Chapter 16 Long-Term Debt and Lease Financing Discussion Questions 16-1. Corporate debt has been expanding very dramatically in the last three decades. What has been the impact on interest coverage, particularly since 1977? In 1977, the average U.S. manufacturing corporation had its interest covered almost eight times. By the 2000s, the ratio had been cut to less than half. 16-2. What are some specific features of bond agreements? The bond agreement specifies such basic items as the par value, the coupon rate, and the maturity date. 16-3. What is the difference between a bond agreement and a bond indenture? 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. Discuss the relationship between the coupon rate (original interest rate at time of issue) on a bond and its security provisions. The greater the security provisions afforded to a given class of bondholders, the lower the coupon rate. 16-5. Take the following list of securities and arrange them in order of their priority of claims: Preferred stock Senior debenture Subordinated debenture Senior secured debt Common stock Junior secured debt 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. What method of “bond repayment” reduces debt and increases the amount of common stock outstanding? Conversion of bonds to common stock through either a convertible bond or an exchange offer. 16-7. What is the purpose of serial repayments and sinking funds? The purpose of serial and sinking fund payments is to provide an orderly procedure for the retirement of a debt obligation. To the extend bonds are paid off over their life, there is less risk to the security holder. 16-8. Under what circumstances would a call on a bond be exercised by a corporation? What is the purpose of a deferred call? 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 5 or 10 years. 16-9. Discuss the relationship between bond prices and interest rates. What impact do changing interest rates have on the price of long-term bonds versus short-term bonds? Bond prices on outstanding issues and market 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. 16-10. What is the difference between the following yields: coupon rate, current yield, and yield to maturity? 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. How does the bond rating affect the interest rate paid by a corporation on its bonds? The higher the rating on a bond, the lower the interest payment that will be required to satisfy the bondholder. 16-12. Bonds of different risk classes will have a spread between their interest rates. Is this spread always the same? Why? 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 percent less return to go into very high-quality securities, whereas in more normal times the spread may only be 1½ percent. 16-13. Explain how the bond refunding problem is similar to a capital budgeting decision. 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. 16-14. What cost of capital is generally used in evaluating a bond refunding decision? Why? We use the after tax 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. 16-15. Explain how the zero-coupon rate bond provides a return to the investor. What are the advantages to the corporation? 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. Furthermore, the difference between the initial bond price and the maturity value may be amortized for tax purposes over the life of the bond by the corporation. 16-16. Explain how floating rate bonds can save the investor from potential embarrassments in portfolio valuations. 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. 16-17. Discuss the advantages and disadvantages of debt. The primary advantages of debt are: a. Interest payments are tax deductible. b. The financial obligation is clearly specified and of a fixed nature. c. In an inflationary economy, debt may be paid back with cheaper dollars (the dollars have less purchasing power than when received). d. 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. 16-18. What is a Eurobond? 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. 16-19. What do we mean by capitalizing lease payments? Capitalizing lease payments means computing the present value of future lease payments and showing them as an asset and liability on the balance sheet. 16-20. Explain the close parallel between a capital lease and the borrow-purchase decision from the viewpoint of both the balance sheet and the income statement. 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. Appendix 16A-1. What is the difference between technical insolvency and bankruptcy? Technical insolvency refers to the circumstances 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. What are the four types of out-of-court settlements? Briefly describe each. 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. What is the difference between an internal reorganization and an external reorganization under formal bankruptcy procedures? 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. What are the first three priority items under liquidation in bankruptcy? (1) Cost of administering the bankruptcy procedures. (2) Wages due workers if earned within three months of filing the bankruptcy petition. The maximum amount is $600 per worker. (3) Tax due at the federal, state, or local level. Chapter 16 Problems (Assume the par value of the bonds in the following problems is $1,000 unless otherwise specified.) 1. Bond yields (LO16-2) The Pioneer Petroleum Corporation has a bond outstanding with an $85 annual interest payment, a market price of $800, and a maturity date in five years. Find the following: a. The coupon rate. b. The current rate. c. The yield to maturity. 