Case Studies Question 1 Neptune is a stock market listed company in the UK. It is a parts supplier to the automotive industry. Neptune has won a big new contract, which would require new investment by the company. The new contract is in the same line of business, but it would require a sizeable investment by the company. The contract is expected to produce after-tax cash flows of 45 million per annum for five years. The investment will need 135 million of financing. The company is considering various mixes of financing, from 100% equity through to 65% equity and 35% debt financing. The company can borrow at 7.5%. Whatever sum the company borrows for the project, it will repay all the principal back to the end of year 5 in the one payment. Interest would be paid annually on the outstanding principal It will cost Neptune to raise funds from the markets. Equity finance will have issue costs to the company of 10% of whatever sum it raises. With debt finance the issue costs for borrowing would be 5% of the sum raised. Neptune needs a net 135m to invest in the project. The company tax rate is 25%. Senior management have asked you to evaluate the attractiveness to shareholders (ie. wealth maximisation) of the two options: all-equity funding or 35% debt funding. They want you to conduct the analysis using the Adjusted Present Value (APV) method. With the debt funding proportion (i.. 65% equity and 35% debt), the debt beta will be 0.32 and the equity beta will be 1.495. The risk-free rate of interest is 5.5% and the market risk premium is 6%. Required: Maximum Word Limit 1000 words (a) Calculate the APV of the project if it was funded entirely with a new issue of equity. (6 marks) (b) Calculate the APV of the project if it was funded with 35% new debt and 65% new equity. Comment on the suitability of the project under the different funding arrangements. (10 marks) (c) Why should managers use the adjusted present value (APV) technique if they can use the WACC/NPV method instead? What advantages does the APV have? Give examples where it would be more useful than WACC/NPV. (8 marks) 1 (d) Explain fully how the following are dealt with in the capital budgeting process: inflation, working capital, sunk costs and cannibalisation, giving examples where you can. (6 marks) Section 11 2 Short Questions Maximum Word Limit 2000 words 1. In January 2021, Tesla Inc shares were priced at $860. The value of the company at that stock price was $810 billion. The reported price earnings ratio TTM (Trailing Twelve Month) ratio in the Financial Times at that date was 1,693. At the same date, Volkswagen (VW) was worth 89 billion and had P/E (TTM) of 18. In January 2021, 15 of the 25 investment analysts following Tesla had buy or hold ratings on the stock and 10 had sell. In finance terms, how can you justify Tesla's stock price? It is a growth stock, but how can you pay that price for growth? (8 marks) Discuss how the pricing inputs for the real options model differ from those for the financial option as used in the Black-Scholes model? What are the key differences? (8 marks) 3. What can go wrong with capital budgeting projects? Give an example of a project that has gone badly wrong and discuss the reasons why it has failed (this can be a project you have been involved with). (8 marks) The BP share price is 353p. The risk-free rate of interest is 2.5% and the volatility of the stock is 40%. What is the call price of a 360p three-month option using the Black-Scholes model? (8 marks) Palozzi will pay a dividend next year of 25p. Dividends are then expected to grow at a rate of 15% per annum for three further years after that. The dividend will then grow at 6% per annum for five years. After that (year 10 onwards) growth will slow to 2% per annum, which will be assumed to be the dividend growth rate thereafter. The cost of equity is 12%, the debt rate is 6% and the tax rate is 25%. Palozzi is 80% equity financed. What is the share price today? (8 marks) Total 40 marks 5 Case Studies Question 1 Neptune is a stock market listed company in the UK. It is a parts supplier to the automotive industry. Neptune has won a big new contract, which would require new investment by the company. The new contract is in the same line of business, but it would require a sizeable investment by the company. The contract is expected to produce after-tax cash flows of 45 million per annum for five years. The investment will need 135 million of financing. The company is considering various mixes of financing, from 100% equity through to 65% equity and 35% debt financing. The company can borrow at 7.5%. Whatever sum the company borrows for the project, it will repay all the principal back to the end of year 5 in the one payment. Interest would be paid annually on the outstanding principal It will cost Neptune to raise funds from the markets. Equity finance will have issue costs to the company of 10% of whatever sum it raises. With debt finance the issue costs for borrowing would be 5% of the sum raised. Neptune needs a net 135m to invest in the project. The company tax rate is 25%. Senior management have asked you to evaluate the attractiveness to shareholders (ie. wealth maximisation) of the two options: all-equity funding or 35% debt funding. They want you to conduct the analysis using the Adjusted Present Value (APV) method. With the debt funding proportion (i.. 65% equity and 35% debt), the debt beta will be 0.32 and the equity beta will be 1.495. The risk-free rate of interest is 5.5% and the market risk premium is 6%. Required: Maximum Word Limit 1000 words (a) Calculate the APV of the project if it was funded entirely with a new issue of equity. (6 marks) (b) Calculate the APV of the project if it was funded with 35% new debt and 65% new equity. Comment on the suitability of the project under the different funding arrangements. (10 marks) (c) Why should managers use the adjusted present value (APV) technique if they can use the WACC/NPV method instead? What advantages does the APV have? Give examples where it would be more useful than WACC/NPV. (8 marks) 1 (d) Explain fully how the following are dealt with in the capital budgeting process: inflation, working capital, sunk costs and cannibalisation, giving examples where you can. (6 marks) Section 11 2 Short Questions Maximum Word Limit 2000 words 1. In January 2021, Tesla Inc shares were priced at $860. The value of the company at that stock price was $810 billion. The reported price earnings ratio TTM (Trailing Twelve Month) ratio in the Financial Times at that date was 1,693. At the same date, Volkswagen (VW) was worth 89 billion and had P/E (TTM) of 18. In January 2021, 15 of the 25 investment analysts following Tesla had buy or hold ratings on the stock and 10 had sell. In finance terms, how can you justify Tesla's stock price? It is a growth stock, but how can you pay that price for growth? (8 marks) Discuss how the pricing inputs for the real options model differ from those for the financial option as used in the Black-Scholes model? What are the key differences? (8 marks) 3. What can go wrong with capital budgeting projects? Give an example of a project that has gone badly wrong and discuss the reasons why it has failed (this can be a project you have been involved with). (8 marks) The BP share price is 353p. The risk-free rate of interest is 2.5% and the volatility of the stock is 40%. What is the call price of a 360p three-month option using the Black-Scholes model? (8 marks) Palozzi will pay a dividend next year of 25p. Dividends are then expected to grow at a rate of 15% per annum for three further years after that. The dividend will then grow at 6% per annum for five years. After that (year 10 onwards) growth will slow to 2% per annum, which will be assumed to be the dividend growth rate thereafter. The cost of equity is 12%, the debt rate is 6% and the tax rate is 25%. Palozzi is 80% equity financed. What is the share price today? (8 marks) Total 40 marks 5