Chapter 16 Discussion Questions 16-1. In the 1970s the average Canadian industrial corporation had its interest covered over 5 times. By 1981, the ratio was about 3.5 times but in the early 90s had slipped below 1, but by 2000 had rebounded above 3 times where it stands today. 16-2. The bond agreement specifies such basic items as the par value, the coupon rate, and the maturity date. 16-3. The bond agreement covers a limited number of items, whereas the bond indenture is a supplement that often contains over 100 pages of complicated legal wording and specifies every minute detail concerning the bond issue. The bond indenture covers such topics as pledged collateral, methods of repayment, restrictions on the corporation, and procedures for initiating claims against the corporation. 16-4. The greater the security provisions afforded to a given class of bondholders, the lower the coupon rate. 16-5. The priority of claims can be determined from Figure 16-2: • senior secured debt, • junior secured debt, • senior debenture, • subordinated debenture, • preferred stock, • common stock. 16-6. Bond conversion. 16-7. The purpose of serial and sinking fund payments is to provide an orderly procedure for the retirement of a debt obligation. To the extent bonds are paid off over their life, there is less risk to the security holder. 16-8. A call provision may be exercised when interest rates on new securities are considerably lower than those on previously issued debt. The purpose of a deferred call is to insure that the bondholder will not have to surrender the security due to a call for at least the first five or ten years. 16-9. Bond prices on outstanding issues and interest rates move in opposite directions. If interest rates go up, bond prices will go down and vice versa. Long-term bonds are particularly sensitive to interest rate changes because the bondholder is locked into the interest rate for an extended period of time. Table 16 – 2 demonstrates these facts. 16-10. The different bond yield terms may be defined as follows: • • • Coupon rate: stated interest rate divided by par value. Current yield: stated interest rate divided by the current price of the bond. Yield to maturity: the interest rate that will equate future interest payments and payment at maturity to a current market price. 16-11. The higher the rating on a bond, the lower the interest payment that will be required to satisfy the bondholder. 16-12. The spread in the yield between bonds in different risk classes is not always the same. The yield spread changes with the economy. If investors are pessimistic about the economy, they will accept as much as 3% less return to go into very high-quality securities-whereas, in more normal times the spread may only be 1 1/2%. 16-13. a. The Hydro One bond and the Thomson Reuters bond are both rated A, which is investment grade. However the Hydro One bond has a longer time to maturity (2036 versus 2020). Generally a longer term maturity requires a higher yield to compensate for liquidity risk. b. The Government of Canada short-term bond yields (2016) 1.61% NAV 2.21 – 1.61 = 0.60 (or 60 basis points) Baytex 7.11 – 1.61 = 5.50 (or 550 basis points) The reason for the basis point spreads can be attributed to greater risk of default (investment grade – A versus junk bond - BB, as evidenced by the bond ratings). The large spread can be attributed the great uncertainty in the financial markets in 2011. 16-14. The bond refunding problem is similar to a capital budgeting problem in that an initial investment must be made in the form of redemption and reissuing costs, and cash inflows will take place in the form of interest savings. We take the present value of the inflows to determine if they equal or exceed the outflow. 16-15. We use the aftertax cost of new debt as the discount rate rather than the more generalized cost of capital. Because the net cash benefits are known with certainty, the refunding decision represents a riskless investment. For this reason, we use a lower discount rate. 16-16. The primary advantages of debt are: a. b. c. d. Interest payments are tax deductible. The financial obligation is clearly specified and of a fixed nature. In an inflationary economy, debt may be paid back with cheaper dollars. The use of debt, up to a prudent point, may lower the cost of capital to the firm. The disadvantages are: a. Interest and principal payment obligations are set by contract and must be paid regardless of economic circumstances. b. Bond indenture agreements may place burdensome restrictions on the firm. c. Debt, utilized beyond a given point, may serve as a depressant on outstanding common stock. 16-17. The zero-coupon-rate bond is initially sold at a deep discount from par value. The return to the investor is the difference between the investor's cost and the face value received at the end of the life of the bond. The advantages to the corporation are that there is immediate cash inflow to the corporation, without any outflow until the bond matures. The zero coupon bond is no longer sold in Canada. A stripped bond is packaged by investment dealers to suit investor requirements. With no coupon payments until the bond or coupon’s maturity the investor receives a true yield and does not have to worry about reinvesting the coupon payments. 16-18. Interest payments change with changing interest rates rather than with the market value of the bond. This means that the market value of a floating rate bond is almost fixed. The one exception is when interest rates dictated by the floating rate formula approach (or exceed) broadly defined limits. 