16-1. Solution: The Pioneer Petroleum Company a. $85 Interest / $1,000 Par = 8.5% Coupon rate b. $85 Interest / $800 Market price = 10.625% Current yield Calculator Solution: (c) N I/Y PV PMT FV 5 CPT I/Y 14.3788 –800 85 1,000 Answer: 14.38 2. Bond yields (LO16-2) Preston Corporation has a bond outstanding with an $80 annual interest payment, a market price of $1,250, and a maturity date in 10 years. Assume the par value of the bonds is $1,000. Find the following: a. The coupon rate. b. The current rate. c. The yield to maturity. 16-2. Solution: Preston Corporation a. $80 Interest / $1,000 Par = 8.00% Coupon rate b. $80 Interest / $1,250 Market price = 6.40% Current yield (c) N I/Y PV PMT FV 10 CPT I/Y 4.7946 –1,250 80 1,000 Answer: 4.79 3. Bond yields (LO16-2) Harold Reese must choose between two bonds: Bond X pays $95 annual interest and has a market value of $900. It has 10 years to maturity. Bond Z pays $95 annual interest and has a market value of $920. It has two years to maturity. a. Compute the current yield on both bonds. b. Which bond should he select based on your answer to part a? c. A drawback of current yield is that it does not consider the total life of the bond. For example, the yield to maturity on Bond X is 11.21 percent. What is the yield to maturity on Bond Z? d. Has your answer changed between parts b and c of this question? 16-3. Solution: a. Bond X $95 interest / $900 market price = 10.56% current yield Bond Z $95 interest / $920 market price = 10.33% current yield b. He should select Bond X. It has a higher current yield. (c) N I/Y PV PMT FV 2 CPT I/Y 14.38223 –920 95 1,000 Answer: 14.38 d. Yes. Bond Z has the higher yield to maturity. This is because the discount will be recovered over only two years. With Bond X there is a $100 discount, but a 10-year recovery period. 4. Bond yields (LO16-2) An investor must choose between two bonds: Bond A pays $72 annual interest and has a market value of $925. It has 10 years to maturity. Bond B pays $62 annual interest and has a market value of $910. It has two years to maturity. Assume the par value of the bonds is $1,000. a. Compute the current yield on both bonds. b. Which bond should she select based on your answer to part a? c. A drawback of current yield is that it does not consider the total life of the bond. For example, the yield to maturity on Bond A is 8.33 percent. What is the yield to maturity on Bond B? d. Has your answer changed between parts b and c of this question in terms of which bond to select? 16-4. Solution: a. Bond A $72 Interest / $925 Market price = 7.78% Current yield Bond B $62 Interest / $910 Market price = 6.81% Current yield b. Bond A. It has a higher current yield. (c) N I/Y PV PMT FV 2 CPT I/Y 11.48959 –910 62 1,000 Answer: 11.49% d. Yes. Bond B now has the higher yield to maturity. This is because the $90 discount will be recovered over only two years. With Bond A there is a $75 discount, but a 10-year recovery period. 5. Secured vs. unsecured debt (LO16-1) Match the yield to maturity in column 2 with the security provisions (or lack thereof) in column 1. Higher returns tend to go with greater risk. (1) (2) Security Provision Yield to Maturity a. Debenture a. 6.85% b. Secured debt b. 8.20% c. Subordinated debenture c. 7.76% 16-5. Solution: Security Provision Yield to Maturity a. Debenture a. 7.76% b. Security debt b. 6.85% c. Subordinated debenture c. 8.20% The greater the risk, the higher the yield. 6. Bond value (LO16-2) The Florida Investment Fund buys 58 bonds of the Gator Corporation through a broker. The bonds pay 10 percent annual interest. The yield to maturity (market rate of interest) is 12 percent. The bonds have a 10-year maturity. Using an assumption of semiannual interest payments: a. Compute the price of a bond (refer to “Semiannual Interest and Bond Prices” in Chapter 10 for review if necessary). b. Compute the total value of the 58 bonds. 16-6. Solution: Florida Investment Company a. Present value of interest payments PVA = A × PVIFA (n = 20, i = 6%) Appendix D PVA = $50 × 11.470 = $573.50 Present value of principal payment at maturity PV = FV × PVIF (n = 20, i = 6%) Appendix B PV = $1,000 × .312 = $312.00 Total present value Present value of interest payments $573.50 Present value of payment at maturity 312.00 Total present value or price of the bond $885.50 b. Value of 58 bonds $ 885.50 × 58 $51,359.00 (a) N I/Y PV PMT FV 20 6 CPT PV –885.30 50 1,000 Answer: 885.30 7. Bond value (LO16-2) Cox Media Corporation pays an 11 percent coupon rate on debentures that are due in 10 years. The current yield to maturity on bonds of similar risk is 8 percent. The bonds are currently callable at $1,110. The theoretical value of the bonds will be equal to the present value of the expected cash flow from the bonds. a. Find the market value of the bonds using semiannual analysis. b. Do you think the bonds will sell for the price you arrived at in part a? Why? 16-7. Solution: Cox Media Corporation a. Present value of interest payments PVA = A × PVIFA (n = 20, i = 4%) Appendix D PVA = $55 × 13.590 = $747.45 Present value of principal payment at maturity PV = FV × PVIF (n = 20, i = 4%) Appendix B PV = $1,000 × .456 = $456 Total present value Present value of interest payments $747.45 Present value of payment at maturity 456.00 Total present value or price of the bond $1,203.45 No. The call price of $1,110 will keep the bonds from getting much over $1,110. Since the bonds are currently callable, investors will not want to buy the bonds at almost $1,300 and risk having them called away at $1,110. (a) N I/Y PV PMT FV 20 4 CPT PV –1,203.85 55 1,000 Answer: 1,203.85 8. Effect of bond rating change (LO16-2) The yield to maturity for 10-year bonds is as follows for four different bond rating categories: Aaa 9.40% Aa2 10.00% Aal 9.60% Aa3 10.60% The bonds of Falter Corporation were rated as Aaa and issued at par a few weeks ago. The bonds have just been downgraded to Aa2. Determine the new price of the bonds, assuming a 10-year maturity and semiannual interest payments. (Refer to “Semiannual Interest and Bond Prices” in Chapter 10 for a review if necessary.) 