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27/08/2022
FNCE 370v9: Assignment 5
Note on Decimal Places
When working through numerical problems, use as many decimal places as shown on your financial calculator. Do not round your calculated answers until you have reached the final answer. When you reach your final answer, round as follows, unless the question specifies otherwise.
· Percentages: round to two decimal places
· Dollars: round to two decimal places
· Others: round to four decimal places
Questions
1. Discuss the three plausible reasons why stock prices tend to decline following the announcement of a new equity issue, but tend to rise following a debt announcement. (3 marks)
2. What are the advantages and disadvantages of “going public” (i.e., selling shares to the general public)? (6 marks)
3. WUV Ltd. wants to raise $3.29 million via a rights offering. The company currently has 420,000 shares of common stock outstanding that sell for $30 per share. Its underwriter has set a subscription price of $25 per share and will charge WUV a 6% spread. If you currently own 6,000 shares of stock in the company and decide not to participate in the rights offering, how much money can you get by selling your rights? (6 marks)
4. a. Using the M&M Proposition II without taxes and security market line, we can
derive the relationship among equity beta, asset beta, and capital structure. Write out this formula. (1 mark)
b. Using this formula, explain the meanings of business risk and financial risk. (3 marks)
c. Explain, in words, the relationship among business risk, financial risk, and the cost of equity. (3 marks)
5. Explain the static theory of capital structure using the graph below. Describe the meaning of each term (RU, RE, WACC*, RDx(1-Tc), and D*/E*) on the graph below. (7 marks)
6. DEF Company is comparing three different capital structures. Plan I would result in 800 shares of stock and $9,000 in debt. Plan II would result in 700 shares of stock and $13,500 in debt. Plan III is an all-equity plan and would result in 1,000 shares of stock. The firm’s EBIT will be $8,000 per year until infinity. The interest rate on the debt is 10%. (12 marks total)
a. Ignoring taxes, compute the EPS for each of the three plans. Which of the three plans has the highest EPS? Which has the lowest? (4 marks)
b. Compute the break-even EBIT that will cause the EPS on Plan I to be equal to the all-equity EPS. (2 marks)
c. Compute the break-even EBIT that will cause the EPS on Plan II to be equal to the all-equity EPS. (2 marks)
d. Compare your results from parts (b) and (c) above. Is one higher than the other? Why? (1 mark)
e. Ignoring taxes, what is the break-even EBIT that will cause the EPS on Plan I to be equal to the EPS on Plan II? What conclusions do you reach when you compare the outcomes of parts (b), (c), and (e) above? (3 marks)
7. Q Corporation and R Inc. are two companies with very similar characteristics. The only difference between the two companies is that Q Corp. is an unlevered firm, and R Inc. is a levered firm with debt of $5 million and cost of debt of 10%. Both companies have earnings before interest and taxes (EBIT) of $2 million and a marginal corporate tax rate of 40%. Q Corp. has a cost of capital of 15%. (20 marks total)
a. What is Q’s firm value? (2 marks)
b. What is R’s firm value? (2 marks)
c. What is R’s equity value? (1 mark)
d. What is Q’s cost of equity capital? (1 mark)
e. What is R’s cost of equity capital? (2 marks)
f. What is Q’s WACC? (1 mark)
g. What is R’s WACC? (3 marks)
h. Compare the WACC of the two companies. What do you conclude? (1 mark)
i. What principle have you proven in this case? (1 mark)
j. Both companies are now evaluating a project that requires an initial investment of $1.15 million and that will yield cash inflows of $500,000 per year for the next three years. Assume that this project has the same risk level as the individual firm’s assets. Should Q invest in this project? Should R invest in this project? (5 marks)
k. Based on your results for part (j), discuss the effects of leverage and its tax shields effects on the future value of the two firms. (1 mark)
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