Finance Management
1. Barry’s Steroids Company has $1,000 par value bonds outstanding at 14 percent interest. The bonds will mature in 30 years.
If the percent yield to maturity is 12 percent, what percent of the total bond value does the repayment of principal represent? Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
What is principle of a percentage of bond price?
Refer to Table 10-1, which is based on bonds paying 10 percent interest for 20 years. Assume interest rates in the market (yield to maturity) decline from 9 percent to 8 percent.
a. What is the bond price at 9 percent?
b. What is the bond price at 8 percent?
c. What would be your percentage return on investment if you bought when rates were 9 percent and sold when rates were 8 percent? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
Return on profit? % and loss/profit
2 Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bonds had a 30-year life when issued and the annual interest payment was then 13 percent. This return was in line with the required returns by bondholders at that point as described below:
Real rate of return
3
%
Inflation premium
5
Risk premium
5
Total return
13
%
3. Assume that five years later the inflation premium is only 3 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 25 years remaining until maturity.
Compute the new price of the bond. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. (Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)
New price of the bond?
4. Katie Pairy Fruits Inc. has a $1,100, 12-year bond outstanding with a nominal yield of 16 percent (coupon equals 16% × $1,100 = $176 per year). Assume that the current market required interest rate on similar bonds is now only 12 percent. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods.
a. Compute the current price of the bond. (Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)
b. Find the present value of 4 percent × $1,100 (or $44) for 12 years at 12 percent. The $44 is assumed to be an annual payment. Add this value to $1,100. (Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)
5. Lance Whittingham IV specializes in buying deep discount bonds. These represent bonds that are trading at well below par value. He has his eye on a bond issued by the Leisure Time Corporation. The $1,000 par value bond pays 6 percent annual interest and has 15 years remaining to maturity. The current yield to maturity on similar bonds is 11 percent.
a. What is the current price of the bonds? Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. (Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)
b. By what percent will the price of the bonds increase between now and maturity? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
6. You are called in as a financial analyst to appraise the bonds of Olsen’s Clothing Stores. The $1,000 par value bonds have a quoted annual interest rate of 13 percent, which is paid semiannually. The yield to maturity on the bonds is 8 percent annual interest. There are 10 years to maturity. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods.
a. Compute the price of the bonds based on semiannual analysis. (Do not round intermediate calculations. Round your final answer to 2 decimal places.)
b. With 5 years to maturity, if yield to maturity goes down substantially to 6 percent, what will be the new price of the bonds? (Do not round intermediate calculations. Round your final answer to 2 decimal places.)
7. BioScience Inc. will pay a common stock dividend of $5.20 at the end of the year (D1). The required return on common stock (Ke) is 14 percent. The firm has a constant growth rate (g) of 7 percent.
Compute the current price of the stock (P0). (Do not round intermediate calculations. Round your answer to 2 decimal places.)
8. Ecology Labs Inc. will pay a dividend of $7.20 per share in the next 12 months (D1). The required rate of return (Ke) is 20 percent and the constant growth rate is 8 percent. (Each question is independent of the others.)
a. Compute the price of Ecology Labs’ common stock. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
b. Assume Ke, the required rate of return, goes up to 25 percent. What will be the new price? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
c. Assume the growth rate (g) goes up to 11 percent. What will be the new price? Ke goes back to its original value of 20 percent. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
d. Assume D1 is $7.90. What will be the new price? Assume Ke is at its original value of 20 percent and g goes back to its original value of 8 percent. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
9. Justin Cement Company has had the following pattern of earnings per share over the last five years:
Year
Earnings
Per Share
20X1
$
13.00
20X2
13.78
20X3
14.61
20X4
15.49
20X5
16.42
The earnings per share have grown at a constant rate (on a rounded basis) and will continue to do so in the future. Dividends represent 40 percent of earnings.
a. Project earnings and dividends for the next year (20X6). (Round the growth rate to the nearest whole percent. Do not round any other intermediate calculations. Round your answers to 2 decimal places.)
Earnings 20X16
dividends
b. If the required rate of return (Ke) is 13 percent, what is the anticipated stock price (P0) at the beginning of 20X6? (Round the growth rate to the nearest whole percent. Do not round any other intermediate calculations. Round your answer to 2 decimal places.)
