revision for final 2012 mba 680 soluti
INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.
COURSE: MBA-680-50-F12 Corporate Financial Theory
SEMESTER: I, 2012
Revision for the Final Exam
(with results)
Konstantinos Kanellopoulos
12th December 2012
PART I EXERCISES FROM CHAPTERS 18-19-26-27-33
Exercise 1 – Chapter 18
“I was amazed to find that the announcement of a stock issue drives down the value of the issuing firm by 30%, on average, of the proceeds of the issue. That issue cost dwarfs the underwriter’s speed and the administrative costs of the issue. It makes common stock issues prohibitively expensive”.
a) You are contemplating a $100 million stock issue. On past evidence, you anticipate that announcement of this issue will drive down stock price by 3% and that the market value of your firm will fall by 30% of the amount to be raised. On the other hand, additional equity funds are necessary to fund an investment project that you believe has a positive NPV of $40 million. Should you proceed with the issue?
b) Is the fall in market value on announcement of a stock issue an issue cost in the same sense as an underwriter’s spread? Respond to the quote that begins this question.
Use your answer to (a) as a numerical example to explain your response to (b).
Solution Other things equal, the announcement of a new stock issue to fund an investment project with an NPV of $40 million should increase equity value by $40 million (less issue costs). But, based on past evidence, management expects equity value to fall by $30 million. There may be several reasons for the discrepancy:
(i) Investors may have already discounted the proposed investment. (However, this alone would not explain a fall in equity value.)
(ii) Investors may not be aware of the project at all, but they may believe instead that cash is required because of, say, low levels of operating cash flow.
(iii) Investors may believe that the firm’s decision to issue equity rather than debt
COURSE: MBA-680-50-F12 Corporate Financial Theory
SEMESTER: I, 2012
Revision for the Final Exam
(with results)
Konstantinos Kanellopoulos
12th December 2012
PART I EXERCISES FROM CHAPTERS 18-19-26-27-33
Exercise 1 – Chapter 18
“I was amazed to find that the announcement of a stock issue drives down the value of the issuing firm by 30%, on average, of the proceeds of the issue. That issue cost dwarfs the underwriter’s speed and the administrative costs of the issue. It makes common stock issues prohibitively expensive”.
a) You are contemplating a $100 million stock issue. On past evidence, you anticipate that announcement of this issue will drive down stock price by 3% and that the market value of your firm will fall by 30% of the amount to be raised. On the other hand, additional equity funds are necessary to fund an investment project that you believe has a positive NPV of $40 million. Should you proceed with the issue?
b) Is the fall in market value on announcement of a stock issue an issue cost in the same sense as an underwriter’s spread? Respond to the quote that begins this question.
Use your answer to (a) as a numerical example to explain your response to (b).
Solution Other things equal, the announcement of a new stock issue to fund an investment project with an NPV of $40 million should increase equity value by $40 million (less issue costs). But, based on past evidence, management expects equity value to fall by $30 million. There may be several reasons for the discrepancy:
(i) Investors may have already discounted the proposed investment. (However, this alone would not explain a fall in equity value.)
(ii) Investors may not be aware of the project at all, but they may believe instead that cash is required because of, say, low levels of operating cash flow.
(iii) Investors may believe that the firm’s decision to issue equity rather than debt