ECM152 Corporate Finance Coursework 1 Academic Year 2021/2022 Module Leaders: Prof. Albert Banal-Estanol Dr Anna Kaliciak Criteria The coursework should be submitted as a single file in the .pdf or .doc format. The file should be uploaded within the dedicated section of the Moodle page for the module by 4pm on Wednesday, 16 March 2022. You are asked to answer all four exercises. Please provide all your step-by-step calculations and the relevant explanation. Plagiarism Please be advised that this coursework reflects an individual work of each student, and any form of plagiarism is strictly prohibited – it is considered a very serious matter and severe penalties can apply. Word Count The coursework should not exceed 900 words in total. References, figures, formulas and equations are not included in the word count. The 10% (up or down) rule applies. Files that are outside this word count limit will be penalised. State the word count at the end of your coursework. EXERCISE 1 [15 marks] Michael is considering opening a new factory. The cost of factory is $100 million upfront. After that, it is expected to produce profits of $30 million in the first year, and $40 million each year for the following 4 years. A. What is the Net Present Value (NPV) of this investment opportunity if the cost of capital is 8% [2 marks] B. Would you advise Michael to make the investment Explain your reasoning. [2 marks] C. What is the payback period of this investment [2 marks] D. Suppose the Internal Rate of Return (IRR) of this investment opportunity is 10%. Based on this information, should Michael make the investment Explain your reasoning. [4 marks] E. Now assume that an alternative project would generate immediate (time zero) net profits of $100 million upfront, but after that, you would incur net losses of $30 million in the first year, and $40 million each year for the following 4 years. The cost of capital is 8% and the IRR is 10%. Should you start this project Explain your reasoning. [5 marks] EXERCISE 2 [25 marks] Indicate whether each of the following statements is true or false. Support your answers with the relevant explanations. A. Modigliani and Miller’s Proposition II says that the cost of equity is independent of the firm’s capital structure. (Explain your reasoning.) [5 marks] B. Modigliani and Miller’s Proposition II assumes that increased borrowing does not affect the interest rate on the firm’s debt. (Explain your reasoning.) [5 marks] C. Borrowing does not increase the firm’s cost of capital only if there is no risk of bankruptcy. (Explain your reasoning.) [5 marks] D. In the presence of corporate taxes, a company would prefer to raise debt on
ly when the benefits of the tax shield fully offset the cost of debt. (Explain your reasoning – in your explanation, provide a numerical example supporting your answer.) [5 marks] E. The CAPM implies that the expected rate of return changes linearly with the systematic risk. (Explain your reasoning.) [5 marks] EXERCISE 3 [30 marks] Sunny Side Corp. is planning to develop a new product. Next year, depending on the response of the customers, the company can generate cash flows of either $180 million, $100 million, or $40 million, with all three scenarios equally likely. The company requires an initial investment of $80 million. Due to the risk of the project, investors require an additional 4% return over the risk-free rate of 4%. Assume perfect capital markets. A. What is the Net Present Value (NPV) of the project Should the investors invest in the company Explain your reasoning. [3 marks] B. If the company is financed with 100% equity, what is its market value today [3 marks] C. If the company is financed with 100% equity, what are the equity returns in each scenario What is the expected equity return [4 marks] Suppose Sunny Side Corp. chooses to finance the project partially by borrowing $30 million and financing the other $50 million with equity. D. What should the interest rate be Explain your reasoning. [4 marks] E. How much would the firm owe in a year [4 marks] F. What is the market value of the equity today, according to Modigliani and Miller Proposition I Explain your reasoning. [5 marks] G. What are the equity returns in each scenario What is the expected equity return Is it the same as in case of a 100% equity financing Explain your reasoning. [7 marks] EXERCISE 4 [30 marks] The equity cost of capital of Creek Corp. is 12%. Its market capitalisation amounts to ￡100 million, and the enterprise value is ￡145 million. Creek’s debt cost of capital is 3% and its marginal tax rate is 21%. A. Calculate Creek’s Weighted Average Cost of Capital (WACC). [4 marks] B. If Creek maintains a constant debt-to-equity (D/E) ratio, what is the value of a project with average risk and the following expected free cash flows (FCF) [4 marks] Year 0 1 2 3 Free Cash Flow -80 30 50 90 C. If Creek maintains a constant debt-to-equity ratio, what is the debt capacity of the project in part (b) every year (0, 1, 2, and 3) [6 marks] D. What is the unlevered value of the project [5 marks] E. What are the interest tax shields from the project every year (1, 2, and 3) What is their present value [6 marks] F. Does the Adjusted Present Value (APV) of Creek’s project match the value computed using the WACC method (part b) Explain your reasoning. [5 marks]