CGA-CANADA ADVANCED CORPORATE FINANCE [FN2] EXAMINATION June 2011 Marks Notes: 1. Questions 1 and 2 are multiple choice. For these questions, select the best answer for each of the unrelated items. Answer each of these items in your examination booklet by giving the number of your choice. For example, if the best answer for item (a) is (1), write (a)(1) in your examination booklet. If more than one answer is given for an item, that item will not be marked. Incorrect answers will be marked as zero.
Marks will not be awarded for explanations. Except for multiple-choice questions, answers should include all supporting calculations where appropriate. If you provide alternative answers to Questions 3, 4, 5, or 6, only the first answer will be marked. If you wish to change your answer, you must cross out the answer you do not wish to submit for marking. Time: 4 Hours 2. 3. 12 Question 1 Note: 2 marks each a. Which of the following is least likely to increase market efficiency? 1) Governments relax restrictions on foreign investment. ) Corporations disseminate more information to investors. 3) More new investors choose to invest in individual stocks on their own rather than invest in mutual funds. 4) More stock transactions are conducted online than on the floor of an exchange. b. Which of the following is the best example of ethical behaviour? 1) 2) 3) 4) c. ABC Corp. cut employees’ hours and pay without laying off anyone. Instead of depleting its retained earnings, DEF Inc. borrowed heavily to expand. JKL Ltd. used government bailout money to pay wages owed to its mployees. Executives at MBI Corp. shared their performance bonus with new employees. Which of the following represents one of the classes for cash inflows and outflows relevant to a capital budgeting decision? 1) 2) 3) 4) Terminal cash flows Sunk cost Undepreciated capital allowance Investment credit d. Which of the following statements is true about the weighted average cost of capital (WACC) method? 1) WACC can be used to evaluate projects in which the capital structure is significantly different from the firm’s overall structure. ) WACC is very efficient in evaluating the impact of special financing arrangements on projects because it determines the cash flows that can be distributed to shareholders after paying operating costs, financing costs, and debt repayments. 3) WACC explicitly calculates interest tax shields that are generated by debt securities for the financing of a project. 4) WACC adjusts for the deductibility of interest costs. Continued… EFN2J11 ©CGA-Canada, 2011 Page 1 of 7 e. Which of the following statements is true about lease financing? 1) 2) 3) 4) The term of a typical operating lease is almost equal to the useful life of the asset.
Leasing always provides the same tax breaks to the lessor and the lessee. Operating leases can avoid the risk of obsolescence. In a typical sale and leaseback arrangement, the asset is sold for its book value and is leased using a capital lease. f. Which of the following is the best alternative for a Canadian exporter that is expected to receive US dollar payments? 1) 2) 3) 4) Buy calls on US dollars Buy puts on US dollars Buy puts on Canadian dollars Sell puts on US dollars 18 Question 2 Note: 3 marks each a. BMINE Inc. has sales of $500,000 with a degree of operating leverage of 1. 5.
To increase earnings before interest and taxes (EBIT) by 10% for this year, how much sales would it require? 1) 2) 3) 4) $533,333 $550,000 $575,000 $750,000 b. What is the effective annual interest rate on a bank loan that charges 13% interest compounded semi-annually with a 9% compensating balance, with loan payments made semi-annually? 1) 2) 3) 4) c. 10. 34% 14. 29% 14. 80% 16. 67% To make a Canadian investor indifferent between investing in 1-year Canadian dollar term deposits and investing in 1-year British pound term deposits, what should the 1-year forward exchange rate of the British pound be?
Annual rate on a 1-year term deposit denominated in Canadian dollars Annual rate on a 1-year term deposit denominated in British pounds Spot rate to buy 1 British pound 1) 2) 3) 4) C$1. 3492 C$1. 4971 C$1. 5398 C$1. 7086 1. 49% 2. 93% C$1. 5183 Continued… EFN2J11 ©CGA-Canada, 2011 Page 2 of 7 d. MNO Corp. is considering either leasing or borrowing to purchase a machine costing $100,000 with a 5-year life. If the machine is purchased, MNO will be responsible for the annual pre-tax maintenance costs of $5,000. MNO’s tax rate is 30% and it is able to borrow at a 10% interest rate.
The CCA rate is 20% and the machine has no scrap value. Alternatively, a manufacturer offers to lease the machine to MNO for a 5-year term at $25,000 per year with the first lease payment due when the contract is signed. What is the equivalent loan for this lease? 1) 2) 3) 4) e. $ 43,083 $ 71,785 $ 86,073 $ 109,680 What is the average rate of return for a 5-year project costing $250,000 and generating $50,000 in annual cash flows in the first 2 years and $30,000 in the last 3 years? 1) 2) 3) 4) 15. 20% 20. 00% 30. 40% 76. 00% f. LED Inc. s issuing rights to its shareholders of record as of the close of business on Thursday, June 23, 2011. Each right entitles its holder to purchase 1 new share for $10. 00. Just after the rights offering announcement, LED shares were trading at $12. 00 per share. Without any material marketwide or firm-specific event occurring after the rights offering announcement, what will the value of 1 LED share be on June 22, 2011? 1) 2) 3) 4) $ 9. 00 $10. 00 $11. 00 $12. 00 EFN2J11 ©CGA-Canada, 2011 Page 3 of 7 15 Question 3 Gifts-R-Us Inc. (GRU) is an Ontario-based company with a national chain of gift shops.
The business is seasonal, with 50% of GRU’s sales occurring during the months of October, November, and December. Net working capital doubles throughout this high sales season. Credit sales are high, with only 25% of customers paying in cash. Sales for the year are $10,000,000. The cost of goods sold is 75% of sales, and it is not expected to change. The following is GRU’s balance sheet at November 30, 2010. EXHIBIT 3-1 GIFTS-R-US INC. Balance Sheet November 30, 2010 Assets Current assets Cash Accounts receivable Inventory $ 150,000 850,000 1,200,000 2,200,000 Liabilities Current liabilities Accounts payable Accrued expenses
Notes payable Current portion of long-term debt $ 450,000 100,000 170,000 40,000 760,000 1,400,000 2,040,000 $ 4,200,000 Capital assets Total assets Required 2 1 8 a. 2,000,000 $ 4,200,000 Long-term debt Shareholders’ equity Total liabilities and shareholders’ equity Calculate the estimated seasonal portion of net working capital. b. Indicate what policy GRU is following regarding the financing of its net working capital needs. c. Calculate the cash conversion period and the operating cycle, and explain the significance of the cash conversion period in general and in this particular case. d. The local bank has quoted the following term structure of interest rates: 3 month 1 year 3 year 5 year 7. 5% 7. 0% 6. 5% 6. 0% Identify the market’s expectation for future interest rates. Discuss one disadvantage of the financing policy that GRU is using. Recommend one alternative for GRU to avoid this disadvantage. EFN2J11 ©CGA-Canada, 2011 Page 4 of 7 15 Question 4 BC Transport Inc. (BCT) is a British Columbia-based company providing transportation services to the mining industry. It has 8 million common shares outstanding.