16-8. Solution: With a Aaa rating at issue, the coupon rate is 9.4 percent annually or 4.7 percent semiannually. With a downgrading to Aa2, the new yield to maturity is 10 percent or 5 percent semiannually. Present value of interest payments PVA = A × PVIFA (n = 20, i = 5%) Appendix D PVA = $47 × 12.462 = $585.71 Present value of principal payment at maturity PV = FV × PVIF (n = 20, i = 5%) Appendix B PV = $1,000 × .377 = $377 Total present value Present value of interest payments $585.71 Present value of payment at maturity 377.00 Total present value or price of the bond $962.71 N I/Y PV PMT FV 20 5 CPT PV –962.61 47 1,000 Answer: 962.61 9. Interest rates and bond ratings (LO16-2) Twenty-five-year B-rated bonds of Parker Optical Company were initially issued at a 12 percent yield. After 10 years, the bonds have been upgraded to Aa2. Such bonds are currently yielding 10 percent to maturity. Use Table 16-3 to determine the price of the bonds with 15 years remaining to maturity. (You do not need the bond ratings to enter the table. just use the basic facts of the problem.) 16-9. Solution: Parker Optical Company Using Table 16-3: 12 percent initial coupon rate, 10 percent yield to maturity, 15 years remaining to maturity: = $1,153.32 10. Interest rates and bond ratings (LO16-2) A previously issued A2, 15-year industrial bond provides a return three-fourths higher than the prime interest rate of 11 percent. Previously issued A2 public utility bonds provide a yield of three-fourths of a percentage point higher than previously issued A2 industrial bonds of equal quality. Finally, new issues of A2 public utility bonds pay three-fourths of a percentage point more than previously issued A2 public utility bonds. What should be the interest rate on a newly issued A2 public utility bond? 16-10. Solution: Interest rate on previously issued A2 15-year industrial bonds 11% × 1.75 = 19.250% Additional return on A2 15-year public utility bond + .750% Additional return on new issues + .750% Anticipated return on newly issued A2 public utility bonds 20.750% 11. Zero-coupon rate bond (LO16-2) A 17-year, $1,000 par value zero-coupon rate bond is to be issued to yield 7 percent. a. What should be the initial price of the bond? (Take the present value of $1,000 for 17 years at 7 percent, using Appendix B.) b. If immediately upon issue, interest rates dropped to 6 percent, what would be the value of the zero-coupon rate bond? c. If immediately upon issue, interest rates increased to 9 percent, what would be the value of the zero-coupon rate bond? 16-11. Solution: a. PV of $1,000 for n = 17, i = 7%, PVIF = .317 $1,000 × .317 $ 317 b. PV of $1,000 for n = 17, i = 6%, PVIF = .371 $1,000 × .371 $ 371 c. PV of $1,000 for n = 17, i = 9%, PVIF = .231 $1,000 × .231 $ 231 (a) N I/Y PV PMT FV 17 7 CPT PV –316.57 0 1,000 Answer: $317 (b) N I/Y PV PMT FV 17 6 CPT PV –371.36 0 1,000 Answer: $371 (c) N I/Y PV PMT FV 17 9 CPT PV –231.07 0 1,000 Answer: $231 12. Zero-coupon bond Yield (LO16-2) Assume a zero-coupon bond that sells for $403 and will mature in 10 years at $1,250. What is the effective yield to maturity? (Compute PVIF and go to Appendix B for the 10-year figure to find the answer, or compute FVIF and go to Appendix A for the 10-year figure to find the answer. Either approach will work.) 16-12. Solution: PVIF = PV/FV = $403/$1,250 = .322 Using Appendix B for n = 10, the yield is 12 percent or FVIF = FV/PV = $1,250/$403 = 3.102 Using Appendix A for n = 10, the yield is approximately 12 percent. N I/Y PV PMT FV 10 CPT I/Y 11.985 –403 0 1,250 Answer: 12 13. Floating rate bond (LO16-2) You buy an 8 percent, 25-year, $1,000-par-value floating rate bond in 1999. By the year 2004, rates on bonds of similar risk are up to 11 percent. What is your one best guess as to the value of the bond? 16-13. Solution: With a floating rate bond, the rate the bond pays changes with interest rates in the market. Therefore, the price of the bond stays constant. The one best guess is $1,000. 14 Effect of inflation on purchasing power of bond (LO16-2) Seventeen years ago, the Archer Corporation borrowed $6,500,000. Since then, cumulative inflation has been 65 percent (a compound rate of approximately 3 percent per year). a. When the firm repays the original $6,500,000 loan this year, what will be the effective purchasing power of the $6,500,000? (Hint: Divide the loan amount by one plus cumulative inflation.) b. To maintain the original $6,500,000 purchasing power, how much should the lender be repaid? (Hint: Multiply the loan amount by one plus cumulative inflation.) c. If the lender knows he will receive only $6,500,000 in payment after 17 years, how might he be compensated for the loss in purchasing power? A descriptive answer is acceptable. 16-14. Solution: Archer Corporation a. Loan amount/(1 + Cumulative inflation) = $6,500,000/1.65 = $3,939,394 b. $6,500,000 × 1.65 = $10,725,000 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. A $10,725,000 loan repayment in a 65 percent cumulative inflationary environment will provide $6,500,000 in purchasing power to the original lender. 15. Profit potential associated with margin (LO16-2) A $1,000 par value bond was issued 25 years ago at a 12 percent coupon rate. It currently has 15 years remaining to maturity. Interest rates on similar obligations are now 8 percent. a. What is the current price of the bond? (Look up the answer in Table 16-3.) b. Assume Ms. Bright bought the bond three years ago when it had a price of $1,050. What is her dollar profit based on the bond’s current price? c. Further assume Ms. Bright paid 30 percent of the purchase price in cash and borrowed the rest (known as buying on margin). She used the interest payments from the bond to cover the interest costs on the loan. How much of the purchase price of $1,050 did Ms. Bright pay in cash? d. What is Ms. Bright’s percentage return on her cash investment? Divide the answer to part b by the answer to part c. e. Explain why her return is so high. 16-15. Solution: Ms. Bright a. The original bond was issued at 12 percent. Yield to maturity is now 8 percent. 