Solutions Manual CHAPTER 25
SOURCESOFLONGTERM FI NANCI NG EVIEW QUESTIONS AND PROBLEMS SUGGESTED ANSWERS TO THE R EVIEW
I.
Questions
1. In 1978, 1978, the average average manufac manufacturi turing ng corporati corporation on had its its interest interest covered covered almost eight times. By the mid 1990s, the ratio had been cut in half. 2. he bond agreeme agreement nt specifies basic items such as the par value, the coupon rate, and the maturity date. !. he he pri prior ority ity clai claims ms are" are" Preerre! S"are
Senior Secured Debt
Senior De#enture
Subordinated Debenture
Su#or!inate! De#enture
Junior Secured Secured Debt
Senior Se$ure! De#t
Preferred Preferred Share
Or!inar% E&uit% S"are
Senior Debenture
'unior Se$ure! De#t
Ordinary Equity Share
#. he method method of of $bond $bond repayment% repayment% reduces reduces debt and and increase increasess the amount amount of ordinary e&uity share outstanding is called bond conversion. conversion . '. he he pu purpo rpose of serial and sinking fund payments is to provide an orderly procedure for the retirement of a debt obligation. o o the e(tent bonds are paid off over their life, life, there is less ris) to the the security holder. holder. *. he diffe different rent bond bond yield yield terms terms may may be defined defined as follo+s follo+s"" Coupon rate is the stated interest rate divided by par value. Current yield is the stated interest rate divided by the current price of the bond. Yield Yield to matur maturity ity is the the inter interest est rate rate that that +ill +ill e&uate e&uate future future inter interest est payments and payment payment at maturity to a current mar)et price. price. 7. he higher higher the the rating rating on a bond, bond, the lo+er lo+er the the interest interest paym payment ent that +ill +ill be re&uired to satisfy the the bondholder. bondholder.
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Sources of Long-term Financing
8. efer to pages *!* through *!7. 9. Capitaliing lease payments means computing the present value of future lease payments and sho+ing them as an asset and liability on the statement of financial position. 10. -ounders share may carry special voting rights that allo+ the original founders to maintain voting privileges in e(cess of their proportionate o+nership. 11. he preemptive right provides current shareholders +ith a first option to buy ne+ shares. In this fashion, their voting right and claim to earnings cannot be diluted +ithout their consent. 12. he actual o+ners have the last claim to any and all funds that remain. If the firm is profitable, this could represent a substantial amount. hus, the residual claim may represent a privilege as +ell as a potential dra+bac). /enerally, other providers of capital may only receive a fi(ed amount. 1!. Preferred share is a $hybrid% or intermediate form of security possessing some of the characteristics of debt and ordinary e&uity share. he fi(ed amount provision is similar to debt, but the noncontractual obligation is similar to ordinary e&uity share. hough the preferred shareholder does not have an o+nership interest in the firm, the priority of claim is higher than that of the ordinary shareholder. 1#. ost corporations that issue preferred share do so to achieve a balance in their capital structure. It is a means of e(panding the capital base of the firm +ithout diluting the ordinary e&uity share o+nership position or incurring contractual debt obligations. 1'. referred share may offer a slightly lo+er yield than bonds in spite of greater ris) because corporate recipients of preferred share dividends must add only !0 percent of such dividends to its ta(able income. hus, 70 percent of such dividends are e(empt from ta(ation. 1*. ith the cumulative feature, if preferred share dividends are not paid in any one year, they accumulate and must be paid in total before ordinary e&uity shareholders can receive dividends. 3ven though preferred share dividends are not a contractual obligation as is true of interest debt, the cumulative feature tends to ma)e corporations very a+are of obligations to preferred shareholders. referred shareholders may even receive ne+ securities for forgiveness of missed dividend payments.
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II. Multiple Choice Questions
1. 2. !.
4 B 5
#. '. *.
B 6 6
7. 8. 9.
:
90 interest 1,000 par
B 4 B
10.
5
III. Problems Pro#le, -
a
b
c
6oupon rate
6urrent rate
:
9;
:
90 interest 820 mar)et price
:
10.98;
4ppro(imate = ield to aturity
4nnual Interest ayment
=
rincipal ayment ? rice of the Bond @umber of ears to aturity
.* rice of the Bond = .# rincipal ayment 1,000 > 820 '
90= =
.* 820 = .# 1,000 180 '
90= =
#92 = #00
=
90 =
!*
892 =
=
12* 892 1#.1!; 25-3
("a)ter *+
Sources of Long-term Financing
Pro#le, * Bon! A
a 6urrent rate
Bon! B
:
80 interest 800 mar)et price
:
10;
6urrent rate
:
8' interest 900 mar)et price
:
9.##;
b he bond that the investor should select is Bond 4 because it has a higher current yield.
c
4ppro(imate = ield to aturity
4nnual Interest ayment
=
rincipal ayment ? rice of the Bond @umber of ears to aturity
.* rice of the Bond = .# rincipal ayment
8'= =
1,000 > 900 2
.* 900 = .# 1,000
8'= =
100 2
'#0 = #00 8' =
'0
=
9#0 =
=
1!' 9#0 1#. !*;
d es. Bond B no+ has the higher yield to maturity. his is because the 100 discount +ill be recovered over only t+o years. ith Bond 4, there is a 200 discount, but a 10Ayear recovery period.
