The consequence of failing to adjust the discount rate for the risk implicit in projects is that the firm will accept high-risk projects, which usually have higher IRR due to their high-risk nature, and reject low-risk or safe projects, which usually have a low IRR due to their low-risk nature. The firm will become increasingly risk-taking. If we apply a risk-adjusted discount rate to evaluate Manitou s projects, we will come to very different conclusions: Project C falls into the class of a new product. It should have a beta of 2.2; therefore, its required rate of return should be: 5% + 2.2(13% - 5%) = 22.6% > IRR So Manitou should reject this risky project because its return is not sufficient to compensate for taking such high risk. Project A falls into the class of capacity expansion and should have a beta of 1.54. Its required rate of return should be: 5% + 1.54(13% - 5%) = 17.32% > IRR Although it is close to break-even, the IRR of 17.07% is not enough reward to compensate investors for the required return of 17.32%. Therefore, Project A should also be rejected. Because it is so close, management may want to review the project beta estimate of 1.54 to ensure it is correct. Project B falls into the class of replacement and should have a beta of 1. Its required rate of return should be: 5% + 1(13% - 5%) = 13% < IRR Therefore, this project should also be accepted. Management s beta estimate may be faulty for Project B. Since it is a replacement project, one might argue the average asset beta should equal the firm s beta of 1.6. If the firm is replacing an average asset then the 1.6 beta is more appropriate and the IRR of the replacement project should be at least 17.8%, the firm s WACC or average return. b) Firms usually apply so-called comparative analysis. A firm may find for each of its divisions, units, or different kinds of projects a so-called pure-play firm; that is, a firm exclusively in the same line of business as the division, unit, or project. CHAPTER THREE Qualitative Questions Question 1 Term loans are often used to finance capital equipment or plant costs or to provide permanent working capital. Term loans are preferable when the cost of public offerings of bonds or shares is too high. Term loans are needed temporarily until cash flows from operations are sufficient to repay the loan. Term loans can be structured so that the cash flows from the asset coincide with the interest and repayment schedule of the loan. Term loan provisions can be worked out more quickly than the provisions for a new bond issue. Term loan provisions are more flexible than bond provisions. Question 2 An instalment loan is a type of term loan that specifies that the borrower will make periodic payments or instalments. These instalments include principal and interest. 23
Term loans are generally repaid from the ability of the firm to generate cash flows. Instalment loans reduce the risk that the borrower will not have enough cash to repay the loan at maturity. Term loans are often secured by capital assets or by the equipment purchased from the proceeds of the loan. Borrowers are normally required to satisfy covenants attached to the loan agreement. Question 3 First mortgage bonds have a first claim on the pledged assets. Second mortgage bonds are junior in priority to the claims of first mortgage bonds. Debentures are unsecured bonds that do not have a specific claim or assignment on any particular asset or property. Subordinated debentures are junior to other debt securities issued by a firm. Question 4 The firm makes sinking fund or purchase fund payments. The bonds are called by the issuing firm. Bondholders exercise their retraction or conversion options. Question 5 Preferred dividends are normally paid quarterly after approval from the board of directors. Preferred share dividends can be cumulative in that unpaid dividends accumulate in arrears. Variable or floating rate preferred shares pay dividends that fluctuate to reflect changes in interest rates. Participating preferred shares entitle shareholders to share in the earnings of the company over and above their specified dividend rate. Question 6 Dividend payments are not a tax-deductible expense. Dividends received by a taxable Canadian corporation from another taxable Canadian corporation are not