Question 1 (25 marks)

King Ltd and Queen Ltd are both listed on the New York Stock Exchange having the same business risk. The expected return on the S&P 500 Index is 10% and the risk-free rate is 6%. These two firms are identical in all aspects except for their capital structure. Queen is an all-equity firm. King has both perpetual debts and common stocks. It has a debt to equity ratio of 1:4 and an equity beta which is equal to 1.25. Assume both firms can borrow at the risk-free rate. The EBIT of Queen Ltd is expected to be $100,000 per year in perpetuity. Assume there are no taxes, and all earnings of both firms are paid out as dividends.

(a) Calculate the cost of capital of each firm. (Show your calculations). (10 marks)

(b) Mr. Jackson, a shareholder of Queen Ltd, owns stocks that are worth $10,000. Calculate his annual cash flow from dividend under the current capital structure of Queen. (Show your calculations). (3 marks)

(c) Mr. Jackson believes that if he invests in King Ltd, it is impossible for him to have the same cash flows as he prefers from Queen Ltd. Critically evaluate whether he is true. Explain your justifications clearly with necessary calculations presented. (12 marks)

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Question 2 (20 marks)

PKC Ltd is considering raising $120 million from the markets. In its recent management meeting, Winnie Poon, the CFO, suggested PKC to issue perpetual bonds with a face value of $1,000 each and a coupon rate of 8.1% paid annually. The current market interest rate is 8%. Winnie estimates a 0.3 probability that next years interest rate will increase to 10%, and a 0.7 probability that it will fall to 6%.

(a) Calculate the current market value of the perpetual bond If PKC issues perpetual bond based on Winnies suggestion . (Show your calculations). (7 marks)

(b) The CEO, John Lung, decides to include a call provision in the bond contract such that the bonds are callable in one year. Calculate the coupon rate of the callable bonds such that the bonds will be sold at par. Assume the bonds will be called if the interest rates fall and the call premium is $150. (Show your calculations). (7 marks)

(c) Suppose after evaluating market conditions, PKC finally issued callable bonds with a coupon rate of 8.2% paid annually, and the call premium is equal to 16% of the principal amount of bonds. The total principal amount of the bonds issued is $100 million. The firm is subject to a tax rate of 35%. Assume it is now 1 year after the callable bonds were issued and the current market interest rate is 7.35%. PKC is considering calling back the callable bonds. If the transaction cost of refunding equals $1,000,000, should KPC call back the callable bonds? (Show your calculations). (6 marks)

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Question 3 (17 marks)

Freedom Ltd is considering whether to lease or buy an advanced machine for its new product. The following information is available for this decision: Buy: The purchase price of the machine is $4.85 million. The machine will be depreciated using straight-line method over 4 years with a zero salvage value. Lease: The annual lease payments will be $1.1 million, payable at the beginning of each of the four years of the lease. The annual interest rate of secured debt is 11.67%. The corporate tax rate is 40%.

(a) Should the firm lease or buy the machine? Why? (Show your calculations). (13 marks)

(b) Calculate the maximum amount of lease payment that Freedom Ltd is willing to pay. (Show your calculations). (4 marks)

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Question 4 (25 marks)

SOS Ltd is currently an all-equity firm and has a market value of $800,000. SOS is evaluating whether a levered capital structure would maximize the wealth of shareholders. The cost of equity is currently 15%. The new capital structure under consideration is an issue of $400,000 new perpetual debt with an 8% interest rate. There are currently 32,000 shares outstanding and a tax rate of 35% applies to this firm. If SOS finally changes to the new levered capital structure,

(a) Calculate the present value of tax shield and explain it briefly. (Show your calculations). (3 marks)

(b) Calculate the firm value and the cost of equity under the levered capital structure. Explain the change in cost of equity briefly. (Show your calculations). (7 marks)

(c) Calculate the WACC under the levered capital structure. (Show your calculations). (4 marks)

(d) What are the stock prices of SOS before and after announcement of the new capital structure? Explain the price change briefly. (Show your calculations). (7 marks)

(e) Suppose the actual stock price of SOS after announcement of the new capital structure is lower than your answer in part (d) above, what could be the possible reasons for this? (4 marks)

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Question 5 (13 marks)

(a) HSU has announced a rights offer to issue 2,000,000 new shares at a $11 subscription price. There are 5,000,000 shares outstanding trading at $12 each. Calculate the ex-rights price and the value of a right. (Show your calculations). (5 marks)

(b) HSU issued an annual coupon convertible bond with a coupon rate of 10% and a face value of $1,000. The bond will mature 2 years from today. The annual market interest rate is 10%. The conversion ratio is 40 shares. The current stock price is $35 per share. (i) Calculate the option value of the bond if each convertible bond is trading at $1,520. (Show your calculations). (5 marks) (ii) Explain the meaning of your answer in part (i) above.