Flotation costs are deductible for tax purposes over a 5-year period. Assume a 40% corporate tax rate.

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Elfreda Wilkins
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1 MODULE 3: LONG-TERM SOURCES OF FUNDS QUESTION 1 TM Corp. has $10,000,000 bond issue outstanding, with annual interest payments at 12%. The issue has 15 years remaining until maturity, but it is callable now with a call premium equal to one year s interest. Call premiums are not deductible for tax purposes. A new bond issue at an interest cost of only 6% can now be raised, with 15 years to maturity and annual interest payments. Flotation costs of $500,000 would be incurred. In order to be sure of having the needed financing, TM would issue the new bonds 1 month prior to calling the current bond issue. Extra funds from the new issue can be invested in short-term securities at an annual rate of 4%, for the 1-month overlap period. Flotation costs are deductible for tax purposes over a 5-year period. Assume a 40% corporate tax rate. Required: Should TM pursue the bond refinancing opportunity? Explain your reasoning and provide supporting calculations. 1

2 QUESTION 1 SOLUTION Appropriate discount rate = after tax borrowing rate = 6 (1 -.4) = 3.6% Call premium: 10,000,000 x.12 ( 1,200,000) Flotation costs ( 500,000) After tax interest expense on the old issue: 10,000,000 x.12 x 1/12 (1 -.4) ( 60,000) After tax interest earned on funds invested: (10,000,000 x.04) (1 -.4) x 1/ ,000 ( 1,740,000) PV of tax savings on flotation costs: + 180,092 Pmt = 40,000 n = 5 FV = 0 i = 3.6% PV =? = 180,092 PV of after tax interest savings: + 4,116,935 Pmt = 360,000 n = 15 FV = 0 i = 3.6% PV =? = 4,116,935 NPV of refunding + 2,557,027 CONCLUSION: Since the NPV is positive, go for it! 2

3 QUESTION 2 AG Corp. has an outstanding $5,000,000 of preferred shares, with a $50 face value per share and $1.25 per share of quarterly dividends. The call premium on this issue is 5%, and it would cost $750,000 to float a new preferred share issue. A new issue would pay only $1.00 per share per quarter in dividends. If preferred shares are refinanced, AG would issue the new preferred shares 2 months prior to calling the outstanding issue. During the overlap period, extra funds from the new issue can be invested in short-term securities at an annual rate of 4.25%, and dividends continue to accrue on the existing issue of preferred shares. Flotation costs are deductible for tax purposes over a 5-year period. Assume a 40% corporate tax rate. Required: Should AG pursue the preferred share refinancing opportunity? Explain your reasoning and provide supporting calculations. 3

4 QUESTION 2 SOLUTION Appropriate discount rate = cost of new preferred share financing IF, you can get $1.00 for every $50 you own per quarter, isn t that like getting a $1.00 of income? So what is the rate? It is equal to: 1/50 = 2%. BUT, that 2% is a quarterly rate. When you are calculating the PV of the annual dividend savings, you need a quarterly rate so use that 2%. When you are calculating the PV of the tax savings on flotation costs, you need an annual rate, so you must determine the annual rate. The nominal rate is: 2% x 4 = 8%. From the formula sheet, EAR = (1 + k nom /m) m - 1 = (1 +.08/4) 4-1 = (1 +.02) 4-1 = = 8.24% Cost of calling:.05 x 5,000,000 ( 250,000) Flotation costs ( 750,000) PV of tax savings on flotation costs: + 238,055 Pmt = 60,000 n = 5 FV = 0 i = 8.24% PV =? = 238,055 After tax overlap interest received: 5,000,000 x.0425 x 2/12 (1 -.4) + 21,250 Overlap dividends paid: 5,000,000/50 x 1.25 x 2/3 ( 83,333) + PV of annual dividend savings (treat as a perpetual) ( 824,028) 100,000 shares x ( ) = 25,000 : as a perpetual: 25,000/.02 your quarterly rate + 1,250,000 NPV + 425,972 Since NPV is positive, the refinancing should be pursued. 4