The market value of its debt is $400 million at an interest rate of 10%. BCT has a corporate tax rate of 40% and a levered beta of 1. 8. The risk-free rate is 5% and the stock market is expected to return 11%. BCT expects annual earnings before interest and taxes (EBIT) of $70 million forever, and it pays out all the earnings as dividends to shareholders. Observing that many companies with a high debt load have gone bankrupt during the recent financial crisis, Al, BCT’s CFO, is concerned with BCT’s market-value-based high debt-to-asset ratio.
He would like to reduce BCT’s debt-to-asset ratio to 40%, by issuing additional equity and paying off some debt. Required 5 a. Calculate the current cost of equity, value of equity, price per share, total value of BCT, and its current debt-to-asset ratio. 10 b. i) Calculate the total value of equity that BCT should issue to reduce the debt-to-asset ratio to 40%. ii) Prove that the cost of equity decreases after BCT pays off some debt. Question 5 Recent positive economic data indicates that the recession is over and that the Canadian economy will soon enter a period of growth and prosperity.
The recession made financially healthy firms stronger and weak firms weaker. In order to profit from the upcoming economic growth, strong companies have begun to expand their capacity. They are either building new plants or expanding their existing capacity by taking over weaker competitors. ABL Corp. is one of the industry leaders looking for target companies to acquire on the market. One such target, AIM Inc. , is being pursued by ABL’s main rival, LAB Inc. LAB has made a bid valuing AIM at $100,000. Senior management are seeking your advice on whether ABL should also bid on AIM.
You have projected AIM’s free cash flows and estimated other information if it is acquired as follows: Year 0 Free cash flows to the firm Outstanding long-term debt Annual capital amortization Net working capital N/A 52,500 11,300 11,000 1 $ 6,500 50,000 11,500 10,500 2 $ 6,950 47,500 12,000 11,000 3 4 5 $ 7,650 $ 8,050 $ 9,000 45,000 42,500 40,000 12,000 12,200 12,200 10,600 11,000 11,800 20 The current expected market return is 12%, and the long-term government bond rate is 6%. AIM’s debt pays 8% (effective) interest. Debt principal is repaid in equal amounts at the end of each fiscal year.
Its levered stock beta is 1. 5. The corporate income tax rate for both ABL and AIM is 40%. ABL intends to achieve a long-term debt-to-equity ratio for AIM of 40%, and plans to assume AIM’s current long-term debt. Continued… EFN2J11 ©CGA-Canada, 2011 Page 5 of 7 Required 3 a. Indicate what type of merger and acquisition this example is and identify two possible reasons for ABL to acquire AIM. 3 b. Identify the appropriate discount rate(s) for the valuation of AIM based on free cash flows to the firm (FCFF) using the APV method. c.
Determine AIM’s value including and excluding the long-term debt based on FCFF using the APV method (including debt and common shares only). Assume that debt interest applies to the previous-year long-term debt, and that residual cash flows to the firm are expected to increase at a rate of 3% per year. (Ignore any tax shield related to debt remaining after 5 years. ) 5 1 d. Calculate the appropriate discount rate(s) for the valuation of AIM using the free cash flow to equity (FCFE) method. e. AIM’s FCFE cash flows for 5 years are as follows: Year 0 Free cash flows to equity N/A 1 $1,480 2 $2,050 3 $2,870 4 $3,390 5 $4,460 Explain how these FCFE cash flows were calculated, using year 1 as an example. Show the calculation for year 1. 5 f. Determine the value of the FCFE for AIM (including both debt and common shares only), assuming that the residual cash flows to equity are expected to increase at a rate of 3% per year. Based on your valuation, explain whether ABL should also bid on AIM against LAB. EFN2J11 ©CGA-Canada, 2011 Page 6 of 7 20 Question 6 Bank of Manitoba (BM) is the banking division of a financial holding company.
A schedule of the average yields and costs on assets and liabilities of BM appears in Exhibit 6-1: EXHIBIT 6-1 Average yields and costs on assets and liabilities of BM Assets Cash Rate-sensitive Fixed-rate Equity Total Amount (in $ millions) $ 950 11,590 19,500 1,790 $ 33,830 Average Yield % 0. 0 7. 0 10. 0 N/A Liabilities Non-earning Rate-sensitive Fixed-rate Total Amount (in $ millions) $ 4,080 18,850 10,900 $ 33,830 Average Cost % 0. 0 5. 0 6. 5 As the assistant CFO of BM, you have been assigned to study the interest-rate risk facing BM. Your first step is to calculate BM’s gap by using the data in the above schedule.
Gap analysis gives a rough measure of the bank’s overall interest-rate risk. Next, you want to focus on rate-sensitive assets and liabilities. Your goal is to accurately predict the percentage change in the market value of BM’s assets for a given change in interest rates. You have already collected some data (Exhibit 6-2) on a representative portfolio of 3 bonds BM owns. EXHIBIT 6-2 Characteristics of BM’s representative bond portfolio Bond A B C Required 2 2 4 1 2 1 5 a. Calculate BM’s gap, and state the implications of such a gap. Coupon rate % 0. 0 8. 0 6. 0 Payment Frequency N/A Annual Semi-annual Maturity (Years) 10 5 2 Yield % 6. 3. 0 8. 0 Face Value $ 100 100 100 b. Assuming a 1-percentage-point rise in rates, calculate the magnitude of the bank’s risk. c. Determine the duration and price of Bond A and Bond C, respectively. d. Bond B has a duration of 4. 386 years and a price of $122. 90. Calculate the duration of the portfolio. e. f. Calculate the weighted average discount rate of the portfolio. Indicate what the effect would be on this portfolio if all interest rates go up by 1%. g. Based on your answers to parts (a) through (f), identify whether BM is exposed to the risk of an increase or a decrease in interest rates.
Altogether, BM has a $1 billion investment portfolio. Historically, the return on this portfolio follows a normal distribution pattern, with an average daily return of 0% and a standard deviation of 5. 867%. Calculate the portfolio’s value at risk (VaR) at the 90%, 95%, and 99% levels and explain the meaning of these VaRs. h. Explain how BM could use an interest rate swap and the Canadian Government Bond futures contracts traded on the Montreal Exchange to hedge against the risk you identified in part (g). 3 100 EFN2J11 ©CGA-Canada, 2011 END OF EXAMINATION Page 7 of 7
ADVANCED CORPORATE FINANCE [FN2] EXAMINATION FN2 Before starting to write the examination, make sure that it is complete and that there are no printing defects. This examination consists of 7 pages and 21 pages of attachments. There are 6 questions for a total of 100 marks. READ THE QUESTIONS CAREFULLY AND ANSWER WHAT IS ASKED. To assist you in answering the examination questions, CGA-Canada includes the following glossary of terms. Glossary of Assessment Terms Adapted from David Palmer, Study Guide: Developing Effective Study Methods (Vancouver: CGA-Canada, 1996). Copyright David Palmer.
