CH-18-20 Dividends and Other Payouts – Corporate Finance : Book Guide

This Document Contains Chapters 18 to 20 Chapter 18 Dividends and Other Payouts 1. A cash dividend is a payment of cash to the shareholders of a company. This payment may be once, twice or four times a year. A stock dividend replaces cash with equity, which means that no cash leaves the firm. 2. The share price may not fall as much as the dividend because of market inefficiencies. For example, the investors in some markets may not correctly value the company without the cash. Alternatively, taxes may cause the share price not to fall as much as it should. Similarly, other transaction costs may mean that the share price does not move continuously but in discrete jumps. 3. Dividend policy deals with the timing of dividend payments, not the amounts ultimately paid. Dividend policy is irrelevant when the timing of dividend payments doesn’t affect the present value of all future dividends. 4. A share repurchase reduces equity while leaving debt unchanged. The debt ratio rises. A firm could, if desired, use excess cash to reduce debt instead. This is a capital structure decision. 5. Individuals face taxation from their investments in two ways. Tax on capital gains relates to the tax paid when an investor sells their shares at a profit. Tax on income relates to the tax paid when an investor receives dividends. Because an investor can put off selling their shares for a long time, the effective tax rate on capital gains is almost always lower than the tax rate on income. Given that dividends are taxed at the income tax rate, they are disadvantaged compared to capital gains. A tax free financial institution may still be interested in dividend policy because if the market values dividend paying firms at a discount (because of the tax disadvantage), a tax-free institution could buy up cheap dividend paying equities and not be affected by the dividends. In equilibrium, excess demand from tax free institutions would drive up the share price of these companies until they are fairly priced. 6. There are a number of reasons why firms pay dividends. First is that many individuals desire current income rather than future income. Periodic dividends provide this without the hassle of selling shares. Dividends can also act as an efficient monitoring mechanism. If firms have excess cash, they may waste it on poor investments. By distributing the cash as dividends, they have to be more disciplined in their decision-making. High dividends also act as a signal to investors that the company is able to maintain this high level of payment, which is obviously good news. This Document Contains Chapters 18 to 20 7. Some participants in the financial markets prefer dividends (low-tax paying institutions) and others prefer capital gains (high tax paying individuals). In equilibrium, the appropriate proportion of firms will pay dividends and not pay dividends. A firm changing its dividend policy will not experience any gains because it is moving from one clientele to another, where demand has already been satiated. 8. The Catering Theory of Dividends predicts that firms will rationally respond to changing market preferences and pay dividends when dividend paying firms are in demand and stop paying dividends when low or non-dividend paying firms are in demand. 9. Dividend policy is important in practice because of the amount of attention that firms focus on the dividend policy decision. If it was irrelevant, there wouldn’t be any news about a cut or increase in dividends. 10. Although reverse splits should not have an impact on the value of a company’s shares, it may actually do so because of inefficiencies in the market. If the reverse split puts the share price in a range where most investors trade, the demand for the company’s shares may increase. Alternatively, the higher price means that less shares are traded and this may reduce transaction costs. Another reason links into behavioural finance whereby investors irrationally viewed low-priced shares as poor quality. Finally, some stock exchanges have minimum price levels. If a firm’s share price drops below this threshold, a reverse split will bring it back into the acceptable range. 11. The chief drawback to a strict dividend policy is the variability in dividend payments. This is a problem because investors tend to want a somewhat predictable cash flow. Also, if there is information content to dividend announcements, then the firm may be inadvertently telling the market that it is expecting a downturn in earnings prospects when it cuts a dividend, when in reality its prospects are very good. In a compromise policy, the firm maintains a relatively constant dividend. It increases dividends only when it expects earnings to remain at a sufficiently high level to pay the larger dividends, and it lowers the dividend only if it absolutely has to. 12. a) The investor’s argument only makes sense if dividends are taxed differently from capital gains, and the investor is in a tax bracket where this is important. Otherwise, it should not be viewed as an important factor. b) The main argument should be that the investor can recreate any cash flow stream from selling shares in Bodyswerve to replicate dividend payments from the firm. c) Again, tax considerations would be brought into play. It could also be argued that dividends impose discipline on the management of Bodyswerve because the requirement to pay out dividends means that the firm does not waste spare cash. 13. This question solely relies on the tax laws of the country in which the investor resides. If dividend income is taxed at a higher rate than capital gains, then non-dividend stocks should be chosen. In contrast if capital gains is taxed at a higher rate then dividend-paying stocks should be chosen. In most countries the effective capital gains tax is lower than income tax and so non-dividend paying stocks should be targeted. 14. Several explanations have been proposed for why dividend paying stocks are more attractive in some countries than others. One reason is that countries with poor investor protection have higher dividends because investors prefer to have their cash to invest themselves rather than the managers of the firm. Another is investor sophistication, where the concept of homemade dividends is not well-known. Other explanations are given in the chapter. 15. The statement does not make sense because the firm will find it exceptionally difficult to maintain dividends if they only increase and never decrease. 16. This finding implies that firms use initial dividends to “signal” their potential growth and positive NPV prospects to the stock market. The initiation of regular cash dividends also serves to convince the market that their high current earnings are not temporary. It says nothing about dividend policy in itself. 17. The ex-dividend price will be (£8.40 - £2 = ) £6.40. 18. a. The shares outstanding increases by 10 percent, so: New shares outstanding = 10,000(1.10) = 11,000 New shares issued = 1,000 Since the par value of the new shares is £1, the additional paid in capital per share is £24. The total additional paid in capital is therefore: Ordinary Shares (£1 par value) £11,000 Additional Paid in Capital £204,000 Retained Earnings £561,500 Total Owners' Equity £776,500 b. The shares outstanding increases by 25 percent, so: New shares outstanding = 10,000(1.25) = 12,500 New shares issued = 2,500 Since the par value of the new shares is £1, the additional paid in capital per share is £24. The total additional paid in capital is therefore: Additional Paid in Capital on new shares = 2,500(£24) = £60,000 Ordinary Shares (£1 par value) £12,500 Additional Paid in Capital £240,000 Retained Earnings £524,000 Total Owners' Equity £776,500 19. a. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so: New shares outstanding = 10,000(4/1) = 40,000 The equity accounts are unchanged except that the par value of the equity is changed by the ratio of new shares to old shares, so the new par value is: New par value =£1(1/4) = £0.25 per share. b. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so: New shares outstanding = 10,000(1/5) = 2,000. The equity accounts are unchanged except that the par value of the equity is changed by the ratio of new shares to old shares, so the new par value is: New par value = £1(5/1) = £5.00 per share. 20. To find the new share price, we multiply the current share price by the ratio of old shares to new shares, so: a. £5.16(2/3) = £3.44 b. £5.16(1/1.08) = £4.78 c. £5.16(1/1.20) = £4.30 d. £5.16(3/2) = £7.74 To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so: a: 2.4(5/3) = 3.6 million b: 2.4(1.08) = 2.592 million c: 2.4(1.20) = 2.88 million d: 2.4(2/3) = 1.6 million 21. The stock price is the total market value of equity divided by the shares outstanding, so: P0 = £4,022 equity/2,400 shares = £1.68 per share Ignoring tax effects, the share price will drop by the amount of the dividend, so: PX = £1.68 – £0.61 = £1.07 per share The total dividends paid will be: £0.61 per share (2.4 billion shares) = £1.464 billion The equity and cash accounts will both decline by £1.464 billion. 22. Repurchasing the shares will reduce shareholders’ equity by £1 billion. The shares repurchased will be the total purchase amount divided by the share price, so: Shares bought = £1 billion/£1.68 = 595.238 million shares And the new shares outstanding will be: New shares outstanding = 2,400 million – 595.238 million = 1,805 million shares After repurchase, the new share price is: Share price = £3,022/1,805 shares = £1.68 per share b. The repurchase is effectively the same as the cash dividend because you either hold a share worth £1.68, or a share worth £1.07 and £0.61 in cash. Therefore, you participate in the repurchase according to the dividend payout percentage; you are unaffected. 