taxable. Individual investors pay a reduced tax rate on dividend income. Preferred shares are considered by investors to be riskier than debt. Question 7 Common shareholders are entitled to any cash flows earned by a company after interest to bondholders and dividends to preferred shareholders have been paid. Common shareholders have the right to vote on the selection of directors and on important matters. Pre-emptive rights and different voting schemes are features designed to influence ownership and control structures. There are different classes of common shares. Question 8 It provides flexibility regarding dividend payments. There is a permanent source of capital, which reduces the risk to the issuer. It improves the firm s debt-to-equity ratio and increases the firm s ability to use debt in the future. Issuing new common shares dilutes the control of current shareholders. The cost of underwriting and distributing new common shares generally exceeds the cost of preferred shares or debt. 24
Question 9 The issuer is not required to publish and distribute a prospectus. Flotation costs of a private placement are generally less than those of a public placement of similar size. Private placements can be finalized more quickly than a public offering. Private placements provide more flexibility than public offerings. Question 10 The investment banker: serves as an intermediary between the issuer and the purchasers of the securities provides advice regarding the type and terms of the security to be issued and assists in preparing the prospectus underwrites the issue helps in setting the offering price sells the shares to the public Question 11 Rights enable current shareholders to subscribe to additional shares of the company at a specified price. Rights enable current shareholders to maintain their control of the company. Rights are essentially call options on newly issued shares. The value of a right during the rights-on period is different from its value during the exrights period. Qualitative Multiple Choice Questions Question 1 i) Simple interest loans, annual compounding, and no compensating balance Question 2 i) Bonds denominated in a currency foreign to the country in which they are sold Question 3 iv) 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. Question 4 iv) To increase borrowing costs Question 5 iv) Management fee plus underwriting fee plus selling fee Question 6 iv) A 10% discount loan with interest paid every three months Question 7 iv) If the risk-free rate is higher Question 8 iv) The right to share in the earnings of the company over and above their specified dividend rate 25
Question 9 i) Foreign bonds are issued in a country other than the country of the issuer and are denominated in the currency of the foreign country in which they are issued. Question 10 ii) A purchase fund is set up to retire, through purchases in the market, a specified amount of outstanding bonds or debentures only if purchases can be made at or below a stipulated price. Question 11 ii) Because it protects the current shareholders degree of ownership Quantitative Multiple Choice Questions Question 1 ii) $2,781,250 Question 2 iv) $6,750,000 Question 3 iii) 3,637 shares (5,000,000)a $1.20 b(2) - (1-0.35)(5,000,000)($45)a 0.05 3 12 b(2) = $4,000,000 - $1,218,750 = $2,781,250 5,000,000($45)(0.03) = $6,750,000 c(4) (10,000) d + 1 = 3,637 shares (10 + 1) Question 4 iv) $602,410 $500,000 Face value = (1-0.10-0.07) = $100,000 = $602,410 0.83 Question 5 iv) 11.19% The effective annual rate of interest is calculated as follows: 1 + a 0.10 4 b J (1.0-0.07) K 4-1 Question 6 i) $252 Number of new shares to issue: Number of rights required to purchase each new share: Solve for P on = $252 = [1.02688172] 4-1 = 0.111940867 $5 million $50 2 = P on - 50 100 + 1 = 100,000 new shares 10 million 100,000 = 100 rights 26
