Lecture 11

Corporate Finance

Hanoi University-FMT

Corporate Finance (FIN3CFI) Lecture 11

1

Topic 1: Share Repurchases - A Dividend Policy Alternative

2

Introduction

• Australian companies are increasingly opting to repurchase (or buy-back) their own shares as an alternative or an addition to paying out earnings as dividends

• Background to share repurchases:

– Prohibited in Australia up until 1989

– Revision of Companies legislation in 1989 allowed listed companies to buy-back up to 10% of their issued share capital each year (12 month period) without shareholder approval (10/12 rule)

3

Types of Share Buy-Backs

• There are five types of share buy-backs:

– On-market buy-back

• Purchase undertaken on the ASX at a price no greater than 5% of the average last sale price of shares over the 5 previous trading days

• Represents the most common form of buy-back

– Selective (off-market) buy-back

• Shares are acquired from specified shareholders in off-market transactions at a specified price

• Often used to remove particular shareholders from the company’s share registry, or as a means of distributing excess franking credits

5

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Introduction cont.

• A share buy-back involves a company making an offer to shareholders to buy their shares at a fixed (or market) price

– These share must then be ‘retired’ or removed from the issued capital of the company

– Can be financed out of retained earnings or debt

– Buy back will have an influence on the ownership structure of the firm, the firm’s capital structure and earnings per share (EPS) and possibly its share price (and shareholder wealth)

– The announcement of buy-backs normally has a

positive influence on company share prices

4

Types of Share Buy-Backs cont.

– Employee share scheme buy-back

• Off-market purchases of shares from employee shareholders

– Odd-lot buy-back

• Off-market purchases of shareholdings below a marketable parcel which can not be economically sold on-market

– Equal access buy-back

• Off-market purchase where each shareholder can sell a fixed proportion of their shares to the company at a set price (such as 10% of shares)

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Page 70 of 90

Lecture 11

Corporate Finance

Hanoi University-FMT

	Motives for Share Buy-Backs
• Dividend substitution: A share repurchase is an additional means of paying shareholders
	– Without tax, the “direct effects” of dividend and repurchase are identical
	– With tax: dividends have franking credits vs. only 50% of capital gains (from repurchases) are taxable
	– Australian companies, with significant foreign operations and earnings, do not pay Australian tax dividends have no franking credits
						7
	Tax rates 2005-06			Tax rates 2006-07
Income		Rate		Income	Rate
$0 – $6,000		Nil		$0 – $6,000	Nil
$6,001 – $21,600		15%		$6,001 – $25,000	15%
$21,601 – $63,000		30%		$25,001 – $75,000	30%
$63,001 – $95,000		42%		$75,001 – $150,000	40%
Over $95,000		47%		Over $150,000	45%
Medicare levy: 1.5%; Medicare levy surcharge: 1.0%
•	With the tax reduction, there is almost no advantages of capital gains over dividends for Australian investors invested in Australian companies					9

Motives for Share Buy-Backs cont.

• Shareholder preferences for dividends v. capital gains

– An on-market buy-back is treated as a normal share sale and results in a capital gains tax liability (if shares were purchased after September 1985)

– An off-market buy-back comprises a dividend portion (can be distributed with franking credits), which is the excess of the buy-back price over the capital contribution

– Use of on-market or off-market buy-backs to best suit investors’ tax and shareholding status

8

Motives for Share Buy-Backs cont.

• Improved “performance measures”

– A buy-back will have the immediate effect of increasing EPS, as the number of issued shares decreases after a buy-back

– This often follows with a corresponding share price increase, due to an increase in EPS being perceived as a signal of improved performance

– A buy-back will also result in an increase in the effective debt/equity ratio of the company which may have positive incentive effects, but also raises the firm’s relative level of financial risk

10

Motives for Share Buy-Backs cont.

• Free cash flow (agency theory explanation)

– For firms with few positive NPV investments, it is better to return cash to shareholders than waste it on bad investments or perquisite consumption

• Information asymmetry and signalling

– Similar to dividends, a share buy-back may signal an increase in future earnings and performance

– May also signal that the share price is undervalued and the firm is buying back its shares at a lower price than they are worth

11

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Motives for Share Buy-Backs cont.

• Financial flexibility

– Buy-backs preserve financial flexibility whereas dividends represent an ongoing commitment to future payments

– Dividends signal a permanent increase in earnings, whereas a buy-back represents a temporary increase in earnings

• Remove particular shareholders (use of selective buy-backs)

– Such as a troublesome shareholder, a potential future takeover bidder or small employee or

individual holdings

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Page 71 of 90

Lecture 11

Corporate Finance

Hanoi University-FMT

Comparison of a Share Buy- Back and a Dividend Payment

• In a M&M world, a dividend payment and a share buy-back are perfect substitutes (see numerical example in Lecture 11)

• Market imperfections will result in an influence on shareholder wealth of dividend announcements and buy-back transactions

– Share prices typically fall by less than dividend payments

– Share price typically increase on announcement of buy- backs

– Also the existence of different preferences by shareholders for dividends versus capital return through buy-backs

13

Evaluation of Share Buy-Back Motives

• Consider the following two examples of companies which have recently (2006) conducted share buy-backs:

• Commonwealth Bank Limited (CBA)

– One of the ‘Big four’ banks, involved in banking, funds management and insurance activities

– Around 95% of their revenue and profits are derived from Australia or New Zealand

– Highly profitable and has achieved significant

share-price growth in recent years

14

Evaluation of Share Buy-Back Motives _cont.

