This Document Contains Chapters 28 to 30 Chapter 28 Mergers and Acquisitions 1. Acquisitions can be horizontal, vertical or conglomerate. There are numerous examples of all three and students should be expected to choose ones from their own environment. 2. Synergy is where combining two separate units creates value. That is, the value of the combination is greater than the sum of the two separate units. Students are expected to provide their own examples. 3. There are many reasons for synergy. These include marketing gains, strategic benefits, market power, economies of scale, efficiency enhancement from vertical integration, technology transfer, complementary resources, elimination of inefficient management, tax gains, increased debt capacity, surplus cash, and reduced capital requirements. 4. Bad reasons for mergers are earnings growth and diversification. Managers should not focus on maximising accounting figures to fool the market. Similarly, if a merger is justified on the basis of diversification, the value gains shift from shareholders to bondholders and shareholder value is not maximised. Moreover, a merger cannot eliminate or reduce systematic risk, which is the only risk that is valued in financial markets. Investors can just as easily diversify two separate companies themselves through buying shares in both firms. 5. Shareholders could retire the firm’s debt just before the merger announcement and reissue an equal amount of debt after the merger. The firm could also issue more debt after the merger. 6. The main uncertainties in merger valuation are estimating the value of both firms before the merger and the value of the combined firm, or synergy, after the merger. Real option analysis is always a good idea and some ways in which it would be useful is to explore the increased opportunities that are available to the combined firm. 7. There are several stages: a) Value the target as a stand-alone firm, b) Calibrate the valuation, c) Value the synergies, d) Value the merger. These are discussed in more detail in section 28.7. 8. Among the defensive tactics often employed by management are seeking white knights, threatening to sell the crown jewels, appealing to regulatory agencies and the courts (if possible), and targeted share repurchases. Frequently, anti-takeover charter amendments are available as well, such as poison pills, poison puts, golden parachutes, lockup agreements, and supermajority amendments, but these require shareholder approval, so This Document Contains Chapters 28 to 30 they can’t be immediately used if time is short. While target firm shareholders may benefit from management actively fighting acquisition bids, in that it encourages higher bidding and may solicit bids from other parties as well, there is also the danger that such defensive tactics will discourage potential bidders from seeking the firm in the first place, which harms the shareholders. 9. Defensive tactics include corporate charters, golden parachutes, poison pills, greenmail and standstill agreements, white knights and white squires, recapitalisations and repurchases, exclusionary self-tenders, and asset restructurings. These are discussed in more detail in section 28.9. 10. The Ryanair takeover failed because it did not persuade Aer Lingus takeovers of the benefits of the merger. 11. Mergers create value if there are inefficiencies in either firm. However, the costs of mergers may offset any benefits. Academics are still arguing over this question and although the evidence is that on average they do not create value for acquiring shareholders, they still occur fairly regularly. This means that there must be something of value in them. 12. The acquisition method of accounting for mergers and acquisitions is based on the concept of fair value. The first step is to identify the acquirer and target in the merger, then the acquisition date must be determined. The third stage recognises and measures the identifiable assets that have been acquired, the liabilities assumed and any non-controlling interest in the target firm. The final stage is recognising and measuring goodwill or a gain from a bargain purchase as of the acquisition date. Expensing merger costs will reduce the attractiveness of this activity to potential acquirers because it will have a direct detrimental impact on the acquirer’s net income. 13. Sometimes firm’s need cash and other firms strategically require specific business units to synergise with their own activities. In addition, if a large firm has a lot of inefficiencies, major gains can be realised from becoming more focussed. 14. a. False. Although the reasoning seems correct, in general, the new firms do not have monopoly power. This is especially true since many countries have laws limiting mergers when it would create a monopoly. b. True. When managers act in their own interest, acquisitions are an important control device for shareholders. It appears that some acquisitions and takeovers are the consequence of underlying conflicts between managers and shareholders. c. False. Even if markets are efficient, the presence of synergy will make the value of the combined firm different from the sum of the values of the separate firms. Incremental cash flows provide the positive NPV of the transaction. d. False. In an efficient market, traders will value takeovers based on “fundamental factors” regardless of the time horizon. Recall that the evidence as a whole suggests efficiency in the markets. Mergers should be no different. e. False. The tax effect of an acquisition depends on whether the merger is taxable or non-taxable. In a taxable merger, there are two opposing factors to consider, the capital gains effect and the write-up effect. The net effect is the sum of these two effects. f. True. Because of the coinsurance effect, wealth might be transferred from the shareholders to the bondholders. Acquisition analysis usually disregards this effect and considers only the total value. 15. Diversification doesn’t create value in and of itself because diversification reduces unsystematic, not systematic, risk. As discussed in the chapter on options, there is a more subtle issue as well. Reducing unsystematic risk benefits bondholders by making default less likely. However, if a merger is done purely to diversify (i.e., no operating synergy), then the NPV of the merger is zero. If the NPV is zero, and the bondholders are better off, then stockholders must be worse off. 16. A firm might choose to divest business lines because the newer, smaller firms may be better able to focus on their particular markets. Thus, reverse synergy is a possibility. An added advantage is that performance evaluation becomes much easier once the split is made because the new firm’s financial results (and stock prices) are no longer commingled. 17. It depends on how they are used. If they are used to protect management, then they are not good for shareholders. If they are used by management to negotiate the best possible terms of a merger, then they are good for shareholders. The illegality of many types of shareholder rights plans in Europe means that hostile takeovers are more likely to be successful, and therefore are more common. 18. Mergers and acquisitions are extremely complex. By making tax laws similarly across countries, cross-border mergers become more attractive and this will bring efficiencies across the global economy. 