23. The share price is the total market value of equity divided by the shares outstanding, so: P0 = R5,047,500 equity/15,000 shares = R336.50 per share The shares outstanding will increase by 20 percent, so: New shares outstanding = 15,000(1.20) = 18,000 The new share price is the market value of equity divided by the new shares outstanding, so: PX = R5,047,500/18,000 shares = R280.41 24. With a stock dividend, the shares outstanding will increase by one plus the dividend amount, so: New shares outstanding = 350,000(1.12) = 392,000 The additional paid in capital is the capital paid in excess of par value, which is €1, so: Additional paid in capital for new shares = 42,000(€19) = €798,000 The new additional paid in capital will be the old additional paid in capital plus the additional paid in capital for the new shares, so: Additional paid in capital = €1,650,000 + €798,000 = €2,448,000 The new equity portion of the balance sheet will look like this: Ordinary Shares (€1 par value) € 392,000 Additional Paid in Capital 2,448,000 Retained earnings 2,160,000 Total owners' equity €5,000,000 25. The only equity account that will be affected is the par value of the equity. The par value will change by the ratio of old shares to new shares, so: New par value = €1(1/5) = €0.20 per share. The total dividends paid this year will be the dividend amount times the number of shares outstanding. The company had 350,000 shares outstanding before the split. We must remember to adjust the shares outstanding for the stock split, so: Total dividends paid this year = €0.70(350,000 shares)(5/1 split) = €1,225,000 The dividends increased by 10 percent, so the total dividends paid last year were: Last year’s dividends = €1,225,000/1.10 = €1,113,636.36 And to find the dividends per share, we simply divide this amount by the shares outstanding last year. Doing so, we get: Dividends per share last year = €1,113,636.36/350,000 shares = €3.18 26. The equity portion of capital outlays is the retained earnings. Subtracting dividends from net income, we get: Equity portion of capital outlays = £524,292 – £50,000 = £474,292 Since the debt-equity ratio is 0.60, we can find the new borrowings for the company by multiplying the equity investment by the debt-equity ratio, so: New borrowings = 0.60(£474,292) = £284,575.2 And the total capital outlay will be the sum of the new equity and the new debt, which is: Total capital outlays = £474,292 +£284,575.2 = £758,867.2 27. a. The payout ratio is the dividend per share divided by the earnings per share, so: Payout ratio = SFr1.50/SwFr14 Payout ratio = 0.1071 or 10.71% b. Under a residual dividend policy, the additions to retained earnings, which is the equity portion of the planned capital outlays, is the retained earnings per share times the number of shares outstanding, so: Equity portion of capital outlays = 12 million shares (SFr14 – 1.50) = SFr150 million This means the total investment outlay will be: Total investment outlay = SFr150 million+ SFr25 million Total investment outlay = SFr175 million The debt-equity ratio is the new borrowing divided by the new equity, so: D/E ratio = SFr25 million/SFr150 million= 0.16667 28. a. Since the company has a debt-equity ratio of 3, they can raise £3 in debt for every £1 of equity. The maximum capital outlay with no outside equity financing is: Maximum capital outlay = £180,000 + 3(£180,000) = £720,000. b. If planned capital spending is £760,000, then no dividend will be paid and new equity will be issued since this exceeds the amount calculated in a. c. No, they do not maintain a constant dividend payout because, with the strict residual policy, the dividend will depend on the investment opportunities and earnings. As these two things vary, the dividend payout will also vary. 29. a. We can find the new borrowings for the company by multiplying the equity investment by the debt-equity ratio, so we get: New debt = 2(€56M) = €112M Adding the new retained earnings, we get: Maximum investment with no outside equity financing = €56M + 2(€56M) = kr168M b. A debt-equity ratio of 2 implies capital structure is 2/3 debt and 1/3 equity. The equity portion of the planned new investment will be: Equity portion of investment funds = 1/3(€72M) = €24M This is the addition to retained earnings, so the total available for dividend payments is: Residual = €56M – €24M = €32M This makes the dividend per share: Dividend per share = €32M/12M shares = €2.67 c. The borrowing will be: Borrowing = €72M – €24M = €48M Alternatively, we could calculate the new borrowing as the weight of debt in the capital structure times the planned capital outlays, so: Borrowing = 2/3(€72M) = €48M The addition to retained earnings is €24M, which we calculated in part b. d. If the company plans no capital outlays, no new borrowing will take place. The dividend per share will be: Dividend per share = €56M/12M shares = €4.67 30. a. If the dividend is declared, the share price will drop on the ex-dividend date by the value of the dividend, £5. It will then trade for £95. b. If it is not declared, the price will remain at £100. In one year, the total income to shareholders must be 10% (the discount rate or cost of capital) and so the price should be £110 if no dividend is paid. c. Mann’s outflows for investments are £2,000,000. These outflows occur immediately. One year from now, the firm will realize £1,000,000 in net income and it will pay £500,000 in dividends, but the need for financing is immediate. Mann must finance £2,000,000 through the sale of shares worth £100. It must sell £2,000,000 / £100 = 20,000 shares. d. The MM model is not realistic since it does not account for taxes, brokerage fees, and uncertainty over future cash flows, investors’ preferences, signaling effects, and agency costs. 31. The share price today is the PV of the dividends, so: P0 = £0.25/1.18 + £0.75/1.182 = £0.7505 To find the equal two year dividends with the same present value as the share price, we set up the following equation and solve for the dividend (Note: The dividend is a two year annuity, so we could solve with the annuity factor as well): £0.7505 = D/1.18 + D/1.182 D = £0.4793 We now know the cash flow per share we want each of the next two years. We can find the share price in one year, which will be: P1 = £0.75/1.18 = £0.636 Since you own 2,000 shares, in one year you want: Cash flow in year one = 2,000(£0.4793) = £958.71 But you’ll only get: Dividends received in one year = 2,000(£.25) = £500 Thus, in one year you will need to sell additional shares in order to increase your cash flow. The number of shares to sell in year one is: Shares to sell at time one = (£958.71 – £500)/£0.636 = 721.7071 shares. At Year two, your cash flow will be the dividend payment times the number of shares you still own, so the Year two cash flow is: Year two cash flow = £0.75(2,000 – 721.7071) = £958.71 32. If you only want £0.20 in Year one, you will buy: (£500 – £400)/£0.636 = 157.33 shares at Year one. Your dividend payment in Year two will be: Year two dividend = (2,000 + 157.33)(£.75) = £1,618 Note that the present value of each cash flow stream is the same. Below we show this by finding the present values as: PV = £400/1.18 + £1,618/1.182 = £1,501 PV = 2,000(£0.25)/1.18 + 2,000(£0.75)/1.182 = £1,501 33. a. If the company makes a dividend payment, we can calculate the wealth of a shareholder as: Dividend per share = €5,000/200 shares = €25 The share price after the dividend payment will be: PX = €40 – €25 = €15 per share The shareholder will have equity worth €15 and a €25 dividend for a total wealth of €40. If the company makes a repurchase, the company will repurchase: Shares repurchased = €5,000/€40 = 125 shares If the shareholder lets their shares be repurchased, they will have €40 in cash. If the shareholder keeps their shares, they’re still worth €40. b. If the company pays dividends, the current EPS is €0.95, and the P/E ratio is: P/E = €15/€0.95 = 15.79 If the company repurchases shares, the number of shares will decrease. The total net income is the EPS times the current number of shares outstanding. Dividing net income by the new number of shares outstanding, we find the EPS under the repurchase is: EPS = €0.95(200)/(200 − 125) = €2.53 The share price will remain at €40 per share, so the P/E ratio is: P/E = €40/€2.53 = 15.79 A share repurchase would seem to be the preferred course of action. Only those shareholders who wish to sell will do so, giving the shareholder a tax timing option that he or she doesn’t get with a dividend payment. 34. a. Since the firm has a 100 percent payout policy, the entire net income, DKr32,000 will be paid as a dividend. The current value of the firm is the discounted value one year from now, plus the current income, which is: Value = Dkr32,000 + DKr1,545,600/1.12 Value = DKr1,412,000 b. The current share price is the value of the firm, divided by the shares outstanding, which is: Stock price = DKr1,412,000/10,000 Stock price = DKr141.20 Since the company has a 100 percent payout policy, the current dividend per share will be the company’s net income, divided by the shares outstanding, or: Current dividend = DKr32,000/10,000 Current dividend = DKr3.20 The share price will fall by the value of the dividend to: Ex-dividend stock price = DKr141.20 – DKr 3.20 Ex-dividend stock price = DKr138.00 c. i. According to MM, it cannot be true that the low dividend is depressing the price. Since dividend policy is irrelevant, the level of the dividend should not matter. Any funds not distributed as dividends add to the value of the firm, hence the share price. These directors merely want to change the timing of the dividends (more now, less in the future). As the calculations below indicate, the value of the firm is unchanged by their proposal. Therefore, the share price will be unchanged. To show this, consider what would happen if the dividend were increased to DKr4.25. Since only the existing shareholders will get the dividend, the required kroner amount to pay the dividends is: Total dividends = DKr4.25(10,000) Total dividends = DKr42,500 To fund this dividend payment, the company must raise: Kroner raised = Required funds – Net income Kroner raised = DKr42,500 – DKr 32,000 Kroner raised = DKr10,500 This money can only be raised with the sale of new equity to maintain the all-equity financing. Since