It makes common stock issues prohibitively expensive”. A) You are contemplating a $100 million stock issue. On past evidence, you anticipate that announcement of this issue will drive down stock price by 3% and that the market value of your firm will fall by 30% of the amount to be raised. On the other hand, additional equity funds are necessary to fund an investment project that you believe has a positive NP of $40 million. Should you proceed with the issue? B) Is the fall in market value on announcement of a stock issue an issue cost in the same sense as an underwriter’s spread?
Respond to the quote that begins this question. Use your answer to (a) as a numerical example to explain your response to (b). Solution Other things equal, the announcement of a new stock issue to fund an investment project with an NP of $40 million should increase equity value by $40 million (less issue costs). But, based on past evidence, management expects equity value to fall by $30 million. There may be several reasons for the discrepancy: (I) Investors may have already discounted the proposed investment. (However, this alone would not explain a fall in equity value. (ii) Investors may not be aware of the project at all, but they may believe instead that cash is required because of, say, low levels of operating cash flow. Iii) Investors may believe that the firm’s decision to issue equity rather than debt signals management’s belief that the stock is overvalued. Fifth stock is indeed overvalued, the stock issue merely brings forward a stock price decline that will occur eventually anyway. Therefore, the fall in value is not an issue cost in the same sense as the underwriter’s spread.
If the stock is not overvalued, management needs to consider whether it could release some information to convince investors that its stock is correctly valued, or whether it could finance the project by an issue of debt. Exercise 2 – Chapter 18 Compute the present value of interest tax shields generated by these three debt issues. Consider corporate taxes only. The marginal tax rate is Etc = . 35. C) A $1 ,OHO, one year loan at 8%. D) A five-year loan Of $1 ,OHO at Assume no principal is repaid until maturity. E) A $1 ,OHO perpetuity at 7%.
Solution a. B. C. IV(tax shield) -? – $350 Exercise 3 – Chapter 18 Ronald Missals has analyzed the stock price impact of exchange offers of debt for equity or vice versa. In an exchange offer, the firm offers to trade freshly issued securities for seasoned securities in the hands of investors. Thus, a firm that wanted to move to a higher debt ratio could offer to trade new debt for outstanding shares. A firm that wanted to move to a more conservative capital structure could offer to trade new shares for outstanding debt securities.
Missals found that debt for equity exchanges Were good news (stock price increased on announcement) and equity for debt exchanges were bad news. F) Are these results consistent with the trade-off theory of capital structure? G) Are the results consistent with the evidence that investors regard announcements of (I) stock issues as bad news, (ii) stock purchases as good news, and (iii) debt issues as no news, or at most trifling disappointments? H) How could Mainsail’s results be explained? Solution a.
Missals’ results are consistent with the view that debt is always preferable because of its tax advantage, but are not consistent with the ‘tradeoff theory, which holds that management strikes a balance between the tax advantage of debt and the costs of possible financial distress. In the tradeoff theory, exchange offers would be undertaken to move the firm’s debt level toward the optimum. That ought to be good news, if anything, regardless of whether leverage is increased or decreased. . The results are consistent with the evidence regarding the announcement effects on security issues and repurchases. . One explanation is that the exchange offers signal managements assessment of the firm’s prospects. Management would only be willing to take on more debt if they were quite confident about future cash flow, for example, and would want to decrease debt if they were concerned about the firm’s ability to meet debt payments in the future. Exercise 4 – Chapter 18 The Salad Oil Storage (SO) Company has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is tot on the ropes yet.
Explain: a) Why SO stockholders could lose by investing in a positive-NP project financed by an equity issue. B) Why SO stockholders could gain by investing in a negative-NP project financed by cash. C) Why SO stockholders could gain from paying out a large cash dividend. A. SO stockholders could lose if they invest in the positive NP project and then SO becomes bankrupt. Under these conditions, the benefits of the project accrue to the bondholders. B. If the new project is sufficiently risky, then, even though it has a negative NP, it might increase stockholder wealth by more than the money invested.
This is a result of the fact that, for a very risky investment, undertaken by a firm with a significant risk of default, stockholders benefit if a more favorable outcome is actually realized, while the cost of unfavorable outcomes is borne by bondholders. C. Again, think of the extreme case: Suppose SO pays out all of its assets as one lump-sum dividend. Stockholders get all of the assets, and the bondholders are left with nothing. Exercise 5 – Chapter 19 Calculate the weighted average cost of capital (WAC) for Federated Junkyards of America, using the following information: I) Debt: $75,000,000 kook value outstanding.
The debt is trading at 90% of book value. The yield to maturity is 9%. J) Equity: 2,500,000 shares selling at $42 per share. Assume the expected rate of return on Federates stock is 18%. K) Taxes: Federates marginal tax rate is Etc = . 35. Market values of debt and equity are D . 9*75 – – $67. 5 million and 2. 5 -$105 million. D/V= . 39. Or 13. 25%. The key assumptions: stable capital Structure (D/ V constant); Federated will pay taxes at 35% marginal rate in all relevant future years; use WAC as discount rate for projects with same risk as average of firm’s assets. Exercise 6 – Chapter 19
The WAC_C formula seems to imply that debt is “cheaper” than equity – that is, that a firm with more debt could use a lower discount rate. Does this make sense? Explain briefly. Debt is tax deductible – Initially it is good to use some debt in the capital structure. But there is a point where the advantages of using debt are counterbalanced by their disadvantages, especially when there is a case of a high debt ratio. Exercise 7 – Chapter 19 The Bunsen Chemical Company is currently at its target debt ratio of 40%. It is contemplating a $1 million expansion of its existing business.
This expansion s expected to produce a cash inflow of $1 30,000 a year in perpetuity. The company is uncertain whether to undertake this expansion and how to finance it. The two options are a $1 million issue of common stock or a $1 million issue of AD-year debt. The flotation costs of a stock issue would be around 5% of the amount raised, and the flotation costs of a debt issue would be around lo 96. Bunge’s financial manager, Miss Poly Ethylene, estimates that the required on the company’s equity is 14%, but she argues that flotation costs increase the cost of new equity’ to 19%.