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How high are the current cash flows of the firm (to service the debt) and how

stable are these cash flows? (Look at the variability in the operating income
over time)
How easy is it for bondholders to observe what equity investors are doing?

Are the assets tangible or intangible? If not, what are the costs in terms of
monitoring stockholders or in terms of bond covenants?
How well can this firm forecast its future investment opportunities and needs?


Getting Information about Current Financing Choices
The information about current financing choices can almost all be extracted from
the financial statements. The balance sheet should provide a summary of the book values
of the various financing choices made by the firm, though hybrids are usually categorized
into debt (if they are debt hybrids) and equity (if they are equity hybrids). The description
of warrants outstanding as well as the details of the borrowing that the firm has should be
available in the footnotes to the balance sheets. In particular, the maturity dates for
different components of borrowing, the coupon rates and information on any other
special features should be available in the footnotes.
Online sources of information:



1. An income bond holder receives interest payments only if the firm makes income. If
the firm does not make interest payments in a year, the interest is cumulated and paid
in the first year the firm makes income. A preferred stock receives preferred
dividends only if the firm makes income. If a firm does not make preferred dividend
payments in a year, the dividend is cumulated and paid in the first year the firm
makes income. Are income bonds really preferred stock? What are the differences?
For purposes of calculating debt how would you differentiate between income bonds
and regular bonds?

2. A commodity bond links interest and principal payments to the price of a commodity.
Differentiate a commodity bond from a straight bond, and then from equity. How
would you factor these differences into your analysis of the debt ratio of a company
that has issued exclusively commodity bonds?

3. You are analyzing a new security that has been promoted as equity, with the
following features:
The dividend on the security is fixed in dollar terms for the life of the security, which

is 20 years.
The dividend is not tax deductible.

In the case of default, the holders of this security will receive cash only after all debt

holders, secured as well as unsecured, are paid.
The holders of this security will have no voting rights.

Based upon the description of debt and equity in the chapter, how would you classify this
security? If you were asked to calculate the debt ratio for this firm, how would you
categorize this security?

4. You are analyzing a convertible preferred stock, with the following characteristics for
the security:
There are 50,000 preferred shares outstanding, with a face value of $ 100 and a 6%

preferred dividend rate.


The firm has straight preferred stock outstanding, with a preferred dividend rate of

The preferred stock is trading at $105.

Estimate the preferred stock and equity components of this preferred stock.

5. You have been asked to calculate the debt ratio for a firm that has the following
components to its financing mix “
The firm has 1 million shares outstanding, trading at $ 50 per share.

The firm has $ 25 million in straight debt, carrying a market interest rate of 8%.

The firm has 20,000 convertible bonds outstanding, with a face value of $1000, a

market value of $1100, and a coupon rate of 5%.
Estimate the debt ratio for this firm.

6. You have been asked to estimate the debt ratio for a firm, with the following
financing details:
The firm has two classes of shares outstanding; 50,000 shares of class A stock, with 2

voting rights per share, trading at $ 100 per share and 100,000 shares of class B stock,
with 1/2 voting right per share, trading at $ 90 per share.
The firm has $ 5 million in bank debt, and the debt was taken on recently.

Estimate the debt ratio. Why does it matter when the bank debt was taken on?

7. Zycor Corporation obtains most of its funding internally. Assume that the stock has a
beta of 1.2, the riskless rate is 6.5% and the market risk premium is 6%.
a. Estimate the cost of internal equity.
b. Now assume that the cost of issuing new stock is 5% of the proceeds. Estimate
the cost of external equity.

8. Office Helpers is a private firm that manufactures and sells office supplies. The firm
has limited capital and is estimated to have a value of $ 80 million with the capital
constraints. A venture capitalist is willing to contribute $ 20 million to the firm in
exchange for 30% of the value of the firm. With this additional capital, the firm will
be worth $ 120 million.
a. Should the firm accept the venture capital?


b. At what percentage of firm value would you (as the owner of the private firm)
break even on the venture capital financing?

9. Assume now that Office Helpers in problem 2 decides to go public and that it would
like to have its shares trade at a target price of $ 10 per share. If the initial public
offering is likely to be under priced by 20%, how many shares should the firm have?

10. You are a venture capitalist and have been approached by Cirrus Electronics, a
private firm. The firm has no debt outstanding and does not have earnings now but is
expected to be earning $ 15 million in four years, when you also expect it to go
public. The average price earnings ratio of other firms in this business is 50.
a. Estimate the exit value of Cirrus Electronics.
b. If your target rate of return is 35%, estimate the discounted terminal value of
Cirrus Electronics
c. If you are contributing $ 75 million of venture capital to Cirrus Electronics, at
the minimum, what percentage of the firm value would you demand in return?
11. The unlevered beta of electronics firms, on average, is 1.1. The riskless rate is 6.5%
and the market risk premium is 6%.
a. Estimate the expected return, using the capital asset pricing model.
b. As a venture capitalist, why might your have a target rate of return much higher
than this expected return?