those new shareholders must also earn 12 percent, their share of the firm one year from now is: New shareholder value in one year = DKr10,500(1.12) New shareholder value in one year = DKr11,760 This means that the old shareholders' interest falls to: Old shareholder value in one year = DKr1,545,600 – DKr 11,760 Old shareholder value in one year = DKr1,533,840 Under this scenario, the current value of the firm is: Value = DKr42,500 + DKr1,533,840/1.12 Value = DKr1,412,000 Since the firm value is the same as in part a, the change in dividend policy had no effect. ii. The new shareholders are not entitled to receive the current dividend. They will receive only the value of the equity one year hence. The present value of those flows is: Present value = DKr1,533,840/1.12 Present value = DKr1,369,500 And the current share price will be: Current share price = DKr1,369,500/10,000 Current share price = DKr136.95 So, the number of new shares the company must sell will be: Shares sold = DKr10,500/DKr136.95 Shares sold = 76.67 shares 35. a. The current price is the current cash flow of the company plus the present value of the expected cash flows, divided by the number of shares outstanding. So, the current share price is: Stock price = (£4,200,000 + £72,000,000) / 1,000,000 Stock price = £76.20 b. To achieve a zero dividend payout policy, you can invest the dividends back into the company’s equity. The dividends per share will be: Dividends per share = [(£4,200,000)(.40)]/1,000,000 Dividends per share = £1.68 And the shareholder in question will receive: Dividends paid to shareholder = £1.68(1,000) Dividends paid to shareholder = £1,680 The new share price after the dividends are paid will be: Ex-dividend share price = £76.20 – £1.68 Ex-dividend share price = £74.52 So, the number of shares the investor will buy is: Number of shares to buy = £1,680 / £74.52 Number of shares to buy = 22.54 36. a. Using the formula from the text proposed by Lintner: Div1 = Div0 + s(t EPS1 – Div0) Div1 = €1.25 + .3[(.4)(€4.50) – €1.25] Div1 = €1.415 b. Now we use an adjustment rate of 0.60, so the dividend next year will be: Div1 = Div0 + s(t EPS1 – Div0) Div1 = €1.25 + .6[(.4)(€4.50) – €1.25] Div1 = €1.58 c. The lower adjustment factor in part a is more conservative. The lower adjustment factor will always result in a lower future dividend. 37. Assuming no capital gains tax, the after-tax return for the Gordon Company is the capital gains growth rate, plus the dividend yield times one minus the tax rate. Using the constant growth dividend model, we get: After-tax return = g + D(1 – t) = .15 Solving for g, we get: .15 = g + .06(1 – .125) g = .0975 The equivalent pretax return for Gecko Company, which pays no dividend, is: Pre-tax return = g + D = .0975 + .06 = 15.75% 38. Using the equation for the decline in the share price ex-dividend for each of the tax rate policies, we get: (P0 – PX)/D = (1 – tP)/(1 – tG) a. P0 – PX = D(1 – 0)/(1 – 0) P0 – PX = D b. P0 – PX = D(1 – .15)/(1 – 0) P0 – PX = .85D c. P0 – PX = D(1 – .15)/(1 – .20) P0 – PX = 1.0625D d. Since different investors have widely varying tax rates on ordinary income and capital gains, dividend payments have different after-tax implications for different investors. This differential taxation among investors is one aspect of what we have called the clientele effect. 39. Since the £2,000,000 cash is after corporate tax, the full amount will be invested. So, the value of each alternative is: Alternative 1: The firm invests in financial assets, and then pays out as special dividend in 3 years If the firm invests in T-Bills: If the firm invests in T-bills, the after-tax yield of the T-bills will be: After-tax corporate yield = .07(1 – .28) After-tax corporate yield = .0504 or 5.04% So, the future value of the corporate investment in T-bills will be: FV of investment in T-bills = £2,000,000(1 + .0504)3 FV of investment in T-bills = £2,317,897 Since the future value will be paid to shareholders as a dividend, the aftertax cash flow will be: After-tax cash flow to shareholders = £2,317,897(1 – .125) After-tax cash flow to shareholders = £2,028,160 If the firm invests in preference shares: If the firm invests in preference shares, the assumption would be that the dividends received will be reinvested in the same preference shares. The preference shares will pay a dividend of: Preferred dividend = .11(£2,000,000) Preferred dividend = £220,000 And the taxes the company must pay on the preferred dividends will be: Taxes on preferred dividends = .28(£220,000) Taxes on preferred dividends = £61,600 So, the after-tax dividend for the corporation will be: After-tax corporate dividend = £220,000 – £61,600 After-tax corporate dividend = £158,400 This means the after-tax corporate dividend yield is: After-tax corporate dividend yield =£158,400 / £2,000,000 After-tax corporate dividend yield = .0792 or 7.92% The future value of the company’s investment in preference shares will be: FV of investment in preferred stock =£2,000,000(1 + .0792)3 FV of investment in preferred stock = £2,513,829 Since the future value will be paid to shareholders as a dividend, the aftertax cash flow will be: After-tax cash flow to shareholders = £2,513,829(1 – .125) After-tax cash flow to shareholders = £2,199,601 Alternative 2: The firm pays out dividend now, and individuals invest on their own. The after-tax cash received by shareholders now will be: After-tax cash received today = £2,000,000(1 – .125) After-tax cash received today = £1,750,000 The individuals invest in Treasury bills: If the shareholders invest the current after-tax dividends in Treasury bills, the after-tax individual yield will be: After-tax individual yield on T-bills = .07(1 – .4) After-tax individual yield on T-bills = .042 or 4.2% So, the future value of the individual investment in Treasury bills will be: FV of investment in T-bills = £1,750,000(1 + .042)3 FV of investment in T-bills =£1,979,891 The individuals invest in preference shares: If the individual invests in preference shares, the assumption would be that the dividends received will be reinvested in the same preference shares. The preference shares will pay a dividend of: Preferred dividend = .11(£1,750,000) Preferred dividend = £192,500 And the taxes on the preferred dividends will be: Taxes on preferred dividends = .40(£192,500) Taxes on preferred dividends = £77,000 So, the after-tax preferred dividend will be: After-tax preferred dividend = £192,500 – £77,000 After-tax preferred dividend = £115,500 This means the after-tax individual dividend yield is: After-tax corporate dividend yield = £115,500 / £1,750,000 After-tax corporate dividend yield = .066 or 6.6% The future value of the individual investment in preference shares will be: FV of investment in preference shares = £1,750,000(1 + .066)3 FV of investment in preferred stock =£2,119,872 The after-tax cash flow for the shareholders is maximized when the firm invests the cash in the preference shares and pays a special dividend later. 40. a. Let x be the ordinary income tax rate. The individual receives an after-tax dividend of: After-tax dividend = £1,000(1 – x) Which she invests in Treasury bonds. The Treasury bond will generate after-tax cash flows to the investor of: After-tax cash flow from Treasury bonds = £1,000(1 – x)[1 + .08(1 – x)] If the firm invests the money, its proceeds are: Firm proceeds = £1,000[1 + .08(1 – .23)] And the proceeds to the investor when the firm pays a dividend will be: Proceeds if firm invests first = (1 – x){£1,000[1 + .08(1 – .23)]} To be indifferent, the investor’s proceeds must be the same whether she invests the after- tax dividend or receives the proceeds from the firm’s investment and pays taxes on that amount. To find the rate at which the investor would be indifferent, we can set the two equations equal, and solve for x. Doing so, we find: £1,000(1 – x)[1 + .08(1 – x)] = (1 – x){£1,000[1 + .08(1 – .23)]} 1 + .08(1 – x) = 1 + .08(1 – .23) x = .23 or 23% Note that this argument does not depend upon the length of time the investment is held. b. Yes, this is a reasonable answer. She is only indifferent if the after-tax proceeds from the £1,000 investment in identical securities are identical. That occurs only when the tax rates are identical. Chapter 19 Equity Financing 1. There are five steps in the public issue of equity. These steps are generalisations and therefore the exact process will differ from country to country. 1. Issue of pathfinder prospectus, 2. Pre-underwriting conferences, 3. Issue of the full prospectus, 4. The public offering and sale, and 5. The post offering stabilisation of prices. 2. Equity issues can be public or private. When public, the shares are offered in a public way to all investors. In a private equity issue, the shares are only offered to a small number of investors. Each issue is different and managers will choose that method that minimises the cost of capital. 3. Most issues are underpriced to induce investors to buy shares in the new offering. As it stands, there is no consensus on why this happens. An argument against market efficiency is that the issue would be sold at the correct value if the market was efficient. However, an alternative argument is that new issues have higher risk because of the lack of information about the company, no share price information, and prior trading history is very weak. This means that investors discount the new offering and the issue price is a rational valuation. Again, a counter-argument is that new offerings are mispriced because of unobservable risk characteristics. 4. There are several reasons why the share price may fall on the announcement of an equity issue. These are due to managerial asymmetric information, inferences that debt capacity may have been fully utilised, and the possibility that the equity has been raised to offset earnings shortfalls in the future. 5. This is covered in Section 19.5. The main costs of equity issues are 1) the spread or underwriting discount, 2) direct expenses of the issue, 3) indirect expenses, 4) abnormal returns on the announcement date, 5) under-pricing, and 6) the green shoe option held by underwriters. 