Please show calculations/formulas for the first problem and please check my work on the last two problems and comment:
O,Meara, Inc., plans to issue $6 million of perpetual bonds. The face value of each bond is $1,000
The semi-annual coupon on the bonds is 4.5%
Market interest rates on one-year bonds are 8%
With equal probability, the long-term market interest rate will be either 12% or 16%
next year. Assume investors are risk-neutral.
a. If the O'Meara bonds are noncallable,what is the price of the bonds?
b. If the bonds are callable one year from today at $1,250, will their price be greater than
or less than the price you computed in (a)? Why?
check the two below:
a. Why do venture capital companies prefer to
advance money in stages? If you were
the management of Marvin Enterprises, would you have
been happy with such an
arrangement? With the benefit of hindsight did First
Meriam gain or lose by advancing
money in stages?
b. The price at which First Meriam would invest more
money in Marvin was not fixed
in advance. But Marvin could have given First Meriam
an option to buy more shares
at a preset price. Would this have been better?
c. At the second stage Marvin could have tried to
raise money from another venture
capital company in preference to First Meriam. To
protect themselves against this,
venture capital firms sometimes demand first refusal
on new capital issues. Would
you recommend this arrangement?
Here is recent financial data on Pisa Construction,
Stock price $40 Market value of firm $400,000
Number of shares 10,000 Earnings per share $4
Book net worth $500,000 Return on investment 8%
Pisa has not performed spectacularly to date. However,
it wishes to issue new shares to
obtain $100,000 to finance expansion into a promising
market. Pisa's financial advisers
think a stock issue is a poor choice because, among
other reasons, "sale of stock at a
price below book value per share can only depress the
stock price and decrease shareholders'
wealth." To prove the point they construct the
following example: "Suppose 2,500 new shares are
issued at $40 and the proceeds are invested. (Neglect
Suppose return on investment does not change. Then
Book net worth _ $600,000
Total earnings _ .08(600,000) _ $48,000
Thus, EPS declines, book value per share declines, and
share price will decline proportionately
Evaluate this argument with particular attention to
the assumptions implicit in the
A. Venture capital is a term to describe the financing
of startup and early stage businesses as well as
businesses in "turn around" situations. Venture
capital investments generally are higher risk
investments but offer the potential for above average
returns. A venture capitalist (VC) is a person who
makes such investments.
Venture capitalists generally:
* Finance new and rapidly growing companies;
* Purchase equity securities;
* Assist in the development of new products or
* Add value to the company through active
* Take higher risks with the expectation of higher
* Have a long-term orientation
When considering an investment, venture capitalists
carefully screen the technical and business merits of
the proposed company. Venture capitalists only invest
in a small percentage of the businesses they review
and have a long-term perspective. Going forward, they
actively work with the company's management by
contributing their experience and business savvy
gained from helping other companies with similar
Venture capitalists mitigate the risk of venture
investing by developing a portfolio of young companies
in a single venture fund. Many times they will
co-invest with other professional venture capital
firms. In addition, many venture partnerships will
manage multiple funds simultaneously. For decades,
venture capitalists has nurtured the growth of
America's high technology and entrepreneurial
communities resulting in significant job creation,
economic growth and international competitiveness.
Companies such as Digital Equipment Corporation,
Apple, Federal Express, Compaq, Sun Microsystems,
Intel, Microsoft and Genentech are famous examples of
companies that received venture capital early in their
Thus, VENTURE CAPITAL COMPANIES PREFERS TO ADVANCE
MONEY IN STAGES in order to make a balance between
risk and reward equation. Advancing money in stages as
it brings more accountability and tracking of the
performance diminishes the risks of the investor.
Therefore First Meraim will be the gainer as there
will be less risk associated with it. But if First
Meriam is comfortable about the performance in future
than it should invest earlier at lesser price.
B. Marvin could have given the opportunity to First
Meriam to buy at present price. This could have been
better as it could have saved the part of the
underwriting cost & the issue expenses. This could
have instilled more confidence in the mind of the
C. This arrangement can be done as it will give
assurance to the First Meriam that they are the
partners in the progress. It will be fair for the
venture capital firms as they are taking high risks.
The argument here is whether the shares should be
issued below the book value or not!
If we see the Market value per share is $40 and the
new issue is also supposed to be at $40.
It is unrealistic that one can issue more than $40 as
then the investor will purchase from the market
instead of taking from the corporation.
Now the EPS declines because Book value per share is
more than market value per share. Book value per share
Therefore one has to see the practical market
consideration also. The debt can also be issued if the
interest cost is less than 8% i.e less than ROI. But
the issuance of debt will increase the financial risk
of the firm. Therefore the firm has to maintain the
optimum ration between the two to increase the return
to the shareholders.
a. If the O, Meara bonds are noncallable, what is the price of the bonds?
The price of the bond today would be the discounted sum of the cash flows to the investor. The cash flow to the investor are the coupon interest and the price of the bond one year from today. The interest amount is $45 every six months. The price of the bond at the end of 1 year would depend on the interest rate. For a perpetual bond, the price is coupon rate/interest rate. The price could be 45/.06=750 or 45/.08=562.5. $45 is the semiannual coupon and the interest rate is divided by 2 for semi annual. Since both the interest rates have equal probability, the expected price, end of the year, would be0.5X750+0.5X562.5 = 656.25.
We discount these cash flows to get the price today. The interest is semi annual so
we discount at 4% ( half of 8% the annual rate).
The price today would be 45/(1.04) + 45/(1.04)^2 + ...
The solution has three problems- 1. Issue price of perpetual bonds, 2. Venture capital investments and 3. EPS and stock issue.