Finance Chapter 16

Chapter 16

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 early 2000’s, the ratio had been cut in 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.

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16-5. Take the following list of securities and arrange them in order of their priority of claims:

Preferred stock Senior debentureSubordinated debenture Senior secured debtCommon 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 extent 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 five or ten years.

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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, 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% less return to go into very high-quality securities-whereas, in more normal times the spread may only be 1 ½%.

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.

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16-14. What cost of capital is generally used in evaluating a bond refunding decision? Why?

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.

16-15. Explain how the zero-coupon rate bond provides 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.

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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.

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Appendix16A-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.

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Chapter 16Problems(Assume the par value of the bonds in the following problems is $1,000 unless otherwise specified.)

1. 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 approximate 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

c. Approximate yield to maturity = (Y')

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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 approximate yield to maturity on Bond X is 11.17 percent. What is the approximate yield to maturity on Bond Z?

d. Has your answer changed between parts b and c of this question?

16-2. 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.

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16-2. (Continued)

c. Approximate yield to maturity = (Y')

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.

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3. An investor must choose between two bonds:Bond A pays $90 annual interest and has a market value of $850. It has 10 years to

maturity.Bond B pays $80 annual interest and has a market value of $900. 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 approximate yield to maturity on Bond A is 11.54 percent. What is the approximate 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?

16-3. Solution:

a. Bond A$90 interest/$850 market price = 10.59% current yield

Bond B$80 interest/$900 market price = 8.89% current yield

b. Bond A. It has a higher current yield.

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16-3. (Continued)

c. Approximate yield to maturity = (Y') Bond B

d. Yes. Bond B now has the higher yield to maturity. This is because the $100 discount will be recovered over only two years. With Bond A there is a $150 discount, but a 10-year recovery period.

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4. 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%

16-4. 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.

5. The Southeast Investment Fund buys 70 bonds of the Hillary Bakery Corporation through its broker. The bonds pay 9 percent annual interest. The yield to maturity (market rate of interest) is 12 percent. The bonds have a 25-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 70 bonds.

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16-5. Solution:

The Southeast Investment Fund

a. Present value of interest payments

PVA = A × PVIFA (n = 50, i = 6%) Appendix DPVA = $45 × 15.762 = $709.29

Present value of principal payment at maturity

PV = FV × PVIF (n = 50, i = 6%) Appendix BPV = $1,000 × .054 = $54.00

Total present value

Present value of interest payments $709.29Present value of payment at maturity 54.00Total present value or price of the bond $763.29

b. Value of 70 bonds

$ 763.29 × 70 $53,430.30

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6. Sanders & Co. pays a 12 percent coupon rate on debentures that are due in 20 years. The current yield to maturity on bonds of similar risk is 10 percent. The bonds are currently callable at $1,060. The theoretical value of the bonds will be equal to the present value of the expected cash flow from the bonds. This is the normal definition we use.a. Find the theoretical 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?

16-6. Solution:

Sanders & Co.


PVA = A × PVIFA (n = 40, i = 5%) Appendix DPVA = $60 × 17.159 = $1,029.54



Total present value

Present value of interest payments $1,029.54Present value of payment at maturity 142.00Total present value or price of the bond $1,171.54

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 almost $1,171 and risk having them called away at $1,060.

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7. The yield to maturity for 25-year bonds is as follows for four different bond rating categories:

Aaa 9.4% Aa2 10.0%

Aal 9.6% Aa3 10.2%

The bonds of Evans Corporation were rated as Aal 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 25-year maturity and semiannual interest payments. As a first step, use the data above as a guide to appropriate interest rates for bonds with different ratings.

16-7. Solution:

Evans Corporation

With a Aal rating at issue, the coupon rate is 9.6% annually or 4.8% semiannually. With a downgrading to Aa2, the new yield to maturity is 10% or 5% semiannually.

Present value of interest payments

PVA = A × PVIFA (n = 50, i = 5%) Appendix DPVA = $48 × 18.256 = $876.29


PV = PV × PVIF (n = 50, i = 5%) Appendix BPV = $1,000 × .087 = $87.00

Total present value of the bondPresent value of interest payments $876.29Present value of payment at maturity 87.00

$963.29

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8. 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.)