6. Investors may not like shelf registration because it gives managers freedom to issue new shares in the future without first consulting them. In addition, shelf registration may create a market overhang in that the market will expect new issues to occur in the future, which would depress the price of the shares. If investors wish to stop shelf registration or make it more difficult, they could propose a resolution at the AGM that any new issue, shelf, public or private, first be cleared with shareholders. 7. The private equity market has many dimensions. Private equity may be driven by a management buyout, a private equity firm or from the major shareholder’s decision that stock market listing is not appropriate for the firm. Venture capital is also a part of the private equity market. Firms can also privately place their shares with a very small number of institutions. Firms choose private equity if they can raise money more cheaply than in public equity markets. 8. It is clear that the equity was sold too cheaply, so Unicredit had reason to be unhappy. 9. No, but, in fairness, pricing the equity in such a situation is extremely difficult. 10. It’s an important factor. Only 3.84 billion of the shares were underpriced. The other 5.4 billion were, in effect, priced completely correctly. 11. It is likely that the firm will have a requirement to issue shares to its own shareholders first before being allowed to issue them to the public. Even if this is not the case, the evidence suggests that a rights issue might be substantially cheaper than a public offer. However, their may be strategic considerations in having a public offer in Poland. For example, the firm may wish to raise its visibility in the country. 12. You could have done worse since your access to the oversubscribed and, presumably, underpriced issues was restricted while the bulk of your funds were allocated to equity from the undersubscribed and, quite possibly, overpriced issues. 13. a. The price will probably go up because IPOs are generally underpriced. This is especially true for smaller issues such as this one. b. It is probably safe to assume that they are having trouble moving the issue, and it is likely that the issue is not substantially underpriced. 14. Competitive offer and negotiated offer are two methods to select investment bankers for underwriting. Under the competitive offer, the issuing firm can award its securities to the underwriter with the highest bid, which in turn implies the lowest cost. On the other hand, in negotiated deals, the underwriter gains much information about the issuing firm through negotiation, which helps increase the possibility of a successful offering. 15. There are two possible reasons for share price drops on the announcement of a new equity issue: 1) Management may attempt to issue new shares when the equity is over-valued, that is, the intrinsic value is lower than the market price. The price drop is the result of the downward adjustment of the overvaluation. 2) When there is an increase in the possibility of financial distress, a firm is more likely to raise capital through equity than debt. The market price drops because the market interprets the equity issue announcement as bad news. 16. If the interest of management is to increase the wealth of the current shareholders, a rights offering may be preferable because issuing costs as a percentage of capital raised are lower for rights offerings. Management does not have to worry about under-pricing because shareholders get the rights, which are worth something. Rights offerings also prevent existing shareholders from losing proportionate ownership control. Finally, whether the shareholders exercise or sell their rights, they are the only beneficiaries. 17. Reasons for shelf registration include: 1) Flexibility in raising money only when necessary without incurring additional issuance costs. 2) As Bhagat, Marr and Thompson showed, shelf registration is less costly than conventional underwritten issues. 3) Issuance of securities is greatly simplified. 18. Basic empirical regularities in IPOs include: 1) under-pricing of the offer price, 2) best-efforts offerings are generally used for small IPOs and firm-commitment offerings are generally used for large IPOs, 3) the underwriter price stabilization of the after market and, 4) that issuing costs are higher in negotiated deals than in competitive ones. 19. a. The new market value will be the current shares outstanding times the stock price plus the rights offered times the rights price, so: New market value = 120,000(£2.32) + 12,000(£1.50) = £296,400 b. The number of rights associated with the old shares is the number of shares outstanding divided by the rights offered, so: Number of rights needed = 120,000 old shares/12,000 new shares = 10 rights per new share c. The new share price will be the new market value of the company divided by the total number of shares outstanding after the rights offer, which will be: PX = £296,400/(120,000 + 12,000) = £2.245 d. The value of the right Value of a right = £2.32 – £2.245= £0.75 e. A rights offering usually costs less, it protects the proportionate interests of existing share- holders and also protects against underpricing. 20. a. The maximum subscription price is the current share price, or £40. The minimum price is anything greater than £0. b. The number of new shares will be the amount raised divided by the subscription price, so: Number of new shares = £50,000,000/£35 = 1,428,571 shares And the number of rights needed to buy one share will be the current shares outstanding divided by the number of new share offered, so: Number of rights needed = 5,200,000 shares outstanding/1,428,571 new shares = 3.64 c. A shareholder can buy 3.64 rights on shares for: 3.64(£40) = £145.60 The shareholder can exercise these rights for £35, at a total cost of: £145.60 + £35.00 = £180.60 The investor will then have: Ex-rights shares = 1 + 3.64 Ex-rights shares = 4.64 The ex-rights price per share is: PX = [3.64(£40) + £35]/4.64 = £38.92 So, the value of a right is: Value of a right = £40 – £38.92 = £1.08 d. Before the offer, a shareholder will have the shares owned at the current market price, or: Portfolio value = (1,000 shares)(£40) = £40,000 After the rights offer, the share price will fall, but the shareholder will also hold the rights, so: Portfolio value = (1,000 shares)(£38.92) + (1000 rights)(£1.08) = £40,000 21. Using the equation we derived in Problem 20, part c to calculate the price of the equity ex- rights, we can find the number of rights needed to buy a share, which is: PX = €3.00 = [N(€3.38) + €2]/(N + 1) N = 2.62 The number of new shares is the amount raised divided by the per-share subscription price, so: Number of new shares = €2,000,000/€2 = 1,000,000 And the number of old shares is the number of new shares times the number rights needed to buy one share, so: Number of old shares = 2.622(1,000,000) = 2,622,000 22. If you receive 1,000 shares of each, the profit is: Profit = 1,000(£11) – 1,000(£6) = £5,000 Since you will only receive one-half of the shares of the oversubscribed issue, your profit will be: Expected profit = 500(£11) – 1,000(£6) = –£500 This is an example of the winner’s curse. 23. We need to calculate the net amount raised and the costs associated with the offer. The net amount raised is the number of shares offered times the price received by the company, minus the costs associated with the offer, so: Net amount raised = (5M shares)(€19.75) – €800,000 – €250,000 = €97.7M The company received €97.7 million from the equity offering. Now we can calculate the direct costs. Part of the direct costs are given in the problem, but the company also had to pay the underwriters. The equity was offered at €21 per share, and the company received €19.75 per share. The difference, which is the underwriters spread, is also a direct cost. The total direct costs were: Total direct costs = €800,000 + (€21 – €19.75)(5M shares) = €7.05M We are given part of the indirect costs in the problem. Another indirect cost is the immediate price appreciation. The total indirect costs were: Total indirect costs = €250,000 + (€26 – €21)(5M shares) = €25.25M This makes the total costs: Total costs = €7.05M + €25.25M = €32.3M The floatation costs as a percentage of the amount raised is the total cost divided by the amount raised, so: Flotation cost percentage = €32.3M/€97.7M = .3306 or 33.06% 24. The number of rights needed per new share is: Number of rights needed = 100,000 old shares/20,000 new shares = 5 rights per new share. Using PRO as the rights-on price, and PS as the subscription price, we can express the price per share of the equity ex-rights as: PX = [NPRO + PS]/(N + 1) a. PX = [5(€90) + €90]/6 = €90.00; No change. b. PX = [5(€90) + €85]/6 = €89.17; Price drops by €0.83 per share. c. PX = [5(€90) + €70]/6 = €86.67; Price drops by €3.33 per share. 