This Document Contains Chapters 14 to 16 Brealey 5CE Solutions for Chapter 14 1. a. Authorized share capital = 100,000. Presently 20,000 shares are issued and outstanding. So 80,000 more shares can be issued without approval of shareholders. b. After new issue; Book value of common stockholders’ equity (figures in thousands) Common Shares Retained Earnings $110 30 Net Common Equity 140 Note: Authorized Shares Issued Shares 100 30 2. The cost of the share repurchase is $5 x 1000 = $5,000. If the average issue price of these share was $ 5, the common shares account would be reduced by $5,000. The company’s accounts in the books would appear as follows: Common shares $ 55,000 Retained earnings 30,000 Net common equity 85,000 14-1 This Document Contains Chapters 14 to 16 3. a. Funded b. Eurobond c. Subordinated d. Sinking fund e. Call f. Prime rate g. Floating rate h. Private placement, public issue i. Lease j. Convertible k. Warrant 4. a. True. b. False. c. True. 5. Preferred stock is like long-term debt in that it commits the firm to paying the security holder a fixed sum — either a specified coupon payment in the case of bonds or a specified dividend in the case of preferred stock. Like equity and unlike debt, however, failure to pay the dividend on preferred stock does not set off bankruptcy. 6. a. Under majority voting, the shareholder can cast 90 votes for a favorite candidate. b. Under cumulative voting with 10 candidates, the shareholder can cast 10 x 90 = 900 votes for a favorite candidate. 7. a. Under majority voting, each candidate is voted on in a separate election. To ensure that your candidate is elected, you need to own at least half the shares, which is 200,000 shares (or 200,001 shares to ensure a strict majority of the votes). b. Under cumulative voting, all candidates will be voted on at once, and there will be 5 × 400,000 = 2,000,000 votes cast. If your candidate receives one- fifth of the votes, he or she will place at least fifth in the balloting and will be elected to the board. Therefore, you would need to cast 400,000 votes for your candidate, which would require that you own 80,000 shares. 8. a. Common shares will go up by 10 million shares x $55 per share = $550 million. The accounts will appear as follows: 14-2 Book value of common stockholders’ equity of George Weston Limited (figures in millions) Common Shares Retained Earnings Foreign Currency Translation Adjustments $683 6,084 (92) Net Common Equity 6,675 b. The cost of the share repurchase to George Weston is $60 x 500,000 = $30,000,000. If the average issue price of these shares is $30, common shares will be reduced by $30 x 500,000 = $15,000,000. The rest of the reduction is to retained earnings: $30 x 500,000 = $15,000,000. Common shareholders’ equity is now arrived at as follows: (figures in millions) Common Shares (683 - 15) Retained Earnings (6,084 - 15) Foreign Currency Translation Adjustments $668 6,069 (92) Net Common Equity 6,645 9. Lease obligations are like debt in that both legally obligate the firm to make a series of specified payments. Bondholders would like the firm to limit lease obligations for the same reason that they desire limits on debt: to keep the firm’s financial burden at manageable levels and make the already existing debt safer. 10. a. A call provision gives the firm a valuable option. It will require the firm to compensate the investor by promising a higher yield to maturity. b. A restriction on further borrowing protects bondholders. They will therefore require a lower yield to maturity. 14-3 c. Collateral also protects the bondholder and results in a lower yield to maturity. d. The option to convert gives the bondholders a valuable option. They will therefore be satisfied with a lower promised yield to maturity. 11. Income bonds are like preferred stock in that the firm promises to make specified payments to the security holder. If the firm cannot make those payments, however, the firm is not forced into bankruptcy. The advantage of income bonds over preferred stock is that the interest payments are tax-deductible expenses. 12. In general, the fact that preferred stock has lower priority in the event of bankruptcy reduces its price and increases its yield compared to bonds; on the other hand, the fact that the dividend payments are free of taxes to corporate holders increases the price and reduces the yield at which preferred stock trades. For strong firms, the default premium will be small and the tax effect will dominate, so the preferred will have a lower yield than the bonds. For weaker firms the default premium will dominate. 13. From Enbridge’s Annual Report for 2009, we get the following: Equity Debt (note 16) • Common shares • Contributed surplus • Retained earning • Debentures and term notes • Medium-term notes • US Dollar term notes • Commercial paper 14. Bell Canada’s 2009 annual report can be accessed through its website at http://www.bce.ca/data/documents/BCE_annual_2009_en.pdf • Book value of common equity from 2009 Annual Report- Balance Sheet: 2009 – $14,204 million, 2008 – $14,541 million • Common shares outstanding from Note 20: Share Capital of the 2009 Annual Report: 2009 – 767,180,429, 2008 – 803,056,958 • Bell Canada has raised money in a variety of ways, including plowing back earnings (through an increase in retained earnings) and issuing new common 14-4 shares. During 2009, the company raised more money through retained earnings (2009 – increase by $169 million), than through the issue of common shares (2009 – $2 million). (See cash flow statement). 15. Enbridge • Long-term debt-to-equity (Book – in millions of dollars) 2009 - 11,581/7,261 = 1.59 2008 - 10,155/6,619 = 1.53 Note: Equity =total shareholders’ equity. • Long term debt-to-equity (Market Value) = long-term debt/ (average price per share × average shares outstanding) Note: 1. Average shares outstanding at year end taken from Annual Report (in millions)-2009 = 364 and 2008 = 360 (Note 20) 2. Average Stock Price 2009 = $38.91, 2008 = $38.38. For each year, average stock price was computed as sum of monthly adjusted closing prices (close prices adjusted for dividends and stock splits) divided by 12. Monthly closing price taken from Yahoo Finance. 2009 - 11,581/(364 × $38.91) = 0.82 2008 - 10,155/(360 × $38.38) = 0.73 (Here, the numerator is comprised of the book value of long-term debt). 16. Research in Motion Ltd. - For year ending February 27, 2010: USES OF FUNDS • Increase in investments • Capital Expenditures • Repayment of debt • Acquisitions • Purchase of treasury stock • Common shares repurchased SOURCES OF FUNDS • Issuance of common shares • Proceeds on sale or maturity of investments Aastra Technologies Ltd. - For year ending December 31, 2009: USES OF FUNDS 14-5 • Increase in investments • Capital Expenditures • Cash dividends • Repurchase of shares • Payments of loan SOURCES OF FUNDS • Issuance of common shares • Proceeds on disposal of property, plant and equipment Notice the similarity in the financing patterns of the two companies. 17. a). Heineken’s internal source of funds includes Retained earnings. External source – debt financing. Heineken’s primary uses of funds during 2009 include Purchase of property, plant & equipment and Repayment of loans and borrowings (Cash Flow Statement). b). Long-term debt-to-equity (book value - in millions of EUR) • 2009 – €7,401/€5,647 = 1.31 • 2008 – €9,084/€4,752 = 1.91 Long-term debt-to-equity (market value - in millions of EUR) • 2009 – €7,401/(€26.27 x 488.7) = 0.58 • 2008 – €9,084/(€30.00 x 488.9) = 0.62 Long term debt-to-equity (Market Value) = Book value of long-term debt/(average price per share x weighted average number of shares outstanding) Note: • Monthly adjusted closing price taken from Yahoo Finance. • Weighted average number of shares outstanding at year end taken from Annual Report (in millions) 2009 = 488.7, 2008 = 488.9. • Average Stock Price 2009 = €26.27, 2008 = €30.00 (sum of monthly adjusted closing price/12) • Market value of equity and long-term debt are quoted in EUR. • Long-term debt/common equity. Using market value of equity, the long-term debt-to-equity has improved significantly for Heineken. This is due to higher market value of equity. 14-6 c. i). For example, Cott Corporation’s internal sources of financing during 2009 include retained earnings and equity issues. External source of financing – long term debt. Cott Corporation’s primary use of funds – short-term repayments. ii). Long term debt –to- equity (book value - in millions of U.S. dollars) 2009 - $233.2/$401.3 = 0.58 2008 - $294.4/$246.5 = 1.19 Long term debt-to-equity (market value) 2009 - $233.2/($5.00 x 75.215) = 0.62 2008 - $294.4/($2.49 x 71.017) = 1.66 Note: • Monthly closing price taken from Yahoo Finance. • Weighted average number of shares outstanding at year end taken from Annual Report (in millions) 2009 = 75.215, 2008 = 71.017. • Average Stock Price 2009 = $5.00, 2008=$2.49 (sum of monthly adjusted closing price/12) • Market value of equity and long-term debt are quoted in U.S. dollars. • Long-term debt/common equity. Appendix 14A: Practice Problem Solutions 1. Before making the bond refunding decision, we calculate the present value of the net investment cost for E-Books.com by following the steps below: Call premium = 0.05 x $1,000,000 = $50,000. The annual tax deduction on flotation cost of new issue = $25,000/5 = $5,000. The annual tax savings over 5 years will be 0.25 x $5,000 = $1,250. After-tax cost of new debt = 9.0% (1- 0.25) = 6.75% The present value of the tax savings on the flotation cost is computed by applying the annuity formula as follows: The present value of the tax savings = − × 0.0675 1.0675 1 1 $1,250 5 = $5,160 The net after-tax flotation cost on the new issue is calculated as follows: Gross flotation costs on new issue $ 25,000 14-7 Present value of associated tax savings - 5,160 Net after-tax flotation cost on new issue $19,840 The additional interest cost on the old issue = 0.11 (1 0.25) 12 $1,000,000 1 × − × × = $6,875 Since E-Books.com can invest the proceeds from the new issue in the money market for one month, we consider the after-tax interest E-Books.com would earn. After-tax