1. During recent years your company has made considerable use of debt financing, to the extent that it is generally agreed that the percent debt in the firm’s capital structure is too high. Further use of debt will likely lead to a drop in the firm’s bond rating. You would like to recommend that the next major investment be financed with a new equity issue. Unfortunately, the firm has not been doing very well recently (nor has the market). In fact, the rate of return on investment has just been equal to the cost of capital. As shown below, the market value of equity is less than book value.
Total market value of equity
Number of shares outstanding 1,000
Price per share $ 2.00
Book value per share $ 4.00
Total earnings for the year $ 600
Earnings per share $ .60
This means that even a profitable project will decrease earnings per share if it is financed with new equity. For example, the firm is considering a project which costs $400 but has a value of $500 (i.e. an NPV of 100), and which will increase total earnings by $60 per year. If it is financed with equity, the $400 will require approximately 200 shares, thus bringing the total shares outstanding to 1200. The new earnings will be $660, and earnings per share will fall to $.55. The president of the firm argues that the project should be delayed for three reasons.
a) It is too expensive for the firm to issue new debt.
b) Financing the project with new equity will reduce earnings per share because the market value of equity is less than book value.
c) Equity markets are currently depressed. If the firm waits until the market index improves, the market value of equity will exceed the book value and equity financing will no longer reduce earnings per share.
Critique the president’s logic.
2. Comment on the following quote from the L.A Times:
The unusual $200-per-share offer that Teledyne inc. made … for at least 25% of its common stock has astounded even veteran financial analysts, who predict that the vast majority of big institutions that own the shares will jump at the lucrative offer. Although Teledyne has made seven previous offers to repurchase its shares since the early 1970s, never before has the conglomerate offered such a substantial premium over its existing trading price or sought such a large repurchase…. The motivation behind the unprecedented offer is a belief by Teledyne Chairman Henry Singleton and the Teledyne board that the firm’s stock is undervalued, according to Fayez Sarofim, one of Teledyne’s largest shareholders….. “ In a slow-growth environment, it is a viable strategy, “ he said in a telephone interview. “when your shares are undervalued you are going to increase your earnings per share for the remaining shares. How can you argue with success? A lot of companies follow the tender route to best serve their stockholders.” Sarofim said.
3. State what grade you actually deserve for your performance in this class. Show evidence supporting why you deserve this grade. Present your case!
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