25. In general, the new price per share after the offering will be: P = Old shares New shares Current market value Proceeds from offer + + The current market value of the company is the number of shares outstanding times the share price, or: Market value of company = 10,000(£40) Market value of company = £400,000 If the new shares are issued at £40, the share price after the issue will be: P = £400,000 5,000(£40) 10,000 5,000 + + P = £40.00 If the new shares are issued at £20, the share price after the issue will be: P = £400,000 5,000(£20) 10,000 5,000 + + P = £33.33 If the new shares are issued at £10, the share price after the issue will be: P = £400,000 5,000(£10) 10,000 5,000 + + P = £30.00 26. a. The number of shares outstanding after the equity offer will be the current shares outstanding, plus the amount raised divided by the current share price, assuming the share price doesn’t change. So: Number of shares after offering = 10M + €35M/€50 = €10.7M The old book value is €40 per share. From the previous solution, we can see the company will sell 700,000 shares, and these will have a book value of €50 per share. New book value per share = [10M(€40) + .7M(€50)]/10.7M = €40.65 The current EPS for the company is: EPS0 = NI0/Shares0 = €15M/10M shares = €1.50 per share And the current P/E is: (P/E)0 = €50/€1.50 = 33.33 If the net income increases by €500,000, the new EPS will be: EPS1 = NI1/shares1 = €15.5M/10.7M shares = €1.45 per share Assuming the P/E remains constant, the new share price will be: P1 = (P/E)0(EPS1) = 33.33(€1.45) = €48.29 The current market-to-book ratio is: Current market-to-book = €50/€40 = 1.25 Using the new share price and book value per share, the new market-to-book ratio will be: New market-to-book = €48.29/€40.65 = 1.1877 Accounting dilution has not occurred because the new book value per share is higher than the old book value per share; market value dilution has occurred because the firm financed a negative NPV project. The cost of the project is given at €35 million. The NPV of the project is the new market value of the firm minus the current market value of the firm minus the cost of the project, or: NPV = [10.7M(€48.29) – 10M(€50)] – €35M = –€18,333,333 b. For the price to remain unchanged when the P/E ratio is constant, EPS must remain constant. The new net income must be the new number of shares outstanding times the current EPS, which gives: NI1 = (10.7M shares)(€1.50 per share) = €16.05M 27. The current ROE of the company is: ROE0 = NI0/TE0 = £630,000/£3,600,000 = .1750 or 17.50% The new net income will be the ROE times the new total equity, or: NI1 = (ROE0)(TE1) = .1750(£3,600,000 +£ 1,100,000) = £822,500 The company’s current earnings per share are: EPS0 = NI0/Shares outstanding0 = £630,000/14,000 shares = £45.00 The number of shares the company will offer is the cost of the investment divided by the current share price, so: Number of new shares = £1,100,000/£98 = 11,224 The earnings per share after the equity offer will be: EPS1 =£822,500/25,224 shares = £32.61 The current P/E ratio is: (P/E)0 = £98/£45.00 = 2.178 Assuming the P/E remains constant, the new stock price will be: P1 = 2.178(£32.61) = £71.01 The current book value per share and the new book value per share are: BVPS0 = TE0/shares0 = £3,600,000/14,000 shares = £257.14 per share BVPS1 = TE1/shares1 = (£3,600,000 + 1,100,000)/25,224 shares = £186.33 per share So the current and new market-to-book ratios are: Market-to-book0 = £98/£257.14 = 0.38 Market-to-book1 = £71.01/£186.33 = 0.38 The NPV of the project is the new market value of the firm minus the current market value of the firm minus the cost of the project, or: NPV = [£71.01(25,224) – £98(14,000)] - £1,100,000 = –£680,778 Accounting dilution takes place here because the new BVPS is less than the old BVPS. Market value dilution has occurred since the firm is investing in a negative NPV project. 28. Using the P/E ratio to find the necessary EPS after the equity issue, we get: P1 = £98 = 2.178(EPS1) EPS1 = £45.00 The additional net income level must be the EPS times the new shares offered, so: NI = £45(11,224 shares) = £505,102 And the new ROE is: ROE1 = £505,102/£1,100,000 = .4592 Next, we need to find the NPV of the project. The NPV of the project is the new market value of the firm minus the current market value of the firm minus cost of the project, or: NPV = [£98(25,224) – £98(14,000)] – £1,100,000 = £0 Accounting dilution still takes place, as BVPS still falls from £257.14 to £186.33, but no market dilution takes place because the firm is investing in a zero NPV project. 29. a. Assume you hold three shares of the company’s equity. The value of your holdings before you exercise your rights is: Value of holdings = 3(£45) Value of holdings = £135 When you exercise, you must remit the three rights you receive for owning three shares, and £10. You have increased your equity investment by £10. The value of your holdings after surrendering your rights is: New value of holdings = £135 + £10 New value of holdings = £145 After exercise, you own four shares of equity. Thus, the share price is: Share price = £145 / 4 Share price = £36.25 b. The value of a right is the difference between the rights-on price of the equity and the ex- rights price of the equity: Value of rights = Rights-on price – Ex-rights price Value of rights = £45 – £36.25 Value of rights = £8.75 c. The price drop will occur on the ex-rights date, even though the ex-rights date is neither the expiration date nor the date on which the rights are first exercisable. If you purchase the equity before the ex-rights date, you will receive the rights. If you purchase the equity on or after the ex-rights date, you will not receive the rights. Since rights have value, the shareholder receiving the rights must pay for them. The share price drop on the ex-rights day is similar to the share price drop on an ex-dividend day. 30. a. The number of new shares offered through the rights offering is the existing shares divided by the rights per share, or: New shares = 1,000,000 / 2 New shares = 500,000 And the new price per share after the offering will be: P = Old shares New shares Current market value Proceeds from offer + + P = 1,000,000(€13) €2,000,000 1,000,000 500,000 + + P = €10.00 The subscription price is the amount raised divided by the number of number of new shares offered, or: Subscription price = €2,000,000 / 500,000 Subscription price = €4 And the value of a right is: Value of a right = (Ex-rights price – Subscription price) / Rights needed to buy a share of equity Value of a right = (€10 – €4) / 2 Value of a right = €3 b. Following the same procedure, the number of new shares offered through the rights offering is: New shares = 1,000,000 / 4 New shares = 250,000 And the new price per share after the offering will be: P = Old shares New shares Current market value Proceeds from offer + + P = 1,000,000(€13) €2,000,000 1,000,000 250,000 + + P = €12.00 The subscription price is the amount raised divided by the number of number of new shares offered, or: Subscription price = €2,000,000 / 250,000 Subscription price = €8 And the value of a right is: Value of a right = (Ex-rights price – Subscription price) / Rights needed to buy a share of equity Value of a right = (€12 – 8) / 4 Value of a right = €1 c. Since rights issues are constructed so that existing shareholders' proportionate share will remain unchanged, we know that the shareholders’ wealth should be the same between the two arrangements. However, a numerical example makes this more clear. Assume that an investor holds 4 shares, and will exercise under either a or b. Prior to exercise, the investor's portfolio value is: Current portfolio value = Number of shares × Share price Current portfolio value = 4(€13) Current portfolio value = €52 After exercise, the value of the portfolio will be the new number of shares time the ex-rights price, less the subscription price paid. Under a, the investor gets 2 new shares, so portfolio value will be: New portfolio value = 6(€10) – 2(€4) New portfolio value = €52 Under b, the investor gets 1 new share, so portfolio value will be: New portfolio value = 5(€12) – 1(€8) New portfolio value = €52 So, the shareholder's wealth position is unchanged either by the rights issue itself, or the choice of which right's issue the firm chooses. 31. The number of new shares is the amount raised divided by the subscription price, so: Number of new shares = €60M/PS And the number of rights needed to buy a share (N) is equal to: N = Old shares outstanding/New shares issued N = 5M/(€60M/PS) N = 0.0833PS We know the equation for the ex-rights share price is: PX = [NPRO + PS]/(N + 1) We can substitute in the numbers we are given, and then substitute the two previous results. Doing so, and solving for the subscription price, we get: PX = €52 = [N(€55) + PS]/(N + 1) €52 = [55(0.0833PS) + PS]/(0.0833PS + 1) €52 = 5.58PS/(1 + 0.0833PS) PS = €41.60 32. Using PRO as the rights-on price, and PS as the subscription price, we can express the price per share ex-rights as: PX = [NPRO + PS]/(N + 1) And the equation for the value of a right is: Value of a right = PRO – PX Substituting the ex-rights price equation into the equation for the value of a right and rearranging, we get: Value of a right = PRO – {[NPRO + PS]/(N + 1)} Value of a right = [(N + 1)PRO – NPRO – PS]/(N+1) Value of a right = [PRO – PS]/(N + 1) 33. The net proceeds to the company on a per share basis is the subscription price times one minus the underwriter spread, so: Net proceeds to the company = £22(1 – .06) = £20.68 per share So, to raise the required funds, the company must sell: New shares offered = £3.65M/£20.68 = 176,499 The number of rights needed per share is the current number of shares outstanding divided by the new shares offered, or: Number of rights needed = 490,000 old shares/176,499 new shares Number of rights needed = 2.78 rights per share The ex-rights share price will be: PX = [NPRO + PS]/(N + 1) PX = [2.78(£30) + 22]/3.78 = £27.88 So, the value of a right is: Value of a right = £30 – £27.88 = £2.12 And your proceeds from selling your rights will be: Proceeds from selling rights = 6,000(£2.12) = £12,711.13 34. Using the equation for valuing an equity ex-rights, we find: PX = [NPRO + PS]/(N + 1) PX = [4(€80) + €40]/5 = €72 The equity is correctly priced. Calculating the value of a right, we find: Value of a right = PRO – PX Value of a right = €80 – €72 = €8 So, the rights are underpriced. You can create an immediate profit on the ex-rights day if the equity is selling for €72 and the rights are selling for €6 by executing the following transactions: Buy 4 rights in the market for 4(€6) = €24. Use these rights to purchase a new share at the subscription price of €40. Immediately sell this share in the market for €72, creating an instant €8 profit. Chapter 19 Case Study West Coast Yachts Goes Public 1. The main difference in the costs is the reduced possibility of underpricing in a Dutch auction. As to which is better, we don’t actually know. In theory, the Dutch auction should be better since it should eliminate underpricing. However, as Google shows, underpricing can still exist in a Dutch auction. Whether the underpricing is as severe in a Dutch auction as it would be in a traditional underwritten offer is unknown. 