Exam 2-03085-Answer

Exam 2-03085-Answer - Exam#II Finance 357 Business...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Exam #II Finance 357: Business Finance (03085) Last Name First Name UTEID After graduating from the McCombs School of Business, you are hired by Silver Sachs as its investment banker. You are given with the following tasks: 1. (True or False) The CEO of your client firm, Outel Inc., is confused with many of the financial concepts, and sometimes makes false statements. For each of the following statements, evaluate whether it is true or false. If false, explain why. a) (1 point) According to the Modigliani-Miller model with corporate income tax, weighted-average cost of capital (WACC) falls with leverage. True. Tax shield benefit increases with leverage and thus drop the cost of debt, which in turn drops the weighted-average cost of capital (WACC). Otherwise, it is being inconsistent with Proposition I (firm value increases with leverage). b) (1 point) Direct costs of financial distress are typically greater than the indirect costs. False. Empirical evidence shows that the direct cost is 1~2% of firm value, while the indirect cost is 10-20% of firm value. c) (1 point) Under financial distress, equity holders have an incentive to increase dividends. True. Paying high dividend is one way to withdraw equity capital from the firm. d) (1 point) Leveraged buyout (LBO) typically increases the agency costs. False. LBO typically decreases the agency problem because the firm will be typically 100% owned by a single investor and will have a lot of debt. e) (1 point) According to the trade-off model, profitable firms are less likely to use debt. False. Profitable firms are more like to use debt for a number of reasons. They enjoy more tax savings, less likelihood to undergo financial distress, and less agency problem. Under information asymmetry, debt issuance can also convey information about high profitability. f) (1 point) According to the pecking-order theory, internal financing is the most preferred way to finance a project. True. This is because internal financing is not subject to any information asymmetry problem. g) (1 point) On the first day of trading, IPO stocks typical show a negative return. False. Typically, IPO stocks show a positive return on the first day of trading. h) (1 point) Firms raise capital from the “secondary” offerings and let existing shareholders harvest their investments from the “primary” offerings. False. Firms raise capital from the “primary” offerings and let existing shareholders harvest their investments from the “secondary” offerings. i) (1 point) A higher dividend payout ratio will increase share price if the firm’s ROE is greater than its cost of equity. False. A higher dividend payout ratio will lead the firm to forego a valueincreasing project (ROE > cost of equity). j) (1 point) Individuals in peak earnings years prefer to hold stocks with a low dividend payout ratio. True. Individuals in peak earning years are sensitive to tax and are no in need of cash, which lead them to prefer stocks with a low dividend payout ratio. 2. (Capital Structure) In the process of evaluating your client’s new business project, you noticed that the cost of debt is much lower than the cost of equity. So, you decided to persuade the CEO of Outel Inc. to increase leverage throughout the company. As a way of convincing her, you decided to compute gains from leverage if Outel’s leverage increases from 0 to $100 million. Following information was collected. Assume that leverage does not affect the firm’s earnings. Each year’s EBIT = $20 million Cost of equity under no leverage = 10% 30-year corporate bond yield = 7% a) (2 points) What is the value of Outel if its leverage is 0%? Assume that the corporate income tax rate is 40% and that no personal income tax exists. VU = EBIT(1-TC)/r0 = 20(1-0.4)/0.1 = $120 million b) (2 points) What is the value of Outel if it takes $100 million of debt? Assume that the corporate income tax rate is 40% and that no personal income tax exists. What is the gain from this leverage? VL = VU + BTC = 120 + 100(0.4) = 120 + 40 = $160 million Gains from leverage = $40 million c) (3 points) Compute the gain from leverage if the personal income tax rate on equity is 20% and the rate on debt is 25% (Also, assume a leverage of $100 million and a 40% corporate income tax rate). VU = EBIT(1-TC)(1-TB)/r0 = 20(1-0.4)(1-0.2)/0.1 = $96 million VL = VU + B(1-TB)[1-(1-TC)(1-TS)/(1-TB)] = 96 + 100(1-0.25)[1-(1-0.4)(1-0.2)/(1-0.25)] = 96 + 27 = $123 million Gains from leverage = $27 million This can be also obtained by computing the second part of the VL equation. 