CORPORATE FINANCE

Seminar 5:

1. Nolimits Ltd. is at the present time an all equity financed company with a cost of capital
of 12.5%. The manager, Ms Doverdecash, is considering whether it might be desirable
to issue some debt capital. Debt is currently yielding 5% p.a. and may be assumed to be
risk free for all firms who issue it (or who wish to issue it). To this end Ms Doverdecash
has collected data on four other companies, each of which falls into one of two
industrial sectors (A and B). The data she has collected are summarised below:

Industrial Leverage Expected growth Price Dividend

Company Sector Ratio of earnings/divs per share per share

X A 0 0 £1 10p
Y A 0.5 0 £2 30p
T B 0 0 £2 30p
U B 0.2 0 £2 35p

Where Leverage Ratio = Debt/(Debt +Equity)

There is no taxation.

(i) Calculate the cost of Equity capital, the cost of Debt capital and the WACC for the
four companies.
(ii) Given your answers to (i), advise Ms Doverdecash on the capital structure policy
which she should follow. Explain and justify your answer by reference to relevant
economic theory.
(iii) Indicate how your advice might be modified if corporate taxes were introduced into
the analysis.

2. Clacher plc and Holmes plc are two firms with identical prospects regarding their future
cash flows. The cash flows are expected to remain constant forever into the future. The
market assesses the prospects of the two companies and believes that there is a 30%
probability that the cash flow will be £20,000 and a 70% probability it will be £40,000.

The firms are the same in all respects except for their capital structures. Clacher is
entirely financed by equity capital, while Holmes has perpetual riskless debt outstanding
with an annual interest payment of £6,000. Clacher’s equity is valued at £200,000. The
risk-free rate of return in the economy is 10%. There is no taxation, and there are no
agency costs or bankruptcy costs.

(i) Assume that both firms are correctly priced by financial markets in accordance with
the Modigliani and Miller theorem. What is the expected rate of return on equity
for the two firms? (Hint: you will need to calculate the expected cash flow for the
firm and use the perpetuity formula).
(ii) Calculate the weighted average cost of capital (WACC) for the two firms.
 (iii) Holmes plc announces that it is going to issue additional perpetual debt, with
promised interest payments of £1,200. The funds generated will be used to make a
one-off payment to equity holders and there will be no other impact on expected
cash flows. Calculate the value of Holmes’ equity after the transaction described
above has been undertaken.

3. You are a financial analyst and your boss provides you with the following information on
ABC company:

 The company has issued common stock equity and bonds to finance its operations.
 ABC has currently 3 million stocks outstanding.
 The current market price of ABC stock is £5.3
 The beta of ABC stock is 1.2
 The risk premium for the stock market is estimated at 8%.
 The risk-free rate, which is determined by the central’s bank reference interest rate,
is 3%.
 The corporate bonds of ABC have a face value of £100 per unit, are coupon-bearing,
mature in 8 years from today, and they are currently selling at £106 per unit.
 When the corporate bonds were issued they had a total face value of £5,000,000
 According to the current market value of the corporate bonds, we can infer that
bondholders demand a risk premium of 4% for holding the company’s debt
securities.
Assuming that all rates are annual and CAPM holds, your boss asks you to:

(i) Calculate the cost of equity capital for ABC.

(ii) Calculate the cost of debt capital for ABC.
(iii) Calculate the pre-tax WACC for ABC.

4. Given the following situations, determine in each case whether the semi-strong EMH is
contradicted.

(a) Through the introduction of a complex computer programme into the analysis of
past stock price changes, a brokerage firm is able to predict price movements well
enough to earn a consistent 3% profit, adjusted for risk, above normal market
returns.

(b) On the average, investors in the stock market this year are expected to earn a
positive return on their investment. Some investors will earn considerably more
than others.

(c) You have discovered that the square root of any given stock price multiplied by the
day of the month provides an indication of the direction in price movement of that
particular stock with a probability of 0.7.
 (d) A Securities and Exchange Commission suit was filed against Texas Gulf Sulphur
Company in 1965 because its corporate employees had made unusually high profits
on company stock that they had purchased after exploratory drilling had started in
Ontario (in 1959) and before stock prices rose dramatically (in 1964) with the
announcement of the discovery of large mineral deposits in Ontario.

5. GameStop is a US video game retail company, whose shares are publicly traded in NYSE.
Being still a bricks-and-mortar company in a market that is rapidly moving online,
GameStop has been struggling for the past seven years. Reflecting the company’s
deteriorating financial performance, the stock price of GameStop has been steadily
declining over the last 7 years, from a 10-year high of $50 in 2013 to single-digit figures
in 2020.

In late January 2021, the stock price experienced an astronomical surge to almost $400
within a few days, only to tumble back below $50 a few days later. In mid-March, the
stock price rallied again, surpassing 200$ within a few days. “The stock surge (in mid-
March) came after the company announced that its activist investor and Chewy.com co-
founder Ryan Cohen would take the lead in transforming the gaming retailer into an e-
commerce business (FT, 9 March 2021)”.

GameStop stock price

Read the following articles on GameStop from the Financial Times:

https://www.ft.com/content/4916c465-99ec-46f4-a889-df845ad1bcd2 (29 Jan 2021)

https://www.ft.com/content/f41dc7b3-d2d5-43ba-bf75-42e5dbcc0efa (10 Mar 2021)

Based on the above information and the information contained in the two FT articles,
discuss (i) the decline in GameStop stock price over the period 2013 - 2020 and (ii) the
two stock price increase episodes in 2021, in the context of market efficiency. Is any of
the two price increase episodes in 2021 driven by news that change the fundamental
prospects of the firm and thus should be reflected in the stock price?

Some extra information that will help you understand the two FT articles:

 Short squeeze:

A short squeeze occurs when a stock jumps sharply higher, forcing investors who
had open short positions on the stock, to buy it in order to forestall even greater
losses. Their scramble to buy only adds to the upward pressure on the stock's
price.

Short sales have often an expiration date. This means that short-sellers have to
return the borrowed stocks at a specified date, so sometimes they don’t have
the luxury to wait for the price to revert back to lower levels. So when a stock
unexpectedly rises in price, the short-sellers may have to act fast to limit their
losses. A short squeeze accelerates a stock's price rise as short-sellers rush to
buy the stock to cut their losses, and thereby fuel the price rise further. For a
refresher on the basic mechanics of short selling, please watch Lecture 11c.

 Reddit / WallStreetBets:

Reddit is a social media site, which includes a channel called WallStreetBets.

WallStreetBets is essentially a chat forum where participants discuss stock and
option trading. During the last few months, there has been a huge increase in
the number of WallStreetBets users, who are mostly amateur retail investors.
Retail investing over the same period has surged. The interrelated increase in
retail investing and participation in social media forums about investing can be
attributed to many factors. The spectacular performance of the stock market
over the last few months that has attracted many amateur investors, the surge
in the use of social media over the quarantine, and the pandemic-induced
suspension of many sport activities that made many sports gamblers to turn to
the stock market instead, are among those factors. WallStreetBets is among the
most popular investing forums. The users of WallStreetBets are often referred to
as Redditors.