2. There is no way to calculate the optimum size of the IPO, so whether Dan is correct or Larissa is correct will only be told in time. The disadvantages of raising the extra cash in the IPO include the agency costs of excess cash. The extra cash may encourage management to act carelessly. The extra cash will also earn a small return unless invested in income producing assets. At best, cash and short-term investments are a zero NPV investment. The advantages of the increased IPO size include the increased liquidity for the company, and the lower probability that the company will have to go back to the primary market in the near term future. The increased size will also reduce the costs of the IPO on a percentage of funds raised, although this may not be a large advantage. 3. The underwriter fee is 7 percent of the amount raised, or: Underwriter fee = £60,000,000(.07) Underwriter fee = £4,200,000 Since the company must currently provide audited financial statements due to the bond covenants, the audit costs are not incremental costs and should not be included in the calculation of the fees. So, the sum of the other fees is: Total other fees = £1,200,000 + £12,000 + £15,000 + £100,000 + £6,500 + £450,000 + £75,000 Total other fees = £1,858,500 This means the total fees are: Total fees = £4,200,000 + £1,858,500 Total fees = £6,058,500 The net amount raised is the IPO offer size minus the underwriter fee, or: Net amount raised = £60,000,000 – £4,200,000 Net amount raised = £55,800,000 So, the fees as a percentage of the net amount to the company are: Fee percentage = £6,058,500 / £55,800,000 Fee percentage = .1086 or 10.86% 4. Because of legal repercussions, you should not provide specific advice on which option the employees should choose. There are advantages and disadvantages to each. If the employee tenders the stock to be sold in the IPO, the employee will lose out on any underpricing. This could be a significant cost. However, if the employee retains the stock, he/she must hold the stock for the lockup period, typically 180 days. Additionally, during the lockup period, the employee is legally prohibited from hedging the price risk of the stock with any derivatives. And heavy selling by insiders is considered a negative signal by the market. Another risk in not selling in the IPO is that after the lockup period expires, the employees may be considered insiders, subject to SEC restrictions on selling stock. Chapter 20 Debt Financing 1. The characteristics of a bond are as follows: Term to maturity, the coupon, the face value, the yield to maturity. Short term debt is sometimes called unfunded debt because it appears as a current liability in a firm’s statement of financial position. Long-term debt is shown as a non-current liability in the statement of financial position. 2. A bond covenant is a legal agreement between bondholders and the firm and forms part of an indenture associated with a specific bond issue. Covenants can be positive, in that managers are obligated to undertake specific actions, or they can be negative, where the firm is forbidden from doing something. Examples of positive covenants include providing financial statements to the bond holder and maintaining a minimum level of working capital. Examples of negative covenants include not being allowed to merge, issue new debt, or pay an extraordinary dividend. 3. Firms issue callable bonds because the call option has value when comparable market rates fall below the coupon rate of the bond. Firms can then call in the existing issue and have another issue with a lower coupon rate. 4. This is evidence of market inefficiency. There is empirical evidence to suggest that investors react more to negative information than to positive information. A credit rating downgrade is universally regarded as bad news. 5. A sukuk is an Islamic financing vehicle. The term, ‘bond’ to describe a sukuk is technically incorrect because no interest is being paid. However, given that the cash flow streams can be identical, it is commonly referred to as a bond. 6. Private bonds have benefits over public bonds in the following ways: A private bond avoids the cost of registration with stock exchange authorities. Private bonds are likely to have more restrictive covenants. It is easier to renegotiate a term loan and a private placement in the event of a default. It is harder to renegotiate a public issue because hundreds of holders are usually involved. Finally, the costs of distributing bonds are lower in the private market. 7. Syndicated bond issues should be priced in the same way as normal bond issues because the way in which an asset is sold should be independent of its value. There are agency relationships between banks in the syndicate as larger banks wish to take a larger share of the tranche than small banks. 8. There are two benefits. First, the company can take advantage of interest rate declines by calling in an issue and replacing it with a lower coupon issue. Second, a company might wish to eliminate a covenant for some reason. Calling the issue does this. The cost to the company is a higher coupon. A put provision is desirable from an investor’s standpoint, so it helps the company by reducing the coupon rate on the bond. The cost to the company is that it may have to buy back the bond at an unattractive price. 9. Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such bonds are used to establish the coupon rate necessary for a particular issue to initially sell for par value. Bond issuers also simply ask potential purchasers what coupon rate would be necessary to attract them. The coupon rate is fixed and determines what the bond’s coupon payments will be. The required return is what investors actually demand on the issue, and it will fluctuate through time. The coupon rate and required return are equal only if the bond sells for exactly at par. If the project in China raises the risk of the company, then the coupon will be higher given the higher risk. 10. Companies pay to have their bonds rated simply because unrated bonds can be difficult to sell; many large investors are prohibited from investing in unrated issues. The firm would get the credit rating by hiring one of the ratings agencies to give one. It is a good idea because it makes the bond more liquid (and therefore will lead to a lower coupon). 11. The offer price was lower than par because the coupon was lower than the bond’s yield to maturity. The bond has a semi annual coupon and so every six months a coupon of €1,125 is paid. The maturity of the bond is 5 years, which means there are 10 payments. This allows us to calculate the 6-month yield: Price = €99,982 = €1,125(PVAF10, r%) + €100,000/(1+r%)10 r% = 1.1252% YTM = 2.254% 12. Although it may not seem that a government credit rating would have an effect on a company’s credit rating, research has shown that there is an impact. This is most likely down to the fact the there is greater political risk that may be manifest in higher potential future taxes, lower growth and more expensive financing. All of these will reduce the value of firms operating in the country. 13. Bond ratings have a subjective factor to them. Split ratings reflect a difference of opinion among credit agencies. 14. Lack of transparency means that a buyer or seller can’t see recent transactions, so it is much harder to determine what the best bid and ask prices are at any point in time. 15. Bonds have indentures to ensure that in the event of default, the lender can receive as much of its money back as possible. They are also in place to make sure that companies do not take on additional risks that put the lender’s capital at risk. Paradoxically, indentures are not particularly important for junk bonds. Because they are so low down in the priority ladder of a company’s financing, they are unlikely to receive any cash in the event of a default. This is because all the remaining money has been used to pay off the senior creditors. 16. Companies charge that bond rating agencies are pressuring them to pay for bond ratings. When a company pays for a rating, it has the opportunity to make its case for a particular rating. With an unsolicited rating, the company has no input. 17. A 100-year bond looks like a preference share. In particular, it is a loan with a life that almost certainly exceeds the life of the lender, assuming that the lender is an individual. With a junk bond, the credit risk can be so high that the borrower is almost certain to default, meaning that the creditors are very likely to end up as part owners of the business. In both cases, the “equity in disguise” has a significant tax advantage. 18. The statement is true. In an efficient market, the callable bonds will be sold at a lower price than that of the non-callable bonds, other things being equal. This is because the holder of callable bonds effectively sold a call option to the bond issuer. Since the issuer holds the right to call the bonds, the price of the bonds will reflect the disadvantage to the bondholders and the advantage to the bond issuer (i.e., the bondholder has the obligation to surrender their bonds when the call option is exercised by the bond issuer.) 19. As the interest rate falls, the call option on the callable bonds is more likely to be exercised by the bond issuer. Since the non-callable bonds do not have such a drawback, the value of the bond will go up to reflect the decrease in the market rate of interest. Thus, the price of non-callable bonds will move higher than that of the callable bonds. 20. Bonds with an S&P’s rating of BB and below or a Moody’s rating of Ba and below are called junk bonds (or below-investment grade bonds). Some controversies surrounding junk bonds are: 1) Junk bonds increase the firm’s interest deduction. 2) Junk bonds increase the possibility of high leverage, which may lead to wholesale defaults in economic downturns. 