FINA3070 Corporate Finance: Theory and Practice

Problem Set 3

Question 1

You own 1,000 shares of stock in Avondale Corporation. You will receive a 70 cent per share
dividend in one year. In two years, Avondale will pay a liquidating dividend of $40 per share. The
required return on Avondale stock is 15 percent. What is the current share price of your stock
(ignoring taxes)? If you would rather have equal dividends in each of the next two years, show
how you can accomplish this by creating homemade dividends. Suppose you want only $200 total
in dividends the first year. What will your homemade dividend be in two years?

Question 2

The net income of Takamaka Cruises is $32,000. The company has 10,000 outstanding shares and
a 100 percent payout policy. The expected value of the firm one year from now is $1,545,600.
The appropriate discount rate for Takamaka is 12 percent, and the dividend tax rate is zero.

a) What is the current value of the firm assuming the current dividend has not yet been paid?

b) What is the ex-dividend price of Takamaka’s stock if the board follows its current policy?

c) At the dividend declaration meeting, several board members claimed that the dividend is too
meager and is probably depressing Takamaka’s price. They proposed that Takamaka sell
enough new shares to finance an $4.25 dividend.
I. Comment on the claim that the low dividend is depressing the stock price. Support your
argument with calculations.
II. If the proposal is adopted, at what price will the new shares sell? How many will be
sold?

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Question 3

We use the same setting in our lecture note “7.3.1 Dividend Signaling Example”.

Again, there are two types of firms: Good with q = 0.1 and Bad with q = 0.9 , half of each kind.
Now you need $10 for an investment project to get a payoff of $5 with probability q and $20 with
C
probability 1 – q. Firms have cash with C = 3.
1.05

But this time, there is a corporate tax rate T = 20% on equity.

For simplicity, assume risky debt is not an option, so firms can raise at most $5 + C in debt.

a) If Good firm raises $5 + C face value of debt, what is the fraction (  ) of the new equity that
the firm offers to the market?

b) If Bad firm raises $5 + C face value of debt, what is the fraction (  ) of the new equity that
the firm offers to the market?

c) For Good firm, what is the value to old equity after issuing new equity?

d) If Good firm raises only equity, what will be the fraction and the value to old equity after
issuing new equity?

e) Compare your answers in part (c) and part (d). Which financing scheme would Good firm
select?

However, the market cannot tell the firms. It uses p = 0.5 .

f) Using p = 0.5 , what is the value of Good firm’s old equity given Good firm raises C + 5 face
value debt?

Good firm decides to issue only equity as a signal. If this signal is credible, Bad firm will find it
suboptimal to follow. Under full information, Good firm that issues equity only will get
 = 61.05% . The value to old equity of Good firm will be 6.38.

g) Verify the signalling strategy is credible. What is the value to old equity of Bad firm?
Compare the results with the one that Bad firm does nothing and sits on its cash.

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Question 4

This is a Hong Kong IPO empirical project. The excel file of “HK IPO Data.xls” contains 448
Hong Kong IPOs from 1986 to 1999. For each IPO, use the data to calculate:

i. Issue proceeds
= Offer Price × Shares Offered, in million HK$
ii. Market capitalization
= First Day Closing Price × Shares Outstanding, in million HK$
iii. Initial returns
= (First Day Closing Price - Offer Price) / Offer Price, in %
iv. Money left on the table
= Shares Offered ×(First Day Closing Price - Offer Price), in million HK$

a) For items (i) to (iv), report the summary statistics including mean, median, maximum,
minimum, and standard deviation in the following table.

Mean Median Max Min Sd

Issue proceeds
(HK$ million)
Market capitalization
(HK$ million)
Initial returns
(%)
Money left on table
(HK$ million)

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The excel file of “IPOs.xls” contains the return index of 20 IPOs in the sheet “20IPOs”. (Note:
The return index takes into account of dividends, stock splits, etc, so the return index can be
immediately used to construct returns.) Follow the lecture notes and calculate the monthly market
adjusted excess return. (Use Hang Seng Index as benchmark)

b) For each of the 20 IPOs, list out the excess return according to its IPO month. To save space,
you only have to report IPO Month 1 and IPO Month 36.

Stock_Code Company IPOmonth1 ... IPOmonth36

995 Anhui Expressway Co Ltd
522 ASM Pacific Technology
341 Cafe de Coral Group Ltd.
688 China Overseas Land & Investment Ltd
223 Dao Heng Bank Group Ltd
330 Esprit Asia Holdings Ltd
483 Eu Yan Sang (HK) Ltd
420 Fountain Set (Holdings) Ltd
709 Giordano Holdings Ltd
123 Guangzhou Investment Co Ltd
1170 Kingmaker Footwear Holdings Ltd
494 Li & Fung Ltd
685 Ming Pao Enterprise Corporation Ltd.
1122 Qingling Motors Co. Ltd
363 Shanghai Industrial Holdings Ltd
338 Shanghai Petrochemical Co Ltd
315 SmarTone Telecommunications Ltd
990 Theme International Holdings Ltd
168 Tsingtao Brewery Co Ltd
345 Vitasoy International Holdings Ltd

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Combine your results to the rest of the 297 IPOs in sheet “297IPOs”.

c) Calculate the cumulative adjusted average excess return, CARs (36 months). For reporting
purpose, just fill in the 12 CARs. Plot out the graph for 36 months also.

IPO Month 1 2 3 4 5 6
CAR
… … … … … …
IPO Month 31 32 33 34 35 36
CAR

d) Based on your previous results, please comment on the following 2 investment strategies:
i. Subscribe and sell the IPOs on the first day.
ii. Subscribe and hold the IPOs for 36 months.