Problem 1 (issuing equity in a perfect market).
Zancorp is a drug manufacturer with 200 million shares and no debt outstanding. Its net income is expected to be $450 million next year and grow at 6% forever. Its dividend payout ratio is 40%, and the required return on its type of business is 11.5%. Assume markets are "perfect" (efficient, with no taxes, transaction costs, or concerns about inside information).
a. What is Zancorp's current share price? (Hint: use the Gordon growth model.)
b. Zancorp announces it will raise $100 million in additional equity to finance a new drug. The new drug has higher risk than the rest of the firm (required return is 14%). After the $100 million is invested, the new drug will generate "free cash flows" of $8.7 million in Year 1, which will then grow at 8% per year forever. How many new shares will Zancorp issue to fund the project, and what will the share price be?
Problem 2 (capital structure and corporate taxes).
Apex Industries is a precision toolmaker. In a good economy (80% chance), its earnings before interest and taxes (EBIT) are $50 million; in a bad economy (20% chance), EBIT is $30 million. These scenarios and associated probabilities and earnings are expected to be the same every year forever. Apex faces a 30% tax rate, is funded with 7 million shares of common stock and no debt, and pays out all its net income as dividends. Markets are efficient.
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a. Suppose the risk-free rate is 2%, the market risk premium is 5%, and Apex stock has a beta of 1.1. What is Apex's current share price? (Hints: use the CAPM for Apex's equity return, and remember that, if you face the same earnings scenarios every year, expected growth is zero).
b. Apex issues $50 million of debt with an interest rate of 2%. Its plan is to roll over this debt at the same amount and rate every time it matures. Apex uses the $50 million in proceeds to buy back shares. After these transactions are complete, what is the new share price, and how many shares are outstanding?
Problem 3 (WACC).
Glominoid Corporate is a diversified conglomerate that makes everything from wiffle-balls to warheads. It currently has $7.4 billion of debt (market value) outstanding, with an average yield (return) of 4.35%, and 640 million common shares outstanding, which are currently trading at $21/share. Glominoid expects to pay a dividend of $2/share this coming year and grow it at 4%/year thereafter for the foreseeable future (i.e., forever). Glominoid's corporate taxes total 37% of income.
Given this information, what is Glominoid's WACC? (Hint: remember that we went over two different ways of calculating a firm's return on equity. Which is most useful here?)
Problem 4 (issuing shares and earnings per share).
Go back to Problem 1. Suppose that, instead of the share issue and new drug project in 1.b., Zancorp announced it would issue $100 million of new equity and use the proceeds to buy risk-free Treasury bills worth $100 million.
a. After the transaction, what is Zancorp's share price and number of shares outstanding?
b. If the Treasury bills pay 2% interest, what will Zancorp's total net income and earnings per share be next year? (Remember, there are no taxes in this problem.)
c. Is this transaction good for the initial shareholders? Why or why not (two sentences)?