15 years remain to maturity. The bond price is $1,345.52. b. $1,345.52 Current price 1,050.00 Purchase price $ 295.52 Dollar increase c. Purchase price $1,050.00 × 30% Margin $ 315.00 Purchase price paid in cash d. 93.82 percent represents Ms. Bright’s return on her investment. Ms. Bright 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 $1,070 initial investment with only $315 in cash. The low cash investment tends to magnify gains (as well as losses). 16. Loss exposure and profit potential (LO16-2) A $1,000 par value bond was issued 20 years ago at a 9 percent coupon rate. It currently has five years remaining to maturity. Interest rates on similar debt obligations are now 10 percent. a. Compute the current price of the bond using an assumption of semiannual payments. b. If Mr. Robinson initially bought the bond at par value, what is his percentage loss (or gain)? c. Now assume Mrs. Pinson buys the bond at its current market value and holds it to maturity, what will her percentage return be? d. Although the same dollar amounts are involved in part b and c, explain why the percentage gain is larger than the percentage loss. 16-16. Solution: Mr. Robinson – Mrs. Pinson a. Present value of interest payments PVA = A × PVIFA (n = 10*, i = 5.00%) Appendix D PVA = 45 × 7.722 = $347.49 Present value of principal payment at maturity PV = FV × PVIF (n = 10*, i = 5.00%) PV = $1,000 × .614 = $614.00 Appendix B Total present value Present value of interest payments $347.49 Present value of payment at maturity 614.00 Total present value or price of the bond $961.49 b. Purchase price $1,000.00 Current value 961.49 Dollar loss $ 38.51 Dollar loss/Investment = $38.51/$1,000 = 3.85% c. Maturity value $1,000.00 Purchase price 961.49 Dollar gain $ 38.51 Dollar gain/Investment = $38.51/$961.49 = 4.01% d. The percentage gain is larger than the percentage loss because the investment is smaller ($961.49 versus $1,000). The gain/loss is the same ($38.51). Calculator Solution: (a) N I/Y PV PMT FV 10 5 CPT PV –961.39 45 1,000 Answer: 961.39 b. Purchase price $1,000.00 Current value 961.39 Dollar loss $ 38.61 Dollar loss/Investment = $38.61/$1,000 = 3.86% c. Maturity value $1,000.00 Purchase price 961.39 Dollar gain $ 38.61 Dollar gain/Investment = $38.61 / $961.39 = 4.02% The percentage gain is larger than the percentage loss because the investment is smaller ($961.39 versus $1,000). The gain/loss is the same ($38.61). 17. Advanced refunding decision (LO16-3) The Bowman Corporation has a $18 million bond obligation outstanding, which it is considering refunding. Though the bonds were initially issued at 10 percent, the interest rates on similar issues have declined to 8.5 percent. The bonds were originally issued for 20 years and have 10 years remaining. The new issue would be for 10 years. There is a 9 percent call premium on the old issue. The underwriting cost on the new $18,000,000 issue is $530,000, and the underwriting cost on the old issue was $380,000. The company is in a 35 percent tax bracket, and it will use an 8 percent discount rate (rounded after tax cost of debt) to analyze the refunding decision. a. Calculate the present value of total outflows. b. Calculate the present value of total inflows. c. Calculate the net present value. d. Should the old issue be refunded with new debt? 16-17. Solution: Bowman Corporation Outflows 1. Payment of call premium $18,000,000 × 9% = $1,620,000 $1,620,000 (1 – .35) = $1,053,000 2. Underwriting cost on new issue Amortization of costs ($530,000/10) (.35) $53,000 × (.35) = $18,550 tax savings per year Actual expenditure $530,000 PV of future tax savings $18,550 × 6.710* 124,471 Net cost of underwriting expense on new issue $405,529 *PVIFA for n = 10, i = 8% (Appendix D) Outflows 1. $1,053,000 2. 405,529 $1,458,529 Inflows 3. Cost savings in lower interest rates 10% (interest on old bond) × $18,000,000 = $ 1,800,000/year 8.5% (interest on new bond) × $18,000,000 = 1,530,000/year Savings per year before taxes = $ 270,000 After tax Savings $270,000 × (1 – .35) = $ 175,500 per yr. 16-17. (Continued) $ 175,500 × 6.710 PVIFA (n = 10, i = 8%) Appendix D $1,177,605 4. Underwriting cost on old issue Original amount $380,000 Amount written off over 10 years at $19,000 per year 190,000 Unamortized old underwriting cost $190,000 Present value of deferred future write-off $19,000 × 6.710 (n = 10, i = 8%) 127,490 Immediate gain in old underwriting cost write-off $62,510 Tax rate × .35 After tax value of immediate gain in old Underwriting cost write-off $ 21,879 Inflows 3. $1,177,605 4. 21,879 $1,199,484 Summary Outflows Inflows 1. $1,053,000 3. $1,177,605 2. 405,529 4. 21,879 $1,458,529 $1,199,484 PV of inflows $1,199,484 PV of outflows 1,458,529 Net present value $ –259,045 Do not refund the old issue (particularly if it is perceived that interest rates will go down even more). Calculator solution: Summary Outflows Inflows 1. $1,053,000 3. $1,174,264** 2. 405,528* 4. 