• Financial information for CBA:

	2003	2004	2005
Share price	$29.55	$32.58	$37.95
Earnings per share $1.57		$1.97	$3.03
Dividends per share $1.54		$1.83	$1.97
Capital exp. per share	$0.11	$0.34	-$1.38
Franking percentage 100%		100%	100%

Dividend payout ratio 98.1% 92.9% 65.0%

Issued shares (Million)

1,254

1,264

1,280

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Evaluation of Share Buy-Back Motives _cont.

• Orica Limited (ORI)

– Diversified firm involved in the manufacturing of commercial explosives, industrial and mining chemicals, agricultural chemicals and fertilisers and paint and other consumer products

– Around 60-65% of the firms revenues are generated in Australia and New Zealand, with the remainder based on their US and European explosives businesses

– Star performer following a major share-price

slump up to 2001

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Evaluation of Share Buy-Back Motives _cont.

• Financial information for ORI:

	2003	2004	2005
Share price	$11.68	$16.83	$20.44
Earnings per share $0.93		$1.13	$1.14
Dividends per share Capital exp. per share Franking percentage Dividend payout ratio	$0.50	$0.66	$0.69
	$0.41	$0.70	$1.24
	21%	41%	32%
	53.8%	58.4%	60.5%

Issued shares (Million) 286 278

281

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Evaluation of Share Buy-Back Motives _cont.

• Conclusions on CBA motives

– Buy-back most likely used as a means to distribute excess free cash flow

– Very high earnings and dividends and low capital expenditure

– Has a high dividend payout and pays fully- franked dividends, so a buy-back is unlikely to represent a form of dividend substitution

– No real evidence of undervaluation, or the

need to signal an increase in EPS

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Page 72 of 90

Lecture 11

Corporate Finance

Hanoi University-FMT

	Evaluation of Share Buy-Back Motives cont.
•	Conclusions on ORI motives
	– Buy-back is most likely as a form of dividend substitution. Has a lower dividend payout ratio and pays predominantly unfranked dividends
	– This is due to significant degree of foreign operations which generate profits not subject to Australian corporate tax that, therefore, cannot be used to pay franked dividends
	– Shareholders would likely prefer a capital gain (through sale into a buy-back) than receive unfranked dividends
	– Has significant capital expenditure relative to its level of earnings
	– Evidence of share price and EPS growth	19
	Topic 2: Mergers, Acquisitions and Takeovers
		21

Evaluation of Share Buy-Back Motives cont.
• General conclusion is that the motives differ across the two companies
– An interesting fact is that both companies also offer dividend re-investment schemes for shareholders
– This is inconsistent with a buy-back being used for excess cash flow reasons
					20
	What is a takeover?
• Takeovers typically involve one company purchasing another by acquiring a controlling interest in its voting shares
• Also called ‘acquisitions’ and ‘mergers’
				Merger or consolidation
		Acquisition		Acquisition of stock
Takeovers		Proxy contest		Acquisition of assets
		Going private
		(leveraged buyouts)			22

Takeover: Investment Nature

• A takeover is an investment decision

– Should only takeover a company when the acquisition will create value for the firm and shareholders (when the acquisition represents a positive NPV investment) – May also have financing and capital structure effects, depending on how the takeover is financed

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Importance of Takeovers in Australia

• Takeovers are important because they involve changes in the ownership and/or control of valuable assets

• From 1999-2003 there were 1,834 takeovers of Australian listed and non-listed companies with a total value of $99.56 billion

• Takeover activity tends to occur in waves

– Runs in cycles with the economy

– Evidence that takeover activity is positively related to the behaviour of the stock-market and

movement in share prices

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Page 73 of 90

Lecture 11

Corporate Finance

Hanoi University-FMT

Types of Takeovers

• There are three main types of takeovers:

– Horizontal takeover: takeover of a target company operating in the same line of business as the acquiring company.

– Vertical takeover: takeover of a target company which is either a supplier of goods to, or a consumer of goods produced by, the acquiring company (upstream or downstream takeover).

– Conglomerate takeover: takeover of a target company in an unrelated type of business.

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Motives for Takeovers

• General idea of synergy creation or gains

– Situation where the value of a combined entity exceeds the sum of the previously separate components

– Based on the ‘1 + 1 = 3’ concept:

where:

V AB

> V + V

A

B

• V _AB = the value of the assets of the combined company

• V _A = the independent value of Company A

• V _B = the independent value of Company B

26

Motives for Takeovers cont.