interest earned = 0.05 (1 0.25) 12 $1,000,000 1 × − × × = $3,125 Now, we compute the net after-tax additional interest cost to E-Books.com: after-tax additional interest paid on the old issue $6,875 the after-tax interest earned on the new issue - 3,125 The net after-tax additional interest cost $3,750 The total present value of the net investments costs associated with the refunding decision is provided below: Call premium $50,000 Net after-tax flotation cost on new issue 19,840 Net after-tax additional interest + 3,750 Total present value of net investment costs $73,590 We consider the net savings from refunding. Therefore, we first compute the following: The annual after-tax interest cost on the old issue: = $1,000,000 x 0.11 x (1- 0.25) = $82,500. The annual after-tax interest cost on the new issue: = $1,000,000 x 0.09 x (1-0.25) = $67,500. The yearly interest saving from going forward with refunding is $82,500 - $67,500 = $15,000. To find the present value of this stream of yearly savings, we, once again, discount the annuity by the after-tax interest cost of the new issue. The present value of the net savings from refunding: 14-8 = − × 0.0675 1.0675 1 1 $15,000 5 = $61,917 Finally, we calculate the net present value from bond refunding. PV of net savings over 5 years $61,917 PV of net investment cost - 73,590 NPV of bond refunding ($11,673) Since NPV is negative, E-Books.com should not refund the bond issue. Rate Time period (years) Dollar amount ($) Outstanding bond issue 0 1,000,000 Coupon interest rate on old issue 11% New bond issue 0 1,000,000 Coupon interest rate on new issue 9.0% After-tax coupon interest rate on new issue 6.8% Short-term investment yield per annum 5.0% Marginal tax rate 25% Present Value of Net Investment Costs Call premium on outstanding bond issue 5% 0 50,000 Rate Time period (years) Dollar amount ($) Flotation cost on new issue 0 25,000 Flotation cost amortized for tax purposes 1-5 5,000 Annual tax savings 1-5 1,250 PV of tax savings on flotation costs 0 5,160 Net after-tax flotation cost on new issue 0 19,840 Additional interest cost on old issue 0 6,875 Interest earned on S-T investment of new issue (after tax) 0 3,125 Net after-tax additional interest 0 3,750 Total PV of after-tax investment costs 0 73,590 Net Savings from Refunding Annual after tax interest on old issue 1-5 82,500 14-9 Annual after tax interest on new issue 1-5 67,500 Net annual savings in interest cost 1-5 15,000 PV of total interest cost savings over 5 years 0 61,917 Net Present Value (NPV) from bond refunding 0 -11,673 Since the NPV is negative, E-Books.com concludes that it will not be profitable for the firm to refund the existing bond issue at this time. 2. We calculate the present value of the net investment cost as follows: Call premium = 0.07 x $10,000,000 = $700,000. The annual tax deduction on flotation cost of new issue = $150,000/5 = $30,000. The annual tax savings over 5 years will be 0.35 x $30,000 = $10,500. After-tax cost of new debt = 9.0% (1- 0.35) = 5.85% The present value of the tax savings on the flotation cost is computed by applying the annuity formula as follows: The present value of the tax savings = − × 0.0585 1.0585 1 1 $10,500 5 = $44,411 The net after-tax flotation cost on the new issue is calculated as follows: Gross flotation costs on new issue $ 150,000 Present value of associated tax savings - 44,411 Net after-tax flotation cost on new issue $105,589 The additional interest cost on the old issue: = 0.12 (1 0.35) 12 $10,000,000 1 × − × × = $65,000 Since Food-Galore can invest the proceeds from the new issue in the money market for one month, we consider the after-tax interest E-Books.com would earn. After-tax interest earned = 0.10 (1 0.35) 12 $10,000,000 1 × − × × = $54,167 14-10 Now, we can calculate the net after-tax additional interest cost to Food-Galore as follows: After-tax additional interest paid on the old issue $65,000 The after-tax interest earned on the new issue - 54,167 The net after-tax additional interest cost $10,833 We can now arrive at the total present value of the net investments cost of refunding. Call premium $700,000 Net after-tax flotation cost on new issue 105,589 Net after-tax additional interest + 10,833 Total present value of net investment costs $816,422 Now, we must consider the net savings from refunding. Therefore, we must first calculate the following: The annual after-tax interest cost on the old issue = $10,000,000 x 0.12 x (1- 0.35) = $780,000. The annual after-tax interest cost on the new issue = $10,000,000 x 0.09 x (1- 0.35) = $585,000. Therefore, the yearly interest saving from going forward with refunding is $780,000 - $585,000 = $195,000. To find the present value of this stream of yearly savings, we, once again, discount the annuity by the after-tax interest cost of the new issue. The present value of the net savings from refunding: = − × 0.0585 1.0585 1 1 $195,000 20 = $2,264,127 Finally, we calculate the net present value from bond refunding: PV of net savings over 5 years $2,264,127 PV of net investment cost - 816,422 NPV of bond refunding $1,447,705 Since the NPV is positive, Food-Galore should go forward with the bond refunding activities. Rate Time period (years) Dollar amount ($) 14-11 Outstanding bond issue 0 10,000,000 Coupon interest rate on old issue 12% New bond issue 0 10,000,000 Coupon interest rate on new issue 9.0% After-tax coupon interest rate on new issue 5.9% Short-term investment yield per annum 10% Marginal tax rate 35% Present Value of Net Investment Costs Call premium on outstanding bond issue 7.0% 0 700,000 Flotation cost on new issue 0 150,000 Flotation cost amortized for tax purposes 1-5 30,000 Annual tax savings 1-5 10,500 PV of tax savings on flotation cost 0 44,411 Net after-tax flotation cost on new issue 0 105,589 Additional interest cost on old issue 0 65,000 Interest earned on S-T investment of new issue (after tax) 0 54,167 Net after-tax additional interest 0 10,833 Total PV of after-tax investment costs 0 816,422 Net Savings from Refunding Annual after tax interest on old issue 1-20 780,000 Annual after tax interest on new issue 1-20 585,000 Rate Time period (years) Dollar amount ($) Net annual savings in interest cost 1-20 195,000 PV of total interest cost savings over 20 years 0 2,264,127 Net Present Value (NPV) from bond refunding 0 1,447,705 Since the NPV is positive, Food Galore Inc. concludes that it will be profitable for the company to refund the existing bond issue 3.1 The present value of the net investment cost is computed as follows: Call premium = 0.12 x $100,000,000 = $12,000,000. The annual tax deduction on flotation cost of new issue = $5,000,000/5 = $1,000,000. The annual tax savings over 5 years will be 0.35 x $1,000,000 = $350,000. After-tax cost of new debt = 10% (1- 0.35) = 6.5% 14-12 The present value of the tax savings on the flotation cost is computed as follows: The present value of the tax savings = − × 0.065 1.065 1 1 $350,000 5 = $1,454,488 The net after-tax flotation cost on the new issue is calculated as follows: Gross flotation costs on new issue $ 5,000,000 Present value of associated tax savings - 1,454,488 Net after-tax flotation cost on new issue $3,545,512 The additional interest cost on the old issue: = 0.14 (1 0.35) 12 $100,000,000 1 × − × × = $758,333 Food-Galore can invest the proceeds from the new issue in the money market for one month. The after-tax interest E-Books.com would earn is: After-tax interest earned = 0.06 (1 0.35) 12 $100,000,000 1 × − × × = $325,000 The net after-tax additional interest cost is: After-tax additional interest paid on the old issue $758,333 The after-tax interest earned on the new issue - 325,000 The net after-tax additional interest cost $433,333 We now arrive at the total present value of the net investments cost of refunding. Call premium $12,000,000 Net after-tax flotation cost on new issue 3,545,512 Net after-tax additional interest + 433,333 Total present value of net investment costs $15,978,845 Now, we must consider the net savings from refunding. Therefore, we must first calculate the following: The annual after-tax interest cost on the old issue: = $100,000,000 x 0.14 x (1- 0.35) = $9,100,000. The annual after-tax interest cost on the new issue: 14-13 = $100,000,000 x 0.10 x (1-0.35) = $6,500,000. Therefore, the yearly interest saving from going forward with refunding is $9.1 million - $6.5 million = $2.6 million. To find the present value of this stream of yearly savings, we, once again, discount the annuity by the after-tax interest cost of the new issue. The present value of the net savings from refunding: = − × 0.065 1.065 1 1 $2,600,000 20 = $28,648,119 Finally, we can now calculate the net present value from bond refunding by taking the difference between the present value of the net savings and the present value of the net investment cost. PV of net savings over 5 years $28,648,119 PV of net investment cost - 15,978,845 NPV of bond refunding $12,669,274 Since the NPV is positive, Universal Heavy Equipment should go forward with the bond refunding activities at this time. Rate Time period (years) Dollar amount ($) Outstanding bond issue 0 100,000,000 Coupon interest rate on old issue 14% New bond issue 0 100,000,000 Coupon interest rate on new issue 10.0% After-tax coupon interest rate on new issue 6.5% Short-term investment yield per annum 6.0% Marginal tax rate 35% Present Value of Net Investment Costs Call premium on outstanding bond issue 12% 0 12,000,000 Flotation cost on new issue 0 5,000,000 Flotation cost amortized for tax purposes 1-5 1,000,000 14-14 Annual tax savings 1-5 350,000 PV of tax savings on flotation cost 0 1,454,488 Net after-tax flotation cost on new issue 0 3,545,512 Additional interest cost on old issue 0 758,333 Interest earned on S-T investment of new issue (after tax) 0 325,000 Net after-tax additional interest 0 433,333 Total PV of after-tax investment costs 0 15,978,846 Net Savings from Refunding Annual after tax interest on old issue 1-20 9,100,000 Annual after tax interest on new issue 1-20 6,500,000 Net annual savings in interest cost 1-20 2,600,000 PV of total interest cost savings over 20 years 0 28,648,119 Net Present Value (NPV) from bond refunding 0 12,669,274 Since the NPV is positive, Universal Heavy Equipment concludes that it will be profitable for the company to refund the existing bond issue. 