Lecture 11

Corporate Finance Hanoi University-FMT

Corporate Finance (FIN3CFI) Topic 1: Share Repurchases - A

Lecture 11 Dividend Policy Alternative

1 2

Introduction Introduction cont.

• Australian companies are increasingly • A share buy-back involves a company

opting to repurchase (or buy-back) their making an offer to shareholders to buy their
own shares as an alternative or an addition shares at a fixed (or market) price
to paying out earnings as dividends – These share must then be ‘retired’ or removed
• Background to share repurchases: from the issued capital of the company
– Prohibited in Australia up until 1989 – Can be financed out of retained earnings or debt
– Revision of Companies legislation in 1989 – Buy back will have an influence on the
allowed listed companies to buy-back up to ownership structure of the firm, the firm’s capital
10% of their issued share capital each year (12 structure and earnings per share (EPS) and
month period) without shareholder approval possibly its share price (and shareholder wealth)
(10/12 rule) – The announcement of buy-backs normally has a
3
positive influence on company share prices 4

Types of Share Buy-Backs Types of Share Buy-Backs cont.

• There are five types of share buy-backs:

– Employee share scheme buy-back
– On-market buy-back • Off-market purchases of shares from employee
• Purchase undertaken on the ASX at a price no shareholders
greater than 5% of the average last sale price of
shares over the 5 previous trading days
– Odd-lot buy-back
• Represents the most common form of buy-back • Off-market purchases of shareholdings below a
marketable parcel which can not be economically
– Selective (off-market) buy-back sold on-market
• Shares are acquired from specified shareholders – Equal access buy-back
in off-market transactions at a specified price
• Off-market purchase where each shareholder can
• Often used to remove particular shareholders from sell a fixed proportion of their shares to the company
the company’s share registry, or as a means of at a set price (such as 10% of shares)
distributing excess franking credits
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Motives for Share Buy-Backs Motives for Share Buy-Backs cont.

• Dividend substitution: A share repurchase

• Shareholder preferences for dividends v.
is an additional means of paying capital gains
shareholders – An on-market buy-back is treated as a normal
– Without tax, the “direct effects” of dividend and share sale and results in a capital gains tax
repurchase are identical liability (if shares were purchased after
– With tax: dividends have franking credits vs. September 1985)
only 50% of capital gains (from repurchases) – An off-market buy-back comprises a dividend
are taxable portion (can be distributed with franking
credits), which is the excess of the buy-back
– Australian companies, with significant foreign price over the capital contribution
operations and earnings, do not pay Australian – Use of on-market or off-market buy-backs to
tax Æ dividends have no franking credits best suit investors’ tax and shareholding status
7 8

Tax rates 2005-06 Tax rates 2006-07 Motives for Share Buy-Backs cont.

Income Rate Income Rate • Improved “performance measures”

$0 – $6,000 Nil $0 – $6,000 Nil – A buy-back will have the immediate effect of
$6,001 – $21,600 15% $6,001 – $25,000 15% increasing EPS, as the number of issued
$21,601 – $63,000 30% $25,001 – $75,000 30% shares decreases after a buy-back
$63,001 – $95,000 42% $75,001 – $150,000 40% – This often follows with a corresponding share
Over $95,000 47% Over $150,000 45% price increase, due to an increase in EPS being
perceived as a signal of improved performance
Medicare levy: 1.5%; Medicare levy surcharge: 1.0%
– A buy-back will also result in an increase in the
• With the tax reduction, there is almost no effective debt/equity ratio of the company which
advantages of capital gains over dividends may have positive incentive effects, but also
for Australian investors invested in raises the firm’s relative level of financial risk
Australian companies 9 10

Motives for Share Buy-Backs cont. Motives for Share Buy-Backs cont.

