Question

Sales is expected to increase 15% per year from the new machine project. Working capital at the beginning of a given year is 20% of sales for that year, allocated at the beginning of the project and recouped at the end of project life. Depreciation uses straight line method and reduces the machine salvage value to zero over its useful life The CFO is confident of this project and expects the company-wide dividends to grow at the same rate as the sales growth of this new project for the next 3 years before reverting to a constant perpetual rate of 4%. Acme Corporation equity rights issuance data $20 Current share price $15 Suggested subscription price

Acme Corporation needs further capital injection for its ambitious growth plans. The Acme CFO is wary of the risk of high debt issuance, and will issue new shares through
a rights offering for additional equity capital of $1,500,000.

Question 1
(a) Calculate the current number of shares outstanding and the number of shares to be issued.
(b) Calculate the theoretical ex-rights share price if all are exercised.

(c) What is the value of the rights per share if all are exercised?
(d) Analyse on the inherent risks of having too much debt in a firm’s capital structure.

Question 2
(a) Calculate the intrinsic value of the stock using dividend discount model.
(b) Based on the calculated intrinsic value, is Acme Corporation a buy, sell or hold?

Answer 1

10 a

No of shares to be issued = $ 1500000/15 = 100000

Current outstanding shares = MV of firm / Market price of share

1 d)

A company that is heavily leveraged - too much debt relative to equity - may find that its creditors eventually restrict its freedom of action; Or it may experience lower profitability as a result of payment of steep interest costs. In addition, a firm may have trouble meeting its operations and debt liabilities during adverse economic conditions. Or, if the business sector is highly competitive, competing companies may swoop in to gain more market share and take advantage of debt-laden firms. Certainly, a worst-case scenario may be that a firm is required to declare bankruptcy.