Tutorial 2(Equities-Revision)

1. The authorized share capital of the Alfred Cake Company is 100,000 shares. The
equity is currently shown in the company’s books as follows:

Common stock ($1 par value) $60,000

Additional paid-in capital $10,000
Retained earnings $30,000
Common equity $100,000
Treasury stock (2,000 shares) $5,000
Net Common Equity $95,000

a) How many shares are issued?

Number of shares = par value of issued stock/par value per share

= $60,000/$1.00 = 60,000 shares

b) How many are outstanding?

Outstanding shares = issued shares – Treasury stock

= 60,000 – 2,000 = 58,000 shares

c) How many more shares can be issued without the approval of shareholders?

The firm can issue up to a total of 100,000 shares. Because 60,000 shares have
been issued, another 40,000 shares can be issued without approval from
shareholders.
d) Suppose that the company issues 10,000 shares at $4 a share. Which of the above
figures would change?

The issue of 10,000 shares would increase the par value of common stock by:
10,000 shares  $1.00 = $10,000
Additional paid-in capital increases by:
10,000 shares  $3.00 per share = $30,000
The new accounts would be as follows:
Common stock $ 70,000
Additional paid-in capital 40,000
Retained earnings 30,000
 Common equity 140,000
Treasury stock 5,000
Net common equity $135,000

e) What would happen to the company’s books if instead it bought back 1,000 shares
at $4 per share?

If the company bought back 1,000 shares, Treasury stock would increase by the amount spent
on the stock: $4,000. The accounts would be:
Common stock $ 60,000
Additional paid-in capital 10,000
Retained earnings 30,000
Common equity 100,000
Treasury stock 9,000
Net common equity $ 91,000

2. “Since internal funds provide the bulk of industry’s needs for capital, the securities
markets serve little function.” Does the speaker have a point?

Capital markets provide liquidity for investors. Because individual stockholders can
always lay their hands on cash by selling shares, they are prepared to invest in companies
that retain earnings rather than pay them out as dividends. Well-functioning capital
markets allow the firm to serve all its stockholders simply by maximizing value. Capital
markets also provide managers with information. Without this information, it would be
very difficult to determine opportunity costs of capital or to assess financial performance.

3. In 1987 RJR Nabisco, the food and tobacco giant, had $5 billion of A-rated debt
outstanding. In that year the company was taken over, and $19 billion of debt was
issued and used to buy back equity. The debt ratio skyrocketed, and the debt was
downgraded to a BB rating. The holders of the previously issued debt were furious,
and one filled a lawsuit claiming that RJR had violated an implicit obligation not to
undertake major financing changes at the expense of existing bondholders. Why did
these bondholders believe they had been harmed by the massive issue of new debt?
What type of explicit restriction would you have wanted if you had been one of the
original bondholders?

The extra debt makes it more likely that the firm will not be able to make good on its
promised payments to its creditors. If the new debt is not junior to the already-issued
debt, then the original bondholders suffer a loss when their bonds become more
susceptible to default risk.
A protective covenant limiting the amount of new debt that the firm can issue would have
prevented this problem. Investors, having witnessed the problems of the RJR
bondholders, generally demanded the covenant on future debt issues.

4. What information is contained in the shareholders' equity account in the firm's

financial statements?

The shareholders' equity account breaks down the book value of equity into par value,
additional paid-in capital, retained earnings, and Treasury stock. For most purposes, the
allocation among the first three categories is not important. These accounts also show the
total number of shares issued as well as shares repurchased by the company.

5. Discuss why more firms are turning to internally generated funds to finance new
projects.

Many firms have a long-term goal of sustaining a growth rate consistent with their
capacity to generate funds internally. They also tend to pursue internally financed
projects with greater ease because there is no need to go to the capital market, and
therefore the costs associated with new security issues will be avoided. Even though the
opportunity cost of capital does not depend on whether projects are financed internally or
externally, managers tend to avoid the capital markets by retaining sufficient earnings to
be able to meet unanticipated demands for cash.

6. Disregarding issues of risk and return, why might it be important to shareholders and
management alike as to what class of equity is issued (e.g., common, preferred, etc.)?