• Free cash flow (agency theory explanation) • Financial flexibility

– For firms with few positive NPV investments, it is – Buy-backs preserve financial flexibility whereas
better to return cash to shareholders than waste dividends represent an ongoing commitment to
it on bad investments or perquisite consumption future payments
• Information asymmetry and signalling – Dividends signal a permanent increase in
earnings, whereas a buy-back represents a
– Similar to dividends, a share buy-back may
temporary increase in earnings
signal an increase in future earnings and
performance • Remove particular shareholders (use of
– May also signal that the share price is selective buy-backs)
undervalued and the firm is buying back its – Such as a troublesome shareholder, a potential
shares at a lower price than they are worth future takeover bidder or small employee or
11 12
individual holdings

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Comparison of a Share Buy- Evaluation of Share Buy-Back

Back and a Dividend Payment Motives
• In a M&M world, a dividend payment and a share
buy-back are perfect substitutes (see numerical • Consider the following two examples of
example in Lecture 11) companies which have recently (2006)
• Market imperfections will result in an influence on conducted share buy-backs:
shareholder wealth of dividend announcements • Commonwealth Bank Limited (CBA)
and buy-back transactions
– One of the ‘Big four’ banks, involved in banking,
– Share prices typically fall by less than dividend
payments
funds management and insurance activities
– Share price typically increase on announcement of buy- – Around 95% of their revenue and profits are
backs derived from Australia or New Zealand
– Also the existence of different preferences by – Highly profitable and has achieved significant
shareholders for dividends versus capital return through
13 share-price growth in recent years 14
buy-backs

Evaluation of Share Buy-Back Evaluation of Share Buy-Back

Motives cont. Motives cont.

• Financial information for CBA: • Orica Limited (ORI)

2003 2004 2005 – Diversified firm involved in the manufacturing of
Share price $29.55 $32.58 $37.95 commercial explosives, industrial and mining
Earnings per share $1.57 $1.97 $3.03 chemicals, agricultural chemicals and fertilisers
and paint and other consumer products
Dividends per share $1.54 $1.83 $1.97
– Around 60-65% of the firms revenues are
Capital exp. per share $0.11 $0.34 -$1.38 generated in Australia and New Zealand, with
Franking percentage 100% 100% 100% the remainder based on their US and European
Dividend payout ratio 98.1% 92.9% 65.0% explosives businesses
Issued shares (Million) 1,254 1,264 1,280 – Star performer following a major share-price
15
slump up to 2001 16

Evaluation of Share Buy-Back Evaluation of Share Buy-Back

Motives cont. Motives cont.

• Financial information for ORI: • Conclusions on CBA motives

2003 2004 2005 – Buy-back most likely used as a means to
Share price $11.68 $16.83 $20.44 distribute excess free cash flow
Earnings per share $0.93 $1.13 $1.14 – Very high earnings and dividends and low
Dividends per share $0.50 $0.66 $0.69 capital expenditure
Capital exp. per share $0.41 $0.70 $1.24 – Has a high dividend payout and pays fully-
franked dividends, so a buy-back is unlikely to
Franking percentage 21% 41% 32% represent a form of dividend substitution
Dividend payout ratio 53.8% 58.4% 60.5% – No real evidence of undervaluation, or the
Issued shares (Million) 286 278 281 need to signal an increase in EPS
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Evaluation of Share Buy-Back Evaluation of Share Buy-Back

Motives cont. Motives cont.
• Conclusions on ORI motives
• General conclusion is that the motives differ
– Buy-back is most likely as a form of dividend
substitution. Has a lower dividend payout ratio and across the two companies
pays predominantly unfranked dividends – An interesting fact is that both companies also
– This is due to significant degree of foreign operations offer dividend re-investment schemes for
which generate profits not subject to Australian shareholders
corporate tax that, therefore, cannot be used to pay
franked dividends – This is inconsistent with a buy-back being used
– Shareholders would likely prefer a capital gain (through for excess cash flow reasons
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 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’
Topic 2: Mergers, Acquisitions Merger or consolidation

and Takeovers
Acquisition Acquisition of stock

Takeovers Proxy contest Acquisition of assets

Going private
21 22
(leveraged buyouts)

Importance of Takeovers in
Takeover: Investment Nature Australia
• Takeovers are important because they
• A takeover is an investment decision involve changes in the ownership and/or
– Should only takeover a company when the control of valuable assets
acquisition will create value for the firm and
shareholders (when the acquisition represents • From 1999-2003 there were 1,834 takeovers
a positive NPV investment) of Australian listed and non-listed companies
– May also have financing and capital structure with a total value of $99.56 billion
effects, depending on how the takeover is • Takeover activity tends to occur in waves
financed – Runs in cycles with the economy
– Evidence that takeover activity is positively
23
related to the behaviour of the stock-market and
24
movement in share prices

