FIN3004 Revision Exercise 2018-2019 Semester-1

Question 1 (Homemade Dividend Policy)

Goblet Inc. has excess cash of $10,000 and other assets of $55,000. Equity is worth
$65,000. There are 5000 shares outstanding and earnings for the year are $8,000. The
current market price of the stock is $19. Ignore the effects of taxes and transaction costs.

(a) Suppose Goblet decided to pay out half of the excess cash as dividends to the
shareholders. Donald owns 100 shares but he prefers to have $2 dividends.
Assume that the irrelevance dividend policy theory holds, what should Donald
do to implement the homemade dividend strategy? (assume fractional shares can
be traded and round up to two decimal points)

(b) Suppose Goblet decided to pay out half of the excess cash as dividends to the
shareholders. Donald owns 100 shares but he prefers to have $0 dividends.
Assume that the irrelevance dividend policy theory holds, what should Donald
do to achieve it? (assume fractional shares can be traded and round up to two
decimal points)

(c) Suppose Goblet decided to use all of its excess cash to complete a stock
repurchase. Show that Goblet’s EPS (Earnings Per Share) will increase after the
share repurchase? (assume fractional shares can be traded and round up to two
decimal points)

(d) “Since Goblet’s earnings per share will increase after a stock repurchase, it
shows that a stock repurchase is always better than paying cash dividends
because the shareholders are better off.” Comment why this statement is wrong.
Illustrate with the Goblet case above.

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Question 2 (Capital structure without tax)
Dickson Company and Samson Inc. are identical firms in all aspects except for their
capital structure. Dickson is all equity financed with $3,200,000 in stock. Samson uses
both perpetual debts and stock. There are 1,200 units of perpetual debts outstanding,
paying 5% coupon annually and the market required yield on its debts is 5%. Par value
of the debts is $1,000. Both firms expect EBIT to be $380,000 per year forever. Both
firms have a 100% dividend payout rate. Assume no taxes.

(a) Bonnie owns $120,000 worth of Dickson’s stock. Compute her cash flow from
dividend under the current capital structure.

(b) Compute the current market value of Samson’s perpetual debts, and determine the
debt to equity ratio of Samson. Assume MM proposition I is valid.

(c) Bonnie holds the view that if she invests in Samson she cannot generate the same
cash flows she prefers from Dickson. Critically evaluate if this is true by referring to
the relevant strategy. Prove your argument by showing in detail the steps and
computation involved.

(d) John owns $120,000 worth of Samson’s stock. Compute his cash flow from
dividend under the current capital structure.

(e) John thinks that if he invests in Dickson he cannot generate the same cash flows he
would get from Samson. Critically evaluate if this is true by referring to the relevant
strategy. Prove your argument by showing in detail the steps and computation
involved.

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Question 3 (Capital structure with tax)
David Airline is currently an unlevered firm with value $500. The corporation tax rate
is 35%. The firm is considering a capital restructuring to allow $200 of debt. Its cost of
debt capital is 10%. Unlevered firms in the same industry have a cost of equity of 20%.

(a) What is the new firm value of David Airlines?

(b) What is the cost of equity for David Airlines after using leverage?

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(c) Calculate the weighted average cost of capital (WACC) for the corporation after
using leverage.

Question 4 (Limits to the use of debt)

(a) Sixzung Group has promised payments to its bondholders that total $3,000 one year
from today. The company believes that there is a 65% chance that the cash flow will
be just sufficient to meet these claims. However, there is a 35% chance cash flows
will fall short, in which case total earnings are expected to be $2,000. If
bondholders estimate the bankruptcy costs to be $350, what should be the bond
price in the market? Assume a cost of debt of 15%.

(b) Sixzung Group considers a risky investment project. If it takes it, there will be 10%
chance that the total cash flow one year later will become $5,000 and 90% chance
of failure with no cash remains.

(i) Analyze from the shareholders’ point of view if they prefer accepting that risky
investment project by referring to the present value of stocks with and without the
project. Assume the required return of shareholders is 45%.

(ii) Evaluate if bondholders will be better off or worse off if the risky project is
accepted.

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Question 5 (Callable Bond)
Canton Industries Limited (CIL) is considering raising funds over a short period. In its last
management meeting, the finance director, Ben Lo (Ben), suggested CIL to issue perpetual
bonds with a face value of $1,000 each with a coupon rate of 8.1% paid in annually.