19. Economies of scale occur when average cost declines as output levels increase. A merger in this particular case might make sense because Eastern and Western may need less total capital investment to handle the peak power needs, thereby reducing average generation costs. 20. The bid offer for Rangers (which was ultimately unsuccessful) is typical of bids. In analysing such a bid, one must first of all consider the timing of cash flows. Then, one must assess the expected value of each cash flow. For example, quarter final stages of a major European tournament may not have been likely between 2012-2014. There was no time limit on payment of football debts and this amount may have been staggered over a few years. In terms of cash, only £5,000,000 was certain. The rest would have been affected by cash flow timing and likelihood of payment. 21. The bid mitigated bidder risk by not putting all cash up front. It also gave an upside to the creditors if the restructuring was a success. Bids of this type are exceptionally common in takeovers or buyouts of distressed firms. 22. For the merger to make economic sense, the acquirer must feel the acquisition will increase value by at least the amount of the premium over the market value, so: Minimum economic value = €1.93 billion – €1.03 billion = €.90 billion 23. Since neither company has any debt, the assets of the combined firm will be the book value of Firm X, the acquiring company, plus the market value of Firm Y, the target company, so: Assets from X = 21,000(£20) = £420,000 (book value) Assets from Y = 10,000(£28) = £280,000 (market value) The purchase price of Firm Y is the number of shares outstanding times the sum of the current share price plus the premium per share, so: Purchase price of Y = 10,000(£28 + 5) = £320,000 The goodwill created will be: Goodwill = £320,000 – 280,000 = £40,000. And the total asset of the combined company will be: Total assets XY = Total equity XY = £420,000 + 280,000 + 40,000 = £740,000 24. First calculate the asset value of Reflection and Lhanger. Since Reflection is the acquirer, this is the same as the book value. The assets of Lhanger are estimated at market value. Assets from Lhanger = £10,000 + £6,400 = £16,400 The goodwill created will be: Goodwill = £18,000 – 16,400 = £1,600. Assuming that the Reflection plc pays off all current and non-current liabilities of Lhanger, the new balance sheet will be: Current Assets 18,400 Current Liabilities 2,100 Non-Current Assets 27,000 Non-current Liabilities 23,900 Goodwill 1,600 Equity 21,000 Total 47,000 Total 47,000 25. Since the acquisition is funded by long-term debt, the post-merger balance sheet will have long-term debt equal to the original long-term debt of Silver’s balance sheet plus the new long-term debt issue, so: Post-merger long-term debt = £5,900 + £8,400 = £14,300 Goodwill will be created since the acquisition price is greater than the market value. So: Goodwill created = £8,400 – (£5,800 + 1,100 + 350) = £1,150 The post-merger balance sheet will be: Silver Enterprises, post-merger Current assets £ 7,700 Current liabilities £4,800 Goodwill £2,300 Non-current liabilities £14,300 Non-current Assets £13,700 Equity £4,600 Total £23,700 £23,700 26. a. The cash cost is the amount of cash offered, so the cash cost is £1.6 billion. To calculate the cost of the share offer, we first need to calculate the value of the target to the acquirer. The value of the target firm to the acquiring firm will be the market value of the target plus the PV of the incremental cash flows generated by the target firm. The cash flows are a perpetuity, so V* = £1.3 billion + £.183/.12 = £2.825 billion The cost of the share offer is the percentage of the acquiring firm given up times the sum of the market value of the acquiring firm and the value of the target firm to the acquiring firm. So, the equity cost will be: Equity cost = .50(£2.9 billion + £2.825 billion) = £2.8625 b. The NPV of each offer is the value of the target firm to the acquiring firm minus the cost of acquisition, so: NPV cash = £2.825 billion – £1.6 billion = £1.225 billion NPV share = £2.825 – £2.8625 = -£0.0375 billion c. Since the NPV is positive with the cash offer, the acquisition should be in cash. 27. a. The EPS of the combined company will be the sum of the earnings of both companies divided by the shares in the combined company. Since the share offer is one share of the acquiring firm for three shares of the target firm, new shares in the acquiring firm will increase by one-third. So, the new EPS will be: EPS = (€300,000 + €675,000)/[180,000 + (1/3)(60,000)] = €4.875 The market price of Stultz will remain unchanged if it is a zero NPV acquisition. Using the PE ratio, we find the current market price of Stultz shares, which is: P = 21(€675,000)/180,000 = €78.75 If the acquisition has a zero NPV, the share price should remain unchanged. Therefore, the new PE will be: P/E = €78.75/€4.875 = 16.15 b. The value of Flannery to Stultz must be the market value of the company since the NPV of the acquisition is zero. Therefore, the value is: V* = €300,000(5.25) = €1,575,000 The cost of the acquisition is the number of shares offered times the share price, so the cost is: Cost = (1/3)(60,000)(€78.75) = €1,575,000 So, the NPV of the acquisition is: NPV = 0 = V* + V – Cost = €1,575,000 + V – €1,575,000 V = €0 Although there is no economic value to the takeover, it is possible that Stultz is motivated to purchase Flannery for other than financial reasons. 28. The decision hinges upon the risk of surviving. That is, consider the wealth transfer from bondholders to shareholders when risky projects are undertaken. High-risk projects will reduce the expected value of the bondholders’ claims on the firm. The telecommunications business is riskier than the utilities business. If the total value of the firm does not change, the increase in risk should favour the shareholder. Hence, management should approve this transaction. If the total value of the firm drops because of the transaction, and the wealth effect is lower than the reduction in total value, management should reject the project. 29. a. The NPV of the merger is the market value of the target firm, plus the value of the synergy, minus the acquisition costs, so: NPV = 900(£24) + £3,000 – 900(£27) = £300 b. Since the NPV goes directly to shareholders, the share price of the merged firm will be the market value of the acquiring firm plus the NPV of the acquisition, divided by the number of shares outstanding, so: Share price = [1,500(£34) + £300]/1,500 = £34.20 c. The merger premium is the premium per share times the number of shares of the target firm outstanding, so the merger premium is: Merger premium = 900(£27 – £24) = £2,700 d. The number of new shares will be the number of shares of the target times the exchange ratio, so: New shares created = 900(3) = 2700 new shares The value of the merged firm will be the market value of the acquirer plus the market value of the target plus the synergy benefits, so: VBT = 1,500(£34) + 900(£24) + £3,000 = £75,600 The price per share of the merged firm will be the value of the merged firm divided by the total shares of the new firm, which is: P = £75,600/(1,500 + 2700) = £18 e. The NPV of the acquisition using a share exchange is the market value of the target firm plus synergy benefits, minus