3.2 Detailed Formula Inserts for the Excel Spreadsheet used in Practice Problem 3. A B C D 1 Rate Time period (years) Dollar amount ($) 2 Outstanding bond issue 0 100000000 3 Coupon interest rate on old issue 0.14 4 New bond issue 0 100000000 5 Coupon interest rate on new issue 0.1 6 After-tax coupon interest rate on new issue =B5*(1-B8) 7 Short-term investment yield per annum 0.06 8 Marginal tax rate 0.35 9 Present Value of Net Investment Costs 10 Call premium on outstanding bond 0.12 0 =D2*B10 14-15 issue 11 Flotation cost on new issue 0 5000000 12 Flotation cost amortized for tax purposes 1-5 =D11/5 13 Annual tax savings 1-5 =D12*B8 14 PV of tax savings on flotation cost 0 =D13*(1-(1/(B6+1)^5))/B6 15 Net after-tax flotation cost on new issue 0 =D11-D14 16 Additional interest cost on old issue 0 =D2*(1/12*B3)*(1-B8) 17 Interest earned on S-T investment of new issue (after tax) 0 =D4*(1/12*B7)*(1-B8) 18 Net after-tax additional interest 0 =D16-D17 19 Total PV of after-tax investment costs (D10 + D15 + D18) 0 =D10+D15+D18 20 Net Savings from Refunding 21 Annual after tax interest on old issue 1-20 =D2*B3*(1-B8) 22 Annual after tax interest on new issue 1-20 =D4*B5*(1-B8) 23 Net annual savings in interest cost 1-20 =D21-D22 24 PV of total interest cost savings over 20 years 0 =D23*(1- (1/(B6+1)^20))/B6 25 Net Present Value (NPV) from bond refunding 0 =D24-D19 3.3. The present value of the net investment cost with Canada call feature is computed as follows: Price of a bond = 140(PVIFA 10%, 20) + {1000/ (1+r) 20 = 140(8.5136) + {1000/ (1.10) 20 = 1191.90 + 148.64 = $ 1,340.54 Call premium per bond = price per bond – par value of bond. = 1,340.54 – 1000.00 = $ 340.54 Total Call Premium = 340.54 X 100,000 = $ 34,054,000 The annual tax deduction on flotation cost of new issue = $5,000,000/5 = $1,000,000. The annual tax savings over 5 years will be 0.35 x $1,000,000 = $350,000. After-tax cost of new debt = 10% (1- 0.35) = 6.5% The present value of the tax savings on the flotation cost is computed as follows: 14-16 The present value of the tax savings = − × 0.065 1.065 1 1 $350,000 5 = $1,454,488 The net after-tax flotation cost on the new issue is calculated as follows: Gross flotation costs on new issue $ 5,000,000 Present value of associated tax savings - 1,454,488 Net after-tax flotation cost on new issue $3,545,512 The additional interest cost on the old issue: = 0.14 (1 0.35) 12 $100,000,000 1 × − × × = $758,333 Food-Galore can invest the proceeds from the new issue in the money market for one month. The after-tax interest E-Books.com would earn is: After-tax interest earned = 0.06 (1 0.35) 12 $100,000,000 1 × − × × = $325,000 The net after-tax additional interest cost is: After-tax additional interest paid on the old issue $758,333 The after-tax interest earned on the new issue - 325,000 The net after-tax additional interest cost $433,333 We now arrive at the total present value of the net investments cost of refunding. Call premium $34,054,000 Net after-tax flotation cost on new issue 3,545,512 Net after-tax additional interest + 433,333 Total present value of net investment costs $38,032,845 Now, we must consider the net savings from refunding. Therefore, we must first calculate the following: The annual after-tax interest cost on the old issue: = $100,000,000 x 0.14 x (1- 0.35) = $9,100,000. The annual after-tax interest cost on the new issue: = $100,000,000 x 0.10 x (1-0.35) = $6,500,000. 14-17 Therefore, the yearly interest saving from going forward with refunding is $9.1 million - $6.5 million = $2.6 million. To find the present value of this stream of yearly savings, we, once again, discount the annuity by the after-tax interest cost of the new issue. The present value of the net savings from refunding: = − × 0.065 1.065 1 1 $2,600,000 20 = $28,648,119 Finally, we can now calculate the net present value from bond refunding by taking the difference between the present value of the net savings and the present value of the net investment cost. PV of net savings over 5 years $28,648,119 PV of net investment cost - 38,032,845 NPV of bond refunding - $9,384,726 Since the NPV is negative, Universal Heavy Equipment should not go forward with the bond refunding activities at this time. A B C D 1 Rate Time period (years) Dollar amount ($) 2 Outstanding bond issue 0 100,000,000 3 Par Value per bond 1,000 4 Coupon interest rate on old issue 14% 5 New bond issue 0 100,000,000 6 Coupon interest rate on new issue 10.0% 7 After-tax coupon interest rate on new issue 6.5% 8 Short-term money market investment yield 6.0% 9 Marginal tax rate 35% 10 Present Value of Net Investment Costs 11 Call price per bond 1340.54 12 Call premium per bond 340.54 13 Call premium on outstanding bond issue 34,054,000 14-18 14 Flotation cost on new issue 0 5,000,000 15 Flotation cost amortized for tax purposes 1-5 1,000,000 16 Annual tax savings on amortized flotation cost 1-5 350,000 17 PV of tax savings on flotation cost 0 1,454,488 18 Net after-tax flotation cost on new issue 0 3,545,512 19 Additional interest cost on old issue 0 758,333 20 Interest earned on S-T investment of new issue (after tax) 0 325,000 21 Net after-tax additional interest 0 433,333 22 Total PV of after-tax investment costs (D13 + D18 + D21) 0 38,032,846 23 Net Savings from Refunding 24 Annual after tax interest on old issue 1-20 9,100,000 25 Annual after tax interest on new issue 1-20 6,500,000 26 Net annual savings in interest cost 1-20 2,600,000 27 PV of total interest cost savings over 15 years 0 28,648,119 28 Net Present Value (NPV) from bond refunding (D27- D22) 0 -9,384,726 14-19 A B C D 1 Rate Time period (years) Dollar amount ($) 2 Outstanding bond issue 0 100000000 3 Par Value per bond 1000 4 Coupon interest rate on old issue 0.14 5 New bond issue 0 100000000 6 Coupon interest rate on new issue 0.1 7 After-tax coupon interest rate on new issue =B6*(1-B9) 8 Short-term money market investment yield 0.06 9 Marginal tax rate 0.35 10 Present Value of Net Investment Costs 11 Call price per bond =(B4*D3)*(1-(1/1.1)^20/0.1) +1000/(1.1)^20 12 Call premium per bond =D11-D3 13 Call premium on outstanding bond issue =D12*D2/D3 14 Flotation cost on new issue 0 2500000 15 Flotation cost amortized for tax purposes 1-5 =D14/5 16 Annual tax savings on amortized flotation cost 1-5 =D15*B9 17 PV of tax savings on flotation cost 0 =D16*(1-(1/(B7+1)^5))/B7 18 Net after-tax flotation cost on new issue 0 =D14-D17 19 Additional interest cost on old issue 0 =D2*(1/12*B4)*(1-B9) 20 Interest earned on S-T investment of new issue (after tax) 0 =D5*(1/12*B8)*(1-B9) 21 Net after-tax additional interest 0 =D19-D20 22 Total PV of after-tax investment costs (D13 + D18 + D21) 0 =D13+D18+D21 23 Net Savings from Refunding 24 Annual after tax interest on old issue 1-20 =D2*B4*(1-B9) 25 Annual after tax interest on new issue 1-20 =D5*B6*(1-B9) 26 Net annual savings in interest cost 1-20 =D24-D25 27 PV of total interest cost savings over 15 years 0 =D26*(1-(1/(B7+1)^20))/B7 28 Net Present Value (NPV) from bond refunding (D27 - D22) 0 =D27-D22 14-20 Brealey 5CE Solutions to Chapter 15 1. a. Subsequent issue. A rights issue requires that there are already existing shareholders. b. Seasoned offerings are security issues by firms that are already publicly traded. Publicly traded firms usually find it advantageous to sell new shares in a public offering because the public offering is less costly. In contrast, even publicly traded firms may find it advantageous to make a private placement of bonds. Such bonds can be issued with unusual terms and allow the firm to negotiate directly with the bondholders should it later wish to make changes in the terms of the debt. Therefore, it is more likely that the private placement is used for the bond issue. c. Bond issue of large industrial company 2. a. C b. A c. B 3. a. A large issue (economies of scale). See Figure 15.1. b. A bond issue is less expensive c. Private placements are less expensive for small amounts. 4. Issue costs for debt are less than for equity for several reasons. Underwriting spreads are lower because there is less risk to the underwriters concerning the price at which the debt can be placed. Debt is more standard than equity, so it can be evaluated by and marketed to the public more easily. Underpricing is much less of a concern because debt issues are far less likely to signal management assessments of the value of the firm relative to the market price. 5. Issuing in stages rather than fully funding a project all at once serves at least two goals. First, it keeps the entrepreneur on a “short leash.” There will not be any excess funds available to squander on luxuries. Moreover, the firm will have to show good evidence of progress and likely success in order to proceed successfully to the next stage of financing. Second, staged financing limits the amount of money 15-1 initially put at risk by the venture capitalist. New money will not be committed until evidence of the likely success of the firm is forthcoming. 6. You should be suspicious. If the issue were underpriced, preferred customers would be likely to snap up the offering. If the underwriters have to aggressively market the issue to the general public, it could be a sign that more knowledgeable investors are staying away because they view the issue as overpriced. 7. a. Average underpricing may be estimated as the average initial return on the sample of IPOs: (7 + 12 – 2 + 23) / 4 = 10% b. My initial return, weighted by amount invested, is calculated as follows: Investment Initial Profit (Shares × price) Return (%) (% return × investment) A $ 5,000 7 $350 B 4,000 12 480 C 8,000 – 2 −160 D 0 23 0 Total $17,000 $670 Average return = 670/17,000 = .0394 = 3.94% Alternatively, you can calculate average return as: 5,000 17,000 × 7 + 4,000 17,000 × 12 + 8,000 17,000 × (−2) = 3.94% c. My average return is far below the average initial return on the sample of IPOs. This is because I have received lower allocations of the best performing IPOs and higher allocations of the poorly performing IPOs. I have suffered the winner’s curse: On average, I have been awarded greater allocations of the IPOs that other players in the market knew to stay away from, and my average performance has suffered as a result. 