Question: HighTech Inc. was founded by Roger Mortimer last year. The company is developing a new technology that may enhance significantly the speed of the Internet. There has been a debate in the board of directors about the alternative sources to finance R&D investments ($5,000,000) and its impact on the market price of HighTech Inc. The CEO was reluctant to issue new shares and suggested the company issue long-term bonds instead. The company is expecting a supernormal growth rate while it exploits its technological and marketing lead. Dividends are expected to rise by 25 percent per year for the next 5 years. However, the growth rate will revert to only 5 percent per year indefinitely. The company has just paid dividends of $1.5 per share. The Treasury bill rate of interest is 5 percent and the risk premium has been 5 percent. HighTech Inc. is in a higher systematic risk class than the average market index and, therefore, has a beta of 1.2. The CFO of the company convinced the board of directors to fund the R&D investments and the company has recently issued 8 percent coupon bonds and preference shares both with par value $100. The coupon bonds mature in 5 years and the competitive market interest rate on similar bonds is 12 percent However, the preference shares are expected to offer a fixed 8 percent preferred dividends.
a. Calculate the intrinsic value of the ordinary and preference shares of HighTech Inc.
b. Calculate the market price of coupon bonds.
c. Some board directors advocate the use of more debt because of its positive effect on managerial actions. Explain.
d. Explain to the board of directors of HighTech Inc. that the price of their coupon bonds will necessarily respond to the interest rate fluctuations in the market.