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Types of Takeovers Motives for Takeovers

• General idea of synergy creation or gains
• There are three main types of takeovers: – Situation where the value of a combined entity
– Horizontal takeover: takeover of a target exceeds the sum of the previously separate
company operating in the same line of components
business as the acquiring company. – Based on the ‘1 + 1 = 3’ concept:
– Vertical takeover: takeover of a target
company which is either a supplier of goods to,
V AB > V A + V B
where:
or a consumer of goods produced by, the
• VAB = the value of the assets of the combined
acquiring company (upstream or downstream
company
takeover).
• VA = the independent value of Company A
– Conglomerate takeover: takeover of a target • VB = the independent value of Company B
company in an unrelated type of business.
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Motives for Takeovers cont. Motives for Takeovers cont.

• Target company is managed inefficiently • Increased market power or share

– Replacing the current management with a more – Buy/remove an existing competitor
efficient management team – Easiest way to expand is to buy assets in place
• Strategic or complementary benefits – May also provide greater price-setting power or
– Entering a new market or industry greater bargaining power with suppliers
– Gaining first-mover benefits among competitors • The target company is undervalued
– Acquiring employee expertise or production – The market value of the target company <
technology market or break-up value of its assets (potential
– Secure or monopolies input recourses and/or for asset stripping)
output distribution
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Motives for Takeovers cont. Motives for Takeovers cont.

• The target company has excess liquidity or • Diversification benefits

free cash flow – Potential to reduce overall company risk
– Access to excess funding for investment – Acquiring a firm with a different earnings
purposes pattern lowers systematic risk
– Solve a growth-resource imbalance problem – Increase overall debt capacity and reduce the
• Cost reductions result risk of default on debt (overall default risk)
– Savings due to economies of scale (size benefit) – But the diversification benefits are
or scope (good or service production or sales) questionable since investors can diversify risk
– Removal of duplicate activities (eg. head office, by themselves
finance and payroll, distribution network)
– Use of excess capacity (storage, warehouse or
29 30
production facilities)

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Motives for Takeovers cont.

Types of Takeover Offers
• Tax benefits result
• There are three forms of takeover offers
– Use tax losses to offset against company tax
payable
available to bidding companies in
Australia:
– Acquiring excess debt capacity to increase tax
– Off-market (formal) takeover offer
shield benefits or imputation tax credits
– On-market (tender) takeover announcement
• Increased earnings per share and price- – Time-delayed purchase (creeping takeover)
earnings ratio effects • Trigger for a takeover bid:
– Can ↑ EPS without generating any real benefits – The Corporations Law in Australia prohibits
– Takeover a firm with a lower P/E ratio than the any shareholder from acquiring more than
bidder’s 20% ownership of a listed company without
– Buying a firm with ‘cheaper’ earnings using one of these methods
31 32

Off-market Takeover Offer On-Market Takeover

• Off-market takeover offer represents: • On-market takeover bid:
– An offer to all shareholders of the target to – Also known as tender offers, and are commonly
acquire part or all of their shares used in the US
– Consideration can be cash, shares or a – Requires an unconditional undertaking by a
combination member firm of the ASX, on behalf of the
– Offer terms can be revised during the offer bidder, to stand in the market and acquire, for a
period period of at least 1 month, all shares offered on
– Must remain open for between 1 and 6 months the exchange at a specified cash-only price
– Bidder required to issue a Part A statement – Offer can be revised and extended up to 6
outlining the terms of the offer months
– Target management required to respond with a – Bidder must issue a Part C statement and the
Part B statement (including a recommendation to target can respond in a Part D statement
shareholders and possibly expert’s information)
33
– Not very commonly used in Australia 34

