Compute the present value of interest tax shields generated by these three debt issues. Consider corporate taxes only. The marginal tax rate is Tc = .35.
a) A $1,000, one year loan at 8%.
b) A five-year loan of $1,000 at 8%. Assume no principal is repaid until maturity.
c) A $1,000 perpetuity at 7%.
“I was amazed to find that the announcement of a stock issue drives down the value of the issuing firm by 30%, on average, of the proceeds of the issue. That issue cost dwarfs the underwriter’s speed and the administrative costs of the issue. It makes common stock issues prohibitively expensive”.
d) You are contemplating a $100 million stock issue. On past evidence, you anticipate that announcement of this issue will drive down stock price by 3% and that the market value of your firm will fall by 30% of the amount to be raised. On the other hand, additional equity funds are necessary to fund an investment project that you believe has a positive NPV of $40 million. Should you proceed with the issue?
e) Is the fall in market value on announcement of a stock issue an issue cost in the same sense as an underwriter’s spread? Respond to the quote that begins this question.
Use your answer to (a) as a numerical example to explain your response to (b).
Ronald Masulis has analyzed the stock price impact of exchange offers of debt for equity or vice versa. In an exchange offer, the firm offers to trade freshly issued securities for seasoned securities in the hands of investors. Thus, a firm that wanted to move to a higher debt ratio could offer to trade new debt for outstanding shares. A firm that wanted to move to a more conservative capital structure could offer to trade new shares for outstanding debt securities.
Masulis found that debt for equity exchanges were good news (stock price increased on announcement) and equity for debt exchanges were bad news.
f) Are these results consistent with the trade-off theory of capital structure?
g) Are the results consistent with the evidence that investors regard announcements of (i) stock issues as bad news, (ii) stock repurchases as good news, and (iii) debt issues as no news, or at most trifling disappointments?
h) How could Masulis’s results be explained?
The Salad Oil Storage (SOS) Company has financed a large part of its facilities with long-term debt. There is a significant risk of default, but the company is not on the ropes yet. Explain:
a) Why SOS stockholders could lose by investing in a positive-NPV project financed by an equity issue.
b) Why SOS stockholders could gain by investing in a negative-NPV project financed by cash.
c) Why SOS stockholders could gain from paying out a large cash dividend.
Calculate the weighted average cost of capital (WACC) for Federated Junkyards of America, using the following information:
i) Debt: $75,000,000 book value outstanding. The debt is trading at 90% of book value. The yield to maturity is 9%.
j) Equity: 2,500,000 shares selling at $42 per share. Assume the expected rate of return on Federated’s stock is 18%.
k) Taxes: Federated’s marginal tax rate is Tc = .35.
The WACC formula seems to imply that debt is “cheaper” than equity – that is, that a firm with more debt could use a lower discount rate. Does this make sense? Explain briefly.
The Bunsen Chemical Company is currently at its target debt ratio of 40%. It is contemplating a $1 million expansion of its existing business. This expansion is expected to produce a cash inflow of $130,000 a year in perpetuity.
The company is uncertain whether to undertake this expansion and how to finance it. The two options are a $1 million issue of common stock or a $1 million issue of 20-year debt. The flotation costs of a stock issue would be around 5% of the amount raised, and the flotation costs of a debt issue would be around 1½ %.
Bunsen’s financial manager, Miss Polly Ethylene, estimates that the required on the company’s equity is 14%, but she argues that flotation costs increase the cost of new equity to 19%. On this basis, the project does not appear viable.
On the other hand, she points out that the company can raise new debt on a 7% yield, which would make the cost of new debt 8½ %. She therefore recommends that Bunsen should go ahead with the project and finance it with an issue of long-term debt. Is Miss Ethylene right? How would you evaluate the project?
Blades plc would like to speculate on the anticipated movement of the bahlt currency against the British pound. Blades plc expects that the bahlt currency would move from a current level of 0.0147 British pounds to the level of 0.0133 British pounds within the next 30 days. The following interbank lending and borrowing rates exist:
Assume that Blades plc has a borrowing capacity of either 7 million British Sterling or the bahlt equivalent of this amount, depending on which currency it wants to borrow. How could Blades plc capitalize on its expectations without using deposited funds? Estimate the speculative profits (in pounds) that could be generated from this strategy.
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