21,878*** $1,458,528 $1,196,142 PV of inflows $1,196,142 PV of outflows 1,458,528 Net present value $ –262,386 Do not refund the old issue (particularly if it is perceived that interest rates will go down even more). *Present value of future tax savings N I/Y PV PMT FV 10 8 CPT PV –124,472.01 18,550 0 PV of future tax savings $124,472 Actual expenditure $530,000 PV of future tax savings 124,472 Net cost of underwriting expense on new issue $405,528 **Present value of future tax savings N I/Y PV PMT FV 10 8 CPT PV –1,177,619.285 175,500 0 PV of future tax savings $1,177,619 ***Present value of deferred future write-off N I/Y PV PMT FV 10 8 CPT PV –127,491.55 19,000 0 PV of deferred future write-off $127,492 Unamortized old underwriting cost $190,000 Present value of deferred future write-off 127,492 Immediate gain in old underwriting cost write-off $62,508 Tax rate × .35 After tax value of immediate gain in old Underwriting cost write-off $ 21,878 18. Refunding decision (LO16-3) The Robinson Corporation has $43 million of bonds outstanding that were issued at a coupon rate of 11¾ percent seven years ago. Interest rates have fallen to 10¾ percent. Mr. Brooks, the vice-president of finance, does not expect rates to fall any further. The bonds have 17 years left to maturity, and Mr. Brooks would like to refund the bonds with a new issue of equal amount also having 17 years to maturity. The Robinson Corporation has a tax rate of 30 percent. The underwriting cost on the old issue was 2.4 percent of the total bond value. The underwriting cost on the new issue will be 1.7 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a 9 percent call premium starting in the sixth year and scheduled to decline by one-half percent each year thereafter. (Consider the bond to be seven years old for purposes of computing the premium.) Assume the discount rate is equal to the after tax cost of new debt rounded up to the nearest whole number. a. Compute the discount rate. b. Calculate the present value of total outflows. c. Calculate the present value of total inflows. d. Calculate the net present value. 16-18. Solution: Robinson Corporation First compute the discount rate 10.75% (1 – .30) = 10.75% (.70) = 7.53%. Round to 8%. Outflows 1. Payment on call provision (7th year = 8.5% call premium) $43,000,000 × 8.5% = $3,655,000 $3,655,000 (1 – .30) = $2,558,500 after tax cost 2. Underwriting cost on new issue Actual expenditure 1.7% × $43,000,000 = $731,000 Amortization of costs ($731,000/17) = $ 43,000 Tax savings per year = $43,000 (.30) = $ 12,900 Actual expenditure $731,000 PV of future tax savings $ 12,900 × 9.122* 117,674 Net cost of underwriting expense on new issue $613,326 *PVIFA for n = 17, i = 8% (Appendix D) Outflows 1. $2,558,500 2. 613,326 $3,171,826 16-18. (Continued) Inflows 3. Cost savings in lower interest rates 11 3/4% (interest on old bond) × $43,000,000 = $5,052,500 10 3/4% (interest on new bond) × 43,000,000 = 4,622,500 Savings per year $ 430,000 Savings per year $430,000 × (1 – 0.3) = $301,000 After tax $ 301,000 × 9.122 PVIFA (n = 17, i = 8%) Appendix D $2,745,722 Present value of savings 4. Underwriting cost on old issue Original amount (2.40% × $43,000,000) $1,032,000 Amount written off over last 7 years at $43,000 per year ($1,032,000/24) × 7 301,000 Unamortized old underwriting cost $ 731,000 Present value of deferred future write-off: $43,000 × 9.122 392,246 Immediate gain in old underwriting write-off $ 338,754 Tax rate × .30 After tax value of immediate gain in old underwriting cost write-off $ 101,626 16-18. (Continued) Inflows 3. $2,745,722 4. 101,626 $2,847,348 Summary Outflows Inflows 1. $2,558,500 3. $2,745,722 2. 613,326 4. 101,626 $3,171,826 $2,847,348 PV of inflows $2,847,348 PV of outflows 3,171,826 Net present value $ –324,478 Based on the negative net present value, the Robinson Corporation should not refund the issue. As time passes, the call premium will decline and if interest rates stay down or decline further, the refunding decision could have a positive net present value in the future. Calculator Solution: Summary Outflows Inflows 1. $2,558,500 3. $2,745,613** 2. 613,331* 4. 101,631*** $3,171,831 $2,847,244 PV of Inflows $2,847,244 PV of outflows 3,171,831 Net present value $ -324,587 *Present value of future tax savings N I/Y PV PMT FV 17 8 CPT PV –117,669.13 12,900 0 PV of future tax savings $117,669 Actual expenditure $731,000 PV of future tax savings 117,669 Net cost of underwriting expense on new issue $613,331 **Present value of savings N I/Y PV PMT FV 17 8 CPT PV –2,745,613.07 301,000 0 PV of future tax savings $2,745,613 ***Present value of deferred future write-off: N I/Y PV PMT FV 17 8 CPT PV –392,230.44 43,000 0 PV of deferred future write-off $392,230 Unamortized old underwriting cost $731,000 PV of deferred future write-off 392,230 Immediate gain in old underwriting write-off 338,770 Tax rate × .30 After tax value of immediate gain in old Underwriting cost write-off $101,631 19. Call premium (LO16-3) The Sunbelt Corporation has $40 million of bonds outstanding that were issued at a coupon rate of 12⅞ percent seven years ago. Interest rates have fallen to 12 percent. Mr. Heath, the vice-president of finance, does not expect rates to fall any further. The bonds have 18 years left to maturity, and Mr. Heath would like to refund the bonds with a new issue of equal amount also having 18 years to maturity. The Sunbelt Corporation has a tax rate of 36 percent. The underwriting cost on the old issue was 2.5 percent of the total bond value. The underwriting cost on the new issue will be 1.8 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with an 8 percent call premium starting in the sixth year and scheduled to decline by one-half percent each year thereafter (consider the bond to be seven years old for purposes of computing the premium). Assume the discount rate is equal to the after tax cost of new debt rounded up to the nearest whole number. Should the Sunbelt Corporation refund the old issue? 