FINANCIAL MANAGEMENT-CASE 2 |
BEN GRAHAMVIRGINIA MARTINEZPABLO MEDINA |
A. JANUARY 2005
(A.1) Firm values
We need E[EBIT] and r0.
Due to V=E+D= E[EBIT]/r0 :
| E[EBIT] | r0 | V |
Firm 1 | 2000 | 8% | 25000 |
Firm 2 | 480 | 8% | 6000 |
Firm 3 | 700 | 8% | 8750 |
(A.2) Share values
We need the value of equity and the number of shares in order to compute share values.
| V | D | E | Nºshares | Share Value |
Firm 1 | 25000 | 7000 | 18000 | 4125 | 4.36 |
Firm 2 | 6000 | 0 | 6000 | 4800 | 1.25 |
Firm 3 | 8750 | 7050 | 8000 | 3312.5 | 2.0 |
| | D=interests/rD | E=V+D | Net profit/EPS | E/nºshares |
This higher risk is evidenced in the higher expected return on equity, which tends to increase with leverage (higher risk for shareholders, higher returns). The WACC is the return expected by providers of capital, but it doesn’t reflect the risk faced by shareholders of the three companies.
If the firm publishes this statement investors will think the company is trying to trick them, and that could lead to a serious reputation loss for firm 1.
(B.2) The CFO of firm 2 is worried about getting a loan, because he knows most of its shareholders are risk averse and will oppose this proposal. He wants you to come up with a solution that satisfies the desires of the big shareholder, of having the same expected return on his investment as the expected return on the shares of Firm 1, without having to leverage Firm 2 and without completely losing him as a shareholder.
As the target expected return is higher than the expected return that the shareholder currently gets, we would recommend this shareholder to leverage his position by acquiring a personal loan following this procedure:
X is the amount of the loan the shareholder has to get. Y is the value of his current investment.
X= (0.0916-0.08)/(0.08-0.05)*1350=522 euro is the value of the loan he has to get.
With that amount he will be able to buy 348 shares of firm 2(522/1.5=348)
Value of shareholder’s shares- personal loan= (1248*1.5)-522=1350 (same value of his initial investment)
Expected return= 1872/1350*8% – 522/1350*5%=9.16%, which is the expected return of Firm 1 and the one the shareholder wants.
The shareholder will get a loan that will allow him to leverage his position, and he will buy more shares of Firm 2. With this solution there is no need to leverage firm 2 and the shareholder will be satisfied as he is getting the expected return he wants.
(B.3) Describe the positive and negative aspects of the solution you propose.
A positive aspect of this strategy is that the firm manages to keep an important shareholder, who initially had almost 25% of the shares of the company, and they manage to do so without making other shareholders worse and without having to leverage the firm and increase their risk.
We are giving more power to a shareholder who threatened to leave the company if his request wasn’t met, so we are not sure of his commitment to the company. Furthermore, if he sees that whatever request he makes is met he may try to demand the company to make further measures that benefit him in the future, and those may not have a solution like the one found in this case.
C. JULY 2005
(C.1) One investor of Firm 1 with 300 shares is worried with the analyst’s recommendations. He would like to act on it but doesn’t know how. What advice can you give him? Can he increase his expected earnings from the apparent market inefficiency?
The case here is one of over and undervaluation of shares. Firm 1 is overvalued...