10. Beasley Ball Bearings paid a $4 dividend last year. The dividend is expected to grow at a constant rate of 2 percent over the next four years. The required rate of return is 15 percent (this will also serve as the discount rate in this problem). Use Appendix B for an approximate answer but calculate your final answer using the formula and financial calculator methods.
a. Compute the anticipated value of the dividends for the next four years. (Do not round intermediate calculations. Round your final answers to 2 decimal places.)
b. Calculate the present value of each of the anticipated dividends at a discount rate of 15 percent. (Do not round intermediate calculations. Round your final answers to 2 decimal places.)
c. Compute the price of the stock at the end of the fourth year (P4). (Do not round intermediate calculations. Round your final answer to 2 decimal places.)
d. Calculate the present value of the year 4 stock price at a discount rate of 15 percent. (Do not round intermediate calculations. Round your final answer to 2 decimal places.)
e. Compute the current value of the stock. (Do not round intermediate calculations. Round your final answer to 2 decimal places.)
f. Use the formula given below to show that it will provide approximately the same answer as part e. (Do not round intermediate calculations. Round your final answer to 2 decimal places.)
P0
=
D1
Ke − g
g. If current EPS were equal to $4.98 and the P/E ratio is 1.2 times higher than the industry average of 6, what would the stock price be? (Do not round intermediate calculations. Round your final answer to 2 decimal places.)
h. By what dollar amount is the stock price in part g different from the stock price in part f? (Do not round intermediate calculations. Round your final answer to 2 decimal places.)
i. With regard to the stock price in part f, indicate which direction it would move if:
11. Speedy Delivery Systems can buy a piece of equipment that is anticipated to provide an 5 percent return and can be financed at 2 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a 12 percent return but would cost 20 percent to finance through common equity. Assume debt and common equity each represent 50 percent of the firm’s capital structure.
a. Compute the weighted average cost of capital. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
b. Which project(s) should be accepted?
New machine
Piece of equipment
12. A brilliant young scientist is killed in a plane crash. It is anticipated that he could have earned $380,000 a year for the next 50 years. The attorney for the plaintiff’s estate argues that the lost income should be discounted back to the present at 6 percent. The lawyer for the defendant’s insurance company argues for a discount rate of 12 percent.
What is the difference between the present value of the settlement at 6 percent and 12 percent? Compute each one separately. Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. (Do not round intermediate calculations. Round your answers to 2 decimal places.)
Pv at 6% rate
PV at 12% rate
Difference
13. The Goodsmith Charitable Foundation, which is tax-exempt, issued debt last year at 14 percent to help finance a new playground facility in Los Angeles. This year the cost of debt is 30 percent higher; that is, firms that paid 16 percent for debt last year will be paying 20.80 percent this year.
a. If the Goodsmith Charitable Foundation borrowed money this year, what would the aftertax cost of debt be, based on their cost last year and the 30 percent increase? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
b. If the receipts of the foundation were found to be taxable by the IRS (at a rate of 20 percent because of involvement in political activities), what would the aftertax cost of debt be? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
14. Airborne Airlines Inc. has a $1,000 par value bond outstanding with 30 years to maturity. The bond carries an annual interest payment of $110 and is currently selling for $850. Airborne is in a 25 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar.
a. Compute the yield to maturity on the old issue and use this as the yield for the new issue. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
b. Make the appropriate tax adjustment to determine the aftertax cost of debt. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
15. Terrier Company is in a 45 percent tax bracket and has a bond outstanding that yields 11 percent to maturity.
a. What is Terrier’s aftertax cost of debt? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
b. Assume that the yield on the bond goes down by 1 percentage point, and due to tax reform, the corporate tax rate falls to 30 percent. What is Terrier’s new aftertax cost of debt? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
c. Has the aftertax cost of debt gone up or down from part a to part b?
It has gone up
It has gone down
16. Keyspan corp. is planning to issue debt that will mature in 2,035. In many respects, the issue is similar to the currently outstanding debt of the corporation. Use Table 11-3.
a. Calculate the yield to maturity on similarly outstanding debt for the firm, in terms of maturity. (Input your answer as a percent rounded to 2 decimal places.)