8. Underwriting costs for Moonscape: Underwriting spread: $.50 × 3 million = $ 1.5 million Underpricing: $3.00 × 3 million = 9.0 million Other direct costs: 0.1 million 15-2 TOTAL $10.6 million Funds raised = $8 × 3 million = $24 million Flotation costs Funds raised = 10.6 24 = .442 = 44.2% 9. a. The offering is both a primary and secondary offering. The firm is selling 500,000 shares (primary) and the existing shareholders are selling 300,000 shares (secondary). b. Direct costs are as follows: Underwriting spread: $1.30 × 800,000 = $1.04 million Other direct costs: 0.40 million TOTAL $1.44 million Funds raised = 12 × $800,000 = $9.6 million Direct costs Funds raised = 1.44 9.6 = .15 = 15% From Figure15.1, direct costs for IPOs in the range of $1 to $10 million (US) have been around 12%. Direct costs for IPOs in higher ranges have been lower. The direct costs of this $9.6 million IPO, at 15%, seem to be on the higher side relative to the size of the issue. c. If the stock price rises from $12 to $15 a share, we would infer underpricing of $3 per share. Direct costs per share are $1.44 million/800,000 = $1.80. Total costs are thus $4.80 per share, which is $4.80/$15 = .32 or 32% of the market price. d. Emma Lucullus will sell 25,000 shares and retain 375,000 shares. She will receive $12 for each of her shares, less $1.80 per share direct costs: ($12 - $1.80) × 25,000 = $255,000. Notice that we compute per share direct costs as the sum of the underwriting discount of $1.30 per share and $0.50 per share as the proportion of expenses payable by selling shareholders ($150,000/300,000). Her remaining shares, selling at $15 each, will be worth $15 × 375,000 = $5,625,000. 10. Unlike interest payments, which are made annually, the issue cost is a one time cost. Rather than adjust the cost of capital, the issue costs should be deducted from 15-3 the project’s NPV. Remember that the cost of capital is the required rate of return to investors in a project with a given level of risk. While flotation costs can reduce the NPV of a project by requiring an extra cash outflow, they do not affect the rate of return commensurate with the project’s risk. 11. a. The price of each share net of the underwriting spread was $21 − $1.31 = $19.69. Therefore, the firm raised 2 million × $19.69 = $39.38 million by selling new stock in the primary issue. b. The existing shareholders sold their 800,000 shares to the underwriters for total proceeds of 800,000 × 19.69 = $15.752 million. c. If the underwriters had paid $30 a share, only 1.313 million new shares would have been required to obtain the same $39.38 million proceeds. d. If the existing shareholders had sold their 800,000 shares to the underwriters for $30 rather than $19.69, the increase in their proceeds would have been 800,000 × ($30 –$19.69) = $8.248 million. 12. The lost value to the original shareholders is 2 percent of $600 million = $12 million. This is 12 percent of the value of the funds raised. 13. a. The firm will receive only $30 × (1 – .08) = $27.60 per share. It will need to issue $3,000,000/$27.60 = 108,696 shares. The gross proceeds from the issue will be 108,696 × $30 = $3,260,880, and the firm will be left with $3,000,000 (which it uses in part to pay the other direct costs of the issue). b. The underwriting spread costs the firm $260,880. Therefore, total direct costs are $260,880 + $60,000 = $320,880. c. The total market value of the stock is $30 million. If the share price falls by 3% on the announcement of the offering, the existing shareholders suffer a loss in value of .03 × $30 million = $0.9 million, or $900,000. This figure is nearly three times the direct costs of the offering. 14. a. Net proceeds of public issue = $10,000,000 – $150,000 – $80,000 = $9,770,000 Net proceeds of private placement = $9,970,000 15-4 b. The extra interest paid on the private placement equals .005 × $10 million = $50,000 per year. The present value is $50,000 × annuity factor(8.5%,10 years) = $328,000. This exceeds the savings in direct issue costs (which are, $230,000 for the public issue and $30,000 for the private placement, respectively), so the public issue appears to be the better deal. (We use a discount rate of 8.5% rather than 9% because 8.5% is the yield to maturity at which public investors are willing to invest in the bond when the company pays the cost of the issue directly to the underwriters. In the private placement, part of the 9% coupon rate should be considered compensation for issuance costs that are not charged for explicitly.) c. The private placement is more expensive, but it has the advantages that the terms of the debt can be custom-tailored and its terms can be more easily renegotiated. 15. a. The number of new shares is 10 million/4 = 2.5 million. Each share is sold for $5, so new money raised is $12.5 million. b. After the issue, there are 12.5 million shares. The total value of the firm is $60 million (the original value of the firm) plus $12.5 million. The new share price is $72.5 million/12.5 million shares = $5.80 per share. 16. If the new stock were issued at $4 a share, the company would have needed to issue $12.5 million/$4 per share = 3.125 million shares. The stock would then sell for $72.5/13.125 = $5.5238 per share. (The firm will need to issue 3.125 million rights, meaning that one new share can be purchased for every 3.2 shares currently held.) Despite the lower stock price, the shareholders are just as well off. In the original plan an investor who owns 1000 shares would have the right to buy 250 additional shares for $5 each. The total value of the position would be 1000 × $5.80 + 250 × ($5.80 – $5.00) = $6000 In the modified plan the investor will be able to buy 1000/3.2 = 312.5 shares for $4 each. Total value is the same: 1000 × $5.5238 + 312.5 × ($5.5238 – $4.00) = $6000 17. a. $2 million/200,000 = $10 b. The total value of the firm currently is $20 million, and there are 1 million shares outstanding. When the rights are exercised, the firm will raise $2 million, and total value will increase to $22 million. Shares outstanding will increase to 1.2 million. Price per share will be $22/1.2 = $18.3333. 15-5 c. The value of each right is the difference between the value of each share after exercise, $18.3333, and the $10 subscription price (the price the right holder pays for each share). Each right is therefore worth $8.3333. d. An investor who holds 1000 shares would receive 200 rights. (The firm distributes 200,000 rights among its 1 million shares, or 1 right per 5 shares.) e. Before the announcement of the rights offering, the 1000 shares were worth $20,000. After the announcement, the stock price falls and the shares fall in value to $18,333. However, the rights are worth 200 × $8.3333 = $1,667. The value of the rights plus the value of the shares is $20,000. Wealth is unchanged. 18. a. New shares = 50,000 since one new share will be issued for every two of the outstanding 100,000 shares. b. New investment = 50,000 shares × $10 per share = $500,000 c. Value of company = $4,000,000 original value + 500,000 new investment $4,500,000 new value d. Total number of shares = 100,000 original shares + 50,000 new shares 150,000 total shares e. New share price = $4.5 million/150,000 = $30 19. From the Globe and Mail Investor Shaw Communications Inc. has the higher price-earnings ratio (18.86 as of September 2011) where as Telus Corp. had a price-earnings ratio of 14.82 in September 2011. Price-earnings ratio is a function of dividend growth rate, retention rate and return on equity. 20. During the internet boom years (1999-2000) there were 858 IPOs, 63.6% average first day returns and an average of US$33.32 billion was left on the table. In comparison, during 2009-2010, there were 135 IPO’s, average first day returns of approximately 9.45%, and average amount of money left on the table of US$1.67 billion. Free Markets (FMKT) provided the highest 1-day dollar gain to investor during 1998-2000. With an IPO date of 10/12/99, Free Market had a US$232 1-day gain. The offer price was US$48 and the first closing market price was US$280. 21. The payoffs in year 5 to George Pickwick and First Cookham (FC) are as follows: 15-6 a. FC buys 2 million shares at $1 This gives FC two-thirds of Pickwick. Thus the possible payoffs at the end of 5 years are determined by splitting up the company value in proportions of 1/3 and 2/3: Company value in 5 years after stage 2 financing $2 million $12 million Payoff to: G. Pickwick (1 million shares) $0.67 million $ 4 million FC (2 million shares) $1.33 million $ 8 million b. FC buys 1 million shares now and invests an additional $1 million in shares in year 5 The possible payoffs are shown next: Company value in 5 years after stage 2 financing $2 million $12 million Company value in 5 years before issue of $1 million $1 million $11 million in 2nd stage financing Price per share $ 0.50 $ 5.50 (Price = value/2 million shares) No. of new shares issued to FC $1m/$.50 = $1m/$5.50 = 2 million 0.182 million Total shares outstanding 4 million 2.182 million Total shares owned by FC 3 million 1.182 million % of shares owned by Pickwick .25 .4583 % of all shares owned by FC .75 .5417 Payoff* to: G. Pickwick (1 million shares) $ 0.5 million $ 5.5 million FC $ 1.5 million $ 6.5 million *Payoff equals percentage ownership times total value of firm after issue of stage 2 financing. 15-7 Note that by putting up only part of the money now, FC takes on less risk. If the company does not do well (future value = $2 million), then FC can buy a large number of shares for the $1 million of stage 2 financing. If the firm does well, FC receives fewer shares. Staged financing gives George Pickwick more risk and makes it more important for him to make a success of stage 1. 