Time-Delayed Purchase Defensive Tactics in Takeovers

• Takeover bids are often unsolicited (known as
• Creeping takeovers: hostile or unwanted bids)
– Allows the acquisition of no more than 3% of – In this case the target company can employ
the target’s shares every 6 months, provided various strategies to try and fight off takeover bids
that a threshold ownership level of 19% has
– Use of arrangements such as poison pills, anti-
been maintained for at least 6 months
takeover amendments, golden parachutes, white
– No public statement (Part A or C) is knights, crown jewel lock-ups
necessary
– Formal defensive mechanisms such as poison
– Because of the time required, such an pills are legislatively prohibited in Australia
approach to a takeover is not normally used
– Australian defensive tactics are based on use of
– Most takeovers in Australia are formal or off- going private transactions, expert’s valuations,
market bids (probably about 90% of all bids) 35 litigation, advertising and media reporting 36

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Corporate Finance (FIN3CFI) Topic 1: Mergers and

Lecture 12 Acquisitions Continued

1 2

Gain and Cost from a Takeover

Evaluation of Takeovers
• The gain from a takeover is the difference
• Takeovers represent investment decisions between the value of the combined
• Whether a takeover bid is a good company and the sum of their values as
investment or not should be evaluated independent entities:
based on whether it generates positive Gain (ΔV ) = V AB − (V A + V B )
NPV for the bidding firm or not. • Note:
– The analysis below assumes firms are
unlevered
– For levered firms, certain adjustments are
required, particularly the interpretations of VA,
3 VB, VAB 4

Gain and Cost from a Takeover cont.

Acquisition by cash payment
• This gain is normally shared between • Cost is the offer price × no. of company B shares
– Premium associated with the takeover is the difference
bidding and target company shareholders: between the amount paid and value of the target firm.
– Depends on the takeover offer relative to the Premium = Cash payment – VB
value of the target firm – Premium is also the gain to the shareholders of B

– But all costs (particularly the takeover premium • The takeover will have a positive NPV for firm A
only if the value A gets exceeds the cost paid, or
offered) are borne by the bidding firm if the gain exceeds the premium
• In the analysis below, the costs only include – NPVAB = (VB + ΔV) – Cost
the consideration from the bidding firm to the = [VAB - (VA + VB)] – (Cash – VB)
target firm. But beware of other costs • If the NPVAB > 0, then the merger is worthwhile
(value increasing for firm A) and gain to
shareholders of A = NPVAB
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Acquisition by cash payment cont.

The Gains and Costs of Cash
Acquisition
• Maximum payment to company B is VB + • The amount of the cash consideration
ΔV: Value of target plus any perceived offered determines how the total gain is
takeover gain divided between the two sets of shareholders
• Maximum offer price for B shares is (VB + – Every additional $1 paid to the target’s
ΔV )/no. of B shares shareholders means $1 less for the bidder’s
– What the bidder is getting from the takeover? shareholders
• Of course, the minimum offer price is the – Target shareholders get the difference between
cash payment and target company value
market price of B shares before the merger
– Bidder shareholders get the difference between
– Then what the bidder is getting from the the takeover gain and the premium paid
takeover?
– The higher the premium => ↓ benefit for A => ↑
7 benefit for B 8

Acquisition by a Share Exchange Acquisition by a Share Exchange cont.

• This complicates the analysis • The proportional ownership of AB by former

– The cost of the takeover (and the premium paid) company B shareholders is:
depends on the takeover gain and the value of Shares issued to company B
company A’s shares μ=
No. of shares in company AB
– Need to determine the proportion of the merged
firm which will be owned by target shareholders: • Let the share exchange ratio be ω
Premium= μVAB − VB – ω shares of firm A offered for one B share
where: – This will be provided in the takeover terms (such
• μ = the proportional ratio of shares owned by B as 1 company A share offered for every 4
• Cost of takeover = μVAB company B shares Æ ω = ¼ = 0.25)
9 10

Takeover Valuation Example

Acquisition by a Share Exchange cont.

• Details of takeover example

• If NA, NB and NAB are the numbers of firms
– Alinta Limited (ALN) takeover bid for Australian
A, B, and AB, we have
Gas Light Co. Ltd (AGL) announced on 20/3/06
NAB = NA + ωNB
– Both are utilities companies involved in gas and
μ = ωN B N AB = ωN B ( N A + ωN B ) electricity transmission and distribution networks
• Premium per share – Takeover proposal involves acquiring 100% of
AGL shares
( μV AB − V B ) / N B = ωV AB / N AB − VB / N B
– Share exchange terms are 1.773 ALN shares for
• This premium differs from naïve premium every 1 AGL share held
ωpA – pB (it is usually greater if the merger – To show the cash offer process, assume there is
has positive gain), where pA and pB are pre- an alternative cash offer of $19.31 per AGL
merger prices of firms A and B 11
share 12

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Takeover Example cont. Takeover Example cont.