5 QUESTION 3 Lucy has $100,000 cash and 5,000 shares of ABC Inc. stock in her portfolio. She was just notified that ABC will issue additional common shares via a rights offering. Every shareholder will get 1 right for each share held. The current share price is $40 and the rights entitle the holders to purchase ABC shares at $36 per share for every 4 rights. The shares are now trading rights-on. ABC now has 40,000 shares outstanding and the company has to elect 5 directors at its upcoming annual meeting. There is one candidate that Lucy would like to elect to serve on the board. The meeting will occur in a fe w months time, after the rights offering is completed. Required: a. Calculate the value of a right during the rights-on period. b. Lucy can exercise her rights, or sell them to other investors. How will each of these two options affect the following? i) the amount she has invested in ABC ii) the number of shares she owns iii) her overall wealth iv) her percentage of ownership c. If ABC has cumulative voting, how many shares must Lucy own to elect one board member? Show your calculation. Explain how Lucy can obtain the required number of shares. 5

6 QUESTION 3 SOLUTION An investor holds shares in a firm that is issuing additional shares via a rights offering. The investor must decide whether to exercise or sell her rights. She would also like to elect a member of the board, and the firm has cumulative voting. The question requires that you calculate the number of shares needed to elect the board member, and to determine how to achieve that goal. a. The value of a right during the rights-on period: = (Rights on price Exercise price)/(number of rights required for the purchase of 1 new share + 1) = ($40 $36) / (4 + 1) = 4/5 = $0.80 b. Prior to the rights offering, Lucy owns 5,000 shares worth $40 each, so the value of her holdings is $200,000. She owns 5,000 / 40,000 = 12.5% of the shares of the company. If Lucy sells her rights, she will receive 5,000 ($0.80) = $4,000, and she will continue to own 5,000 shares in the company. The company will have 40,000 (1.25) = 50,000 shares outstanding, with a total value of 40,000 (40) + 10,000 (36) = 1,600, ,000 = $1,960,000. Each share, ex-rights,will be worth 1,960,000 / 50,000 = $ Lucy will continue to have 5,000 shares, which will be worth 5,000 ($39.20) = $196,000. Overall, her wealth will continue to be $200,000, but it will be composed of $196,000 of shares in ABC and $4,000 of cash. She will have a smaller percentage of outstanding ABC shares, or 5,000 / 50,000 = 10%. If she exercises her rights, Lucy will purchase 5,000 / 4 = 1,250 additional shares, which will cost her 1,250 ($36) = $45,000. Her total wealth in ABC will be $245,000, and her percentage ownership will remain at 6,250 / 50,000 = 12.5%. Summary: Prior to Exercise of Rights Offering Sale of Rights Rights Cash $100,000 $104,000 $55,000 i) Amount invested in ABC $200,000 $196,000 $245,000 ii) # of ABC shares owned 5,000 5,000 6,250 iii) Overall wealth $300,000 $300,000 $300,000 iv) Percentage ownership 12.5% 10% 12.5% Lucy s overall wealth will not be affected. 6

7 c. After the rights issue, ABC will have 50,000 shares outstanding. To ensure that she can elect one member of the board, Lucy would have to have the following number of shares: (50,000) / (5 + 1) + 1 = 50,000 / = 8,335 shares If Lucy exercises all of her rights, she will only own 6,250 shares. To obtain the required shares, she must purchase 2,085 more shares from other investors. These will cost her $ rights each, or $ ($0.80) = $39.20 each. 2,085 $39.20 = $81,732 Lucy would own 8,335 shares and have $326,732 invested in ABC. She would need to borrow $26,732 to reach this level of investment. 7

8 QUESTION 4 Rock Inc. has 2,000,000 shares outstanding with a market price of $13 per share. The company plans to raise $5,000,000 of new equity capital through a rights offering with a subscription price of $10. The value of one right is $.60. You own 135,000 shares and the company has 15 directors. Four rights are required to subscribe to one share of the new offering. One right is attached to each share. Answer the following: a) How many directors can you elect before the offering? b) How many rights must you exercise in order to be able to elect one director after the offering? 8

