Reference no: EM131001905

Question #1 –Empirical evidence shows that issuances of different types of securities (common stock, preferred stock, etc.) are priced by financial markets in different ways. Explain how investors typically react to the news of issuance of: (1) common stock, (2) preferred stock, and (3) bonds by firms. What is the typical reaction from investors to the news of a firm getting a (4) bank loan? Hint: Discuss the differences in magnitudes and directions of the cumulative abnormal returns after the announcement of such issuances to support your arguments.

Question #2 –

Bingo Wingo & Co (NYSE: BWC) has been in business for many years. The firm is suffering from declining cash flows in a declining industry. At the same time, the firm has raised large amounts of long-term debt over the years. Indeed, 20% of BWC’s total liabilities are composed of 10-year bonds and the firm has no short-term debt. A large fraction of BWC’s bonds are maturing next year.

BWC has a very simple asset structure. Half of its assets are composed of machines and plants. The other half is composed by cash and liquid securities. The company has 1 million shares outstanding and they each sell for $1,000. BWC’s Q (ratio of market over book value of assets) is 1.

BWC does not have new investment opportunities, and it has been rumored in the market that the managers may be looking into “cashing out” (managers hold most of the shares in BWC). Specifically, the WSJ reports that managers are considering the implementation of two financial policies. The first policy (“Policy 1”) consists of paying a large one-time cash dividend of $400 million. The other policy (“Policy 2”) involves issuing $500 million in short-term debt.

You manage a hedge fund family and your “Conservation Value Plus Portfolio®” is heavily invested in BWC’s long-term bonds. You wonder about the impact of these potential policies at BWC and need to re-evaluate your holdings.

Part A. A.1) Using the bottom of this page, describe the original balance sheet of BWC (before any policies are implemented by the managers).

A.2) Augment the balance sheet in A.1) adding a column depicting Policy 1.

A.3) Augment the balance sheet in A.2) adding an extra column depicting Policy 2.

                                                              Balance sheet in millions

                                              Original                  Policy 1              Policy 2

Assets

Cash/Liquid securities

Machines and plants

Total Assets

Liabilities

Short-term debt

Long-term debt

Equity

Total Liabilities

Part B. [5 points] BWC’s bonds were issued with AAA ratings and paid very low interest in face of the loose monetary policy of the early 2000’s. What should happen to the firm’s leverage ratio under Policy 1 and Policy 2? What should happen with the BWC’s credit ratings? Would these policies have positive or negative implications for your bond portfolio?

Part C. [5 points] After some additional investigation, BWC managers found out that their bond indentures had no provisions against a maneuver that combined both Policy 1 and Policy 2 (call it “Policy 3”). Describe BWC’s new asset and liability structure under Policy 3 in the last column of the balance sheet below. What should happen to the value of the bonds held in your portfolio under Policy 3?

                                                     Balance sheet in millions

                                          Original                     Policy 1                 Policy 2           Policy 3 

Assets

Cash/Liquid securities

Machines/ plants

Total Assets

Liabilities

Short-term debt

Long-term debt

Equity

Total Liabilities

Question #3 – 25 Points [From RWJ: Questions and Problems # 17.7] Fountain Corporation´s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that the project Fountain chooses will be the firm´s only activity and that the firm will close one year from today. Fountain is obligated to make a $2,500 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects

Economy               Probability        Low-Volatility Project Payoff          High-Volatility Project Payoff

Bad                        0.50                        $2,500                                     $2,100 

Good                       0.50                       $2,700                                      $2,800

Part A. [5 points] What is the expected value of the firm if the low-volatility project is undertaken? Which of the two strategies maximize the expected value of the firm?

Part B. [5 points] What is the expected value of the firm´s equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken?

Part C. [5 points] Which project would Fountain´s stockholders prefer? Explain.

Part D. [10 points] Suppose bondholders are fully aware that stockholders might choose to maximize equity value rather than total firm value and opt for the high volatility project. To minimize this agency cost, the firm´s bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if Fountain chooses to take on the high-volatility project. What payment to bondholders would make stockholders indifferent between the two projects?

Question #4 – 25 Points [From Lecture Notes #6] Hank&Tank Corp. is a privately-owned family business whose managers always opposed the idea of leveraging up the firm’s capital structure. The firm’s equity is valued at $2,500,000 and its operating profits (EBIT) are $400,000 per year. Corporate taxes paid by H&T Corp. are 35%.

Part A. [5 points] Fill the entries in column (2) using the information you have on H&T Corp. What are the cost of equity and the WACC of the firm?

(1)                   (2)

EBIT

Interest Payment

EBT

Tax Payment

Net Income

Equity Holders + Debt Holders Payments

Part B. [10 points] H&T is approached by a PE firm with the proposal of raising $1,500,000 of debt to repurchase equity and leverage up the firm’s capital structure. The cost of debt is 5% per year. Under this new scenario, fill the entries in column (2) assuming the proposed financial maneuvering does not change the firm’s real side operations. What are the new debt-to-assets ratio of H&T, the new cost of equity and the new WACC?

(1)                   (2)

EBIT

Interest Payment

EBT

Tax Payment

Net Income

Equity Holders + Debt Holders Payments

Part C. [10 points] Considering the leveraging-up deal from Part B, how exactly do equity holders benefit from the proposal made by the PE firm? What is the present value of the tax-shield benefits? Is H&Ts equity more or less risky now (quantify costs)?