16-19. A Eurobond is a bond payable in the borrower's currency but sold outside the borrower's country. It is usually sold by an international syndicate. 16-20. Capitalizing lease payments means computing the present value of future lease payments and showing them as an asset and liability on the balance sheet. 16-21. In both cases we create an asset and liability on the balance sheet. Furthermore in both cases, for income statement purposes, we amortize the asset and write off interest (implied or actual) on the debt. 16-22. In the lease versus borrow to purchase decision most of the cash flows are relatively certain because they are fixed payment streams. This should be acknowledged in the analysis with a lower discount rate. We generally use the cost of capital to discount uncertain cash flows such as the salvage value or the revenue streams in capital budgeting projects. We are comparing the lease to a borrowing alternative so the choice of the aftertax borrowing rate, which has been objectively determined in the financial marketplace, seems a good choice. Finally aftertax cash flows should be analyzed with an aftertax rate. Discussion Question: Appendix 16A 16A-1. Technical insolvency refers to the circumstance where a firm is unable to pay its bills as they come due. A firm may be technically insolvent even though it has a positive net worth. Bankruptcy, on the other hand, indicates that the market value of a firm's assets is less than its liabilities and the firm has a negative net worth. Under the law, either technical insolvency or bankruptcy may be adjudged as a financial failure of the business firm. 16A-2. Extension: Creditors agree to allow the firm more time to meet its financial obligations. Composition: Creditors agree to accept a fractional settlement on their original claims. Creditor committee: A creditor committee is set up to run the business because it is believed that management can no longer conduct the affairs of the firm. Assignment: Liquidation of assets takes place without going through formal court action. 16A-3. An internal reorganization calls for an evaluation and restricting of the current affairs of the firm. Current management may be replaced and a redesign of the capital structure may be necessary. An external reorganization means that an actual merger partner will be found for the firm. 16A-4. (1) Cost of administering the bankruptcy procedures. (2) Wages due workers to a maximum of $2,000 per worker. (3) Outstanding source deductions. Internet Resources and Questions Please refer to Finance in Action boxes. Problems 16-1. Garland Corporation a. Coupon rate = $90 Annual interest = = 0.0900 = 9.0% Par (maturity) value $1,000 b. Current yield = Annual interest $90 = = 0.1098 = 10.98% Market (price) value $820 c. Approximate yield to maturity = (Y') Principal payment - Price of the bond Annual interest payment + Number of years to maturity Y1 = 0.6 (Price of the bond ) + 0.4 (Principal payment ) $1,000 − $820 $90 + $90 + $18 10 = = = 0.1211 = 12.11% 0.6 ($820 ) + 0.4 ($1,000 ) $492 + $400 Yield to maturity: Calculator: Compute: PV = $820 FV = 1,000 PMT = $90/2 = $45 %I/Y =? N = 10 × 2 =20 %I/Y = 6.079 × 2 = 12.16% d. Holding period return Calculator: Compute: Calculator: Compute: PV = 0 FV =? %I/Y = 6%/2 = 3% N = 20 FV = $1,209.17 PMT = $45 PV = $820 FV = 2,209.17 PMT = 0 %I/Y =? N = 20 %I/Y = 5.08 × 2 = 10.16% (or 10.42% if N = 10, for effective return) 16-2. Preston Corporation a. Coupon rate = $70 Annual interest = = 0.070 = 7.0% Par (maturity) value $1,000 b. Current yield = Annual interest $70 = = 0.0655 = 6.55% Market (price) value $1,068 c. Approximate yield to maturity = (Y') Principal payment - Price of the bond Annual interest payment + Number of years to maturity Y1 = 0.6 (Price of the bond ) + 0.4 (Principal payment ) $1,000 − $1,068 $70 + $70 − $9.71 7 = = = 0.0579 = 5.79% 0.6 ($1,068) + 0.4 ($1,000 ) $640.8 + $400 Yield to maturity: Calculator: Compute: PV = $1,068 FV = 1,000 PMT = $70/2 = $35 %I/Y =? N = 7 × 2 = 14 %I/Y = 2.90 × 2 = 5.80% d. Holding period return Calculator: Compute: Calculator: Compute: PV = 0 FV =? PMT = $35 %I/Y = 9%/2 = 4.5% N = 14 FV = $662.62 PV = $1,068 FV = 1,662.62 PMT = 0 %I/Y =? N = 14 %I/Y = 3.21 × 2 = 6.42% (or 6.53% if N = 7, for effective return) 16-3. Myra Breck a. Bond A Current yield = $100 Annual interest = = 0.1250 = 12.50% Market (price) value $800 Bond B Current yield = Annual interest $100 = = 0.1111 = 11.11% Market (price) value $900 b. Bond A. It has a higher current yield. c. Yield to maturity = (Y') Bond A: Calculator: Compute: Bond B: Calculator: Compute PV = $800 FV = 1,000 PMT = $100/2 = $50 %I/Y =? N = 10 × 2 = 20 %I/Y = 6.87% × 2 = 13.74% PV = $900 FV = 1,000 PMT = $100/2 = $50 %I/Y =? N=2×2=4 %I/Y = 8.02% × 2 = 16.04% d. Yes. Bond B has the higher yield to maturity. This is because the discount will be recovered over only two years. With Bond A there is a 10-year recovery period. Yield to maturity is a better measure of return. 16-4. Bill Board a. Bond A Current yield = $90 Annual interest = = 0.1059 = 10.59% Market (price) value $850 Bond B Current yield = $80 Annual interest = = 0.0889 = 8.89% Market (price) value $900 b. Bond A. It has a higher current yield. c. Yield to maturity = (Y') Bond A: Calculator: Compute: Bond B: Calculator: Compute PV = $850 FV = 1,000 PMT = $90/2 = $45 %I/Y =? N = 10 × 2 = 20 %I/Y = 5.785 × 2 = 11.57% PV = $900 FV = 1,000 PMT = $80/2 = $40 %I/Y =? N=2×2=4 %I/Y = 6.95% × 2 = 13.90% d. Yes. Bond B has the higher yield to maturity. This is because the discount will be recovered over only two years. With Bond A there is a 10-year recovery period. Yield to maturity is a better measure of return. 