the cost. The cost is the value per share of the merged firm times the number of shares offered to the target firm shareholders, so: NPV = 900(£24) + £3,000 – 2,700(£18) = -£24,000 30. The share offer is better for target firm shareholders since with a cash offer they receive £27 per share. In the share offer, the target firm’s shareholders will receive: Equity offer value = (3)(£24) = £72 per share The shareholders of the target firm would prefer the share offer. The exchange ratio which would make the target firm shareholders indifferent between the two offers is the cash offer price divided by the new share price of the firm under the cash offer scenario, so: Exchange ratio = £27/£18 = 1.5 31. The cost of the acquisition is: Cost = 220(kr20) = kr4,400 Since the share price of the acquiring firm is kr40, the firm will have to give up: Shares offered = kr4,400/kr40 = 110 shares a. The EPS of the merged firm will be the combined EPS of the existing firms divided by the new shares outstanding, so: EPS = (kr900 + kr 600)/(550 + 110) = kr2.27 b. The PE of the acquiring firm is: Original P/E = kr40/(kr900/550) = 24.44 times Assuming the PE ratio does not change, the new share price will be: New P = kr2.27(24.44) = kr55.56 c. If the market correctly analyzes the earnings, the share price will remain unchanged since this is a zero NPV acquisition, so: New P/E = kr40/kr2.27 = 17.60 times d. The new share price will be the combined market value of the two existing companies divided by the number of shares outstanding in the merged company. So: P = [(550)(kr40) + 220(kr15)]/(550 + 110) = kr38.33 And the PE ratio of the merged company will be: P/E = kr38.33/kr2.27 = 16.87 times At the proposed bid price, this is a negative NPV acquisition for A since the share price declines. They should revise their bid downward until the NPV is zero. 32. Beginning with the fact that the NPV of a merger is the value of the target minus the cost, we get: NPV = VB* – Cost NPV = V + VB – Cost NPV = V – (Cost – VB) NPV = V – Merger premium 33. a. The synergy will be the present value of the incremental cash flows of the proposed purchase. Since the cash flows are perpetual, the synergy value is: Synergy value = £1,300,000 / .08 Synergy value = £16,250,000 b. The value of Bichiery to Tazza is the synergy plus the current market value of Bichiery, which is: Value = £16,250,000 + £500,000,000 Value = £516,250,000 c. The value of the cash option is the amount of cash paid, or £600 million. The value of the share acquisition is the percentage of ownership in the merged company, times the value of the merged company, so: Share acquisition value = .40(£516,250,000 + £1,500,000,000) Share acquisition value = £806,500,000 d. The NPV is the value of the acquisition minus the cost, so the NPV of each alternative is: NPV of cash offer = £516,250,000 – £600,000,000 NPV of cash offer = -£83,750,000 NPV of share offer = £516,250,000 – £806,500,000 NPV of share offer = -£290,250,000 e. The acquirer should not make any offer since the NPV of both projects is negative. 34. a. The number of shares after the acquisition will be the current number of shares outstanding for the acquiring firm, plus the number of new shares created for the acquisition, which is: Number of shares after acquisition = 35,000,000 + 20,000,000 Number of shares after acquisition = 55,000,000 And the share price will be the value of the combined company divided by the shares outstanding, which will be: New share price = £1,500,000,000 / 55,000,000 New share price = £27.27 b. Let equal the fraction of ownership for the target shareholders in the new firm. We can set the percentage of ownership in the new firm equal to the value of the cash offer, so: (£1,500,000,000) = £350,000,000 = .2333 or 23.33% So, the shareholders of the target firm would be equally as well off if they received 23.33 percent of the shares in the new company as if they received the cash offer. The ownership percentage of the target firm shareholders in the new firm can be expressed as: Ownership = New shares issued / (New shares issued + Current shares of acquiring firm) .2333 = New shares issued / (New shares issued + 35,000,000) New shares issued = 10,680,000 To find the exchange ratio, we divide the new shares issued to the shareholders of the target firm by the existing number of shares in the target firm, so: Exchange ratio = New shares / Existing shares in target firm Exchange ratio = 10,680,000 / 25,000,000 Exchange ratio = .4272 An exchange ratio of .4272 shares of the merged company for each share of the target company owned would make the value of the share offer equivalent to the value of the cash offer. 35. a. The value of each company is the sum of the probability of each state of the economy times the value of the company in that state of the economy, so: ValueBentley = .45(£300,000) + .55(£110,000) ValueBentley = £195,500 ValueRolls = .45(£260,000) + .55(£80,000) ValueRolls = £161,000 b. The value of each company’s equity is sum of the probability of each state of the economy times the value of the equity in that state of the economy. The value of equity in each state of the economy is the maximum of total company value minus the value of debt, or zero. Since Rolls is an all equity company, the value of its equity is simply the total value of the firm, or £161,000. The value of Bentley’s equity in a boom is £160,000 (£300,000 company value minus £140,000 debt value), and the value of Bentley’s equity in a recession is zero since the value of its debt is greater than the value of the company in that state of the economy. So, the value of Bentley’s equity is: EquityBentley = .45(£160,000) + .55(£0) EquityBentley = £72,000 The value of Bentley’s debt in a boom is the full face value of £140,000. In a recession, the value of the company’s debt is £110,000 since the value of the debt cannot exceed the value of the company. So, the value of Bentley’s debt today is: DebtBentley = .45(£140,000) + .55(£110,000) DebtBentley = £123,500 Note, this is also the value of the company minus the value of the equity, or: DebtBentley = £195,500 – £72,000 DebtBentley = £123,500 c. The combined value of the companies, the combined equity value, and combined debt value is: Combined value = £195,500 + £161,000 Combined value = £356,500 Combined equity value = £72,000 + £161,000 Combined equity value = £233,000 Combined debt value = £123,500 d. To find the value of the merged company, we need to find the value of the merged company in each state of the economy, which is: Boom merged value = £300,000 + £260,000 Boom merged value = £560,000 Recession merged value = £110,000 + £80,000 Recession merged value = £190,000 So, the value of the merged company today is: Merged company value = .45(£560,000) + .55(£190,000) Merged company value = £365,500 Since the merged company will still have £140,000 in debt, the value of the equity in a boom is £420,000, and the value of equity in a recession is £50,000. So, the value of the merged company’s equity is: Merged equity value = .45(£420,000) + .55(£50,000) Merged equity value = £216,500 The merged company will have a value greater than the face value of debt in both states of the economy, so the value of the company’s debt is £140,000. e. There is a wealth transfer in this case. The combined equity value before the merger was £233,000, but the value of the equity in the merged company is only £216,500, a loss of £16,500 for shareholders. The value of the debt in the combined companies was only £123,500, but the value of debt in the merged company is £140,000 since there is no chance of default. The bondholders gained £16,500, exactly the amount the shareholders lost. f. If the value of Bentley’s debt before the merger is less than the lowest firm value, there is no coinsurance effect. Since there is no possibility of default before the merger, bondholders do not gain after the merger. 