3) Mergers financed by junk bonds have frequently resulted in dislocations and loss of jobs. 21. Sinking funds provide additional security to bonds. If a firm is experiencing financial difficulty, it is likely to have trouble making its sinking fund payments. Thus, the sinking fund provides an early warning system to the bondholders about the quality of the bonds. A drawback to sinking funds is that they give the firm an option that the bondholders may find distasteful. If bond prices are low, the firm may satisfy its sinking fund obligation by buying bonds in the open market. If bond prices are high though, the firm may satisfy its obligation by purchasing bonds at face value (or other fixed price, depending on the specific terms). Those bonds being repurchased are chosen through a lottery. 22. Open-end mortgage is riskier because the firm can issue additional bonds on its property. The additional bonds will cause an increase in interest payments; this increases the risk to the existing bonds. 23. Characteristic Public Issues Direct Financing a. Require SE registration Yes No b. Higher interest cost No Yes c. Higher fixed cost Yes No d. Quicker access to funds No Yes e. Active secondary market Yes No f. Easily renegotiated No Yes g. Lower floatation costs No Yes h. Require regular amortization Yes No i Ease of repurchase at favourable prices Yes No j. High total cost to small borrowers Yes No k. Flexible terms No Yes l. Require less intensive investigation Yes No 24. Much of the information used in a bond rating is based on publicly available information and therefore may not provide information that the market did not have before the rating change. 25. Accrued interest is the coupon payment for the period times the fraction of the period that has passed since the last coupon payment. Since we have a semi-annual coupon bond, the coupon payment per six months is one-half of the annual coupon payment. There are five months until the next coupon payment, so one month has passed since the last coupon payment. The accrued interest for the bond is: Accrued interest = R64.50/2 × 1/6 = R5.375 And we calculate the clean price as: Clean price = Dirty price – Accrued interest = R9,342– R5.375 = R3,336.63 26. Accrued interest is the coupon payment for the period times the fraction of the period that has passed since the last coupon payment. Since we have a semi-annual coupon bond, the coupon payment per six months is one-half of the annual coupon payment. There are two months until the next coupon payment, so four months have passed since the last coupon payment. The accrued interest for the bond is: Accrued interest = £52/2 × 4/6 = £17.33 And we calculate the dirty price as: Dirty price = Clean price + Accrued interest = £865 + £17.33 = £882.33 27. a. The price of the bond today is the present value of the expected price in one year. So, the price of the bond in one year if interest rates increase will be: P1 = €3,500(PVIFA8%,8) + €100,000(PVIF8%,8) P1 = €74,140 If interest rates fall, the price if the bond in one year will be: P1 = €3,500(PVIFA5%,8) + €100,000(PVIF5%,8) P1 = €90,305 Now we can find the price of the bond today, which will be: P0 = [.50(€74,140) + .50(€90,305)] / 1.032 P0 = €77,502.74 For students who have studied term structure: the assumption of risk-neutrality implies that the forward rate is equal to the expected future spot rate. b. If the bond is callable, then the bond value will be less than the amount computed in part a. If the bond price rises above the call price, the company will call it. Therefore, bondholders will not pay as much for a callable bond. 28. The price of the bond today is the present value of the expected price in one year. The bond will be called whenever the price of the bond is greater than the call price of €1,200. First, we need to find the expected price in one year. If interest rates increase next year, the price of the bond will be the present value of the perpetual interest payments, plus the interest payment made in one year, so: P1 = (€40 / .08) + €40 P1 = €540 This is lower than the call price, so the bond will not be called. If the interest rates fall next year, the price of the bond will be: P1 = (€40 / .06) + €40 P1 = €706.667 This is still lower than the call price, so the bond will not be called. The present value of the expected value of the bond price in one year is: P0 = [.40(€540) + .60(€706.67)] / 1.07 P0 = €598.13 29. If interest rates rise, the price of the bonds will fall. If the price of the bonds is low, the company will not call them. The firm would be foolish to pay the call price for something worth less than the call price. In this case, the bondholders will receive the coupon payment, C, plus the present value of the remaining payments. So, if interest rates rise, the price of the bonds in one year will be: P1 = C + C / 0.09 If interest rates fall, the assumption is that the bonds will be called. In this case, the bondholders will receive the call price, plus the coupon payment, C. So, the price of the bonds if interest rates fall will be: P1 = €12,500 + C The selling price today of the bonds is the PV of the expected payoffs to the bondholders. To find the coupon rate, we can set the desired issue price equal to present value of the expected value of end of year payoffs, and solve for C. Doing so, we find: P0 = €10,000 = [.60(C + C / .09) + .40(€12,500 + C)] / 1.06 C = €730.43 So the coupon rate necessary to sell the bonds at par value will be: Coupon rate = £730.43 / €10,000 Coupon rate = .073 or 7.30% 30. a. The price of the bond today is the present value of the expected price in one year. So, the price of the bond in one year if interest rates increase will be: P1 = €60 + €60 / .07 P1 = €917.14 If interest rates fall, the price if the bond in one year will be: P1 = €60 + €60 / .05 P1 = €1,260 Now we can find the price of the bond today, which will be: P0 = [.35(€917.14) + .65(€1,260)] / 1.06 P0 = €1,075.47 b. If interest rates rise, the price of the bonds will fall. If the price of the bonds is low, the company will not call them. The firm would be foolish to pay the call price for something worth less than the call price. In this case, the bondholders will receive the coupon payment, C, plus the present value of the remaining payments. So, if interest rates rise, the price of the bonds in one year will be: P1 = C + C / .07 If interest rates fall, the assumption is that the bonds will be called. In this case, the bondholders will receive the call price, plus the coupon payment, C. The call premium is not fixed, but it is the same as the coupon rate, so the price of the bonds if interest rates fall will be: P1 = (€1,000 + C) + C P1 = €1,000 + 2C The selling price today of the bonds is the PV of the expected payoffs to the bondholders. To find the coupon rate, we can set the desired issue price equal to present value of the expected value of end of year payoffs, and solve for C. Doing so, we find: P0 = €1,000 = [.35(C + C / .07) + .65(€1,000 + 2C)] / 1.06 C = €61.654 So the coupon rate necessary to sell the bonds at par value will be: Coupon rate = €61.654 / €1,000 Coupon rate = .0617 or 6.17% c. To the company, the value of the call provision will be given by the difference between the value of an outstanding, non-callable bond and value of callable bond, with both bonds offering the same coupon rate. Non-callable bond value = € 1,075.47 (as calculated in requirement (a) Value of callable bond = (€ 917.14 x 35% + €1,060 x 65%) / 1.06 = €952.83 So, the value of the call provision to the company is: Value of call provision = €1,075.47 - €952.83 = €122.64 31. The company should refund when the NPV of refunding is greater than zero, so we need to find the interest rate that results in a zero NPV. The NPV of the refunding is the difference between the gain from refunding and the refunding costs. The gain from refunding is the bond value times the difference in the interest rate, discounted to the present value. We must also consider that the interest payments are tax deductible, so the after-tax gain is: NPV = PV(Gain) – PV(Cost) The present value of the gain will be: Gain = €120,000,000(.066 – R) / R Since refunding would cost money today, we must determine the after-tax cost of refunding, which will be: After-tax cost = €120,000,000(.12)(1 – .125) After-tax cost = €12,600,000 So, setting the NPV of refunding equal to zero, we find: 0 = –€12,600,000+ €120,000,000(.066 – R) / R R = 0.0597 or 5.97% Any interest rate below this will result in a positive NPV from refunding. 32. In this case, we need to find the NPV of each alternative and choose the option with the highest NPV, assuming either NPV is positive. The NPV of each decision is the gain minus the cost. So, the NPV of refunding the 8 percent perpetual bond is: Bond A: Gain = €75,000,000(.08 – .07) / .07 Gain = €10,714,285.71 Assuming the call premium is tax deductible, the after-tax cost of refunding this issue is: Cost = €75,000,000(.085)(1 – .125) + €10,000,000(1 – .125) Cost = €14,328,125 Note that the gain can be calculated using the pre-tax or after-tax cost of debt. If we calculate the gain using the after-tax cost of debt, we find: After-tax gain = €75,000,000[.08(1 – .125) – .07(1 – .125)] / [.07(1 – .125)] After-tax gain = €10,714,286 Thus, the inclusion of the tax rate in the calculation of the gains from refunding is irrelevant. The NPV of refunding this bond is: NPV = –€14,328,125 + €10,714,286 NPV = -€3,613,839 The NPV of refunding the second bond is: Bond B: Gain = €87,500,000(.09 – .0725) / .0725 Gain = €21,120,689.66 Assuming the call premium is tax deductible, the after-tax cost of refunding this issue is: Cost = (€87,500,000)(.095)(1 – .125) + €12,000,000(1 – .125) Cost = €17,773,438 The NPV of refunding this bond is: NPV = –€17,773,438 + €21,120,689.66 NPV = €3,347,252 Since the NPV of refunding bond B is positive and bond A is negative, only bond B should be refunded. 