THE UNIVERSITY OF HONG KONGFACULTY OF BUSINESS AND ECONOMICS FINA1003/1310A/B/C – Corporate Finance FIRST SEMESTER, 2014-2015 Tutorial 10 – Chapter 15 & 16 – Raising Capital and Capital Structure Question 1 (Rights Offerings) The Clifford Corporation has announced a right offer to raise 50 million for a new journal, the Journal of Financial Excess. The journal will review potential articles after the author pays a non-refundable reviewing fee of 5,000 per page. The stock currently sells for 50 per share, and there are 5.2 million shares outstanding. What is the maximum possible subscription price? What is the minimum? (b) If the subscription price is set at 45 per share, how many shares must be sold? How many rights will it take to buy one share? (a) What is the ex-rights price? What is the value of a right? (d) Show how a shareholder with 1,000 shares before the offering and no desire (or money) to buy additional shares is not harmed by the rights offer? (c) Question 2 (Break-Even EBIT) Malang Fabric Manufacturing is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Malang would have 150,000 shares of stock outstanding. Under Plan II, there would be 60,000 shares of stock outstanding and 15 million in debt outstanding. The interest rate on the debt is 10 percent and there are no taxes. If EBIT is 2 million, which plan will result in the higher EPS? (b) If EBIT is 7 million, which plan will result in the higher EPS? (c) What is the break-even EBIT? (a) 1 000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $80. its stock is worth $300. and XYZ Co. What is the cost of equity for ABC? What is it for XYZ? (d) What is the WACC for ABC? For XYZ? What principle have you illustrated? (c) 2 . XYZ uses both stock and perpetual debt. Ignore taxes. What rate of return is he expecting? (b) Show how Wilson could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage. (a) Wilson owns $30.FINA1003/1310 – Corporate Finance Tutorial Problem Set 10 Question 3 (Homemade Leverage and WACC) ABC Co. are identical firms in all respects except for their capital structure.000 worth of XYZ’s stock.000. ABC is all-equity financed with $600.000 in stock. so you will get less shares . and syndicate .Positive initial returns Winner’s Curse: . dutch auction .For overpriced shares.Offering price set below the true value of the security .Uninformed investors like you will suffer loss on average 3 . you will get most shares . also called follow-on offerings Cash Offer: Securities are sold to general public Rights Offer: Securities are first sold to existing shareholders IPOs are cash offers (ii) Underwriting Offerings Underwriter: Buy securities from the firm and resells them to the public . best efforts. since others investors do not want.Raising Capital (i) Equity Offerings Initial Public Offerings (IPOs): First offering of stock to the general public Seasoned Equity Offerings (SEOs): New issue for firms that are already listed.Spread: diff between offer price and price paid by underwriter Firm commitment.Lead underwriter.You are more likely to be allocated overpriced shares . co-lead.If an issue is underpriced.FINA1003/1310 – Corporate Finance Tutorial Problem Set 10 Chapter 15 . everyone wants to get some shares.Price is set by auction (iii) IPO Under-pricing .Promised payment to issuer .No commitment . FINA1003/1310 – Corporate Finance Tutorial Problem Set 10 .Allows current shareholders to avoid the dilution that can occur with a new stock issue .Issue of common stock offered to existing shareholders .The price specified in a rights offering is generally less than the current market price .The share price will adjust based on the number of new shares issued . IPOs need to be underpriced to encourage participation of uninformed investors.Rights may be traded OCT or on an exchange The Value of a Right: .“Rights” are given to the shareholders (Specify number of shares that can be purchased. purchase price and time frame) .The value of the right is the difference between the old share price and the “new” share price 4 .So. but your average return maybe zero Reasons of IPO Under-pricing: - Compensation for taking risks Information asymmetry / Signaling Information acquisition Lawsuit avoidance (iv) Rights Offerings: Basic Concepts . the market value of a company does not depend on its capital structure MM Proposition I: .FINA1003/1310 – Corporate Finance Tutorial Problem Set 10 Chapter 16 – Capital Structure We want to choose the capital structure that will maximize stockholder wealth We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC (i) Break-Even EBIT Find EBIT where EPS is the same under both the current and proposed capital structures If expected EBIT > break-even.Capital structure does NOT affect firm value or WACC .WACC keeps the same for any debt ratio 5 . leverage is bad (ii) Capital Structure Theory MM Theory (with no tax. and no bankruptcy costs Capital structure does not affect cash flows It is the same firm value whether or not the firm or individual borrows Therefore. leverage is good If expected EBIT < break-even. with Corporate Tax) Trade-off Theory Pecking order Theory (iii) MM Theory (no tax) - The original MM theory assumes no taxes. When needs external financing is necessary. no incentives to work.The expected return on equity increases with the debt-equity ratio (iv) MM Theory (with taxes) If tax shield is perpetual: PV of tax shield: Value of levered firm (VL) = unlevered firm value (VU) + PV of tax shield More debt is better. Larger than direct costs. managerial efforts.Equity is the last resort to finance projects .FINA1003/1310 – Corporate Finance Tutorial Problem Set 10 MM Proposition II: .Given proposition I. but difficult to measure Costs of financial distress: Costs arising from bankruptcy or distorted business decisions before bankruptcy (vi) Pecking Order Theory . because the interest deduction generates extra value (tax-saving) (v) Bankruptcy Costs Direct Costs: Legal and administrative costs. debt is the primary way to get financing .Firms prefer to issue debt rather than equity if internal finance is insufficient 6 .Firms prefer to use internally generated funds . Bondholders lose benefits Indirect Costs: Lose sales. WACC keeps the same . FINA1003/1310 – Corporate Finance Tutorial Problem Set 10 Implications: .Profitable firms borrow less .Financial slack (can reserve or the extent to access financial markets) is valuable 7 .No target (optimal) capital structure .