Business Models — MCQs

Valeron Components manufactures precision parts for industrial equipment. Management is evaluating a three-year automated production project and has asked corporate finance analyst Sofia Reid to estimate its value using incremental after-tax cash flows. All project cash flows occur at year-end except for the initial equipment purchase, commitment of working capital, and use of company-owned land, which occur at time 0. The project has the same operating risk as Valeron's existing manufacturing assets, and the 10% discount rate in Exhibit 1 is an after-tax nominal rate appropriate for the project. Valeron paid for a feasibility study six months ago. The study cost cannot be recovered regardless of whether the project proceeds. The equipment will be depreciated for tax purposes on a straight-line basis to a zero book value over three years. At the end of Year 3, Valeron expects to sell the equipment for the amount shown in Exhibit 1. Capital gains on equipment disposal are taxed at the corporate tax rate. The company currently owns the required land and could sell it immediately for the stated after-tax amount if the project is rejected. No sale of the land is planned at project termination, and no terminal value for the land should be included. The project requires an immediate investment in inventory and receivables net of payables. The full net working capital commitment will be recovered at the end of Year 3. Reid is instructed to treat the operating forecasts in Exhibit 1 as incremental and to assume Valeron can use all project tax deductions when they arise. Separately, the treasurer is attempting to reduce Valeron's reliance on external financing by changing inventory and collection practices. Exhibit 2 presents current and proposed operating-cycle measures. The treasurer also proposes increasing the percentage of permanent current assets financed with short-term bank borrowing. The bank facilities are repriced every 90 days and are subject to annual renewal. Temporary seasonal current assets are already financed entirely with short-term credit, while fixed assets are financed with long-term debt and equity. Reid notes that reducing the cash conversion cycle would ordinarily release funds from operations. She also warns that financing a greater proportion of permanent current assets with short-term borrowing may reduce current borrowing costs but would increase rollover exposure if credit conditions deteriorate.

Arden Components manufactures industrial sensors and also owns a fast-growing logistics-software subsidiary. The two businesses have different customers, capital requirements, and employee compensation structures. Arden's board is reviewing several alternatives after shareholders argued that consolidated reporting obscures the performance of the software business. The finance team first estimates Arden's equity value using a guideline public-company enterprise value multiple. All debt in Exhibit 1 is interest-bearing, and all reported cash is excess cash not required in operations. The normalized EBITDA estimate excludes non-recurring restructuring charges. No other debt-like claims, non-operating assets, or minority interests require adjustment. Arden is also considering using USD 60 million of excess cash to repurchase shares at the prevailing market price. The repurchase would occur immediately, and the number of shares purchased can be determined directly from the transaction value and price per share. The cash currently earns the pre-tax return shown in Exhibit 1, and the lost interest income would reduce net income on an after-tax basis. Management expects no other immediate change in operating income, financing expense, or the repurchase price. A second proposal would distribute the software subsidiary's shares pro rata to Arden's existing shareholders in a tax-free spin-off. The transaction would create separately traded companies with independent boards, financial reporting, and management incentive plans. The spin-off would not involve a sale to a third party and would not generate cash proceeds for Arden at the distribution date. Management expects limited operating synergies between the two businesses, although each would continue to face its existing commercial and execution risks. Finally, the chief executive proposes a large special dividend financed entirely with newly issued long-term debt. Arden currently has unused borrowing capacity and no near-term covenant breach, but rating analysts have indicated that the additional debt would weaken credit metrics. The treasurer notes that higher contractual interest and principal obligations would leave less capacity to fund acquisitions or withstand an operating downturn. The chief executive nevertheless argues that any distribution to shareholders should be viewed as beneficial because it immediately returns capital. The board asks analyst Marcus Lee to distinguish transaction mechanics from value creation. Lee notes that a repurchase can increase earnings per share without necessarily increasing intrinsic value, a spin-off can improve transparency without eliminating business risk, and a debt-financed payout changes both leverage and future financing capacity.

