FM212: Principles of Finance

Lent Term: Corporate Finance

Workshop 2

1. Micromanaged Catering Inc. (MCI) has two assets: £1,600 in cash and an investment project.
The cash is invested in the risk-free asset which earns 5% per year. The project requires an
investment of £800 today and generates an expected cash flow of £1,600 one year from now.
This opportunity recurs perpetually each year. Thus, for example, one year from now MCI
can again invest £800 and generate £1,600 one year subsequent to that investment. MCI
has 800 shares outstanding. The market equity premium is 5% per year, and the investment
project has unit beta. Assume a Modigliani and Miller world.

(a) Should MCI invest in the project? Explain.

(b) Suppose MCI’s CFO decides to pursue the project. What is the value of MCI? After
investing in the project, what is MCI’s equity beta?
(c) Suppose MCI’s CFO decides to take the project and always pay out all free cash flow
as a dividend. What is MCI’s cum-dividend price expected to be one year from now?
(d) MCI’s investment banker suggests that MCI instead pays out the £1,600 in cash as
a dividend today, reverting to the CFO’s proposed dividend policy described in part
(c) in one year. In order to continue to invest in the project, MCI must raise equity
immediately after the dividend is paid to raise the cash needed for the project. How
many shares must be issued to new shareholders?
(e) Describe both the dollar amount and timing of the expected dividend stream to old
shareholders under the investment banker’s proposal. Has old shareholder wealth changed?

2. Anchor Gaming, a manufacturer of gambling machines, has a firm value of $100 million and
has $40 million of outstanding debt. Initially, there are 1 million shares of common stock
outstanding. Anchor Gaming has only two assets: gambling assets with a beta of 1.2 and
$10 million cash. Assume a Modigliani-Miller world.

(a) Suppose that Anchor Gaming issues $20 million of equity and uses the proceeds to pay
down debt. Thus, after the equity issue, $20 million of debt is outstanding. What would
be the effect of debt reduction on firm value? Explain.
(b) Suppose that instead of using the $20 million proceeds from the equity issue to pay
down debt, Anchor Gaming uses the $20 million to purchase additional gambling assets.
Calculate Anchor Gaming’s equity beta after the new equity is issued. Assume that the

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 new gambling assets have the same beta as its existing gambling assets, and that the
beta on Anchor Gaming debt is 0.20 before and after the new equity is issued.
(c) Will the actions in (b) cause the expected return on Anchor gaming’s equity to rise or
fall? Explain.
(d) How many shares of stock must Anchor Gaming issue in order to raise $20 million?
Assume the $20 million is used to reduce debt from $40 million to $20 million. What
will the stock price be after the new equity issue?