16-8. Solution:

Parker Optical Company

Using Table 16-3:12% initial coupon rate, 10% yield to maturity, 15 years remaining to maturity: = $1,153.32

9. A previously issued Aal, 20-year industrial bond provides a return one-fourth higher than the prime interest rate assumed to be at 8 percent. Previously issued public utility bonds provide a yield of three-fourths of a percentage point higher than previously issued industrial bonds of equal quality. Finally, new issues of Aal public utility bonds pay one-fourth of a percentage point more than previously issued public utility bonds. What should the interest rate be on the newly issued Aa1 public utility bond?

16-9. Solution:

Interest rate on previously issued

Aal 20-year industrial bonds 8% × 1.25 = 10.00%Additional return on Aal 20-year

public utility bond + .75%Additional return on new issues + .25%Anticipated return on newly issued

Aal public utility bonds 11.00%

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10. A 15-year, $1,000 par value zero-coupon rate bond is to be issued to yield 10 percent.a. What should be the initial price of the bond? (Take the present value of $1,000 to be

received after 15 years at 10 percent, using Appendix B at the back of the text.)b. If immediately upon issue, interest rates dropped to 8 percent, what would be the

value of the zero-coupon rate bond?c. If immediately upon issue, interest rates increased to 12 percent, what would be the

value of the zero-coupon rate bond?

16-10. Solution:

a. PV of $1,000 for n = 15, i = 10%, PVIF = .239$1,000× .239$ 239

b. PV of $1,000 for n = 15, i = 8%, PVIF = .315$1,000× .315$ 315

c. PV of $1,000 for n = 15, i = 14%, PVIF = .183$1,000× .183$ 183

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11. What is the effective yield to maturity on a zero-coupon bond that sells for $131 and will mature in 30 years at $1,000? (Compute PVIF and go to Appendix B for the 30-year figure to find the answer or compute FVIF and go to Appendix A for the 30-year figure to find the answer. Either approach will work.)

16-11. Solution:

Using Appendix B for n = 30, the yield is 7 percent

or

Using Appendix A for n = 30, the yield is approximately 7 percent.

12. 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?

16-12. 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.

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13. Fourteen years ago, the U.S. Aluminum Corporation borrowed $9.9 million. Since then, cumulative inflation has been 98 percent (a compound rate of approximately 5 percent per year).a. When the firm repays the original $9.9 million loan this year, what will be the

effective purchasing power of the $9.9 million? (Hint: Divide the loan amount by one plus cumulative inflation.)

b. To maintain the original $9.9 million 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 $9.9 million in payment after 14 years, how might he be compensated for the loss in purchasing power? A descriptive answer is acceptable.

16-13. Solution:

U.S. Aluminum Corporation

a.

b. $9,900,000 × 1.98 = $19,602,000

A $19,602,000 loan repayment in a 98% cumulative inflationary environment will provide $9,000,000 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.

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14. 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 on page ___.)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.

16-14. Solution:

Ms. Bright

a. The original bond was issued at 12%Yield to maturity is now 8%15 years remain to maturityThe bond price is $1,345.52

b. $1,345.52 Current price 1,050.00 Purchase price$ 295.52 Dollar profit

c. Purchase Price $1,050.00× 30% Margin $ 315.00 Purchase price paid in cash

d.

93.82% represents Ms. Bright’s return on her investment.

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16-14. (Continued)

e. 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).

15. A $1,000 par value bond was issued 25 years ago at a 8 percent coupon rate. It currently has 15 years remaining to maturity. Interest rates on similar debt obligations are now 14 percent.a. Compute the current price of the bond using an assumption of semiannual payments.b. If Mr. Mitchell initially bought the bond at par value, what is his percentage loss

(or gain)?c. Now assume Mrs. Gordon 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.