• Financial information for the two firms: • Expected gains from the takeover are
ALN AGL estimated by ALN’s bidder statement:
Earnings after tax $101,988,000 $387,200,000 – Corporate cost savings of $34 million per year
Issued shares 260,009,100 456,577,000 – Asset management cost savings of $39 million
EPS $0.392 $0.848 per year
Share price (17/3/06) $10.89 $18.39 – Energy sales and marketing cost savings of $27
million per year
Share price (20/3/06) $10.95 $18.80
– Total per year earnings gain = $100 million
P/E ratio 27.780 21.686
– Alinta Limited’s overall cost of capital (before-
Market value $2,831,499,099 $8,396,451,030
tax) is 12.50%, assumed to be the cost of
13
capital after the takeover 14

Takeover Example cont. Takeover Example cont.

• Naïve premium of share exchange takeover: • Gain of T/O: ΔV =

– Price per AGL share =
• Cash Offer ($19.31 per share)
– Premium = – Value of AGL to ALN =
– This figure probably underestimates the true – Cost of takeover =
premium because it does not include takeover – NPV of takeover =
gain, evidenced by price raises after the takeover – Gain to AGL =
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 16

Takeover Example cont.

Takeover Example cont.

• Share exchange offer (ω = 1.773) – NPV of Takeover =

– No. of shares to issue (ωNB) = – Gain to AGL =
– Shares on issue after takeover (NAB) = – The gain to ALN (AGL) with the share
– Ownership of AGL in post-merger ALN (μ)= exchange is substantially lower (higher), even
– MV of firm (VAB) = though they are offering the same naïve bid
premium as in the cash offer
– Cost of takeover =
– Actual per share premium to AGL =
– This implies a premium =

17 18

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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 Topic 2: Course Summary and
– Will examine mergers and acquisitions in much Revision
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 20

What Have the Unit Covered? What Have the Unit Covered?
• Company Structures and Goals, Agency • Issues in Investment Evaluation
Theory – Conflicts between NPV and IRR and between
other evaluation methods
– Nature of listed companies versus other
business structures – Projects with non-conventional cash flows
– Multiple internal rates of return
– Agency theory considerations with listed firms
– Evaluating projects with unequal lives
• Investment Evaluation Process and – Incremental approach to project evaluation
Techniques – Adjusting for risk in investment decision-making
– Cash flow calculations (initial, annual and – Abandonment and other contingency options
terminal cash flows)
• Lease and Equipment Financing
– NPV, IRR, payback, present value index and – Types of leases
accounting rate of return methods
21 – Net advantage of leasing (NAL) evaluation 22

What Have the Unit Covered? . What Have the Unit Covered?
• Sources of Short-Term and Long-Term
Financing • The Financing Decision and the Effects of
– Characteristics of debt and equity finance Financial Leverage
– Different issue methods for debt and equity – Use of financial leverage
– The initial public offering (IPO) process – Business and financial risk
– Public, private and rights issues – Effect of leverage and financing choice
– Rights issue valuation
• Capital Structure Determination
• Required Rates of Return and the Cost of
– Determining a firm’s optimal capital structure
Capital
– Cost of capital calculation using a pure play – M&M and Static (trade-off) approaches
– Calculation of the cost of various forms of capital – Pecking order (signalling) theory
– Incorporating the effect of flotation (issue) costs – Implications for firm value and shareholder
23 24
– Calculation of WACC wealth

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What Have the Unit Covered? What Have the Unit Covered?
• Taxes and Capital Structure Policy
– Effect of company taxes and bankruptcy costs • Share Repurchases (Buy-backs)
on capital structure – Types of share buy-backs
– Classical v. imputation tax systems – Motives for companies buying back shares
– Gain from leverage with company and personal – Investor preferences for buybacks v. dividends
taxes
– Effects on share price and the relationship with
– Impact on firm value and capital structure choice dividend policy
• Dividend Policy
• Mergers and Takeovers
– Types of dividend policies used by firms
– Different types of takeovers and the methods of
– Irrelevance of dividend policy (M&M)
undertaking takeovers
– Reasons for dividend policy relevance
– Motives for takeovers
– Preferences of investors for different dividend25
policies – Evaluation of takeovers 26

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SAMPLE EXAM

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.