12. Sunshine Media has just completed an initial public offering, where 50 million shares
of the 125 million shares outstanding were issued to the public at an offering price of
$ 22 per share. On the offering date, the stock price zoomed to $ 40 per share. Who
gains from this increase in the price? Who loses, and how much?

13. Initial public offerings are difficult to value because firms going public tend to be
small and little information is available about them. Investment bankers have to under
price initial public offerings because they bear substantial pricing risk. Do you agree
with this statement? How would you test it empirically?


14. You are the owner of a small and successful firm with an estimated market value of $
50 million. You are considering going public.
a. What are the considerations you would have in choosing an investment banker?
b. You want to raise $ 20 million in new financing, which you plan to reinvest
back in the firm. (The estimated market value of $ 50 million is based upon the
assumption that this $20 million is reinvested.) What proportion of the firm would
you have to sell in the initial public offering to raise $ 20 million?
c. How would your answer to (b) change if the investment banker plans to under
price your offering by 10%?
d. If you wanted your stock to trade in the $20-$25 range, how many shares
would you have to create? How many shares would you have to issue?

15. You have been asked for advice on a rights offering by a firm with 10 million shares
outstanding, trading at $ 50 per share. The firm needs to raise $ 100 million in new
equity. Assuming that the rights subscription price is $ 25, answer the following
a. How many rights would be needed to buy one share at the subscription price?
b. Assuming that all rights are subscribed to, what will the ex-rights price be?
c. Estimate the value per right.
d. If the price of a right were different (higher or lower) than the value estimated
in (c), how would you exploit the difference?

16. You are stockholder in a SmallTech Inc., a company that is planning to raise new
equity. The stock is trading at $ 15 per share, and there are 1 million shares
outstanding. The firm issues 500,000 rights to buy additional shares at $ 10 per share
to its existing stockholders.
a. What is the expected stock price after the rights are exercised?
b . If the rights are traded, what is the price per right?
c. As a stockholder, would you be concerned about the dilution effect lowering
your stock price? Why or why not?


17. Assume that SmallTech has net income of $ 1 million and that the earnings will
increase in proportion with the additional capital raised.
a. Estimate the earning per share that SmallTech will have after the rights issue
described in the last problem.
b. Assume that SmallTech could have raised the capital by issuing 333,333
shares at the prevailing market price of $ 15 per share (thus raising the same
amount of equity as was raised in the rights issue) to the public. Estimate the
earnings per share that SmallTech would have had with this alternative.
c. As a stockholder, are you concerned about the fact that the rights issue results
in lower earnings per share than the general subscription offering (described
in (b)).

18. MVP Inc., a manufacturing firm with no debt outstanding and a market value of $100
million is considering borrowing $ 40 million and buying back stock. Assuming that
the interest rate on the debt is 9% and that the firm faces a tax rate of 35%, answer the
following questions:
a. Estimate the annual interest tax savings each year from the debt.
b. Estimate the present value of interest tax savings, assuming that the debt change is
c. Estimate the present value of interest tax savings, assuming that the debt will be
taken on for 10 years only.
d. What will happen to the present value of interest tax savings, if interest rates drop
tomorrow to 7% but the debt itself is fixed rate debt?

19. A business in the 45% tax bracket is considering borrowing money at 10%.
a. What is the after-tax interest rate on the debt?
b. What is the after-tax interest rate if only half of the interest expense is allowed as a
tax deduction?
c. Would your answer change if the firm is losing money now and does not expect to
have taxable income for three years?


20. WestingHome Inc. is a manufacturing company that has acccumulated an net
operating loss of $ 2 billion over time. It is considering borrowing $ 5 billion to
acquire another company.
a. Based upon the corporate tax rate of 36%, estimate the present value of the tax
savings that could accrue to the company.
b. Does the existence of a net operating loss carry forward affect your analysis? (Will
the tax benefits be diminished as a consequence?)

21. Answer true or false to the following questions relating to the free cash flow
hypothesis (as developed by Jensen).
a. Companies with high operating earnings have high free cash flows.
b. Companies with large capital expenditures, relative to earnings, have low free cash
c. Companies that commit to paying a large portion of their free cash flow as
dividends do not need debt to add discipline.
d. The free cash flow hypothesis for borrowing money makes more sense for firms in
which there is a separation of ownership and management.
e. Firms with high free cash flows are inefficiently run.

22. Assess the likelihood that the following firms will be taken over, based upon your
understanding of the free cash flow hypothesis.
a. A firm with high growth prospects, good projects, low leverage, and high earnings.
b. A firm with low growth prospects, poor projects, low leverage, and poor earnings.
c. A firm with high growth prospects, good projects, high leverage, and low earnings.
d. A firm with low growth prospects, poor projects, high leverage, and good earnings.
e. A firm with low growth prospects, poor projects, low leverage, and good earnings.
You can assume that earnings and free cash flows are highly correlated.

23. Nadir, Inc., an unlevered firm, has expected earnings before interest and taxes of $2 million
per year. Nadir's tax rate is 40%, and the market value is V=E=$12 million. The stock has a
beta of 1, and the risk free rate is 9%. [Assume that E(Rm)-Rf=6%] Management is



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