• Target company is managed inefficiently

– Replacing the current management with a more efficient management team

• Strategic or complementary benefits

– Entering a new market or industry

– Gaining first-mover benefits among competitors

– Acquiring employee expertise or production technology

– Secure or monopolies input recourses and/or output distribution

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Motives for Takeovers cont.

• Increased market power or share

– Buy/remove an existing competitor

– Easiest way to expand is to buy assets in place

– May also provide greater price-setting power or greater bargaining power with suppliers

• The target company is undervalued

– The market value of the target company < market or break-up value of its assets (potential for asset stripping)

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Motives for Takeovers cont.

• The target company has excess liquidity or free cash flow

– Access to excess funding for investment purposes

– Solve a growth-resource imbalance problem

• Cost reductions result

– Savings due to economies of scale (size benefit) or scope (good or service production or sales)

– Removal of duplicate activities (eg. head office, finance and payroll, distribution network)

– Use of excess capacity (storage, warehouse or production facilities)

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Motives for Takeovers cont.

• Diversification benefits

– Potential to reduce overall company risk

– Acquiring a firm with a different earnings pattern lowers systematic risk

– Increase overall debt capacity and reduce the risk of default on debt (overall default risk)

– But the diversification benefits are questionable since investors can diversify risk by themselves

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Lecture 11

Corporate Finance

Hanoi University-FMT

Motives for Takeovers cont.

• Tax benefits result

– Use tax losses to offset against company tax payable

– Acquiring excess debt capacity to increase tax shield benefits or imputation tax credits

• Increased earnings per share and price- earnings ratio effects

– Can ↑ EPS without generating any real benefits

– Takeover a firm with a lower P/E ratio than the bidder’s

– Buying a firm with ‘cheaper’ earnings

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Types of Takeover Offers

• There are three forms of takeover offers available to bidding companies in Australia:

– Off-market (formal) takeover offer

– On-market (tender) takeover announcement

– Time-delayed purchase (creeping takeover)

• Trigger for a takeover bid:

– The Corporations Law in Australia prohibits any shareholder from acquiring more than 20% ownership of a listed company without using one of these methods

32

Off-market Takeover Offer

• Off-market takeover offer represents:

– An offer to all shareholders of the target to acquire part or all of their shares

– Consideration can be cash, shares or a combination

– Offer terms can be revised during the offer period

– Must remain open for between 1 and 6 months

– Bidder required to issue a Part A statement outlining the terms of the offer

– Target management required to respond with a Part B statement (including a recommendation to shareholders and possibly expert’s information)

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On-Market Takeover

• On-market takeover bid:

– Also known as tender offers, and are commonly used in the US

– Requires an unconditional undertaking by a member firm of the ASX, on behalf of the bidder, to stand in the market and acquire, for a period of at least 1 month, all shares offered on the exchange at a specified cash-only price

– Offer can be revised and extended up to 6 months

– Bidder must issue a Part C statement and the target can respond in a Part D statement

– Not very commonly used in Australia

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Time-Delayed Purchase

• Creeping takeovers:

– Allows the acquisition of no more than 3% of the target’s shares every 6 months, provided that a threshold ownership level of 19% has been maintained for at least 6 months

– No public statement (Part A or C) is necessary

– Because of the time required, such an approach to a takeover is not normally used

– Most takeovers in Australia are formal or off- market bids (probably about 90% of all bids)

35

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Defensive Tactics in Takeovers

• Takeover bids are often unsolicited (known as hostile or unwanted bids)

– In this case the target company can employ various strategies to try and fight off takeover bids

– Use of arrangements such as poison pills, anti- takeover amendments, golden parachutes, white knights, crown jewel lock-ups

– Formal defensive mechanisms such as poison pills are legislatively prohibited in Australia

– Australian defensive tactics are based on use of going private transactions, expert’s valuations,

litigation, advertising and media reporting

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Page 75 of 90

Lecture 12

Corporate Finance

Hanoi University-FMT

Corporate Finance (FIN3CFI) Lecture 12

1

Evaluation of Takeovers

• Takeovers represent investment decisions

• Whether a takeover bid is a good investment or not should be evaluated based on whether it generates positive NPV for the bidding firm or not.

3

Topic 1: Mergers and Acquisitions Continued
								2
Gain and Cost from a Takeover
• The gain from a takeover is the difference between the value of the combined company and the sum of their values as independent entities:
Gain ΔV = V − V + V ( ) (							)
• Note:			AB		A	B
– The analysis below assumes firms are unlevered – For levered firms, certain adjustments are required, particularly the interpretations of V A ,
V B , V AB								4

Gain and Cost from a Takeover cont.

• This gain is normally shared between bidding and target company shareholders:

– Depends on the takeover offer relative to the value of the target firm – But all costs (particularly the takeover premium offered) are borne by the bidding firm

• In the analysis below, the costs only include the consideration from the bidding firm to the target firm. But beware of other costs

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Acquisition by cash payment

• Cost is the offer price × no. of company B shares

– Premium associated with the takeover is the difference between the amount paid and value of the target firm. Premium = Cash payment – V _B

– Premium is also the gain to the shareholders of B

• The takeover will have a positive NPV for firm A only if the value A gets exceeds the cost paid, or if the gain exceeds the premium

– NPV _AB = (V _B + ΔV) – Cost = [V _AB - (V _A + V _B )] – (Cash – V _B )

• If the NPV _AB > 0, then the merger is worthwhile (value increasing for firm A) and gain to

shareholders of A = NPV _AB

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Lecture 12

Corporate Finance

Hanoi University-FMT

Acquisition by cash payment cont.