16-19. Solution: The Sunbelt Corporation First compute the discount rate 12% (1 – .36) = 12% × .64 = 7.68%. Round up to 8 percent. Outflows 1. Payment on call provision $40,000,000 × 7.5% = $3,000,000 $3,000,000 (1 – .36) = $1,920,000 2. Underwriting cost on new issue Actual expenditure 1.8% × $40,000,000 = $720,000 Amortization of costs ($720,000/18) (.36) = Tax savings per year = $40,000 (.36) = $ 14,400 Actual expenditure $720,000 PV of future tax savings $ 14,400 × 9.372* 134,957 Net cost of underwriting expense on new issue $585,043 for n = 18, i = 8% (Appendix D) 16-19. (Continued) Inflows 3. Cost savings in lower interest rates 12 7/8% (interest on old bond) × $40,000,000 = $5,150,000 12% (interest on new bond) × $40,000,000 = 4,800,000 Savings per year $ 350,000 Savings per year $350,000 × (1 – .36) = $224,000 After tax $ 224,000 × 9.372 PVIFA (n = 18, i = 8%) Appendix D $2,099,328 Present value of savings 4. Underwriting cost on old issue Original amount (2.5% × $40,000,000) $1,000,000 Amount written off over last 7 years at $40,000 per year ($1,000,000/25) × 7 280,000 Unamortized old underwriting cost $ 720,000 Present value of deferred future write-off: $40,000 × 9.372 (n = 18, i = 8%) 374,880 Immediate gain in old underwriting write-off $ 345,120 Tax rate × .36 After tax value of immediate gain in old underwriting cost write-off $ 124,243 Summary Outflows Inflows 1. $1,920,000 3. $2,099,328 2. 585,043 4. 124,243 $2,505,043 $2,223,571 PV of inflows $2,223,571 PV of outflows 2,505,043 Net present value $ (281,472) Based on the negative net present value, the Sunbelt Corporation should not refund the issue. Calculator solution: Summary Outflows Inflows 1. $1,920,000 3. $2,099,303** 2. 585,045* 4. 124,245*** $2,505,045 $2,223,548 PV of inflows $2,223,548 PV of outflows 2,505,045 Net present value $ (281,497) Based on the negative net present value, the Sunbelt Corporation should not refund the issue. *Present value of future tax savings N I/Y PV PMT FV 18 8 CPT PV –134,955.17 14,400 0 PV of future tax savings $134,955 Actual expenditure $720,000 PV of future tax savings 134,955 Net cost of underwriting expense on new issue $585,045 **Present value of savings N I/Y PV PMT FV 18 8 CPT PV –2,099,302.72 224,000 0 PV of future tax savings $2,099,303 ***Present value of deferred future write-off: N I/Y PV PMT FV 18 8 CPT PV –374,875.49 40,000 0 PV of deferred future write-off $374,875 Unamortized old underwriting cost $720,000 PV of deferred future write-off 374,875 Immediate gain in old underwriting write-off 345,125 Tax rate × .36 After tax value of immediate gain in old Underwriting cost write-off $124,245 20. Capital lease or operating lease (LO16-4) The Deluxe Corporation has just signed a 168-month lease on an asset with a 19-year life. The minimum lease payments are $1,300 per month ($15,600 per year) and are to be discounted back to the present at a 9 percent annual discount rate. The estimated fair value of the property is $165,000. a. Calculate the lease period as a percentage to the estimated life of the leased property. b. Calculate the present value of lease payments as a percentage to the fair value of the property. c. Should the lease be recorded as a capital lease or an operating lease. (Use criteria 3 and 4 for a capital lease.) 16-20. Solution: The Deluxe Corporation The lease is less than 75 percent of the estimated life of the leased property. 168 months = 14 years 14/19 = 74% The present value of the lease payments is less than 90 percent of the fair value of the property. $ 15,600 Annual lease payments 7.786 PVIFA (n = 14, i = 9%) Appendix D $121,462 Present value of lease payments $121,462 = 73.6% $165,000 Since none of the four criteria for compulsory treatment as an capital lease is indicated, the transaction must be treated as an operating lease. Calculator solution: Present value of lease payments N I/Y PV PMT FV 14 9 CPT PV – 121,463.95 15,600 0 PV of lease payments $121,464 $121,464 = 73.6% $165,000 21. Balance sheet effect of leases (LO16-4) The Ellis Corporation has heavy lease commitments. Prior to SFAS No. 13, it merely footnoted lease obligations in the balance sheet, which appeared as follows: In $ millions In $ millions Current asserts $ 70 Current liabilities $ 30 Fixed asserts 70 Long-term liabilities 30 Total liabilities $ 60 Stockholders’ equity 80 Total assets $140 Total liabilities and stockholders’ equity $140 The footnotes stated that the company had $14 million in annual capital lease obligations for the next 20 years. a. Discount these annual lease obligations back to the present at a 10 percent discount rate (round to the nearest million dollars). b. Construct a revised balance sheet that includes lease obligations, as in Table 16-8. c. Compute total debt to total assets on the original and revised balance sheets. d. Compute total debt to equity on the original and revised balance sheets. e. In an efficient capital market environment, should the consequences of SFAS No. 13, as viewed in the answers to parts c and d, change stock prices and credit ratings? f. Comment on management’s perception of market efficiency (the viewpoint of the financial officer). 16-21. Solution: The Ellis Corporation a. $14 million annual lease payments 8.514 (PVIFA for n = 20, i = 10%) $119.196 million (round to $119 million) 16-21. (Continued) b. Current assets $70 million Current liabilities $ 30 million Fixed assets 70 million Long-term liabilities 30 million Leased property under capital lease 119 million Total assets $259 million Obligations under capital lease 119 million Total liabilities 179 million Stockholders’ equity 80 million Total liabilities and Stockholders’ equity $259 million c. Original Revised d. Original Revised 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. Calculator solution: *Present value of annual lease payments N I/Y PV PMT FV 20 10 CPT PV – 119,189,892 14,000,000 0 PV of future tax savings $119.190 million rounds to $119 million 22. Determining size of lease payment (LO16-4) The Hardaway Corporation plans to lease a $740,000 asset to the O’Neil Corporation. The lease will be for 11 years. a. If the Hardaway Corporation desires a 13 percent return on its investment, how much should the lease payments be? b. If the Hardaway Corporation is able to take a 10 percent deduction from the purchase price of $740,000 and will pass the benefits along to the O’Neil Corporation in the form of lower lease payments (related to the Hardaway Corporation in the form of lower initial net cost), how much should the revised lease payments be? The Hardaway Corporation desires a 13 percent return on the 11-year lease. 