Quantitative Problems Problem 1 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 candidates to 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) = ($50 - $46) (4 + 1) = 4 5 = $0.80 b) Prior to the rights offering, Sueng-Soo owns 10,000 shares worth $50 each, so 10,000 the value of her holdings is $500,000. She owns 80,000 = 12.5% of the shares of the company. If Sueng-Soo sells her rights, she will receive 10,000($0.80) = $8,000, and she will continue to own 10,000 shares in the company. The company will have 80,000(1.25) = 100,000 shares outstanding, with a total value of 80,000(50) + 20,000(46) = 4,000,000 + 920,000 = $4,920,000. Each share, ex-rights, will be worth 4,920,000 100,000 = $49.20. Sueng-Soo will continue to have 10,000 shares, which will be worth 10,000($49.20) = $492,000. Overall, her wealth will continue to be $500,000, but it will be composed of $492,000 of shares in Westol and $8,000 of cash. She will have a smaller 10,000 percentage of outstanding Westol shares, or 100,000 = 10%. 10,000 If she exercises her rights, Sueng-Soo will purchase 4 = 2,500 additional shares, which will cost her 2,500($46) = $115,000. Her total wealth in Westol will be (12,500)($49.20) 12,500 = $615,000, and her percentage ownership will remain at 100,000 = 12.5%. Summary Prior to Exercise of rights offering Sale of rights rights Cash $115,000 $123,000 $0 i) Amount $500,000 $492,000 $615,000 invested in Westol ii) Number of 10,000 10,000 12,500 Westol shares owned iii) Overall $615,000 $615,000 $615,000 wealth iv) Percentage 12.5% 10% 12.5% ownership Sueng-Soo s overall wealth will not be affected. 27
c) After the rights issue, Westol will have 100,000 shares outstanding. To ensure that she can elect two members of the board, Sueng-Soo would have to have the following number of shares: c (2)(100,000) (8 + 1) d + 1 = a 200,000 b + 1 = 22,223 shares 9 If Sueng-Soo exercises all of her rights, she will only own 12,500 shares. To obtain the required shares, she must purchase 9,723 more shares from other investors. These will cost her $46 + 4 rights each, or $46 + 4 ($0.80) = $49.20 each. 9,723 shares @ $49.20 = $478,372 Sueng-Soo would own 22,223 shares and have $1,093,372 invested in Westol. She would need to borrow $478,372 to reach this level of investment. Problem 2 The NPV of this refinancing opportunity has several dimensions: The discount rate will be the after-tax cost of the new bond issue. This is (1 - t) times the effective before-tax interest rate on the bond issue: (1.05 2-1) (1-0.4) = 0.1025(0.6) = 0.0615 or 6.15% Flotation costs are 2% of face value = 0.02 ($100,000,000) = $2,000,000 Flotation costs are paid immediately upon redemption of the preferred shares. Tax shields on flotation costs are calculated as follows: $2,000,000 * (0.4) * PVIFA(6.15%, 5 years) 5 $400,000(0.4)(4.19523) = $671,237 Face value of the debt issue = $100,000,000 Semi-annual interest payments = 0.05 ($100,000,000) = $5,000,000 Semi-annual interest rate is approximately (1.0615) 1/2-1 = 3.03% Present value of interest payments, after tax: = $5,000,000(1-0.4) PVIFA (20 half-years, 3.03) = $3,000,000 14.836294 = $44,508,882 Present value of dividends saved, using the given 1.5% quarterly discount rate stated in the question: Quarterly dividend = 0.03 (face value) = 0.003 ($100,000,000) = $3,000,000 PV of 10 years of quarterly dividends = $3,000,000 PVIFA (1.5%, 40) = $3,000,000 (29.9158452) = $89,747,536 2 Overlap interest revenue = 4% a ($100,000,000) = $666,667 12 months b Tax on overlap interest revenue = 0.4($666,667) = $266,667 After-tax overlap interest revenue = $666,667 - $266,667 = $400,000 Additional dividends during the overlap period = $100,000,000 0.03a 2 3 b = $2,000,000 28
Net additional cost during the overlap period = $2,000,000 - $400,000 = $1,600,000 NPV of refinancing: Flotation cost $(2,000,000) Tax shield on flotation cost 671,237 Present value of dividends saved 89,747,536 Present value of interest cost of new issue (44,508,882) Net additional cost during the overlap period (1,600,000) NPV of refinancing $42,309,891 The NPV of this refinancing opportunity is highly positive. The firm should proceed with the refinancing. Problem 3 This question involves the preparation of a report to management, comparing three alternative bank financing choices available to a borrowing firm. 1. Loan ALB is a simple interest loan with no compensating balance. All borrowed funds are available for use by the firm so the face value of the loan will be $100,000. The effective annual interest rate is calculated as follows, for monthly compounding: EAR = a 1 + 0.07 12 b - 1 = 7.229% 12 2. Loan BCC is a discount interest loan so the interest is deducted in advance and not all funds are available for use by the firm. In order to obtain $100,000 of funds to use, the firm must borrow: Face value = $100,000 a 1-0.07 b 2 = $100,000 0.965 = $103,627 The effective annual interest rate is calculated as follows: EAR = 1 + 0.07 2 1-0.07 2 2-1 3. Loan NFL has a compensating balance, which again means that not all funds are available for use by the firm. In this case, 10% of the funds borrowed must be left in the bank balance. In order to obtain $100,000 of funds to use, the firm must borrow: Face value = = 1 + a 0.035 0.965 b 2-1 = 7.385% $100,000 (1-0.06-0.10) = $100,000 = $119,048 0.84 The effective annual interest rate is calculated as follows: EAR = 6% 0.84 = 7.143% In summary, the three loans can be compared as follows: 29
Loan face value required EAR ALB $100,000 7.229% BBC $103,627 7.385% NFL $119,048 7.143% If the choice is to be based on EAR, then loan NFL is preferred. Other factors to consider might include the nature of the relationship with the lending institution and whether the face value of outstanding debt might affect remaining borrowing capacity, for example. Problem 4 a) Differences between preferred shares and common shares: Preferred shares have stated dividends that do not change over time and common shares do not. Preferred shares have no voting rights and common shares have voting rights. Preferred shares have higher priority for residual payment in bankruptcy than common shares. Preferred shares often have cumulative dividends that must be paid before the common share dividends can be paid, whereas common shares do not have such a feature. b) Differences between preferred shares and debt: Preferred shares have an infinite life, whereas most debt has a finite life. Preferred shares have stated dividends but if these are not declared, the preferred shareholders cannot force the firm into bankruptcy because there is no legal liability. On the other hand, interest on debt must be accrued and paid, or the firm may face bankruptcy. Preferred share dividends are not deductible for tax purpose, whereas interest on debt is. c) Expected savings from refinancing the NOVA preferred share issue: NPV of refinancing = PV of dividend savings - call premium - net flotation cost PV of dividend savings: Quarterly dividend on new issue = $1.75 2,000,000 shares $3,500,000 Quarterly dividend on old issue = $2.25 2,000,000 shares 4,500,000 Net savings per quarter $1,000,000 PV discounted at the quarterly cost of the new issue, which is 1.75%: PV = $1,000,000 0.0175 Call premium = $6 2,000,000 shares = $12 million Net flotation costs = $1,000,000 - $1,000,000 5 Annual cost = (1.0175) 4-1 = 7.1859% 7.19% Therefore, net flotation costs = 1,000,000-80,000 PVIFA (7.19%, 5 years) = 1,000,000-80,000 (4.0794) = $673,646 = $57,142,857 NPV of savings if the issue is refinanced = $57,142,857 - $12,000,000 - $673,646 = $44,469,211 The refinancing is worthwhile since it has a positive NPV. * 0.4 * PVIFA (annual cost of new issue, 5 years) 30
d) If the company calls its preferred share issue at face value plus the call premium, but the market value is above this amount, then the holders of these preferred shares are disadvantaged. They have no recourse. If the issue is callable for a set premium, this is part of the contractual relationship between the firm and these shareholders. Cases Case 1: SASK This question involves analysis of a bond refinancing opportunity. A new public bond issue and a potential term loan are considered. The term loan requires a compensating balance. a) The new public bond issue has an after-tax cost of 7%(1-0.35) = 4.55% per annum. The NPV of refinancing includes a call premium of 0.01 (20,000,000) = $200,000, plus the difference in present values of the after-tax interest costs on the two bond issues. The discount rate appropriate for this analysis is the after-tax cost of the new bond, which is 4.55% per annum, or roughly 2.28% semi-annually, or effectively 2.25% (2.2496944%) per six months. PV of interest costs on existing bond issue: 0.05(20,000,000)(1-0.35) = $650,000 each half-year = 650,000 PVIFA (10 periods, 2.28%) = 650,000 8.85240 = $5,754,061 PV of interest costs on new bond issue: 0.07(20,000,000)(1-0.35) = 910,000 each year = 910,000 PVIFA (5 periods, 4.55%) = 910,000 4.3839 = $3,989,319 PV of difference in interest costs = $5,754,061 - $3,989,319 = $1,764,742 NPV of