Langford Components is a publicly traded manufacturer evaluating an automated production project. The equipment would be installed on land that the company has owned for several years. The land is currently unused, but a third party has offered to purchase it immediately for the after-tax amount shown in Exhibit 1. Langford commissioned a technical feasibility study last year and paid the consultant in full. The study has no alternative use and its cost cannot be recovered. The chief financial officer instructs the corporate development team to evaluate only incremental after-tax cash flows. Equipment and initial working capital would be paid immediately at Time 0. Annual operating cash flows occur at each year-end. The equipment would be sold at the end of Year 3, and all project working capital would be recovered at that time. The project's cash flows are nominal, and the stated project discount rate is a nominal after-tax rate. Langford also reviews its liquidity policy. Management classifies USD 7 million of current assets as a permanent operating requirement. During the seasonal production peak, an additional USD 3 million of inventory and receivables is required. At that peak, the company uses USD 8 million of short-term bank borrowing and finances all remaining assets with long-term capital. The treasurer argues that this policy reduces expected financing cost, although it increases refinancing and interest-rate exposure. For issuer-level capital allocation, Langford estimates its weighted average cost of capital from the financing data in Exhibit 2. The debt is publicly traded at par, so its market and book values are identical. The equity trades above book value. The company expects to maintain its current market-value capital structure and can use interest expense fully as a tax deduction. Separately, Langford is considering a robotics project in an emerging business line. A comparable-company analysis indicates that the project's operating beta is materially higher than the beta of Langford's existing manufacturing assets. The chief executive proposes discounting the robotics cash flows at the company-wide WACC because Langford will finance the project using the same mix of debt and equity as its existing operations. The analyst must determine whether that approach appropriately reflects project risk.

Northstar Manufacturing is considering an automated production line that would replace part of its existing manual process. A corporate finance analyst is instructed to value the project using incremental, after-tax cash flows and a discount rate reflecting the project's operating risk. All project cash flows occur at year-end except for the initial investment and working-capital commitment, which occur immediately. Northstar paid for a technical feasibility study during the previous financial year. The study has no alternative use and cannot be sold. The proposed production line must be installed on land Northstar already owns. The land is currently unused, but an unrelated developer has offered to purchase it for the after-tax amount shown in Exhibit 1. If Northstar accepts the project, it will reject that offer and use the land for the full four-year project life. The land is expected to retain the same after-tax value at the end of Year 4, but management has instructed the analyst to exclude the later land sale because Northstar intends to continue using the site for other operations. The equipment is depreciated for tax purposes on a straight-line basis over four years from its installed cost to a USD 1.0 million residual book value. Northstar expects annual revenue and cash operating costs to remain constant. There are no cannibalization effects, allocated corporate overhead is unaffected, and no additional capital expenditures are expected. Initial net working capital will be fully recovered at the end of Year 4. The equipment will be sold at the end of the project, and tax is payable on any sale price exceeding its tax book value. Northstar finances its existing operations using a debt-to-equity ratio of 0.25. Management, however, has established the higher target debt-to-equity ratio in Exhibit 2 for projects in the automated production segment. The analyst identifies a publicly traded pure-play comparable with no debt and operating risk similar to the proposed line. Northstar can borrow for the project at the stated pre-tax rate. The company has sufficient taxable income to use all depreciation and interest tax deductions as they arise. Management requires the analyst to use the target capital structure, the comparable-company beta, and the capital asset pricing model when estimating the project discount rate.

A project has beta 1.20, a 3.0% risk-free rate, 5.0% equity risk premium, and 2.0% country risk premium. If project exposure to country risk is 0.75, its cost of equity is closest to:

An analyst purchases a non-controlling common equity interest in a corporation. The ownership feature the analyst most likely receives is:

An analyst reviews a limited partnership in which passive investors contribute capital and a general partner controls operations. Which conclusion is most likely correct?

A company has net income of USD 36 million, capital spending of USD 50 million, and a target debt weight of 40%. Under a residual dividend policy, the calculated payout ratio is closest to: