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Microsoft Inc. is considering an expansion project. i. The firm is an all equity firm with a book...

Question:

Microsoft Inc. is considering an expansion project.

i. The firm is an all equity firm with a book value of $1,200,000 and the firm has 375,000 shares issued and outstanding.

ii. The firm has a tax rate of 40 percent, has just paid its most recent dividend of $3.80 and the firm is expected to grow at 5 percent forever.

iii. The return on government T-bills is 3 percent, the return on the market portfolio is 15 percent and the firm has a beta 0.9979.

iv. Microsoft has determined the cost of the expansion will be $4,500,000. They have decided to raise the funds by issuing new equity shares through a rights offering.

v. The flotation cost of equity will be 4 percent, and the firm requires that the flotation costs must be covered by the new issue.

vi. The new shares will be sold to the existing shareholders at a subscription price of $37.50, which is a discount of the current market price.

a) Calculate the number of rights a shareholder will need to provide when buying a share of the new equity issue.

b) Calculate the value of each right.

c) You own 37,500 of the shares of Mapleton on the announcement date.

Calculate your net wealth and ownership position in the company on the announcement date.

Right Issue:

Rights are the common stock that is issued by the company to existing common stockholders. These stocks are exclusively offered to the existing stockholders at a discount price.

Answer and Explanation:

Given:

Book value = $1,200,000

Shares outstanding = 375,000

Tax rate = 40%

Dividend = $3.80

Growth rate = 5%

Risk free rate = 3%

Market portfolio = 15%

Beta = 0.9979

Cost of the expansion = $4,500,000

Flotation cost of equity = 4%

Subscription price = $37.50

Working:

a)

Cost of equity of Microsoft = Risk free rate + (Beta * (Market portfolio - Risk free rate))

Cost of equity of Microsoft = 3% + (0.9979 * (15% - 3%))

Cost of equity of Microsoft = 3% + (0.9979 * 12%)

Cost of equity of Microsoft = 3% + 11.9748%

Cost of equity of Microsoft = 14.9748%


{eq}Price \ of \ one \ share \ = \ \dfrac{Dividend \ \times \ \left ( 1 \ + \ Growth \ rate \right )}{Cost \ of \ equity \ of \ Microsoft \ - \ Growth \ rate} \\ Price \ of \ one \ share \ = \ \dfrac{3.8 \ \times \ \left ( 1 \ + \ 5\% \right )}{14.9748\% \ - \ 5\%} \\ Price \ of \ one \ share \ = \ \dfrac{3.8 \ \times \ 1.05}{9.9748\%} \\ Price \ of \ one \ share \ = \ \dfrac{3.99}{0.099748} \\ Price \ of \ one \ share \ = \ \$40 {/eq}


{eq}Amount \ required \ to \ be \ raised \ = \ \dfrac{Cost \ of \ the \ expansion}{1 \ - \ Flotation \ cost \ of \ equity} \\ Amount \ required \ to \ be \ raised \ = \ \dfrac{4,500,000}{1 \ - \ 4\%} \\ Amount \ required \ to \ be \ raised \ = \ \dfrac{4,500,000}{1 \ - \ 0.04} \\ Amount \ required \ to \ be \ raised \ = \ \dfrac{4,500,000}{0.96} \\ Amount \ required \ to \ be \ raised \ = \ \$4,687,500 {/eq}


{eq}Number \ of \ rights \ shares \ to \ be \ issued \ at \ 37.50 \ = \ \dfrac{Amount \ required \ to \ be \ raised}{Subscription \ price} \\ Number \ of \ rights \ shares \ to \ be \ issued \ at \ 37.50 \ = \ \dfrac{4,687,500}{37.5} \\ Number \ of \ rights \ shares \ to \ be \ issued \ at \ 37.50 \ = \ 125,000 {/eq}


{eq}Rights \ ratio \ = \ \dfrac{Shares \ outstanding}{Number \ of \ rights \ shares \ to \ be \ issued \ at \ 37.50} \\ Rights \ ratio \ = \ \dfrac{375,000}{125,000} \\ Rights \ ratio \ = \ 3 {/eq}

Hence, the rights issue is one share for every three held.

Number of rights required to buy one share is 3.


b)

{eq}Value \ of \ each \ right \ = \ Price \ of \ one \ share \ - \ \dfrac{\left ( Price \ of \ one \ share \ \times \ Rights \ ratio \right ) \ + \ Subscription \ price}{Rights \ ratio \ + \ 1} \\ Value \ of \ each \ right \ = \ 40 \ - \ \dfrac{\left ( 40 \ \times \ 3 \right ) \ + \ 37.5}{3 \ + \ 1} \\ Value \ of \ each \ right \ = \ 40 \ - \ \dfrac{120 \ + \ 37.5}{4} \\ Value \ of \ each \ right \ = \ 40 \ - \ \dfrac{157.5}{4} \\ Value \ of \ each \ right \ = \ 40 \ - \ 39.375 \\ Value \ of \ each \ right \ = \ 0.625 {/eq}


c.

Own share = 37,500

Net wealth = Price of one share * Own share

Net wealth = 40 * 37,500

Net wealth = $1,500,000


{eq}Ownership \ position \ = \ \dfrac{Own \ share}{Shares \ outstanding} \\ Ownership \ position \ = \ \dfrac{37,500}{375,000} \\ Ownership \ position \ = \ 0.10 \ or \ 10\% {/eq}


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