• Maximum payment to company B is V _B + ΔV: Value of target plus any perceived takeover gain

• Maximum offer price for B shares is (V _B + ΔV )/no. of B shares

– What the bidder is getting from the takeover?

• Of course, the minimum offer price is the market price of B shares before the merger

– Then what the bidder is getting from the takeover?

7

The Gains and Costs of Cash Acquisition

• The amount of the cash consideration offered determines how the total gain is divided between the two sets of shareholders

– Every additional $1 paid to the target’s shareholders means $1 less for the bidder’s shareholders

– Target shareholders get the difference between cash payment and target company value

– Bidder shareholders get the difference between the takeover gain and the premium paid

– The higher the premium => ↓ benefit for A => ↑

benefit for B

8

Acquisition by a Share Exchange

• This complicates the analysis

– The cost of the takeover (and the premium paid) depends on the takeover gain and the value of company A’s shares

– Need to determine the proportion of the merged firm which will be owned by target shareholders:

Premium= μV

AB

where:

− V

B

• μ = the proportional ratio of shares owned by B

• Cost of takeover = _{μV AB}

9

Acquisition by a Share Exchange cont.

• The proportional ownership of AB by former company B shareholders is:

μ=

Shares issued to company B

No of shares in company AB

.

• Let the share exchange ratio be ω

– ω shares of firm A offered for one B share – This will be provided in the takeover terms (such as 1 company A share offered for every 4 company B shares ω = ¼ = 0.25)

10

Acquisition by a Share Exchange cont.

• If N A , N B and N AB are the numbers of firms

A, B, and AB, we have

N AB = N A + ωN B

μ=ωN N =ωN N +ωN

(

)

B

AB

B

A

B

• Premium per share

(μV

− V ) / N =ωV / N

− V / N

AB

B

B

AB

AB

B

B

• This premium differs from naïve premium

ωp A – p B (it is usually greater if the merger

has positive gain), where p A and p B are pre-

merger prices of firms A and B

11

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Takeover Valuation Example

• Details of takeover example

– Alinta Limited (ALN) takeover bid for Australian Gas Light Co. Ltd (AGL) announced on 20/3/06

– Both are utilities companies involved in gas and electricity transmission and distribution networks

– Takeover proposal involves acquiring 100% of AGL shares

– Share exchange terms are 1.773 ALN shares for every 1 AGL share held

– To show the cash offer process, assume there is an alternative cash offer of $19.31 per AGL

share

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Page 77 of 90

Lecture 12

Corporate Finance

Hanoi University-FMT

Takeover Example cont.

• Financial information for the two firms:

ALN

AGL

Earnings after tax

$101,988,000 $387,200,000

Issued shares	260,009,100	456,577,000
EPS	$0.392	$0.848
Share price (17/3/06)	$10.89	$18.39
Share price (20/3/06)	$10.95	$18.80
P/E ratio	27.780	21.686

Market value

$2,831,499,099 $8,396,451,030

13

Takeover Example cont.

• Naïve premium of share exchange takeover:

– Price per AGL share =

– Premium =

– This figure probably underestimates the true premium because it does not include takeover gain, evidenced by price raises after the takeover announcement

• $19.31 is chosen to make the cash offer premium = ($19.31 - $18.39)/$18.39 = 0.0500 (5.00%), the same as share exchange offer

15

Takeover Example cont.

• Share exchange offer (ω = 1.773)

– No. of shares to issue (ωN _B ) =

– Shares on issue after takeover (N _AB ) =

– Ownership of AGL in post-merger ALN (μ)=

– MV of firm (V _AB ) =

– Cost of takeover =

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Takeover Example cont.
• Expected gains from the takeover are estimated by ALN’s bidder statement:
– Corporate cost savings of $34 million per year
– Asset management cost savings of $39 million per year
– Energy sales and marketing cost savings of $27 million per year
– Total per year earnings gain = $100 million
– Alinta Limited’s overall cost of capital (before- tax) is 12.50%, assumed to be the cost of
capital after the takeover	14
Takeover Example cont.
• Gain of T/O: ΔV =
• Cash Offer ($19.31 per share)
– Value of AGL to ALN =
– Cost of takeover =
– NPV of takeover =
– Gain to AGL =
	16

Takeover Example cont.