22. As an example, we selected GPS Investment Corp. GPS Investment Corp. with its head office in Calgary, Alberta is pursuing an IPO offering and proposed listing on the TSX venture exchange. As a capital pool company, GPS Investment Corp. identifies and evaluates assets or businesses in order to complete a Qualifying Transaction. Information about directors and management, use of proceeds, and risk factors are very useful in analyzing a potential investment. Some information may be quite technical in nature and, therefore, less useful to the average investor. For instance, the information about the criteria and process of identification of a Qualifying Transaction would perhaps be appreciated more by an individual with a business or legal background than by the lay investor. 15-8 Solution to Minicase for Chapter 15 Underwriting costs for Mutt.com (including costs to the existing shareholders) are: Underwriting spread: $1.25 × 1.25 million shares = $ 1.56 million Other direct expenses: = $1.30 million Underpricing*: $6 × 1.25 million shares = $7.50 million TOTAL $10.36 million * Underpricing based on the assumption that the shares could be sold for $24 rather than $18. Funds raised = $18 × 1.25 million shares = $22.5 million Value of shares issued = $24 × 1.25 million shares= $30 million Direct costs Funds raised = 2.86 22.5 = .127 = 12.7% Underpricing costs Funds raised = 7.5 22.5 = .333 = 33.3% Total flotation costs Value of shares issued = 10.36 30 = .345 = 34.5% Notice that we follow convention by reporting the direct costs as a percentage of the issue price ($18), but total costs as a percentage of the market value of the shares ($24). The underwriter’s comments miss the point. Of course managers and shareholders prefer a high price to a low price. For any given price at which the shares are issued, they still prefer the stock price to rise. However, a very high initial-day return (i.e., evidence of considerable underpricing) indicates that the shares could have been issued at a higher price − in other words, that the company “left some money on the table.” To the extent that the shares are issued at a lower-than-necessary price, the firm gives up some value to the new shareholders. This is correctly considered a cost of the issue. Moreover, this is a cost to existing shareholders whether or not they plan to sell their shares. Underpricing means the firm must sell more new shares to raise the same amount of cash. Consequently, the existing shareholders end up owning a smaller fraction of the firm than they would if the shares were issued at a higher price. Their wealth is lower. 15-9 Appendix 15A . 1. If you go to the Canadian Venture Capital Association website (at www.cvca.ca), you will be able to access the directory of venture capital firms which are members of the association. This directory also lists website addresses of these venture capital firms. Similarly, the National Venture Capital Association (NVCA) is the trade association representing the venture capital industry in the United States. Its website is at www.nvca.org. Through the NVCA website, you will be able to access information about member venture capital firms. 2. a. Table 15A.3 of the text provides details regarding venture capital investment activity by stage of development in 2008 and 2009. From details provided by venture capital firms at the CVCA website (for 2011), it appears that the type of venture capital firm (i.e. private independent, labour sponsored, etc) does not necessarily have an association with type of investment strategy. For instance, New Brunswick Innovation Foundation (NBIF), a New Brunswick- based private independent fund has a stated preference for seed and start-up investing. On the other hand, Clairvest Group, another private independent fund, based in Ontario, prefers to finance expansion (later stage), and acquisition or buy-out, but no start-ups. Similarly, Covington Capital Corporation, a labour-sponsored venture capital fund, prefers predominantly early-stage financings (Seed). But CAI Capital Management Co., a corporate venture capital fund, prefers expansion, acquisition or buyout, and turnaround investing. b. Portfolio theory suggests that a venture capital fund manager may reduce the portfolio risk of investments by diversification across industries and stages of development. However, studies (for instance, Norton & Tennenbaum (1993)), have found that venture capital firms prefer to reduce their risk through specialization within industries and sometimes syndicating investments with other venture capital firms. From the CVCA website (for 2011), we see that different Canadian venture capital firms indeed have different investment preferences. For instance, Covington Capital Corporation prefers to invest only in information technologies, life sciences, and other technologies, but Fonds de solidarité FTQ, another labour-sponsored fund states that it will consider all industries. Usually, corporate venture capital funds tend to specialize in specific areas of investment which are tied to the overall strategic goals of the corporation. However, here also differences abound with regard to the range of activities. For example, whereas Telsoft prefers investing in information technology field, iGan Partners has a wider range of investment preferences (all industries). Overall, according to the CVCA, in recent years there is a trend toward smaller numbers of investments with larger dollar amounts. 15-10 c. Venture capital firms do appear to generally prefer investing in regions that are in close proximity with their own operations. This could provide for easier and cheaper monitoring of their investments. For instance, from the CVCA website, as of 2011, InNOVAcorp, a Halifax based venture capital firm, prefers to invest in businesses which have a presence in Nova Scotia. GrowthWorks has its head quarters in Vancouver and branch offices in Toronto, Winnipeg, Nova Scotia, NewFoundland, and New Brunswick. Its geographic preference is Canada. 3. Venture capitalists and angel investors actively work with company management by contributing their experience and business savvy gained from helping other companies with similar growth challenges. They also assist investee firms in a variety of other ways, for instance helping them with their product and marketing strategies. Many angel investors are themselves successful entrepreneurs and start-up firms in which they have invested are able to draw upon their skills and business acumen. Of course, some angels are just “passive” investors and prefer not to play an active role in the investee firms. When a reputable venture capital organization invests in a start-up firm, it also provides a signal that the venture capitalist believes that the start-up has high future growth prospects. This in turn may enable the start-up firm to get favourable terms in its business dealings with other organizations. Thus accounting firms may charge reduced audit fees or advertising agencies may charge concessional rates in the hope that, by building good relations with the firm now, they will get good business opportunities in the future when the firm has matured. By working closely with investee firms, venture capitalists and angels are better able to monitor their investments. Usually, venture capital firms require one or more seats on the board of directors of the start-up organization. 4. We note from the NVCA Yearbook 2011 that the level of venture capital (VC) investment in 2010 was only about 22% of what it used to be during the boom years (2010: about US$22 billion versus 2000: about US$99 billion). Out of the 2,749 companies that received funding during 2010, 58% went to firms in Information Technology sector, followed by firms in Medical/Health/Life Science sector (25%). Majority of the VC funds went to expansion (39%) and later stage companies (29%). 15-11 Brealey 5CE Solutions to Chapter 16 1. a. True. b. False. As leverage increases, the expected rate of return on equity rises by just enough to compensate for its higher risk. The stock price and stockholders’ wealth are unaffected. c. False. The sensitivity of equity returns to business risk, and therefore the cost of equity, rises with leverage even without a change in the risk of financial distress. d. True. 2. While the costs of both debt and equity do increase, the weight applied to debt in the cost of capital formula also increases. Applying a higher weight to the lower- cost source of capital offsets the increase in the expected returns. 3. The interest tax shield is the reduction in corporate income taxes due to the fact that interest payments are treated as expenses that reduce taxable income. To the extent that the government collects less taxes, there is a bigger pie of after-tax income available to the debt and equity holders. Example: assume operating income is $100,000, the interest rate on debt is 10%, the tax rate is 35%, and compare income for an unlevered firm versus one that borrows $400,000. Zero-debt firm $400,000 of debt Operating income $100,000 $100,000 Interest on debt 0 40,000 Before-tax income 100,000 60,000 Tax at 35% 35,000 21,000 After-tax income 65,000 39,000 Sum of debt interest plus after-tax income $ 65,000 $ 79,000 The combined debt plus equity income is higher for the levered firm. The difference equals $14,000, which also is the difference in taxes paid by the two firms. 4. PV(Tax shield) = .37 × 800 × .076 .076 = .37 × 800 = $296 million. 16-1 5. The tradeoff theory of capital structure holds that the optimal debt ratio is determined by striking a balance between the advantages and disadvantages of debt finance. The advantage of debt finance is the tax shield on interest payments. The disadvantages are the various costs of financial distress. As leverage increases, the marginal tax shield from each dollar of additional borrowing falls. This is a consequence of the increasing probability that, with higher interest expense, the firm will not have positive taxable income and will not pay taxes. At the same time, the expected costs of financial distress rise with leverage. As leverage increases, the marginal cost of financial distress eventually outweighs the interest tax shield. At the optimal debt ratio, the increase in the PV of tax savings from additional borrowing is just offset by increases in the PV of costs of financial distress. 