FIN501 Corporate Finance

ASSIGNMENT II

PART A - Case study (45 marks)

Dwayne Stevenson, aged 58, had joined the Pharmacopia Company approximately thirty years ago, as a post-doctoral researcher in the field of immunology. Through his strong work ethic and knowledge of science, he was given share options as part of his remuneration package five years ago. At that time, shares of Pharmacopia (PCU) were trading at $35 per share. The company had annual sales in excess of $5 billion and the sales of earnings growth forecast for the next few years were good. However, PCU suffered a few setbacks about 3 years later. Sales began to suffer and profits began to shrink sending its stock price into a downward spiral.

About a year later, when the company was downsizing and cost cutting, Dwayne was offered the option to take early retirement. Part of the retirement package included a significant amount of PCU shares which was trading at $15 at the time. As a result of having exercised share options and his early retirement package, Dwayne had accumulated over 100,000 PCU shares. This caused his investment portfolio to not be well diversified and Dwayne knew that he needed to restructure it.

In recent month, the share price of PCU has declined to $12 per share. Dwayne wonderedwhether he should sell the share or hold it until it reached a better price. Having had verylittle financial and investment training, Dwayne contacted his broker, Jonathan Price, for

some advice. His main question to Jonathan was, How low can it go?Jonathan told him to hold on to the share because his calculations showed that it was significantly undervalued at $12 per share and should rise to about $35 per share in three years. He felt that the company was having temporary regulatory problems and should be able to weather the storm quite well. He said the current intrinsic value of the share, in his opinion, was in the range of $16 $26. Not convinced, Dwayne asked him to explain how he arrived at that range. Jonathan replied that he used alternate forms of the dividend discount

model, to which Dwayne responded, Dividend what? Jonathan realised that he would have

to give Dwayne an educational presentation on share valuation and set up an appointment for the following week.

In preparation for the appointment, Jonathan prepared Table 1 showing the sales, net income, earnings per share (EPS), and dividend per share (DPS) data for the prior 10-year period. In addition, he estimated the firms beta and noted down the risk-free rate, market risk premium, and the expected growth rate of the pharmaceutical industry (shown in Table 2). Jonathan knew that he would have to keep his explanation simple, yet convincing, and expected to be faced with many difficult questions.

TABLE 1 Pharmacopia Company

Key Financial Data for Prior 10-year Period (in $ millions, except EPS, DPS)

YearSalesNet IncomeEPSDPS

20053,4001701.700.68

20063,8001901.900.76

20074,5002252.250.90

20084,7002352.350.94

20095,2002602.601.04

20105,4002702.701.08

20115,8002902.901.16

20125,6002802.801.12

20135,3002652.651.06

20145,5002752.751.10

TABLE 2

Systematic Risk, Industry Growth, Interest Rates

Beta0.8

30-year Treasury Bond Yield5%

Expected Market Risk Premium10%

Industry Average Growth Rate9%

You are required to answer the following questions 1 to 6. Your assignment will be graded based on presentation, good understanding and logical explanation, and accuracy of calculations in solving the problems.

QUESTIONS:

1. How should Jonathan describe the rationale of the dividend discount model (DDM) and demonstrate its use in calculating the justifiable price of PCU share?

(8 marks)2. Being a researcher, Dwayne asked Jonathan a key question, How did you estimate the growth rates used in applying the model? Using the data given in Tables 1 and 2 explain how Jonathan should respond.(7 marks)3. Why are you using dividends and not earnings per share, Jonathan? ask Dwayne. What do you think Jonathan would have said?

(7 marks)4. Dwayne wondered whether PCUs preference share would be a better investment than its ordinary share, given that it was paying a dividend of $2.50 and trading at a price of $25. He asked Jonathan to explain to him the various features of preference share, how it differed from ordinary share and the method that could be used for estimating its value.

(7 marks)5. If PCU has an outstanding issue of $1,000-par-value bonds with a 11% coupon interest rate, would it be a better investment than its ordinary share, given that it was paying interest semi-annually, maturing in five years and trading at a price of $1,050. He asked Jonathan to explain to him the various features of corporate bond, how it differed from ordinary and preference shares, and the method that could be used for estimating its value.

(8 marks)6. How did Jonathan derive the intrinsic value of PCU share to be in the range of $16 $26? [Hint: Assume the dividend would grow at current rate for the next five years and thereafter the industry growth rate.] Why did Jonathan think that the PCU share would

rise to $35 per share in three years time? Justify your analysis.

(8 marks)PART B (55 Marks) Question 1 (20 marks)

(a) Equity holders want 16% on their investment, whereas debt holders only require 8%. I would be crazy to expand using equity since debt is so much cheaper. Comment.

(10 marks)(b) Explain the trade-off between retaining internally generated funds and paying cash dividends.

(10 marks)Question 2 (25 marks)

R. Stewart Co. Ltd. is a firm that pays its profits as franked dividends to shareholders who are able to utilise the franking credits. Below is the capital structure of the firm together with additional information.

-Issue costs would be (a) 13% of market value for a new bond issue, (b) $0.125 per

share for ordinary equity, and (c) $0.24 per share for preference shares.

-The recent dividends on ordinary shares were $0.325 and are projected to have an

annual growth rate of 6%.

-Coupon payments on bonds are paid annually.

-The firm is in a 30% tax bracket.

-Current market prices are $104 for bonds, $1.80 for preference shares, and $3 for

ordinary shares.

-There is $250,000 of retained earnings available for investment.

% of Capital

Source of FinanceStructureBonds: (8% coupon, $100 par, 16 year maturity)38

Preference Shares: (50,000 shares, $5 par, $0.15 dividend)15

Ordinary Equity47

100What will be the weighted average cost of capital for a project if the amount of capital required is:

a. $ 500,000 (15 marks)

b. $1,000,000 (10 marks)

Question 3 (10 marks)

Relative to total assets, businesses in the retail and wholesale sectors invest substantially more in short term assets than do businesses in the service sector. Suggest reasons for this difference.**********END**********