EXAMINATION I: Economics Corporate Finance Financial Accounting and Financial Statement Analysis Equity Valuation and Analysis Questions Final Examination March 2009
Question 1: Economics (37 points) The following chart was obtained from UBS Wealth Management Research (summer 2008). The more volatile of the two plots shows the development of the exchange rate between the US dollar (USD) and the Euro (EUR), quoted as USD per 1 EUR. The more steady plot shows the value of this exchange rate pair implied by purchasing power parity. EUR-USD line PPP EUR-USD line a) Explain the theory of relative purchasing power parity (PPP). (3 points) b) What is the reason for the gradual upward movement in the PPP EUR-USD line from 1986 until 2008? Answer briefly by considering that the relative PPP holds. (4 points) c) For the past decade, the United States of America has been running ever increasing current account deficits. What are the options available to a nation to finance a current account deficit? Answer briefly. (4 points) d) Give two reasons why a large current account deficit is often seen as a cause for concern by economic analysts. (6 points) e) Exchange rate volatility appears to be higher than justified by economic fundamentals. One explanation for this fact is provided by the Overshooting Model. Explain this model and its stylized facts in the context of the Euro and the US-Dollar, assuming for example that the US central bank announces a surprisingly high growth rate of a monetary aggregate (money supply). (Hint: Start by giving the Overshooting Model assumptions. Then describe the short-run effect on the interest rate, the price level, etc. And finally describe the long-run effect.) (14 points) f) Excessive exchange rate volatility occasionally leads to calls for more stability in the international financial system. One possibility to achieve this is with the help of fixed exchange rates. State and briefly explain one major advantage of fixed exchange rate systems as well as one major advantage of floating exchange rate systems. (6 points) Page 1 / 9
Question 2: Financial Accounting (20 points) Metro Group, a German company, is an important retailing firm. Its 2008 consolidated balance sheet prepared in conformity with IFRS contains the following information about intangible assets: Concessions franchises, trademarks and similar rights, licenses and other such rights (thereof internally generated intangible assets) Prepayments (Unit: EUR million) Purchase or production costs At Dec 31, 2007/Jan 1, 2008 867 320 1 868 Currency translation -1-1 0-1 Change in consolidation group 15 15 Additions 167 112 0 167 Disposals -36-2 0-36 Transfers -12 6-1 -13 At Dec 31, 2008 1,000 435 1,000 Depreciation/amortisation At Dec 31, 2007/Jan 1, 2008 435 134 435 Currency translation 0 0 0 Additions, scheduled 114 53 114 Additions, non-scheduled 3 1 3 Disposals -27 0-27 Write-ups 0 0 Transfers -3 4-3 At Dec 31, 2008 522 192 522 Transition of Book value Book value on Jan 1, 2007 394 136 394 Book value on Dec 31, 2007 432 186 1 433 Book value on Dec 31, 2008 478 243 478 Total a) According to IFRS, what are the conditions that internally generated intangibles must meet to be recognized as assets? Answer specifically about development costs and research costs. (6 points) b) Assume that the tax authorities do not admit the capitalization of internally generated intangible assets. How would deferred tax assets and liabilities on 31.12.2008 be affected? Assume an income tax rate of 40%. (5 points) c) Now assume that despite IFRS, development costs for internally generated intangible assets were recognised as expenses in the period in which they were incurred. c1) What impact would it have on the Metro Group consolidated equity on 31.12.2008? (5 points) Page 2 / 9
c2) What influence (increase, decrease, no impact) would it have on the following items: net income of year 2008. cash flow from operating activities of year 2008. cash flow from investing activities of year 2008. cash and cash equivalents on 31.12.2008. (4 points) Page 3 / 9