refinancing = $1,764,742 - call premium of 200,000 = $1,564,742 Yes, the issue should be refinanced if this is the only alternative, as the NPV of refinancing is positive. b) Advantages of a term loan for the lender include: Term loans do not have to be registered with provincial securities commissions as bond issues do. Term loans have much lower issue costs. Terms loans provide security for the lender, as term loans are often backed by capital assets. Advantages of a term loan for the borrower include: Term loans are faster to obtain. Term loans provide more flexible loan provisions. It is easier to negotiate changes in a loan contract, and the contract can be tailored to meet the needs of the borrower. c) i) A compensating balance is the average minimum cash balance required to be kept by a borrower on deposit with the lending institution. A compensating balance requirement increases the effective cost of financing, because less funds are available for the borrower to use. A compensating balance increases the loan face value a borrower requires to achieve the desired level of financing. 31
ii) The effective cost of financing is 4 0.0115 1 + c 1-0.02 d - 1 = 1.011735 4-1 = 4.78% The effective after-tax cost is 4.78%(1-0.35) = 3.105%. The amount SASK must borrow to receive $20,000,000 to use is 20,000,000 (1-0.02) = $20,408,163 d) The effective after-tax cost of the term loan is 3.105%. This compares favourably with the effective after-tax cost of the existing public bond issue, and the effective after-tax cost of the proposed new debt issue: Cost of existing public debt issue = (1.05) 2-1 = 10.25% After-tax cost = 10.25%(1-0.35) = 6.6625% After-tax cost of proposed public bond issue = 7%(1-0.35) = 4.55% The term loan has the lowest effective after-tax cost. An additional $408,163 must be borrowed, however, and the opportunity cost of these funds must be considered. The term loan is still cheaper, since the effective after-tax cost of 3.105%(1.02) = 3.1671%. Case 2: Mrs. Finacco a) i) With cumulative voting, the number of shares needed to ensure that one director can be elected is: (1)(12,000,000) (10 + 1) + 1 = 1,090,910 shares Mrs. Finacco has 40% of the 12,000,000 outstanding shares, or 4,800,000 shares. 4,800,000 With 4,800,000 shares, Mrs. Finacco can currently elect 1,090,910 = 4.4, or 4 directors. ii) To ensure that 6 directors can be elected would require 1,090,910 (6) = 6,545,460 shares. Since Mrs. Finacco already has 4,800,000 shares she would need an additional (6,545,460-4,800,000) = 1,745,460 shares to ensure that she can elect 6 directors, if the number of shares outstanding remains at 12 million. iii) At current share prices, an additional 1,745,460 shares will cost (1,745,460)($5.45) = $9,512,757. iv) Her new, higher ownership percentage is 6,545,460 12,000,000 = 54.55% b) To make this decision, we calculate the NPV of refunding the existing debt, replacing it with a bank loan, as follows: Call premium = 0.03($20,000,000) = $600,000 Interest savings, per year for 10 years, after tax = (10% - 8%)($20,000,000)(1-0.40) = $240,000 Discount rate = after-tax cost of new debt = 8%(1-0.40) = 4.8% PVIFA (4.8%, 10 years) = 7.797286 32
Present value of interest savings [$240,000 (7.797286)] $1,871,349 Less call premium 600,000 NPV $1,271,349 As the NPV of refunding is positive, the results of this analysis indicate that the debt should be refunded. (rights-on price - exercise price) c) i) The value of 1 right = (number of rights needed to buy 1 share) + 1 As there is a need to raise $20 million, at a subscription price of $4.45 per share the firm must issue 4,494,382 additional shares. As there are currently 12,000,000 shares outstanding, 2.67 rights must be needed to purchase 1 additional share. ii) Value of 1 right = (5.45-4.45) 3.67 = $0.2725 iii) Ex-rights share price = rights-on price - value of 1 right = 5.45-0.2725 = $5.18 d) i) New capital structure after the rights offering: Outstanding debt = existing bank debt = $10,000,000 Market value of equity = 16,494,382 shares @ $5.18 = $85,440,899 Capital structure prior to the rights offering: Outstanding debt = Bank debt + Public debt issue = $30,000,000 Market value of equity = 12,000,000 shares @ $5.45 = $65,400,000 Debt-to-equity ratio = 30,000,000 65,400,000 = 0.4587 ii) Earnings level prior to the rights offering: EBIT $21,500,000 Interest on bank debt (0.07)($10,000,000) 700,000 Interest on bond issue (0.10)($20,000,000) 2,000,000 Earnings before taxes 18,800,000 Tax at 40% 7,520,000 Net earnings $11,280,000 Net earnings per share = $11,280,000 12,000,000 = $0.94 33
