1. Midland Corporation has a net income of $15 million and 6 million shares outstanding. Its common stock is currently selling for $40 per share. Midland plans to sell common stock to set up a major new production facility with a net cost of $21,660,000. The production facility will not produce a profit for one year, and then it is expected to earn a 15 percent return on the investment. Stanley Morgan and Co., an investment banking firm, plans to sell the issue to the public for $38 per share with a spread of 5 percent.
a. How many shares of stock must be sold to net $21,660,000? (Note: No out-of-pocket costs must be considered in this problem.)
b. Why is the investment banker selling the stock at less than its current market price?
c. What are the earnings per share (EPS) and the price-earnings ratio before the issue (based on a stock price of $40)? What will be the price per share immediately after the sale of stock if the P/E stays constant?
d. Compute the EPS and the price (P/E stays constant) after the new production facility begins to produce a profit.
e. Are the shareholders better off because of the sale of stock and the resultant investment? What other financing strategy could the company have tried to increase earnings per share?
2. The management of Mitchell Labs decided to go private in 1994 by buying in all 3 million outstanding shares at $19.50 per share. By 1996, management had restructured the company by selling off the petroleum research division for $13 million, the fiber technology division for $9.5 million, and the synthetic products division for $21 million. Because these divisions had been only marginally profitable, Mitchell Labs is a stronger company after the restructuring. Mitchell is now able to concentrate exclusively on contract research and will generate earnings per share of $1.25 this year. Investment bankers have contacted the firm and indicated that if it reentered the public market, the 3 million shares it purchased to go private could now be reissued to the public at a P/E ratio of 16 times earnings per share.
b. What is the total value to the company from (1) the proceeds of the divisions that were sold as well as (2) the current value of the 3 million shares (based on current earnings and an anticipated P/E of 16)?
In $ millions In $ millions
Current assets....................... $50 Current liabilities................... $ 10
Fixed assets.......................... 50 Long-term liabilities............... 30
Total liabilities................... $ 40
Total assets.......................... $100 Stockholders' equity............. 60
Total liabilities and
Stockholders' equity......... $100
The footnotes stated that the company had $10 million in annual capital lease obligations for the next 20 years.
a. Discount these annual lease obligations back to the present at a 6 percent discount rate (round to the nearest million dollars).
b. Construct a revised balance sheet that includes lease obligations, as in Table 16-8.
c. Compute total debt to total assets on the original and revised balance sheets.
d. Compute total debt to equity on the original and revised balance sheets.
e. In an efficient capital market environment, should the consequences of SFAS No. 13, as viewed in the answers to parts c and d, change stock prices and credit ratings?
f. Comment on management's perception of market efficiency (the viewpoint of the financial officer).
4. Mr. and Mrs. Anderson own five shares of Magic Tricks Corporation's common stock.
The market value of the stock is $60. The Andersons also have $48 in cash. They have just received word of a rights offering. One new share of stock can be purchased at $48 for
each five shares currently owned (based on five rights).
a. What is the value of a right?
b. What is the value of the Andersons' portfolio before the rights offering? (Portfolio in this question represents stock plus cash.)
c. If the Andersons participate in the rights offering, what will be the value of their portfolio, based on the diluted value (ex-rights) of the stock?
d. If they sell their five rights but keep their stock at its diluted value and hold on to their cash, what will be the value of their portfolio?
5. Omni Telecom is trying to decide whether to increase its cash dividend immediately or use the funds to increase its future growth rate. It will use the dividend valuation model originally presented in Chapter 10 for purposes of analysis. The model was shown as formula 10-9 and is reproduced below (with a slight addition in definition of terms). P0 = Price of the stock today
D1 = Dividend at the end of the first year
D0 * (1 + g)
D0 = Dividend today
Ke = Required rate of return
g = Constant growth rate in dividends
D0 is currently $2.00, Ke is 10 percent, and g is 5 percent.
Under Plan A, D0 would be immediately increased to $2.20 and Ke and g will remain unchanged.
Under Plan B, D0 will remain at $2.00 but g will go up to 6 percent and Ke will remain unchanged.
a. Compute P0 (price of the stock today) under Plan A. Note D1 will be equal to D0 * (1 + g) or $2.20 (1.05). Ke will equal 10 percent and g will equal 5 percent.
b. Compute P0 (price of the stock today) under Plan B. Note D1 will be equal to D0 * (1 + g) or $2.00 (1.06). Ke will be equal to 10 percent and g will be equal to 6 percent.
c. Which plan will produce the higher value?
The solution answers various finance questions: selling shares of stock, computing EPS, investing and more.