9 QUESTION 4 SOLUTION a) Before the offering: 135,000 = [ (d x 2,000,000)/ (15 + 1) ] ,999 = 125,000d 1.08 = d Before the offering, you can elect one director. b) Currently, the company has 2,000,000 shares which equals 2,000,000 rights. The new offering will add: 2,000,000/4 = 500,000 shares Without exercising, you will not be able to elect any directors because d =.86 which is less than one. 135,000 = [ (d x 2,500,000)/ (15 + 1) ] = d The number of shares needed to elect one director is: N = [ (1 x 2,500,000) / 16] + 1 = 156,251 Since you own 135,000 shares, you must buy (156, ,000) = 21,251 more. Therefore, you must exercise 21,251 x 4 = 85,004 rights to buy the shares. IF, you were to exercise all your rights you could elect: 135, ,000/4 = [ (d x 2,500,000)/ (15 + 1) ] = d 9

10 QUESTION 5 Q1. Which of the following statements best describes the annual loan payments for a bank loan with a balloon payment? 1) All of the outstanding principal is amortized. 2) Some, but not all, of the total loan principal is amortized. 3) Only interest is paid on the loan, with no principal repayment until the loan matures. 4) The annual loan payments will increase in magnitude over time. Q2. All else equal, investors will pay more for a bond if it has which of the following features? i) It is callable. ii) It is retractable. iii) It is convertible. 1) i) only 2) i) and ii) 3) ii) and iii) 4) i) and ii), and iii) Q3. Preferred share financing can be characterized by which of the following statements? i) It entitles owners to periodic dividend payments from the firm. ii) It has no specified maturity date. iii) It has a claim on assets superior to those of creditors, in the event of liquidation of the firm. 1) i) only 2) i) and ii) 3) i) and iii) 4) i) and ii), and iii) Q4. Which of the following statements best describes preferred share financing? 1) Preferred share dividends are tax deductible. 2) Preferred share dividends are payable semi-annually. 3) Preferred shares carry no voting rights unless the firm defaults on its dividend payments. 4) Preferred shareholders claims on liquidation proceeds in the event of bankruptcy are second only to the claims of secured lenders. Q5. Which of the following is an advantage of bond financing over equity financing? 1) In bond financing, interest payments are deductible from income for tax purposes. 2) Bond financing is more permanent than other forms of financing. 3) In bond financing, issuers are not restricted from issuing other forms of financing. 4) In bond financing, there is additional risk resulting from higher financial leverage. 10

11 Q6. Which of the following statements correctly describes the disadvantages to an issuer of common share financing? i) It requires high rates of return. ii) It magnifies losses in earnings per share in bad years. iii) It has high flotation costs per dollar raised. 1) i) only 2) i) and ii) 3) i) and iii) 4) i) and ii), and iii) Q7. If a company has different classes of common shares, what restrictions are there on shareholders who purchase the restricted voting shares of the firm? 1) These shareholders have no voting rights except in certain limited circumstances. 2) These shareholders have no voting rights. 3) These shareholders do not share in the regular dividends paid to other common shareholders. 4) These shareholders are limited in their voting rights to a certain percentage, so that the maximum percentage of shares that can be voted by a person, company, or group is specified. Q8. The most important factor determining whether rights offering will be successful is the: 1) credit rating of the issuing firm 2) subscription price. 3) number of institutional investors 4) dividend per share. 5) number of shares which an investor can buy. Q9. Everything else being equal, which of the following combinations of term loan features will provide the lowest effective annual interest rate? 1) Simple interest loans, annual compounding, and no compensating balance 2) Discount interest loans, quarterly compounding, and no compensating balance 3) Simple interest loans, monthly compounding, and a compensating balance 4) Discount interest loans, monthly compounding, and a compensating balance Q10. Which of the following statements correctly describes Eurobonds? 1) Bonds denominated in a currency foreign to the country in which they are sold 2) Bonds that do not promise any cash flows to the owner until maturity, when the face value is paid back to the owner 3) Bonds that have no maturity 4) Bonds issued in a country other than the country of the issuer, denominated in the currency of the foreign country in which they are issued. 11

12 QUESTION 5 SOLUTIONS 1 (2) 2 (3) 3 (2) 4 (3) 5 (1) 6 (3) 7 (4) 8 (2) 9 (1) 10 (1) 12

Lecture 3. Chapter 4: Allocating Resources Over Time

Lecture 3. Chapter 4: Allocating Resources Over Time Lecture 3 Chapter 4: Allocating Resources Over Time 1 Introduction: Time Value of Money (TVM) $20 today is worth more than the expectation of $20 tomorrow because: a bank would pay interest on the $20