Calculate Mathematically determine the amount or number, showing formulas used and steps taken. (Also Compute). Examine qualities or characteristics that resemble each other. Emphasize similarities, although differences may be mentioned. Compare by observing differences. Stress the dissimilarities of qualities or characteristics. (Also Distinguish between) Express your own judgment concerning the topic or viewpoint in question. Discuss both pros and cons. Clearly state the meaning of the word or term. Relate the meaning specifically to the way it is used in the subject area under discussion.
Perhaps also show how the item defined differs from items in other classes. Provide detail on the relevant characteristics, qualities, or events. Create an outcome (e. g. , a plan or program) that incorporates the relevant issues and information. Calculate or formulate a response that considers the relevant qualitative and quantitative factors. Give a drawing, chart, plan or graphic answer. Usually you should label a diagram. In some cases, add a brief explanation or description. (Also Draw) This calls for the most complete and detailed answer. Examine and analyze carefully and present both pros and cons.
To discuss briefly requires you to state in a few sentences the critical factors. This requires making an informed judgment. Your judgment must be shown to be based on knowledge and information about the subject. (Just stating your own ideas is not sufficient. ) Cite authorities. Cite advantages and limitations. In explanatory answers you must clarify the cause(s), or reasons(s). State the “how” and “why” of the subject. Give reasons for differences of opinions or of results. To explain briefly requires you to state the reasons simply, in a few words.
Identify Distinguish and specify the important issues, factors, or items, usually based on an evaluation or analysis of a scenario. Illustrate Make clear by giving an example, e. g. , a figure, diagram or concrete example. Interpret Translate, give examples of, solve, or comment on a subject, usually making a judgment on it. Justify Prove or give reasons for decisions or conclusions. List Present an itemized series or tabulation. Be concise. Point form is often acceptable. Outline This is an organized description. Give a general overview, stating main and supporting ideas.
Use headings and sub-headings, usually in point form. Omit minor details. Prove Establish that something is true by citing evidence or giving clear logical reasons. Recommend Propose an appropriate solution or course of action based on an evaluation or analysis of a scenario. Relate Show how things are connected with each other or how one causes another, correlates with another, or is like another. Review Examine a subject critically, analyzing and commenting on the important statements to be made about it. State Clearly provide a position based on an evaluation, e. g. , Agree/Disagree, Correct/Incorrect, Yes/No. Also Indicate) Summarize Give the main points or facts in condensed form, like the summary of a chapter, omitting details and illustrations. Trace In narrative form, describe progress, development, or historical events from some point of origin. Explain Compare Contrast Criticize Define Describe Design Determine Diagram Discuss Evaluate Advanced Corporate Finance [FN2] PV ? FV (1 ? i) n Present value of a future value (FV) amount n = number of periods i = rate per period FV ? PV(1? i) n Future value of a present value (PV) amount ?? ?? ?? ?? ?? ?? ?? 1 1? ?? (1? i) n PV ? PMT?? i ?? ?? ??
Present value of an ordinary annuity PMT = periodic payment ?? 1? i n ? 1?? ? ? ?? FV ? PMT?? i ?? ?? ?? ?? Future value of an ordinary annuity PMT = periodic payment PV ? C 0 ? CF1 C ? C0 ? 1 1? r 1? r Present value of an asset discounted at the lending and borrowing rate C0 = current cash flow CF1 = C1 = cash flow expected next period r = market lending/borrowing rate PV ? CF1 C ? 1 1? k 1? k Present value of an asset discounted at the cost of capital k = cost of capital NPV ? CF1 C ? C0 ? 1 ? C0 1? k 1? k Net present value of a single future cash flow C0 = cost of acquiring the asset C1 CF1 ? C 0 or ?
C0 1 ? IRR 1 ? IRR Internal rate of return for a current cash outflow followed by a single cash inflow EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 1 of 21 CCAi = C ? d ? (1 – d/2)(1 – d)i–2 CCA for year i C = capital cost d = capital cost allowance rate of the class i = year 2, 3, 4, … UCCi = C ? (1 – d/2)(1 – d)i–1 UCC at beginning of year i PV ? ? CFi Sn ? i (1? k) n i? 1 (1? k) n Present value of future incremental cash flows without tax shield formula method CFi = expected cash flows at the end of period i k = discount rate Sn = salvage value at the end of n periods PV ? ? i? 1 n Sn Fi ? PVTS i (1? k) (1? k) n Present value of future incremental cash flows separating out the present value of tax shields Fi = cash flow during period i, excluding the tax shield PVTS = present value of the tax shield ? C ? d ? T ?? 2 ? k ? PVTS ? ? ?? ? ? 2(d ? k) ? ? 1 ? k ? Present value of perpetual tax shields (half-year rule) C = capital cost d = capital cost allowance rate of the class T = tax rate ?? S ???? d ? T ?? PVTSL n ? ?? n n ???? ?? ?? (1? k) ???? d ? k ?? ?? UCC n ???? d ? T ?? PVTSL n ? ?? ???? ?? ?? (1? k) n ???? d ? k ?? Present value of lost perpetual tax shields with a continuing CCA pool
