Mock Class Test Flashcards
(5 cards)
a) What is the role of the board of directors in corporate governance?
b) How does a board become captured by a CEO?
c) How can proxy contests be used to overcome a captured board?
Your colleague asks you about proposed financial synergies in a merger the company is considering. The combination of the two companies will reduce overall firm volatility (i.e. cash flows and stock returns will be more stable for the combined firm than for either firm alone). How will this affect firm value? Why?
Outline of Answer:
Firm value will increase.
Decrease in firm volatility can lead to an increase in debt capacity. This can lead to larger tax shields for the firm.
(a) First, we will calculate the annual depreciation of the new fixed asset. It will be:
Annual depreciation = $2,820,000/3
Annual depreciation = $ 940,000
(b)
Reminder:
Free cash flow in each year = EBIT *(1- tax) + Depreciation – Capital Expenditure – Increases in net working capital
The Year 0 cash flow includes the capital expenditure as well as the initial investment in NWC because there are no sales or EBIT or depreciation in year 0, so:
Year 0 cash flow = −$2,820,000 − 340,000
Year 0 cash flow = –$3,160,000
(c) We find the operating cash flow (OCF) for the project:
OCF = EBIT (1-t) + Depreciation
= (Sales – Costs – Depreciation) (1 – t) + Depreciation
= (2,120,000 – 815,000 – 940,000)*(1 – 0.3) + 940,000
OCF = $1,195,500
(d) We assume that the initial investment in net working capital is recouped / retrieved at the end of the project horizon, i.e., in Year 3.
Year 3 investments = - 340,000 = -340,000 (cash inflow from net working capital)
Year 3 free cash flow = OCF – Investments
= $1,195,500 + $340,000
Year 3 free cash flow = $1,535,500
(e) Now, we calculate the terminal value.
Year 4 free cash flow = 1,535,500 * (1 + 0%) = 1,535,500
Year 3 terminal value = 1,535,500 / 0.12 = 12,795,833
(f) Now we can find the project NPV.
NPV = −$3,160,000 + $1,195,500/1.12 + ($1,195,500/1.12^2) + ($1,535,500 / 1.12^3) + ($12,795,833 / 1.12^3)
NPV = $8,891,211
