978-1285429649 Chapter 2

Principles of Finance 6e Chapter 2

Besley/Brigham

2-1

CHAPTER 2

ANSWERS

2-2 A bond represents a loan contract between the firm that issued the bond and the investors that

2-3 The dividend that is paid to preferred stockholders generally is stated as a percentage of the

preferred stock’s par value. The preferred stocks’ par value also represents the per share dollar

2-4 a. 0 Bonds and term loans are equivalent debt instruments and should have about the same

interest rate.

b. + Debentures are riskier than mortgage bonds and, hence, would require a higher interest

d. (1) + Because the debentures will be subordinated to its bank debt, the debentures will have

a higher interest rate.

f. (1) – The more of the property that is mortgaged the weaker the claim of the debenture

holders. Thus, going from $75 million to $50 million of first mortgage debt will

strengthen the debentures and lower their interest rate.

g. + A call provision increases the risk to the bondholders, so a higher rate would be required.

Chapter 2 Principles of Finance 6e

1-2

2-5 Safety Rank

a. Income bond 7

b. Subordinated debenture—noncallable 5

2-6 From the corporation’s viewpoint, one important factor in establishing a sinking fund is that its own

bonds generally have a higher yield than do government bonds; hence, the company saves more

interest by retiring its own bonds than it could earn by buying government bonds. This factor causes

2-7 ($ million)

Common stock (42 million shares outstanding

At $1 par) [$40 million + $2 million] $ 42

2-8 a. The average investor in a listed firm is not really interested in maintaining his or her

proportionate share of ownership and control. An investor could increase ownership by simply

2-3

2-9 Preferred stock can be classified only when the one doing the classification is considered. From the

standpoint of the firm, preferred stock is like equity in that it cannot force the firm into bankruptcy,

but it is like debt in that it causes fluctuations in earnings available to the common stockholders.

2-10 When the price of its stock is temporarily depressed and a firm wishes to raise funds via an equity

issue, the company’s investment banker probably will recommend convertible debt be issued. The

2-11 The convertible bond has an expected return that consists of an interest yield (9 percent) plus an

expected capital gain. We know the expected capital gain must be at least 3 percent, because the

2-12 a. Most firms have a continuing need for long-term debt to finance operations (at least as long as

they are still in business). It would make sense for a firm to issue bonds like the Canadian

b. The default risk will be negligible for each bond. The interest rate risk, however, will be greatest

for the bond with the longest term to maturity. As a result, the perpetual bonds’ interest rate risk

d. If the information bondholders used to reach their conclusion that the bonds would be called

was unfounded, then there should be no reason to expect the Canadian government to foot the

Chapter 2 Principles of Finance 6e

1-4

─────────────────────────────────────────────────

SOLUTIONS

2-1 a. The conversion price simply is the face (par) value of the bond divided by the conversion

b. The conversion feature would add some flexibility to the bonds as an investment. Investors

might find it attractive to buy the bonds because they can later decide whether they prefer to

2-2 a. Dividend = $50(0.08) =$4

2-3 a. Number of zeros = Amount needed/Price per bond

2-4 a. If P0 = $18, the option is exercised, and the stock is sold immediately, the gain would be ($18 –

$15) x 100 = $300. Therefore, it would be beneficial to exercise the option.

c. The answers in part (a) and part (b) would be reversed if the option were a put with the same

exercise price:

Principles of Finance 6e Chapter 2

Besley/Brigham

2-5

2-5 a. If the stock is purchased for $26 per share and sold to the option writer by exercising the

option, the gain/loss would be ($25 – $26) x 200 = –$200.

2-6 a. Balance sheets:

Meyer Balance Sheet ($ thousands):

Debt $400

Equity 200

b. Haugen sold $200,000/$50 = 4,000 shares to raise the funds needed to purchase the new

machine. Therefore, because the stock issue increased the number of existing shares by 20

percent, the number of shares Haugen had outstanding before the issue was

c. Income Statement for Meyer Manufacturing ($ thousands):

ΔEBIT $100.0

ΔInterest = $200 x 0.08 ( 16.0)

Income Statement for Haugen Mills ($ thousands):

Chapter 2 Principles of Finance 6e

Besley/Brigham

1-6

d. Meyer issued bonds, not stock, so it has 20,000 shares of common stock outstanding.

Therefore, Meyer’s earnings per share, EPS, is

$2.52 =

20,000

$50,400

=

EPSMeyer

2-7 a. Cox Computer Company Balance Sheet:

Alternative 1:

Short-term debt $ 25,000

Long-term debt 25,000

Alternative 2:

Short-term debt $ 25,000

Long-term debt 25,000

Principles of Finance 6e Chapter 2

Besley/Brigham

2-7

Alternative 3:

Short-term debt $ 25,000

b. Original Alt. 1 Alt. 2 Alt. 3

________ _______ _______ _______

c. Original Alt. 1 Alt. 2 Alt. 3

________ ________ ________ __________

Total assets $275,000 $375,000 $375,000 $375,000

EBIT $ 55,000 $ 75,000 $ 75,000 $ 75,000

2-8 a. Book value per share = ($364,000 + $336,000)/20,000 = $35.00

b. Total amount of issue = 10,000 x $32.55 = $325,500

2-9 a. Today, the amount Fibertech has to pay today is known with certainty because the current

exchange rate is known. In other words, if Fibertech decides to pay the bill today, it needs

Chapter 2 Principles of Finance 6e

Besley/Brigham

2-8

c. At $0.100 per yen, the cost to purchase the needed amount of yen would be:

At $0.085 per yen, the cost to purchase the needed amount of yen would be:

d. The primary benefit Fibertech would receive by entering a futures contract is that it would be

2-10 Integrative Problem

Part I: Initial Expansion

a. Financing with stock offers several advantages over debt, but there are also disadvantages.