36. a. To find the value of the target to the acquirer, we need to find the share price with the new growth rate. We begin by finding the required return for shareholders of the target firm. The earnings per share of the target are: EPSP = €580,000/550,000 = €1.05455 per share The price per share is: PP = 9(€1.05455) = €9.49095 And the dividends per share are: DPSP = €290,000/550,000 = €0.52727 The current required return for Palmer shareholders, which incorporates the risk of the company is: RE = [€0.52727(1.05455)/€9.49095] + .05 = .10859 The price per share of Palmer with the new growth rate is: PP = €0.52727(1.07)/(.10859 – .07) = €14.61982 The value of the target firm to the acquiring firm is the number of shares outstanding times the price per share under the new growth rate assumptions, so: VT* = 550,000(€14.61982) = €8,040,901.00 b. The gain to the acquiring firm will be the value of the target firm to the acquiring firm minus the market value of the target, so: Gain = €8,040,901.00 – 550,000(€9.49095) = €2,820,878.50 c. The NPV of the acquisition is the value of the target firm to the acquiring firm minus the cost of the acquisition, so: NPV = €8,040,901.00 – 550,000(€18) = –€1,859,099.00 d. The most the acquiring firm should be willing to pay per share is the offer price per share plus the NPV per share, so: Maximum bid price = €18 + (–€1,859,099.00/550,000) = €14.61982 Notice that this is the same value we calculated earlier in part a as the value of the target to the acquirer. e. The price of the equity in the merged firm would be the market value of the acquiring firm plus the value of the target to the acquirer, divided by the number of shares in the merged firm, so: PFP = (€25,000,000 + €8,040,901.00)/(1,000,000 + 100,000) = €30.03718 The NPV of the share offer is the value of the target to the acquirer minus the value offered to the target shareholders. The value offered to the target shareholders is the share price of the merged firm times the number of shares offered, so: NPV = $8,040,901.00 – 100,000(€30.03718) = €5,037,183.00 f. Yes, the acquisition should go forward, and Plant should offer the 100,000 shares since the NPV is higher. g. Using the new growth rate in the dividend growth model, along with the dividend and required return we calculated earlier, the price of the target under these assumptions is: PP = €0.52727(1.06)/(.10859 – .06) = €11.50249 And the value of the target firm to the acquiring firm is: VP* = 550,000(€11.50249) = €6,326,369.50 The gain to the acquiring firm will be: Gain = €6,326,369.50 – 550,000(€9.49095) = €1,106,347.00 The NPV of the cash offer is now: NPV cash = €6,326,369.50 – 550,000(€18) = –€3,573,630.50 And the new price per share of the merged firm will be: PFP = [€25,000,000+ 6,326,369.50]/(1,000,000 + 100,000) = €28.47852 And the NPV of the share offer under the new assumption will be: NPV share = €6,326,369.50 – 100,000(€28.47852) = €3,478,517.50 Even with the lower projected growth rate, the share offer still has a positive NPV. Plant should purchase Palmer with a share offer of 100,000 shares. 37. a. To find the distribution of joint values, we first must find the joint probabilities. To do this, we need to find the joint probabilities for each possible combination of weather in the two towns. The weather conditions are independent; therefore, the joint probabilities are the products of the individual probabilities. Possible states Joint probability Rain-Rain .1(.1) = .01 Rain-Warm .1(.4) = .04 Rain-Hot .1(.5) = .05 Warm-Rain .4(.1) = .04 Warm-Warm .4(.4) = .16 Warm-Hot .4(.5) = .20 Hot-Rain .5(.1) = .05 Hot-Warm .5(.4) = .20 Hot-Hot .5(.5) = .25 Next, note that the revenue when rainy is the same regardless of which town. So, since the state "Rain-Warm" has the same outcome (revenue) as "Warm-Rain", their probabilities can be added. The same is true of "Rain-Hot" / "Hot-Rain" and "Warm-Hot" / "Hot-Warm". Thus the joint probabilities are: Possible states Joint probability Rain-Rain .01 Rain-Warm .08 Rain-Hot .10 Warm-Warm .16 Warm-Hot .40 Hot-Hot .25 Finally, the joint values are the sums of the values of the two companies for the particular state. Possible states Joint value Rain-Rain £100,000 + £100,000 = £200,000 Rain-Warm £100,000 + £200,000 = £300,000 Rain-Hot £100,000 + £400,000 = £500,000 Warm-Warm £200,000 + £200,000 = £400,000 Warm-Hot £200,000 + £400,000 = £600,000 Hot-Hot £400,000 + £400,000 = £800,000 b. Recall that if a firm cannot service its debt, the bondholders receive the value of the assets. Thus, the value of the debt is the value of the company if the face value of the debt is greater than the value of the company. If the value of the company is greater than the value of the debt, the value of the debt is its face value. Here, the value of the equity is always the residual value of the firm over the value of the debt. So, the value of the debt and the value of the shares in each state is: Possible states Joint Prob. Joint Value Debt Value Stock Value Rain-Rain .01 £200,000 £200,000 £0 Rain-Warm .08 £300,000 £300,000 0 Rain-Hot .10 £500,000 £400,000 £100,000 Warm-Warm .16 £400,000 £400,000 0 Warm-Hot .40 £600,000 £400,000 £200,000 Hot-Hot .25 £800,000 £400,000 £400,000 c. The bondholders are better off if the value of the debt after the merger is greater than the value of the debt before the merger. The value of the debt is the smaller of the debt value or the company value. So, the value of the debt of each individual company before the merger in each state is: Possible states Probability Debt Value Rain .10 £100,000 Warm .40 £200,000 Hot .50 £200,000 Individual debt value = .1(£100,000) + .4(£200,000) + .5(£200,000) Individual debt value = £190,000 This means the total value of the debt for both companies pre-merger must be: Total debt value pre-merger = 2(£190,000) Total debt value pre-merger = £380,000 To get the expected debt value, post-merger, we can use the joint probabilities for each possible state and the debt values corresponding to each state we found in requirement b. Using this information to find the value of the debt in the post-merger firm, we get: Total debt value post-merger = .01(£200,000) + .08(£300,000) + .10(£400,000) + .16(£400,000) + .40(£400,000) + .25(£400,000) Total debt value post-merger = £390,000 The bondholders are better off by £10,000. Since we have already shown that the total value of the combined company is the same as the sum of the value of the individual companies, the implication is that the shareholders are worse off by £10,000. Chapter 28 Case Study The Birdie Golf-Hybrid Golf Merger 1. As with any other merger analysis, we need to examine the present value of the incremental cash flows. The cash flow today from the acquisition is the acquisition costs plus the dividends paid today, or: Acquisition of Hybrid –€550,000,000 Dividends from