(7 + 3 = 10 marks)

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SAMPLE EXAM

Question 2.

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.

(4 + 3 + 3 = 10 marks)

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SAMPLE EXAM
Question 3.

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 30th 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 29th 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 10th 2003 to September 10th 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 29th 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?

(4 + 3 + 3 = 10 marks)

TB 3 Page 83 of 90
 Corporate Finance Hanoi University-FMT

SAMPLE EXAM
Question 4.

On March 8th 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 9th 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 8th 2005 $18.86 $7.46
Closing share price on March 9th 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 9th 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
 Corporate Finance Hanoi University-FMT

SAMPLE EXAM

Question 5.

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.

(7 + 3 = 10 marks)

OVER/

TB 5 Page 85 of 90
 Corporate Finance Hanoi University-FMT

SAMPLE EXAM
Question 6.

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).

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

OVER/

TB 6 Page 86 of 90
 Corporate Finance Hanoi University-FMT

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

Time Value of Money

Present value of an ordinary annuity:

⎡1 − 1 /(1 + r ) t ⎤
PV = C × ⎢ ⎥ OR PV = C × PVIFA ( t , r %)
⎣ r ⎦
where:
C = equal annuity amount
r = interest or discount rate
t = number of periods of the annuity
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:

C
PV =
r
where:
C = the annual perpetuity amount

Present value of a growing perpetuity:

C
PV =
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):

Annual cash flow = Net income (1 − t C ) + Depreciati on (t C )

OVER/

TB 7 Page 87 of 90
 Corporate Finance Hanoi University-FMT

SAMPLE EXAM

Initial project cost:

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:

NPV = Abandonment value − Present value of future cash flows

Cost of Capital Estimation

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

WACC = ( D / V )( R D )(1 − t C ) + ( P / V )( R P ) + ( E / V )( R E )

where:
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)
tC = the applicable corporate tax rate
RD = the before-tax cost of debt
RP = the after-tax cost of preference shares
RE = the after-tax cost of equity

Capital Structure Determination

Earnings per share (EPS):

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

OVER/
TB 8 Page 88 of 90
 Corporate Finance Hanoi University-FMT

SAMPLE EXAM

Without Corporate Taxes

Value of the firm (V):

EBIT
V =D+ E OR V =
RA
where:
RA = overall cost of capital for the firm

Overall cost of capital (RA):

EBIT
R A = E / V × RE + D / V × R D OR RA =
V
Cost of equity capital (RE):

Net income
R E = R A + ( R A − R D ) × ( D / E ) or RE =
E
where:
Net income = EBIT - Interest

With Corporate Taxes

Value of the levered firm (VL):

V L = VU + ( D × t C )
where:
VU = the value of an unlevered firm
D = the market value of debt
tC = the corporate tax rate

Value of the unlevered firm (VU):

( EBIT − Tax )
VU =
RU
where:
RU = the cost of equity for the unlevered firm

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SAMPLE EXAM
OVER/

Cost of equity capital (RE):

(EBIT − Interest)(1 − t C )
RE = RU + (RU − RD ) × (D / E) × (1 − t C ) OR RE =
E

Overall cost of capital (RA):

EBIT (1 − tC )
RA = OR Using WACC equation
V

Mergers, Acquisitions and Takeovers

Gain from a takeover (ΔV):

ΔV = V AB − (V A + V B )
where:
VAB = the value of the merged firm
VA = the value independently of the bidding firm
VB = the value independently on the target firm

Value of firm B to firm A: (VB*):

V B* = Δ V + V B
NPV of a takeover:

NPV = V B* − Cost to Firm A of the takeover

Proportional ownership from a share exchange takeover (μ):

Shares issued to Company B

μ=
Total issued shares in Company AB

TB 10 Page 90 of 90