FNCE 370v8: Assignment 5

Assignment 5 is worth 5% of your final mark. Complete and submit Assignment 5 after you complete Lesson 15.

There are 12 questions in this assignment. The break-down of marks for each question is presented in the table below. Please show all your work as this will help the marker give you part marks as well as serve as a good study aid as you prepare for the Final Examination.

Question

Marks Available

Reference

1

5

Lesson 13

2

5

Lesson 13

3

10

Lesson 13

4

10

Lesson 13

5

10

Lesson 14

6

5

Lesson 14

7

10

Lesson 14

8

15

Lesson 14

9

5

Lesson 15

10

5

Lesson 15

11

10

Lesson 15

12

10

Lesson 15

Total

100

1. Describe the role that the “winner’s curse” may play in the underpricing of IPOs.

(5 marks)

2. (5 marks)

a. Does a rights offer cause a share price decrease? Why or why not?

b. How are existing shareholders affected by a rights offer? Illustrate your answer with an example.

3. TUV Guy Inc. is proposing a rights offering. There are currently 240,000 shares outstanding at $80 each. There will be 60,000 new shares offered at $60 each.

(10 marks)

What is the new market value of the company?

How many rights are associated with one of the new shares?

What is the value of a right?

What is the ex-rights price per share?

Why might a company have a rights offering rather than a general cash offer?

4. WXYZ Co. has concluded that additional equity financing will be needed to expand operations, and that the needed funds will be best obtained through a rights offering. It has correctly determined that as a result of the rights offering, the share price will fall from $50 to $45 ($50 is the rights-on price; $45 is the ex-rights price). The company is seeking $12.5 million in additional funds with a per share subscription price of $25.

How many shares are there currently, before the offering? (Assume that the increment to the market value of the equity equals the gross proceeds from the offering.)

(10 marks)

5. (10 marks)

a. In five sentences or less, briefly explain the M&M Proposition I with taxes. Ensure that you include the appropriate formula in your explanation.

b. What are the two implications of M&M Proposition I with taxes?

c. In five sentences or less, briefly explain the M&M Proposition II with taxes. Ensure that you include the appropriate formula in your explanation.

d. What are the two implications of M&M Proposition II with taxes?

6. Under what conditions of personal and corporate taxation will there be no gain from financial leverage? Explain using the formula

VL = VU + [1 – (1-TC) x (1-TS)/(1-Tb)] x D

(5 marks)

7. VWX Corporation has an EBIT of $166,666.67, a corporate tax rate of 40%, debt of $500,000, and unlevered cost of capital of 20%. The cost of debt capital is 10%.

(10 marks)

a. What is the value of VWX’s equity?

b. What is the cost of equity capital for VWX?

c. What is the WACC?

d. Compare the WACC of VWX to the WACC of an unlevered firm. What is your conclusion? What principle have you proven in this case?

8. STU’s Disco Factory Inc. is financed solely by equity and it is considering issuing debt and using the proceeds to repurchase some of the outstanding shares at the current market price of $30. There are currently 200,000 shares outstanding. EBIT is expected to remain at $1.5 million, with all earnings paid out as dividends. The firm can issue debt at a rate of 8%, and the firm’s tax rate is 40%. Three alternative amounts of debt are being considered:

Amount of debt

0

$1,000,000

$2,000,000

Required return on equity

15%

15.5%

16%

Assume that all stock repurchases will be made at $30 per share. (15 marks)

Using the M&M Proposition I with taxes, calculate the value of the firm at each debt level.

What is the optimum amount of debt?

Show that, at the optimum capital structure, the firm also minimizes the WACC.

Show that, at the optimum capital structure, the firm also maximizes the price of the outstanding shares.

9. Explain homemade leverage and why it matters. (5 marks)

10.Positive NPV projects enhance shareholder wealth. However, in some cases the payment of dividends limits the number of positive NPV projects a firm can take. Why, then, shouldn’t shareholders prefer a residual dividend policy? (5 marks)

11.You own 1,000 shares of stock in ABC Corporation. You will receive a 60 cent per share dividend in one year. In two years, ABC will pay a liquidating dividend of $30 per share. The required return on ABC stock is 15%. What is the current share price of your stock (ignoring taxes)? If you would rather have equal dividends in each of the next two years, show how you can accomplish this by creating homemade dividends.

(Hint: Dividends will be in the form of an annuity.)

Suppose you want only $200 total in dividends the first year. What will your homemade dividend be in two years? (10 marks)

12.Suppose we have two equally risky firms, Firm A and B. Firm B’s shares are currently worth $100, and they are expected to be worth $120 in one year. Personal dividend tax rate is 30%, and capital gains are exempt from taxes. (10 marks)

a. What is the after-tax return on Firm B?

b. If Firm A opts to pay a dividend of $20 per share in one year, what is the after-tax return on Firm A?

c. Given that dividends will reduce firm value proportionally, what is the share price of Firm A’s stock if it pays a dividend of $20 in one year?

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