THE UNIVERSITY OF HONG KONG

FACULTY OF BUSINESS AND ECONOMICS

FINA1003/1310A/B/C Corporate Finance
FIRST SEMESTER, 2014-2015

Tutorial 10 Chapter 15 & 16 Raising Capital and Capital

Structure

Question 1 (Rights Offerings)

The Clifford Corporation has announced a right offer to raise 50 million for a new
journal, the Journal of Financial Excess. The journal will review potential articles
after the author pays a non-refundable reviewing fee of 5,000 per page. The stock
currently sells for 50 per share, and there are 5.2 million shares outstanding.
What is the maximum possible subscription price? What is the minimum?
(b) If the subscription price is set at 45 per share, how many shares must be sold?
How many rights will it take to buy one share?
(a)

What is the ex-rights price? What is the value of a 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?
(c)

Question 2 (Break-Even EBIT)

Malang Fabric Manufacturing is comparing two different capital structures, an

all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Malang would have
150,000 shares of stock outstanding. Under Plan II, there would be 60,000 shares of
stock outstanding and 15 million in debt outstanding. The interest rate on the debt is
10 percent and there are no taxes.
If EBIT is 2 million, which plan will result in the higher EPS?
(b) If EBIT is 7 million, which plan will result in the higher EPS?
(c) What is the break-even EBIT?
(a)

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Tutorial Problem Set 10

Question 3 (Homemade Leverage and WACC)

ABC Co. and XYZ Co. are identical firms in all respects except for their capital
structure. ABC is all-equity financed with $600,000 in stock. XYZ uses both stock
and perpetual debt; its stock is worth $300,000 and the interest rate on its debt is 8
percent. Both firms expect EBIT to be $80,000. Ignore taxes.
(a)

Wilson owns $30,000 worth of XYZs stock. What rate of return is he expecting?

(b)

Show how Wilson could generate exactly the same cash flows and rate of return
by investing in ABC and using homemade leverage.

What is the cost of equity for ABC? What is it for XYZ?

(d) What is the WACC for ABC? For XYZ? What principle have you illustrated?
(c)

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Tutorial Problem Set 10

Chapter 15 - Raising Capital

(i) Equity Offerings
Initial Public Offerings (IPOs): First offering of stock to the general
public
Seasoned Equity Offerings (SEOs): New issue for firms that are already
listed; also called follow-on offerings
Cash Offer: Securities are sold to general public
Rights Offer: Securities are first sold to existing shareholders
IPOs are cash offers

(ii) Underwriting Offerings

Underwriter: Buy securities from the firm and resells them to the public
- Lead underwriter, co-lead, and syndicate
- Spread: diff between offer price and price paid by underwriter
Firm commitment, best efforts, dutch auction
- Promised payment to issuer
- No commitment
- Price is set by auction

(iii) IPO Under-pricing

- Offering price set below the true value of the security
- Positive initial returns
Winners Curse:
- If an issue is underpriced, everyone wants to get some shares, so you
will get less shares
- For overpriced shares, since others investors do not want, you will get
most shares
- You are more likely to be allocated overpriced shares
- Uninformed investors like you will suffer loss on average
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- So, IPOs need to be underpriced to encourage participation of

uninformed investors; but your average return maybe zero
Reasons of IPO Under-pricing:
-

Compensation for taking risks

Information asymmetry / Signaling
Information acquisition
Lawsuit avoidance

(iv) Rights Offerings: Basic Concepts

- Issue of common stock offered to existing shareholders
- Allows current shareholders to avoid the dilution that can occur with a
new stock issue
- Rights are given to the shareholders
(Specify number of shares that can be purchased, purchase price and
time frame)
- Rights may be traded OCT or on an exchange

The Value of a Right:

- The price specified in a rights offering is generally less than the
current market price
- The share price will adjust based on the number of new shares issued
- The value of the right is the difference between the old share price and
the new share price

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Tutorial Problem Set 10

Chapter 16 Capital Structure

We want to choose the capital structure that will maximize stockholder
wealth
We can maximize stockholder wealth by maximizing the value of the
firm or minimizing the WACC

(i) Break-Even EBIT

Find EBIT where EPS is the same under both the current and proposed
capital structures

If expected EBIT > break-even, leverage is good

If expected EBIT < break-even, leverage is bad

(ii) Capital Structure Theory

MM Theory (with no tax; with Corporate Tax)

Trade-off Theory

Pecking order Theory

(iii) MM Theory (no tax)

-

The original MM theory assumes no taxes, and no bankruptcy costs

Capital structure does not affect cash flows
It is the same firm value whether or not the firm or individual borrows
Therefore, the market value of a company does not depend on its
capital structure

MM Proposition I:
- Capital structure does NOT affect firm value or WACC
- WACC keeps the same for any debt ratio

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Tutorial Problem Set 10

MM Proposition II:
- Given proposition I, WACC keeps the same

- The expected return on equity increases with the debt-equity ratio

(iv) MM Theory (with taxes)

If tax shield is perpetual: PV of tax shield:

Value of levered firm (VL) = unlevered firm value (VU) + PV of tax shield

More debt is better, because the interest deduction generates extra value
(tax-saving)

(v) Bankruptcy Costs

Direct Costs: Legal and administrative costs; Bondholders lose benefits
Indirect Costs: Lose sales, managerial efforts, no incentives to work;
Larger than direct costs, but difficult to measure
Costs of financial distress: Costs arising from bankruptcy or distorted
business decisions before bankruptcy

(vi) Pecking Order Theory

- Firms prefer to use internally generated funds
- When needs external financing is necessary, debt is the primary way
to get financing
- Equity is the last resort to finance projects
- Firms prefer to issue debt rather than equity if internal finance is
insufficient
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Implications:
- No target (optimal) capital structure
- Profitable firms borrow less
- Financial slack (can reserve or the extent to access financial markets)
is valuable