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Overview of the Financing Decision - Applied Corporate Finance - Solved Quiz, Exercises of Corporate Finance

Overview of the Financing Decision, Capital Structure, Income bonds, Preferred stock, Equity component, Dividend rate, Debt ratio, Total equity value, Annual interest tax savings. Above points are only few to make points to guide you to this file. You can see, there are many helpful questions and their answers in this file.

Typology: Exercises

2011/2012

Uploaded on 11/13/2012

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Download Overview of the Financing Decision - Applied Corporate Finance - Solved Quiz and more Exercises Corporate Finance in PDF only on Docsity! Chapter 7: Capital Structure: An Overview of the Financing Decision 1. Income bonds are similar to preferred stock in several ways. Payment of interest on income bonds depends on the availability of sufficient earnings, just like preferred stock. However, income bonds would be paid ahead of preferred stock. On the other hand, both would be paid ahead of common stock. Missed payments are cumulated as with preferred stock. For purposes of analyzing debt, the major differences would be that payments on income bonds, while they can be deferred, must be paid contractually and are tax deductible. Failure to make payments can lead to default and bring on bankruptcy. This is not the case with preferred stock. 2. The contractual payments on a commodity bond depend directly on the price of a commodity. However, like a straight bond, the payments on the commodity bond are capped at some predetermined amount. The contractual payments on a straight bond do not depend on the price of the commodity. However, the ability of the company to make the payments might depend upon commodity prices. In the case of equity, there are no contractual payments at all, although the value of the equity could depend on commodity prices. From the point of view of analyzing capital structure, commodity bonds would qualify as debt, since the payments are contractual, and non-payment could bring on bankruptcy. However, since the amount that has to be paid is tied to commodity prices, the risk of bankruptcy is smaller. 3. This security resembles straight debt, except for two things: the “dividend” is not tax- deductible, and it is subordinated to all other debt. Alternatively, it could be compared to preferred stock with a finite life. I would classify this security as equity, since the payments are not contractual. Alternatively, it might be included in a special category like preferred debt. 4. If we assume that the straight preferred stock is trading at par, the return on the straight preferred = 9%. If the convertible preferred, which has a 6% dividend rate were evaluated as a straight preferred at this yield, we would get a price of 6/0.09 = $66.67. Since it is actually trading at $105, the equity component = 105 - 66.67 = $38.33 5. The convertible bond is a 10-year bond with a face value of $1000 and a coupon rate of 5%. If it yielded the same rate as the straight bond, i.e. 8%, its price would be equal to 25 04 1 1 104 1000 104 79615 20 20. ( . ) . .− + = , assuming semi-annual coupons. Hence, the equity component of the convertible can be estimated as 1100 - 796.15 = 303.85. The total equity component of the firm’s asset value = 50(1 m.) + 303.85(20000) = $56.077m. The debt component = $25m. + 796.15(20000) = 40.923m. Hence, the debt ratio = 40.923/(40.923 + 56.077) = 42.19% 6. Both Class A and Class B stocks are effectively equity securities, rather than debt securities. The reduced control value/voting rights in the Class B simply mean greater control value for the Class A stocks. It would be appropriate to simply treat both as equity for the purpose of the debt ratio computation. Hence the total equity value = 50000(100) + (100000(90) = $14m. The bank debt is also debt; hence the debt ratio = 5/(14+5) = 26.32%. If the $25m. represents the book value of the bank debt, and it were taken on recently, then that would be close to the market value as well. This is relevant, since we need to use market values in the computation of the debt ratio. 7. a. Even though the firm is successful, given the small size and inexperience in the market, the owner should make sure that he chooses a reputable investment banker, to make up for the reputation that he himself is lacking. Also, for similar reasons, the investment banker chosen should be knowledgeable about the industry that the firm is in,. b. The required proportion = 20m./50m. = 40%, if the offering is fairly priced. c. If the offering is to be underpriced by 10%, then a portion of the firm worth 20/.9 = $22.22m. would need to be given up in exchange for the $20m. of proceeds. Hence, 22.22/50 = 44.44% of the firm would have to be given up. d. Since the total value of the shares, subsequent to the offering would be $50 m., if the shares were to trade in the $20 to $25 range, the number of shares would be 50/20 to 50/25 million share range, i.e. 2m. to 2.5m. shares. 8. It is not true that the dependence on debt for external financing makes US firms overleveraged. We need to take internal equity into account as well to determine the actual level of leverage. In any case, US firms relative dependence on debt for external financing is comparable to other countries. 9. There are two factors. One is that small high growth companies do not have substantial current cash flows. Convertible bonds, by keeping the interest expense low, allow these companies to borrow. The second factor is that small high growth companies tend to be volatile. This volatility makes the conversion option more valuable to investors, and reduces the interest expense on the debt further. 