16-5. Yield/ Security Matching Secured Debt Debenture Subordinated debenture 6.85% 7.76% 8.20% With greater risk, a higher yield is expected. 16-6. Milken Investment Fund a. Present value of interest payments A × PV IFA (N = 40, %I/Y = 7%) (Appendix D) PV A = $55 × 13.332 = $733.26 PV A = Present value of principal payment at maturity PV = FV × PV IF (N = 40, %I/Y = 7%) (Appendix B) PV = $1,000 × 0.067 = $67.00 Total present value Present value of interest payments $733.26 Present value of payment at maturity 67.00 Total present value or price of the bond $800.26 Calculator: Compute: PV =? FV = 1,000 %I/Y = 7% (14%/2) PV = $800.02 b. Value of 70 bonds $800.02 × 90 $72,002.00 PMT = $55 ($110/ 2) N = 40 (20 × 2) 16-7. Pacific Western Corporation a. Present value of interest payments PV A = A × PV IFA (N = 50, %I/Y = 5%) (Appendix D) PV A = $60 × 18.256 = $1,095.36 Present value of principal payment at maturity PV = FV × PV IF (N = 50, %I/Y = 5%) (Appendix B) PV = $1,000 × 0.087 = $87.00 Present value of interest payments $1,095.36 Present value of payment at maturity 87.00 PV or price of the bond $1,182.36 Calculator: Compute: PV =? FV= 1,000 %I/Y = 5% (10%/2) PV = $1,182.56 PMT = $60 ($120/ 2) N = 50 (25 × 2) b. No. The call price of $1,060 will keep the bonds from getting much over $1,060. Since the bonds are currently callable, investors will not want to buy the bonds at $1,182 and risk having them called away at $1,060. 16-8. Falter Corporation An AA rating at issue gives a coupon rate is 6.6% annually (3.3% semiannually). With a downgrading to A, the new yield to maturity is 7% (3.5% semiannually). Present value of interest payments PV A = A × PV IFA (N = 30, %I/Y = 3.5%) (Appendix D) PV A = $33 × 18.392 = $606.94 Present value of principal payment at maturity PV = FV × PV IF (N = 30, %I/Y = 3.5%) (Appendix B) PV = $1,000 × 0.356 = $356.00 Present value of interest payments $606.94 Present value of payment at maturity 356.00 Present value of the bond $962.94 Calculator: Compute: PV =? FV = 1,000 %I/Y = 3.5% (7%/2) PV = $963.22 PMT = $33 ($66/ 2) N = 30 (15 × 2) 16-9. Polly Cracker Company 10% initial coupon rate, 8% current yield to maturity: Calculator: Compute: 16-10. PV =? FV = 1,000 %I/Y = 4% (8%/2) PV = $1,172.92 PMT = $50 ($100/ 2) N = 30 (15 × 2) Industrial A Bonds Interest rate on previously issued A 20-year industrial bonds: 9% × 1.25 = 11.250% Additional return on A 20-year public utility bonds Additional return on new issues Anticipated return on newly issued A public utility bonds 16-11. a. Calculator: Compute: b. Calculator: Compute: c. Calculator: Compute: + 0.500% + 0.375% 12.125% Strip Bond PV =? FV = 1,000 %I/Y = 8% PV = $463.19 PMT = 0 N = 10 PV =? FV = 1,000 %I/Y = 6% PV = $558.39 PMT = 0 N = 10 PV =? FV = 1,000 %I/Y = 10% PV = $385.54 PMT = 0 N = 10 16-12. Strip Bond Yield Calculator: Compute: PV = $131 FV = 1,000 %I/Y =? N = 30 %I/Y = 7.01% 16-13. PMT = 0 Millennium Bonds with a floating rate covenant will have their coupon payment reset periodically to reflect current market yields. If the coupon rate and the current market rate are similar the bonds will sell at close to par value of $1,000. 16-14. a. Anchor Corporation Loan amount $6,000,000 = = $3,333,333 1 + cumulative inflation 1.80 b. $6,000,000 × 1.80 = $10,800,000 A $10,800,000 loan repayment in an 80% cumulative inflationary environment will provide $6,000,000 in purchasing power to the original lender. c. Charge a high enough interest rate to not only provide an adequate annual return on the borrowed funds, but also compensate for the loss of purchasing power. 16-15. Igor Sharp a. The original bond was issued at 14% Yield to maturity is now 8% 10 years remain to maturity Calculator: Compute: PV =? FV= 1,000 %I/Y = 4% (8%/2) PV = $1,407.71 b. $1,407.71 1,025.00 $ 382.71 Current price Purchase price Dollar increase c. Purchase Price × 20% Margin d. Return = $1,025.00 $ 205.00 PMT = $70 ($140/ 2) N = 20 (10 × 2) Purchase price paid in cash Money gained $382.71 = = 1.8669 = 186.69% Original investment $205.00 e. Mr. Sharp has not only benefited from an increase in the price of the bond (due to lower interest rates), but she also has benefited from the use of leverage by buying on margin. She has controlled a $1,025 initial investment with only $205 in cash. The low cash investment tends to magnify gains (as well as losses). 16-16. Bonds of Mitchell and Gordon Calculator: PV =? FV= 1,000 PMT = $40 ($80/ 2) %I/Y = 7% (14%/2) N = 30 (15 × 2) Compute: PV = $627.73 a. Present value of interest payments PVA = A × PVIFA N = 30*, I/Y = 7%) Appendix D = $35 × 12.409 = $496.36 PV A Present value of principal payment at maturity PV = FV × PV IF (N = 30*, I/Y = 7%) PV = $1,000 × .131 = $131.00 Appendix B Total present value Present value of interest payments Present value of payment at maturity Total present value or price of the bond b. Purchase price Current value Dollar loss Dollar loss Investment c. Maturity value Purchase price Dollar gain $496.36 312.00 $627.36 $1,000.00 627.73 $ 372.27 $ 372.27 = 37.23% $1,000.00 $1,000.00 627.73 $ 372.27 Dollar gain $372.27 = 59.30% Investment $627.73 d. The percentage gain is larger than the percentage loss because the investment is smaller ($627.73 vs. $1,000). The gain/loss is the same ($372.27). 