EXAMINATION I Corporate Finance - Economics Financial Accounting

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EXAMINATION I:
Corporate Finance - Economics
Financial Accounting and
Financial Statement Analysis
Equity Valuation and Analysis

Questions

Final Examination

March 2006
Question 1: Economics (40 points)

a) China has been experiencing very high growth rates of both its GDP and its exports. At
the same time it has been tying its currency, the Yuan, at a fixed exchange rate to the US
dollar. Lately, there has been the claim by its trading partners, especially the US that the
Yuan is undervalued and should be re-valued.

a1) Exchange rates are sometimes said to follow purchasing power parity (PPP). Explain
what purchasing power parity is, both in its absolute form and in its relative form.
(5 points)

a2) Discuss in detail the effects of a revaluation of the Yuan on the Chinese current
account if we assume that the Marshall-Lerner condition holds. Then analyze – both
graphically (using the IS-LM framework) and verbally - the medium-run effects of
this revaluation of the Yuan on the Chinese economy, i.e. Chinese output. For
simplicity assume that domestic prices in China are fixed. (15 points)

a3) Now let prices also be flexible. Show graphically - using the AS/AD-framework –
what the medium-run and what the long-run effects of this revaluation on the Chinese
economy (output, prices) would be. Assume that initially there was full employment
in the Chinese economy and that nominal wages are rigid only in the medium-run.
(10 points)

b) The US Federal Reserve has been raising the target rate for the federal funds rate by
reducing the quantity of money (i.e. the central bank’s monetary policy rate) repeatedly,
in order to cool the US economy and to reduce inflationary pressures. Explain the
economic mechanism that links these interest rate moves to output and prices in the US.
Use the appropriate graphs to show what happens in the money market as well as in the
overall economy. (10 points)

ACIIA® Questions Examination Final I – March 2006
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Question 2: Corporate finance (40 points)

The table below contains the balance sheet (book value) of Company ABC as of December
31, 2004. The short-term debt is a 250 million euro bank loan at 6% interest. The bonds, of
which face value is 800 million euros, are straight bonds maturing in 2014 with a coupon rate
of 7.8% paid once a year at the end of the year. At the end of 2004, the yield to maturity was
8.1% with a bond price of 98.00 euros per 100 euros par value. ABC has 50 million shares
issued and outstanding. At the end of 2004, the share price was 40 euros.

Table: Company ABC's Balance Sheet (December 31, 2004; million euros)
Cash 150 Accounts payable 600
Accounts receivable 800 Short-term debt 250
Inventories 700 Total current liabilities 850
Total current assets 1,650 Bonds 800
Tangible fixed assets 1,200 Deferred tax 350
Other fixed assets 650 Shareholders' equity 1,500
Total assets 3,500 Total liabilities and equity 3,500

a) To estimate the after-tax weighted average cost of capital (WACC), you need to
determine the capital structure. When doing this, explain how you should handle the
accounts payable and deferred tax that are included in ABC's balance sheet. (8 points)

b) Knowing that in December 2004, the risk-free rate was 5%, the stock market risk
premium 6% and the beta of ABC's shares 1.20, calculate ABC's after-tax weighted
average cost of capital based on the following assumptions:
(1) the capital structure at the end of 2004 is equivalent to the target capital structure;
(2) the book and market values of short-term-debt are equivalent; and
(3) the company's marginal corporate tax rate is 40%. (9 points)

c) ABC is studying whether to undertake an investment project worth a total of 500 million
euros in order to substantially strengthen capacity in its mainline businesses. Its
investment decision-making policy requires the calculation of the net present value of the
project (NPV) using the after-tax WACC as the discount rate. The procedure the company
uses to estimate the after-tax cash flows clearly indicates that the interest expenses should
not be included. Explain why ABC assumes 100% equity financing when estimating the
cash flows even though it does in fact finance part of the investment with debt. (4 points)

d) For this project, the NPV was negative, with the implication that the company should not
accept it. Then Mr. Anderson, the head of the department proposing the project, argued
that the discount rate used to calculate NPV was too high. He claimed, "The entire
investment for the project should be funded with bond issues, and when calculating NPV
we should use the cost of debt as the discount rate." Do you agree with Mr. Anderson's
argument? Provide two reasons supporting your point of view. (6 points)

ACIIA® Questions Examination Final I – March 2006
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e) The XYZ investment bank proposes a deal in which ABC would reduce its WACC by
issuing 300 million euros in bonds and using the proceeds to repurchase shares, thereby
increasing ABC's debt ratio and allowing it to take advantage of increased tax benefits.
You are to consider below how much ABC would be able to reduce its WACC by
accepting the deal. For simplicity assume: (1) the deal will not have a signaling effect on
the capital markets; (2) the deal will not affect interest rates on ABC's long-term debt; and
(3) transaction costs can be ignored.

e1) Assuming the liability beta to be zero, calculate the asset beta of ABC. (3 points)

e2) Estimate the change in ABC's firm value from the tax benefits that arise with the
300 million euro bond issue. (3 points)

e3) Calculate the cost of ABC's shareholders' equity after it issues the bond and
repurchases shares as proposed by XYZ. (7 points)

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Question 3: Equity Valuation and Analysis (32 points)

The JUN Corporation's share price is currently 95 euros, and its book value per share was 100
euros at the end of last year. The Research Department at MKI Asset Management has
published an investment opinion on JUN's stock, forecasting a return on equity (ROE) of
10% and a payout ratio of 30% into perpetuity. The risk-free rate is 3%, the stock market risk
premium 7% and JUN's estimated beta is 1.1.

