The Concept of Dividend Signalling - Essay Example

• What is the weighted-average cost of capital for a firm with the following sources of funds and corresponding required rates of return: $5 million common stock at 16 percent, $500,000 preferred stock at 10 percent, and $3 million debt at 9 percent? All amounts are listed at market values and the firm's tax rate is 35 percent.

WACC    =             (Weight of Equity x Cost of Equity) + (Weight of Preferred Stocks x Cost of Preferred Stocks) + (Weight of Debt x After-tax Cost of Debt)

=             ($5/8.5) x 16% + ($0.5/8.5) x 10% + ($3/8.5) x 9% x (1-35%)]

               =             12.06%

• Firms A and B intend to merge and Firm A has calculated the NPV of the merger to be $2 million after paying $8 million for Firm B. If Firm A had a pre-merger value of $10 million and Firm B had a pre-merger value of $6 million, calculate the value of the merged entity, as well as the cost of the merger.

Value of the merged entity = Value of A + Value of B + NPV

                                                   = $10 million + $6 million + $2 million

                                                   = $18 million

Cost of the merger = Cash Price – Value of B

                                    = $8 million - $6 million

                                    = $2 million

• Circular File stock is selling for $25 a share. You see that call options on the stock with an exercise price of $20 are selling at $3. What should you do? What will happen to the option price as investors identify this opportunity? Then you observe that put options on Circular File with exercise price $30 are selling for $4. What should you do?

In the first case, I will be exercising the call option since it gives me the intrinsic benefit of $2 ($25 - $20 - $3). My total cost of the stock would be $23 however; I will still earn the benefit of $2 as compared to a market where the stock is selling at $25. When other investors would see this opportunity, there are two possibilities to happen. Firstly, the current share price is likely to reduce to $23, or secondly, the value of the call option may increase to $5.

In the case of a put option, I will be exercising the put option as it will allow me to generate the intrinsic benefit of $1 ($30 - $25 - $4). I would be purchasing the stock at a total cost of $29 i.e. $25 current price plus $4 the value of the put option. I would then be selling the stock at $30, which would earn me a $1 gain.