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Financial Management and Dividend Policy: Questions and Answers

## Dilution of Percentage Ownership and Market Value in Rights Offering

Discuss dilution of percentage ownership and dilution of market value in the context of rights offering.

How can he use homemade leverage on Yummy Corporation’s dividends to achieve this goal?

Discuss three plausible reasons for underpricing in an IPO.

QRS N-Queries Company has an exciting new project that will cost \$10,000,000. The company proposes to finance this project by issuing new shares with a rights offering. Currently, the company has 2,000,000 shares outstanding, each valued in the financial market at \$30. With the rights offering, shareholders will be able to purchase one new share for a subscription price of \$10.

What is the rights-on price for each share, M0?

How many new shares will be issued?

How many rights will be required to buy one new share, N?

What is the value of a right before the ex-rights date, R0?

What is the ex-rights price for each share, Me?

What is the value of a right after the ex-rights date, Re?

1. M&M Propositions

2. In five sentences or fewer, briefly explain the M&M Proposition I without taxes. Include the appropriate formula in your explanation. (2.5 marks)

What are the two implications of M&M Proposition I without taxes?

1. In five sentences or fewer, briefly explain the M&M Proposition II without taxes. Include the appropriate formula in your explanation.

2. What are the two implications of M&M Proposition II without taxes?

Explain the static theory of capital structure using the following graph. Describe the meaning of each term (RU, RE, WACC*, RDx(1 – Tc), and D*/E*) presented on the graph.

DEF Company is comparing three different capital structures. Plan A is an all-equity plan and would result in 1000 shares of stock. Plan B would result in 700 shares of stock and \$13,500 in debt. Plan C would result in 800 shares of stock and \$9000 in debt. The firm’s EBIT will be \$10,000 per year until infinity. The interest rate on the debt is 12%.

1. Ignoring taxes, compute the EPS for each of the three plans. Which of the three plans has the highest EPS? Which has the lowest?

2. Compute the break-even EBIT that will cause the EPS on Plan B to be equal to the all-equity EPS (Plan A).

3. Compute the break-even EBIT that will cause the EPS on Plan C to be equal to the all-equity EPS (Plan A).

## Homemade Leverage and Rights Offering for Financing a Project

4. Compare your results from parts (b) and (c) above. Is one higher than the other? Why?

5. Ignoring taxes, what is the break-even EBIT that will cause the EPS on Plan B to be equal to the EPS on Plan C? What conclusions do we reach when we compare the results from parts (b), (c), and (e) above?

6. Q Corporation and R Inc. are two companies with very similar characteristics. The only difference between the two companies is that Q Corporation is an unlevered firm, and R Inc. is a levered firm with debt of \$3.5 million and cost of debt of 10%. Both companies have earnings before interest and taxes (EBIT) of \$1.5 million and a marginal corporate tax rate of 35%. Q Corporation has a cost of capital of 15%.

What is Q Corporation’s firm value? What is R Inc.’s firm value?

What is R Inc.’s equity value? What is Q Corporation’s cost of equity capital?

At is R Inc.’s cost of equity capital? What is Q Corporation’s WACC? What is R Inc.’s WACC?

Compare the WACC of the two companies. What is your conclusion?

What principle have you proven in this case?

Both companies are now evaluating a project that requires an initial investment of \$1.15 million, that will yield after tax cash inflows of \$500,000 per year for the next three years. Assume that this project has the same risk level as each individual firm’s assets. Should Q Corporation invest in this project? Should R Inc. invest in this project? Based on your results in part (j), discuss the effects of leverage and its tax shields on the future value of the two firms. Mr. Toriop owns 5000 shares of stock in Yummy Corporation. The company has announced that it will pay a dividend of \$5 per share in one year and then a liquidating dividend of \$50 per share in two years. The required return on ABC stock is 10%.

What is the current share price of your stock? What will be the company’s share price in one year? Mr. Toriop wishes to have equal amount of dividend income for the next two years. How can he use homemade leverage on Yummy Corporation’s dividends to achieve this goal? Check that the present value of the cash flows will be the same as they are before the homemade leverage. (Hint: Dividends will be in the form of an annuity.)

Suppose Mr. Toriop is thinking about buying a house for \$220,000 in one year. How can he use homemade leverage on Yummy Corporation’s dividends to achieve this goal? Check that the present value of the cash flows will be the same as they are before the homemade leverage.

Suppose Mr. Toriop is thinking about postponing the house purchase for two years, by which time the price of the house will have increased by \$35,000. How can he use homemade leverage on Yummy Corporation’s dividends to achieve this goal? Check that the present value of the cash flows will be the same as they are before the homemade leverage. Dividend policy.

Define the information content effect of a dividend, and discuss whether or not it conveys information about a firm’s dividend policy.

Define the clientele effect of dividend policy, and discuss whether or not it conveys information about a firm’s market value. The management of Oodles N Noodles Inc. is contemplating a 20% stock dividend. The company currently has cash of \$300,000, fixed assets of \$3.5 million, and debt of \$1 million. Its net income for the most recent fiscal year was \$500,000. The company’s shares are currently selling for \$15 per share, and it has one million shares outstanding. Assume that there are no costs associated with issuing a stock dividend. Before issuing the stock dividend, the company’s management would like to know the effect of such a stock dividend on the following:

1. The number of shares outstanding

2. Earnings

3. Market value of cash

4. Market value of equity

5. Share price

6. Earnings per share (EPS)

7. Price-earnings ratio (P/E)

8. Shareholders’ wealth

The company’s management would like to hold its earnings per share within the range of 0.4–0.6. Given this constraint, should the company go ahead with the stock dividend?

If all that the company’s shareholders care about are their wealth and the P/E ratio, should the company go ahead with the stock dividend?