Corporation Finance

ASSIGNMENT 3

QUESTION 1

1 . a ) Missing Values

Type of

Option Exercise

Price ) Intrinsic

Value ) Time

Value ) Option

Market

Price ) Underlying

Stock Price

Call 20 5 .0 1 .0 6 .0 25

Call 70 0 2 .5 2 .5 66

Put 52 4 .0 4 .0 8 .0 56

Put 30 0 8 .0 8 .0 24 The Missing values are calculated using the formula set out below

Intrinsic Value IV Max (Stock price - Exercise price , 0

Option Market Price OP Intrinsic Value

IV Time Value TV

Time Value TV Option Market Price OP - Intrinsic Value IV

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1 . b ) Combining two companies with volatile earnings will enhance value because earnings will become more stable after the merger

The above statement is true , since mergers often take place to take advantage of

Revenue enhancement

Cost reduction

Lower taxes and

Lower cost of capital

The volatility of earnings in the existing companies many be due to

Inefficient management

Lack of economies of scale

Higher cost of production

Lower marketing gains due to the weakness of the existing distribution network and an improper product mix

Hence by combining the two firms with volatile earnings , there is every chance that the earnings will get stabilized and improved because the new entity can enjoy the advantages of

economies of scale

better product mix

efficient management

lower cost of production

better marketing strategies and a new efficient distribution system

tax advantages and

other strategic advantages like the benefit of capturing new opportunities

Because of these benefits accruing to the new entity , the earnings may go up and hence the value will get automatically enhanced

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QUESTION 2

2 . a ) Texas Corporation - Rights

i 5 ,000 ,000

No of rights needed to buy one new share 5

No of New shares to be issued No of rights 5 ,000 ,000

5 1 ,000 ,000

Subscription Price per share 16 ii ) Expected Stock Price

Initial Position

Number of shares 5

Share Price 18

Value of holding 90

Terms of offer

Subscription price 16

Number of rights issued 1

Number of rights per share 5

After offer

Number of shares 6

Value of holding 90 16 106

Share Price 106 /6 17 .67

Expected Stock Price is 17 .67 per share

iii ) Rights Issue Vs Common Stock offering

There are different costs associated with common stock offering which makes this route of raising funds for the company undesirable . The costs involve in common stock offering are

Spread or Underwriting discount

Other direct expenses like filing fees , legal fees etc

Indirect Expenses like management time to be spent

Abnormal returns due to drop in prices of share after announcement of the new issue

Underpricing in the case of IPOs where the share price increases after the issue which is a loss to the firm

Greenshoe option exercised by the underBecause of the above costs associated with the common stock offering pure rights issue is being favoured by the companies , as the raising of equity in the cheapest manner...