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16-15. Solution:

Mr. Mitchell – Mrs. Gordon


PVA = A × PVIFA (n = 30, i = 7%) Appendix DPVA = 40 × 12.409 = $496.36



Total present valuePresent value of interest payments $496.36Present value of payment at maturity 131.00Total present value or price of the bond $627.36

b. Purchase price $1,000.00Current value 627.36Dollar loss $ 372.64

c. Maturity value $1,000.00Purchase price 627.36Dollar gain $ 372.64

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d. The percentage gain is larger than the percentage loss because the investment is smaller ($627.36 vs. $1,000). The gain/loss is the same ($372.64).

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16. The Delta Corporation has a $20 million bond obligation outstanding, which it is considering refunding. Though the bonds were initially issued at 13 percent, the interest rates on similar issues have declined to 11.5 percent. The bonds were originally issued for 20 years and have 16 years remaining. The new issue would be for 16 years. There is a 9 percent call premium on the old issue. The underwriting cost on the new $20 million issue is $560,000, and the underwriting cost on the old issue was $400,000. The company is in a 40 percent tax bracket, and it will use a 7 percent discount rate (rounded after-tax cost of debt) to analyze the refunding decision. Should the old issue be refunded with new debt?

16-16. Solution:

The Delta Corporation

Outflows1. Payment of call premium

$20,000,000 × 9% = $1,800,000$1,800,000 (1 – .4) = $1,080,000 Aftertax cost of call

2. Underwriting cost on new issueAmortization of costs ($560,000/16) (.4)$35,000 (.4) = $14,000 tax savings per year

Actual expenditure $560,000PV of future tax savings $14,000 × 9.447* 132,258Net cost of underwriting expense on new issue $427,742

for n = 16, i = 7% (Appendix D)

Inflows3. Cost savings in lower interest rates

13% (interest on old bond) × $20,000,000 = $2,600,000/year11.5% (interest on new bond) × $20,000,000 = $2,300,000/yearSavings per year $ 300,000Savings per year $300,000 × (1 – .4) = $ 180,000 aftertax

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16-16. (Continued)

$ 180,000× 9. 447 PVIFA (n = 16, i = 7%) Appendix D$1,700,460

4. Underwriting cost on old issueOriginal amount $400,000Amount written off over 4 years

at $20,000 per year 80,000Unamortized old underwriting cost $320,000Present value of deferred future write-off

$20,000 × 9.447 (n = 16, i = 7%) 188,940Immediate gain in old underwriting

cost write-off $131,060Tax rate × 40Aftertax value of immediate gain in old

underwriting cost write-off $ 52,424

Summary

Outflows Inflows1. $1,080,000 3. $1,700,4602. 427,742 4. 52,424

$1,507,742 $1,752,884

PV of inflows $1,752,884PV of outflows 1,507,742Net present value $ 245,142

Refund the old issue (particularly if it is perceived that interest rates will not go down even more).

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17. 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 aftertax cost of new debt rounded up to the nearest whole number. Should the Sunbelt Corporation refund the old issue?

16-17. Solution:

The Sunbelt Corporation

First compute the discount rate 12% (1 – .36) = 12% × .64 = 7.68%. Round up to 8%.

Outflows1. 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 issueActual expenditure 1.8% × $40,000,000 = $720,000Amortization of costs ($720,000/18) (.36) =Tax savings per year = $40,000 (.36) = $ 14,400

Actual expenditure $720,000PV of future tax savings $ 14,400 × 9.372* 134,957Net cost of underwriting expense on new issue $585,043

for n = 18, i = 8% (Appendix D)

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16-17. (Continued)

Inflows

3. Cost savings in lower interest rates12 7/8% (interest on old bond) × $40,000,000 = $5,150,00012% (interest on new bond) × $40,000,000 = 4,800,000Savings per year $ 350,000

Savings per year $350,000 × (1 – .36) = $224,000 Aftertax

$ 224,000× 9.372 PVIFA (n = 18, i = 8%) Appendix D$2,099,328 Present value of savings

4. Underwriting cost on old issueOriginal amount (2.5% × $40,000,000) $1,000,000Amount written off over last 7 years at

$40,000 per year ($1,000,000/25) × 7 280,000Unamortized 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 $ 345,120Tax rate × .36Aftertax value of immediate gain in old


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16-17. (Continued)

Summary


$2,505,043 $2,223,571

PV of inflows $2,223,571PV of outflows 2,505,043Net present value $ (281,472)

Based on the negative net present value, the Sunbelt Corporation should not refund the issue.