Assume that because the new debt wil be issued at par, the required yield to maturity will be .25 percent higher than the value determined in part a.
b. What is the new yield to maturity? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
c. If the firm is in a 35 percent tax bracket, what is the aftertax cost of debt for the yield determined in part b? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
17. Wallace Container Company issued $100 par value preferred stock 10 years ago. The stock provided a 6 percent yield at the time of issue. The preferred stock is now selling for $78.
What is the current yield or cost of the preferred stock? (Disregard flotation costs.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
18. The treasurer of Riley Coal Co. is asked to compute the cost of fixed income securities for her corporation. Even before making the calculations, she assumes the aftertax cost of debt is at least 2 percent less than that for preferred stock.
Debt can be issued at a yield of 13.6 percent, and the corporate tax rate is 25 percent. Preferred stock will be priced at $51 and pay a dividend of $5.80. The flotation cost on the preferred stock is $2.
a. Compute the aftertax cost of debt. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
b. Compute the aftertax cost of preferred stock. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
c. Based on the facts given above, is the treasurer correct?
Yes, the treasurer is correct.
No, the treasurer is incorrect.
19. Compute Ke and Kn under the following circumstances:
a. D1 = $3.20, P0 = $62, g = 5%, F = $2.00. (Do not round intermediate calculations. Round your answers to 2 decimal places.)
b. D1 = $.10, P0 = $22, g = 5%, F = $2.00. (Do not round intermediate calculations. Round your answers to 2 decimal places.)
c. E1 (earnings at the end of period one) = $3, payout ratio equals 20 percent, P0 = $26, g = 2.0%, F = $2.00. (Do not round intermediate calculations. Round your answers to 2 decimal places.)
d. D0 (dividend at the beginning of the first period) = $2, growth rate for dividends and earnings (g) = 3%, P0 = $52, F = $2. (Do not round intermediate calculations. Round your answers to 2 decimal places.)
20. Global Technology’s capital structure is as follows:
Debt
35
%
Preferred stock
15
Common equity
50
The aftertax cost of debt is 6.50 percent; the cost of preferred stock is 10.50 percent; and the cost of common equity (in the form of retained earnings) is 13.50 percent.
Calculate the Global Technology’s weighted cost of each source of capital and the weighted average cost of capital. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
Debt:
Preferred stock:
Common equity:
Weighted average cost of capital:
21. Sauer Milk Inc. wants to determine the minimum cost of capital point for the firm. Assume it is considering the following financial plans:
Cost
(aftertax)
Weights
Plan A
Debt
7.0
%
20
%
Preferred stock
14.0
10
Common equity
18.0
70
Plan B
Debt
7.5
%
30
%
Preferred stock
14.5
10
Common equity
19.0
60
Plan C
Debt
8.0
%
40
%
Preferred stock
14.7
10
Common equity
10.8
50
Plan D
Debt
10.0
%
50
%
Preferred stock
15.2
10
Common equity
12.5
40
a-1. Compute the weighted average cost for four plans. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
plan a
plan b
plan c
plan d
a-2. Which of the four plans has the lowest weighted average cost of capital?
Plan A
Plan B
Plan C
Plan D
b. What is the relationship between the various types of financing costs and the debt-to-equity ratio?
All types of financing costs increase as the debt-to-equity ratio increases.
All types of financing costs decrease as the debt-to-equity ratio increases.
22.A-Rod Manufacturing Company is trying to calculate its cost of capital for use in making a capital budgeting decision. Mr. Jeter, the vice-president of finance, has given you the following information and has asked you to compute the weighted average cost of capital.
The company currently has outstanding a bond with a 10.5 percent coupon rate and another bond with an 8.1 percent rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 11.4 percent. The common stock has a price of $59 and an expected dividend (D1) of $1.79 per share. The historical growth pattern (g) for dividends is as follows:
$
1.34
1.48
1.63
1.79
23.The preferred stock is selling at $79 per share and pays a dividend of $7.50 per share. The corporate tax rate is 30 percent. The flotation cost is 2.0 percent of the selling price for preferred stock. The optimal capital structure for the firm is 20 percent debt, 10 percent preferred stock, and 70 percent common equity in the form of retained earnings.
a. Compute the historical growth rate. (Do not round intermediate calculations. Round your answer to the nearest whole percent and use this value as g. Input your answer as a whole percent.)
growth rate:
b. Compute the cost of capital for the individual components in the capital structure. (Use the rounded whole percent computed in part a for g. Do not round any other intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
debt:
preferred stock:
common equity:
c. Calculate the weighted cost of each source of capital and the weighted average cost of capital. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
debt:
preferred stock:
common equity:
weight average cost equity:
24. Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 30 percent. Northwest’s treasurer is trying to determine the corporation’s current weighted average cost of capital in order to assess the profitability of capital budgeting projects.
