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Long-Term Debt, Preferred Stock, and
Common Stock
An investment in knowledge always pays the best interest.
BENJAMIN FRANKLIN
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ANSWERS TO QUESTIONS
1. Serial bonds mature periodically as opposed to sinking-fund bonds which all mature on the
2. With an income bond, the payment of interest is dependent on the company’s earnings. Like
a preferred stock, the fixed return is not assured. In contrast, a mortgage bond involves a
3. The bank is concerned with protecting its position as a senior-debt holder. If the bank fails
to insist on subordination of such debt, upon liquidation of the company, the bank’s claims
4. “Junk bonds” by definition are speculative-grade bonds, which are rated BA or lower by
Moody’s, or BB or lower by Standard and Poor’s. Over 90 percent of the publicly held
5. Railroads: equipment trust certificates and mortgage bonds.
6. The investor must be compensated for the risk of having his/her bonds called and being able
7. To the firm:
a. The security provides leverage as does debt but cannot drive the firm into bankruptcy.
To the investor:
a. A prior claim (before common shareholders) on income may also be combined with a
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Utilities may use preferred stock because they wish to increase their leverage above the
8. The
call feature provides the corporation flexibility in its financing. With a preferred stock
9. Money market preferred (MMP) stock adjusts in rate every 49 days with a new auction.
Sometimes a ceiling rate of interest is specified. Regular preferred stock has a stipulated or
10. Investors demand a cumulative feature in order to protect themselves. Otherwise a company
11. For a “typical” preferred stock, one would find a cumulative feature, no participating
12. The use of dual-class common stock financing enables a company to raise funds but gives
up less control than it would with a straight common stock issue. By splitting– the common
13. If stockholders purchase new shares below their par value, they may be liable for the
14. In terms of return, it means that the claim to income comes after all creditors and preferred
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15. Management has the use of mailings to stockholders, legal counsel, and other things of this
16. The amount of preferred and common stock financing would be expected to rise
Answers to Appendix Questions:
17. The refunding decision from the firm’s standpoint is a riskless investment project. Investors
include a default risk premium in the market rate of return they require. This sensitivity of
18. Refundings occur only when the interest rates decline significantly from previous levels.
SOLUTIONS TO PROBLEMS
1. If the yield to maturity is 12.21 percent, the bonds will sell at a sizable premium. (Without
the maturity date being given, one cannot calculate the magnitude of the premium.) As a
2. a. $990 = $100(PVIFAr%,5) + $1,060*(PVIFr%,5)
*NOTE: Call price = $1,100 – [(4) ($10)] = $1,060
For r% = 12%:
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For r% = 11%:
Interpolating:
b.
End of year 0 1–5 5 6–25 25
+$1,060
– 1,000
Cash flows –$990 +$100 +$ 60 +$80 +$1,000
For r% = 10%:
P.V. of first interest payments = $100 × 3.791 = $379.10
For r% = 9%:
Interpolating:
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Next, we need to compare this 9.33 percent return to the yield on the bonds had they not
been called. To do this, we must determine the yield implicit in the following cash-flow
pattern:
For r% = 11%:
For r% = 10%:
Interpolating:
$1,000 – $990.00 = $10.00
3. a. Total interest payments for the noncallable bonds =
Interest payments for callable bonds the first five years =
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Interest payments for the next five years:
(a)
Interest
Rate
(b)
5-year
Cost
(millions)
(c)
Issuing
Expenses
(millions)
(d)
(b) + (c)
(millions)
(e)
Probability
(f)
(d) × (e)
(millions)
9% $4.5 $0.2 $4.7 0.1 $0.47
*NOTE: The company would not call its bonds and would continue to pay 12 percent
interest on the original issue.
Expected value of total interest and other costs over the ten years for the callable bonds
= $6.0 million + $5.59 million = $11.59 million.
As this total cost exceeds that for the noncallable bonds ($11.59 million vs. $11.4
million), the company should issue noncallable bonds.
b.
(a)
Interest
Rate
(b)
5-year
Cost
(millions)
(c)
Issuing
Expenses
(millions)
(d)
(b) + (c)
(millions)
(e)
Probability
(f)
(d) × (e)
(millions)
7% $3.5 $0.2 $3.7 0.2 $0.74
*NOTE: The company would not call its bonds and would continue to pay 12 percent
interest on the original issue.
As this total cost is less than that for the noncallable bonds ($11.2 million vs. $11.4
million), the company should issue callable bonds.
The problem illustrates that the greater the variance of future interest rates, the greater
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4. No particular solution recommended.
5. a. $8.00/0.09 = $88.89
6.
a. Preferred Common
7. a. 500,001 shares
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Solution to Appendix Problem:
8.
Cost of calling old bonds (call price 114) $57,000,000
Expenses:
Less: Tax savings
Interest expense on old bonds during
Call premium 7,000,000
Total $8,683,333
Annual net cash outflow of old bonds is …
Total $7,044,000
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Annual net cash outflow of new bonds is …
Interest expense, 12% coupon rate $ 6,000,000
Total $6,028,000
Difference in annual cash flow = $4,182,400 – $3,588,800 = $593,600
SOLUTIONS TO SELF-CORRECTION PROBLEMS
1. (dollars in millions) Let X = the number of millions of dollars of new debt that can be
issued.
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b. $30 + $(.5)X =2
$8 + X
Condition (a) is binding, and it limits the amount of new debt to $2.325 million.
2. a. After-tax cost:
b. The dividend income to a corporate investor is generally either 70 or 80 percent exempt
from taxation. With a corporate tax rate of 40 percent, we have for the preferred stock
either
For the bonds,
3. a.
b.
c.
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4. a. Number of shares necessary to elect one director =
Therefore, she can elect two directors.
b. Number of shares necessary to elect one director =
(3 + 1)
She can elect no directors.