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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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