Question 3: Equity Valuation and Analysis (49 points) Calculate the value of a company based on the following data using a Market Value Added (MVA) approach: (Unit: EUR million) 2008e 2009e 2010e 2011ff Total assets (2007: 7,000) 7,500 7,700 7,900 +2.5% p.a. Net profit after taxes 375 424 474 +3.0% p.a. Net operating profits after 563 742 955 +3.0% p.a. taxes Risk free rate 4% 4% 4% 4% Expected stock market return 8% 8% 8% 8% Interest Rate of companies 6.5% 6.5% 6.5% 6.5% debt Tax rate 28% 28% 28% 28% Free Cash Flow (FCF) 225 400 525 +2.8% Dividend 100 100 150??? Debt / equity ratio (2007: 1.0) 1.0 1.0 1.0 1.0 Beta of the stock 1.2 1.2 1.2 1.2 Value of debt Is equal to the book value of debt 2008e = 2008estimated 2011ff = 2011 and the following years a) a1) Which discount rate do you have to use? Explain your decision. (4 points) a2) Calculate the appropriate discount rate. (8 points) b) MVA approach uses EVA (Economic Value Added). Explain MVA first, then explain how to get EVA and why getting EVA is important. No calculation is required. (6 points) c) Based on the above data, calculate EVAs 2008e, 2009e and 2010e. (6 points) d) Explain the process to get the values of equity by using MVA. (6 points) e) Calculate the value of equity for the company as of 1.1.2008. Suppose a two stage MVA model where stage 1 covers the period from 2008 to 2010 and stage 2 from 2011 and beyond. Predict a constant growth of EVAs from 2011 which equals the growth rate of EVAs from 2010 to 2011. (11 points) [Note: If you need a result from one of the above sub-questions (a to d) which you have not been able to calculate earlier, then make an assumption (and indicate exactly what kind of assumption this is).] f) Suppose that the valuation of equity by a Dividend Discount model will show the same result as the valuation of your MVA model. How large must the growth rate of dividends be for an equivalent result of a DDM from 2012 onward, if the 2011 dividend paid is equal to the 2010 dividend paid? (8 points) Page 4 / 9
[Note: If you need a result from one of the above sub-questions (a to e) which you have not been able to calculate earlier, then make an assumption (and indicate exactly what kind of assumption this is).] Page 5 / 9
Question 4: Corporate Finance (40 points) UVG Inc. is a holding company traded on the Frankfurt stock exchange and consists of two major business divisions. The trucking division RACE services major trading routes between Northern and Southern Europe and has benefited from the surge in trade over the last couple of years. More recently, it has reported lower profits due to some bad decisions made by senior management at the holding company level. Moreover, substantial investments in new trucks will have to be made in the next two years. The second major division ENJOY operates in the travel industry and is separately traded on the stock exchange. Several institutional shareholders are questioning the benefits of operating these two divisions under the same holding company which does not generate synergies from their point of view. Therefore, they have approached UVG s CEO Richard Thales and demanded a break-up of the company. UVG has currently 100,000 shares outstanding and is paying a dividend of 2 EUR per share. Its shares are trading at 80 EUR per share and its beta equals 1.1. UVG s stake in ENJOY has a market value of 4,000,000 EUR. UVG is currently rated B and comparable company debt in this rating category is trading at a yield of 9.5%. The applicable tax rate equals 35%. The risk-free rate is 4.5% and the expected equity market return is 15%. Interest payments are corporate tax deductible. The management of the trucking division has projected the division s income statement and balance sheet as a stand-alone entity based on the assumption of continuing growth in trading between Asia and Europe. These projections are summarized in the table below. Summary Financials for the Trucking Division: (Unit: EUR) Income Statement 2008 2009 2010 2011 Revenues 4,000,000 4,500,000 5,000,000 5,250,000 - Operating Expenses 2,000,000 2,250,000 2,500,000 2,625,000 - General Expenses 500,000 450,000 600,000 625,000 - Depreciation 400,000 600,000 600,000 600,000 EBIT 1,100,000 1,200,000 1,300,000 1,400,000 - Interest Payments 350,000 350,000 350,000 350,000 EBT 750,000 850,000 950,000 1,050,000 - Taxes (35%) 262,500 297,500 332,500 367,500 Net Income 487,500 552,500 617,500 682,500 Capital Expenditures 1,800,000 800,000 - - Increase in Working Capital 400,000 300,000 100,000 100,000 a) Thales has decided to evaluate the financial consequences of the proposed break-up of the company. Analyzing the valuations of the competitors of the trucking division, he notes that their average beta equals 1.3. Discussions with consultants come to the conclusion that the growth rate of the trucking industry will fall to the growth rate of the world economy of 2.5% after the fourth year. Page 6 / 9
