Worksheet #3

Financing and Corporate Valuation

Please do not attempt this worksheet without first reading chapter 15 from RWJ and the three notes on
corporate valuation. The worksheet is designed to reinforce and supplement your learning on the
aforementioned section of the textbook. Do your best in trying to complete this worksheet before the
session but if you do not manage then do not worry as I will provide a set of solutions to these questions
at the end of the session. The worksheet is really to keep you on your toes in learning the material and
staying ahead of me!

1. Why are debt offerings in the whole much more common and larger than equity offerings? A
company’s internally generated cash flow provides a source of equity financing. For a profitable
company, outside equity may never be needed. Debt issues are larger because large companies
have the greatest access to public debt markets (small companies tend to borrow more from
private lenders). Equity issuers are frequently small companies going public; such issues are
often quite small.

2. Beta Industries, a company that develops financial software for Wall Street Trading firms, went
IPO in January 2004. Merrill Lynch was the investment bank advisors to the firm. Beta sold 6.5
million shares at $21 each, hence raising a total of $136.5 million. At the close of the first day of
trading, the stock sold for $32.40 per share, which was slightly down from the day’s high of
$33.00. Based on the end of day numbers, Beta was apparently underpriced by about $11 per
share, thus the company appeared to miss out on an additional $67 million. If the Beta IPO was
underpriced by 54%, should Beta be upset at Merrill Lynch over the underpricing? Would it
affect your thinking if now you were told that the company was only 4 years since incorporation,
had only $30 million in revenues for the first three quarters of 2003, and was yet to turn a
profit? It is clear that the stock was sold too cheaply, so Beta had reason to be unhappy. No, but,
in fairness, pricing the stock in such a situation is extremely difficult.

3. If your firm is interested in minimizing the selling costs of issuing equity then should they opt for
an underwritten cash offer or a rights offering (not underwritten) to current shareholders?
Explain your choice. The evidence suggests that a non-underwritten rights offering might be
substantially cheaper than a cash offer. However, such offerings are rare, and there may be
hidden costs or other factors not yet identified or well understood by researchers.

4. Lisbon Inc., is proposing a rights offering. The company currently has 500,000 shares
outstanding at $81 each. There will be 60,000 new shares offered at $70 each. (a) What is the
new market value of the firm? (b) What is the ex-rights price? (c) What is the value of a right?
(d) How many ex-rights are associated with one of the new shares?
 The new market value will be the current shares outstanding times the stock price plus the
rights offered times the rights price, so:
New market value = 500,000($81) + 60,000($70) = $44,700,000

The number of rights associated with the old shares is the number of shares outstanding divided
by the rights offered, so:
Number of rights needed = 500,000 old shares/60,000 new shares = 8.33 rights per new share

The new price of the stock will be the new market value of the company divided by the total
number of shares outstanding after the rights offer, which will be:
PX = $44,700,000/(500,000 + 60,000) = $79.82

The value of the right

Value of a right = $81.00 – 79.82 = $1.18

5. Ace Corp. and Mace Corp. both announced IPOs at $40 per share. One of the two firms is
undervalued by $7 and the other is overvalued by $5, but you have no way of knowing which is
which. You plan to buy 1,000 shares of each firm at the IPO issue. If an issue is underpriced, it
will be rationed, and only half your order will be filled. If you could get 1,000 shares in each firm,
then what would your profit be? What profit do you actually expect?

If you receive 1,000 shares of each, the profit is:

Profit = 1,000($7) – 1,000($5) = $2,000
Since you will only receive one-half of the shares of the oversubscribed issue, your profit will be:
Expected profit = 500($7) – 1,000($5) = –$1,500
This is an example of the winner’s curse.

6. Gamma Games needs to raise $60 million to finance its overseas expansion. The company will
sell new shares via a general cash offering at a price of $21 per share, and the company’s
investment bankers charge a 9% underwriting spread. How many shares need to be sold?

Using X to stand for the required sale proceeds, the equation to calculate the total sale
proceeds, including floatation costs is:
X(1 – .09) = $60,000,000
X = $65,934,066 required total proceeds from sale.
So the number of shares offered is the total amount raised divided by the offer price, which is:
Number of shares offered = $65,934,066/$21 = 3,139,717

7. Maximum Inc., has 120,000 shares outstanding that are each worth $94, giving a market value
of equity of $11.28 million. If the firm decided to issue 25,000 new shares at (a) $94, (b) $90,
and (c) $85, then what would the effect of each of the three alternatives be on the existing price
of the stock?

The number of rights needed per new share is:

Number of rights needed = 120,000 old shares/25,000 new shares = 4.8 rights per new share.
 Using PRO as the rights-on price, and PS as the subscription price, we can express the price per
share of the stock ex-rights as:
PX = [NPRO + PS]/(N + 1)

a. PX = [4.8($94) + $94]/(4.80 + 1) = $94.00; No change.

b. PX = [4.8($94) + $90]/(4.80 + 1) = $93.31; Price drops by $0.69 per share.
c. PX = [4.8($94) + $85]/(4.80 + 1) = $92.45; Price drops by $1.55 per share.

8. Molar Corp. is contemplating a rights issue. It has established that the ex-rights price would be
$71. The current price per stock is $76, and there are 19 million shares outstanding. The rights
issue is expected to raise $60 million. What is the subscription price?

The number of new shares is the amount raised divided by the subscription price, so:
Number of new shares = $60,000,000/$PS
And the ex-rights number of shares (N) is equal to:
N = Old shares outstanding/New shares outstanding
N = 19,000,000/($60,000,000/$PS)
N = 0.03167PS
We know the equation for the ex-rights stock price is:
PX = [NPRO + PS]/(N + 1)
We can substitute in the numbers we are given, and then substitute the two previous results.
Doing so, and solving for the subscription price, we get:
PX = $71 = [N($76) + $PS]/(N + 1)
$71 = [$76(0.03167PS) + PS]/(0.03167PS + 1)
$71 = $24.0667PS/(1 + 0.03167PS)
PS = $27.48

9. What are the key differences between FCFF (free cash flow to the firm) and FCFE (free cash flow
to equity)? FCFF is the free cash flow to the firm, which is EBIT + Depreciation – Taxes +/- δNWC
– Capital Spending. FCFF is the cash flow due to all the providers of capital, both debt and
equity. FCFE is the free cash flow to equity, which is Net Income + Depreciation (D/(D+E)) +/-
δNWC (D/(D+E)) – Capital Spending (D+(D+E)) +/- Changes in Net Debt – Preferred Dividends.

10. What are the key differences between WACC and APV valuation? When might you favor one
approach to the other? WACC is the weighted average cost of capital and it assumes a target
D/E ratio for the firm, hence leverage changes are minimal around the target level. WACC
valuation is favored when the firm is at its target capital structure or will soon reach its target.
APV is used when a firm undergoes a dramatic change in the $ level of leverage. It is commonly
used in leveraged restructurings, such as LBOs. In APV, we assume that there is a large increase
in the $ level of debt which is then reduced to a manageable level over time, until the $ level of
debt becomes constant.