18. In problem 17, what would be the aftertax cost of the call premium at the end of year 11 (in dollar value)?

16-18. Solution:

The Sunbelt Corporation (Continued)

Call premium (aftertax cost)5 years of 1/2% deductions (7th through 11th year) = 2 1/2%

8% Call premiums–2 1/2% 5 1/2% Call premiums at the end of the 11th year

$40,000,000 × 5 1/2% = $2,200,000$ 2,200,000 (1 – .36) = $1,408,000 aftertax cost of call premium

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19. The Richmond Corporation has just signed a 144-month lease on an asset with an 18-year life. The minimum lease payments are $3,000 per month ($36,000 per year) and are to be discounted back to the present at an 8 percent annual discount rate. The estimated fair value of the property is $290,000. Should the lease be recorded as a capital lease or an operating lease?

16-19. Solution:

Richmond Corporation

Using criteria 3 and 4The lease is less than 75% of the estimated life of the leased property.

144 months = 12 years12/18 = 67%

However, the present value of the lease payments is greater than 90% of the fair value of the property.

$ 36,000 annual lease payments 7.536 (PVIFA (n = 12, i = 8%)$271,296 present value of lease payments

$271,296 = 93.6%$290,000

Since one of the four criteria for compulsory treatment as a capital lease is indicated, the transaction must be treated as a capital lease.

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20. The Bradley Corporation has heavy lease commitments. Prior to SFAS No. 13, it merely footnoted lease obligations in the balance sheet, which appeared as follows:

BRADLEY CORPORATION ($ millions)

Current assets.....................................$150 Current liabilities...............................$ 50Fixed assets........................................250 Long term liabilities...........................100

Total liabilities...............................150Stockholders’ equity..........................250

Total assets.........................................$400Total liabilities and

stockholders’ equity.......................$400

The footnotes stated that the company had $22 million in annual capital lease obligations for the next 20 years.

a. Discount these annual lease obligations back to the present at a 7 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).

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16-20. Solution:

The Bradley Corp.

a. $22 million annual lease payments 10.594 (PVIFA forn n = 20, i = 7%)$233.068 million (round to $233 million)

b. Current assets $150 million Current liabilities $ 50 millionFixed assets 250 million Long-term liabilities 100 millionLeased property under capital lease 233 million

Total assets $633 million

Obligations under capital lease 233 million

Total liabilities 383 millionStockholders' equity 250 millionTotal liabilities and Stockholders' equity $633 million

c. Original Revised

= 60.5%

d. Original Revised

=153.2%

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 academics generally believe. They feel that newly presented information may make their performance look questionable.

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21. The Lollar Corporation plans to lease an $800,000 asset to the Pierce Corporation. The lease will be for 12 years.a. If the Lollar Corporation desires a 10 percent return on its investment, how much

should the lease payments be?b. If the Lollar Corporation is able to generate $120,000 in immediate tax shield benefits

from the asset to be purchased for the lease arrangement and will pass the benefits along to the Pierce Corporation in the form of lower lease payments, how much should the revised lease payments be? Continue to assume the Lollar Corporation desires a 10 percent return on the 12-year lease.

16-21. Solution:

Lollar Corporation

a. Determine 12-year annuity that will yield 10%.

b. Original amount $800,000Tax Benefits 120,000Net cost $680,000

S16-32

COMPREHENSIVE PROBLEMComprehensive Problem 1.

Mike Garcia, the chief financial officer of Endicott Publishing Co., 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 8 percent. The $30 million, 15-year bond issue that his firm has outstanding was initially issued at 11 percent five years ago.

Because interest rates had gone down so dramatically, he was considering refunding the bond issue. The old issue had a call premium of 10 percent. The underwriting cost on the old issue had been 3 percent of par and on the new issue, it would be 4 percent of par. The tax rate would be 40 percent and a 5 percent discount rate will be applied for the refunding decision. The new bond would have a 10-year life.