Assumptions used in the JUN Corporation investment opinion:

Return on shareholders' equity (ROE) 10%
Payout ratio 30%
Book value per share (BVPS) at the end of last year 100 euros
Risk-free rate 3%
Stock market risk premium 7%
JUN's beta 1.1
JUN's share price 95 euros

a) Based on the forecasts from the MKI Asset Management Research Department, calculate
the expected rate of return (implied return) on JUN’s shares at the current share price, by
using the constant growth dividend discount model. Then, discuss whether JUN’s shares
are trading at a discount or at a premium if the CAPM holds. (12 points)

b) Mr. White, an analyst at MKI Asset Management, uses a different approach. He
calculates the theoretical share price by adding the present value (PV) of the future
residual income per share to the current book value per share (BVPS) using the following
formulae:

Theoretical share price =
(BVPS at end of last year) + (PV of residual income per share in and after this year)

Residual income per share =
EPS – (BVPS at end of last year) · (Required rate of return on equity)

Show the calculations following Mr. White’s approach. Then, discuss whether JUN’s
shares are trading at a discount or at a premium. (10 points)

c) Mr. Field, a fund manager at MKI Asset Management, aggressively includes in his
portfolio shares with a price-to-book ratio (PBR) below 1, based on the rationale that such
shares are trading at a discount, as they are cheaper than liquidation value. Based on this
philosophy, he has decided to invest in JUN’s shares. Explain what is wrong with Mr.
Field's investment decision. (4 points)

d) Provide two arguments that could support Mr. Field's investment philosophy mentioned
above. (6 points)

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Question 4: Accounting (53 points)

On 1st January, 2006, Michigan Inc. bought a plant under a finance lease. The CEO of the
company has to prepare the Balance Sheet as of 31.12.2006 and he needs to account for the
lease according to IAS 17.
The principle data relating to the financial lease are indicated below:

• The lessee has to pay two installments of CU 10’000 each on 1st January 2006 and 2007.
A the end of the lease period the price to purchase the asset is 2’000 CU as shown below:

01/01/2006 01/01/2007 01/01/2008
10’000 10’000 2’000

• The lease interest rate is 8% p.a.
• The useful economic life of the plant is 3 years (use the straight-line method of
depreciation to calculate the annual depreciation of the asset).

You will find more information about IAS 16 and IAS 17 in appendices I and II.

a) Calculate :
- the amount at which the asset is recognized at the inception of the lease.
- the liability amount at the inception of the lease.
- the asset carrying amount in the balance sheet as of 31.12.2006.
- the liability amount in the balance sheet as of 31.12.2006. (15 points)

b) On 1st January 2006, Michigan Inc. bought an item of equipment whose useful life was
3 years (use the straight-line method of depreciation to calculate the annual depreciation
of the asset). One year later, i.e. in the balance sheet as of 31.12.2006, the carrying
amount of this equipment is CU 5’000. Assume that on 31.12.2007, the company decides
to follow the IAS 16 revaluation model which permits the valuation of tangible fixed
assets at fair value.

Taking into account that on 31.12.2007 the fair value of the equipment was found to be
CU 7’000, fill in the blanks in the following table which shows the evolution of (1) the
asset value (assuming that there is no change in the useful life of the asset), (2) deferred
taxes (referred to the evaluation of the asset at fair value - assuming that the company tax
rate is equal to 30% and that taxes are based on unrevalued amounts), (3) revaluation
reserve and (4) depreciation expense of the equipment.

(Assume that the revaluation reserve is transferred to retained earnings as the asset is used
by the company)

31.12. 2007 31.12.2008
Equipment (carrying amount)
Deferred taxes
Revaluation reserve
Depreciation for the year

(14 points)
ACIIA® Questions Examination Final I – March 2006
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c) On 1st January in year N, Viel Inc. acquired 20% of the common stock of Ice Inc.
spending CU 120’000. This investment gives Viel Inc. the power to participate in the
financial and operating policy decisions of Ice Inc. The balance sheet of Ice Inc. as of 31st
December, N-1 was as follows:

Assets Liabilities and Equity
Fixed Assets 600’000 Long Term Debt 600’000
Current Assets 500’000 Short Term Debt 200’000
Common stock 200’000
Net profit N-1 100’000
Total Assets 1’100’000 Total Liabilities and 1’100’000
Equity

The following methods of consolidation are available for Viel Inc.:
- Majority control: full consolidation
- Joint control: proportionate method
- Significant influence: equity method

c1) Which consolidation method should Viel Inc. choose and why? (2 points)

c2) Calculate the goodwill arising from the acquisition of the investment in Ice Inc. (2 points)

c3) Complete the table below for each of the following cases:
• Case A: Ice has realized an amount of profit equal to CU 300’000 in year N;
• Case B: Ice has realized an amount of loss equal to CU 100’000 in year N;
• Case C: Ice has realized an amount of profit equal to CU 100’000 in year N, but
distributed dividends for CU 50’000 on 6th June N;
• Case D: Ice has realized an amount of profit equal to CU 0 in year N.