Hybrid €150,000,000 Total –€400,000,000 Using the information provided, the cash flows to Birdie Golf from acquiring Hybrid Golf are for the next five years will be: Year 1 Year 2 Year 3 Year 4 Year 5 Dividends from Hybrid €38,400,000 €12,800,000 €29,400,000 €41,400,000 €59,000,000 Tax-loss carryforwards €25,000,000 €25,000,000 Terminal value of equity 900,000,000 Terminal value of debt –300,000,000 Total €38,400,000 €37,800,000 €54,400,000 €41,400,000 €659,000,000 To discount the cash flows from the merger, we must discount each cash flow at the appropriate discount rate. The additional cash flows from the tax-loss carry forwards and the proposed level of debt should be discounted at the cost of debt because they are determined with very little uncertainty. The terminal value of the company is subject to normal business risk and must be discounted at a normal rate. Current weight of debt and weight of equity in Hybrid’s capital structure is: wD = .50 / (1 + .50) wD = .33 wE = 1 – .33 wE = .67 The beta for Hybrid’s debt is: D = (.08 – .06) / (.13 – .06) D = .29 Thus, the overall beta for Hybrid is: H = (.33 × .29) + (.67 × 1.30) H = .96 Now, we can calculate the required return for normal operations of Hybrid, which is: E–RH = .06 + .96(.13 – .06) E–RH = .1273 or 12.73% To find the discount rate for dividends, we need to find the new beta of equity for the merged Hybrid. The new debt-equity ratio is 1, which implies a weight of debt and a weight of equity equal to 50 percent. The new beta for equity must be: New = [Old – (wD–new × wD–old)] / wE–new New = [.96 – (.50 × .33)] / .50 New = 1.59 So, the discount rate for the dividends to be paid in future is: E–RDiv = .06 + 1.59(.13 – .06) E–RDiv = .1713 or 17.13% Now we can find the present value of the future cash flows. The present value of each year’s cash flows, along with the appropriate discount rate for each cash flow is: Discount rate Year 1 Year 2 Year 3 Year 4 Year 5 Dividends 17.13% €32,783,153 €9,329,298 €18,293,880 €21,992,689 €26,757,744 Tax-loss 8% 21,433,470 19,845,806 TV of equity 12.73% 494,288,796 TV of debt 8% –204,174,959 Total €32,783,153 €30,762,769 €38,139,686 €21,992,689 €316,871,581 And the NPV of the acquisition is: NPV = –€400,000,000 + 32,783,153 + 30,762,768 + 38,139,685 + 21,992,688 + 316,871,581 NPV = €40,549,877.93 Since the NPV is positive, Birdie should proceed with the merger. 2. Since the acquisition is a positive NPV project, the most Birdie would offer is to increase the current cash offer by the current NPV, or: Highest offer = €550,000,000 + €40,549,877.93 Highest offer = €590,549,877.93 The highest share price is the total high offer price, divided by the shares outstanding, or: Highest share price = €590,549,877.93 / 8,000,000 shares Highest share price = €73.82 3. To determine the current exchange ratio which would make a cash offer and a share offer equivalent, we need to determine the new share price under the original cash offer. The new share price of Birdie after the merger will be: PNew = [€94 × 18,000,000 + €40,549,877.93] / 18,000,000 PNew = €96.25 So, the exchange ratio which would make the cash offer and share offer equivalent is: Exchange ratio = €68.75 / €96.25 Exchange ratio = .7143 4. The highest exchange ratio Birdie would accept is an exchange ratio that results in a zero NPV acquisition. This implies the share price of Birdie remains unchanged after the merger, so the exchange ratio is: Exchange ratio = €68.75 / €94 Exchange ratio = .7314 Chapter 29 Financial Distress 1. Financial distress is often linked to insolvency. Value-based insolvency occurs when a firm has a negative net worth. Flow-based insolvency occurs when operating cash flow is insufficient to meet current obligations. 2. Turnaround strategies include asset expansion, operational contraction, financial policies, external control activity, changes in managerial control, or winding up the company. The turnaround strategy should be related to the difficulty in which the firm finds itself. For example, if the reason for failure is poor financial management, the most effective turnaround strategy would relate to change the financial policies of the firm. 3. Administration occurs when the assets of a firm are put under the control of an administrator for sale so that payments can be made to creditors (usually based upon the absolute priority rule). Reorganization is the restructuring of the firm's finances. Financial distress frequently can serve as a firm’s ‘early warning’ sign for trouble. Thus, it can be beneficial since it may bring about new organizational forms and new operating strategies. 4. This is definitely the case. Countries have different approaches to dealing with financial distress. For example, the UK is creditor friendly whereas France is debtor friendly. This will clearly impact upon how the distress company and its creditors behave. 5. The model for the US is: The variables capture different aspect of a firm’s health. For example, Net working capital relates to short-term cash flow, whereas market to book equity relates to a firm’s growth opportunities. 6. Just because a firm is experiencing financial distress doesn’t necessarily imply the firm is worth more dead than alive. Bankruptcy protects the firm from the creditors and gives management a window in which to restructure the firm’s operations and turnaround the company. 7. The absolute priority rule is the priority rule of the distribution of the proceeds of the liquidation. It begins with the first claim to the last, in the order: administrative expenses, EBIT Net working capital Z = 3.3 1.2 Total assets Total assets Sales Market value of equity + 1.0 + .6 Total assets Book value of debt Accumulated retained earnings + 1.4 Total assets + unsecured claims after a filing of involuntary bankruptcy petition, wages, employee benefit plans, consumer claims, taxes, secured and unsecured loans, preference shares and ordinary equity. 8. Bankruptcy allows firms to issue new debt that is senior to all previously incurred debt. This new debt is called DIP (debtor in possession) debt. If DIP loans were not senior to all other debt, a firm in bankruptcy would be unable to obtain financing necessary to continue operations while in bankruptcy since the lender would be unlikely to make the loan. 9. Pre-packs have been criticised by many analysts because it removes the power of creditors to negotiate a solution to financial distress with the firm. However, since a priority of pre- packs is to save jobs (because the jobs are automatically transferred to the new firm), the decision is a trade-off between paying debts to creditors and keeping people in jobs. 10. As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be the best use of the asset. Creditors are aware at the time a loan is made of the possibility of bankruptcy, and the interest charged incorporates it. If the only way a firm can continue to operate is to reduce labour costs, it may be a benefit to everyone, including employees. 11. There are four possible reasons why firms may choose legal bankruptcy over private workout: 1) It may be less expensive (although legal bankruptcy is usually more expensive). 2) Equity investors can use legal bankruptcy to “hold out.” 3) A complicated capital structure makes private workouts more difficult. 4) Conflicts of interest between creditors, equity investors and management can make private workouts impossible. 