16-22. Solution: Hardaway Corporation Determine 11-year annuity that will yield 13 percent. Original amount $740,000 –10% 74,000 Net cost $666,000 Calculator solution: a. N I/Y PV PMT FV 11 13 740,000 CPT PMT – 130,122.68 0 Lease payment is equal to $130,123. b. N I/Y PV PMT FV 11 13 666,000 CPT PMT – 117,110.41 0 Lease payment is equal to $117,110. COMPREHENSIVE PROBLEM Comprehensive Problem 1. Broadband Inc. Bond prices refunding (LO16-2 and 3) Barton Simpson, the chief financial officer of Broadband Inc. could hardly believe the change in interest rates that had taken place over the last few months. The interest rate on A2 rated bonds was now 6 percent. The $30 million, 15-year bond issue that his firm has outstanding was initially issued at 9 percent five years ago. Because interest rates had gone down so much, he was considering refunding the bond issue. The old issue had a call premium of 8 percent. The underwriting cost on the old issue had been 3 percent of par and on the new issue, it would be 5 percent of par. The tax rate would be 30 percent and a 4 percent discount rate will be applied for the refunding decision. The new bond would have a 10-year life. Before Barton used the 8 percent call provision to reacquire the old bonds, he wanted to make sure he could not buy them back cheaper in the open market. a. First compute the price of the old bonds in the open market. Use the valuation procedures for a bond that were discussed in Chapter 10 (use the annual analysis). Determine the price of a single $1,000 par value bond. b. Compare the price in part a to the 8 percent call premium over par value. Which appears to be more attractive in terms of reacquiring the old bonds? c. Now do the standard bond refunding analysis as discussed in this chapter. Is the refunding financially feasible? d In terms of the refunding decision, how should Barton be influenced if he thinks interest rates might go down even more? CP 16-1. Solution: a. Broadband Inc. Price of Old Bond Present Value of Interest Payments Appendix D PVA = A ×PVIFA (n = 10, i = 6%) PVA = $90 × 7.360 = $662.40 Present Value of Principal Payment at Maturity PV = FV x PVIF (n = 10, i = 6%) Appendix D PV = $1,000 × .558 = $558 Total present value Present Value of Interest Payments $ 662.40 Present Value of Principal Payment 558.00 $1,220.40 CP16-1. (Continued) b. The price of $1,220.40 is more than 20 percent over par. The call price ($1080) is only 8 percent over par. Clearly, calling in the bonds is more attractive than repurchasing them in the open market. c. Refunding Decision Outflows 1. Payment of call premium $30,000,000 × 8% = $2,400,000 $2,400,000 × (1 – .30) = $1,680,000 2. Underwriting cost on new issue Actual expenditure $30,000,000 × 5% = $1,500,000 Amortization of cost = ($1,500,000/10) = $ 150,000 Tax savings per year 150,000 × .30 = $ 45,000 PV of future tax savings $45,000 × 8.811* = $ 364,995 *PVIFA for n = 10, i = 5% (Appendix D) Actual expenditure $1,500,000 PV of future tax savings 364,995 New cost of underwriting expense on new issue $1,135,005 CP16-1. (Continued) 3. Cost savings in lower interest rates 9% (interest on old bonds) × $30,000,000 = $2,700,000 6% (interest on new bonds) × $30,000,000 1,800,000 Savings per year $ 900,000 Savings per year $900,000 × (1 – 30) = $630,000 after tax $ 630,000 8.111 PVIFA (n = 10, i = 4%) (Appendix D) $5,109,930 4. Underwriting cost on old issue Original amount (3% × $30,000,000) $900,000 Amount written off over last 5 years at $60,000 per year ($900,000/15) 300,000 Unamortized old underwriting cost $600,000 Present value of deferred future write-off $60,000 × 8.111 (n = 10, i = 4%) 486,660 Immediate gain in old underwriting write- off tax rate $113,340 Tax rate .30 After tax value of immediate gain in old underwriting cost write-off $ 34,002 CP16-1. (Continued) Summary Outflows Inflows 1. $1,680,000 3. $5,109,930 2. 1,135,005 4. 34,002 $2,815,005 $5,143,932 PV of inflows $5,143,932 PV of outflows 2,815,005 Net present value $2,328,927 The refunding is financially feasible. If Barton thinks interest rates are going down even more, he might want to wait on the refunding because the net present value would be even higher. Of course, if he is wrong and interest rates go up, he might miss out on a highly profitable opportunity. Appendix 16A–1. Settlement of claims in bankruptcy liquidation (LO16-5) The trustee in the bankruptcy settlement for Titanic Boat Co. lists the following book values and liquidation values for the assets of the corporation. Liabilities and stockholders’ claims are shown. Liquidation Assets Book Value Value Accounts receivable $1,400,000 $1,200,000 Inventory 1,800,000 900,000 Machinery and equipment 1,100,000 600,000 Building and plant 4,200,000 2,500,000 Total assets $8,500,000 $ 5,200,000 Liabilities and Stockholders’ Claims Liabilities: Accounts payable $2,800,000 First lien, secured by machinery and equipment 900,000 Senior unsecured debt 2,200,000 Subordinated debenture 1,700,000 Total liabilities 7,600,000 Stockholders’ claims: Preferred stock 250,000 Common stock 650,000 Total stockholders’ claims 900,000 Total liabilities and stockholders’ claims $8,500,000 a. Compute the difference between the liquidation