16-17. The Wagner Corporation Discount rate Costs (Outflows) r (%I/Y) = 7.5(1 – .30) = 5.25% 1. Payment of call premium: $20,000,000 × 8% = $1,600,000 2. Borrowing expenses of new issue: Underwriting cost = $525,000 Amortization of expenses ($525,000/ 5) (.30) = $105,000 (.30) $31,500 tax savings per year Actual expenditure PV of future tax savings $31,500 @ PV IFA (N = 5, %I/Y = 5.25%) Net cost of borrowing expenses of new issue 3. Duplicate interest during overlap period: 9% × 1/12 ×$20,000,000 × (1 – 0.30) = 3% × 1/12 ×$20,000,000 × (1 – 0.30) = $525,000 135,441 $389,555 $105,000 35,000 $70,000 Benefits (Inflows) 4. Cost savings in lower interest rates: 9% (interest on old bond) × $20,000,000 = 7.5% (interest on new bond) × $20,000,000 = Savings per year = Aftertax savings per year $300,000 × (1 – .30) = PV of annual aftertax interest savings $210,000/ year @ PV IFA (N = 16, %I/Y = 5.25%) = Summary Costs 1. $1,600,000 2. 389,555 3. 70,000 4. PV of outflows $2,059,555 PV of inflows NPV (Net present value) $1,800,000 1,500,000 $ 300,000 $ 210,000 $2,235,969 Benefits 2,235,969 $2,235,969 $176,414 Wagner Corporation should refund the issue, as the NPV is positive at this time. The underwriting cost of the old issue is irrelevant as cash flow consequences are not changed by the refunding decision. 16-18. Harding Corporation Discount rate r (%I/Y) = 9% (1 – .25) = 6.75% Costs (Outflows) 1. Payment of call premium: $50,000,000 × 7.5% = $3,750,000 2. Borrowing expenses of new issue: Underwriting cost = 1.8% × $50 million = $900,000 Amortization of expenses ($900,000/ 5) (.25) = $180,000 (.25) $45,000 tax savings per year Actual expenditure PV of future tax savings $45,000 @ PV IFA (N = 5, %I/Y = 6.75%) Net cost of borrowing expenses of new issue 3. No overlap period: $900,000 185,751 $714,249 Benefits (Inflows) 4. Cost savings in lower interest rates: 10.25% (interest on old bond) × $50,000,000 = 9% (interest on new bond) × $50,000,000 = Savings per year = Aftertax savings per year $625,000 × (1 – .25) = PV of annual aftertax interest savings $468,750/ year @ PV IFA (N = 18, %I/Y = 6.75%) = Summary 1. 2. 3. PV of outflows Costs $3,750,000 714,249 0 $4,464,249 NPV (Net present value) $5,125,000 4,500,000 $ 625,000 $ 468,750 $4,801,478 Benefits 4. PV of inflows 4,801,478 $4,801,478 $ 337,229 The Harding Corporation should refund the issue, as the NPV is positive at this time. 16-19. Harding Corporation (Continued) Call premium (aftertax cost: not tax deductible) 7 years of 1/2% deductions (7th through 13th year) = 3 1/2% 8 % – 3 1/2% 4 1/2% Call premium Call premium at the end of the 13th year $50,000,000 × 4 1/2% = $2,250,000 16-20. Montilla Industries Discount rate r (%I/Y) = 6(1 – .25) = 4.5% a. Costs (Outflows) 1. Payment of call premium: $18,000,000 × 11% = $1,980,000 2. Borrowing expenses of new issue: Underwriting cost = $360,000 Other costs = 50,000 Total borrowing costs $410,000 Amortization of expenses ($410,000/ 5) (.25) = $82,000 (.25) = $20,500 tax savings per year Actual expenditure PV of future tax savings $20,500 @ PV IFA (N = 5, %I/Y = 4.5%) Net cost of borrowing expenses of new issue 3. No overlap period. $410,000 89,995 $320,009 Benefits (Inflows) 4. Cost savings in lower interest rates: 8.5% (interest on old bond) × $18,000,000 = 6% (interest on new bond) × $18,000,000 = Savings per year = Aftertax savings per year $450,000 × (1 – .25) = PV of annual aftertax interest savings $337,500/ year @ PV IFA (N = 10, %I/Y = 4.5%) = Summary 4. 5. 6. PV of outflows Costs $1,980,000 320,009 0 $2,300,009 NPV (Net present value) $1,530,000 1,080,000 $ 450,000 $ 337,500 $2,670,542 Benefits 4. PV of inflows 2,670,542 $2,670,542 $ 370,533 Montilla Industries should refund the issue, as the NPV is positive and will add value to the firm. b. The cost of capital is too high a discount rate to be used in bond refunding analysis. Cash flows in a bond refunding are relatively certain and a lower discount rate matched to their risk is appropriate. The market borrowing rate is an objective measure of any risk inherent in the anticipated cash flows so it is a good choice. The cash flows are aftertax and the discount rate should also be aftertax. c. To remove restrictive covenants. To alter Montilla’s capital structure. 16-21. United Brits Ltd. Discount rate r (%I/Y) = 7.5(1 – .30) = 5.25% Costs (Outflows) 1. Payment of call premium: $30,000,000 × 10% = $3,000,000 2. Borrowing expenses of new issue: Underwriting cost = $500,000 Amortization of expenses ($500,000/ 5) (.30) = $100,000 (.30) $30,000 tax savings per year Actual expenditure PV of future tax savings $30,000 @ PV IFA (N = 5, %I/Y = 5.25%) Net cost of borrowing expenses of new issue 3. Duplicate interest during overlap period: 10% × 1/12 ×$30,000,000 × (1 – 0.30) = 2.5% × 1/12 ×$30,000,000 × (1 – 0.30) = $500,000 128,992 $371,008 $175,000 43,750 $131,250 Benefits (Inflows) 4. Cost savings in lower interest rates: 10% (interest on old bond) × $30,000,000 = 7.5% (interest on new bond) × $30,000,000 = Savings per year = Aftertax savings per year $750,000 × (1 – .30) = PV of annual aftertax interest savings $525,000/ year @ PV IFA (N = 12, %I/Y = 5.25%) = Summary Costs 1. $3,000,000 2. 371,008 3. 