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Tutorial 3 - Solution

This document contains a tutorial on corporate finance with example questions and answers. It discusses topics such as valuing companies using price to earnings ratios, free cash flow, net asset valuation, dividend discount models, shareholder value analysis, and economic value added. The tutorial provides guidance on how to value companies in different scenarios, examine the drivers of shareholder value, and calculate key financial metrics like economic value added.

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Ng Chun Senf
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
42 views

Tutorial 3 - Solution

This document contains a tutorial on corporate finance with example questions and answers. It discusses topics such as valuing companies using price to earnings ratios, free cash flow, net asset valuation, dividend discount models, shareholder value analysis, and economic value added. The tutorial provides guidance on how to value companies in different scenarios, examine the drivers of shareholder value, and calculate key financial metrics like economic value added.

Uploaded by

Ng Chun Senf
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Corporate Finance – BA303

Tutorial 3 (Answers)
Corporate Finance – BA303

1) XYZ plc, which is unquoted, earns profit before tax of £80 million. It has issued 100
million shares. The rate of Corporation Tax is 30 per cent. A similar listed firm sells at a
P:E ratio of 15:1. What value would you place on XYZ’s shares?

Answer:

2) What is the free cash flow for the following firm?

Operating Profit (after depreciation of £2 m) = £25 m


Interest paid = £1 m
Tax rate = 30%
Investment expenditure = £3 m
Answer:

3) The Board of Directors of Rundum plc are contemplating a takeover bid for Carbo Ltd, an
unquoted company which operates in both the packaging and building materials industries.
If the offer is successful, there are no plans for a radical restructuring or divestment of
Carbo’s assets.

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Corporate Finance – BA303

• Carbo has recently tried to grow sales by extending more generous trade credit terms. As
a result, about a third of its debtors have only a 50 per cent likelihood of paying.
• About half of Carbo’s stocks are probably obsolete with a resale value as scrap of only
£50,000.
Required
Value Carbo using a net asset valuation approach.
Answer:
Net assets from the accounts are £6.6m, allowing for both short- and long-term debt.
However, the debtors and stocks figures are suspect.
‘Realistic’ value of debtors
= £3.0m - [l/3 × £3m × 50% chance of payment]
= £2.5m
‘Realistic’ value of stocks
= £1.5m - [½ × £1.5m] + £50,000
= £0.8m
These adjustments reduce the NAV to £5.4m

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Corporate Finance – BA303

4) Shah plc has a cost of equity of 17 per cent p.a. The business is expected to pay a dividend
in one year’s time of £0.27 per share. Dividends are expected to grow at a steady 5 per cent
each year for the foreseeable future. What is the current price of one share in Shah plc?
Answer:
Price = D1/(k-g)
= 0.27/(0.17-0.05)
= £2.25

5) Lazenby plc has been set up to exploit an opportunity to import a new product from
overseas. It has issued two million ordinary shares of par value 25p, sold at a 25 per cent
premium. Its projected accounts show the following annual operating figures:

Sales revenue £500,000


Operating costs (£300,000)
(after depreciation of £50,000)
Operating profit £200,000
Taxation @ 30% (£60,000)
Profit after tax £140,000

Notes:
(i) Shareholders require a return of 10 per cent p.a.
(ii) Investment expenditure is equal to depreciation provisions.
(iii) 2% of sales should be written off as bad debts.
(iv)Bad debt write-offs are 50 per cent tax-allowable.

Required
Value each share in Lazenby using Future Cash Flows:
(a) Assuming perpetual life.
(b) Over a ten-year horizon.
Answer:
Free cash flow (£) = Revenue less bad debts less operating costs + depreciation less replacement
investment less tax (allowing for relief on bad debts)
= (0.98 x 500,000) – (300,000) + (50,000) – (50,000) – (60,000 – [0.3 x 50%
x 2% x 500,000]) = (490,000 – 300,000 + 50,000 – 50,000 – 60,000 +
1,500) = £131,500.
(a) valued @ 10% as a perpetuity: V = (£131,500/0.1) = £1.315 million or (£1.315 mill/2 mill) =
£0.6575 per share
(b) valued over 10 years: V = (£131,500 x 10 year annuity factor 10%)

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Corporate Finance – BA303

= (£131,500 x 6.1446) = £808,015 mill or £0.405 per share.


6) A company has a dividend growth of 25 per cent for years 1–5 and 7 per cent thereafter.
Assuming shareholders require a return of 10 per cent, and that dividend in year zero is
10p, calculate the value of the share?
Answer

7) What is Shareholder Value Analysis (SVA)?. Explain the value drivers that have an impact
on SVA.
Answers:
SVA is the net present value of its future cash flows, discounted at the appropriate cost
of capital.

The value drivers that have an impact on SVA are as the following:
▪ Sales growth and margin. Sales growth and margins are influenced by competitive
forces (e.g. threat of new entrants, power of buyers and suppliers, threat of substitutes
and competition in the industry).
▪ Working capital and fixed capital investment. Over-emphasis on profit, particularly at
the operating level, may result in neglect of working capital and fixed asset
management.

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Corporate Finance – BA303

▪ The cost of capital. A firm should seek to make financial decisions that minimize the
cost of capital, given the nature of the business and its strategies.
▪ Taxation is a fact of business life, especially as it affects cash flows and the discount
rate.

8) Briefly explain Economic Value Added (EVA). How can we calculate EVA?

Answer:
EVA (Economic Value Added) is an approach to management that seeks to promote
businesses earning more than the shareholders’ required return and so increasing the value.
A measure of a company's financial performance based on the residual wealth calculated by
deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). (Also
referred to as "economic profit".) The formula for calculating EVA is as follows:

= Net Operating Profit After Taxes (NOPAT) - ( Invested Capital x Cost of Capital)

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