Question

1. A company has two open seats, Seat A and Seat B, on its board of directors. There are six candidates vying for these 2 positions. There will be a single election to determine the winner of both open seats. As the owner of 10,000 shares of stock, you will receive one vote per share for each open seat. You decide to cast all 20,000 of your votes for a single candidate.

(i) What is this type of voting called?

(ii) With this type of voting, suppose the company has 1.2 million shares outstanding, how many more shares must you buy to be assured of earning a seat on the board?

b. Discuss the static trade-off theory and the pecking order theory of capital structure. What are the main differences between these two theories?

2. Global Production (GP) is a large conglomerate thinking of entering the smart alarm business, where it plans to finance a project with a debt-to-value ratio of 20 percent (or a debt-to-equity ratio of 1/4). There is currently one firm in the smart alarm industry, American Smart Alarm (ASA). This ASA firm is financed with 25 percent debt and 75 percent equity. The beta of ASA’s equity is 1.8. ASA has a borrowing interest rate of 14 percent, and GP expects to borrow for its smart alarm venture at 11 percent. The corporate tax rate for both firms is 35 percent, the market risk premium is 8 percent, and the risk-free rate is 5 percent. What is the appropriate discount rate (RWACC) for GP to use for its smart alarm venture?

Answer 1

1.

i) This type of voting is called cumulative .. Cumulative voting refers to the fact that a shareholder has votes that are equal to the number of shares multiplied by the number of positions the shareholders are voting for.

ii) The company have 1.2 million or 1,200,000 shares outstanding. I have 10,000 shares of company and there will be a single election to determine the winner of both open seats.  I decide to cast all 20,000 of my votes for a single candidate. So for winning my candidate seat i required min 51 % share that 612,000 share from that i have already 20,000 share , i required 612,000 - 20,000 = 592,000 share so i will have 592,000 *2 =1,184,000 and plus 20,000votes in my hand i.e 1,204,000 votes which are more that half of the total votes of the company.

b) The static trade off theory attempts to explain the optimal capital structure in terms of the balancing act between the benefits of debt (tax shield from interest deduction) and the disadvantage of debt (from the increased expected bankruptcy costs). The tax shield benefit is the corporate income tax rate multiplied by the market value of debt and the expected bankruptcy costs are the probability of bankruptcy multiplied by the estimated bankruptcy costs.

The pecking order theory is the preferred, and empirically observed, sequence of financing type to raise capital. That is, firms first tap retained earnings (internal equity) finance, second source is debt and the last source is issuing new common stock shares (external equity). The empirical evidence of non-financial firm debt ratios coupled with the decision making process of top management and the board of directors point to greater adherence to the pecking order theory.