Present value of lost perpetual tax shields when terminating the asset class (excluding a recapture or terminal loss) EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 2 of 21 PV ? ? n Fi (1 ? k) i i ? 1 ? Sn (1 ? k) n ? C ? d ? T ? ? 2 ? k ? ? Sn ?? ?? ??? n ? 2(d ? k) ? ? 1 ? k ? ? (1 ? k) ? ? ? d ? T ? ?? ? ? ?d ? k ? ? Present value of future incremental cash flows using the tax shield formula method with a continuing (open) CCA pool PV ? ? n Fi (1 ? k) i i ? 1 ? ?C ? d ? T ? ?2 ? k ? ?? ?? ? n (1 ? k) ? 2(d ? k) ? ? 1 ? k ? Sn ? UCC n ?? n ? (1 ? k) ? ? ? d ? T ? ? ? UCC n ? S n ? T ? ?? ??? (1 ? k) n ? ?d ? k ? ? ? ? ? ? Present value of future incremental cash flows using the tax shield formula method when terminating the asset class (closed pool) NPV ? ? n Fi (1 ? k) i i ? 1 ? ?C ? d ? T ? ?? ? (1 ? k) ? 2(d ? k) ? Sn n ?2 ? k ? ?1 ? k ? ? ? Net present value with the present value of tax shields for a continuing CCA pool ? Sn ?? n ? (1 ? k) ? ? ? d ? T ? ?? ? ? C0 ? ?d ? k ? ? NPV ? ? n Fi k) i i ? 1 (1 ? ? ? C? d ? T ? ? 2 ? k ? ?? ?? ? n (1 ? k) ? 2(d ? k) ? ? 1 ? k ? Sn ? UCC n ? ? d ? T ? ? (UCC n ? S n )T ? ?? ? ? C0 ??? n ?? (1 ? k) n ? ? ? ? ? (1 ? k) ? ? d ? k ? ? Net present value with the present value of tax shields when terminating the asset class (closed pool) PI ? PV NPV + C 0 ? C0 C0 Profitability index ARR ? ACF Ia Average rate of return on book value ACF = average annual incremental aftertax cash flows (net income) from operations over the life of the project Ia = average book value of the investment in the project ? ? ? x P(x) all x Expected value (mean) of random variable x ? 2 ? ? (x ? ?) 2 P(x) all x Population variance of random variable x ? E(x 2 ) ? ? 2 where E(x 2 ) ? ? x 2 P(x) EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 3 of 21 xy ? ? ? ?x ? ? x ? y ? ? y P ? x, y ? all x all y ? ? Population covariance of two random variables x and y ? xy ? ? xy ? x? y Coefficient of correlation (population) R= R1 ? R 2 ? … R n n Mean of historical returns ?2 ? R ?R 1 ? R ? 2 ? ?R 2 ? R ? 2 n n ? … ? n ? R n ? R ? 2 ? 1 ? ?R n n t ? 1 1 ?R ? 2 Variance of returns where each outcome has an equal probability (population) ?2 R ?R 1 ? R ? 2 ? ?R 2 ? R ? 2 ? … ? ? R n ? R ? 2 ? ? n -1 n -1 n -1 1 n ? R1 ? R n – 1 t ? 1 ? ? 2 Variance of returns where each outcome has an equal probability (sample) RP = w1R1 + w2R2 + … + wnRn R p ? wi R i i ? 1 n Return of a portfolio based on the weighted average of the asset returns n = number of securities in the portfolio wi = weight of return i, calculated as the ratio of the amount invested in the security i divided by the total investment Ri = return on security i E? R P ? ? ? Pi R Pi i ? 1 n Expected return of a portfolio using probabilities of states of the economy i = 1, 2, … , n n = number of possible outcomes Pi = probability of outcome i RPi = portfolio return associated with outcome i ? p ? ? Pi ? R Pi ? E ? R P ?? 2 n i ? 1 2 Variance of a portfolio (population) E? R P ? ? w i E ? R i ? i ? 1 n Expected return on a portfolio using a weighted average of expected returns wi = weight of investment i in the portfolio n = number of investments in the portfolio EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 4 of 21 ? P = w12? 12 + w22? 22 + 2w1w2? 12? 1? 2 2 Variance of a two-asset portfolio ? 1 = standard deviation of investment 1 ? 2 = standard deviation of investment 2 ? 12 = correlation coefficient of investments 1 and 2 ? P 2 = ? ? ? ij w i w j ? i ? j i =1 j=1 n n Variance of an n-asset portfolio ? ij = correlation coefficient between securities i and j
E(RPi) = wiRf + (1 – wi)E(RM) Expected return on a portfolio containing a risk-free asset and the market portfolio E(RM) = expected return on the market portfolio wi = portion invested in the risk-free asset ?Pi = (1 – wi) ? M Standard deviation of a portfolio containing a risk-free asset and the market portfolio wi = portion invested in the risk-free asset ? M = standard deviation of the market portfolio E(RPi) = Rf + ? Pi [E(RM) – Rf] ? M ? iM ? ? i ? ? M ? M 2 Capital market line ?i ? Cov? R i ,R M ? ?M 2 ? Beta of an asset Cov(Ri,RM) = covariance between return on security i and market return RM
Ri,t = ai + ? iRM,t + ei,t Total security return regression estimation of beta ai = constant term ? i = beta of security i ei,t = error term EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 5 of 21 Ri,t – Rf,t = ai +? i (RM,t – Rf,t) + ei,t Security premium regression estimation of beta (characteristic line) Ri,t – Rf,t = excess return over risk-free rate (Rf) ai = constant term ? i = beta of security i ei,t = error term E(Ri) = Rf + ? i[E(RM) – Rf] Capital asset pricing model Rf = risk-free rate E(RM) = expected return on the market portfolio ? i = beta of security i ?p = w1? 1 + w2? 2 + … wn? n Weighted average of a portfolio beta wi = weight of security i in the portfolio ? i = beta of security i i = 1, 2, 3, … , n ?L = ? U + (1 – T)(D/E)? U Beta for a levered firm ? U = unlevered beta T = tax rate D = market value of debt E = market value of equity CVi ? ?i E(R i ) Coefficient of variation ? i = standard deviation of project i values E(Ri) = expected return on project i CVi ? ?i E(NPVi ) Coefficient of variation for a capital investment ? i = standard deviation of project i NPV values E(NPVi) = expected (mean) NPV of project i EAR = amount of annual interest outstanding balance
Effective annual rate/return for annual interest payments EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 6 of 21 m ?? k nom ?? EAR ? ?? 1? ?? ?1. 0 ?? m ?? Effective annual rate for interest payments more frequent than an annual basis knom = nominal or stated rate m = number of compounding periods per year EAR = k nom 1. 0 ? CB Effective annual rate for a loan with a compensating balance (annual interest payments) CB = compensating balance as a percentage of the total loan amount Face value = funds needed 1. 0 ? CB Face value needed to obtain the desired funds for a loan m ?? k nom ?? ?? ?? m EAR = ?? 1 ?? ? 1. 0 ?? 1. 0 ? CB ?? ?? ?? Effective annual rate for a loan with a compensating balance and interest payments more frequent than an annual basis EAR ? interest k nom or EAR ? face value ? interest 1. 0 ? k nom Effective annual rate (non-discounted equivalent rate) for a discounted loan with annual interest payments ?? k nom ?? m EAR ? ?? 1? k ?? 1. 0 ? nom ?? m m ?? ?? ?? ?1. 0 ?? ?? Effective annual rate for a discounted loan and interest payments more frequent than an annual basis Face value ? funds needed k 1? nom m Face value needed to obtain the desired funds for a discounted loan EAR = nom 1. 0 ? k nom ? CB Effective annual rate for loans with compensating balances, terms of one or more years, and annual interest payments Face value ? funds needed 1. 0 ? k nom ? CB Face value needed to obtain the desired funds for a discounted loan with a compensating balance (annual interest payments) EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 7 of 21 Call premium = Cy ? Nr / N Value of a call premium where the premium declines in proportion to the number of years remaining to maturity Cy = annual coupon Nr = number of years remaining to maturity N = number of years of original maturity ?? d ?