The primary differences between classes of stock revolve around dividends and voting
rights. For example, in return for a fixed dividend with priority of payment, preferred
shareholders often receive less than full voting rights. Thus, common shareholders may
view the issuance of preferred equity as a "good news, bad news" situation: On the one
hand, the common owners are giving up less of their voting power, and thus may be able
to raise funds externally without diluting their ownership. Further, the government is
partially subsidizing preferred issuance by allowing corporate holders to exclude 70% of
the dividends from taxation. This will lower the rate of interest that must be paid, but of
course this form of financing excludes the interest tax shield of debt. The bad news for
common shareholders may be that if too much cash has been promised to preferred
holders, it could jeopardize the dividends to common holders.
From the preferred shareholders' view, voting rights may not be the primary concern.
They may view this form of investment as being similar to corporate debt but with a
higher rate of return. While they know that the corporation may omit a preferred
dividend, it will not be able to keep this up for long without disgruntling common
shareholders. This risk reduces to one of just time value of money if the preferred
dividends are cumulative. Finally, preferred holders know that they stand in line ahead of
common shareholders in the case of bankruptcy.
7. How would a convertible bondholder decide whether to exercise his rights of
exchange?

The number of shares of common stock that a convertible bond may be exchanged for is
known from the time of issuance of the bonds. Therefore, it becomes relatively easy to
multiply the current market value of the stock by the number of shares that can be
received from the exchange of one bond, and compare this to the current value of the
bond. In actuality, the decision is just slightly more difficult because both the bond and
the stock are likely to offer cash payments (interest or dividends). Comparison of these
expected cash flows may make a bondholder more or less likely to exchange. Of course,
management may be very happy to never have to repay the amount of borrowed
principal. This may influence how they initially determine the exchange ratio.

8. Discuss generally the idea of bond ratings, including the difference between
investment grade and junk bonds.

Corporate bonds are rated for safety of interest and principal by agencies such as
Moody's or Standard and Poor's. Their rating systems are similar and, in general, the
higher the rating (e.g., Aaa), the safer the bond. Raters consider many facets of the
corporation when evaluating the margin of safety for interest and principal payments as
well as the fluctuation of protective elements. As can be imagined, the bond rating will
directly affect the yield that the corporation must offer to bondholders. Bonds are
considered investment grade if they receive any of the four top ratings offered by either
agency, or are considered junk bonds if they receive a lower rating. Of course, ratings can
change, meaning that previously investment grade bonds can now be junk bonds and the
company is considered a "fallen angel."

9. Asia Standard International Group Ltd. has perpetual preferred stock outstanding that
sells for RM60 a share and pay a dividend of RM6 at the end of each year. What is
the required rate of return.

Dp = $6.00; Vp = $60; rp = ?

Dp $6.00
rp = = = 10%.
Vp $60.00
10. What will be the nominal rate of return on a perpetual preferred stock with a RM100
par value, a stated dividend of 8% of par, and a current market price of;
(a) RM60
(b) RM80
(c) RM100
(d) RM140

Vp = Dp/rp; therefore, rp = Dp/Vp.

a. rp = $8/$60 = 13.33%.

b. rp = $8/$80 = 10.0%.

c. rp = $8/$100 = 8.0%.

d. rp = $8/$140 = 5.71%.

11. Asia Standard International Group Ltd. issued perpetual preferred stock with a 10%
annual dividend. The stock currently yields 8%, and its par value is RM100.
(a) What is the stock’s value?
(b) Suppose interest rates rise and pull the preferred stock’s yield up to 12%. What is
its new market value?
Dp $10
a. Vp = = = $125.
rp 0.08

$10
b. Vp = = $83.33.
0.12

12. Lippo Ltd. has perpetual preferred stock outstanding with a par value of RM100. The
stock pays a quarterly dividend of RM2, and its current price is RM80.
(a) What is its nominal annual rate of return?
(b) What is its effective annual rate of return.
a. The preferred stock pays $8 annually in dividends. Therefore, its nominal rate of
return would be:
Nominal rate of return = $8/$80 = 10%.

Or alternatively, you could determine the security’s periodic return and multiply by 4.

Periodic rate of return = $2/$80 = 2.5%.

Nominal rate of return = 2.5%  4 = 10%.

b. EAR = (1 + rNOM/4)4 – 1
= (1 + 0.10/4)4 – 1
= 0.103813 = 10.3813%.