– NPV of Takeover =

– Gain to AGL =

– The gain to ALN (AGL) with the share exchange is substantially lower (higher), even though they are offering the same naïve bid premium as in the cash offer

– Actual per share premium to AGL =

– This implies a premium =

18

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Page 78 of 90

Lecture 12

Corporate Finance

Hanoi University-FMT

Semester 2 Unit - Mergers and Acquisitions (FIN3MAQ)

• If this relatively brief analysis of mergers has excited you, consider taking a relatively new unit focusing specifically on Mergers and Acquisitions available in semester 2

– Will examine mergers and acquisitions in much more detail

– More extensive valuation of target firms and evaluation of the gains from takeovers

– Focus on the merger planning process, motives, defensive strategies, pricing, and the factors determining takeover likelihood and outcome

19

Topic 2: Course Summary and Revision

20

What Have the Unit Covered?

• Company Structures and Goals, Agency Theory

– Nature of listed companies versus other business structures

– Agency theory considerations with listed firms

• Investment Evaluation Process and Techniques

– Cash flow calculations (initial, annual and terminal cash flows)

– NPV, IRR, payback, present value index and accounting rate of return methods

21

What Have the Unit Covered?

• Issues in Investment Evaluation

– Conflicts between NPV and IRR and between other evaluation methods

– Projects with non-conventional cash flows

– Multiple internal rates of return

– Evaluating projects with unequal lives

– Incremental approach to project evaluation

– Adjusting for risk in investment decision-making

– Abandonment and other contingency options

• Lease and Equipment Financing

– Types of leases

– Net advantage of leasing (NAL) evaluation

22

What Have the Unit Covered?.

• Sources of Short-Term and Long-Term Financing

– Characteristics of debt and equity finance

– Different issue methods for debt and equity

– The initial public offering (IPO) process

– Public, private and rights issues

– Rights issue valuation

• Required Rates of Return and the Cost of Capital

– Cost of capital calculation using a pure play

– Calculation of the cost of various forms of capital

– Incorporating the effect of flotation (issue) costs

– Calculation of WACC

23

TB

What Have the Unit Covered?

• The Financing Decision and the Effects of Financial Leverage

– Use of financial leverage

– Business and financial risk

– Effect of leverage and financing choice

• Capital Structure Determination

– Determining a firm’s optimal capital structure

– M&M and Static (trade-off) approaches

– Pecking order (signalling) theory

– Implications for firm value and shareholder

wealth

24

Page 79 of 90

Lecture 12

Corporate Finance

Hanoi University-FMT

What Have the Unit Covered?

• Taxes and Capital Structure Policy

– Effect of company taxes and bankruptcy costs on capital structure

– Classical v. imputation tax systems

– Gain from leverage with company and personal taxes

– Impact on firm value and capital structure choice

• Dividend Policy

– Types of dividend policies used by firms

– Irrelevance of dividend policy (M&M)

– Reasons for dividend policy relevance

– Preferences of investors for different dividend policies

25

What Have the Unit Covered?

• Share Repurchases (Buy-backs)

– Types of share buy-backs

– Motives for companies buying back shares

– Investor preferences for buybacks v. dividends

– Effects on share price and the relationship with dividend policy

• Mergers and Takeovers

– Different types of takeovers and the methods of undertaking takeovers

– Motives for takeovers

– Evaluation of takeovers

26

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Page 80 of 90

SAMPLE EXAM

Corporate Finance

Hanoi University-FMT

SAMPLE FINAL EXAM OF CORPORATE FINANCE

Question 1.

Connex Rail Limited is evaluating a proposal to construct and operate a light rail transport link running from the Macleod Railway Station to the Bundoora campus of La Trobe University. The infrastructure of the project would involve the construction of the rail track and the purchase of a multiple-carriage train to operate on the new route. The cost of construction and train acquisition are estimated at $3,000,000. An additional net working capital investment of $250,000 will be required at the beginning of the project to meet start- up and ancillary expenditures. It is assumed that this $250,000 working capital investment will be recovered at the end of the project. The rail link will be constructed on Victorian Government-owned land, which the Victorian Government has agreed to allow Connex Rail Limited to use free of cost, contingent on the land only being used for this particular rail project. The project is expected to have a 20-year useful life, after which the land will revert back to alternative Government use and the company will be able to sell the train and other equipment associated with the project for $1,000,000. A feasibility study commissioned by the company, at a cost of $25,000, estimated that annual before-tax and depreciation net cash flows from operation of the rail link will be $580,000 per year, based on usage projections of 350,000 round-trips per year. The company can claim straight-line depreciation deductions of $150,000 per year against the cost of construction and operation of the rail link. The company faces a 30% corporate tax rate on all earnings and has indicated that its required rate of return on existing similar projects is 12% per annum.

Required:

a) Determine the net present value (NPV) of the project and advise Connex Rail Limited whether they should undertake construction and operation of the rail link project.

b) During the planning process for the project, Connex Rail Limited received an offer from La Trobe University to take over the ownership and operation of the rail link at the end of the tenth year of the project’s operation, as a means of ensuring access to the service for staff and students at the Bundoora campus. La Trobe University is willing to offer $2,000,000 to Connex Rail Limited at this point in time (the end of the tenth year of the project’s operation) to take over the operation of the project from the beginning of year 11. Assuming no change in cash flow or other estimates, and ignoring any consideration of terminal cash flows or other recovery costs, use net present value (NPV) analysis to determine whether Connex Rail Limited should sell the project to La Trobe University at the end of year 10.