12. Under the absolute priority rule (APR), claims are paid out in full to the extent there are assets. In this case, assets are £15,500, so you should propose the following. Original claim Distribution of liquidating value Trade credit £3,000 £3,000 Secured mortgage notes £6,000 £6,000 Senior debentures £5,000 £5,000 Junior debentures £9,000 £1,500 Equity 0 0 13. There are many possible reorganization plans, so we will make an assumption that the mortgage bonds are fully recognized as senior debentures, the senior debentures will receive junior debentures in the value of 65 pence on the pound, and the junior debentures will receive any remaining value as equity. With these assumptions, the reorganization plan will look like this: Original claim Reorganized claim Mortgage bonds £10,000 Senior debenture £10,000 Senior debentures £6,000 Junior debenture £3,900 Junior debentures £4,000 Equity £1,100 14. The data shows a number of things. First, the industry seems to be unviable. Current liabilities are significantly greater than current assets. Also, long-term profitability is poor in many cases. A financial manager should first look to increase liquidity and restructure the company’s operating model. 15. This is very true. An analyst considering the financial position of a firm must use variables that are appropriate to the industry and country and time period. This means that the approaches used in this chapter are suboptimal, since we used only the standard Z-score. 16. It means they are technically insolvent. However, many football clubs have owners who regularly inject cash into the firm and this means that some of the variables used in the z-score analysis are not particularly appropriate. 17. Negative net working capital means that the current liabilities are greater than the current assets. Clearly, it is a danger signal. However, it is also explained by the nature of the industry. In the close season, season tickets are sold to fans. This appears as cash in the balance sheet and a liability as deferred income (since it is for games not yet played). If clubs purchase players on season ticket money, cash will leave the firm but the deferred income liability stays the same. This means that the company will have negative net working capital. 18. Distressed firms may increase the size of their asset base to diversify their income streams and reduce risk. It does not necessarily mean that their value will increase, however. 19. By owning shares, you benefit from the upside growth potential that is inherent in any business. By owning secured debt, you hedge against the downside potential because you can claim the assets of the defaulted firm. 20. By delisting a firm, you take it away from the prying eyes of analysts and investors. This allows you to turn the company around without being subject to the level of scrutiny of publicly listed firms. The companies are brought back to the market as an exit strategy for the private equity investors. Chapter 30 International Corporate Finance 1. A domestic bond is a bond issued by a domestic firm in its domestic currency in its own country. A foreign bond is a bond issued by a firm in a foreign country in the currency of the foreign country. A Eurobond is a bond issued in a foreign country in a currency that is different from the currency of the foreign country. 2. Triangular arbitrage is the ability to make a riskless profit from converting money across three countries. For example, converting euros into pounds into dollars and back to euros again. Given the efficiency of the global FX market, it is exceptionally unlikely that triangular arbitrage opportunities would exist for very long. 3. The answer to this question depends on the asset you are discussing. If we are referring to apples and oranges, the answer would be no. If you are talking about cross-listed shares, the answer would be yes. If country barriers fall, PPP will be more prevalent. 4. The parity conditions: PPP: E(S1) = S0 [1 + (hFC −hHC)] IRP: F1 = S0 [1 + (RFC − RHC)] UFR: F1 = E(S1) IRP is the most likely to hold because it presents the easiest and least costly means to exploit any arbitrage opportunities. Relative PPP is least likely to hold since it depends on the absence of market imperfections and frictions in order to hold strictly. They are less likely to be valid during global recession as recession slows down economic movements. 5. The main issues are the currency in which the analysis is denominated. Should it be the home currency or the foreign currency? What is the relevant discount rate? What about withholding taxes in the foreign country? 6. No. For example, if a country’s currency strengthens, imports become cheaper (good), but its exports become more expensive for others to buy (bad). The reverse is true for currency depreciation. 7. Political risk is the risk that politics in a country could affect the value of a company. Irrespective of a country’s development status, a change in government could change tax policy, regulatory power, or even sentiment towards foreign companies. 8. a. The pound is selling at a premium because it is more expensive in the forward market than in the spot market (NKr13 versus NKr12.54). b. The kroner is expected to depreciate relative to the pound because it will take more kroner to buy one pound in the future than it does today. c. Inflation in Norway is higher than in the United Kingdom, as are nominal interest rates. 9. The exchange rate will increase, as it will take progressively more euros to purchase one pound. This is the relative PPP relationship. 10. a. The Australian dollar is expected to weaken relative to the US dollar, because it will take more A$ in the future to buy one US$ than it does today. b. The inflation rate in Australia is higher. c. Nominal interest rates in Australia are higher; relative real rates in the two zones are the same. 11. A Bulldog bond is most accurately described by A bond issued by BMW in London with the interest payable in British pounds. 12. Additional advantages include being closer to the final consumer and, thereby, saving on transportation, significantly lower wages, and less exposure to exchange rate risk. Disadvantages include political risk and costs of supervising distant operations. 13. One key thing to remember is that dividend payments are made in the home currency. More generally, it may be that the owners of the multinational are primarily domestic and are ultimately concerned about their wealth denominated in their home currency because, unlike a multinational, they are not internationally diversified. 