a1) Calculate the free cash flow to the firm, the annual tax shield due to debt financing for the trucking division and the free cash flow to equity holders for the year 2008. Use the table below and fill out the shadowed cells. (8 points) Hint: When the firm debt amount is constant as in this case, the free cash flow to equity holder is derived by subtracting interest from and adding tax effect (tax shield) of such an interest payment to the free cash flow to the firm. (Unit: EUR) 2008 2009 2010 2011 EBIT 1,100,000 1,200,000 1,300,000 1,400,000 Free Cash flow to the firm 280,000 1,345,000 1,410,000 tax effect (tax shield) Free Cash flow to equity holders 52,500 1,117,500 1,182,500 a2) Should Thales use a division-specific cost of capital when valuing the trucking division? Explain your reasoning. (5 points) a3) Calculate the equity value of the trucking division (date of calculation: 1.1.2008; bear in mind your answer from a2). (7 points) a4) Check whether the assertions made by the investors are correct by estimating the value of the synergies. Show calculations and explain. (5 points) b) Despite the fact that a break-up of UVG would make economic sense, Thales does not want to go ahead with this decision. Moreover, in order to protect himself against the threat of a hostile takeover, he plans to increase the company s leverage by issuing new additional debt which is senior to existing debt and using the proceeds to buy back shares. These transactions will raise UVG s debt-to-equity ratio from 0.5 to 1. Assume the beta of debt to be zero. b1) Determine whether these financing decisions will increase shareholder value by comparing UVG s weighted average cost of capital before and after these transactions are completed. Show your calculations. (10 points) b2) Thales goes ahead with the refinancing. As a result, UVG s share price rises while the price of its outstanding bonds falls to 95% of par value. The bonds have a maturity of 4 years and pay an annual coupon of 9.5%. Calculate the cost of debt based on this observation and interpret your result. (5 points) Page 7 / 9
Question 5: Financial Accounting (34 points) Acquirer (A) bought on 01.01.X1 100% of the shares of Subsidiary (S) at a price of 10 million EUR. The values of the identifiable assets and liabilities of S at the acquisition date are shown below. A prepares its consolidated financial statements in EUR and according to IFRS. Book value on 01.01.X1 (in million EUR) Fair value on 01.01.X1 (in million EUR) Identifiable assets and liabilities of S Intangible assets 15.0 18.0 Property, plant and equipment 15.0 21.0 Current assets 51.0 51.0 Financial liabilities 81.0 81.0 a) Calculate the goodwill resulting from the acquisition of S assuming that the functional currency of S is EUR. (4 points) b) Explain how to recognize and measure an impairment loss of the goodwill resulting from the business combination. (6 points) c) Assuming hereafter that the functional currency of S is USD and that the values above are in million USD (but the acquisition amount which A paid remains the same amount at 10 million EUR): c1) Calculate the goodwill resulting from the acquisition of S. On 01.01.X1 the exchange rate EUR/USD was 1.50 (1 EUR = 1.5 USD). (4 points) c2) Indicate in the table below the impact of the acquisition of S on the consolidated balance sheet of A on 01.01.X1. Assume that A has financed the acquisition of the shares with bank credit. (10 points) Impact of the acquisition of S on the consolidated balance sheet of A on 01.01.X1 Goodwill Other intangible assets Property, plant and equipment Current assets Financial liabilities Equity of which: Retained earnings portion by net income Amount (in million EUR) c3) In year X1, S has earned a net income of 2 million USD from sales to third parties, which has led to an equal increase of short-term assets. All remaining items did not change from 01.01.X1. Page 8 / 9
Assuming that the exchange rate EUR/USD on 31.12.X1 is 2.0 and that the average exchange rate for year X1 was 1.6, indicate in the table below the variations in the consolidated balance sheet of A on 31.12.X1, as compared to the corresponding amounts on 01.01.X1. (10 points) Changes in the consolidated balance sheet of A on 31.12.X1, as compared to 01.01.X1. Goodwill Other intangible assets Property, plant and equipment Current assets Financial liabilities Equity of which: Retained earnings portion by net income Amount (in million EUR) Page 9 / 9