9-1
Chapter 9
Answers to Review Problems
Finance For Executives – 4th Edition
1. Structure and characteristics of financial markets.
a.
In a rights offering, shares are issued exclusively to the firm’s existing shareholders, whereas in a
general cash offering they are sold to any interested buyer.
b.
c.
The originating house is the investment bank that has initiated the issue, whereas the selling
group consists of a number of banks which are brought in to help distribute portions of the shares
that have been allocated to them by the originating house or lead manager.
d.
e.
Credit risk refers to the ability of a firm to service the bonds it has issued (pay interest and repay
the principal) while market risk refers to the unexpected changes in the price of bonds in response
to changes in the rates of interest.
f.
9-2
2. Rights issue.
a.
The number of rights MEC will grant must be equal to the number of MEC’s shares outstanding,
that is, 50 million rights.
b.
c.
The price will drop to $25 to reflect the fact that the share has gone ex-rights, that is, it entitles the
holder to buy new shares at $20. The ex-rights price is (see equation 9.2):
d.
The value of one right is simply $1, the difference between the rights-on price ($26) and the ex-
rights price ($25). It can also be calculated directly with the formula in footnote 13:
9-3
3. Leasing versus borrowing.
The relevant cash flows and the computation of the net present value of lease versus buy are
presented in a spreadsheet format.
A
B
C
D
E
F
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
9
10
Scrap value
-$3,000
11
12
Cash saved from not buying the truck
24,000
13
14
Total differential cash flow
$20,100
-$6,300
-$6,300
-$6,300
-$5,400
15
16
Cost of debt
6%
17
18
19
20
21
22
23
24
a.
Discounting the total differential cash flows at the after-tax cost of debt of 6% yields a negative
net present value, or net advantage of leasing, of –$1,017.
b.
OS Distributors will be indifferent between buying or leasing if the net advantage of leasing
(NAL) is zero, that is, if the present value at 6% of the differential cash flows from year 1 to year
4 is equal to $20,100 (the difference between the cash saved from not buying the truck and the
after tax lease payment now, cell B14) :
Lease payments
-$6,500
-$6,500
-$6,500
4
Tax rate
5
After-tax lease payments
Depreciation expenses
8
Loss of tax savings on depreciation
9-4
4. Leasing.
Using a spreadsheet, the following table shows the after-tax cash flows to Thorenberg Inc. and for
Thorsten Leasing Corporation and the net advantage to leasing to Thorenberg Inc.
A
B
C
D
E
F
G
1
Now
Year 1
Year 2
Year 3
Year 4
Year 5
2
Cash flows to Thorenberg
3
Purchase price
$100,000
4
Depreciation expenses
$20,000
$20,000
$20,000
$20,000
$20,000
5
Lease payments
$25,000
$25,000
$25,000
$25,000
$25,000
6
Corporate tax rate
7
After-tax lease payments
$16,000
$16,000
$16,000
$16,000
$16,000
8
depreciation
9
Differential cash flow
84,000
-23,200
-23,200
-23,200
-23,200
-7,200
10
11
Interest rate
8.00%
12
After-tax interest rate
5.12%
13
14
Net advantage to leasing
-$3,647
15
16
17
18
19
20
21
22
9-5
23
24
Cash flows to Foster
Now
Year 1
Year 2
Year 3
Year 4
Year 5
25
a.
The net advantage to leasing is negative for Thorenberg Inc.: –$3,646. Thus, the firm should buy
rather than lease the equipment.
b.
c.
Leasing cannot take place if the cash flows to the lessee and the lessor are exactly the opposite
and if their borrowing rate is the same. The leasing will take place only if any of these two
conditions is not met. That would happen if:
• The two firms are subject to different effective tax rates
5. Bond valuation.
The market value of a bond is the present value of the bond’s future coupons and principal
repayment discounted at the market interest rate relevant to the risk and maturity of the bond:
26
Purchase price
$100,000
27
Tax savings on depreciation
28
After-tax lease receipts
29
$23,200
$23,200
$7,200
9-6
End of Year
1
….
9
10
11
…..
19
20
Bond A
$100
….
$100
$1,100
Bond B
0
….
$0
$1,000
Bond C
100
….
$100
$100
$100
$100
$100
$1,100
9-7
A B C D E F G H I
1
2Bond A
3 Periods 10
4 Coupon $100 100
5 Principal $1,000
15
16
Market interest rate 0% 2% 4% 6% 8% 10% 12% 14%
17
18 Price Bond A $2,000 $1,719 $1,487 $1,294 $1,134 $1,000 $887 $791
19 Price Bond B $1,000 $820 $676 $558 $463 $386 $322 $270
20 Price Bond C $3,000 $2,308 $1,815 $1,459 $1,196 $1,000 $851 $735
21
22 The formula in cell B18 is: =-PV(B16,$B$3,$B$4,$B$5,1). Then copy formula in cell B18 to cells C18, D18, E18, F18, G18,
23 H18, and I18.
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
$3,000
$3,500
Bond C
9-8
6. Bond valuation.
The rate on the new bond must be the same as the current market yield on the outstanding bond
since both bonds have the same maturity (10 years) and same credit risk (they are both issued by
the same firm). Note that the announcement that the firm’s target debt–to-equity ratio is not going
to change is a signal that the firm’s financial risk is not going to be affected by the bond issue.