14. a. False. If prices are rising faster in Great Britain, it will take more pounds to buy the same amount of goods that one dollar can buy; the pound will depreciate relative to the dollar. b. False. The forward market would already reflect the projected deterioration of the euro relative to the foreign currency. Only if you feel that there might be additional, unanticipated weakening of the euro that isn’t reflected in forward rates today, will the forward hedge protect you against additional declines. c. True. The market would only be correct on average, while you would be correct all the time. 15. a. Danish exporters: their situation in general improves because a sale of the exported goods for a fixed number of euros will be worth more kroner. Danish importers: their situation in general worsens because the purchase of the imported goods for a fixed number of euros will cost more in kroner. b. Danish exporters: they would generally be better off if the British government’s intentions result in a strengthened pound. Danish importers: they would generally be worse off if the pound strengthens. c. Danish exporters: they would generally be much worse off, because an extreme case of fiscal expansion like this one will make Danish goods prohibitively expensive to buy, or else Eurozone sales, if fixed in euros, would become worth an unacceptably low number of kroner. Danish importers: they would generally be much better off, because Eurozone goods will become much cheaper to purchase in kroner. 16. IRP is the most likely to hold because it presents the easiest and least costly means to exploit any arbitrage opportunities. Relative PPP is least likely to hold since it depends on the absence of market imperfections and frictions in order to hold strictly. 17. It all depends on whether the forward market expects the same appreciation over the period and whether the expectation is accurate. Assuming that the expectation is correct and that other traders do not have the same information, there will be value to hedging the currency exposure. 18. One possible reason investment in the foreign subsidiary might be preferred is if this investment provides direct diversification that shareholders could not attain by investing on their own. Another reason could be if the political climate in the foreign country was more stable than in the home country. Increased political risk can also be a reason you might prefer the home subsidiary investment. Indonesia can serve as a great example of political risk. If it cannot be diversified away, investing in this type of foreign country will increase the systematic risk. As a result, it will raise the cost of the capital, and could actually decrease the NPV of the investment. 19. Yes, the firm should reject the foreign investment. If, after taking into consideration all risks, a project in a foreign country has a negative NPV, the firm should not undertake it. Note that in practice, the stated assumption (that the adjustment to the discount rate has taken into consideration all political and diversification issues) is a huge task. But once that has been addressed, the net present value principle holds for foreign operations, just as for domestic. 20. If the foreign currency depreciates, the South African parent will experience an exchange rate loss when the foreign cash flow is remitted to South Africa. This problem could be overcome by selling forward contracts. Another way of overcoming this problem would be to borrow in the country where the project is located. 21. False. If the financial markets are perfectly competitive, the difference between the Eurodollar rate and the U.S. rate will be due to differences in risk and government regulation. Therefore, speculating in those markets will not be beneficial. 22. The difference between a Eurobond and a foreign bond is that the foreign bond is denominated in the currency of the country of origin of the issuing company. Eurobonds are more popular than foreign bonds because of registration differences. Eurobonds are unregistered securities. 23. Using the quotes from the table, we get: a. €100(€0.8196/£1) = £81.96 b. €1.2202 c. £5M(€1.2202/£) = €6.101 million d. New Zealand dollar e. Mexican peso f. (P21.1394/£1)(£.16523/S1) = P3.493/S This is a cross rate. g. The most valuable is the Kuwait dinar. The least valuable is the Iranian rial. 24. a. You would prefer £100, since: (£100)(€1.2202/£1) = €122.02 b. You can use the euro, pound or dollar as the base currency to compare. (SFr100)(£0.6821/SFr) = £68.21 (NKr100)(£0.10843/NKr)= £10.84 You would prefer the Swiss Franc c. Using the quotes in the book to find the SFr/NKr cross rate, we find: (SFr1.4661/£1)(£0.10843/NKr1) = SFr0.15897NKr The NKr/SFr exchange rate is the inverse of the SFr/NKr exchange rate, so: SFr.015897/NKr = NKr6.2904/SFr 25. a. F90 = $1.3215 (per €). The dollar is selling at a discount because it is less expensive in the forward market than in the spot market ($1.3215 versus $1.3208). b. F90 = €1.2198/£. The euro is selling at a premium because it is more expensive in the forward market than in the spot market (€1.2198 versus €1.2202). c. The value of the euro will fall relative to the value of the dollar and increase relative to the value of the pound. 26. a. The British pound, since one British pound will buy 15 South African rand. b. The cost in British pounds is: (R20)/(£0.06667/R) = £1.33 Among the reasons that absolute PPP doesn’t hold are tariffs and other barriers to trade, transactions costs, taxes, and different tastes. c. The British pound is selling at a premium, because it is more expensive in the forward market than in the spot market (R16 versus R15). d. The British pound is expected to appreciate in value relative to the rand, because it takes fewer British pounds to buy one rand in the future than it does today. e. Interest rates in South Africa are probably higher than they are in the UK because the South African rand is at a forward discount. 27. a. The cross rate in rial/baht terms is: (r19823/£1)(£0.02006/Bt1) = rial397.67/Bt b. The rial is quoted too high relative to the baht. Take out a loan for 100 baht and buy £2.006. Use the £2.006 to purchase rial at the cross-rate, which will give you: £2.006(rial19823/£) = rial39,766.57 Use the rial to buy back baht and repay the loan. The cost to repay the loan will be: Rial39,766.57(1/(rial397.67/bt)= 99.998 baht You arbitrage profit is 0.00151 baht per baht used. 28. We can rearrange the interest rate parity condition to answer this question. The equation we will use is: RFC = (FT – S0)/S0 + REuro Using this relationship, we find: Great Britain: RFC = (£0.8251 – £0.8196)/£0.8196 + .038 = 4.47% 29. If we invest in the U.K. for the next three months, we will have: £30M(1.0045)3 = £30,406,825.23 If we invest in the Eurozone, we must exchange the pounds today for euros, and exchange the euros for pounds in three months. After making these transactions, the pound amount we would have in three months would be: (£30M)(€1.12 /£1)(1.0060)3/(€1.15/£1) = £29,746,466 We should invest in U.K. 30. Using the relative purchasing power parity equation: E(St) = S0 × [1 + (hFC – hUK)]t We find: Z5.2= Z5.1134[1 + (hFC – hUK)]3 hFC – hUK = (Z5.2/Z5.1134)1/3 – 1 hFC – hUK = .00561 Inflation in Poland is expected to exceed that in the U.K. by 0.56% over this period. 