Earnings after the rights offering: EBIT $21,500,000 Interest on bank debt (0.07) ($10,000,000) 700,000 Earnings before taxes 20,800,000 Tax at 40% 8,320,00 Net earnings after taxes $12,480,000 Net earnings per share = $12,480,000 16,494,382 = $0.7566 e) To maintain her new, higher ownership percentage, Mrs. Finacco will have to exercise all of the rights she receives. She will receive 1 right for each share held, or 6,545,460 rights. If she exercises all of her rights, she must invest an additional A 6,545,460 ($4.45) = $10,909,100. 2.67 B Then she will own 8,996,943 shares, and since 16,494,382 shares are outstanding, she still owns 54.55%. Mrs. Finacco s overall investment in Vanreal after buying additional shares to gain control over the board, and then purchasing shares in the rights offering to maintain her percentage ownership, is: 8,996,943 shares @ $5.18 = $46,604,165* Original investment 4,800,000($5.45) = $26,160,000 Additional shares 1,745,460($5.45) = 9,512,757 purchased Shares purchased in 2,451,483($4.45) = 10,909,099 the rights offering Total investment = 46,581,856 * Note: Rounding error of $22,308 attributed to ex-rights price used. By using an ex-rights price of $5.1775 instead of $5.18, the total investment sum becomes much closer: 8,996,943 shares @ $5.1775 = $46,581,672,leaving a remaining rounding error (from the number of rights needed to buy each new share) of $46,581,856 - $46,581,672 = $183.62. Case 3: Dorval Inc. Dorval Inc. is establishing new financing arrangements to support its capital expansion plans. Some new equity will be raised internally with retained earnings. For the remainder of the equity requirements, new common shares are to be issued via a rights offering. The firm will also issue new debt, and an existing debt issue may be simultaneously refinanced. The question therefore involves a comprehensive assessment of the impacts of all aspects of the new financing arrangements, from the perspective of the firm, its shareholders, and its debtholders. a) Dorval will give 1 right to each holder of 1 share; therefore, 8,000,000 rights will be issued. The firm will be raising $18 million of new outside equity, so the number of rights that will be needed to purchase 1 new share can be calculated as follows: The subscription price for a new share is $50. The total number of new shares to issue to 18,000,000 raise $18 million is 50 = 360,000 shares. The 8,000,000 existing shares will have the right to purchase 360,000 new shares, so the ratio is 22 to one. 8,000,000 360,000 34
The value of each right will be: After the rights issue, there will be 8.36 million shares outstanding. The value of each share is the total value of new equity divided by 8.36 million: New total value of equity = existing value of equity + new equity to raise = 8 million shares ($60 share price) + $18 million = $480 million + $18 million = $498 million New share price = $498 8.36 Current price - subscription price Number of rights needed to buy 1 share + 1 $60 - $50 = 23 = $10 23 = $0.43478 = $59.5694, or approximately $59.57 per share or New share price = current price - value of the right = 60-0.43478 = $59.57 Note that the retained earnings referred to in the scenario is already owned by the outside shareholders and is therefore included in the current market value of their shares. b) An owner of 50,000 shares would be affected as follows, if they either exercise or sell their rights: Shares owned % ownership Wealth Exercise 50,000 + 50,000/22 UNCHANGED 52,273 52,273/8,360,000 = 52,273($59.57) = 0.006253 or still $3,113,903 or 0.625% (original was 50,000($60) + 2,273 50,000/8,000,000 = ($50) = $3,113,650 0.625%) Note: the difference is rounding; using a price of $59.565 results in wealth of $3,113,641. Sell 50,000 DECREASES 50,000($59.57) + 50,000/8,360,000 = CASH = $2,978,500 + 0.00598 0.60% ($113,650 + $21,500) = $3,113,650 Note: 2,273($50) = $113,650 the cash not used to exercise the rights and 50,000($0.43) = $21,500 the proceeds from selling the rights. 35