S ?? N = ?? +1 ?? D + 1?? ?? Number of shares required to elect a desired number of directors d = number of directors the minority shareholders seek to elect S = total number of shares outstanding D = total number of directors to be elected R on = Pon ? E N +1 Theoretical value of a right during the rights-on period Pon = market price of the underlying share during the rights-on period E = exercise price N = number of rights required to purchase one new share R ex = Pex ? E N Theoretical value of a right during the exrights period Pex = market price of the underlying share during the ex-rights period
Financial risk = ? L – ? U Financial risk ? L = total risk to shareholders of the levered firm as measured by the standard deviation of returns (or profits) ? U = total risk to shareholders of the unlevered firm as measured by the standard deviation of returns (or profits) EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 8 of 21 V= EBIT EBIT = kL kU Value of a firm in the absence of corporate taxes V = VL = VU EBIT = perpetual earnings before interest and taxes kL = risk-adjusted discount rate for the levered firm kU = risk-adjusted discount rate for the unlevered firm k L = kU ?? D ?? k E = k U + ? U ? k B ??? ?? ?? E ?? Cost of equity for a levered firm in the absence of corporate taxes kU = cost of equity of the unlevered firm kB = before-tax cost of debt D = market value of the firm’s debt E = market value of the firm’s equity V = D + E = D + EL ?? D ?? k L = k B ?? + ?? E + D ?? ?? ?? ?? ?? D ?? ?? E ?? k ?? U ? ?k U ? k B ? ?? ?? ?? ?? ?? E ?? ?? E + D ?? ?? ?? ?? Market value of the levered firm Weighted average cost of capital for a levered firm in the absence of corporate taxes Present value of interest tax savings for a perpetual loan TC = corporate tax rate D = amount of debt
PV (interest tax savings) = TCD VU = EBIT(1 ? TC ) kU Value of an unlevered firm in the presence of corporate taxes VL = V U + TC D Value of a levered firm in the presence of corporate taxes VU = unlevered firm’s value TC = corporate tax rate D = amount of debt ?? D ?? k E ? k U ? ?k U ? k B ? ?? ??? 1? TC ? ?? E ?? Cost of equity for a levered firm in the presence of corporate taxes kU = cost of equity to the unlevered firm kB = before-tax cost of debt EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 9 of 21 ?? D ?? ?? E ?? WACC = k L = ?? ?? B ? 1? TC ? + ?? ?? k E ?? V ?? ?? V ?? Weighted average cost of capital V = value of the firm (debt + equity) EL ? (EBIT ? I)(1 ? TC ) kE Estimated value of levered equity with corporate taxes from cash earnings aftertax EL = value of levered equity I = total interest payment kE = cost of levered equity 1 – TD = (1 – TC)(1 – TS) Tax parity between tax rate on interest income, corporate tax rate, and personal tax rate on income from shares TD = tax rate on interest income TC = corporate tax rate TS = personal tax rate on income from shares
VU ? EBIT(1 ? TC )(1 ? TS ) kU Value of an unlevered firm in the presence of personal and corporate taxes TC = corporate tax rate TS = personal tax rate on income from shares kU = cost of equity of the unlevered firm CFL = EBIT (1 – TC)(1 – TS) – I (1 – TC)(1 – TS) + I (1 – TD) Cash flows from a levered firm I = annual payments to debtholders TC = corporate tax rate TS = personal tax rate on income from shares TD = personal tax rate on income from debt ?? ?1? T ?? 1? T ??? C S D VL = VU + ?? 1? ?? ?? ?? ?1? TD ? ?? ??
Value of a levered firm in the presence of personal and corporate taxes VU = value of the unlevered firm D = market value of debt EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 10 of 21 VL = VU + TCD – PV(BC) Value of a levered firm in the presence of bankruptcy costs VU = value of the unlevered firm TC = corporate tax rate D = market value of debt PV(BC) = present value of the expected bankruptcy-related costs ?EBIT DOL = EBIT ? Sales Sales contribution margin (P ? V)Q ? EBIT (P ? V)Q ? FC Degree of operating leverage as a function of sales level ? = change in the variable
DOL ? Degree of operating leverage as a function of a contribution margin P = price per unit V = variable cost per unit Q = amount of sales in units FC = fixed costs excluding financing charges DOL ? PQ ? VQ sales ? variable costs ? PQ ? VQ ? FC sales ? variable costs ? FC Degree of operating leverage as a function of variable costs EPS ? ?EBIT – I?? 1 ? TC ? ? PD S General formula for finding EPS from EBIT I = interest payments TC = corporate tax rate PD = preferred dividends S = number of common shares outstanding ?? ?? ?? ?? ?? EBIT* ? I 2 ?? 1? TC ?? PD 2 EBIT* ?
