Question 5 Elegance, a manufacturer of high-end winter apparel, is keen to expand its offerings by introducing a new range of coats made from the fur of baby sea lions. This project is expected to require an initial investment of $800 million. However, a concerted campaign by animal rights activists has seen the company's sourcing practices draw the ire of legislators. The company is eagerly awaiting the results of a key regulatory ruling that will have a material impact on the value of its existing business and future investment Given the uncertainty, the company is unable to secure additional debt financing (it has $200m of outstanding debt on its balance sheet) and must raise the required $800m by issuing outside equity. The following table details the outcomes depending on whether the regulatory ruling is harsh (State 1) or soft (State 2), as well as the market's assessment of the probability of each state. All dollar values are in millions. Probability Assets in Place Investment Cost Fur Project NPV Debt State 1 State 2 50% 50% 600 1200 800 800 50 150 200 200 Assets in Place Investment Cost Fur Project NPV Debt 507 600 800 50 200 50% 1200 800 150 200 When answering this question, state any additional assumptions you may need to make. Show your calculations. Required: a) If Elegance's managers must issue equity without knowing whether the ruling will be harsh or soft, what percentage of the firm's equity must original equity holders give up in exchange for the capital? (6 marks) b) If there was no debt in Elegance's capital structure, would this raise or lower the percent of equity demanded by outside investors in part a)? Explain briefly. Assume all other numbers remain unchanged. (4 marks) For the remainder of this question, assume the company has $200 million of debt in its capital structure (as per the table above). c) Now assume that management knows the true state of the world before the decision to issue and invest is made. If management is maximising the wealth of old shareholders and can sell equity at the terms described in part a), do they have an incentive to use their inside information when deciding whether to issue equity and invest? Explain. (6 marks) UL20/0369 Page 8 of 10 d) If management knows the true state and announces their intention to issue and invest, what percentage of the firm's equity must original equity holders give up in order to raise the $800 million? (Assume the market believes the managers know the true state even though the state has not been announced to the market) (4 marks) [Total: 20 Marks] Question 5 Elegance, a manufacturer of high-end winter apparel, is keen to expand its offerings by introducing a new range of coats made from the fur of baby sea lions. This project is expected to require an initial investment of $800 million. However, a concerted campaign by animal rights activists has seen the company's sourcing practices draw the ire of legislators. The company is eagerly awaiting the results of a key regulatory ruling that will have a material impact on the value of its existing business and future investment Given the uncertainty, the company is unable to secure additional debt financing (it has $200m of outstanding debt on its balance sheet) and must raise the required $800m by issuing outside equity. The following table details the outcomes depending on whether the regulatory ruling is harsh (State 1) or soft (State 2), as well as the market's assessment of the probability of each state. All dollar values are in millions. Probability Assets in Place Investment Cost Fur Project NPV Debt State 1 State 2 50% 50% 600 1200 800 800 50 150 200 200 Assets in Place Investment Cost Fur Project NPV Debt 507 600 800 50 200 50% 1200 800 150 200 When answering this question, state any additional assumptions you may need to make. Show your calculations. Required: a) If Elegance's managers must issue equity without knowing whether the ruling will be harsh or soft, what percentage of the firm's equity must original equity holders give up in exchange for the capital? (6 marks) b) If there was no debt in Elegance's capital structure, would this raise or lower the percent of equity demanded by outside investors in part a)? Explain briefly. Assume all other numbers remain unchanged. (4 marks) For the remainder of this question, assume the company has $200 million of debt in its capital structure (as per the table above). c) Now assume that management knows the true state of the world before the decision to issue and invest is made. If management is maximising the wealth of old shareholders and can sell equity at the terms described in part a), do they have an incentive to use their inside information when deciding whether to issue equity and invest? Explain. (6 marks) UL20/0369 Page 8 of 10 d) If management knows the true state and announces their intention to issue and invest, what percentage of the firm's equity must original equity holders give up in order to raise the $800 million? (Assume the market believes the managers know the true state even though the state has not been announced to the market) (4 marks) [Total: 20 Marks]