Total wealth remains unchanged whether rights are exercised or sold. c) There are costs associated with Dorval refinancing its existing, outstanding $20 million of debt. These include the call premium and flotation costs for part of the new issue. Offsetting these costs are interest savings on the same amount. The discount rate to calculate present values is the cost of financing the new issue. The effective annual cost for the new issue is calculated as follows: 7% (1-0.40) = 4.20%; Therefore, a 1 + 0.042 2 b - 1 = 4.2441% L 4.24% or semi-annually 4.2% = 2.1% 2 2 Call premium = 0.6 (0.09) ($20,000,000) = $1,080,000 (not tax deductible) Flotation costs for $20 million of the new issue = 0.03 ($20,000,000) = $600,000 Flotation costs are incurred immediately. They are amortized over 5 years and generate tax shields as follows: a $600,000 b(0.40) * PVIFA(4.24%,5) 5 = $120,000(0.40)(4.421966) = $48,000(4.421966) = $212,254 Net flotation costs = $600,000 - $212,254 = $387,746 Semi-annual interest on existing issue = $20,000,000(0.045)(1-0.40) = $540,000 Semi-annual interest portion of on new issue = $20,000,000(0.035)(1-0.40) = $420,000 PV of interest savings = $120,000 PVIFA(2.10%, 10 periods) = $120,000 (8.935768) = $1,072,292 Total PV of effects of refinancing the existing $20,000,000 debt issue: Call premium $(1,080,000) Net flotation costs (387,746) PV interest savings 1,072,292 Total NPV $ (395,454) Dorval should not refinance the existing issue. It should just raise the additional $12 million of debt and leave the existing issue outstanding. PV of flotation costs associated with a $12 million new debt issue: = $12,000,000(0.03) = $360,000 Tax shield on flotation: 36 a $360,000 b(0.40)(pvifa 4.24%,5) = $127,353 5 After-tax flotation costs: $360,000 - $127,353 = $232,647
d) If Dorval calls in the outstanding bonds, a bondholder who currently owns bonds with $100,000 of face value will have to sell them back to the firm at face value. The bonds would be more valuable than the face value since they pay a coupon rate above the current market rate. Bondholders are aware that their bonds can be called as this is one of the features of the issue; they insist on receiving a premium as compensation for this risk. In this case, it is not worthwhile for the firm to call in the outstanding bonds, so it will not happen. CHAPTER FOUR Qualitative Questions Question 1 The cost of debt at low levels of leverage is less than the cost of equity because debt is safer than equity. The cost of debt stays constant up to some safe debt/equity ratio. Financial leverage increases the risk of equity and shareholders will demand a higher rate of return. WACC drops with increasing leverage as high-cost equity is replaced with lower cost debt. There is an optimal capital structure where the WACC is at a minimum. Question 2 Leverage implies that a firm is required to make interest and principal payments, regardless of its cash flows. If such payments are not made on time and as specified by the debt contract, the lender may force the firm into liquidation. Financial leverage magnifies the effects on earnings per share of changes in sales levels. Financial risk is measured as the difference between the total risk to shareholders of the levered firm and the total risk to shareholders of the unlevered firm. Question 3 The firm s choice of financing sources should not affect the value of its assets. Investors can create their own leverage and they are not willing to pay for services that they can do themselves. The cost of equity capital increases as the degree of financial leverage increases. WACC is constant as the advantage of cheaper debt is offset by the higher cost of equity. Question 4 Interest on corporate debt is deductible from income before calculating tax. Interest payments on debt provide a tax shield. Firm value increases by the present value of the interest tax shields. The firm is evaluated as if it were financed with all equity and the present value of the interest tax shield is added. Question 5 Personal taxes favour capital gains and dividend income over interest income. Corporate taxes favour interest income over capital gains and dividend income. The tax shield provided by the corporate interest payments is partially cancelled by the higher personal tax rate on interest income. 37