Question 3

1. Define underpricing in the context of security issues and explain why there is a tendency for IPOs to be underpriced (maximum 250 words).

(Total: 10 Marks)

[Your Answer]

2. Red World generates EBIT of 200 million. It currently does not have debt in the capital structure, but it is considering the use of debt and exploring raising either 700 million or 1,500 million. Interest on debt is payable at the rate of 6%. Ignoring taxation and bankruptcy costs and assuming all earnings after interest are paid to shareholders as dividends, which is the most attractive capital structure for Red World? Explain (maximum 250 words).

(Total: 10 Marks)

[Your Answer]

3. Sun plc expects its EBIT to be 200,000 every year forever. It currently has no debt but can borrow at a rate of 10 per cent. The firms WACC is currently 15 per cent and the tax rate is 25 per cent.

1. What is the value of the firm and its cost of equity? (3 Marks)
2. What would be the value of the firm and its cost of equity if it borrows 300,000 and uses the proceeds to repurchase shares? (4 Marks)
3. Comment on the values you have calculated in parts (a) and (b). (3 Marks)

(Total: 10 Marks)

[Your Answer]

(Total Question 3: 30 Marks)