Discuss the three plausible reasons why stock prices tend to decline following the announcement of a new equity issue, but tend to rise following a debt announcement.

Discuss the three plausible reasons why stock prices tend to decline following the announcement of a new equity issue, but tend to rise following a debt announcement.

FNCE 370v9: Assignment 5
Assignment 5 is worth 5% of your final mark. Complete and submit Assignment 5 after you complete Lesson 15.

Question Marks available Marks awarded Reference
1 3 Lesson 13
2 6 Lesson 13
3 6 Lesson 13
4 7 Lesson 14
5 7 Lesson 14
6 12 Lesson 14
7 20 Lesson 14
8 21 Lesson 15
9 4 Lesson 15
10 14 Lesson 15
Total 100
Note on Decimal Places
When working through numerical problems, use as many decimal places as shown on your financial calculator. Do not round your calculated answers until you have reached the final answer. When you reach your final answer, round as follows, unless the question specifies otherwise.
Percentages: round to two decimal places
Dollars: round to two decimal places
Others: round to four decimal places
Questions
1. Discuss the three plausible reasons why stock prices tend to decline following the announcement of a new equity issue, but tend to rise following a debt announcement. (3 marks)
2. What are the advantages and disadvantages of “going public” (i.e., selling shares to the general public)? (6 marks)
3. WUV Ltd. wants to raise $3.29 million via a rights offering. The company currently has 420,000 shares of common stock outstanding that sell for $30 per share. Its underwriter has set a subscription price of $25 per share and will charge WUV a 6% spread. If you currently own 6,000 shares of stock in the company and decide not to participate in the rights offering, how much money can you get by selling your rights? (6 marks)
4. a. Using the M&M Proposition II without taxes and security market line, we can
derive the relationship among equity beta, asset beta, and capital structure. Write out this formula. (1 mark)
b. Using this formula, explain the meanings of business risk and financial risk. (3 marks)
c. Explain, in words, the relationship among business risk, financial risk, and the cost of equity. (3 marks)
5. Explain the static theory of capital structure using the graph below. Describe the meaning of each term (RU, RE, WACC*, RDx(1-Tc), and D*/E*) on the graph below. (7 marks)

6. DEF Company is comparing three different capital structures. Plan I would result in 800 shares of stock and $9,000 in debt. Plan II would result in 700 shares of stock and $13,500 in debt. Plan III is an all-equity plan and would result in 1,000 shares of stock. The firm’s EBIT will be $8,000 per year until infinity. The interest rate on the debt is 10%. (12 marks total)
a. Ignoring taxes, compute the EPS for each of the three plans. Which of the three plans has the highest EPS? Which has the lowest? (4 marks)
b. Compute the break-even EBIT that will cause the EPS on Plan I to be equal to the all-equity EPS. (2 marks)
c. Compute the break-even EBIT that will cause the EPS on Plan II to be equal to the all-equity EPS. (2 marks)
d. Compare your results from parts (b) and (c) above. Is one higher than the other? Why? (1 mark)
e. Ignoring taxes, what is the break-even EBIT that will cause the EPS on Plan I to be equal to the EPS on Plan II? What conclusions do you reach when you compare the outcomes of parts (b), (c), and (e) above? (3 marks)
7. Q Corporation and R Inc. are two companies with very similar characteristics. The only difference between the two companies is that Q Corp. is an unlevered firm, and R Inc. is a levered firm with debt of $5 million and cost of debt of 10%. Both companies have earnings before interest and taxes (EBIT) of $2 million and a marginal corporate tax rate of 40%. Q Corp. has a cost of capital of 15%. (20 marks total)
a. What is Q’s firm value? (2 marks)

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