CHAPTER 14

An Overview of Corporate Financing

 

 

Answers to Practice Questions

 

1.                  Internet exercise; answers will vary.

 

 

2.                  In general, using market values of equity results in lower debt-to-total capital ratios.This occurs because the book value of equity reflects historical values at the time of the original stock issues.Market values reflect not only the firmís current operations but also the marketís expectations of future operations.

 

 

3.                  Besides the function of providing funds to industry, capital markets also provide managers with information.Without this information, it would be very difficult to determine the firmís opportunity cost of capital or to assess the firmís financial performance.

 

Capital markets provide liquidity for investors.Because individual stockholders can always recover retained earnings by selling shares, they are willing to invest in companies that retain earnings rather than paying out earnings as dividends.Well-functioning capital markets allow the firm to serve all its stockholders simply by maximizing value.

 

 

4.†††††††† a.†††††††† It appears that par value is approximately $0.05 per share, which is computed as follows:

 

††††††††††††††††††††††††††††††††††† $213 million/4,260 million shares

b.                  The shares were sold at an average price of:

††††††††††††††††††††††††††††††††††† [$213 million + $5,416 million]/4,260 million shares = $1.32

c.                  The company has repurchased:

††††††††††††††††††††††† 4,260 million - 3,847 million = 413 million shares.

d.                  Average repurchase price:

††††††††††††††††††††††† $6,851 million/413 million shares = $16.59 per share.

e.                  The value of the net common equity is:

††††††††††† $213 million + $5,416 million + $10,109 million - $6,851 million = $8,887 million

 


 

5.†††††††† a.†††††††† The day after the founding of Inbox:

 

Common shares ($0.10 par value)

$

50,000

Additional paid-in capital

 

1,950,000

Retained earnings

 

0

Treasury shares at cost

 

0

††††††††††† Net common equity

$

2,000,000

 

b.                  After 2 years of operation:

 

Common shares ($0.10 par value)

$

50,000

Additional paid-in capital

 

1,950,000

Retained earnings

 

120,000

Treasury shares at cost

 

0

††††††††††† Net common equity

$

2,120,000

 

c.                  After 3 years of operation:

 

Common shares ($0.10 par value)

$

50,000

Additional paid-in capital

 

6,850,000

Retained earnings

 

370,000

Treasury shares at cost

 

0

††††††††††† Net common equity

$

7,370,000

 

 

6.                  a.

Common shares ($0.25 par value)

$†† 120.5

Additional paid-in capital

1,791.5

Retained earnings

4,757.0

Treasury shares

(2,920.0)

Other adjustments

(652.0)

††††††††††† Net common equity

$3,097.0

 

††††††††††† b.

Common shares ($0.25 par value)

$†† 120.5

Additional paid-in capital

1,791.5

Retained earnings

4,757.0

Treasury shares

(3,620.0)

Other adjustments

(652.0)

††††††††††† Net common equity

$2,397.0

 

 

7.                  One would expect that the voting shares have a higher price because they have an added benefit/responsibility that has value.


 

8.                  a.††††††††

Gross profits

$

760,000

Interest

 

100,000

††††††††††† EBT

$

660,000

Tax (at 35%)

 

231,000

Funds available to common shareholders

$

429,000

 

††††††††††† b.††††††††

Gross profits

$

760,000

Interest

 

100,000

††††††††††† EBT

$

660,000

Tax (at 35%)

 

231,000

Net income

$

429,000

Preferred dividend

 

80,000

Funds available to common shareholders

$

349,000

 

 

9.†††††††† Internet exercise; answers will vary.

 

 

10.†††††† a.†††††††† Less valuable

b.                  More valuable

c.                  More valuable

d.                  Less valuable


 

Challenge Questions

 

 

1.†††††††† a.†††††††† For majority voting, you must own or otherwise control the votes of a simple majority of the shares outstanding, i.e., one-half plus one.Here, with 200,000 shares outstanding, you must control the votes of 100,001 shares.

 

b.                  With cumulative voting, the directors are elected in order of the total number of votes each receives.With 200,000 shares outstanding and five directors to be elected, there will be a total of 1,000,000 votes cast.To ensure you can elect at least one director, you must ensure that someone else can elect at most four directors.That is, you must have enough votes so that, even if the others split their votes evenly among five other candidates, the number of votes your candidate gets would be higher by one.

 

Let x be the number of votes controlled by you, so that others control (1,000,000 - x) votes.To elect one director:

 

 

 


Solving, we find x = 166,667.8 votes, or 33,333.4 shares.Because there are no fractional shares, we need 33,334 shares.

 

 

2.                  A corporation could issue a bond whose interest payments are linked to economic variables, such as the level of unemployment or housing prices.Such a security might not be issued due to problems in measurement of the relevant economic variables, or the cash flows might have a low correlation with the firmís ability to pay.

 

Other possibilities include:

        Securities that act as a hedge for the issuer, such as bonds indexed to copper prices for a copper producer, or to real estate prices for a real estate firm.

        Securities that may help to avoid undesirable outcomes, such as a bond that converts automatically to equity as the firm approaches bankruptcy.