131,250 4. PV of outflows $3,502,258 PV of inflows NPV (Net present value) Calculator: Compute: $1,086,029 $3,000,000 2,250,000 $ 750,000 $ 525,000 $4,588,287 Benefits 4,588,287 $4,588,287 Refund! PV = ? FV = 1,000 PMT = 100/ 2 =$50 %I/Y = 7.5%/ 2 = 3.75% n = 12 × 2 = 24 %PV = $1,195.56; exceeds $1,100 call price 16-22. Circus of the Sun Ltd. Discount rate r (%I/Y) = 8%/ 2 (1 – .40) = 2.40% (semiannual) r (%I/Y) = (1.024)2 – 1 = 4.8576% (annual effective) Costs (Outflows) 1. Payment of call premium: $60,000,000 × 8% = $4,800,000 2. Borrowing expenses of new issue: Underwriting cost = $1,000,000 Amortization of expenses ($1,000,000/ 5) (.40) = $200,000 (.40) $80,000 tax savings per year Actual expenditure PV of future tax savings $80,000 @ PV IFA (N = 5, %I/Y = 4.8576%) Net cost of borrowing expenses of new issue 3. Duplicate interest during overlap period: 11% × 1/12 ×$60,000,000 × (1 – 0.40) = 5% × 1/12 ×$60,000,000 × (1 – 0.40) = $1,000,000 347,726 $652,274 $330,000 150,000 $180,000 Benefits (Inflows) 4. Cost savings in lower interest rates (semiannual): 5.5% (interest on old bond) × $60,000,000 = 4% (interest on new bond) × $60,000,000 = Savings per half year = Aftertax savings per half year $900,000 × (1 – .40) = PV of aftertax interest savings $540,000/ half year @ PV IFA (N = 14, %I/Y = 2.4%) = Summary Costs 1. $4,800,000 2. 652,274 3. 180,000 4. PV of outflows $5,632,274 PV of inflows NPV (Net present value) $3,300,000 2,400,000 $ 900,000 $ 540,000 $6,357,042 Benefits 6,357,042 $6,357,042 $724,768 Circus of the Sun Ltd. should refund the issue, as the NPV is positive. 16-23. Webber Musicals Corporation Discount rate r (%I/Y) = 7% (No tax savings on dividends) Costs (Outflows) 1. Payment of call premium: ($71.43 – $50.00) × ($2,000,000/ $50) = $857,200 2. Borrowing expenses of new issue: Underwriting cost = $160,000 Amortization of expenses ($160,000/ 5) (.28) = $32,000 (.28) $8,960 tax savings per year Actual expenditure $160,000 PV of future tax savings $8,960 @ PV IFA (N = 5, %I/Y = 7%) 36,738 Net cost of borrowing expenses of new issue $123,262 3. No overlap period. Benefits (Inflows) 4. Cost savings in lower interest rates: 10% (dividend on old preferred) × $2,000,000 = $200,000 140,000 7% (dividend on new preferred) × $2,000,000 = Savings per year = $ 60,000 Dividends already aftertax: PV of annual dividend savings D $60,000 $857,143 Pp = = = $857,143 Kp 0.07 Summary Costs Benefits 1. $857,200 2. 123,262 3. 0 4. 857,143 PV of outflows $980,462 PV of inflows $857,143 NPV (Net present value) $ (123,319) Webber Musicals should not buyback. An efficient market is in evidence. The decline in interest rates has caused the value of the preferreds to rise to compensate for the lower interest rates. A lack of a call provision does not limit the rise in the preferred share value making a buyback (refunding) uneconomical. Pp = D $5.00 = = $71.43 0.07 Kp 16-24. The Deluxe Corporation Using criteria 3 and 4 The lease is less than 75% of the estimated life of the leased property. 120 months = 10/ 15 = 10 years 67% However, the present value of the lease payments is greater than 90% of the fair value of the property. $ 24,000 7.024 $168,576 Calculator: Compute: annual lease payments PV (N = 10, %I/Y = 7%) (Appendix D) present value of lease payments PV =? FV = 0 %I/Y = 7% PV = $168,566 % of fair value = PMT = $24,000 N = 10 $168,566 = 0.963 = 96.3% $175,000 Since one of the four criteria for compulsory treatment as a capital lease is indicated, the transaction must be treated as a capital lease. 16-25. The Ellis Corporation a. $10 million annual lease payments × 11.479 (PV IFA for N = 20, %I/Y = 6%) $114.699 million (round to $115 million) Calculator: PV =? FV = 0 PMT = $10 million %I/Y = 7% N = 20 Compute: PV = $114,699,212 b. . Balance sheet ($ millions) Current assets $ 50 Current liabilities Capital assets 50 Long-term liabilities Leased property Obligations under under capital lease 115 capital lease Total liabilities Shareholders' equity Total liabilities and Total assets $215 shareholders' equity c. Original: Total debt Total assets d. $40 million = 40.0% $100 million Original: Total debt Equity $40 million = 66.7% $60 million $ 10 30 115 155 60 $215 Revised: $155 million = 72.1% $215 million Revised: $155 million = 258.1% $60 million e. No, the information was already known by financial analysts before it was brought into the balance sheet. f. Management is concerned about whether the market is as efficient as is generally believed. They feel that newly presented information may make their performance look questionable. 16-26. Hegan Corporation a. Determine 10-year annuity that will yield 10% A = PV A /PV IFA (%I/Y = 10%, N = 10) (Appendix D) $900,000 = $146,461 6.145 Calculator: Compute: Compute: PV = $900,000 FV = 0 %I/Y = 10% N = 10 PMT = $146,471 PMT BGN = $133,155 PMT =? b. The $130,000 tax shield reduces the net cost to: Original cost Tax shield Net cost A= Calculator: Compute: Compute: $900,000 130,000 $770,000 $770,000 = $125,305 6.145 PV = $770,000 FV = 0 %I/Y = 10% N = 10 PMT = $125,314 PMT BGN = $113,922 PMT =? 16-27. Omni Enterprises a. (1) Year 0 1 2 3 4 b. A = Payment $2,600 2,600 4,600 4,600 0 Compute: c. (2) (1) 1 2 3 4 d. (3) Aftertax Cost $2,600 1,690 3,690 2,990 (1,610) PV A $10,000 = = $3,293 (n = 4,%i = 12) (Appendix D) 3.037 PVIFA Calculator: Year (2) Tax Shield 35% of (1) 0 910 910 1,610 1,610 PV = $10,000 FV = 0 %I/Y = 12% N=4 PMT = $3,292.34 (3) PMT =? (4) (5) Annual Repayment Beginning Annual Interest on Balance Payment 12% of (2) Principal (3) – (4) (6) Ending Balance (2) – (5) $10,000 $3,292 $1,200 $2,092 $8,908 7,908 3,292 949 2,343 5,565 5,565 3,292 668 2,624 2,941 2,941 3,292 353 2,939 2 r = 12% (1 – .35) = 7.8% dT 1 + .5r 0.25 × 0.35 1 + .5 × .078 PV (CCA) = [C PV ] C = [$10,000] + + 1 0 . 078 0 . 25 1 + . 