Year
1
2
….
9
10
Cash flow
$100
$100
….
$100
$1,100
The bond’s yield kD is the solution of the following equation:
Using a spreadsheet with the formula mentioned in the section “Finding the Yield of a Bond
When Its Price Is Known” gives the same rate:
A
B
C
D
E
F
G
H
1
Number of periods
10
2
3
Coupon payment
$100
4
5
Market price
$1,065
6
7
Principal repayment
8
9
10
11
9-9
7. Valuation of bonds.
a.
Using a spreadsheet as in the chapter the market prices of the three bonds are calculated as
follows:
A
B
C
D
E
F
G
1
2
Coupon bond
3
Periods
5
10
11
Perpetual bond
12
Coupon
$60
13
14
Market price
15
Market rate
7.0%
7.5%
16
Coupon bond
17
Zero-coupon bond
18
Perpetual bond
19
20
Percentage change
21
Coupon bond
-2.05%
22
Zero-coupon bond
-2.30%
23
Perpetual bond
-6.67%
24
25
26
27
28
29
b.
Bond values are below their face values because the market yield (7%) is above the coupon rate
(6%). Rates have gone up (from 6% to 7%) and, hence, bond values have gone down.
4
Coupon
$60
Zero-coupon bond
9-10
c.
d.
Value of option = Value of convertible – Value if nonconvertible = $1,040 – $959 = $81
e.
8. Common stock valuation.
In an efficient market, the market value of a security is the present value of the cash-flow stream
that is expected from the security’s issuer discounted at the market required rate of return (12
percent).
The payments expected from Therol Co. to the current and future owners of a firm’s share of
common stock are the expected dividends. They can be computed as follows:
Year-end
1
2
3
Dividend
$1.2 (1 + .16) = $1.392
$1.2 (1 + .16)2 = $1.615
$1.2 (1 + .16)3 = $1.873
Year-end
Dividend
$1.873 (1 + .12) = $2.098
After the end of year 5, the dividend is expected to grow forever at a constant rate of six percent.
Since the dividend at that point in time is expected to be $2.350, the expected share price at the
end of year 5 is simply the present value of an annuity of $2.350 × (1+.06) growing at 6 percent
forever. At the required rate of 12 percent, this is $ 41.517, which is $2.491/(12%-6%).
9-11
The same calculations could have been done with a spreadsheet as follows:
A
B
C
D
E
F
G
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
Year-end
5
2
Expected growth rate
16%
16%
16%
12%
12%
3
Expected dividend
$1.20
$1.39
$1.61
$1.87
$2.10
$2.35
4
Expect growth rate
after Year 5
6%
9. Growth stocks versus income stocks.
a.
Therol’s stock price, P0, is the value of a constant annuity equal to the expected dividend per
share discounted at the required rate of return of 10 percent. Since the firm pays out all of its
b.
If the firm plows back 40 percent of its earnings with an expected return of 10 percent, its
earnings will grow at a rate of 10 percent .40 = 4 percent. So will its dividend per share, which
is now 60 percent of $5.00, or $3.00. Under this scenario, Therol’s stock price, P0, is the present
5
Expected share price
Year-end 5
6
Expected cash flows
7
8
Expected return
9
10
11
12
13
14
15
16
9-12
c.
If the return on 40 percent of earnings is 15 percent instead of 10 percent, then dividends can be
expected to grow at a rate of 15 percent .40 = 6 percent and Therol’s stock price, P0, would be:
10. Valuation of preferred shares and common stocks.
a.
Value of the preferred =
51.46$
086.0
4$ =
b.
c.
A
B
C
D
E
F
1
Now
Year-end
1
Year-end
2
Year-end
3
Year-end
4
2
Expected growth rate
8%
8%
8%
4%
3
Expected dividend
$3.50
$3.78
$4.08
$4.41
$4.59
4
Share price – End-of-Year 4
$59.67
5
Expected cash flows
$3.78
$4.08
$4.41
$64.19
6
Expected return
7
8
9
9-13
d.
The observed market price of $53.24 is 5.3% higher than the estimated value of $50.56. This can
be interpreted as follows. If we assume that the estimated value is “correct,” then the shares are
overpriced and should be sold. If we assume that the price is “correct,” then the model and the
assumptions we have used to estimate the value of a share are incorrect and should be revised.