Historically, the corporation’s earnings and dividends per share have increased about 8.3 percent annually and this should continue in the future. Northwest’s common stock is selling at $80 per share, and the company will pay a $7.30 per share dividend (D1).
The company’s $128 preferred stock has been yielding 5 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $5.00 for preferred stock.
The company’s optimal capital structure is 40 percent debt, 15 percent preferred stock, and 45 percent common equity in the form of retained earnings. Refer to the following table on bond issues for comparative yields on bonds of equal risk to Northwest.
Data on Bond Issues
Issue
Moody’s
Rating
Price
Yield to Maturity
Utilities:
Southwest electric power––7 1/4 2023
Aa2
$
975.18
8.34
%
Pacific bell––7 3/8 2025
Aa3
907.25
8.63
Pennsylvania power & light––8 1/2 2022
A2
970.66
8.55
Industrials:
Johnson & Johnson––6 3/4 2023
Aaa
870.24
8.66
%
Dillard’s Department Stores––7 3/8 2023
A2
940.92
8.33
Marriott Corp.––10 2015
B2
1,115.10
9.55
a. Compute the cost of debt, Kd (use the accompanying table—relate to the utility bond credit rating for yield.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
b. Compute the cost of preferred stock, Kp. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
c. Compute the cost of common equity in the form of retained earnings, Ke. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
d. Calculate the weighted cost of each source of capital and the weighted average cost of capital. (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
debt:
preferred stock:
common equity:
weight average cost equity:
24. Delta Corporation has the following capital structure:
Cost
(aftertax)
Weights
Weighted
Cost
Debt (Kd)
8.5
%
20
%
1.70
%
Preferred stock (Kp)
7.2
10
0.72
Common equity (Ke) (retained earnings)
7.5
70
5.25
Weighted average cost of capital (Ka)
7.67
%
a. If the firm has $42 million in retained earnings, at what size capital structure will the firm run out of retained earnings? (Enter your answer in millions of dollars (e.g., $10 million should be entered as “10”).)
b. The 8.5 percent cost of debt referred to earlier applies only to the first $14 million of debt. After that the cost of debt will go up. At what size capital structure will there be a change in the cost of debt? (Enter your answer in millions of dollars (e.g., $10 million should be entered as “10”).)
25. The Nolan Corporation finds it is necessary to determine its marginal cost of capital. Nolan’s current capital structure calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. Initially, common equity will be in the form of retained earnings (Ke) and then new common stock (Kn). The costs of the various sources of financing are as follows: debt, 7.2 percent; preferred stock, 5 percent; retained earnings, 12 percent; and new common stock, 13.2 percent.
a. What is the initial weighted average cost of capital? (Include debt, preferred stock, and common equity in the form of retained earnings, Ke.) (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
debt:
preferred stock:
common equity:
weight average cost equity:
b. If the firm has $29 million in retained earnings, at what size capital structure will the firm run out of retained earnings? (Enter your answer in millions of dollars (e.g., $10 million should be entered as “10”).)
c. What will the marginal cost of capital be immediately after that point? (Equity will remain at 50 percent of the capital structure, but will all be in the form of new common stock, Kn.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
d. The 7.2 percent cost of debt referred to earlier applies only to the first $44 million of debt. After that, the cost of debt will be 9.2 percent. At what size capital structure will there be a change in the cost of debt? (Enter your answer in millions of dollars (e.g., $10 million should be entered as “10”).)
e. What will the marginal cost of capital be immediately after that point? (Consider the facts in both parts c and d.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
26. Eaton Electronic Company’s treasurer uses both the capital asset pricing model and the dividend valuation model to compute the cost of common equity (also referred to as the required rate of return for common equity).
Assume:
Rf
=
6
%
Km
=
8
%
β
=
1.5
D1
=
$
.75
P0
=
$
19
g
=
4
%
a. Compute Ki (required rate of return on common equity based on the capital asset pricing model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
b. Compute Ke (required rate of return on common equity based on the dividend valuation model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
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