FIN208: Corporate Finance

Tutorial 3: Corporate Financing: Equity

Question 1:

You are working for Zenith Machines as a financial consultant. The company is all-equity financed
with 500,000 shares outstanding and fixed assets that are expected to generate a perpetual annual
after-tax cash flow of $1 million. Zenith is contemplating a project to expand its market share. The
project will cost $2 million and is expected to generate a perpetual annual after-tax cash flow of
$300,000. The shareholders feel that a return of 10 percent is appropriate to use in discounting the
cash flows of both the existing assets and the new project.

i) Calculate the Net Present Value (NPV) of the project. Should the project be accepted?

The financial manager has decided to finance the project with a rights issue. But he cannot decide
whether he should propose a "1-for-5" or a "1-for-10" issue. He is afraid that the "1-for-5" issue
many have a larger "dilution effect" on share prices, even though he admits that the whole issue is
not at all clear to him. He wants your advice, including your rationale, on the following questions:

ii) Calculate the subscription price of the new shares and the ex-right stock price under the
"1-for-5" rights issues.

iii) Calculate the subscription price of the new shares and the ex-right stock price under the
"1-for-10" rights issues.

iv) Recommend which rights issue ("1-for-5" or "1-for-10") should be used by Zenith. Does it
matter which rights issue Zenith will use?

Question 2:

Polygram Berhad plans a rights issue to finance its new database program. For every four shares
held, a new share may be purchased. Currently, there are 10 million shares outstanding. Polygram
hopes to raise $80 million in new capital with the rights issue.

i) Calculate the subscription price should Polygram set so that it raises exactly $80
million?
 ii) Suppose Polygram's shares currently trade at $36 per share before the
announcement of the rights issue. Assuming that the software project has the
estimated NPV of $20 million, what is the value of a right? What is the ex-rights
stock price? Calculate.

iii) Explain why rights issues are usually made at a discount and how critical is the
pricing of a rights issue likely to be?

Question 3:

Academe Berhad has announced a right offer to raise $40 million for a new journal, the Journal
of Extreme Finance. This journal will review potential articles after the author pays a non-
refundable reviewing fee of $5000 per page. The stock currently sells for $34 per share, and there
are 3.4 million shares outstanding.

i) What is the maximum possible subscription price? What is the minimum?

ii) Calculate the number of new shares to be sold if the subscription price is set at $30
per share. Calculate also the number of rights needed to buy one new share.

iii) Calculate the ex-rights stock price.

iv) Calculate the value of each right.

v) Show how a shareholder with 1000 shares before the offering and no desire to buy
additional shares is not harmed by the rights offer.

Question 4:

A number of reasons have been advanced for the new issues underpricing phenomenon, with
different theories focusing on various aspects of the relations between investors, issuers, and the
investment bankers taking the firms public. Discuss the literature on the underpricing of IPOs.

Question 5:
GHL System Berhad is a computer services business that is about to expand its operations into the
Middle-East. At a meeting concerning the expansion, the directors decided to make a one-for-five
rights issue at a discount of 40 per cent on the current market value. The most recent income
statement of the business is as follows:

Income statement for the year ended 31 December Year 6

$m
Sales revenue 1,180
Operating profit 75
Interest charges (19)
Profit before taxation 56
Taxation (14)
Profit for the year 42

The business paid a dividend of 17 million in respect of the year.

The equity of the business as at 31 December Year 6 (as shown in the balance sheet) is as follows:

$m
Ordinary shares with $0.50 par value 120
Additional Paid-in Capital 80
Retained profit 560
Total Equity 760

GHL’s shares are being traded on the Stock Exchange at a price earnings (P/E) ratio of 24 times.

An investor owning 1,000 ordinary shares in the business, has received information about the
rights issue but is not sure whether to take up the rights issue, sell the rights, or allow the rights
offer to lapse.

(a) Calculate the theoretical ex-rights price of an ordinary share in GHL System Berhad.

(b) Calculate the price at which the rights in GHL System Berhad are likely to be traded.

(c) Evaluate each of the options available to the investor with 1,000 ordinary shares.

(d) Discuss the potential advantages and disadvantage of a rights issue compared to a public cash
issue of shares?
Question 6:

According to the Securities Commission, what are the common reasons for the IPO rejections in
Malaysia?

Question 7:

Country Sample Size Time Period Average First-

Day Return
Australia 381 1976-1995 12.1%
China 432 1990-2000 256.9
Hong 334 1980-1996 15.9
Kong
Malaysia 401 1980-1998 104.1
Singapore 128 1973-1992 31.4
Thailand 292 1987-1997 46.7%
Source: J. R. Ritter (2003)

The above table shows the phenomenon of underpricing of IPOs in some Asia-Pacific countries,
although the extent of underpricing varies from country to country. Discuss the possible
explanations of IPO underpricing and why the phenomenon seems to be more serious in the
emerging markets.