FINB862 Finance for Corporations

Assignment
File

1

Assignment
1

Due
date:3
December 2013

Important
note

You
must use word processing software (such as Microsoft Word) to prepare the TMAs,
and submit the TMAs via the Online Learning Environment (OLE). All assignments
must be uploaded to the OLE by the due date.

Failure
to upload a TMA in the required format to the OLE may result in the score of
the TMA being adjusted to zero.

Question
1 (30 marks)

Read
the article ‘Telecom Italia cuts dividend as debt bites’.

Telecom Italia
cuts dividend as debt bites

Telecom
Italia has cut its dividend 25%, reversing its pledge for a 15% increase and
echoing moves by peers, as it battles to cut over 30 billion euros ($41
billion) debt in the midst of an economic downturn.

Italy,
whose economy has fallen into recession because of the sovereign debt crisis,
was hit by credit rating cuts in 2012, making debt reduction even more urgent
for Italy’s largest telecom company to prevent a costly downgrade.

The
Rome-based group on Friday cut its 2011 dividend to an overall sum of 900
million euros, and confirmed its target of reducing net debt to about 25
billion euros in 2013. It did not give a dividend per share figure.

‘Such
a dividend policy helps Telecom Italia stay on track with debt-cutting as
outlined in its previous plan. Once this target is reached shareholder
remuneration will start to grow again,’ executive chairman Franco Bernabe said.

Bernabe
said in a conference call on Friday he was ‘quite confident’ his group would
keep its credit ratings target.

By
1100 GMT, Telecom Italia shares were up 5.7% to 0.858 euros, after earlier
reaching 0.868 euros – their highest level in almost one month, outpacing a
slight rise in the European telecoms sector.

An
analyst said Telecom Italia’s commitment to cut debt could reduce risks of a
rating downgrade for Telecom Italia, whose ratings outlook is on watch
negative. Traders said the dividend cut was anticipated.

Other European
telecoms operators, such as France Telecom,

Telekom Austria,
and Telefonica, have recently scaled back dividend
]

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for Corporations

payouts
to counter a negative mix of economic recession, competition and costly network
upgrades in their mature home markets.

Spanish
group Telefonica is struggling to convince investors that a December dividend
cut was enough for it to meet a tough debt reduction plan as restructuring
costs in its crisis-hit home market bite.

The
euro zone economy overall is heading into its second recession in just three
years, the European Commission said on Thursday, warning the currency block has
yet to break its vicious cycle of debt.

The
downturn is hitting demand for telecommunication services, which usually track
economic growth, as consumers trim back talk time and SMS traffic to keep bills
down.

For
Telecom Italia, declining revenues from mobile and fixed-line services to its
Italian customers, however, were more than offset by expansion and double-digit
percentage growth in Telecom Italia’s South American operations.

In
Italy in the fourth quarter, mobile revenue dropped 2.2% because of tough price
competition, while fixed revenue fell 2.7% as broadband subscribers numbers
actually shrunk for the second quarter in a row.

Cost cuts in
Italy also helped.

Total
core earnings rose 7.3% in 2011 to 12.25 billion euros and revenues rose 8.7%,
both broadly in line with analyst expectations.

The worsening of
Italy’s debt woes has pushed Telecom Italia shares down about 21% in the last
year to a level which some investors view as an entry point given the group’s
exposure to fast-

growing Brazil
and softened domestic mobile competition.

Bernabe
said shareholder remuneration would return to growth when its debt reduction
target is reached.

Telecom
Italia said net debt would fall to 27.5 billion euros by the end of 2012 from
30.4 billion euros at end 2011, predicting for 2012 revenues and organic core
earnings stable compared to last year.

Source:
Jewkes, S, Potter, M and Ginsberg, J (2012) ‘Telecom Italia cuts dividend as
debt bites’, Reuters, 24 February, http://www.reuters.com/article/
2012/02/24/telecomitalia-idUSL5E8DO1Z220120224.

Answer the
following questions.

a
According to the
dependence hypothesis of MM, a firm can enhance its total value by raising its
debt-equity ratio. Discuss four potential reasons why Telecom Italia decided to
reduce its debt level.

(15 marks)

Assignment
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3

b
‘The cost of debt is,
in general, lower than the cost of equity, so a company should always use debt
financing in order to lower the company cost of capital.’

Please
comment on the above statement. (15
marks)

Question
2 (20 marks)

Glenlivet
Company is considering a new four-year project that complements its existing
business. This project requires an initial fixed asset investment of
$4,000,000. The fixed asset will be depreciated straight-line to zero over its
four-year tax life, after which it will be worthless. The project is estimated
to generate $2,800,000 in annual sales, with costs of $1,100,000. The company
is an all-equity financed company and its cost of capital is 10%. The tax rate
is 35%.

a Evaluate whether
Glenlivet Company should accept this new project. (8 marks)

b
If the new project’s
beta risk is not equal to that of the company, evaluate whether Glenlivet Company
should accept the new project. Assume the beta risk of the new project is 1.5,
the expected risk premium on the market is 10%, and risk free bonds are
yielding 5%.
(6 marks)

c
Discuss two
consequences if Glenlivet Company always uses the weighted average cost of
capital (WACC) to make decisions for all

new
projects. (6
marks)

Question
3 (35 marks)

This
question is modified from questions and problems 26–27 of our textbook (p.
231):

Consider
a project to supply Detroit with 55,000 tons of machine screws annually for
automobile production. You will need an initial $1,700,000 investment in
threading equipment to get the project started; the project will last for five
years. The accounting department estimates that annual fixed costs will be
520,000 and that variable costs should be $220 per ton; accounting will
depreciate the initial fixed asset investment straight-line to zero over the
five-year project life. It also estimates a salvage value of $300,000 after
dismantling costs. The marketing department estimates that the automakers will
let the contract at a selling price of $245 per ton. The engineering department
estimates you will need an initial net working capital investment of $600,000.
You require a 13% return and face a marginal tax rate of 38% on this project.

a
Determine the estimated
operating cash flow (OCF) and net present value (NPV) for this project and
discuss whether you should pursue

this
project. (8
marks)

b
Suppose you believe
that the accounting department’s initial cost and salvage value projections are
accurate only to within ±15%; the marketing department’s price estimate is
accurate only to within

4 FIN B862 Finance
for Corporations
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±10%;
and the engineering department’s net working capital estimate is accurate only
to within ±5%.

What
is your worst-case scenario for this project? Your best-case scenario? Discuss
whether you still want to pursue the project under each scenario. (10 marks)

c
Suppose you are
confident about your own projections, but you are a little unsure about
Detroit’s actual machine screw requirements. What is the sensitivity of the
project OCF to changes in the quantity supplied? What about the sensitivity of
net present value to changes

in
the quantity supplied? Given the sensitivity number you calculated, is there
some minimum level of output below which you wouldn’t want to operate? Why? (17
marks)

Question 4 (15
marks)

Answer the
following questions on risk and return.

a Explain whether
a risky asset could have a zero beta or negative beta and discuss the expected
return on such an asset. (5 marks)

b
Suppose Tencent
Holdings Ltd has traded as low as HK$180 and as high as its current HK$355.
Explain whether we can conclude that

the
stock of Tencent Holdings Ltd has a very high beta due to its large price
movement. (5 marks)

c
Suppose HSBC has an
expected return of 15%, the risk-free rate is 3%, and the market risk premium
is 10%. Determine the beta of the

stock
of HSBC. (5
marks)