TB

1

(7 + 3 = 10 marks)

Page 81 of 90

SAMPLE EXAM

Question 2.

Corporate Finance

Hanoi University-FMT

Babcock & Brown Limited is a leading, globally-focused investment bank which listed on the Australian Stock Exchange (ASX) in October 2004. Babcock & Brown Limited specialises in structured finance and the creation, syndication and management of asset and cash flow- based investments. More specifically, the company is involved in five types of investment and financing activities: real estate, infrastructure and project financing, operating leasing, structured finance and funds management. Although the company’s head office is located in Sydney, Australia, it has a global investment orientation and operates from 19 offices worldwide, with administrative offices being located in Sydney, San Francisco, New York, Munich and London. Information provided in the company’s initial public offering (IPO) prospectus indicated that the primary purpose for the company listing on the ASX was to expand its capital base to allow for significant expansion in its principal investment-related activities. Furthermore, much of this expansion is envisaged as being achieved in international markets, and ongoing investment opportunities and infrastructure projects will require access to additional internal and external capital in the future.

Required:

a) Based on the information provided above, outline, with appropriate reasoning and justification, what you think a suitable dividend policy strategy for the company to adopt would be.

b) What does the above information suggest about the likelihood of Babcock & Brown Limited being able to pay fully-franked dividends to its shareholders, and what impact might this have on their preferred dividend policy?

c) Following Babcock and Brown’s IPO listing on the Australian Stock Exchange in 2004, its major shareholders comprise the original founders of the company and a number of leading institutional shareholders, including domestic life insurance and superannuation funds and major overseas fund management companies. Outline, once again explaining your reasoning, whether such a clientele of shareholders is likely to favour the company adopting a low dividend or a high dividend payout policy. Think about tax considerations and investment horizon and current income requirements when answering this question component.

TB

2

(4 + 3 + 3 = 10 marks)

Page 82 of 90

SAMPLE EXAM

Question 3.

Corporate Finance

Hanoi University-FMT

Lend Lease Corporation Limited is a leading listed company on the Australian Stock Exchange which operates in the property development and real estate sector. This sector has not always been the company major focus, however, and until very recently the predominant share of the company’s revenues and profits were derived from fund management and investment activities through their subsidiary company, MLC Limited. The company decided to sell MLC Limited to National Australia Bank Limited in 2001 for approximately $5 billion, with these funds used to expand the company’s property and real estate business operations. A major part of this restructuring process was aimed at international expansion, which has resulted in the purchase and development of major business units in the USA, the United Kingdom and Continental Europe. As a consequence of this international expansion, only approximately 25% of the company’s revenues are now derived from its Australian operations, with the remaining 75% associated with their businesses in the USA and Europe. Operating and financial performance information is provided below for Lend Lease Corporation Limited as at their respective 30 ^th June year-ends:

	2000	2001	2002	2003
Earnings per share (EPS)	$0.874	$0.337	$0.524	$0.625
Dividends per share (DPS)	$0.640	$0.210	$0.180	$0.300
Cash flow per share	$1.420	$0.640	$1.290	$0.880
Capital spending per share	$0.090	$0.100	$0.130	$0.060
Dividend pay-out ratio	73.23%	62.31%	34.35%	48.00%
Dividend franking percentage	100.00%	38.00%	50.00%	33.00%
Debt to total capital ratio	23.55%	35.69%	32.18%	37.37%

On August 29 ^th 2003, the company announced the initiation of an on-market share buy-back program as a means of returning capital to company shareholders. The buy-back program will remain open for one year from September 10 ^th 2003 to September 10 ^th 2004, with the aim of repurchasing a maximum of 43,452,820 ordinary shares (equivalent to 10% of the company’s issued share capital).

Required:

a) Using the information provided above, outline the likely reasons or motivations for Lend Lease Corporation Limited announcing the share buy-back program in August 2003.

b) Explain briefly whether the use by Lend Lease Corporation Limited of the on-market buy-back process to return capital to shareholders is consistent with Australian resident investors’ preferences for dividend income versus capital-gain distributions?

c) The last sale share price for Lend Lease Corporation Limited on August 29 ^th 2003 was $4.10, which represented an increase of $0.18 on the previous day’s closing price of $3.92. What does this suggest about the reaction of investors to the announcement of this share buy-back program, and what reasons might explain this share-price reaction?

TB

3

(4 + 3 + 3 = 10 marks)

Page 83 of 90

SAMPLE EXAM

Question 4.

