Finance question – corporate finance

Chapter 18

Read each question carefully and show all of your work clearly on the short-answer problems as partial credit will be given.

1. MEO Foods, Inc., has made cat food for over 20 years. The company currently has a debtequity ratio of 25 percent, borrows at a 10-percent interest rate, and is in the 40-percent tax bracket. Its shareholders require an 18-percent return.

MEO is planning to expand cat food production capacity. The equipment to be purchased would last three years and generate the following unlevered cash flows (UCF):

Year 0: -$15 million

Year 1: +$5 million

Year 2: +$8 million

Year 3: +$10 million

Year 4+: $0

MEO has also arranged a $6 million debt issue to partially finance the expansion. Under the loan, the company would pay 10 percent annually on the outstanding balance. The firm would also make year-end principal payments of $2 million per year, completely retiring the issue at the end of the third year.

Ignoring the costs of financial distress and issue costs, what is the APV of the expansion plans? (8 points)

2. Milano Pizza Club owns a chain of three identical restaurants for their Milan style pizza. Each store has $270,000 in debt outstanding and a debt-to-equity ratio of 30 percent. The prevailing market interest rate is 9.5 percent. An equivalent all-equity financed store would have a discount rate of 15 percent. For each store, the estimated annual sales are $1,000,000, costs of goods sold are $400,000, and overhead costs are $300,000. Each of these cash flow streams is assumed to be a perpetuity. The corporate tax rate is 40 percent. Using the FTE approach, what is the value of Milano’s Pizza Club? (8 points)

Chapter 20

Read each question carefully and show all of your work clearly on the short-answer problems as partial credit will be given.

1. Again, Inc., is proposing a rights offering. Presently, there are 450,000 shares outstanding at $90 each. There will be 80,000 new shares offered at $84 each. (15 points)

a. What is the new market value of the company?

b. How many rights are associated with one of the new shares?

c. What is the ex-rights price?

d. What is the value of a right?

e. Why might a company have a rights offering rather than a general cash offer?

2. The Clifford Corporation has announced a rights offer to raise $40 million for a new journal, the Journal of Financial Excess. This journal will review potential articles after the author pays a nonrefundable reviewing fee of $5,000 per page. The stock currently sells for $34 per share, and there are 3.4 million shares outstanding. (12 points)

a. What is the maximum possible subscription price? What is the minimum?

b. If the subscription price is set at $30 per share, how many shares must be sold? How many rights will it take to buy one share?

c. What is the ex-rights price? What is the value of right?

d. Show how a shareholder with 1,000 shares before the offering and no desire (or money) to buy additional shares is not harmed by the rights offer.

3.  A firm’s existing assets either have a high value of $800 million (the undervalued firm) or a low value of $400 million (the overvalued firm).  The firm’s manager knows the value of her firm’s assets, but the market does not.  The market assesses that there is a 50% chance the firm has high value assets and a 50% chance the firm has low value assets.  Regardless of the value of the firm’s existing assets, the manager and the market are both aware that the firm has the opportunity to invest $150 million in a new project that will generate a cash flow with a present value of $200 million.  The firm currently has 15,000,000 shares outstanding.  The firm does not have the internal cash to fund the project, and thus if they want to fund the project they must conduct an equity issue immediately.  In the long-run (i.e., next year) the markets will learn whether the firm was the undervalued or overvalued.  

Suppose that the market assumes that equity sales are only made by overvalued firms and prices the equity accordingly.  If an undervalued firm did issue equity in this environment, what would the undervalued firm’s manager predict her firm’s long-run stock price to be? (8 points)