Solve the given problems using Excel.
1. Suppose you have a firm with the following information (ignore financial distress costs):
Total Firm value (with $5 million in Debt) = $15 million
r0 = 10%
Tax Rate = 35%
rB = 7%
a. What is the Company's required rate of return on Equity?
b. What is the Company's WACC?
c. Estimate the value of this firm as an unlevered entity.
Now suppose this firm had only $3 million in debt to start off with.
d. What would have been the required rate of return for equity?
e. What would have been the WACC?
2. Vatsug, Inc. is an unlevered firm that has 50,000 shares outstanding, each priced at $40. The firm decides to immediately borrow $1,000,000 for 10 years at a 6% interest rate. Assuming a marginal tax rate of 34%, what is your estimate of Vatsug's value as a levered firm?
3. Define direct and indirect costs of financial distress. Which are believed to be larger? Why?
4. Suppose you have a project with a projected annual cash flow before interest and taxes of $6 million, indefinitely. The initial investment of $18 million will be financed with 60% equity and 40% debt.
Your tax rate is 34%, your cost of capital if you were an all-equity firm is 24%, and your usual borrowing rate is 10%.
Your project has been reviewed by your local city government and has been selected to receive municipal funding at a rate of 8%. There will, however, be a flotation cost to this debt of $500,000, which must be expensed immediately and will be paid from the gross proceeds of your debt. Using APV, determine whether to approve this project or not.
5. Research the financial press (online media) to find two companies that merged within the last 5 years. Determine or estimate the following:
a. Summarize the chronology of events from the first offer that was made by the acquiring firm until the final acquisition was agreed. Include information about other firms that were involved, even in an indirect manner (for example, where there any "white knights" out there?).
b. What potential synergies drove the merger?
c. Was the deal 1) all equity, 2) all cash, or 3) a combination thereof?
d. Consider your answer to part (c). Is this a taxable event to 1) the target firm's existing shareholders, and 2) the acquiring firm's existing shareholders?
e. Was there a premium offered for the shares of the target firm? If so, try to approximate it.
6. Suppose a firm wants to raise money through a seasoned equity offering. The firm's corporate charter states that a rights offering must take place.
Current shares outstanding: 20 million
Current market price per share: $20/share
Suppose the firm wants to raise $100 million in cash at a subscription price of $16/share.
a) How many rights will purchase one new share?
b) On ex-rights day, what does the stock price change to, all else constant?
c) What is the value of one right (i.e. its price)?
7. Suppose that I paid $2,000 for 100 shares of Enlighten Software Solutions on April 4, 1999. Today, the company is worth only 15 cents per share. Suppose that in order to be listed on a particular exchange, it must be priced at $1.50 (or above).
a. What sort of corporate reorganization can the firm conduct to achieve the minimum listing price, holding all else constant?
b. If the firm takes your advice in part (a), how many shares would I own?
8. On April 26, Microsoft declares a $2/share dividend to be paid on May 25 for all holders of record on May 18 (a Monday). Your brokerage account has been established with instructions to "dividend reinvest" your Microsoft cash dividends. No holidays are involved.
a) If you own 2000 shares of Microsoft that you bought last year, and the closing price for Microsoft on May 25 turns out to be $44.00, how many shares will be purchased for you on May 25th (assume no fees).
b) What if you bought 1000 more shares on May 13th? How many shares would you be able to purchase through the reinvestment plan now when the May 25th dividend pays? Explain your answer.
9. Suppose Disney issued a convertible (non-callable) bond with an annual coupon of 10% that matures in 5 years. The conversion ratio is 26.32 shares of stock per bond and Disney's stock is currently trading at $30 per share. The convertible bond is priced at $900 in the market and the appropriate discount rate is 13%.
a. What is the Straight Bond Value of this convertible?
b. What is the Option Value of the Bond?
c. What is the Conversion Value of the Bond?
d. Based solely on today's values, should you convert?
10. Your friend comes to talk to you about a convertible bond that she owns. Comment on the logic in her thought process. She says:
"My convertible bond is currently priced at $800 and can be exchanged for 20 shares of common stock. Currently, that stock is trading at $30 per share. I have been told not to convert my convertible bond into this equity, because the conversion value of equity is only $600. But, I think that I should convert the bond into the equity, because with the equity, I have the potential of a future increase in value that is limitless should the price of the equity skyrocket. Therefore, I'd be willing to trade the $800 bond for the $600 worth of equity because I'd be paying the extra $200 for the growth potential."
11. Eki, Inc., a producer of table lamps, has a total of 1,500,000 shares outstanding. The current value of the firm is $15 million (no debt). It issues a total of 50,000 2-year warrants to its two top executives with an exercise price of $30. If the risk-free rate is 10% and if the standard deviation of the Eki stock is 50%, compute the value (price) of each warrant if it can only be exercised on the expiration date.
12. Explain whether and why the following paragraphs are true or false:
a. Two call options are identical except that option A has a strike price of 25 while option B has a strike price of 30. Option A will have a higher premium than option B.
b. Two call options are identical except that option C has an expiration that is 3 months from now, while option D expires one month later. Both are American options. Option C will have a higher premium than Option D.
c. Holding all else constant, if the price of the underlying stock of a put option increases, the value of the put option decreases.
13. In the 1960s, life insurance companies were signing up baby boomers for whole life policies. A feature often included in the policies was the right to borrow against the cash value of the policy at a fixed rate of interest, say 8 percent. At the time, with interest rates of 3 to 4 percent, this feature didn't seem important. However, this feature proved extremely valuable to the insured, when interest rates soared to double digits in the early 1980s. Suddenly, the baby boomers were able to borrow at 8 percent and invest at 12 percent, while the insurance companies had to borrow at rates higher than 8 percent in order to honor their contracts. Many insurers were threatened with insolvency because of this feature in their contracts.
a. What kind of option position did the insurance companies have? (Long or Short? European or American? Put or Call?) Explain your answer.
b. What is the underlying asset for the options in this real-life example?
14. Firm X is being acquired by Firm Y for $35,000 worth of Firm Y stock (valued at the pre-merger current price of Y). Both firms are "all-equity" financed. The incremental value created by the merger is $2,500. Firm X has 2,000 shares of stock outstanding at $16 per share. Firm Y has 1,200 shares of stock outstanding at a price of $40 per share. What is the actual cost of the acquisition to Firm Y using company stock? Why is the actual cost less than $35,000?