Before Mike used the 10 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.

b. Compare the price in part a to the 10 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 Mike be influenced if he thinks interest rates might go down even more?

S16-33

CP 16-1. Solution:

a.

Endicott Publishing Co.

Price of Old Bond

Present Value of Interest Payments Appendix DPVA = A ×PVIFA (n = 10, i = 8%)PVA = $100 × 6.710 = $738.10

Present Value of Principal Payment at MaturityPV = FV x PVIF (n = 10, i = 6%) Appendix DPV = $1,000 x .558 = $558

Total present valuePresent Value of Interest Payments $738.10Present Value of Principal Payment 463.00

$1,201.10b. The price of $1,201.10 is more than 20 percent over par.

The Call price is only 10 percent over par. Clearly, calling in the bonds is more attractive than repurchasing them in the open market.

c. Refunding Decision

S16-34

CP 16-1. (Continued)Outflows

1. Payment of call premium$30,000,000 × 10% = $3,000,000$3,000,000 x (1 – .30) = $1,800,000

2. Underwriting cost on new issueActual expenditure $30,000,000 × 4% = $1,200,000Amortization of cost = ($1,200,000/10) = $120,000Tax savings per year 120,000 × .40 = $48,000PV of future tax savings $48,000 × 7.722* = $370,656*PVIFA for n = 10, i = 5% (Appendix D)

Actual expenditure $1,200,000PV of future tax savings 370,656New cost of underwriting expense

on new issue $ 829,344

3. Cost savings in lower interest rates11% (interest on old bonds) × $30,000,000 = $3,300,0008% (interest on new bonds) × $30,000,000 2,400,000Savings per year $900,000

Savings per year $900,000 × (1 – 40) = $540,000 after tax

$ 540,000 7,722 PVA (n = 10, i = 5%) (Appendix D)$4,169,880 Present value of interest savings

S16-35

CP 16-1. (Continued)

4. Underwriting cost on old issueOriginal amount (3% × $30,000,000) $900,000Amount written off over last 5 years at

$60,000 per year ($900,000/15) 300,000Unamortized old underwriting cost $600,000

Present value of deferred future write-off$60,000 × 8.111 (n = 10, i = 4%) 463,320

Immediate gain in old underwriting write-off tax rate $136,680

Tax rate .40After tax value of immediate gain in old


Summary


$2,629,344 $4,224,552

PV of inflows $4,224,552PV of outflows 2,629,344Net present value $1,595,208

The refunding is financially feasible.

d. If Mike thought interest rates were 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 were wrong and interest rates went up, he might miss out on a highly profitable opportunity.

S16-36

Appendix

16A–1. The trustee in the bankruptcy settlement for Immobile Corporation lists the book values and liquidation values for the assets of the corporation. Also, liabilities and stockholders’ claims are shown.

LiquidationBook Value Value

AssetsAccounts receivable.............................. $1,000,000 $ 700,000Inventory........................................................1,100,000 600,000Machinery and equipment.............................. 800,000 400,000Building and plant.......................................... 3,000,000 1,800,000

$5,900,000 $3,500,000

Liabilities and Stockholders’ Claims

Liabilities:Accounts payable........................................$2,000,000First lien, secured by

machinery and equipment....................... 650,000Senior unsecured debt.................................1,300,000Subordinated debenture.............................. 1,450,000

Total liabilities........................................5,400,000Stockholders’ claims:

Preferred stock............................................ 100,000Common stock............................................ 400,000

Total stockholders’ claims...................... 500,000 Total liabilities and

stockholders’ claims...................... $5,900,000

S16-37

Appendix A-1 (Continued)

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 $300,000, what is the total of 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 at the bottom portion of Table 16A-3.

f. Compute a ratio of your answers in part d and part 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 of 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.)