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Sources of Long-term Financing
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Pro#le,
a of 1,000 for"
n : 20,
i : 11;,
I- : .12#
1,000 ( .12# 12#
b of 1,000 for"
n : 20,
i : 9;,
I- : .178
1,000 ( .178 178
c of 1,000 for"
n : 20,
i : 1!;,
I- : .087
1,000 ( .087 87
Pro#le, /
@ote" Cife of the asset is 1' years, not ' years. Dince one of the five criterias that is the length of the lease contract is 10 years and the economic life of the asset is 1' years, the arrangement constitutes a maEor part of the assets life, for compulsory treatment as a capital lease is indicatedF the transaction must be treated as a capital lease. Pro#le, +
a 5etermine 10Ayear annuity that +ill yield 12;" 4 : =
=
4<I-4 i : 12;, n : 10 900,000 '.*'0 1'9,292 25-5
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Sources of Long-term Financing
b he 10; deduction reduces the net cost to 810,000. Hriginal cost 10; @et cost
900,000 90,000 810,000
4nnual lease payment
=
=
810,000 '.*'0 1#!,!*2.80
Pro#le, 0
Dince the dividends gro+ at 9.8 percent, the ne(t three annual dividends +ill be" 51 : 1.*8 1.098 : 1.8#
52 : 1.8# 1.098 : 2.0!
5! : 2.0!1.098 : 2.22
5iscounting these cash flo+s results in a value of"
o
=
1.8# 1 = 0.1!'
+
2.0! 1 = 0.1!' 2
=
1.*! = 1.'8 = '0.7*
=
'!.9*
+
2.22 = 72 1 = 0.1!' !
4t the current '# per share price, the e&uity share does not appear undervalued. It appears fairly valued. Pro#le, 1
It is not initially clear +hether this +ill be good or bad ne+s for the e&uity share price. 4 rise in the gro+th rate increases the e&uity shares value. But a higher re&uired return lo+ers the value. he t+o changes some+hat offset one another. Dince the current 70 e&uity share price is fair, investors re&uire a return of 11.' percent 1.7' G 70 = 0.09 before the announcement. 4fter the announcement, investors +ill re&uire a 12.7 percent return 0.11' = 0.012 and e(pect a 10
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Sources of Long-term Financing
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percent gro+th rate. herefore, the ne+ e&uity share price should be *#.81 per share, a decline of '.19 > 7.# percent. o
1.7' 0.127 > 0.10
=
=
*#.81
his +as bad ne+s for the e&uity share price. Pro#le, 2
-ounders family votes : Dhared o+ned ( 10 : '1,!2' 10 : '1!,2'0 6lass B votes
: otal votes ? -ounders family shares : 1,200,000 ? '1,!2' : 1,1#8,*7'
-ounders family votes 6lass B votes
'1!,2'0 1,1#8,*7'
: :
##.*8;
Pro#le, 3
a reasury bonds
: 9; 1 > .!' : 9; .*' : '.8';
b 6orporate bonds
: 12; 1 > .!' : 12; .*' : 7.80;
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Sources of Long-term Financing
c referred share
:
5ividends reserved by a corporation from another corporation is not ta(able in the hilippines. he yield is therefore 10; also.
he preferred share should be selected because it provides the highest afterA ta( return. Pro#le, -4 a referred share 5ividend yield 5ividend 4fterAta( income
100,000 8; 8,000 8,000
b Coan Interest e(pense Interest ( 1 ? 4fterAta( borro+ing cost
100,000 10; 10,000 **; *,*00
c es, the afterAta( income e(ceeds the afterAta( borro+ing cost. Hf course, other factors may be considered as +ell. Pro#le, --
5ividend 4fterAta( income Interest ( 1 ? 4fterAta( borro+ing cost
8,000 8,000 10,000 8'; 8,'00
@o, the afterAta( income is no+ less than the afterAta( borro+ing. Pro#le, -*
he annual interest payment of 1#0 is computed by multiplying the coupon rate of 1# percent by the 1,000 par value of the bond. Pro#le, -
he bond +ill sell at a premium because the re&uired rate of return is less than the bonds coupon rate. hus, investors are +illing to pay more for this bond 25-8
Sources of Long-term Financing
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because it pays more interest than ne+ly issued bonds +ith similar characteristics.
Pro#le, -/
a Bond should have the greater price sensitivity to a change in the re&uired rate of return because of its longer maturity. hat is, the present value of future cash flo+s is more affected by changes in discount rates than less distant cash flo+s. b he intrinsic value of each bond is as follo+s" -or Bond , +hen I : 80, ) d : 9 percent, and n : ' o : 80 !.890 = 1,000 0.*'0 : !11.20 = *'0 : 9*1.20 -or Bond , +hen I : 80, ) d : 9 percent, and n : 1' o : 80 8.0*0 = 1,000 0.27' : *##.80 = 27' : 919.80 c 3ach bond sold for its par value of 1,000 before the change in the re&uired rate of return. Bond +ould decline in value by 80.20 1,000 ? 919.80 compared to a !8.80 1,000 ? 9*1.20 decline for Bond . Pro#le, -+
he re&uired rate of return is" o
=
5 p ) p
Dolve for ) p" ) p
=
=
5 p o 25-9
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Sources of Long-term Financing
*.7' 7'.2' =
8.97;
Pro#le, -0
Dubstituting 5 p : 2.*0 and ) s : 0.1!, the current value is" o
=
=
2.*0 0.1! 20.00
Pro#le, -1
Jsing the /ordon constant gro+th dividend model, the current value of a share of Keth Industries is" a -or 51 : 1.!2 1.20 ( 1.10, ) s : 0.1', and g : 0.10 o
=
=
1.!2 0.1' ? 0.10 2*.#0
b -or 51 : 1.!0 1.20 ( 1.08', ) s : 0.1', and g : 0.08' o
=
=
1.!0 0.1' ? 0.08' 20.00
c -or 51 : 1.!' 1.20 ( 1.12', ) s : 0.1', and g : 0.12' o
=
=
1.!' 0.1' ? 0.12' '#.00
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