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Unformatted text preview: uture value of the individual investment in preferred stock will be: FV of investment in preferred stock = $2,550,000(1 + .0483)3 FV of investment in preferred stock = $2,937,628.94 The aftertax cash flow for the shareholders is maximized when the firm invests the cash in the preferred stocks and pays a special dividend later. 20. a. Let x be the ordinary income tax rate. The individual receives an after-tax dividend of: Aftertax dividend = $1,000(1 – x) which she invests in Treasury bonds. The Treasury bond will generate aftertax cash flows to the investor of: Aftertax cash flow from Treasury bonds = $1,000(1 – x)[1 + .08(1 – x)] If the firm invests the money, its proceeds are: Firm proceeds = $1,000[1 + .08(1 – .35)] And the proceeds to the investor when the firm pays a dividend will be: Proceeds if firm invests first = (1 – x){$1,000[1 + .08(1 – .35)]} 408 To be indifferent, the investor’s proceeds must be the same whether she invests the after-tax dividend or receives the proceeds from the firm’s investment and pays taxes on that amount. To find the rate at which the investor would be indifferent, we can set the two equations equal, and solve for x. Doing so, we find: $1,000(1 – x)[1 + .08(1 – x)] = (1 – x){$1,000[1 + .08(1 – .35)]} 1 + .08(1 – x) = 1 + .08(1 – .35) x = .35 or 35% Note that this argument does not depend upon the length of time the investment is held. b. Yes, this is a reasonable answer. She is only indifferent if the after-tax proceeds from the $1,000 investment in identical securities are identical. That occurs only when the tax rates are identical. Since both investors will receive the same pre-tax return, you would expect the same answer as in part a. Yet, because the company enjoys a tax benefit from investing in stock (70 percent of income from stock is exempt from corporate taxes), the tax rate on ordinary income which induces indifference, is much lower. Again, set the two equations equal and solve for x: $1,000(1 – x)[1 + .12(1 – x)] = (1 – x)($1,000{1 + .12[.70 + (1 – .70)(1 – .35)]}) 1 + .12(1 – x) = 1 + .12[.70 + (1 – .70)(1 – .35)] x = .1050 or 10.50% d. It is a compelling argument, but there are legal constraints, which deter firms from investing large sums in stock of other companies. c. 409 CHAPTER 20 ISSUING SECURITIES TO THE PUBLIC Answers to Concepts Review and Critical Thinking Questions 1. A company’s internally generated cash flow provides a source of equity financing. For a profitable company, outside equity may never be needed. Debt issues are larger because large companies have the greatest access to public debt markets (small companies tend to borrow more from private lenders). Equity issuers are frequently small companies going public; such issues are often quite small. Additionally, to maintain a debt-equity ratio, a company must issue new bonds when the current bonds mature. From the previous question, economies of scale are part of the answer. Beyond this, debt issues are simply easier and less risky to sell from an investment bank’s perspective. The two main reasons are that very large amounts of debt securities can be sold to a relatively small number of buyers, particularly large institutional buyers such as pension funds and insurance companies, and debt securities are much easier to price. They are riskier and harder to market from an investment bank’s perspective. Yields on comparable bonds can usually be readily observed, so pricing a bond issue accurately is much less difficult. It is clear that the stock was sold too cheaply, so Eyetech had reason to be unhappy. No, but, in fairness, pricing the stock in such a situation is extremely difficult. It’s an important factor. Only 6.5 million of the shares were underpriced. The other 32 million were, in effect, priced completely correctly. The evidence suggests that a non-underwritten rights offering might be substantially cheaper than a cash offer. However, such offerings are rare, and there may be hidden costs or other factors not yet identified or well understood by researchers. He could have done worse since his access to the oversubscribed and, presumably, underpriced issues was restricted while the bulk of his funds were allocated to stocks from the undersubscribed and, quite possibly, overpriced issues. The price will probably go up because IPOs are generally underpriced. This is especially true for smaller issues such as this one. It is probably safe to assume that they are having trouble moving the issue, and it is likely that the issue is not substantially underpriced. 2. 3. 4. 5. 6. 7. 8. 9. 10. a. b. 11. Competitive offer and negotiated offer are two methods to select investment bankers for underwriting. Under the competitive offers, the issuing firm can award its securities to the underwriter with the highest bid, which in turn implies the lowest cost. On the other hand, in negotiated deals, the underwriter gains much information about the issuing firm thro...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of Texas-Tyler.

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