years from now.

Assuming that the acquisition occurred immediately and that the appropriate opportunity cost of capital is 10% per annum, answer the following questions.

(a)  What is the gain from the acquisition? Show all workings.

(b)  BI’s chairman is considering splitting the gain 60-40 (that is 60% to BI, 40% to WI)

between the two sets of shareholders. Calculate the offer price BI would need offer to WI shareholders (using cash) on a per share basis to achieve this objective. Show all workings.

(c)  BI’s chairman is also interested in making a stock offer for all of WI shares. What is the  maximum  exchange  ratio  that  BI  can  offer  to  WI’s  shareholders  before  BI shareholders start to suffer a loss on the deal? Show all workings.

(d)  BI’s chairman finally decided to offer 33 % of the ownership of the merged firm to WI’s shareholders. Given this offer, calculate the proportion of synergies from the takeover retained by BI’s shareholders. Show all workings.