6. • Direct costs of bankruptcy such as legal or administrative costs • Indirect costs due to the problems encountered when managing a firm in bankruptcy proceedings (e.g., interference by creditors or difficulties buying supplies on credit) • Poor investment decisions resulting from conflicts of interest between creditors and stockholders. 7. The pecking order theory states that firms prefer to raise funds through internal finance, and if external finance is required, that they prefer debt to equity issues. This preference – or pecking – order is due to the fact that investors may interpret security issues – equity issues in particular – as a signal that managers think the firm is currently overvalued by the market; therefore, investors will reduce their valuation of the firm in response to news of a stock issue. If the pecking order theory is correct, we would expect firms with the highest debt ratios to be those with low profits, because internal finance is less available to these firms. 8. Financial slack refers to a firm’s access to cash, marketable securities, bank financing, or debt financing. Financial slack is valuable because it means financing will be quickly available to take advantage of any positive-NPV investment opportunities. Too much financial slack can be detrimental if it allows managers to take it easy, empire build, or use excess cash on their own perquisites. 16-2 9. Number of shares = 75,000 Price per share = $10 Market value of shares = $750,000 Market value of debt = $250,000 Slump Normal Boom Operating income $75,000 125,000 175,000 Interest $25,000 25,000 25,000 Equity earnings $50,000 100,000 150,000 Earnings per share $ 0.667 1.333 2.000 Return on shares 6.67% 13.33% 20.00% 10. The investor can sell one-fourth of her holdings in the firm, and invest the proceeds in debt. Suppose she has $10,000 currently invested in the firm. She could sell $2,500 worth of shares, using the proceeds to buy bonds yielding 10%. The return on her portfolio in any economic scenario is: Slump Normal Boom Return on Shares 6.67% 13.33% 20.00% Return on Debt 10.00% 10.00% 10.00% Portfolio Return* 7.50% 12.50% 17.50% * Portfolio Return = .25 × return on debt + .75 × return on shares The portfolio return is precisely the same as it was when the $10,000 was invested in the unlevered firm. 11. Share price = $10 From Table 16.1, with no leverage, there are 100,000 shares outstanding. Normal or expected operating income is $125,000. Expected earnings per share = $125,000 100,000 = $1.25 P/E = 10/1.25 = 8 From Problem 9, with leverage, there are 75,000 shares outstanding. Expected earnings per share = $100,000 75,000 = $1.333 P/E = 10/1.333 = 7.5 16-3 P/E falls because the equity is now riskier. Although earnings per share are expected to rise from $1.25 to $1.333, the value of each share of equity is no higher. The increase in risk offsets the increase in expected earnings. 12. After-tax income for all-equity firm: Slump Normal Boom Operating income $75,000 $125,000 $175,000 Tax at 35% 26,250 43,750 61,250 After-tax income $48,750 $ 81,250 $113,750 After-tax income assuming $250,000 of debt financing: Slump Normal Boom Operating income $ 75,000 $125,000 $175,000 Debt interest at 10% 25,000 25,000 25,000 Before-tax income 50,000 100,000 150,000 Tax at 35% 17,500 35,000 52,500 After-tax income 32,500 65,000 97,500 Combined debt and equity income (debt interest + 57,500 90,000 122,500 after-tax income) After-tax income $ 48,750 $ 81,250 $113,750 (All equity case) Difference in income $ 8,750 $ 8,750 $ 8,750 In all states of the economy, the difference in total income to all security holders is $8,750. This is exactly equal to the tax shield from debt: Tc × Interest expense = .35 × $25,000 = $8,750. 13. a. False, at least in part. While the proportion of bad debts should be monitored, one cannot evaluate the credit manager’s performance from the proportion of bad debts alone. Depending on the profit margin, differing probabilities of bad debts may be optimal. Too low a bad debt ratio may signify that credit policy is too strict and results in lost sales. b. False. Equityholders want reorganizations that give the firm a chance of recovering sufficiently to pay off all its debts. c. True. 16-4 d. False. The claims of CRA come after those of secured creditors and post- bankruptcy claims. e. True. f. False. This is true only for reorganizations. Tax loss carry-forwards are extinguished by liquidation. 14. Expected return on assets is: rassets = .08 × 30/100 + .16 × 70/100 = .136 = 13.6% The new return on equity is: requity = rassets + D/E × (rassets – rdebt) = .136 + 20/80 (.136 – .08) = .15 = 15% 15. a. Market value of firm is $100 × 10,000 = $1,000,000. With the low-debt plan, equity falls by $200,000, so D/E = $200,000/$800,000 = .25, and 8,000 shares remain outstanding. With the high-debt plan, equity falls by $400,000, so D/E = $400,000/$600,000 = .67, and 6,000 shares remain outstanding. b. Low-debt plan EBIT $ 90,000 $130,000 Interest 20,000 20,000 Equity Earnings 70,000 110,000 EPS [Earnings/8000] $ 8.75 $ 13.75 Expected EPS = ($8.75 + $13.75)/2 = $11.25 High-debt plan EBIT $ 90,000 $130,000 Interest 40,000 40,000 Equity Earnings 50,000 90,000 EPS [Earnings/6000] $ 8.33 $ 15.00 Expected EPS = (8.33 + 15)/2 = $11.67 Although the high-debt plan results in higher expected EPS, it is not necessarily preferable, since it also entails greater risk. The higher risk shows up in the fact that EPS for the high-debt plan is lower than EPS for the low- debt plan when EBIT is lower but higher when EBIT is higher. 16-5 c. Low-debt plan High-debt plan EBIT $100,000 $100,000 Interest 20,000 40,000 Equity Earnings 80,000 60,000 EPS $ 10.00 $ 10.00 EPS is the same for both plans because EBIT is 10% of assets, equal to the rate the firm pays on its debt. When rassets = rdebt, EPS is unaffected by leverage. 16. Currently, with no outstanding debt, βequity = 1. Therefore, βassets = 1. Also, requity = 10%, so rassets = 10%. Finally, rdebt = 5%. The firm plans to refinance, resulting in a debt-to-equity ratio of 1.0, and debt-to- value ratio: debt/(debt + equity) = .5. a. βequity × .5 + βdebt × .5 = βassets = 1 βequity × .5 + 0 = 1 βequity = 1/.5 = 2.0 b. requity = rassets = 10% risk premium = requity – rdebt = 10% – 5% = 5%. (Note that the debt is risk-free.) c. requity = rassets + D/E × (rassets – rdebt) = 10% + 1 × (10% – 5%) = 15% risk premium = requity – rdebt = 15% – 5% = 10% d. rdebt = 5% e. rassets = .5 × requity + .5 × rdebt = .5 × 15% + .5 × 5% = 10% which is unchanged from before the refinancing. f. Suppose total equity before the refinancing was $1000. Then expected earnings were 10% of $1000, or $100. After the refinancing, there will be $500 of debt and $500 of equity, so interest expense will be $25. Therefore, earnings fall from $100 to $75, but the number of shares is now only half as large. Therefore, EPS rises by 50%: EPS after EPS before = 100/Original shares 75/(Original shares/2) = 1.5 16-6 g. The stock price is unchanged, but earnings per share have increased by a factor of 1.5. Therefore, the P/E ratio must fall by a factor of 1.5, from 10 to 10/1.5 = 6.67. So, while expected earnings per share rise, the earnings multiple falls, and the stock price is unchanged. 17. rassets = .8 × 12% + .2 × 6% = 10.8% After the refinancing, the package of debt and equity must still provide an expected return of 10.8%. Therefore, 10.8% = .4 × requity + .6 × 6% requity = (10.8% – 3.6%)/.4 = 18% 18. This is not a valid objection. MM’s Proposition II explicitly allows for the rates of return on both debt and equity to increase as the proportion of debt in the capital structure increases. The rate on debt increases because the debtholders are taking on more of the risk of the firm; the rate on the common stock increases because of increasing financial leverage. 19. a. The cost of capital of the firm (rassets) is not affected by the choice of capital structure under Proposition I. The reason the stated argument seems to be true is that it doesn’t account for the changing proportions of the firm financed by debt and equity. As the debt-equity ratio increases, it is true that both the costs of equity and debt increase; but a larger portion of the firm is financed by debt. The overall effect is to leave the firm’s cost of capital unchanged. b. Moderate borrowing doesn’t significantly affect the probability of financial distress, but it does increase the variability (and also market risk) borne by stockholders. This additional risk must be offset by a higher expected rate of return to stockholders. c. If the opportunity were the firm’s only asset, this would be a good deal. Stockholders would put up no money and therefore have nothing to lose. The trouble is, rational lenders won’t advance 100 percent of the asset’s value for an 8 percent promised return unless other assets are put up as collateral. Sometimes firms find it convenient to borrow all the cash required for certain investments. But these investments don’t support all of the additional debt; the lenders are protected by the firm’s other assets too. In any case, if firm value is independent of leverage, then any asset’s contribution to firm value must be independent of how it is financed. Note 16-7 also that the statement ignores the effect on the stockholders of an increase in financial leverage. d. This is not an important reason for conservative debt levels. So long as MM’s proposition holds, the company’s overall cost of capital is unchanged despite increasing interest rates paid as the firm borrows more. (However, the increasing interest rates may signal an increasing probability of financial distress — and that can be important.) 20. The ratio of debt to firm value is D D+ E = 1 +1 2 = 31 rassets = 1/3 × 6% + 2/3 × 12% = 10% If the debt-equity ratio were 1/3, then: requity = rassets + D/E(rassets – rdebt) = 10% + 31(10% − 6%) = 11.33% 21. Although both debt and equity are riskier, and therefore command higher expected rates of return, the fraction of the firm financed by debt is now higher. So the weighted average of the debt and equity rates can in fact remain unaffected. The higher expected returns on each source of financing are offset by the re-weighting toward debt, which has a lower expected return than equity. 