Assume that goodwill is not amortized in Viel Inc.

(Also take into account that the fair value of Ice’s identifiable assets as of 31 December N-1
was equal to book value) (12 points)

Extract from company Viel’s consolidated CASE A CASE B CASE C CASE D
Balance Sheet as of 31 December N
Investment in Ice Inc.
of which : Goodwill

Extract from company Viel’s consolidated CASE A CASE B CASE C CASE D
Profit and Loss account for year N
Adjustment of the investment in Ice Inc.

ACIIA® Questions Examination Final I – March 2006
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d) Assume now that the common stock of Ice Inc. belongs to five companies (one of which
is Viel Inc.) in the same proportion (20% each). Further assume that among these
companies there exists a contractual agreement under which the five companies manage
Ice Inc. together, i.e. Ice Inc. is subject to joint control.

Prepare the consolidated balance sheet of Viel Inc. on 31st December N completing the
table below. (by using Viel’s and Ice’s balance sheets as of 31st December N).

Assets Liabilities and Equity
Fixed Assets Long Term Debt
Current Assets Short Term Debt
Investment in Ice Inc. Group shareholders' funds
Goodwil Minority interests

(8 points)

Balance sheet of Viel Inc. as of 31st December N:
Assets Liabilities and Equity
Fixed Assets 2’100’000 Long Term Debt 1’000’000
Current Assets 1’000’000 Short Term Debt 300’000
Investment in Ice Inc. 120’000 Shareholders' Funds 1’920’000

Total Assets 3’220’000 Total Liabilities and 3’220’000
Equity

Balance sheet of Ice Inc. as of 31st December N:
Assets Liabilities and Equity
Fixed Assets 550’000 Long Term Debt 300’000
Current Assets 300’000 Short Term Debt 200’000
Common stock 200’000
Net profit N-1 100’000
Net profit N 50’000
Total Assets 850’000 Total Liabilities and 850’000
Equity

(Take into account that the fair value of Ice’s identifiable assets as of 31.12.N-1 was equal to
book value)

ACIIA® Questions Examination Final I – March 2006
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Question 5: Accounting (15 points)

Sunset Ltd acquired a production facility at a price of 20,000k CU (thousand Cash Units) on
1 January 2005. The production facility is depreciated using the straight line method over a
useful life of 5 years.

On 31 December 2005, the company decided to use the revaluation model allowed by IAS 16
for valuing its production facility. The fair value of this asset was :
- on 31 December 2005: 18,000k CU
- on 31 December 2006: 15,000k CU
- on 31 December 2007: 6,000k CU

Using the table below, calculate the effects based on the cost model and the revaluation
model allowed by IAS 16. Assume that, (1) as long as the asset is not impaired, the
revaluation policy of the company is to make revaluations every 3 years. (2) Assume also that
the revaluation reserve is transferred to retained earnings as the revalued asset is used by the
company. (3) Assume also that impairment loss is recognized on 31 December 2007.

You will find more information about IAS 16 in appendices II and III.

Dec. 31, 2005 Dec. 31, 2006 Dec. 31, 2007
Cost Model Revaluation Cost Model Revaluation Cost Model Revaluation
Model Model Model
Carrying amount of
the production
facility
Revaluation
reserve
Depreciation +
impairment loss
affecting net profit

ACIIA® Questions Examination Final I – March 2006
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APPENDIX I

NOTE to question 4a) (Financial Accounting)

Accounting of finance lease by lessees under IAS 17:
At the inception of the lease, the lessee recognizes the lease as an asset and liability in the
balance sheet at the fair value of the leased asset or the present value of the minimum lease
payments, which ever is the lower.

APPENDIX II

NOTE to questions 4b) and 5 (Financial Accounting)

Revaluations (allowed alternative under IAS 16):
In the event that devaluation of fixed assets was taken into the income statement in previous
years and there is a subsequent increase in the fair value of fixed assets in a later year, calling
for recognition of revaluation,

a) the increase in the fair value up to the amount equivalent to the devaluation loss in
previous years should be taken into the income statement of the year of revaluation, and
then

b) the proportion of the increase in the fair value in excess of the loss in previous years, if
any, should not be taken into the income statement but be reflected in the revaluation
surplus under shareholders’ equity and deferred.

If there occurs a devaluation loss due to a decrease in the fair value in following years,

c) the loss should be charged to equity (revaluation surplus), and

d) the proportion of the decrease in the fair value in excess of the revaluation surplus, if any,
should be taken into income statement.

APPENDIX III

NOTE to question 5 (Financial Accounting)

Treatment under IAS 16:
Subsequent to initial recognition of fixed asset at cost, its carrying amount is either cost or
revalued amount, less accumulated depreciation and any accumulated impairment losses.

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