Practice Questions for Final Exam

by Kyung Hwan Shim University of New South Wales Australian School of Business School of Banking & Finance for FINS 1613 S1 2010 June 7, 2010

These notes are preliminary and under development. They are made available for FINS 1613 S1 2010 students only and may not be distributed or used without the authors written consent.

Problems on Raising Capital and Venture Capital John is the founder of Prospects Technologies. Prospects is a high technology rm with great prospects. In 1999, John needed capital to nance growth. SkyHigh Venture Capital was willing to provide John with $1M for a 35% stake of the rm value. John accepted SkyHighs oer.

(a) What was Prospects rm value after SkyHigh VCs nancing?

(b) What was Johns stake and what was it worth after the nancing?

(c) What was the rm value after the 2nd round of nancing?

(d) What were Johns and SkyHigh VCs stake in the rm after the 2nd round of nancing and how much were they worth? Comment on your results.

Problems on Raising Capital and IPO John, Skyhigh and 2ndRound VC decided in 2003 to undergo an IPO. The IPO was intended to raise $10M by oating 1M shares corresponding to 1/2 of Prospects stake. The issue price was set to be $12 per share. The underwriting fees were $2M. On the day of the IPO, the stock price closed at $15.

(e) What was the IPO spread per share?

(f ) What was the capital amount raised net of underwriting costs from the IPO?

(g) How much were the underpricing per share and total underpricing cost?

(h) How much was total cost of issuance?

(i) What was the rm value after IPO?

(j) How much did John, SkyHigh, and 2ndRound VC as a group realize in wealth loss due to underpricing?

(k) How much did John, SkyHigh, and 2ndRound VC each realize in wealth loss due to underpricing?

Problems on Dividends

By 2005, Prospects has become a mature rm. Prospects has completely depleted its investment opportunities. Therefore, Prospects future operating prots are generated from existing assets only. Prospects existing assets are expected to generate $7.14286M in operating prots every year for the indenite future. Prospects cost of capital is 10% and not subject to taxes. Prospects dividend policy is a payout ratio of 100%. Prospect is yet to pay current years dividends.

(l) What is Prospects dividend per share?

(m) What is Prospects cum-dividend and ex-dividend share price?

(n) If Prospects increases dividends by $0.5 per share only for the current year and the extra dividend is nanced by issuing stocks, how many new shares must it issue to nance the dividend? What is the cum-dividend price per share? What is the ex-dividend price per share? What is the new annual dividend? Will the new shares be issued at cum-dividend or ex-dividend price?

(o) If 2ndRound did not want the extra dividend, what could 2ndRound have done? Please provide a detailed answer making use of homemade dividends.

Problems on Capital Structure

Now, instead of extra dividends, assume that Prospects is considering a capital restructuring. Again, by 2005, assume that Prospects has become a mature rm. Prospects has completely depleted its investment opportunities. Therefore, Prospects future operating prots are generated from existing assets only. Prospects existing assets are expected to generate $7.14286M in operating prots every year for the indenite future. Prospects cost of capital is 10% and it is subject to 30% taxes on prots.

(p) What is Prospects Firm Value?

(q) What would be the present value of debt tax shields if Prospects converts to 20% debt and 50% debt? Prospects debt will be riskless if its 50% of rm value.

(r) What is Prospects overall cost of capital if Prospects remains unlevered, converts to 20% debt and 50% debt? Explain your results.

(s) What is Prospects cost of equity if Prospects remains unlevered, converts to 20% debt and 50% debt? Prospects debt will remain riskless at 50% debt and the riskless rate of return is 5%. Explain your results.

(t) Validate your answers from questions (r) and (s) are correct by computing Prospects overall cost of capital using the WACC formula under each capital structure policy.

(u) By increasing debt over 50% of the rm value Prospects debt becomes risky. Prospects PV(Distress Cost) associated with dierent amounts of debt are as specied in the table below. What is Prospects optimal amount of debt according to the Trade O Theory?

Debt $29.4118M $40M $60M $80M $100M $120M

PV(Distress Cost) $0 $2M $6M $12M $24M $29M