Zebo Zhang
Professor Khan
BUS 538
3, August, 2017
A Midterm Quiz-(Part A)
Question 1: Project finance is a popular vehicle used to build large infrastructure project. Describe
project finance. what are some of its salient characteristics? offer reasons for its use in building large
projects. Discuss the benefits of project finance?
Project finance is the financing of long-term infrastructure, industrial projects and public services based
upon a non-recourse or limited recourse financial structure, in which project debt and equity used to finance
the project are paid back from the cash flow generated by the project. Project financing is a loan structure
that relies primarily on the project’s cash flow for repayment, with the project’s assets, rights and interests
held as secondary security or collateral. Project finance is especially attractive to the private sector because
companies can fund major projects off balance sheet.
The salient characteristics of project financing are:
1) Financing of long term infrastructure and/or industrial projects using debt and equity.
2) Debt is typically repaid using cash flows generated from the operations of the project
3) Limited recourse to project sponsors
4) Debt is typically secured by project’s assets, including revenue producing contracts.
First priority on project cash flows is given to the lender
Consent of the lender is required to disburse any surplus cash flows to project sponsors
Higher risk projects may require the surety/ guarantees of the project sponsors
There some reasons for its use in building large projects from owners’ and lenders’ Perspective:
Owners’ Perspective
Achievement of Economics of scale
Risk minimization
Preservation of borrowing capacity and credit
rating
Release of free cash flow
Reduce Legal or Regulatory costs
Country specific accounting and/or tax
benefits
Lenders’ Perspective
Competitive pressures: other banks are doing
the business
Seeking higher returns
Easier to assess risks in project finance
situation
There are some benefits of project finance:
1) Eliminate or reduce the lender’s recourse to the sponsors.
2) Permit an off-balance sheet treatment of the debt financing
3) Maximize the leverage of a project
4) Avoid ant restrictions or covenants binding the sponsors under their respective financial obligations
5) Avoid any negative impact of a project on the credit standing of the sponsors
6) Obtain better financial conditions when the credit risk of the project is better than the credit standing of
the sponsors.
7) Allow the lenders to appraise the project on a segregated and stand-alone basis
8) Obtain a better tax treatment for the benefit of the project, the sponsors or both.
Question 4: Discuss stock repurchase? Give reasons why a firm will repurchase their own stock. How is
this accomplished? Give a numerical example.
Stock repurchase may be viewed as an alternative to paying dividends in that it is another method of
returning cash to investors. A stock repurchase occurs when a company asks stockholders to tender their
shares for repurchase by the company that issued them. Essentially, it can happen in three ways – a) either
the company purchases its own shares in open market, b) issue a tender offer and lastly, c) negotiate a
private buyback.
There are several reasons why a firm(s) will repurchase their own stock:
1) Attempt to boost earnings per share (EPS): One of the common reasons why companies go for share
buyback is to boost earnings per share (EPS), because share buyback reduces outstanding shares in the
market.
For a numerical example, Company X announces a share buyback program to repurchase, let’s say,
10% of the outstanding shares at current market price. The company had $1 million in earnings spread
out over 1 million shares, or 1 million shares, equating to EPS of $1. EPS = Total Earnings/Total
number of shares.
Let’s say with a PE of 30, the shares traded at $30. Market price = P/E * EPS.
Now, all else being equal, if 100,000 shares are repurchased (10%), the new EPS would be Total
Earnings/Number of shares, which in this case would become 1,000,000/900,000= $1.11. Now, at a PE
of 30, the shares would trade up by (1.11 * 30) = $33.30
2) Reward shareholders: Another common reason for companies to go for a stock repurchase is to
distribute excess cash to shareholders because the tender offer is usually more than the current price.
This is common practice when the market price keeps falling and there is nervousness among the
shareholders either about the sector or the business itself.
3) Lack of growth opportunities: This is a controversial point, but quite relevant, especially in the case
of IT industry, which has quite a lot of cash on the books but has fewer growth opportunities.
4) Tax advantage: because of tax arbitrage opportunities, where the programme delivers a higher value to
shareholders compared to a dividend distribution.