10. The convertible debt gives bondholders an option to convert in addition to the straight debt component. I would price this option as well before concluding that the 7% yield on the convertible debt is cheaper. 11. The 200,000 warrants are generally treated as equity. Given the trading price of $12, this amounts to $2.4m. If the convertible bonds were priced at 9% (the yield on the straight debt), they would sell at 30 045 1 1 1045 1000 1045 72398 40 40. ( . ) . .− + = . Hence the debt component equals 10000(723.98) = 7,239,800, while the equity component works out to $10m. - 7.24m. = $2.76m. The total equity portion adds up to 50 + 2.4 + 2.76 = $55.16m; the total debt portion adds up to $250m. + 7.24m. = 257.24m. The debt ratio works out to 257.24/(257.24+55.16) = 82.34% 23. The first firm should raise more funds in the form of equity, whereas the second firm might do well to borrow and buy back stock. 24. Maintaining flexibility is good only in an environment where good investment opportunities come unawares. Otherwise, it is bad for stockholder value, because it implies high free cash flow. 25. a. The firm value remains the same. b. The cost of capital also remains the same. c. If there were taxes, firm value would go up as leverage increased. The cost of capital would drop. 26. a. The high growth prospects of the firm in the past probably made debt expensive due to agency costs (due to R&D expenses). The firm would also not have had the ability to pay back debt, since it would continually need additional funds for growth. b. However, now that the firm is more mature, and there are not many new investment opportunities, it should consider more debt. 27. By increasing the riskiness of the firm’s investments, bondholders can be made less well off. By increasing the leverage of the firm, existing bond values can be reduced to the benefit of stockholders. Finally, increasing dividends reduces the asset base available to protect bondholders. 28. This is not true because covenants can be expensive, both in terms of their effect on flexibility and the cost of monitoring and providing the information required in bond covenants. 29. a. Financial flexibility is higher with low leverage in several ways: one, the firm can use retained earnings for whatever purposes it chooses: it is not forced to pay out funds as debt service. Also, with low leverage and high debt capacity, the firm can tap into this debt capacity if funds are urgently needed. Finally, there are likely to be fewer covenants to restrict the firm. b. The tradeoff is flexibility versus the tax advantages of debt and the discipline enforced by debt on wayward managers. 30. a. These firms have stable earnings and fixed assets that can be easily sold in case of bankruptcy to pay off bondholders. b. Since returns are controlled by regulation, the variance of returns is reduced. This increases debt capacity. 31. The tax advantage of debt would be lowered. This would reduce the optimal debt- equity ratio. Removing the tax deductibility of debt would have a similar effect. 32. This would raise their debt ratios, since the probability of bankruptcy would drop for each level of debt. 33. This is true if a. there are no taxes, b. markets are frictionless and there are no transactions costs, and c. if there are no direct or indirect bankruptcy costs. If debt is irrelevant, changing the debt ratio leaves the cost of capital unchanged. 34. We would expect strong firms to issue debt, while financially weak firms would issue equity. This is related to the lower bankruptcy probabilities of the former. 35. This could be because private firms tend to be smaller and tend to be growth firms. Furthermore, information asymmetries would tend to be higher for such firms. Finally, the owner of a private firm may weigh default risk much more than a well diversified investor in a publicly traded firm, since much or all of his or her wealth may be invested in the business. 36. The bankruptcy itself is not what causes stock prices to go to zero. It is the years of poor earnings and investments leading to bankruptcy that wipe out the value of equity. Thus, at the point of bankruptcy the costs are more the costs of liquidation. 37. The direct costs refer to the actual legal costs and reorganization incurred during bankruptcy. Indirect costs refer to negative effects on the operating cashflows of firms because they are in or close to bankruptcy. Firm, such as retailers may find that suppliers refuse to ship to them on credit if they are close to bankruptcy. Also, firms which sell durable goods and/or goods whose quality is not easily observable are subject to such costs, since their customers will prefer other firms that have a higher probability of being around when the customers need further servicing. 38. Managers left to themselves would prefer all equity financed firms, with significant cash balances, since they will be far less pressure to deliver results and be efficient. The greater the leverage, the more managers are under the ball, because debt service payments must be made on time. 39. First of all, there could be direct effects of high leverage on the operating cashflows. Secondly, the cost of capital is obtained by weighting the cost of equity and the cost of debt by their respective shares in the market value of the firm. Even though the cost of debt is always lower than that of equity, since increasing leverage also increases the share of debt in the capital structure of the firm, the net effect on the cost of capital can be to raise it.
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