1. You operate a firm which will last one year. At the end of the year, the firm will generate its single cash flow. It will either be 140 or 40 – each equally likely. (Assume all cash flows are in $million.) You also have debt outstanding with face value of 100. You are the sole equity holder. A new project is now available to you but it requires an investment of 30, of which you have none. If you can obtain financing for the project and undertake it, the project will generate 50 next year (period). Say that the existing debt prevents you from issuing any new debt so that you must issue shares of equity. Assume the following: a discount rate of zero; and you currently have 2 million shares outstanding.
a) Would you issue new equity and undertake the new project? b) Now assume that the bank offers to forgive a little over 20 so that your new debt face value is just under 80. Now, would you undertake the project? c) Would it surprise you that the bank may have unilaterally offered to forgive debt? Explain.
2. Answer the following short answer questions.
a) Read the section in Chapter 16 in the Brealey and Myers textbook concerning Rights Issues. The rights issue is an alternative approach used by management to obtain equity financing. In general, you should note the following about rights issues: • Setting a lower subscription price makes the deal more likely to get done • The deal not getting done will reflect badly on management • It is less likely that underpriced firms will have a significant price drop (which results in the deal not getting done). Given this information and what you've learned in the course, give a qualitative explanation for the following evidence: • Firms who announce cash offers suffer a decrease in stock price. • Firms who announce rights issues enjoy a stock price increase. • For firms who offer rights issues, higher subscription prices lead to higher stock prices.
b) You are consulting the CFO of...
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