078 r + d r = [$10,000](0.266768)(0.9638219 ) = $2,571 e. (Annual Interest × 35%) Year 1 2 3 4 Payment Interest Tax Shield $3,292 3,292 3,292 3,292 Aftertax cost of Borrow/Purchase $420 332 234 124 $2,872 2,960 3,058 3,168 f. Leasing Aftertax Cost 0 $2,600 1 1,690 2 3,690 3 2,990 4 (1,610) Present value Present value @ 7.8% $2,600 1,568 3,175 1,387 (1,192) $8,538 Borrow/Purchase Aftertax Cost 1 2,872 2 2,960 3 3,058 4 3,168 Present value @ 7.8% 2,664 2,547 2,441 2,346 $9,998* 2,571 $7,427 PV of CCA tax shield Present value * Note that this is equal to the cost of the asset. This will always be true if the aftertax cost of borrowing is selected as the discount rate. g. Borrow/ purchase as the present value (as a cost) is lower. 16-28. Exotic Mango Farms Ltd. N=7 T = 25% k = 18% d = 20% Discount rate (r or i) = 12% (1 – .25) = 9% Lease alternative Annual lease payment BGN (in advance) a $4,000 @ PV IFA (N = 7, %I/Y = 9%) Tax savings on annual lease payment (in arrears) $4,000 × 25% = $1,000 @ PV IFA (N = 7, %I/Y = 9%) PV cost of lease alternative $(21,944) 5,033 $(16,911) Borrowing alternative PV of annual loan payments and tax savings from interest expense (cost of machine) b Salvage value $6,000 @ PV IF (N = 7, k = 18%) c PV (CCA) 0.20 × 0.25 1 + .5 × .09 = [$24,000 − $1,884] 0.09 + 0.20 1 + .09 = [$22,116](0.1724138)(0.9587156 ) PV cost of borrowing/ purchase alternative NPV of lease alternative (relative to borrowing) $(24,000) 1,884 = 3,656 $(18,460) $ 1,549 Exotic Mango Ltd. should lease. a In advance payment 1.0 for payment at time 0 and N – 1 factor for the rest of the payments when using tables. b This will always be the case when the aftertax cost of borrowing is used as the discount rate. c The salvage value is a more uncertain cash flow than the other cash flows of the analysis and requires a higher discount rate to account for this greater uncertainty (or risk). 16-29. N=5 T = 25% Discount rate (r or i) = CT All Ltd. k = 15% d = 20% 13.33% (1 – .25) = 10% Lease alternative Annual lease payment BGN (in advance) $64,645 @ PV IFA (N = 5, i = 10%) Tax savings on annual lease payment (in arrears) $64,645 × 25% = $16,161 @ PV IFA (N = 5, %I/Y = 10%) PV cost of lease alternative $(269,561) 61,264 $(208,297) Borrowing alternative PV of annual loan payments and tax savings from interest expense (cost of machine) $(250,000) Salvage value $40,000 @ PV IF (N = 5, %I/Y = 15%) 19,887 PV (CCA ) 0.20 × 0.25 1 + .5 × .10 = [$250,000 − $19,887] 0.10 + 0.20 1 + .10 = [$230,113](0.1666667 )(0.95454545) PV cost of borrowing/ purchase alternative NPV of lease alternative (relative to borrowing) $ = 36,609 $(193,504) (14,793) CT All Ltd. should borrow as the NPV of leasing is a negative 14,793. In an an efficient market for money the NPV of the alternatives should be quite almost equal. 16-30. Orwell Futures N=5 T = 25% k = 15% d = 30% Discount rate (r or i) = 9% (1 – .25) = 6.75% Lease alternative Annual lease payment BGN (in advance) $15,800 @ PV IFA (N = 5, %I/Y = 6.75%) Tax savings on annual lease payment (in arrears) $15,800 × 25% = $3,950 @ PV IFA (N = 5, %I/Y = 6.75%) PV cost of lease alternative $(69,621) 16,305 $(53,316) Borrowing alternative PV of annual loan payments and tax savings from interest expense (cost of machine) $(75,000) Salvage value $25,000 @ PV IF (N = 5, k = 15%) 12,429 PV of annual maintenance payments $750 × (1 – .25) @ PV IFA (N = 5, %I/Y = 6.75%) (2,322) PV (CCA ) 0.30 × 0.25 1 + .5 × .0675 = [$75,000 − $12,429] 0.0675 + 0.30 1 + .0675 = [$62,571](0.204081633)(0.968384075) PV cost of borrowing/ purchase alternative NPV of lease alternative (relative to borrowing) = 12,366 $(52,527) $ (789) Orwell Futures should borrow as the NPV of leasing relative to borrowing is negative. 16-31. Y.B. Leasing N=2 T = 42% Discount rate (r or i) = k = 12% 12% d = 30% Since Y.B. Leasing holds this lease as an asset this is really a capital budgeting decision (for an asset acquisition), which suggests the cost of capital as the appropriate discount rate. To achieve the desired rate of return NPV = 0. Cost of truck $(45,000) Annual lease payment BGN (in advance) L @ PV IFA (N = 2, %I/Y = 12%) L (1.8929) Tax payments on annual lease payment (in arrears) L x 42% @ PV IFA (N = 2, %I/Y = 12%) – .42L (1.6901) 11,161 Salvage value $14,000 @ PV IF (N = 2, %I/Y = 12%) PV (CCA) 0.30 × 0.42 1 + .5 × .12 = [$45,000 − $11,161] 0.12 + 0.30 1 + .12 = [$33,839](0.30 )(0.94642857 ) NPV L (1.8929) – .42L (1.6901) L (1.1830) L = = = = 9,608 $ 0 $45,000 – $11,161 – $9,608 $24,231 $20,482 MINI CASES Leland Industries (Debt financing) This case gives the student a chance to understand the many factors influencing bonds. Initially the student concentrates on the variables affecting a bond rating and actually makes a basic bond rating decision. The relationship of bond ratings to yield to maturity also is stressed through various computations. The case also covers such innovative debt products as floating rate and zero-coupon rate bonds. Finally the use of hedging to cover interest rate exposure is explored. 