The current market interest rate is 8%. Ben estimates a 0.3 probability that next year’s
interest rate will increase to 10%, and a 0.7 probability that it will fall to 6%.

(a) Assuming that CIL adopts Ben’s suggestion, evaluate the current market value of
the perpetual bond given the probabilities of interest rate change.

(b) The chairperson, Joe Man (Joe), decides to add a call provision into the contract and
make the bonds callable in one year.

Determine what the new coupon rate of the callable bonds should be if the bonds are
issued at par. Assume that the bonds will be called if the interest rates fall and the
call premium is equal to twice the annual coupon.

(c) Evaluate the value of the call provision.

Question 6 (Leasing)
Your firm is considering leasing a truck. The lease lasts for 4 years. The lease calls for 4
payments of $300,000 per year with the first payment occurring at the end of first year.
The truck would cost $1,000,000 to buy and would be straight-line depreciated to a zero
salvage value over 4 years. The actual salvage value is negligible. The firm can borrow
at a rate of 10%. The corporate tax rate is 35%.

(a) What are the relevant incremental after-tax cash flows from leasing relative to
purchasing in years 0-4?

(b) What is the NPV of the lease relative to the purchase?

(c) If the lease payment is made at the beginning of the year, what is the NPV of the
lease relative to the purchase?

(d) From part (c), what is the maximum amount of lease payment that you can afford if
the lease payment is made at the beginning of the year?

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Question 7 (Merger and Acquisitions)
The Sligo Co. is planning on acquiring Thorton Inc. Sligo currently has 2,300 shares of
stock outstanding at a market price of $20 a share. Thorton has 1,800 shares
outstanding at a price of $15 a share. Both firms are all-equity financed firms. Sligo has
estimated that, after acquiring Thorton, its cash flow per year will increase by $800
permanently. The discount rate of the combined firm will be 10%.
(a) What is the value of Thorton to Sligo?

(b) If Thorton is willing to be acquired by $18 per share in cash, what is the cost of
acquisition?

(c) What will the NPV of the acquisition to Sligo be assuming the condition in (b)?

(d) Assuming (b), what is the value of Sligo after acquisition?

(e) Suppose Thorton is willing to be acquired by $32,000 worth of Sligo’s stocks, what
is the value of Sligo after acquisition?

(f) In part(e), what is the cost of acquisition?

(g) Assuming (e), what is the NPV of the acquisition to Sligo?

(h) Which one is better for Sligo, cash offer or stock offer?

(i) If Sligo wants to make a counter-offer of stock acquisition to Thorton such that the
actual cost of acquisition is the same as cash acquisition in part (b), how many
shares Sligo pay in exchange for 1 share of Thorton’s stock?

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Question 8 (IPO and right offerings)
Dung Dung Holdings Limited is a listed company. It has announced a rights offer.
There are 200,000 shares outstanding trading at $25 each. There will be 10,000 new
shares issued at a $20 subscription price.

(a) Assume one share has one rights. Identify how many rights are required to buy a
new share.

(b) Identify the new market value of the firm, the ex-rights price and the value of a
right.

(c) If the rights is selling for $0.2 each on the ex-rights day, describe a transaction in
which an investor could create an immediate profit based on your finding in part (b)
above.

(d) If the rights is selling at the price found in part (b), justify a shareholder with 600
share before the offering and no desire to buy additional shares is not harmed by the
right offer.

Question 9 (Convertible Bonds & Warrants)

(a) A-Go-Go Holdings Limited just issued a zero coupon convertible bond due in 10
years. The face value is $1,000. The conversion ratio is 25 shares. The current stock
price is $12 per share. Each convertible is trading at $400. The appropriate discount
rate is 10%

Identify:
(i) the straight bond value (SBV),
(ii) conversion value
(iii)conversion price
(iv)conversion premium
(v) option value of the bond.

(b) Kida Consultants has 100,000 shares of stock outstanding. The firm's value net of
debt is $2 million. Kida has 1,000 warrants outstanding with an exercise price of
$18, where each warrant entitles the holder to purchase one share of stock.
Calculate:
(i) the share price after warrant exercising.

(ii) the gain from exercising a single warrant.