31. The profit will be the quantity sold, times the sales price minus the cost of production. The production cost is in Singapore dollars, so we must convert this to euros. Doing so, we find that if the exchange rates stay the same, the profit will be: Profit = 30,000[€100 – {(S$168.50)/(S$1.6488/€1)}] Profit = -€65,866.08 If the exchange rate rises, we must adjust the cost by the increased exchange rate, so: Profit = 30,000[€100 – {(S$168.50)/(S$1.81368/€1)}] Profit = €212,849.01 If the exchange rate falls, we must adjust the cost by the decreased exchange rate, so: Profit = 30,000[€100 – {(S$168.50)/(S$1.74249/€1)}] Profit = -€406,517.87 To calculate the breakeven change in the exchange rate, we need to find the exchange rate that make the cost in Singapore dollars equal to the selling price in euros, so: €100 = S$168.50/ST ST = S$1.6850/€100 ST = (S$1.6850 - S$1.6488) / S$1.6488 ST = 2.20% 32. a. Since given F180 is Kr12, an arbitrage opportunity exists. Borrow Kr100 today at 1.13% interest. Agree to a 180-day forward contract at Kr12/£. Convert the loan proceeds into pounds: Kr100/(£/Kr10.7917) = £9.2664 Invest these pounds at 2.5% for 6 months, ending up with £9.3822. Convert the pounds back into kroner. £9.3822(Kr12/£) = Kr112.59 Repay the Kr100 loan (at 1.13% for 6 months which amounts to Kr100.565), ending with a profit of: Kr112.59 – Kr100.565 = Kr12.02 b. To find the forward rate that eliminates arbitrage, we use the interest rate parity condition, so: F180 = (Kr 10.7917)[1 + (.0113 – .025)]1/2 F180 = Kr 10.7177 33. The international Fisher effect states that the real interest rate across countries is equal. We can rearrange the international Fisher effect as follows to answer this question: RUK – hUK = RFC – hFC hFC = RFC + hUK – RUK a. hAUS = .05 + .035 – .039 hAUS = .046 or 4.6% b. hCAN = .07 + .035 – .039 hCAN = .066 or 6.6% c. hTAI = .10 + .035 – .039 hTAI = .096 or 9.6% 34. a. The rupee is expected to get stronger, since it will take fewer rupees to buy one euro in the future than it does today. b. hEuro – hIndia (r61.8 – r68.81)/r68.81 hEuro – hIndia = – .1019 or –10.19% (1 – .1019)4 – 1 = –.3493 or –34.93% The approximate inflation differential between the Eurozone and India is – 34.93% annually. Exceptionally high! 35. We need to find the change in the exchange rate over time, so we need to use the relative purchasing power parity relationship: E(St) = S0 × [1 + (hFC – hUK)]T Using this relationship, we find the exchange rate in one year should be: E(S1) = 2,500[1 + (.086 – .035)]1 E(S1) = TSh2,627.50 The exchange rate in two years should be: E(S2) = Tsh2,500[1 + (.086 – .035)]2 E(S2) = TSh2,761.50 And the exchange rate in five years should be: E(S5) = TSh2,500[1 + (.086 – .035)]5 E(S5) = TSh3,205.93 36. Using the interest-rate parity theorem: (1 + RHC) / (1 + RFC) = F1 / S0 We can find the forward rate as: F1 = [(1 + RHC) / (1 + RFC)] S0 F1 = (1.13 / 1.08)$1.6117/£ F1 = $1.686/£ 37. First, we need to forecast the future spot rate for each of the next three years. From the exact form of interest rate parity, the expected exchange rate is: E(ST) = [(1 + REuro) / (1 + RFC)]T S0 So: E(S1) = (1.0212 / 1.0213)1 €1.12/£ = €1.1199/£ E(S2) = (1.0212 / 1.0213)2 €1.12/£ = €1.1198/£ E(S3) = (1.0212 / 1.0213)3 €1.12/£ = €1.1197/£ Now we can use these future spot rates to find the euro cash flows. The euro cash flow each year will be: Year 0 cash flow = –£12,000,000(€1.12/£) = –€13,440,000 Year 1 cash flow = £2,700,000(€1.1199/£) = €3,023,704 Year 2 cash flow = £3,500,000(€1.1198/£) = €3,919,232 Year 3 cash flow = (£3,300,000 + £7,400,000)(€1.1197/£) = €11,980,480 And the NPV of the project will be: NPV = –€13,440,000+ €3,023,704/1.13 + €3,919,232/1.132 + €11,980,480/1.133 NPV = €608,251.7 38. a. Implicitly, it is assumed that interest rates won’t change over the life of the project, but the exchange rate is projected to decline because the Swiss rate is lower than the Euro rate. b. We can use relative purchasing power parity to calculate the euro cash flows at each time. The equation is: E[ST] = (SFr 1.48)[1 + (.07 – .08)]T E[ST] = 1.48(.99)T So, the cash flows each year in euro terms will be: Year SFr E[ST] € PV(€) 0 - 27,000,000 1.48 - 18,243,243.24 - 18,243,243.24 1 7,500,000 1.4652 5,118,755.12 4,529,871.79 2 7,500,000 1.450548 5,170,459.72 4,049,228.38 3 7,500,000 1.436043 5,222,686.58 3,619,583.78 4 7,500,000 1.421682 5,275,440.99 3,235,526.76 5 7,500,000 1.407465 5,328,728.27 2,892,220.22 The NPV is €83,187.68 c. Rearranging the relative purchasing power parity equation to find the required return in Swiss francs, we get: RSFr = 1.13[1 + (.07 – .08)] – 1 RSFr = 11.87% So, the NPV in Swiss francs is: NPV = –SFr 27.0M + SFr 7.5M(PVIFA11.87%,5) NPV = SFr 123,117.76 Converting the NPV to euros at the spot rate, we get the NPV in euros as: NPV = (SFr 123,117.76)(€1/SFr 1.48) NPV = €83,187.68 39. a. The domestic Fisher effect is: 1 + RHC = (1 + rHC)(1 + hHC) 1 + rHC = (1 + RHC)/(1 + hHC) This relationship must hold for any country, that is: 1 + rFC = (1 + RFC)/(1 + hFC) The international Fisher effect states that real rates are equal across countries, so: 1 + rHC = (1 + RHC)/(1 + hHC) = (1 + RFC)/(1 + hFC) = 1 + rFC b. The exact form of uncovered interest rate parity is: E[St] = Ft = S0 [(1 + RFC)/(1 + RHC)]t c. The exact form for relative PPP is: E[St] = S0 [(1 + hFC)/(1 + hHC)]t d. For the home currency approach, we calculate the expected currency spot rate at time t as: E[St] = (€0.5)[1.07/1.05]t = (€0.5)(1.019)t We then convert the euro cash flows using this equation at every time, and find the present value. Doing so, we find: NPV = – [€2M/(€0.5)] + {€0.9M/[1.019(€0.5)]}/1.1 + {€0.9M/[1.0192(€0.5)]}/1.12 + {€0.9M/[1.0193(€0.5/$1)]}/1.13 NPV = $316,230.72 For the foreign currency approach, we first find the return in the euros as: RFC = 1.10(1.07/1.05) – 1 = 0.121 Next, we find the NPV in euros as: NPV = – €2M + (€0.9M)/1.121 + (€0.9M)/1.1212 + (€0.9M)/1.1213 = €158,115.36 And finally, we convert the euros to dollars at the current exchange rate, which is: NPV ($) = €158,115.36 /(€0.5/$1) = $316,230.72 Yes, they should take this investment. Chapter 30 Case Study West Coast Yachts Goes International 1. The biggest advantage is the increased sales, while the biggest risk is exchange rate risk. 2. If the pound strengthens, the profit will decline. Conversely, if the pound weakens, the profit will increase. 3. The company will pay the sales commission out of net sales, so the after-commission value of sales in euros is: After-commission revenue = €5,000,000(1 – .05) After-commission revenue = €4,750,000 At the current exchange rate of €1.12/£, the sales in euros will be converted to pounds in the amount of: Pound sales = €4,750,000/(€1.12/£) Pound sales = £4,241,071 West Coast Yachts has production costs equal to 70 percent of pound sales at this exchange rate, so the production costs are: Production costs = £4,241,071(.70) Production costs = £2,968,750 So, the profit at the current exchange rate is: Profit = £4,241,071 - £2,968,750 Profit = £1,272,321 If the exchange rate changes to €1.20/£, the euros will convert to: Pound sales = €4,750,000/(€1.20/£) Pound sales = £3,958,333 Since the production costs are fixed, the profit at this exchange rate will be: Profit = £3,958,333 – £2,968,750 Profit = £989,583 The breakeven exchange rate is the exchange rate that will allow the after-commission costs in euros to convert to a pound amount that covers the production costs, so: Breakeven exchange rate = £2,968,750/€4,750,000 Breakeven exchange rate = £0.63/€ 4. The company could use options, futures, or forwards. The downside to all three hedging vehicles is the cost. Over time, the company will gain on some contracts and lose on others. 5. At the current exchange rate, the company will make a profit unless the exchange rate moves dramatically. So, it is likely that hedging is not required at this point. Taking this into account, the company should probably pursue international sales further. Solution Manual for Corporate Finance David Hillier, Stephen Ross, Randolph Westerfield, Jeffrey Jaffe, Bradford Jordan 9780077139148
Download
Close
Close
