Finance and Investment
Cemreal and Neisstat are companies that differ only in their capital structures. Cemreal is all equity financed, its shares being currently valued at $20 million. Neisstat has $16 million of debt, paying interest at the risk-free rate of 10%. Research has shown that each will earn profits of $6 million at the peak of the business cycle and $2 million in a slump. It also shows that there is an equal chance of each occurring. You can assume for this question that there are no taxes and no market imperfections.
A pension fund of $800,000 invested on debt and equity at the heavily levered Neisstat has given an identical pay-off for the same amount of investment in the all equity financed company of Cemreal. The amount of $800,000 is four percent of the total value of the firm. At boom and slump period, Cemreal will give the pension fund $240,000 and $80,000 respectively. Neisstat gave the same pay-offs, with the pension fund invested four percent on its debt and four percent on its equity. c.
Using the data in this case, show whether Miller and Modigliani’s Proposition II holds. (15 marks) Miller and Modigliani’s (MM) Proposition II stated that “the expected rate of return in the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values; the rate of increase depends on the spread between rA, the expected rate of return on a portfolio of all the firm’s securities, and rD, the expected return on the debt. rE is equal to rA if the firm has no debt” (Brealey and Myers, 1981, p. 358).
In this case, MM Proposition II holds, considering that Cemreal, which is an unlevered firm, has a 30 percent expected rate of return compared to the highly leveraged firm of Neisstat which has a 46 percent expected rate of return. The expected rate of return of Neisstat is higher than the all equity financed company of Cemreal. Weighted Average Cost of Capital (WACC) for Neisstat without corporation tax is computed at 14 percent while with the introduction of a 30 percent corporate tax, Neisstat’s WACC was reduced to 11. 6 percent. With corporate taxes, Naisstat’s debt provided the company with a valuable tax shield.
This shows how leverage affects the company’s cost of capital if the company pays corporate tax. With the corporate tax, Naisstat was provided with the benefit of a tax shield. Question 2 a. Explain the nature of the real options present in each of these cases: i. An oil company buys a plant for producing biofuels. The project has a negative net present value. (10 marks) Net Present Value (NPV) is calculated by subtracting the initial investment from the present value of each cash inflows discounted at a rate equal to the firm’s cost of capital.
If NPV is greater than or equal to zero, then the project can be accepted; otherwise it is rejected. According to Gitman, if the NPV is greater than or equal to zero, “the firm will earn a return greater than or equal to its cost of capital” (1987, p. 456). He further added that such action “enhances or maintains the wealth of the firm’s owners” (1987, p. 456). However, a project having a negative NPV may be accepted in sequential manner, where new information maybe revealed at each sequence of developmental phase of the project.
Real options can be analyzed and undertaken at each sequential investment, and depending on the information revealed, one can go ahead and exercise more options, or completely abandon the business plan (FAQs, 2007). In the case of the company buying a biofuels plant, the project has a negative NPV using traditional method of analysis. Under real options theory, the firm will look at whether to operate the plant to extract biofuels from certain crops, and whether such crops can produce the required volume of biofuels to be economically viable.
It has to invest in the developmental phase, and depending on the new information that will be revealed, will have to decide on some future phase of the project whether to continue with the project of abandon it completely. ii. A company leaves its parcel of land vacant, even though the present value of rents it would receive by constructing a retail complex would exceed the construction costs. (10 marks) The company probably left the parcel of land vacant because it has considered a similar project with the same amount of initial investment, which gave a better or higher NPV than the retail complex.
It probably has other information, such as a soft market for retail complex, at that point in time. The company is also probably exercising its options to delay or do the project is some future dates. However, if there are no comparable projects equaling the cost to construct the retail complex, and assuming that there are enough investible funds lying around, then the company must take advantage of the investment with a positive NPV from the rentals it can receive from such a real estate property development. iii. Koshima develops and markets its first laptops at a loss.
(10 marks) It is possible that Koshima is exercising a sequential investment in which it accepts a phase of a project that is expected to be at a loss, while anticipating that such phase would reveal new information and opportunities which could improve the potentials of next phase of investment. Such information could lead to a decision by Koshima whether to go further with the project or completely abandon it. b. Caroline International plc has an option to construct, over the next year, on land it owns, a multi-storey office building with ground floor retail units.
The construction cost is likely to be ? 21 million, but given the current low demand for office space in that particular area of the city, such a building is only worth approximately ? 20 million today. Current estimates are that, if demand increases, the value could be as much as ? 25 million one year from today. However, if demand decreases, the value could fall to ? 16 million in a year’s time. Finance for the development is available at the risk-free rate of 10%, and Caroline can lend as well as borrow at this rate.
A business competitor has now offered the company ? 1. 5 million for the right to construct the building. Give a reasoned explanation as to whether Caroline should accept the offer. (20 marks) Caroline International may not accept the offer by a business competitor because such offer limits the options available to Caroline. The offer of competitor for the right to construct the building is smaller compared to what Caroline could earn if it lends the money for construction cost.
By not accepting the offer of the competitor, Caroline will enjoy the option to expand in the future. By holding on to the land it owns, it preserves the flexibility of the “project”, whether to construct immediately, or wait a little longer in anticipation of better future for the building complex project. A flexible project, according to Brealey and Myers, “one that doesn’t commit management to a fixed operating strategy, is more valuable than an inflexible one” (2007, p. 637).
They further added that “when a project is flexible or generates new opportunities for the firm, it is said to contain real options” (2007, p. 637). With the retail complex project, it is therefore better if Caroline will hold on to its options, rather than accept the offer of the competitor. References Brealey, R. , Myers, S. and Marcus, A (2007). Fundamentals of corporate finance. New York: McGraw-Hill Brealey, R. , and Myers, S. (1981) Principles of corporate finance. Tokyo: McGraw-Hill
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