S16-38

16A-1. Solution:

Immobile Corporation

a. Liquidation value of assets $3,500,000Liabilities 5,400,000Difference ($1,900,000)

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 $3,500,000Administrative costs, wages and taxes – 300,000Remaining asset values $3,200,000

d. Remaining asset value $3,200,000Payment to secured creditors – 400,000Amount available to unsatisfied secured claims and unsecured debt $2,800,000

e. Remaining claims of unsatisfied secured debt and unsecured debt holder

Secured debt (unsatisfied first lien) $ 250,000Accounts payable 2,000,000Senior unsecured debt 1,300,000Subordinated debentures 1,450,000

$5,000,000f. Amount available to unsatisfied

S16-39

16A-1. (Continued)

g. Allocation procedures for unsatisfied secured claims and unsecured debt.

(1)

Category

(2)

Amount of Claim

(3)Initial

Allocation (56%)

(4)

AmountReceived

Secured debt(unsatisfied first lien) $ 250,000 $ 140,000 $ 140,000Accounts Payable 2,000,000 1,120,000 1,120,000Senior unsecured debt 1,300,000 728,000 1,300,000

Subordinated debentures* 1,450,000

$5,000,000 812,000

$2,800,000 240,000*$2,800,000

* The subordinated debenture holders must transfer $572,000 of their initial allocation to the senior unsecured debt holders to fully provide for their payment ($728,000 + $572,000 = $1,300,000). This will leave $240,000 for subordinated debentures ($812,000 – $572,000).

S16-40

16A-1. (Continued)

h. Payments and percent of claims

CategoryTotal amount

of claimAmount received

Percent of claim

satisfiedSecured debt(first lien) $ 650,000 *$ 540,000 83.1%Accounts payable 2,000,000 1,120,000 56.0%Senior unsecured debt

1,300,000 1,300,000 100.0%

Subordinated debentures 1,450,000 240,000 16.6%

* $400,000 from the sale of machinery and dequipment and $140,000 from the allocation process in part g.

16B-1. Edison Electronics is considering whether to borrow funds and purchase an asset or to lease the asset under an operating lease arrangement. If it purchases the asset, the cost will be $8,000. 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 $2,100 for the first two years, and the other with payments of $3,700 for the last two years. In your analysis, round all values to the nearest dollar.

a. Compute the aftertax 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 in Chapter 12).e. Compute the aftertax cost of the borrow–purchase alternative.f. Compute the present value of the aftertax 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

aftertax costs?

S16-41

16B-1. Solution:

Edison Electronics

a. (1) (2) (3) (4)

Year PaymentTax Shield 35% of (1)

After tax Cost

1 $2,100 $ 735 $1,3652 $2,100 735 1,3653 $3,700 1,295 2,4054 $3,700 1,295 2,405

b.

c. (1) (2) (3) (4) (5)

YearBeginning Balance

Annual Payment

Annual Interest

12% of (1)

Repayment on Principal

(2) – (3)

Ending Balance (1) – (4)

1 $8,000 $2,634 $960 $1,674 $6,3262 6,326 2,634 759 1,875 4,4513 4,451 2,634 534 2,100 2,3514 2,351 2,634 282 2,352 (1)

d. Depreciation Depreciation

Year Base Percentage Depreciation1 $8,000 .333 $2,6642 8,000 .445 3,5603 8,000 .148 1,1844 8,000 .074 592

$8,000

S16-42

16B-1. (Continued)

e.

(1) (2) (3) (4) (5) (6)

Year Payment Interest Depreciation

Total Tax Deductions

(2) + (3)

Tax Shield

35% × (4)

Net After Tax Cost (1) – (5)

1 $2,634 $960 $2,664 $3,624 $1,268 $1,3662 2,634 759 3,560 4,319 1,512 1,1223 2,634 534 1,184 1,718 601 2,0334 2,634 282 592 874 306 2,328

f.

Year

Aftertax cost of leasing

PV Factor at 8%

Present Value

Aftertax cost of

Borrow-Purchase

PV factor at 8%

Present Value

1 $1,365 .926 $1,264 $1,366 .926 $1,2652 1,365 .857 1,170 1,122 .857 9623 2,405 .794 1,910 2,033 .794 1,6144 2,405 .735 1,768 2,328 .735 1,711

$6,112 $5,552

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.

S16-43

Documents

Finance Chapter 16