The major advantages and disadvantages are discussed below.

ADVANTAGES:

(1) Common stock will not obligate Gonzales to make fixed payments. Gonzales’s managers

DISADVANTAGES:

(1) The Gonzales family might have to give up some voting control if it sells common stock.

b. Because all of Gonzales’s stock is owned by family members, the stock is said to be privately

owned, or closely held. If some stock is sold to the public, the stock will then be publicly held.

c. Classified stock is stock that is given some special designation. Those designations typically

are Class A, Class B, and so on, but any designation can be used. “founders’ shares” is the

Principles of Finance 6e Chapter 2

Besley/Brigham

2-9

d. Yes, it would, although this might make the selling job more difficult both because more shares

Part II: Subsequent Expansions

a. Bonds and term loans both are long-term debt contracts under which a borrower agrees to

b. (1) If Gonzales uses the manufacturing facility as collateral for its debt, the bonds would be

c. A bond indenture is a formal agreement between the issuer of the bond and the investors who

buy the bonds. It is designed to keep the issuing firm from doing something to cause the quality

d. A company will only call a bond issue if interest rates have fallen, and, if the bond is called, the

bondholders will have to reinvest their money at the then prevailing lower interest rate.

e. (1) If Gonzales included a sinking fund provision in the contract, the interest rate would

2-10

(2) A sinking fund provision generally requires the firm to retire a specified percentage of the

bond issue each year. Gonzales would probably be given the option of purchasing bonds

(3) The longer the maturity of a bond, the more logical it is to include a sinking fund provision,

(4) Because Gonzales’s bond matures in only 10 years, it is not likely to include a sinking fund.

f. If Gonzales’s bond rating were lowered by various bond rating agencies (such as Moody’s and

Note these additional points regarding bond ratings:

(1) Moody’s and standard & Poor’s are the major rating agencies. Corporations pay the

agencies to have their debt rated prior to a new offering, and to have a continuing

evaluation after the issuance.

g. Here are some factors that influence financing decisions:

(1) The target capital structure

(2) Maturity matching: use debt that has a maturity equal to the asset’s life.

Principles of Finance 6e Chapter 2

Besley/Brigham

2-11

for 10 year, it would be logical for Gonzales to use a zero coupon bond in order to match its

outflows and inflows from the project.

ETHICAL DILEMMA

Should Maria Take A SINful Cruise?

Ethical dilemma:

Maria must decide how to raise $400 million that is needed for capital investments. Because the CFO of

Paradise Environmental Designs (PED) wants to decrease the firm’s cost of capital, Maria is considering

raising the needed funds by issuing convertible bonds. But, Maria doesn’t know much about these types of

financial assets, other than the fact that they can be quite complex. As a result, she is determined to get

more information about convertible securities before she makes a decision as to whether it would be wise

for PED to use such instruments to raise funds. Roger, who is Maria’s friend, suggested that she attend a

conference that the investment banking firm for which he works is sponsoring. The problem is that the

conference will be presented aboard a cruise ship while it travels to various countries in the Mediterranean

Sea, and all expenses will be paid by Superior Investment Networks (SIN), which is the firm for which

Roger works. It appears that the information Maria seeks will be presented at the conference, and that she

will get sufficient information to make informed decisions about whether/how convertible bonds should be

used to finance PED’s investments. However, she is concerned that the information provided at the

conference might be one-sided—that is, the information might be biased toward the beliefs that SIN has

about convertibles. In addition, because SIN is sponsoring the conference and it is one of the investment

banking firms that PED uses to issue new securities, Maria might be accused of taking a payoff to use

SIN’s services. Further, Roger, her friend who works at SIN, would benefit handsomely if PED uses SIN to

issues convertible bonds.

Discussion questions:

• What is the ethical dilemma?

If she attends SIN’s conference, it appears that Maria might find herself in a situation where she has a

• Do you think that PED should issue convertible bonds?

• Should Maria take the SINful cruise?

Chapter 2 Principles of Finance 6e

Besley/Brigham

2-12

The advantage of taking the cruise is that Maria will have the opportunity to learn much more about

• What would you do if you were Maria?

The simple answer is to attend the conference and enjoy the cruise. Maria probably will get the

information that she needs to make an informed decision about the advantages and disadvantages of

References:

Christopher Cooper, “Giuliani Firms Had Potential Conflict of Interest,” The Wall Street Journal, May 7,

2007, p. A6.

Rebecca Thurlow, “Australia Regulator Faults Citi Officers in Landmark Case,” The Wall Street Journal,

April 11, 2007, p. C2.

Edward Siedle, “The Irrelevant SEC,” Forbes.com, November 27, 2006.

Steve Rosenbush, “Investment Banks Jockey for Position,” BusinessWeek.com, June 30, 2006.