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Prof. Thomas J. Chemmanur MF881: Advanced Corporate Finance Practice Problem Set – IV 1. LMN Corporation, a real-estate corporation, is planning to pay a dividend of 0.50 per share. Most of the investors in LMN are other corporations, who pay 40% of their ordinary income and 28% of their capital gains as taxes. However, they are allowed to exempt 15% of the dividends they receive from taxes. If the shares are selling at $10 per share, how much would you expect the stock price to drop on the ex-dividend day? 2. If Consolidated Power is priced at $50 with dividend, and its price falls to $46.50 when a dividend of $5 is paid, what is the implied marginal rate of personal taxes for its stockholders? Assume that the tax on capital gains for the marginal investor in the firm’s equity is 28%. 3. (Tax Induced Trading around the Ex-dividend Day) Texas utilities pays a quarterly dividend of $0.77. Assume that the stock is trading at $35 per share, and that tomorrow is the ex-dividend date. Based on the past behavior of the firm’s shares on the ex-dividend date, you believe that the drop in the price of the firm’s shares will only be around 85% of the dividend amount paid. Assuming that you work for a non-profit (tax exempt) institution, suggest a dividend capture trading strategy around the ex-dividend day. 4. The CRC company has a current share price of $50. Its expected dividend D1 in the coming year is $2 per share, which reflects the company's current dividend policy of paying out 50% of earnings (i.e., next year's expected earnings is $4 per share). Investors currently expect earnings (and therefore dividends) to grow at a constant rate of 8% per year. The firm has currently 1000 shares outstanding. The required rate of return, r, is 12%. (a) What is the current price per share? What is the expected price one year from now? (b) Suppose the board of directors of the company announces tomorrow that the firm is going to change its payout policy to a payout ratio of 100%. It will, however, keep its investment policy unchanged (i.e., it will take on the same projects as before), but will now raise the money required for investment by issuing new equity at the end of each year, as required. Compute the new share price of the firm today, and at the end of the year, under this new policy. What will be the new growth rate in dividends? Ignore all market imperfections in your computations. 5. (Dividend Signaling Under Asymmetric Information) Johnson Trucking has cash available of $25 million, out of which a portion is to be paid out as dividend , with the remaining re-invested in the firm. It is deciding whether to pay out $10 million (option 1), $15 million (option 2) or $20 million (option 3) in dividends (re-investing the remaining cash in each case in the firm). Since the equity market is characterized by asymmetric information about the firm’s future cash flows, higher dividend will increase the firm’s current cash flows, but will reduce the firm’s intrinsic (long term) value (because increased dividends leads to lower investment in this case). The following table gives the firm’s intrinsic value and current market value for each of the three alternative levels of dividends being considered: Option I Option II Option III Dividend $10 mil $15 mil $20 mil Re-invested $15 mil $10 mil $ 5 mil Intrinsic value $220 mil $210 mil $200 mil Market value $190 mil $210 mil $215 mil (a) If management is indifferent to current market value of the firm’s equity, which option will they choose? (b) If management cares about current market value as well as the intrinsic (long-term) value of the equity, such that they want to maximize an equally weighted average of the firm’s current value and market value, which option will they choose? 6. (Issuing Equity Under Asymmetric Information) Olympus Corporation is currently selling at $50 a share and has $1 million shares outstanding. The $50 share price reflects the values of two components of firm value (as we discussed in class): (1) Value of assets in place, currently valued by the market at $40 million; and (2) NPV of a new project available to the firm, valued at $10 million (PV of future cash flows from the project if it is implemented = $30 million, Investment required to implement, $20 million). Firm management believes that, while the NPV of the firm’s new project is accurately reflected in the market price, the firm’s existing assets in place are undervalued by the market, since they are aware that the firm has discovered a vast amount of oil, worth $50 million, on its property. However, they are unable to credibly convey this information to the market, so that they believe that the firm’s shares will be undervalued for some time. (i) Assume first that the only way the firm can raise the required capital of $20 million to implement the new project is by selling equity. If the firm management wants to maximize the long-term (intrinsic) value of the firm, should they go ahead and sell equity and implement the project? What will be the intrinsic value of the firm’s shares if (a) they implement the project and (b) they abandon the project? (ii) Now assume that the firm can raise the required capital by selling risk-less debt. What will be the intrinsic value of the firm’s share if (1) they implement the project and (2) they abandon the project? 7. (Risk Shifting Caused by High Leverage) Unoit Industries has two mutually exclusive investment opportunities (projects), R and S, each requiring an investment of $50 million, which it plans to fund with debt. Project S pays off $60 million for certain. Project R has an uncertain outcome: it pays $90 million when the economy is good but only $20 million when the economy is poor. (i) What is the NPV of each project, assuming that investors are risk neutral, the risk-free rate is zero and that the economy is equally likely to be good or poor. (ii) Assuming for simplicity that the debt issued will be one period, pure discount debt, compute the face value of the debt that needs to be issued to raise the required investment amount of $50 million, if (a) Lenders believe that the firm will undertake the project S or (b) Lenders believe that the firm will undertake the project R? (iii) I firm management makes its investments decisions in order to maximize the cash flows to equity holders, which project will the firm undertake in practice? If lenders are sophisticated, what is the promised payment that the firm has to offer in return for the $50 million in current debt financing?
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