I1 ?? 1? TC ?? PD1 ?? ? ? ?? ?? ?? ?? ? S1 S2 Leverage indifference EBIT level EBIT* = level of EBIT at which earnings per share for each alternative is equal I = interest payments under each alternative TC = corporate tax rate PD = preferred dividends under each alternative S = number of common shares outstanding under each alternative EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 11 of 21 VN = VC + TCDN Firm value after a new debt issue VC = current (original) market value of the firm TC = corporate tax rate DN = amount of required additional (new) debt
APV = base-case NPV + PV of financing cash flows = NPVB + ITS – FCNS + TSFC + ITCS – IBC + OFRE Adjusted present value NPVB = base-case NPV ITS = PV of interest tax shield FCNS = PV of flotation costs of new securities TSFC = PV of tax shield on flotation cost amortization ITCS = PV of financing-related investment tax credits and subsidies IBC = PV of incremental bankruptcy costs OFRE = PV of other financing-related effects ITS ? T ? IP1 1? kD ?… ? ?1 ? k D ? i ? 1 ? k D ? i ? 1 T ? IPi ? T ? IPi ? 1 ? …? ?1 ? k D ? n T ? IPn
Present value of interest tax shields IPi = interest payment in period i, where i = 1, …, n T = corporate tax rate kD = after-tax required rate of return on the firm’s debt n = number of interest payment periods TSFC ? T ? FCA1 1? kD ? …? ?1 ? k D ? i ? 1 ? k D ? i? 1 T ? FCA i ? T ? FCA i ? 1 ? …? ?1 ? k D ? n T ? FCA n Present value of the tax shields on flotation costs FCAi = flotation cost amortization in period i, where i = 1, …, n T = corporate tax rate kD = after-tax required rate of return on debt n = number of amortization periods for the flotation costs (lesser of 5 years or the maturity of the securities) FC = total flotation costs
For equal period amortization of flotation costs at time zero, TSFC ? ? t ? 1 n T(FC/n) ? T(FC/n) ? PVIFA (k D , n ) (1 ? k D ) t PV(BC) = probability of financial distress ? (1 – T) ? BC Present value of the after-tax bankruptcy costs BC = bankruptcy costs EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 12 of 21 IBC = PV(BC)D – PV(BC)E Incremental present value of bankruptcy costs PV(BC)D = PV of bankruptcy costs under debt financing PV(BC)E = PV of bankruptcy costs under equity financing NPVER ?? RNVi ? CCA i ? IPi ? ? (1 ? T) ? CCA i ? ? DPi ?? i ? 1 ? 1 ? k E ? n ? C0 ? D Net present value of a project (equity residual method) RNVi = revenues – costs during period i CCAi = capital cost allowance in period i IPi = interest payment in period i DPi = debt principal payments in period i D = initial proceeds from the debt issue C0 = initial investment outlays kE = cost of equity + PV of salvage price + PV of investment tax credits & subsidies ? PV of flotation costs PV(? OC) ? (1 ? T)? OC i (1 ? T) ? OC i ? 1 (1 ? T) ? OC n ? ??? i ? 1 1? r (1 ? r) (1 ? r) n Present value of savings in operating costs due to leasing i = 1, …, n
PV ? ? ?? ?? 1 ???? C n ? 1? g??? ? ?? ?? ?? t n t ? 1 ? 1? r? ??? 1? r ? ???? ?r ? g? ?? ?? ?? ?? ?? n OCFt Firm valuation using operating cash flows with WACC OCFt = operating cash flow after tax, including cash flow from (non-cash) depreciation for period t r = discount rate n = period of initial cash flow forecasting Cn = OCFn = cash flow of the last forecast period g = perpetual growth rate after period n ?? ?? ???? OCF 1? g ?? ? ?? 1 n? ???? ? ?? t n ?? t ? 1? 1? WACC? ??? 1? WACC? ????? WACC ? g??? ?? ???? n OCFt NPV ? ? ?? ?? 1 ???? C n ? 1? g??? ? ?? ??? C 0 ?? n t ? 1 ? 1? r ? ??? 1? r? ???? ?r ? g? ?? ?? ?? ???? n OCFt NPV of acquisition using operating cash flows (with WACC as the required return) C0 = cost of the acquisition in terms of new debt and share purchases NPV = value to debtholders, preferred shareholders, and common equity shareholders EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 13 of 21 PVequity ? ? n t ? 1 ?1 ? r ? t OCFt ? 1 ? ? C n ? 1 ? g ? ? ?? ? ? B 0 ? P0 n ?? ? ? 1 ? r ? ? ? ?r ? g ? ? ? ? Firm value to equity shareholders using operating cash flows B0 = PV of debt P0 = PV of preferred shares
PV ? ? n t ? 1 ?1 ? r ? t OCFt FCFFt ? 1 ?? n ? ?1 ? r ? ? n ? ? FCFFn ? 1 ? g ? ? ?? ? ? ? ? ?r ? g ? ? NCI t ? 1 ?? n ? ?1 ? WACC? ? Firm valuation using free cash flows to the firm and WACC method FCFF = free cash flow to the firm NCI = net capital investments ? ? FCFFn ? 1 ? g ? ? ?? ? g = perpetual growth rate of free cash ? ? ? WACC ? g ? ? flow to the firm after period n ? ?? n t ? 1 ?1 ? WACC? t ?? t ? 1 ?1 ? WACC? t PV ? ? ? 1 ? ? FCFF ? 1 ? g? ? FCFF n It TC n t ?? ?? ? n?? t t t ? 1? 1 ? rD ? t ? 1? 1 ? rU ? ? ? 1 ? rU ? ? ? ?rU ? g? ? n
Firm valuation using free cash flows to the firm and APV method ItTC = period income tax shield on interest from long-term debt rU = kU = unlevered cost of equity rD = kD = after-tax cost of long-term debt g = perpetual growth rate of free cash flow to the firm after period n (For perpetual funding with debt, the debt tax shield could become a perpetuity. ) ?? n t ? 1 ?1 ? kU ? OCF t t ?? n ? 1 ? ? FCFF ? 1 ? g? ? NCIt IT n ? ? t C t ?? t n?? ?1 ? kU ? ? ? ?kU ? g? ? t ? 1? 1 ? k U ? t ? 1? 1 ? k D ? ? ? n PV ? ? n t ? 1 ?1 ? k E ? t n FCFE t ? 1 ?? n ? ?1 ? k E ? ? NCI t ? ?