value of the assets and the liabilities. b. Based on the answer to part a, will preferred stock or common stock participate in the distribution? c. Assuming the administrative costs of bankruptcy, workers’ allowable wages, and unpaid taxes add up to $400,000, what is the total remaining asset value available to cover secured and unsecured claims? d. After the machinery and equipment are sold to partially cover the first lien secured claim, how much will be available from the remaining asset liquidation values to cover unsatisfied secured claims and unsecured debt? e. List the remaining asset claims of unsatisfied secured debt holders and unsecured debt holders in a manner similar to that shown in the bottom portion of Table 16A-3. f. Compute a ratio of your answers in part d and e. This will indicate the initial allocation ratio. g. List the remaining claims (unsatisfied secured and unsecured) and make an initial allocation and final allocation similar to that shown in Table 16A-4. Subordinated debenture holders may keep the balance after full payment is made to senior debt holders. h. Show the relationship of amount received to total amount of claim in a similar fashion to that in Table 16A-5. Remember to use the sales (liquidation) value for machinery and equipment plus the allocation amount in part g to arrive at the total received on secured debt. 16A-1. Solution: Titanic Boat Co. a. Liquidation value of assets $5,200,000 Liabilities 7,600,000 Difference ($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 $5,200,000 Administrative costs, wages and taxes – 400,000 Remaining asset values $4,800,000 d. Remaining asset value $4,800,000 Payment to secured creditors – 600,000 Amount available to unsatisfied secured claims and unsecured debt $4,200,000 e. Remaining claims of unsatisfied secured debt and unsecured debt holder Secured debt (unsatisfied first lien) $ 300,000 Accounts payable 2,800,000 Senior unsecured debt 2,200,000 Subordinated debentures 1,700,000 $7,000,000 f. Amount available to unsatisfied CP16A-1. (Continued) g. Allocation procedures for unsatisfied secured claims and unsecured debt. (1) Category (2) Amount of Claim (3) Initial Allocation (60%) (4) Amount Received Secured ebt (unsatisfied first lien) $ 300,000 $ 180,000 $ 180,000 Accounts Payable 2,800,000 1,680,000 1,680,000 Senior unsecured debt 2,200,000 1,320,000 2,200,000 Subordinated debentures* 1,700,000 1,020,000 140,000* $ 7,000,000 $4,200,000 $4,200,000 * The subordinated debenture holders must transfer $880,000 of their initial allocation to the senior unsecured debt holders to fully provide for their payment ($1,320,000 + $880,000 = $2,200,000). This will leave $140,000 for subordinated debentures ($1,020,000 – $880,000). CP16A-1. (Continued) h. Payments and percent of claims Category Total Amount of Claim Amount Received Percent of Claim Satisfied Secured debt (first lien) $ 900,000 $ 780,000 86.7% Accounts payable 2,800,000 1,680,000 60.0% Senior unsecured debt 2,200,000 2,200,000 100.0% Subordinated debentures 1,700,000 140,000 8.2% 16B-1. Lease versus purchase decision (LO16-4) Howell Auto Parts is considering whether to borrow funds and purchase an asset or to lease the asset under an operating lease arrangement. If the company purchases the asset, the cost will be $10,000. It can borrow funds for four years at 12 percent interest. The firm will use the three-year MACRS depreciation category (with the associated four-year write-off). Assume a tax rate of 35 percent. The other alternative is to sign two operating leases, one with payments of $2,600 for the first two years, and the other with payments of $4,600 for the last two years. In your analysis, round all values to the nearest dollar. a. Compute the after tax cost of the leases for the four years. b. Compute the annual payment for the loan (round to the nearest dollar). c. Compute the amortization schedule for the loan. (Disregard a small difference from a zero balance at the end of the loan due to rounding.) d. Determine the depreciation schedule (see Table 12-9). e. Compute the after tax cost of the borrow-purchase alternative. f. Compute the present value of the after tax cost of the two alternatives. Use a discount rate of 8 percent. g. Which alternative should be selected, based on minimizing the present value of after tax costs? 16B-1. Solution: Howell Auto Parts a. (1) (2) (3) (4) Year Payment Tax Shield 35% of (1) After tax Cost 1 $2,600 $ 910 $1,690 2 $2,600 910 1,690 3 $4,600 1,610 2,990 4 $4,600 1,610 2,990 b. CP16B-1. (Continued) c. (1) (2) (3) (4) (5) (6) Year Beginning Balance Annual Payment Annual Interest 12% of (2) Repayment on Principal (3) – (4) Ending Balance (2) – (5) 1 $10,000 $3,293 $1,200 $2,093 $7,907 2 7,907 3,293 949 2,344 5,563 3 5,563 3,293 668 2,625 2,938 4 2,938 3,293 353 2,940 (2) d. Depreciation Depreciation Year Base Percentage Depreciation 1 $10,000 .333 $ 3,330 2 10,000 .445 4,450 3 10,000 .148 1,480 4 10,000 .074 740 $10,000 e. (1) (2) (3) (4) (5) (6) Year Payment Interest Depreciation Total Tax Deductions Tax Shield 35% × (4) Net After tax Cost (1) – (5) 1 $3,293 $1,200 $3,330 $4,530 $1,586 $1,707 2 3,293 949 4,450 5,399 1,890 1,403 3 3,293 668 1,480 2,148 752 2,541 4 3,293 353 740 1,093 383 2,910 CP16B-1. (Continued) f. Year After tax Cost of Leasing PV Factor at 8% Present Value After tax Cost of Borrow-Purchase PV Factor at 8% Present Value 1 $1,690 .926 $1,565 $1,707 .926 $1,581 2 1,690 .857 1,448 1,403 .857 1,202 3 2,990 .794 2,374 2,541 .794 2,018 4 2,990 .735 2,198 2,910 .735 2,139 $7,585 $6,940 g. The borrow and purchase decision has a lower present value and would be selected based on that criterion. Other factors may also be considered. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160
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