33. To calculate this, we need to set up an equation with the callable bond equal to a weighted average of the non-callable bonds. We will invest X percent of our money in the first non- callable bond, which means our investment in Bond 3 (the other non-callable bond) will be (1 – X). The equation is: C2 = C1 X + C3(1 – X) 8.25 = 6.50 X + 12(1 – X) 8.25 = 6.50 X + 12 – 12 X X = 0.68182 So, we invest about 68 per cent of our money in Bond 1, and about 32 per cent in Bond 3. This combination of bonds should have the same value as the callable bond, excluding the value of the call. So: P2 = 0.68182P1 + 0.31819P3 P2 = 0.68182(106.375) + 0.31819(134.96875) P2 = 115.4730 The call value is the difference between this implied bond value and the actual bond price. So, the call value is: Call value = 115.4730 – 103.50 = 11.9730 Assuming €1,000 par value, the call value is €119.73 34. In general, this is not likely to happen, although it can (and did). The reason that this bond has a negative YTM is that it is a callable U.S. Treasury bond. Market participants know this. Given the high coupon rate of the bond, it is extremely likely to be called, which means the bondholder will not receive all the cash flows promised. A better measure of the return on a callable bond is the yield to call (YTC). The YTC calculation is basically the same as the YTM calculation, but the number of periods is the number of periods until the call date. If the YTC were calculated on this bond, it would be positive. 35. Step Company SPV Sukuk Holders 1. Create SPV 2. Company Sells Assets + BhD20 Billion - BhD20 Billion 3.SPV Issues Securities to Market + BhD20 Billion - BhD20 Billion 4. Company Leases Asset from SPV - BhD1.6 Billion + BhD1.6 Billion - BhD1.6 Billion + BhD1.6 Billion 5. Company Buys Assets Back from SPV. SPV Pays back Sukuk Holders - BhD20 Billion + BhD20 Billion - BhD20 Billion + BhD20 Billion Chapter 20 Case Study Financing West Coast Yacht’s Expansion Plans with a Bond Issue 1. A rule of thumb with bond provisions is to determine who the provisions benefit. If the company benefits, the bond will have a higher coupon rate. If the bondholders benefit, the bond will have a lower coupon rate. a. A bond with collateral will have a lower coupon rate. Bondholders have the claim on the collateral, even in bankruptcy. Collateral provides an asset that bondholders can claim, which lowers their risk in default. The downside of collateral is that the company generally cannot sell the asset used as collateral, and they will generally have to keep the asset in good working order. b. The more senior the bond is, the lower the coupon rate. Senior bonds get full payment in bankruptcy proceedings before subordinated bonds receive any payment. A potential problem may arise in that the bond covenant may restrict the company from issuing any future bonds senior to the current bonds. c. A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. The problem with a sinking fund is that the company must make the interim payments into a sinking fund or face default. This means the company must be able to generate these cash flows. d. A provision with a specific call date and prices would increase the coupon rate. The call provision would only be used when it is to the company’s advantage, thus the bondholders’ disadvantage. The downside is the higher coupon rate. The company benefits by being able to refinance at a lower rate if interest rates fall significantly, that is, enough to offset the call provision cost. e. A deferred call would reduce the coupon rate relative to a call provision with a deferred call. The bond will still have a higher rate relative to a plain vanilla bond. The deferred call means that the company cannot call the bond for a specified period. This offers the bondholders protection for this period. The disadvantage of a deferred call is that the company cannot call the bond during the call protection period. Interest rates could potentially fall to the point where it would be beneficial for the company to call the bond, yet the company is unable to do so. f. A make whole call provision should lower the coupon rate in comparison to a call provision with specific dates since the make whole call repays the bondholder the present value of the future cash flows. However, a make whole call provision should not affect the coupon rate in comparison to a plain vanilla bond. Since the bondholders are made whole, they should be indifferent between a plain vanilla bond and a make whole bond. If a bond with a make whole provision is called, bondholders receive the market value of the bond, which they can reinvest in another bond with similar characteristics. If we compare this to a bond with a specific call price, investors rarely receive the full market value of the future cash flows. g. A positive covenant would reduce the coupon rate. The presence of positive covenants protects bondholders by forcing the company to undertake actions that benefit bondholders. Examples of positive covenants would be: the company must maintain audited financial statements; the company must maintain a minimum specified level of working capital or a minimum specified current ratio; the company must maintain any collateral in good working order. The negative side of positive covenants is that the company is restricted in its actions. The positive covenant may force the company into actions in the future that it would rather not undertake. h. A negative covenant would reduce the coupon rate. The presence of negative covenants protects bondholders from actions by the company that would harm the bondholders. Remember, the goal of a corporation is to maximize shareholder wealth. This says nothing about bondholders. Examples of negative covenants would be: the company cannot increase dividends, or at least increase beyond a specified level; the company cannot issue new bonds senior to the current bond issue; the company cannot sell any collateral. The downside of negative covenants is the restriction of the company’s actions. i. Even though the company is not public, a conversion feature would likely lower the coupon rate. The conversion feature would permit bondholders to benefit if the company does well and also goes public. The downside is that the company may be selling equity at a discounted price. j. The downside of a floating rate coupon is that if interest rates rise, the company has to pay a higher interest rate. However, if interest rates fall, the company pays a lower interest rate. 2. Since the coupon bonds will have a coupon rate equal to the YTM, they will sell at par. So, the number of coupon bonds to sell, assuming a £1,000 face value, will be: Coupon bonds to sell = £30,000,000 / £1,000 = 30,000 Assuming a £1,000 face value, the price of the 20-year, zero coupon bond when it is issued will be: Zero coupon price = £1,000 / 1.0820 = £214.55 So, the number of zero coupon bonds the company will need to sell is: Zero coupon bonds to sell = £30,000,000 / £214.55 = 139,829 3. At maturity, the principal payment for the coupon bonds will be: Coupon bond principal payment at maturity = 30,000(£1,000) = £30,000,000 The principal payment for the zero coupon bonds at maturity will be: Zero coupon bond payment at maturity = 139,829(£1,000) = £139,828,714 4. One of the main considerations is timing of the cash flows. The annual coupon payment on the coupon bonds will be: Annual coupon bond payments = 30,000(£1,000)(.08) = £2,400,000 Since the interest payments are tax deductible, the aftertax cash flow from the interest payments will be: After-tax coupon payments = £2,400,000(1 – .28) = £1,728,000 Even though interest payments are not actually made each year, the implied interest on the zero coupon bonds is tax deductible. The value of the zero coupon bonds next year will be: Value of zero in one year = £1,000/1.0819 = £231.71 So, the growth on the zero coupon bond was: Zero coupon growth = £231.71 – 214.55 = £17.16 This increase in value is tax deductible, so it reduces taxes even though there is no cash flow for interest payments. So, there is a positive cash flow created next year in the amount of: Zero cash flow = 139,829(£17.16)(.28) = £671,850.40 This cash flow will increase each year since the value of the zero coupon bond will increase by a greater amount each year. 5. If the Treasury rate is 5.60 percent, the call price in 7 years is: P = £40({1 – [1/(1 + .03)]26 } / .03) + £1,000[1 / (1 + .03)26] P = £1,178.77 And, if the Treasury rate is 9.10 percent, the call price in 7 years is: P = £40({1 – [1/(1 + .0475)]26 } / .0475) + £1,000[1 / (1 + .0475)26] P = £889.35 6. The investor is not necessarily made whole with the make whole call provision, but is made close to whole. Assume a company issues a bond with a make whole call of the Treasury rate plus 0.5 percent. Further assume this is the correct average spread for the company’s bond over the life of the bond. Although the spread is correct on average, it is not correct at every specific time. The spread over the Treasury rate varies over the life of the bond, and is higher when the bond has a longer time to maturity. To see this, consider, at the extreme, the spread for any bond above the Treasury yield at maturity is zero. So, if the bond is called early in its life, the spread above the Treasury is likely to be too low. This means the investor is more than made whole. If the bond is called late in its life, the spread is too high. This means the interest rate used to calculate the present value of the cash flows is too high, which results in a lower present value. Thus, the bondholder is made less than whole. In practical terms, this difference is likely to be small, and is will almost always result in a higher price paid to the bondholder when compared to a traditional call feature. 7. There is no definitive answer to which type of bond the company should issue. If the intermediate cash flows for the coupon payments will be difficult, a zero coupon bond is likely to be the best solution. However, the zero coupon bond will require a larger payment at maturity. As for the type of call provision, a make whole call provision is generally better for bondholders, therefore the coupon rate of the bond will likely be lower to sell the bond at par value. Again, there is a tradeoff. Solution Manual for Corporate Finance David Hillier, Stephen Ross, Randolph Westerfield, Jeffrey Jaffe, Bradford Jordan 9780077139148