Question

Sm Question 3 (25 marks) The following information of Fortune Co. is given: Balance Sheets: Assets Sm Liabilities and Equity Current assets 10 Current liabilities Fixed assets Non-current liabilities Equity Total assets 100 Total equity and liabilities 20 90 30 50 100 The net income of this financial year is $4 million. The dividends of Fortune Co. are $2 million in total. The current stock price is $6.5 per share and 30 million shares are outstanding, Now, the board directors of Fortune Co. are looking to an investment proposal. To start up the project, new facilities are required. The predicted cost of initial fund is $5 million. After invested the new project, the net income can raise to $6.6 million in next year and the new ROE can maintain forever. Since the project is attractive, the board directors are willing to raise fund from the market. According to the current economic environment, Fortune Co. can issue new bonds or new stocks to fulfill the initial investment Fortune Co. can issue two different types of bonds (1) Bond A: Par value is $1,000, maturity is 4 years, coupon rate is 8% Bond B. Par value is $1,000, maturity is 6 years, coupon rate is 4% Both bonds paid the coupon annually. The required market return of the new bonds is 6%. Alternatively, Fortune Co.can issue new stocks at a discount price $6 per share. The board directors want to maintain the dividend payout ratio. Required: (a). Calculate the market price of Bond A and Bond B. (5 marks) (b). Calculate the number of new bonds should be issued for each of the bond. (2 marks) (C). In the future, if the interest rate is expected to drop, which one has greater price risk? Does it affects the cost of debt of Fortune Co.? Please explain. (Smarks) (d). Calculate the new dividend growth rate. Since the dividend growth is constant after the new investment, based on DGM, please evaluate the cost of equity if Fortune Co. determined to use new share to fulfill the initial fund need. (8 marks) (e). If you are the CEO, will you issue new shares to fulfill the fund need? Please briefly explain your reasons. (5 marks) (25 marks)

Answer 1

Answer:

All amounts are in $

a)

Market price of a bond = Coupon rate x Present Value annuity factor for n years @6% + Par value x present value factor for nth year @6%

Market price for bond A = 80 x 3.465 + 1000 x 0.79209

= 1,069.29

Market price for bond B = 40 x 4.917 + 1000 x 0.70496

= 901.64

b)

No of new bonds to be issued

Bond A to be issued in numbers = Fund required / Bond price

= 5 million / 1069.29

= 4,676

Bond B to be issued in numbers = 5 million / 901.64

= 5,546

c) If in future the interest rate changes then the bond with a longer duration will have higher price fluctuation. So if in future the interest rate comes down, then Bond B will have greater price risk (because it has longer duration).

The fall in interest rate affects the cost of debt, as we use the risk-free rate at different times in computing the weighted average cost of capital. The drop in interest rate also leads to a drop in investors' expectations and thus the drop in the cost of debt. This will help the entity as its bond values increases.

d) Given new net income = $6.6 million

Dividend payout ratio for last year = 2million/4million

= 50%

Assuming the same dividend payout ratio is continued for this year also

The new dividend would be = 6.6 million x 50%

= 3.3 million

Assumed new shares are issued for the requirement

No of new shares = Fund requirement/market price per share

= 5million/6.5 per share

= 769,231

Old dividend per share = 2 million / 30 million shares

= 0.066 per share

New dividend per share (if bonds issued) = 3.3 million / 30 million

= 0.11 per share

New dividend per share (if bonds issued) = 3.3 million / 30.769231 million shares

= 0.10725 per share

Cost of equity if new share issued

Cost of equity = Dividend per share / Price

= 0.10725/6.5

= 0.0165 or 1.65%

Whereas the old cost of equity is 1.02% (0.066/6.5)

e) If I am the fund CEO, I will not issue the shares for the investment. This is because this issue increases the cost of equity.

Note: The last two points will be different practically. In the real world, as there are proposed investments and it will lead to higher Net income, this will push the share price and thus we can issue shares at a higher prices than issuing at 6.5 (which can be calculated through Modigliani and Miller approach). Thus there will be stabilization in the cost of equity as the price increases along with dividend per share.

Note: Assumed the given net income of $6.6 million doesn't change based on the type of funding (equity or bonds). Alternatively, if we assume that the interest expense on bonds has to be deducted from $6.6 million, then there will be a change in dividend per share and thus the cost of equity. But as in the question it is mentioned as "Net income" we have taken that those expenses are already provided.

Note: Given that the Net income will rise to $6.6 million and them ROE will be maintained forever, that means there is no increase in net income or dividend per share after that year. (We assumed the dividend payout will remain same)

Please give a positive rating