Corporate Finance

Hanoi University-FMT

On March 8 ^th 2005, after the close of trading on the Australian Stock Exchange (ASX), BHP Billiton Limited (BHP) announced a takeover offer for all of the outstanding issued shares in WMC Resources Limited (WMR). The takeover bid involved a cash offer of $7.85 per share for the entire issued capital of WMC Resources Limited, exceeding a competing cash takeover bid of $7.20 per WMC Resources Limited share made earlier by Xstrata Plc. On March 9 ^th 2005, the Board of Directors of WMC Resources Limited released an announcement recommending that WMC Resources Limited shareholders accept the takeover offer from BHP Billiton Limited in the absence of a superior takeover proposal from a competing bidder. WMC Resources Limited is a major diversified Australian resources company involved in the exploration and production of nickel, copper, uranium oxide and phosphate fertilisers, with operations in South Australia, Western Australia and Queensland. NHP Billiton Limited is the world’s largest diversified resources company, with major world-wide commodities businesses in aluminium, energy and metallurgical coal, copper, iron ore and titanium minerals, and also has substantial interests in oil, gas, liquefied natural gas, nickel, diamond and silver mining. In its bidder statement, BHP Billiton Limited suggested that the takeover of WMC Resources Limited will provide synergistic benefits from combining their nickel and coal businesses, complementary benefits from adding uranium assets to its existing energy portfolio of oil, gas and coal businesses and gains through the removal of duplicate functions and improved logistics management. The company estimates that these benefits will equate to additional after-tax profits of $115 million per year into perpetuity. Financial information for the two companies at the time of the takeover announcement is provided in the table below:

	BHP Billiton	WMC Resources
Market capitalisation (in $million)	65,600	9,107
Number of issued shares (in million)	3,478	1,172
Sales revenue (in $million)	33,222	3,828
Net profit after-tax (in $million)	4,939	736
Earnings per share (in $)	0.793	0.628
Dividends per share (in $)	0.261	0.370
Price-earnings (P/E) ratio (number of times)	24.12	11.88
Dividend pay-out ratio (%)	32.91	58.92
Closing share price on March 8 th 2005	$18.86	$7.46
Closing share price on March 9 th 2005	$19.08	$7.99

BHP Billiton Limited estimates that the company’s after-tax weighted average cost of capital (WACC) would be 15.00% following the successful takeover of WMC Resources Limited.

a) Outline the possible reasons why the closing share price for WMC Resources Limited on March 9 ^th 2005 was $7.99, which is higher than the takeover offer price of $7.85 per share.

b) Based on the above provided information, calculate the total gains or losses to the shareholders of both BHP Billiton Limited and WMC Resources Limited, assuming that the takeover transaction is successfully completed.

c) Rework your takeover valuation analysis assuming that, instead of using a cash offer, BHP Billiton Limited offered WMC Resources Limited shareholders one BHP Billiton Limited share for every 2.30 WMC Resources Limited shares. What are the gains to both companies under these share-exchange terms, and which method of payment would WMC Resources Limited shareholders prefer?

(2 + 4 + 4 = 10 marks)

TB

4

Page 84 of 90

SAMPLE EXAM

Question 5.

Corporate Finance

Hanoi University-FMT

Capital structure change and modification is an important ongoing decision that companies and their managements have to contemplate and evaluate. Choosing between different sources of financing, including debt and equity finance sources, can have major implications, not only on the company’s cost of capital and market value, but also on the company’s perceived level of risk and investor confidence.

Consider the takeover situation in Question 4 above involving BHP Billiton Limited’s takeover proposal to acquire WMC Resources Limited. The acquisition of 100% of the issued share capital of WMC Resources Limited in a successful takeover will cost BHP Billiton Limited approximately $9.20 billion. The company is unlikely to have cash reserves sufficient to meet this takeover funding requirement and, unless the company decides to use a share-exchange payment process for the takeover, it will have to raise funds in external capital markets to pay for this acquisition.

Required:

a) Outline the factors that the directors of BHP Billiton Limited would consider when evaluating whether to issue debt or equity securities to meet the financing needs for this takeover transaction. What factors are likely to be most persuasive in determining whether debt financing should be used to provide the required takeover financing?

b) Assume that the directors of BHP Billiton Limited believe that the recent strong performance of the Australian sharemarket has resulted in an increase in the company’s share price above their perceived intrinsic valuation for the company of $18.00 per share. Based on this knowledge, following the pecking order theory of capital structure determination would suggest the use of what form of finance – debt finance or equity finance or a combination of both? Briefly explain your reasoning.

TB

5

(7 + 3 = 10 marks)

OVER/

Page 85 of 90

SAMPLE EXAM

Question 6.

Corporate Finance

Hanoi University-FMT

Biotechnology Development Limited is a relatively new company on the Australian Stock Exchange and is currently all-equity financed with 40 million shares on issue that are trading at a current market price of $8.00 per share. The company has a perpetual net operating income (NOI) of $50 million per annum and has been exempted from corporate taxation due to a Government ruling regarding the technology-related nature of its operations. Assume you are operating in an environment consistent with the Modigliani and Miller (M&M) irrelevance theory.

Required:

a) What are the current earnings per share (EPS), cost of equity and overall cost of capital for the company?

b) The company is considering the repurchase of 10 million of its issued shares at the current market share price of $8.00, funded by an issue of perpetual corporate debentures. These debentures will carrying an 8% before-tax coupon interest rate and will be issued at a face value of $50,000 per debenture. What will be the value of the company, the earnings per share (EPS), the cost of equity and the overall cost of capital after this financing re-structure?

c) The Government surprisingly announces a change in policy emphasis away from biotechnology research and towards higher education and removes the taxation exemption previously afforded to the company. Assuming the company is now required to pay tax on its earnings at the 30% corporate tax rate, re-work your answers to part b) based on this corporate tax change.

d) Identify the optimal capital structure choice for Biotechnology Development Limited in parts b) and c).