1. International Bakeries Calculator: PV = $1,100 %I/Y =? Compute i% = 4.66 × 2 = 9.31% Gates Bakeries Calculator: PV = $920 %I/Y =? Compute i% = 5.20 × 2 = 10.41% Prairie Products Calculator: PV = $1,150 %I/Y =? Compute i% = 6.70 × 2 = 13.40% Dyer Pastries Calculator: PV = $1,060 %I/Y =? Compute i% = 4.81 × 2 = 9.62% Nolan Bread Calculator: PV = $950 %I/Y =? Compute i% = 5.44 × 2 = 10.88% FV= 1,000 PMT = $51.75 ($103.50/2) N = 50 (25 × 2) FV= 1,000 PMT = $47.25 ($94.50/2) N = 40 (20 × 2) FV= 1,000 PMT = $78.75 ($157.50/2) N = 30 (15 × 2) FV= 1,000 PMT = $51.50 ($103.00/2) N = 40 (20 × 2) FV= 1,000 PMT = $51.50 ($103.00/2) N = 50 (25 × 2) K d (cost of debt) = Y (Yield) (1 – T) International Bakeries Gates Bakeries Prairie Products Dyer Pastries Nolan Bread 9.31% (1 – .35) 10.41% (1 – .35) 13.40% (1. – .35) 9.62% (1. – .35) 10.88% (1 – .35) = 9.31% (.65) = 10.41% (.65) = 13.40% (.65) = 9.62% (.65) = 10.88% (.65) = 6.05% = 6.77% = 8.71% = 6.25% = 7.07% 2. A potential bond issue by Leland would definitely not qualify for the AA (high) rating that International Bakeries enjoys and would be well above the B (low) rating of Prairie Products. The bond would undoubtedly fall somewhere between AA (low) and A (medium). A comparative analysis with the three most similar firms is presented below. Rating Debt to Total Assets Times interest earned Fixed charge coverage Current ratio Return on equity Dyer Pastries AA3 35% 6.0× Gates Bakeries A1 42% 5.5× Nolan Bread A2 47% 4.9× Leland Industries ? 44% 5.7× 3.6× 4.2× 3.8× 3.7× 2.8× 19% 2.3× 17.1% 2.1X 15% 2.0× 16.8% Leland generally falls below Dyer Pastries on all measures except fixed charge coverage, so it is unlikely to qualify for an AA (low) rating. The firm appears to fall between the A (high) and A (medium) categories. Its debt ratio, times earned and return on equity ratios indicate that it falls closer to the A (high) category than the A (medium). However, its fixed charge coverage and current ratio are more in line with an A (medium) rating. On balance, A (high) is probably the most appropriate answer. 3. Debt Outstanding Year 1 $20,000,000 × .95 = $19,000,000 Year 2 $19,000,000 × .95 = $18,050,000 Year 3 $18,050,000 × .95 = $17,147,500 Interest Payment on Debt Debt outstanding Interest expense (10%) Aftertax cost (1 – .35) Aftertax interest expense $17,147,500 1,714,750 .65 $ 1,114,588 4. Interest savings on $20 million debt outstanding Size of issue .................................................................. $20 million Interest savings (%) ...................................................... 1.25 Interest savings ($)........................................................ $250,000 Taxes (.35) .................................................................... 87,500 Aftertax benefit ............................................................. $162,500 Since the aftertax cost of hedging is $120,000, there is a net aftertax benefit of $42,500 per year Aftertax interest savings ............................................... Aftertax cost of hedging ............................................... Net aftertax benefit ....................................................... $162,500 120,000 $ 42,500 5. Assuming the A (high) rating we get a current yield of 10.41%. Adding ¾ of 1% produces a yield of 11.16% a) Present value of $1,000 zero-coupon rate bond. PV = FV × PV IF (Appendix B) FV = $1,000, N = 20, i = 11% PV = $1,000 × .124 = $124 The bond price would be $124 Calculator: Compute PV PV =? %I/Y = 11.16% = $120.51 FV= 1,000 N = 20 PMT = $0 b) The number of bonds to be issued is: $20,000,000 = 165,961 $120.51 (Note: with $1,000 per value bonds, only 20,000 bonds would be issued) c) The danger is that the corporation is not paying any interest on an annual basis, and for this reason, the repayment obligation expands beyond the initial capital received. Thus, the firm must be sure that it is accumulating adequate funds to meet its future obligations (or will be able to issue new securities to refund the debt when it comes due). Warner Motor Oil Co. (Bond Refunding) This case gives the student a clear insight into the refunding process. The importance of the Call privilege is emphasized. Clearly, a refunding would not be feasible if the old issue had to be reacquired at market value. The case also provides an example of where a positive net present value may not be sufficient justification for taking action if the NPV is likely to be even larger in the future. There is also the option of comparing accounting implications with cash flow and net present value considerations. Normally, a refunding decision hurts accounting profits in the first year, and increases them in all subsequent years. Price of Previously Issued Bonds Present value of interest payments PV A = A × PV IFA (N = 30, %I/Y = 5%) (Appendix D) (A = 11.5%/ 2 × $1,000 = 5.75% × $1,000 = $57.50) PV A = $57.50 × 15.372 = $883.89 Present value of principal payment at maturity PV = FV × PV IF (N = 30, %I/Y = 5%) (Appendix B) PV = $1,000 × .231 = $231.00 Total present value Present value of interest payments .......................................................................... Present value of payment at maturity ...................................................................... Total present value of price of the bond.................................................................. Calculator: PV =? FV= 1,000 PMT = $57.50 %I/Y = 5% N = 30 Compute PV = $1,115.29 Market price ............................................................................................................ Par + 8% call premium............................................................................................ Savings per $1,000 bond ......................................................................................... Added comment—On 30,000 bonds, this represents total savings of $1,058,700. $ 883.89 231.00 $1,114.89 $1,115.29 1,080.00 $ 35.29 Refunding Analysis Discount rate = 10% (1-.3) = 7% Costs (Outflows) 1. Payment of call premium $30,000,000 × 8% = $2,400,000 2. Underwriting cost on new issue $30,000,000 × 2.8% = $840,000 Amortization of cost ($840,000/5) (.3) = $168,000 (.3) = $50,400 tax savings per year Actual expenditure ......................................................................................... $840,000 PV of future tax savings $50,400 (N =5, %I/Y = 7%.................................... 206,650 Net cost of underwriting expense on new issue ............................................ $633,350 3. There is no overlap period. Benefits (Inflows) 4. Cost savings in lower interest rates 11.5% (interest on old bond) × $30,000,000 10.0% (interest on new bond) × $30,000,000 Savings per year Savings per year $450,000 × (1 – .3) $ 315,000 (N = 15, %I/Y = 7%) = $3,450,000/year = 3,000,000/year $ 450,000 = $ 315,000 aftertax PV IFA = $2,868,993 Summary 3. 4. Benefits $2,868,993 . $2,868,993 PV of inflows ............... PV of outflows ............. Net of present value ..... $2,868,993 3,033,350 $(164,357) 1. 2. Costs $2,400,000 633,350 $3,033,350 The potential refunding has a negative net present value. Gina and Al must consider whether interest rates will go even lower. If this is likely to be the case, they still may be able to refund the old issue. It would be unwise to refund an issue, and then attempt to refund it again shortly thereafter if rates go down even further because of the large costs involved. Furthermore, if there is a deferred call provision on the new bonds issued after refunding, it may not be feasible to refund the new issue in any event. The accounting numbers for 2012 are very different from net present value figures. From an accounting viewpoint, the numbers for 2012 are as follows: Payment of call premium .................................................................................... Amortization of underwriting cost on new issue (annual) ................................. Interest savings ................................................................................................... Before tax loss .................................................................................................... Tax rate (not applied on call premium) .............................................................. Taxes paid (450,000 – 168,000) × tax rate = Aftertax loss ....................................................................................................... – $2,400,000 – 168,000 + 450,000 – $2,118,000 .30 84,600 – $2,202,600 The large loss is due to the payment of the call premium which is not tax deductible and the write-off of underwriting costs in 2012. In 2013, the benefit of refunding begins to show up in terms of profitability. Amortization of underwriting cost on new issue (annual) ................................. – $168,000 Interest savings ................................................................................................... + 450,000 Before tax profit.................................................................................................. $282,000 Tax rate ............................................................................................................... .30 Aftertax profit (Before tax profit × (1 – tax rate)) .............................................. $197,400 Although the firm’s profitability suffers in 2012 due to one time write-offs, the benefits begin in 2013 and take place for the remaining life of the new issue. Problems: Appendix 16A 16A-1. Immobile Homes a. Liquidation value of assets Liabilities Difference $3,500,000 5,900,000 ($2,400,000) b. Preferred and common stock will not participate in the distribution because the liquidation value of the assets does not cover creditor claims. c. Asset values in liquidation Administrative costs, wages and taxes Remaining asset values $3,500,000 – 400,000 $3,100,000 d. Remaining asset value Payment to secured creditors Amount available to unsatisfied secured claims and unsecured debt $3,100,000 – 400,000 $2,700,000 e. Remaining claims of unsatisfied secured debt and unsecured debt holders Secured debt (unsatisfied first lien) Accounts payable Senior unsecured debt Subordinated debentures $ 250,000 2,000,000 1,300,000 1,450,000 $5,000,000 f. Amount available to unsatisfied security claims and unsecured debt (part d) Remaining claims of unsatisfied secured $2,700,000 debt and unsecured debt holders (part e) $5,000,000 $2,700,000 Allocation ratio = = 0.54 = 54% $5,000,000 g. Allocation procedures for unsatisfied secured claims and unsecured debt (1) (2) (3) (4) Amount of Initial Amount Category claim allocation received (54%) Secured debt (unsatisfied first lien) Accounts Payable Senior unsecured debt Subordinated debentures $ 250,000 $ 135,000 $ 135,000 2,000,000 1,080,000 1,080,000 1,300,000 702,000 1,300,000 1,450,000 $5,000,000 783,000 $2,700,000 185,000 $2,700,000 *The subordinated debenture holders must transfer $598,000 of their initial allocation to the senior unsecured debt holders to fully provide for their payment ($702,000 + $598,000 = $1,300,000). This will leave $185,000 for subordinated debentures. h. Payments and percent of claims Total amount Amount Category of claim received Secured debt (first lien) Wages Accounts payable Senior unsecured debt Subordinated debentures Percent of Claim satisfied $ 650,000 $ 535,000 82.31% 50,000 50,000 100.00% 1,950,000 1,030,000 52.82% 1,300,000 1,300,000 100.00% 1,450,000 185,000 12.76% Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015
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