FCFE n ? 1 ? g ? ? ?? ? ? ? ? k E ? g ? ? ? n Firm valuation using free cash flows to equity and ERM method FCFE = free cash flow to equity kE = return to levered equity OCFt = operating cash flow for period t NCIt = net capital investment for period t It = interest payment on debt for period t TC = effective corporate tax rate PDivt = preferred share dividend for period t Bt = bond repayment for period t Pt = preferred share repayment for period t B0 = initial bond amount P0 = initial preferred share amount g = perpetual growth rate of free cash flow to equity after period n 1 ? k E ? t ? 1 ? 1 ? k E ? ? ? ? FCFE n ? 1 ? g ? ? 1 ?? ? ? B 0 ? P0 n ? ? ? ?1 ? k E ? ? ? ?k E ? g ? ? ? ? t ? 1 t t ? 1 t ?? n ?1 ? k E ? OCFt ?? ?? I t (1 ? TC ) ? PDiv t t ?? n t ? 1 ?1 ? k E ? t B t ? Pt EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 14 of 21 PV0 ? D ? 1 ? g ? D1 ? 0 ? r ? g ? ?r ? g ? Valuation using dividend cash flows and ERM method PV0 = present value at the current time (end of period 0) D1 = cash dividend payment at the end of period 1 D0 = cash dividend payment at the end of period 0 r = discount rate = kE g = perpetual growth rate in dividends
PV0 ? ? or n t ? 1 ?1 ? r ? t ? 1 ? r ? Dt t Dt ? 1 ? ? D n ? 1 ? ?? ? n ? ? ? ?1 ? r ? ? ? ?r ? g ? ? ? ? ? 1 ? ? D n ? 1 ? g ? ? ?? ? n ?? ? ? 1 ? r ? ? ? ?r ? g ? ? ? ? Valuation using dividend cash flows and ERM method with initial period of specific dividend amounts n = number of periods of specific dividend amounts PV0 ? ? n t ? 1 ? D1 ? ? ? 1 ? g 1 ? n ? ? 1 ? ? D n ? 1 ? PV0 ? ? ??? ?? ? ? 1 ? ? ? 1 ? r ? n ? ? ? 1 ? r ? n ? ? ? r ? g 2 ? ? ? ?r ? g 1 ? ? ? ? ? ? ? or ? D1 ? ? ? 1 ? g 1 ? n ? ? 1 ? ? D1 ? 1 ? g 1 ? n ? PV0 ? ??? ? ?? ? ? 1 ? ?1 ? r ? n ? ? ? 1 ? r ? n ? ? ? r ? g 2 ? ? ? ?r ? g 1 ? ? ? ?? ? ? ? ? Valuation using dividend cash flows and ERM method with initial period of high dividend growth g1 = initial high growth rate g2 = perpetual growth at the market rate D? ? ? (1 ? i) ? ? t ? 1 n ? CFt t ? ? t? ? ? Duration of a security CFt = cash flow expected at time t t = number of periods until cash flow payment i = yield to maturity n = number of anticipated cash flows ? ? CFt ? ? t ? ? ? t ? 1 ? (1 ? i) ? n ? ? V ? ? ? ? V ? ?D ? i ? r 1? m
Volatility (percentage change) of a security’s value from changes in the required yield (stated per year) D = duration measured in years V = market value of the security ? V = change in market value of the security ? r = change in interest rates i = yield to maturity m = number of compounding periods per year EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 15 of 21 ?V ? ?D ? V ? ?r ? D ? V ? ?r or i i 1? 1? m m Change in market (dollar) value of a security for a given change in interest rate (stated per year) ?NII = ? r ? gap Change in net interest income due to gap ? r = expected change in interest rates DP ? D1V1 ? D i Vi ? ? ?
D n Vn V1 ? Vi ? ? ? Vn Duration of a portfolio Di = durations of i securities (i = 1, …, n) Vi = market values of i securities (i = 1, …, n) Change in a portfolio’s value as a function of a weighted average expected change in individual yields Dp = portfolio’s duration ? r = change in interest rates dW = weighted average discount rate, where the component rate for an asset is the yield to maturity per compounding period Weighted average interest rate for a portfolio i = quoted interest rate for a bond m = number of compounding periods per year for the bond V = market value of the bond Price index id = annual discount rate in percent VP ? ? D P ? VP ? ?r ? D P ? VP ? ?r or 1? dW 1? d W i1 i2 in m1 V1 ? m2 V2 ? … ? mn Vn dw ? V1 ? V2 ? … ? Vn Price index = 100 – id F0,T = S0 (1 + Rf0,T – Rh0,T) Futures price for financial futures F0,T = futures price at time 0 for delivery at time T S0 = spot price at time 0 Rf0,T = rate at time 0 on the risk-free asset maturing at time T Rh0,T = rate of cash payments expected to be paid by the underlying asset between time 0 and time T EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 16 of 21 F0,T = S0 (1 + Rf0,T – Rh0,T) + H0,T
Futures price for non-financial or general assets H0,T = holding costs from time 0 to time T F0,T = S0 [1 + Rf0,T – E(D0,T)] General pricing formula for index futures prices E(D0,T) = opportunity loss for the contract holder from the loss of dividends during the contract period F0,T M? N ?? R D ?? D 1 ?? + ?? N D ?? ?? ? S0 M? N ?? R F ?? F 1 + ?? ?? N F ?? ?? Forward exchange rate using the interest rate parity relationship F0,T = forward rate at time 0 quoted in domestic currency at which the foreign urrency can be purchased for delivery at time T S0 = spot rate at time 0 quoted in domestic currency at which the foreign currency can be purchased for immediate delivery RD = annual interest rate on the domestic currency RF = annual interest rate on the foreign currency ND = number of compounding periods per year for the domestic interest rate NF = number of compounding periods per year for the foreign interest rate M = number of years until the forward contract matures HR ? ? ? V MC ? FF M F
Hedge ratio V = market value of assets/liabilities to be hedged FF = face value of the security underlying the futures contract MC = maturity of the assets/liabilities to be hedged MF = maturity of the security underlying the futures contract ? = correlation of the change in volatility of the rate to be hedged in relation to the change in volatility of the rate on the security underlying the futures contract EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 17 of 21 ?TB = ? ? ? BA Change in value of T-bill rates as a function of the bankers’ acceptance futures rates Price ? $100 ?? ays to maturity ?? 1? ?? yield ? ?? ?? ?? 365 Price of a short-term, pure discount security C = SN(d1) – EN(d2) e–rT ? S? ln? ? ? rT ? T ? ?E? d1 ? ? 2 ? T ? d2 = d1 – ? T? Black-Scholes option-pricing model for a call S = share price E = exercise price r = continuously compounded risk-free rate T = time to expiration measured in years ? = standard deviation of the share’s continuously compounded rate of return N(d) = probability that a standardized, normally distributed, random variable will be less than or equal to d ? d * ? d L ? ? ? N ? d U ? ? N? d L ?? ? N ? d *?? N? L ? ? ? d U ? d L ? ? Interpolation formula to determine N(d1) or N(d2) N(d*) = probability that an outcome will be less than or equal to d* dL = value of d in the normal curve table that is smaller than and nearest to d* dU = value of d in the normal curve table that is greater than and nearest to d* Present value = Ee – rT Present value of the exercise price at the expiry date C + Ee – rT = S + P Put-call parity relationship P = put premium C = call premium S = share price E = cash exercise price on option expiration r = risk-free rate T = time to expiration of the options
P = C + Ee – rT – S Value of a put option in terms of the putcall parity relationship EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 18 of 21 P = [1 – N(d2)] Ee – rT – S[1 –N(d1)] Value of a put option using the BlackScholes formula Security value = value of straight security + option value Value of a security with built-in options ?RX = RFX X – RFL X Change in degree of risk from borrowing in fixed-rate market compared with the floating-rate market RFX X = risk to lenders from lending to X in the fixed-rate market RFL X = risk to lenders from lending to X in the floating-rate market RY = RFL Y – RFX Y Change in degree of risk from borrowing in the floating-rate market compared with the fixed-rate market RFL Y = risk to lenders from lending to Y in the floating-rate market RFX Y = risk to lenders from lending to Y in the fixed-rate market r eff, ann ?e r cnt,ann ?1 Conversion of annual continuously compounded rate to annual effective rate and vice versa reff,ann = effective annual return rcnt,ann = continuously compounded annual return 1? rcnt,ann ? ln? reff,ann ?
