Subject: Finance - Recommended textbook for the subject: Ross, Stephen A., Westerfield, Randolph W., Jordan, Bradford D. Essentials of Corporate Finance. (CHAPTERS 12, 13, 14 & 15) - Answer the fo

A nsw er t h ese e ssay q uestio ns:

1. T he D RK C orp ora tio n r e ce ntly d eve lo ped a d iv id end r e in ve stm ent p la n ( D RIP ).

T he p la n a llo w s in ve sto rs to r e in ve st c a sh d iv id ends a uto m atic a lly in D RK in

e xch ange fo r n ew s h are s o f s to ck. O ve r tim e, in ve sto rs in D RK w ill b e a ble to b uild

t h eir h old in gs b y r e in ve stin g d iv id ends to p urc h a se a ddit io nal s h are s o f th e

co m pany. O ve r 1 ,0 00 c o m panie s o ff e r d iv id end r e in ve stm en t p la ns. M ost

c o m panie s w it h D RIP s c h arg e n o b ro ke ra ge o r s e rv ic e fe es. In fa ct, th e s h are s o f

D RK w ill b e p urc h ase d a t a 1 0 p erc e n t d is co unt fr o m th e m ark e t p ric e . A c o nsu lt a nt

fo r D RK e stim ate s th at a bout 7 5 p erc e n t o f D RK's s h a re hold ers w ill ta ke p art in th is

p la n. T his is s o m ew hat h ig her th an th e a ve ra ge. E va lu ate D RK's d iv id end

re in ve stm ent p la n. Wi ll it in cre a se s h a re hold er w ealt h ? D is cu ss th e a dva nta ges a nd

dis a dva nta ges in vo lv e d h ere .

2 . S TE PH EN SO N R EAL E STA T E R EC APIT A LIZ AT IO N

Robert S te phenso n fo unded S te p henso n R eal E sta te C om pa ny y e ars a go a nd is it s

c u rre nt C EO . T he c o m pany p urc h ase s r e al e sta te , in clu din g la nd a nd b uild in gs, a nd

re nts th e p ro perty to te nants . T he c o m pa ny h as s h o w n a p ro fit e ve ry y e ar fo r th e

past 1 8 y e ars , a nd th e s h are hold ers a re s a tis fie d w it h th e c o m pany's m anagem ent.

P rio r to fo undin g S te phenso n R eal E sta te , R obert w as th e fo under a nd C EO o f a

f a ile d a lp aca fa rm in g o pera tio n. T he r e su lt in g b ankru ptc y m ad e h im e xtr e m ely

a ve rs e to d ebt fin ancin g. A s a r e su lt , th e c o m pa ny is e ntir e ly e quit y fin ance d, w it h 9

m illio n s h are s o f c o m mon s to ck o uts ta ndin g. T he s to ck c u rre ntly tr a des a t $ 42.5 0

per s h are . S te phenso n is e va lu a tin g a p la n to p urc h a se a h uge tr a ct o f la nd in th e

so uth easte rn U nit e d S ta te s fo r $ 50 m illio n. T he la nd w ill s u b se q uently b e le ase d to

t e nant fa rm ers . T his p urc h ase is e xp e cte d to in cre ase S te phenso n's a nnual p re ta x

earn in gs b y $ 12 m illio n in p erp e tu it y . K im W eya n d, th e c o m pa ny's n ew C FO , h as

been p ut in c h arg e o f th e p ro je ct. K im h as d ete rm in ed th at th e c o m pany's c u rre nt

co st o f c a pit a l is 1 2.5 p erc e nt. S he fe els th at th e c o m pa ny w ould b e m ore v a lu able

i f it in clu ded d ebt in it s c a pit a l s tr u ctu re , s o s h e is e va lu atin g w heth er th e c o m pany

sh ould is su e d ebt to e ntir e ly fin ance th e p ro je ct. B ase d o n s o m e c o nve rs a tio ns w it h

in ve stm ent b anks, s h e th in ks th at th e c o m pa ny c a n is su e b onds a t p ar v a lu e w it h

a n 8 p erc e nt c o upon r a te . F ro m h er a naly sis , s h e a ls o b elie ve s th at a c a pit a l

str u ctu re in th e r a nge o f 7 0 p erc e n t e quit y /3 0 p erc e n t d ebt w ould b e o ptim al. If th e

co m pany g oes b eyo nd 3 0 p erc e nt d ebt, it s b onds w ould c a rry a lo w er r a tin g a nd a

m uch h ig her c o upon b eca use th e p ossib ilit y o f fin ancia l d is tr e ss a nd th e a sso cia te d

co sts w ould r is e s h arp ly . S te phenso n h as a 4 0 p erc e n t c o rp ora te ta x r a te ( s ta te a nd

fe dera l) .

a . If S te phenso n w is h es to m axim iz e it s to ta l m ark e t v a lu e, w ould y o u

re co m mend th at it is su e d ebt o r e quit y to fin ance th e la nd p urc h ase ? E xp la in . b. C onstr u ct S te phenso n's m ark e t v a lu e b ala nce s h e et b efo re it a nnounce s th e

purc h ase .

c. S uppose S te phenso n d ecid es to is su e e quit y to fin ance th e p urc h ase .

i. Wh at is th e n et p re se nt v a lu e o f th e p ro je ct?

ii. C onstr u ct S te phenso n's m ark e t v a lu e b ala nce s h e et a fte r it a nnounce s

th at th e fir m w ill fin ance th e p urc h a se u sin g e quit y . W hat w ould b e th e n ew

pric e p er s h are o f th e fir m 's s to ck? H ow m an y s h a re s w ill S te phenso n n eed

to is su e to fin ance th e p urc h ase ?

