PROFESSOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.

COURSE: MBA-680-50-SUII12 Corporate Financial Theory

SEMESTER: Summer Session II

Exercises 14 , 15
(with solutions)

Konstantinos Kanellopoulos
13th August 2012

PART I EXERCISES FROM CHAPTERS 14 and 15

Exercise 1
Inbox Software was founded in 2008. Its founder put up $2 million for 500,000 shares of
common stock. Each share had a par value of $.10.
a) Construct an equity account for Inbox on the day after its founding. Ignore any legal or
administrative costs of setting up the company.
b) After two years of operation, Inbox generated earnings of $120,000 and paid no dividends.
What was the equity account at this point?
c) After three years the company sold 1 million additional shares for $5 per share. It earned
$250,000 during the year and paid no dividends. What was the equity account?

Solution 1
a.

The day after the founding of Inbox:

Common shares ($0.10 par value)
Additional paid-in capital
Retained earnings
Treasury shares
Net common equity

b.

b.

$50,000
1,950,000
0
0
$ 2,000,000

After 2 years of operation:

Common shares ($0.10 par value)
Additional paid-in capital
Retained earnings
Treasury shares
Net common equity

$50,000
1,950,000
120,000
0
$ 2,120,000

After 3 years of operation:

Common shares ($0.10 par value)
Additional paid-in capital
Retained earnings
Treasury shares
Net common equity

$150,000
6,850,000
370,000
0
$ 7,370,000

Exercise 2
In 2011 Beta Corporation earned gross profits of $760,000.
a) Suppose that it is financed by a combination of common stock and $1 million of debt. The
interest rate on the debt is 10%, and the corporate tax rate is 35%. How much profit is
available for common stockholders after payment of interest and corporate taxes?
b) Now suppose that instead of issuing debt Beta is financed by a combination of common
stock and $1 million of preferred stock. The dividend yield on the preferred is 8% and the
corporate tax rate is still 35%. How much profit is now available for common stockholders
after payment of preferred dividends and corporate taxes?

Solution 2
a.
Gross profits
Interest
EBT
Tax (at 35%)
Funds available to common shareholders

$ 760,000
100,000
$ 660,000
231,000
$ 429,000

Gross profits (EBT)

Tax (at 35%)
Net income
Preferred dividend
Funds available to common shareholders

$ 760,000
266,000
$ 494,000
80,000
$ 414,000

b.

Exercise 3
Which of the following features would increase the value of a corporate bond? Which would
reduce its value?
a)
b)
c)
d)

The borrower has the option to repay the loan before maturity.
The bond is convertible into shares.
The bond is secured by a mortgage on real estate.
The bond is subordinated.

Solution 3
a.
b.
c.
d.

Less valuable
More valuable
More valuable
Less valuable
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Exercise 4
There are three reasons that a common stock issue might cause a fall in price: (a) the price fall is
needed to absorb the extra supply, (b) the issue causes temporary price pressure until it has been
digested, and (c) management has information that stockholders do not have. Explain these
reasons more fully. Which do you find most plausible? Is there any way that you could seek to
test whether you are right?

Solution 4
a.

Inelastic demand implies that a large price reduction is needed in order to sell
additional shares. This would be the case only if investors believe that a stock has
no close substitutes (i.e., they value the stock for its unique properties).

b.

Price pressure may be inconsistent with market efficiency. It implies that the
stock price falls when new stock is issued and subsequently recovers.

c.

If a companys stock is undervalued, managers will be reluctant to sell new stock,

even if it means foregoing a good investment opportunity. The converse is true if
the stock is overvalued. Investors know this and, therefore, mark down the price
when companies issue stock. (Of course, managers of a company with
undervalued stock become even more reluctant to issue stock because their
actions can be misinterpreted.)
If (b) is the reason for the price fall, there should be a subsequent price recovery.
If (a) is the reason, we would not expect a price recovery, but the fall should be
greater for large issues. If (c) is the reason, the price fall will depend only on
issue size (assuming the information is correlated with issue size).

Exercise 5
Construct a simple example to show the following:
a. Existing shareholders are made worse off when a company makes a cash offer of new stock
below the market price.
b. Existing shareholders are not made worse off when a company makes a rights issue of new
stock below the market price even if the new stockholders do not wish to take up their rights.

Solution 5
a.

Example: Before issue, there are 100 shares outstanding at $10 per share. The
company sells 20 shares for cash at $5 per share. Company value increases by:
(20 x $5) = $100. Thus, after issue, each share is worth:

(100 $10) $100 $1,100

$9.17
100 20
120
Note that new shareholders gain: 20 $4.17 = $83
Old shareholders lose: 100 $0.83 = $83
b.

Example: Before issue, there are 100 shares outstanding at $10 per share. The
company makes a rights issue of 20 shares at $5 per share. Each right is worth:
Value of right

(rights on price) (issue price) 10 5

$0.83
N1
6

The new share price is $9.17. If a shareholder sells his right, he receives $0.83
cash and the value of each share declines by: $10 - $9.17 = $0.83
The shareholders total wealth is unaffected.

Exercise 6
In 2011 the Pandora Box Company made a rights issue at $5 a share of one new share for every
four shares held. Before the issue there were 10 million shares outstanding and the share price
was $6.
a. What was the total amount of new money raised?
b. What was the value of the right to buy one new share?
c. What was the prospective stock price after the issue?
d. How far could the total value of the company fall before shareholders would be unwilling to
take up their rights?

Solution 6
a.

5 (10,000,000/4) = 12.5 million

b.

Value of right

c.

Stock price

(rights on price) ( issue price) 6 5

0.20
N1
4 1

(10,000,00 0 6) 12,500,000
5.80
10,000,000 2,500,000

A stockholder who previously owned four shares had stocks with a value of: (4
6) = 24. This stockholder has now paid 5 for a fifth share so that the total
value is: (24 + 5) = 29. This stockholder now owns five shares with a value
of: (5 5.80) = 29, so that she is no better or worse off than she was before.
d.

The share price would have to fall to the issue price per share, or 5 per share.
Firm value would then be: 10 million 5 = 50 million.
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