After enlivening equity betas in the “Contract Services” industry, you find that the industry asset beta is 1. 03. What is your advice to Hotel Inc. ‘s SCOFF? Should he follow the proposal of the Contract Services divisional manager? Motivate your answer. 18 marks Question 2 The Kelly Solar case we considered in class is a clear example of the negative effects of debt overhang. Indeed, the case shows that the possibility to generate a potentially positive payoff (positive NP) is hindered by the existence of maturing debt.
That is, if Kelly was to inject equity to acquire the additional patents that would tilt upwards the probability of success, the terms of the outstanding debt would make such injection unprofitable, since the lion’s share of the final payoff would to towards paying the debtors. Answer the following questions: (a) The case states that the terms of the debt contract do not allow Kelly to issue senior debt. Explain why if Kelly could issue new senior debt, the debt overhang problem would not arise. B) In the case, Kelly obtains debt funding from a single investor. Suppose that instead Kelly obtained debt from several different debtor’s. Do you think that in this way the renegotiation would become easier? Motivate your answer. 18 marks Question 3 “It is a year since investors began a concerted campaign to secure a greater share of impasses’ profits, putting pressure on boards to cut pay and raise dividends. Nowhere was the call more vociferous than among shareholders of Rupee’s banks.
And it has worked. A look back at the full-year results of the region’s lenders, strung out over the past five weeks, shows a story of rising dividends across a number of big European names, underpinned by better than expected capital ratios rather than resurgent profits[… ] Barclay paid out generously in spite of a lassoing year and promised future payouts would be at a rate of 30 per cent of earnings. Deutsche Bank made a similar promise, while the likes of BAN Paris and UBS edged up their payouts. (“Investors win rewards in payout battle,” FT March 10, 2013) The article argues that most banks have stepped up their dividend payout ratios. We know that in perfect capital markets such decisions are irrelevant. However, we also know that capital markets are far from perfect, which suggests that banks’ decision can during the course. 18 marks Continued on next page… 2 Section B Answer ONE of the following questions: Question 4 An unleavened firm has market value V = U = EYE million, and 1 million shares outstanding. Its corporate tax rate is 38%. The firm stock has a beta of 1. , the risk free rate is 6%, and the expected market rate is 8%. The firm manager is considering issuing debt to buy back stock. The interest rate on debt is 12% (irrespective of the probability of failure and the size of debt). As debt increases, there is a higher probability of bankruptcy. The management has estimated that the present value of any bankruptcy costs is E million, and the probability of bankruptcy increases with leverage according to the following schedule: Value of debt Probability of failure E, 500, OHO E, OHO 8% E, 500, OHO 22% E, 000, OHO
E, 000, OHO 45% EIA, 000, OHO 54. 5% When choosing its capital structure, the firm restricts its choice to the above levels of all-equity capital structure? (b) Calculate the annual and the present value of the tax shield for all the levels of debt above, assuming that debt lasts forever. Are those increasing or decreasing? Find the optimal capital structure when bankruptcy costs are considered. (c) Assuming efficient markets, (I) At which price will the firm be able to repurchase the stock? How many shares will the company be able to repurchase at this price?
What is the number of shares outstanding after the rationalization? It) What is the capital gain implied by the repurchase price? What will the stock price be after the rationalization? 28 marks Question 5 Company A has been trying to acquire company T for some time. Rumors about the potential deal have been spreading in the market and now A proposes a stock swap. Prior to the spreading of rumors, shares in A traded at Ell while shares in T traded at El 5. A has 50 million shares outstanding and the price per share as of today (28/3) is EYE.
T has 30 million shares outstanding and the price per share is EYE. In order for the deal to go through, the board of A is ready to forego part of the value it intrigues to create in the new entity. This is reflected in the decision to exchange each share of T with 1. 6 shares of A. 3 (a) Given the price of the shares in the two firms (which partly reflects the synergies from the merger), what is the contribution the market attributes to each firm in the new entity? (b) Should the shareholders in firm A approve the deal? C) Assuming that, if the deal fails the two companies’ share prices revert to their levels prior to rumors spreading, and given that the market assigns a probability of 0. 7 that the deal goes through, can you infer the synergies implied by the current arrest price? (d) Determine the forecasted share price in the merged firm. Can you determine whether the merger is a positive-NP investment for A? 4 Section C Answer the following question: Question 6 Delaney Pumps manufactures and distributes an extensive line of agricultural irrigation systems.
In recent years, computerized control systems used to automate end systems. Delaney management, is thus considering investing $160 million to develop a state-of-the-art, computerized controller that promises to leapfrog competition. Development work would be contracted to a software development company on a cost-plus basis. Revenue would come from a new product line featuring the controller and from license fees from selected competitors who elected to include the controller in their products. Projected cash-flows for the investment are given in the following table: Year Expected FCC $(160. ) $50. 0 BIT $150. 0 $80. 0 $30. 0 30. 0 120. 0 60. 0 70. 0 The projections extend for only 4 years because management anticipates that other, more advanced controllers will be available by this time. Two challenges confronted Delaney management as they began their deliberations. 1 . Because the digital controller appeared much riskier than the company’s usual usual 10%. The treasurer reasoned that the digital controller would be an average risk project for software companies, and identified five smaller, publicly traded firms specializing in business automation software.
By enlivening their equity betas, she estimated the industry asset beta to be PA = 2. 41 . 2. Delaney had traditionally financed its business with the goal of maintaining a target timeservers-earned ratio of 3 to 1 (times-interest-earned ratio = BIT/lintiest Expenditure). But since this project consisted almost entirely of intangible computer code and because its cash flows were quite uncertain, Delaney treasurer thought it rodent to target a higher interest coverage of 10 to 1. Delaney treasurer chooses to evaluate the project using the APP method.