22. AstraZeneca’s interest expense is given in Table 3.2 (Finance expense) as $1,033 million. Its annual tax shield is .35 × $1,033 = $361.55 million. If the tax shield is expected to remain constant indefinitely, then we can find the present value of the stream of tax savings using the no-growth valuation model (see Chapter 6). The discount rate for the tax shield is given as 8%. Therefore, the present value of the perpetuity of tax savings is: PV = r First year savings = .08 361.55 = $4,519.375 million 23. a. WACC = 8 27 × 7.6% × (1 − .37) + 19 27 × 14% = 11.27% b. If the firm has no debt, the market value of the firm would fall by the present value of the tax shield (.37 × 800 = $296), to a value of $2,404. Equity will fall by the same amount. The long-term assets of the firm (which previously 16-8 included the PV of the tax shield) also will fall by $296. The new market value balance sheet is therefore: Net working capital $ 550 Debt $ 0 Long-term assets 1,854 Equity 2,404 Value of firm $2,404 $2,404 24. a. PV tax shield = .35 × Debt = .35 × $40 = $14 b. [The following solution assumes that the cost of debt is 8.0% and the cost of equity is 15%.] WACC = 40 160 × 8.0% × (1 − .35) + 120 160 × 15% = 12.55% c. Annual tax shield = .35 × Interest expense = .35 × (.08 × $40) = $1.12 PV tax shield = $1.12 × annuity factor(8%, 5 years) = $4.47 The total value of the firm falls by $14 – $4.47 = $9.53, from $160 to $150.47. 25. Firms operating close to bankruptcy face two general types of problems. First, other firms they do business with will try to protect themselves, in the process, impeding the firm’s business. For example, suppliers will not be willing to extend credit to the firm. Banks and other lenders will be less willing to lend money even if the firm has identified attractive investment opportunities. In addition, as the firm nears bankruptcy, its own incentives to invest become distorted. The firm may inappropriately favor high-risk investments, reasoning that the creditors bear a large portion of the risk. Or the firm may be less willing to raise new equity to finance a project, reasoning that if the firm goes under, the debtholders will capture all or part of the new funds raised. 26. a. If SOS runs into financial difficulties, the additional funds contributed by the equityholders to pay for the new project will end up being available to pay the debtholders. To the extent that the financing for the new project increases the value of debt, it represents a transfer of wealth from stockholders to bondholders. b. If the new project is sufficiently risky, it may increase the expected payoff to equity holders. To see this, imagine the following extreme case: The face value of SOS’s debt is $100 and the market value of its assets is $90. The 16-9 assets are risk free and therefore SOS is certain to default and the equity currently is valueless. But suppose the stockholders use $10 of the firm’s cash to invest in a very risky new project. The project will pay off $100 with probability .09 and $0 with probability .91. (Notice that the expected payoff from the project is $9, which is less than its cost: project NPV is negative.) If the project is successful, the assets of the firm will be $190, and the equity holders will have a claim worth $90. Therefore, if they pursue the project, their expected payoff is .09 × $90 = $8.10. The project is a long shot, but it is obviously preferable to the equityholders’ current position in which they are guaranteed to receive nothing. 27. Financial distress can lead to distorted investment incentives. For example, a firm in distress might be tempted to engage in a highly risky negative-NPV venture, reasoning that the bondholders bear the risk if things go poorly but the equity- holders keep the upside if things go well. (This was called “bet the bank’s money” in the text.) Or, a firm on the brink of insolvency might be unwilling to engage in a positive-NPV venture if it requires additional capital, reasoning that even if the project goes well, the firm’s creditors will capture much of the returns. (This was called “don’t bet your own money” in the text.) These conflicts of interest lead to costs of financial distress since the potential for poor decisions (which reduce firm value) is reflected in the stock price that investors see as reasonable for the firm. 28. There are several reasons why this may be so: (a) Courts do not always follow the absolute priority rule, and there is therefore a chance that equityholders may end up with something. (b) Equityholders can play for time. In particular, debtholders may consent to a reorganization in which equityholders receive some continuing interest if the equityholders promptly agree to the overall reorganization plan, thus speeding its approval. (c) The courts have power to impose reorganization plans on limited groups of creditors. (d) Sometimes, profitable firms file for bankruptcy to escape paying costly contractors or suits. 29. The computer software company would experience higher costs of distress if its business became shaky. Its assets – largely the skills of its trained employees – are intangible. In contrast, the shipping company could sell off some of its assets if demand for its product was slack. In the event of financial distress, the shipping company would find a market in which it could sell off its assets. This is not true of the software company. 16-10 30. a. V = EBIT(1 − Tc) r = 25,000(1 − .35) .10 = $162,500 b. The value of the firm increases by the present value of the interest tax shield, or .35 × $50,000 = $17,500. c. The expected cost of bankruptcy is .30 × $200,000 = $60,000. The present value of this cost is $60,000/(1.10)3 = $45,079. Since this is greater than the PV of the potential tax shield, the firm should not issue the debt. 31. Alpha Corp will have higher profitability and therefore will be able to rely to a greater extent on internal finance (retained earnings) as a source of capital. It will therefore have less dependence on debt, and will have the lower debt ratio. 32. Sealed Air started with considerable financial slack. Unlike most firms, it actually was a net lender. The value of such slack is that it could enable the firm to take advantage of any investment opportunities that might arise without the need to raise funds in the securities market. However, top management realized that there could be too much slack in that managers had become complacent about seeking to enhance efficiency. The dramatic change in capital structure put the firm under great pressure to enhance efficiency, and employees responded to the new pressure. The success of the restructuring says that, even in a pecking order world, there may be a tradeoff between the advantages of slack and the incentive effects of debt. We would not recommend that all firms restructure as Sealed Air did. This restructuring made sense because the firm had an unusual amount of slack to start with, and top management felt that it had an unusual amount of room for improvement in employees’ sense of urgency toward instituting productive change. 33. Debt ratio of Magna International - 2008 = debt/ (debt + equity) = $6,099,000/($6,099,000 + $7,249,000) = 0.46 Market Value of debt ratio – 2008 = debt/ (debt + market value of equity) = $6,099,000/($6,099,000 + $3,079,440) = 0.66 In this instance, as market value of equity is lower than its book value, debt increases as a proportion of the firm’s value when we switch from book to market value of equity. 16-11 Note: Mkt. Value of equity (in thousands) = (112,800 shares x $27.30 = $3,079,440). Average number of shares was taken from the 2008 annual report and the average share price is the average monthly adjusted closing price. 34. Let us, for example examine some relevant financial ratio information for Hertz Global Holdings (HTZ) for the period of 2007-2010. We discuss ratios in depth in Chapter 17 so you may want to read up on this Chapter before you attempt this question. The liquidity ratios for the company as represented by the current, quick, and cash ratios were high in 2007 and 2008 with a sharp decrease in 2009 followed by a slight increase in 2010. The profitability ratios such as, net profit and pretax profit margin were positive in 2007, however, they turned to negative in 2008, followed by an increase in 2009 and 2010. Also, the returns ratios (pre-tax ROE and after-tax ROE) show similar trends. Overall these figures suggests a trend towards a potential financial distress in 2008 followed by a recovery during 2009 and 2010. When you examine relevant financial information for the other two companies listed in the question, you may find similar trends for these companies as well. 35. a. Present value of interest tax shield = long-term debt x tax rate. IBM PV interest tax shield = $21.846 billion x 0.34 = $7.43 billion PV interest tax shield with an additional $3 billion in long-term debt = $24.846 x 0.34 = $8.45 billion Pepsi PV interest tax shield = $19.999 billion x 0.34 = $6.80 billion PV interest tax shield with an additional $3 billion in long-term debt = $22.999 x 0.34 = $7.82 billion By increasing the long-term debt the interest tax shield will increase. b. The trade-off theory predicts that firms with safe, tangible assets and lots of tangible income to shield should have higher debt ratios. On the other hand, unprofitable firms with risky, intangible assets should rely more on equity financing and have low debt ratios. Pecking order theory predicts that most profitable firms have less need for external funds and, therefore, borrow less. On the other hand, less profitable firms issue debt because they do not have sufficient funds for their capital investment programs and because debt is first in the pecking order for external financing. 16-12 When we look at the long term debt to equity ratios for different industry sectors through the Yahoo Finance site (as of September 2011) we find that while some industries seem to substantiate the trade-off theory, others substantiate the pecking order theory. 