TB

6

(2 + 3 + 4 + 1 = 10 marks)

OVER/

Page 86 of 90

SAMPLE EXAM

Corporate Finance

Hanoi University-FMT

Formula Sheet for the Corporate Finance (FIN31CFI) Final Examination Paper

Time Value of Money

Present value of an ordinary annuity:

PV

=

C

×

⎡ 1

⎢

⎣

1/(1

+ r

)

t

−

r

where:

C = equal annuity amount

⎤

⎥

⎦

OR

r	= interest or discount rate
t	= number of periods of the annuity

PV

=

C

×

PVIFA

(

t

,

r %)

PVIFA _{(t , r%)} = annuity discount factor for t periods at r%, from the present value of an

ordinary annuity table

Present value of an ordinary perpetuity:

		PV	=	C
				r
where:
C	= the annual perpetuity amount
Present value of a growing perpetuity:
		PV =		C
			r	−	g

where:

C = cash flow in year 1

r	= interest rate or required rate of return
g	= long-term growth rate in cash flows

Capital Investment Decision-Making

Net present value (NPV) method:

NPV = Present value of

future project cash flows − Initial Investment Cost

Annual cash flows from an investment project (Short-cut method):

TB

Annual cash flow = Net income

7

(1

− t

C

)

+ Depreciati on

(

t

C

)

OVER/

Page 87 of 90

SAMPLE EXAM

Initial project cost:

Corporate Finance

Asset purchase or construction cost

+ Installation and set-up costs

+ Increase in net working capital requirements

+ Opportunity costs

- Salvage value from disposal of old asset (if relevant)

± Tax gain (loss) on disposal of old asset (if relevant)

Terminal Cash Flow from an Investment:

Salvage value from disposal of the asset ± Tax loss (gain) on disposal of asset

+ Recovery of net working capital

- Completion expenses

NPV of Abandonment decision:

Hanoi University-FMT

NPV = Abandonment value − Present value of future cash flows

Cost of Capital Estimation

After-tax weighted average cost of capital (WACC):

where:

WACC =

(

D

/

V

)(

R

D

)(1

− t

C

)

+

(

P

/

V

)(

R

P

)

+

(

E

/

V

)(

R

E

)

D	= the market value of debt
P	= the market value of preference shares
E	= the market value of equity
V	= the market value of the firm (V = D + P + E)

t _C = the applicable corporate tax rate R _D = the before-tax cost of debt R _P = the after-tax cost of preference shares R _E = the after-tax cost of equity

Capital Structure Determination

Earnings per share (EPS):

EPS = After-tax earnings available to shareholders / Number of issued shares

TB

8

OVER/

Page 88 of 90

TB

SAMPLE EXAM

Corporate Finance

Without Corporate Taxes

Value of the firm (V):

EBIT

V

	OR		V	=
					R
/	V	× R	D	OR
	D	/ E )		or	R
U		+ ( D		× t C		)
( EBIT			−	Tax	)
		R	U

= D + E

R

−

E

R

+

D

D

) × (

V L

V ^U

= V

=

A

E

where:

R _A = overall cost of capital for the firm

Overall cost of capital (R _A ):

R

A

=

E

/

V

×

Cost of equity capital (R _E ):

R R

E

=

A

+ (

R

A

where:

Net income = EBIT - Interest

With Corporate Taxes

Value of the levered firm (V _L ):

EBIT

V

R

A

=

=

Net income

E

where:

V _U = the value of an unlevered firm D = the market value of debt t _C = the corporate tax rate

Value of the unlevered firm (V _U ):

where:

R _U = the cost of equity for the unlevered firm

9

Hanoi University-FMT

Page 89 of 90

SAMPLE EXAM

Cost of equity capital (R _E ):

R

E

=

R

U

+

(

R

U

−

R

D

)

×

(

D

/

)

E

×

Overall cost of capital (R _A ):

R

A

=

EBIT

(1 −

t

C

)

V

Corporate Finance

Hanoi University-FMT

OVER/

(1

−

t

C

)

OR

OR

R

E

=

(

EBIT

−

)(1

Interest

−

t

C

)

E

Using WACC equation

Mergers, Acquisitions and Takeovers

Gain from a takeover (ΔV):

ΔV = V − V + V

AB

(

A

B

)

where:

V _AB = the value of the merged firm V _A = the value independently of the bidding firm V _B = the value independently on the target firm

Value of firm B to firm A: (V _B ^* ):

NPV of a takeover:

NPV

=

V

*

B

−

V

*

B

Cost

=ΔV + V

B

to Firm

A of

the takeover

Proportional ownership from a share exchange takeover (μ):

TB

μ=

Shares issued to Company B

Total issued shares in Company AB

10

Page 90 of 90