iii. C onstr u ct S te phenso n's m ark e t v a lu e b ala nce s h e et a fte r th e e quit y is su e

but b efo re th e p urc h ase h as b e en m ad e. H ow m an y s h a re s o f c o m mon

sto ck d oes S te phenso n h ave o u ts ta ndin g? W hat is th e p ric e p er s h are o f th e

fir m 's s to ck?

d . C onstr u ct S te phenso n's m ark e t v a lu e b ala nce s h e et a fte r th e p urc h ase h as

been m ade.

e. S uppose S te phenso n d ecid es to is su e d ebt to fin ance th e p urc h ase .

i. Wh at w ill th e m ark e t v a lu e o f th e S te phenso n C om pa ny b e if th e p urc h ase

is fin ance d w it h d ebt?

ii. C onstr u ct S te phenso n's m ark e t v a lu e b ala nce s h e et a fte r b oth th e d ebt

is su e a nd th e la nd p urc h ase . Wh at is th e p ric e p er s h a re o f th e fir m 's s to ck?

f. Wh ic h m eth od o f fin ancin g m axim iz e s th e p er-s h a re s to ck p ric e o f

S te phenso n's e quit y ?

3 . C O ST O F C APIT A L F O R H UBBAR D C O M PU TE R , IN C.

Hubbard C om pute r, In c. ( H CI) h as r e ce n tly h ir e d y o u in it s r e la tiv e ly n ew tr e asu ry

m anagem ent d epartm ent. H CI w as fo unded e ig ht y e a rs a go b y B ob H ubbard a nd

cu rre ntly o pera te s 7 4 s to re s in th e S outh east. H CI is p riv a te ly o w ned b y B ob a nd

his fa m ily , a nd h ad s a le s o f $ 97 m illio n la st y e a r. H CI p rim arily s e lls to in -s to re

c u sto m ers w ho c o m e to th e s to re a nd ta lk w it h a s a le s r e pre se n ta tiv e . T he s a le s

re pre se nta tiv e a ssis ts th e c u sto m er in d ete rm in in g th e ty p e o f c o m pute r a nd

perip hera ls th at a re n ece ssa ry fo r th e in div id ual c u sto m er's c o m putin g n eeds. A fte r

th e o rd er is ta ke n, th e c u sto m er p ays fo r th e o rd er im media te ly , a nd th e c o m pute r is

m ade to fill th e o rd er. D eliv e ry o f th e c o m pu te r a ve ra ges 1 5 d ays, a nd it is

g uara nte ed in 3 0 d ays.

Q UESTIO NS

HCI's g ro w th to d ate h as b een fin ance d b y it s p ro fit s . W hen th e c o m pany h ad

su ff ic ie nt c a pit a l, it w ould o pen a n ew s to re . O th er th an s co utin g lo ca tio ns, r e la tiv e ly

l it tle fo rm al a naly sis h as b een u se d in it s c a p it a l b udgetin g p ro ce ss. B ob h as ju st

re ad a bout c a pit a l b udgetin g te ch niq ues a nd h as c o m e to y o u fo r h elp . F or s ta rte rs , the company has never attempted to determine its cost of capital, and Bob would

like you to perform the analysis. Since the company is privately owned, it is difficult

to determine the cost of equity for the company. Bob wants you to use the pure play

approach to estimating the cost of capital for HCI, and he has chosen Dell as a

representative company. The following steps will allow you to calculate this

estimate.a. Most publicly traded corporations are required to submit quarterly (10Q) and

annual reports (10K) to the SEC detailing the financial operations of the

company over the past quarter or year, respectively. These corporate filings are

available on the SEC website at www.sec.gov. Go to the SEC website and

search for SEC filings made by Dell. Find the most recent 10Q or 10K and

download the form. Look on the balance sheet to find the book value of debt and

the book value of equity. If you look further down the report, you should find a

section titled "Long-term Debt and Interest Rate Risk Management" that will

provide a breakdown of Dell's long-term debt.

b. To estimate the cost of equity for Dell, go to finance.yahoo.com and enter the

ticker symbol DELL. Follow the various links to answer the following questions:

What is the most recent stock price listed for Dell? What is the market value of

equity, or market capitalization? How many shares of stock does Dell have

outstanding? What is the most recent annual dividend? Can you use the

dividend discount model in this case? What is the beta for Dell? Now go back to

finance.yahoo.com and find the "Bonds" link. What is the yield on 3-month

Treasury bills? Using the historical market risk premium, what is the cost of

equity for Dell using the CAPM?

c. You now need to calculate the cost of debt for Dell. The following

table provides the yield to maturity for each of Dell's bonds. What is the

weighted aver-age cost of debt for Dell using the book value weights and the

market value weights? Does it make a difference in this case if you use book

value weights or market value weights?

d. You now have all the necessary information to calculate the weighted average

cost of capital for Dell. Calculate the weighted average cost of cap-ital for Dell using book value weights and market value weights. Assume Dell has a 35

percent marginal tax rate. Which cost of capital number is more relevant?

e. You used Dell as a pure play company to estimate the cost of capital for HCI.

Are there any potential problems with this approach in this situation?4. What was the largest IPO? Go to

www.hoovers.com and find out. In what country

was the company located? What was the largest IPO in the United States?

5. Explain this concept: “The cost of capital depends primarily on the use of the

funds, not the source.”