IC = average inventory / (COGS/365) RC = average accounts receivable / (CS/365) PD = (average accounts payable + average accruals) / (COGS/365) Cash conversion period = IC + RC – PD Cash conversion cycle and net working capital IC = inventory conversion period RC = receivables conversion period PD = payables deferral period COGS = cost of goods sold CS = annual credit sales NWC = net working capital AC = average cash level ANP = average notes payable CPLD = current portion of long-term debt ?? COGS ?? ?? CS ?? NWC ? ?? ? PD) ? (IC RC ??? ?? ? 365 ??? AC ? ANP ? CPLD ?? ?? 365 ?? ?? EFN2J11 [FN2. 011] ?CGA-Canada, 2011 Attachment 19 of 21 EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 20 of 21 EFN2J11 [FN2. 1011] ?CGA-Canada, 2011 Attachment 21 of 21 CGA-CANADA ADVANCED CORPORATE FINANCE [FN2] EXAMINATION June 2011 SUGGESTED SOLUTIONS Marks 12 Question 1 Note: 2 marks each Time: 4 Hours Sources: a. b. c. d. e. f. 18 3) 4) 1) 4) 3) 2) Topic 1. 4 (Level 2) Topic 1. 8 (Level 1) Topic 2. 2 (Level 1) Topic 5. 4 (Level 1) Topic 5. 5 (Level 1) Topic 9. 4 (Level 1) Question 2 Note: 3 marks each Sources: a. 1) Topic 4. 3 (Level 1) ? Sales / Sales = (? EBIT / EBIT) / DOL = 10% / 1. 5 = 6. 7% Sales = (1 + 6. 67%) ? $500,000 = $533,333 b. 3) Topic 3. 1 (Level 1) 13% ? ? ? ? Effective annual rate = ? 1 ? 2 ? ? 1 ? 14. 80% ? 1 ? 9% ? ? ? ? ? 2 c. 2) Topic 8. 2 (Level 1) ? RD ? ?1 + ? ? ND ? ? RF ? ?1 + ? ? NF ? M? N D F0,T = S0 M? N F = 1. 5183 ? ?1 ? 1. 49%? 1? 1 ? 1 ? 2. 93%? 1? 1 ? 1. 4971 Continued… SFN2J11 ©CGA-Canada, 2011 Page 1 of 9 d. 3) Topic 5. 6 (Level 1) After-tax cost of debt = 10% ? (1 – 30%) = 7% Present value of the CCA tax shield for the machine: 100,000 ? 0. 2 ? 0. 3 ? (2 ? 0. 07) ? $21,495 2 ? (0. 2 ? 0. 07) (1 ? 0. 07) Present value of after-tax operating costs = $5,000 ? 1 – 30%) ? PVIFA (7%, 5) = $14,351 Present value of lease payments (annuity due): $25,000 ? PVIFA (7%, 5) ? (1 + 7%) = $109,680 Present value of tax shield on lease payments: $25,000 ? 30% ? PVIFA (7%, 5) = $30,751 Equivalent loan = $109,680 + $21,495 – $14,351 – $30,751 = $86,073 e. 3) Topic 2. 4 (Level 1) ? 50,000 ? 2 ? 30,000 ? 3 ? ARR = ACF / Ia = ? ? 5 ? ? f. 3) Topic 3. 10 (Level 1) ? 250,000 ? 0 ? ? ? = 30. 40% 2 ? ? The ex-rights date is Tuesday, June 21, 2011, 2 business days before the record date, Thursday, June 23, 2011. June 22, 2011 is one day after the ex-rights date.
The ex-rights share price can be calculated as follows: R on ? Pon ? E $12. 00 ? $10. 00 ? ? $1. 00 N? 1 1? 1 R ex ? Pex ? E ($12. 00 ? $1. 00) ? $10. 00 ? ? $1. 00 N 1 Pex = Pon – Rex = $12. 00 – $1. 00 = $11. 00 Alternatively, Pex = Pon – Ron = $12. 00 – $1. 00 = $11. 00 SFN2J11 ©CGA-Canada, 2011 Page 2 of 9 15 Question 3 Source: Topics 7. 1, 8. 4, 10. 4, and 10. 5 (Level 1) 2 a. The firm’s sales peak during the months of October, November, and December. Net working capital doubles during this period. Given that the balance sheet is as of November 30, the current working capital includes the seasonal portion.
Therefore, the seasonal portion of net working capital can be estimated as: ($2,200,000 – $450,000 – $100,000) / 2 = $825,000 1 b. The firm has $2,200,000 in current assets and $720,000 in current liabilities, excluding the current portion of long-term debt. Therefore, $1,480,000 of its current assets is financed with long-term debt or with shareholders’ equity. The seasonal portion of net working capital is much higher than the amount of short-term borrowing. Therefore, the firm seems to be following a conservative strategy in which part of the seasonal working capital needs are financed with long-term debt or equity.
Continued… SFN2J11 ©CGA-Canada, 2011 Page 3 of 9 8 (1) c. Cash conversion period = Inventory conversion period + Receivables conversion period – Payables deferral period. Inventory conversion period: = average inventory cost of goods sold ? ? ? ? 365 ? ? $1,200,000 ? $10,000,000 ? 0. 75 ? ? ? 365 ? ? = = 58. 4 days (1) Receivables conversion period: = accounts receivable ? annual credit sales ? ? ? 365 ? ? $850,000 ? $10,000,000 ? 0. 75 ? ? ? 365 ? ? = = 41. 4 days (1) Payables deferral period: = accounts payable ? other deferrals ? cost of goods sold ? ? ? 365 ? ? $450,000 ? $100,000 ? $10,000,000 ? 0. 75 ? ? ? 365 ? ? = 26. 8 days (1) The operating cycle: = 58. 4 + 41. 4 = 99. 8 or 100 days (1) The cash conversion period: = 99. 8 – 26. 8 = 73 days (3) The cash conversion period represents the average period of time elapsing between the payment of a supplier and the time that payment from sales is received. It shows how long the firm has to wait to receive cash from sales after paying the obligations that produced these sales. It also indicates whether the firm is a user or supplier of trade credit. The positive cash conversion period means that GRU has to wait approximately 73 days for cash coming from sales after paying the obligations.
GRU is therefore a supplier of trade credit. Continued… SFN2J11 ©CGA-Canada, 2011 Page 4 of 9 4 d. The term structure of interest rates suggests that the market expects rates to go down (downwardsloping yield curve). This is according to the pure expectations model of term structure. GRU is following a conservative policy and has its interest rates locked in for a longer term. It will not benefit from the declining interest rates. In addition, it also faces the risk of having to invest excess cash on hand at decreasing rates. One possible alternative for GRU to avoid this disadvantage is to engage in an