3. (Rights Offering) Debt financing was not enough to finance Outel’s new business project. So, you advised the CEO of Outel Inc. to issue new shares via rights offering. It was decided to raise $10 million and the subscription price was set to be $100 per share. Presently, the market price is $125 and there are 1 million shares outstanding. a) (1 point) How many new shares should Outel issue? Capital raised / subscription price = 10,000,000/100 = 100,000 shares b) (2 points) How many rights should one receive to purchase one share? No. of rights / No. of new shares = 1,000,000/100,000 = 10 rights c) (2 points) What is the per share value after the rights offering? Ex post total market cap / Ex post no. of shares = 135,000,000/1,100,000 = $122.72 d) (3 points) What is the value of each right? Value of 10 rights = 122.72 – 100 = $22.72 Value of each right = 22.72/10 = $2.272 One can also obtain this by (initial market price – ex post share value) = $125 – $122.72 = $2.272 e) (4 points) Shareholder A and B both held 100 shares before the rights offering. Shareholder A exercised all the stock purchase rights she received. But, shareholder B exercised only half of the stock purchase rights (and did not sell the remaining rights). Compute the overall loss shareholder B experienced compared to shareholder A. Shareholder A: Loss from dilution: 100 shares × $2.272 = $227.2 Gain from purchasing 10 shares: 10 × $22.72 = $227.2 Net loss: 0 Shareholder B: Loss from dilution: 100 shares × $2.272 = $227.2 Gain from purchasing 5 shares: 5 × $22.72 =$113.6 Net loss: $227.2 - $113.6 = $113.6 f) (3 points) How would the answer to sub-question (e) change if shareholder B was able to sell half of the stock purchase rights at the price equal to the value computed in sub-question (d)? No loss for shareholder B Sell 50 stock purchase rights: 50 × $2.272 = $113.6 4. (Dividend) Based on your recommendation, the board of directors of Outel Inc. decided to enter the new business. This, however, meant a lower dividend. To convince the shareholders that they are not necessarily worse off, you decided to compute the per share value after plowing back more earnings. You collected the following information: Net income per share at year end = $12 30-year government bond is currently being traded at 4.5% Historically, market risk premium has been 7% Equity beta of Samson Electronics is 1.5 ROE of all future investments = 24% a) (3 points) What is the per share value of Outel with a plowback ratio of 1/3? rS = rF +β[E(rM) – rF] = 4.5 + 1.5(7) = 15% (0.15) g = ROE x b = 0.24 x (1/3) = 0.08 P0 = D1/(rS – g) = (2/3)12 / (0.15 – 0.08) = 8/0.07 = $114.3 b) (3 points) What is the per share value of Outel with a plowback ratio of 1/2? What is the gain (in terms of share price) from a lower dividend? g = ROE x b = 0.24x (1/2) = 012 P0 = D1/(rS – g) = (1/2)12 / (0.15 – 0.12) = 6/0.03 = $200 Gains from lower dividend = $85.7 per share 5. (Stock Repurchase) The new business turned out to be a big success and this year Outel Inc. generated more income than needed for new investments. You now need to advise the CEO of Outel Inc. on distributing out such income to the shareholders. Outel Inc. can take two measures: cash dividend or stock repurchase. There are one million shares outstanding and Outel Inc. wants to distribute out $20 million. Per share price of Outel Inc. is currently $100. a) (2 points) If cash dividend is paid out, what is the per share dividend? Total dividend = $20 million Per share dividend or dividend per share (DPS) = $20 million /$1 million = $20 b) (2 points) What will be the ex-dividend market capitalization of the firm? What will be the share price? (Assumption: shareholders are equally well off before and after the dividend pay out) Ex-dividend market cap / no. of shares = $80 million / $1 million = $80 c) (2 points) If you repurchase shares, how many shares do you have to purchase? Total distribution / market price = $20 million / $100 = 200,000 shares d) (2 points) What is the ex-repurchase market capitalization of the firm? What will be the share price? (Assumption: shareholders are equally well off before and after the repurchase) Ex-repurchase market cap / no. of shares = $80 million / 800,000 = $100 ...
View Full Document

{[ snackBarMessage ]}

Ask a homework question - tutors are online