36. a Stockholders gain and bondholders lose. Bond value falls because the value of assets securing the bond has fallen. b. If we assume the cash is left in Treasury bills, then bondholders gain. The bondholders are sure to get $26 plus interest. This is better than the $25 market value of the debt. Stockholders lose; in fact stock value falls to zero, because there is now no chance that firm value can rise above the $50 face value of the debt. c. The bondholders lose and the stockholders gain. The firm adds assets worth $10 and debt worth $10. This increases the debt ratio, leaving the old bondholders more exposed. The old bondholders’ loss is the stockholders’ gain. d. The original stockholders lose and bondholders gain. There are now more assets backing the bondholders’ claim. Since the bonds are worth more, the market value of all outstanding stock must have increased by less than the additional investment in the firm. This implies a loss to stockholders. However, because the new stockholders will invest only if they receive stock with value at least equal to their investment, the loss must be borne by the old shareholders. 37. a. Masulis’s results are consistent with the view that debt is always preferable because of its tax advantage, but are not consistent with the trade-off theory, which holds that management strikes a balance between the tax advantage of debt and the costs of possible financial distress. In the trade-off 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. b. The results are consistent with the evidence on the announcement effects of security issues and repurchases. You can view a debt-for-equity exchange as equivalent to two separate transactions: (i) issue debt (no news) and (ii) repurchase stock (good news). 38. Suppose the firm has assets in place that can generate cash flows with present value of $100 million, but the market believes the assets are actually worth $110 million. If there are 1 million shares outstanding, the shares will sell for $110. The managers (but not the shareholders) know that the stock price will fall to $100 when the 16-13 market reassesses the value of the firm’s project. But if the firm issues new shares while the stock is overpriced, this can benefit the current shareholders. Suppose the firm sells an additional 100,000 shares at $110 and invests the proceeds in a zero-NPV project. The new project is thus worth exactly $11 million (i.e. $110 × 100,000 shares). Now look at the market value balance sheet of the firm after the market reassesses the value of the firm (therefore using the true value of the original assets) and assuming there is no debt outstanding: Assets Liabilities & shareholders’ equity Original assets $100 New assets $ 11 Shareholders’ equity $111 There are now 1.1 million shares outstanding, so the price per share is $111/1.1 = $100.91. The original shareholders now have a claim worth 1 million × $100.91 = $100.91 million, while the new shareholders have a claim worth 100,000 × $100.91 = $10.09 million. Thus the total gain to the original shareholders is $.91 million (the true value of the firm was originally $100 million, but the value of their shares is now $100.91 million), while the new shareholders lose $.91 million (they paid $11 million for shares worth only $10.09 million). This transfer of wealth occurs because the new shareholders invested when the shares were overpriced. 39. Because debtholders share in the success of the firm only to a minimal extent (i.e., to the extent that bankruptcy risk falls), an issue of debt is not usually taken as a signal that a firm’s management has concluded that the market is overvaluing the firm. Thus debt issues are not signals of the firm’s future success and they therefore do not induce investors to reassess the value of the firm. 40. Suppose the firm’s tax bracket is 35% while shareholders’ tax bracket is 28%. The firm has EBIT per share of $5. Compare two situations, one in which the interest on the firm’s borrowing is $1 per share, the other in which the investor has borrowed and pays an amount of interest equal to $1 per share. In the case that the firm has not borrowed, but the investor has, the investor’s total after-tax income (on a per share basis) is computed as follows: EBIT $5.00 Taxes 1.75 Net income earned per share 3.25 Less interest per share paid by investor (after tax) 0.72 [ = $1 × (1 − .28)] Net income earned per share $2.53 16-14 Now consider the case that the firm has borrowed and pays interest of $1 per share, but the investor has not borrowed: EBIT $5.00 Interest paid 1.00 Taxable income 4.00 Taxes 1.40 Net income earned per share $2.60 Total after-tax income going to the investor is $.07 per share higher when the firm, rather than the investor, borrows. This is because the difference in the tax rate is 7% (i.e., 35% – 28%). The difference in the tax payments going to the government is $.07 per dollar of interest paid. When individuals are in a lower tax bracket than the firm is, there is an advantage to switching borrowing from the individual to the firm. 41. If there is a tax advantage to firm borrowing, there must be a symmetric disadvantage to firm lending. If the firm lends, it pays taxes on its interest income. If its tax bracket is higher than the personal bracket of the shareholder, then lending increases the total tax burden. If the shareholders were to lend instead, the tax rate on the interest income would be less than the 35% tax rate paid by the firm on the interest income. 16-15 Solution to Mini-case, Chapter 16 First we confirm some of the numbers cited in the case: Market value of bonds: $162 million [n = 20; PMT = 10; FV = 100; i = 5%; implies PV = 162.] Value of shares = $10 × 10 million = $100 million Long-term debt ratio = 162/(100 + 162) = .62 With additional borrowing of $15 million, the long-term debt ratio will increase to 177/(100 + 177) = .64 Solution At a debt ratio of 62%, a firm in an industry with volatile profits probably should not issue much more debt. (The 45% debt ratio cited by the chief executive is based on book values of debt and equity.) A $15 million increase in debt would increase the debt ratio to 64%. Johnson’s arguments are based on the pecking order theory of capital structure. He is right that investors may interpret an issue of stock as a signal that management views shares as currently overpriced. If the stock price declines at the announcement of the equity offer, equity would indeed be a very expensive source of financing. Explaining the reasons for the equity offer to investors will go only so far. Actions speak louder than words; a concrete signal of management’s confidence in the firm would be more helpful. Thus, Johnson’s suggestion of a dividend increase makes sense. If management commits to the higher dividend level, it must anticipate that the firm will generate enough cash flow to pay the dividend. Otherwise, the firm will have to make repeated costly trips to the capital market to raise the additional cash necessary to pay the dividends. Thus, an increase in dividends would corroborate management’s stated belief that the firm is doing well, and should serve to mitigate investors’ fears that an equity issue is a bad signal. LA’s chief executive raises several false concerns about the equity issue. The fact that the stock price is down relative to recent levels does not make equity a more expensive source of financing. Equity is more expensive only if management has reasons to believe (reasons not also known to public investors) that the stock price has fallen too much and will soon recover. Similarly, the dividend yield on the stock does not indicate whether equity is an expensive source of financing. The dividend yield does not indicate anything about the expected total rate of return investors expect on the equity. That rate of return includes 16-16 capital gains, and is not affected by how the return is divided between capital gains and dividends. Moreover, according to the Modigliani-Miller propositions, even if equity has a higher expected rate of return than debt, it is not a more expensive source of financing. Debt has an implicit cost that LA’s chief executive does not recognize: the issue of more debt makes both the existing debt and the existing equity riskier. So the observation that the yield to maturity on the firm’s bonds is only 5% is irrelevant to the issue of whether equity or debt is the better financing alternative. Nor is the chief executive’s concern about the book value of the equity warranted. This value has nothing to do with the value of the firm as an ongoing business. As long as the stock is fairly priced, the firm will be issuing equity at fair terms. Changes in the book value per share of equity — the chief executive’s concern about dilution — have no effect on the share price or stockholders’ wealth. To calculate the required rate of return on the new planes, we use the weighted average cost of capital. Market values of financing sources are as follows: Debt: $50 million bank loan + $162 million bonds = $212 million Equity: Value of shares = $10 × 10 million = $100 million Therefore, debt (including short-term debt) comprises 212/312 = 67.9% of total financing, and equity is 32.1% of financing. The expected return on debt is 5% and the expected return on equity is (using data from the notes to the financial statements) rf + β(rm – rf) = 4% + 1.25 × 8% = 14%. Therefore, WACC = .679 × 5% × (1 – .35) + .321 × 14% = 6.70% A slightly more sophisticated approach to calculating WACC would recognize that when calculating the company’s capital structure, the company’s $20 million cash holdings should be netted out against the bank loan. In that case, net debt equals $212 – 20 = $192 million, so debt (including short-term debt) comprises 192/(192 + 100) = 65.8% of total financing, and equity is 34.2% of financing. Therefore, WACC = .658 × (1 – .35) × 5% + .342 × 14% = 6.93% 16-17 Solution Manual for Fundamentals of Corporate Finance Richard A. Brealey, Stewart C. Myers, Alan J. Marcus, Elizabeth Maynes, Devashis Mitra 9780071320573, 9781259272011
Download
Close
Close
