FIN60204 – CORPORATE FINANCE

TUTORIAL QUESTIONS

TOPIC 10 – CHAPTER 20 (HOW FIRMS ISSUE SECURITIES? VC, IPO &

RIGHTS ISSUE)

1. Again Inc. is proposing a rights offering. Presently, there are 550,000 shares
outstanding at $87 each. There will be 85,000 new shares offered at $81 each.
a. What is the new market value of the company?
b. How many rights are associated with one of the new shares?
c. What is the ex-rights price?
d. What is the value of a right?
e. Why might a company have a rights offering rather than a general cash offer?

Answer

a) New market value = existing shares market value + new shares market value
= (550,000 x $87) + (85,000 x $81)
= $54,735,000

b) Total rights associated with 1 new shares is the number of shares outstanding
divided by the rights offered.

Number of rights needed = 550,000 old shares / 85,000 new shares

= 6.47 rights per new share

c) Value of a right @ Ex – Rights Price = New market value / new total of shares
= $54,735,000 / (550,000 + 85,000)
= $86.20

d) Value of a right = Price after rights issue (Ex-Rights Price) – Price of the rights
issue
= $86.20 - $81 = $5.20

e) A rights offering usually costs less, it protects the proportionate interests of

existing shareholders and also protects against under-pricing.
Cost less, protect proportionate interest of existing shareholders, protect against
under-pricing

2. The Taipei Co. and the Tainan Co. have both announced IPOs at $40 per share. One
of these is under-valued by $9, and the other is over-valued by $4, but you have no
vary of knowing which is which. You plan on buying 1,000 shares of each issue. If an
issue is under-priced, it will be rationed and only half your order will be filled. If you
could get 1,000 shares in Taipei and 1,000 shares in Tainan, what would your profit
be? What profit do you actually expect?

Answer

Page 1 of 4
FIN60204 – CORPORATE FINANCE
TUTORIAL QUESTIONS

If you receive 1,000 shares of each, the profit is:

Profit = 1,000($9) – 1,000($4) = $5,000

Since you will only receive one-half of the shares of the oversubscribed issue, your
profit will be:

Expected profit = 500($9) – 1,000($4) = $500

This is an example of the winner’s curse.

The winner's curse is a tendency for the winning bid in an auction to exceed the intrinsic
value of the item purchased. Because of incomplete information, emotions or any other
number of factors regarding the item being auctioned, bidders can have a difficult time
determining the item's intrinsic value. As a result, the largest overestimation of an item's
value ends up winning the auction. Originally, the term was coined as a result of companies
bidding for offshore oil drilling rights in the Gulf of Mexico. In the investing world, the term
often applies to initial public offerings.

3. Well-Bred Service Company earned $50,000,000 during 2005 and paid $20,000,000
in dividends to the holders of its 40 million shares. If the current market price of
Well-Bred’s stock is $31.25, calculate the following:

a. The company’s dividend payout ratio

b. Nominal dividend per share, assuming Well-Bred pays dividends annually
c. Nominal dividend per share, assuming Well-Bred pays dividends in equal
quarterly payments
d. Current dividend yield on Well-Bred stock.

Answer
a. Dividend payout ratio = Dividend Per Share / Earnings Per Share

Or

Dividend payout ratio = Total dividends / Net income

Dividend payout ratio = $20m / $50m = 0.4 @ 40%

b. Dividend per share (DPS) = Total dividend payable / Total outstanding shares
Annually
DPS = $20m / 40m = $0.50

c. Quarterly
DPS = ($20m / 40m) / 4 = $0.50 /4 = $0.125

d. The current yield = Annual dividend per share / current share price

Page 2 of 4
FIN60204 – CORPORATE FINANCE
TUTORIAL QUESTIONS

= $0.50 ÷ $31.25
= 1.60%

4. Before issuance of new shares, there are currently 100 units of shares outstanding at
$10 per share in Dave’s Deli Ltd. The firm sells 20 shares under the rights issue for
cash at $5 per share.

a. What is the price of the firm’s each share after the rights issue?
b. Calculate the value of the rights and how much the new shareholders’ gain and
also how much the old shareholder lose.

Answer
a. Value of a right @ Ex – Rights Price = New market value / new total of shares
= [(100 x $10) + (20 x $5)] / (100 + 20) = $9.17

The new share price is $9.17. If a shareholder sells his right, he receives $4.17
cash and the value of his holding will be $5.

b. Value of the rights = Price after rights issue (Ex-Rights Price) – Price of the
rights issue
= $9.17 - $5 = $4.17

New shareholders’ gain = 20 x ($9.17 - $5) = $83.40

Existing shareholders’ lose = 100 x ($10 - $9.17) = $83

The shareholder’s total wealth is unaffected.

5. Super-Thrift Pharmaceuticals Company traditionally pays an annual dividend equal to

50 percent of its earnings. Earnings this year are $30,000,0000. The company has 15
million shares outstanding. Investors expect earnings to grow at a 5 percent annual
rate in perpetuity, and they require a return of 12 percent on their shares.
a. What is Super-Thrift’s current dividend per share? What is it expected to be
next year?
b. Use the Gordon growth model to calculate Super-Thrift’s stock price today.

Answer
a. Dividend per share (DPS) = Total dividend payable / Total outstanding shares

= ($30m ÷ 2) / 15m = $1

Next year dividend, D1 = D0 x (1 + g)

= $1 x (1 + 5%) = $1.05

a. P = D1 / (R – g) = D0 x (1 + g) / (R – g)
= $1.05 / 12% - 5% = $15

Page 3 of 4
FIN60204 – CORPORATE FINANCE
TUTORIAL QUESTIONS

6. Why are the costs of debt issues less than those of equity issues?

Answer

There are several possible reasons why the issue costs for debt are lower than those of
equity, among them:

1. The cost of complying with government regulations may be lower for debt.
2. The risk of the security is less for debt and hence the price is less volatile as compared
to shares prices which fluctuates more as compared to debt such as bond issuance.
This decreases the probability that the issue will be mis-priced and therefore decreases
the underwriter’s risk.

Page 4 of 4