5) Undervalued shares: Stock can be undervalued for a number of reasons, often due to investors’
inability to see past a business’ short-term performance or sensationalist news items. If a stock is
dramatically undervalued, the issuing company can repurchase some of its shares at this reduced price
and then reissue them once the market has corrected, thereby increasing its equity capital without
issuing any additional shares.
For example, assume a company issues 100,000 shares at $25 per share, raising $2.5 million in
equity. A bad news causes panicked shareholders begin to sell, driving the price down to $15 per share.
The company decides to repurchase 50,000 shares at $15 per share for a total outlay of $750,000 and
wait out the frenzy. The business remains profitable and launches a new and exciting product line the
following quarter, driving the price up past the issuing price to $35 per share. After regaining its
popularity, the company reissues the 50,000 shares at the new market price for a total capital influx of
$1.75 million. Because of the brief undervaluation of its stock, the company was able to turn $2.5
million in equity into $3.5 million without further diluting ownership by issuing additional shares.
Question 5: Define the concept of leverage? The presenters offered you a way of assessing risk of a
capital structure by using degrees of leverage. Define DOL, DFL, and DTL and discuss how it indicates
risk.
Leverage is the investment strategy of using borrowed money: specifically, the use of various financial
instruments or borrowed capital to increase the potential return of an investment. Leverage can also refer to
the amount of debt used to finance assets. When one refers to something (a company, a property or an
investment) as “highly leveraged,” it means that item has more debt than equity.
1) The degree of operating leverage (DOL) assists a company in quantifying its operational risk i.e. the
risk arising from its mix of fixed and variable costs. DOL measures how sensitive a company’s
operating income is to changes in product demand, as measured by unit sales. It is the ratio of the
percentage change in operating income to the percentage change in units sold.
The relationship can be expressed by the following equation:
The percentage change in a firm’s operating profit(EBIT) resulting from a 1 percent change in output.
DOL at Q units of output =
percentage c h ange ∈operating profit (EBIT )
percentage c h ange ∈thenumber of units sold
This simplifies the equation to: DOL =
sales−varibale costs
EBIT =Q(P−V)
Q
(
P−V
)
−F
The plan with higher DOL is the plan that will be most “sensitive” to a change in sales. DOL magnifies
the variability of operating profits, so it also magnifies the business risk.
Example: If DOL for a company is 1.6, and unit sales increase by 3%, what is the percentage change in
operating income that would be expected?
Solution: The percentage change in operating income = 1.6 * 3% = 4.8%.
2) The degree of financial leverage (DFL) assists a company in quantifying its financial risk i.e. the risk
relating to how the company finances its operations. DFL refers to the sensitivity of the cash flows
available to the owners of a company when operating income changes.
The relationship can be expressed by the following equation:
DFL =
percentage c h ange ∈net income
percentage c h ange ∈operating profit (EBIT )
This simplifies the equation to: DFL =
EBIT
EBIT −Interest =Q
(
P−V
)
−F
Q
(
P−V
)
– F−C
DFL helps us to understand how changes in a company’s operating income translate into changes in net
income after interest and tax expenses have been factored in.
For example, if a company’s DFL is 2.0, then a 5% increase in operating income is expected to give rise
to a 10% increase in net income.
3) The degree of total leverage (DTL) is the numerical measure of the firm’s total leverage, which
combine a company’s degree of operating leverage with its degree of financial leverage (DTL = DOL *
DFL). It is a measure of the sensitivity of the company’s net income to changes in the number of units
produced and sold.
The relationship can be expressed by the following equation:
DTL =
percentage c h ange ∈net income
percentage c h ange ∈the number of units sold
This simplifies the equation to: DFL =
sales−varibale costs
EBIT−Interest =Q
(
P−V
)
Q
(
P−V
)
– F−C
For example: If a company’s degree of operating leverage is 2.1, and its degree of financial leverage is
106) $
mil
107) ra
flows
604)
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2
5
6
6
.
9
9
4
.
8
4
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3
2
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