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
wondered
whether he should sell the share or hold it until it reached a better price.
Having had very
little 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.

Year

TABLE 1
Pharmacopia Company
Key Financial Data for Prior 10-year Period
(in $ millions, except EPS, DPS)
Sales
Net Income
EPS

DPS

2005
3,400

170

1.70

0.68

3,800

190

1.90

0.76

4,500

225

2.25

0.90

4,700

235

2.35

0.94

5,200

260

2.60

1.04

5,400

270

2.70

1.08

5,800

290

2.90

1.16

5,600

280

2.80

1.12

5,300

265

2.65

1.06

5,500

275

2.75

1.10

2006

2007
2008
2009
2010
2011

2012
2013
2014

TABLE 2
Systematic Risk, Industry Growth, Interest Rates
Beta
30-year Treasury Bond Yield
Expected Market Risk Premium
Industry Average Growth Rate

0.8
5%
10%
9%

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)
(a) 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 Finance
Structure
Bonds: (8% coupon, $100 par, 16 year maturity)
38
Preference Shares: (50,000 shares, $5 par, $0.15 dividend)
15
Ordinary Equity
47
100
What will be the weighted average cost of capital for a project if the amount of
capital required is:
a.
b.

$ 500,000 (15 marks)

$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.

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