Finance Chapter 15 Homework Number Shares Purchase 19600 25 Number Shares

CHAPTER 15

LONG-TERM FINANCING

Answers to Concepts Review and Critical Thinking Questions

1. The indenture is a legal contract and can run into 100 pages or more. Bond features which would be

2. The differences between preferred stock and debt are:

a. The dividends on preferred stock cannot be deducted as interest expense when determining

taxable corporate income. From the individual investor’s point of view, preferred dividends are

3. Some firms can benefit from issuing preferred stock. The reasons can be:

a. Public utilities can pass the tax disadvantage of issuing preferred stock on to their customers, so

4. The return on non-convertible preferred stock is lower than the return on corporate bonds for two

reasons: 1) Corporate investors receive 70 percent tax deductibility on dividends if they hold the stock.

5. The following table summarizes the main differences between debt and equity:

Debt

Equity

Repayment is an obligation of the firm

Yes

No

6. There are two benefits. First, the company can take advantage of interest rate declines by calling in an

issue and replacing it with a lower coupon issue. Second, a company might wish to eliminate a

8. Preferred stock is similar to both debt and common equity. Preferred shareholders receive a stated

9. A company has to issue more debt to replace the old debt that comes due if the company wants to

maintain its capital structure. There is also the possibility that the market value of a company continues

10. Internal financing comes from internally generated cash flows and does not require issuing securities.

In contrast, external financing requires the firm to issue new securities.

11. The three basic factors that affect the decision to issue external equity are: 1) The general economic

12. When a company has dual class stock, the difference in the share classes is the voting rights. Dual

13. The statement is true. In an efficient market, the callable bonds will be sold at a lower price than the

non-callable bonds, other things being equal. This is because the holder of callable bonds effectively

Grants ownership of the firm

Provides a tax shield

Liquidation will result if not paid

Yes

No

14. As interest rates fall, the call option on the callable bonds is more likely to be exercised by the bond

15. Sinking funds provide additional security to bonds. If a firm is experiencing financial difficulty, it is

likely to have trouble making its sinking fund payments. Thus, the sinking fund provides an early

warning system to the bondholders about the quality of the bonds. A drawback to sinking funds is that

they give the firm an option that the bondholders may find distasteful. If bond prices are low, the firm

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple

steps. Due to space and readability constraints, when these intermediate steps are included in this solutions

manual, rounding may appear to have occurred. However, the final answer for each problem is found

without rounding during any step in the problem.

Basic

1. If the company uses straight voting, the board of directors is elected one at a time. You will need to

own one-half of the shares, plus one share, in order to guarantee enough votes to win the election. So,

the number of shares needed to guarantee election under straight voting will be:

Shares needed = (850,000 shares/2) + 1

Shares needed = 425,001

And the total cost to you will be the shares needed times the price per share, or:

2. If the company uses cumulative voting, the directors are all elected at once. You will need 1/(N + 1)

percent of the stock (plus one share) to guarantee election, where N is the number of seats up for

election. So, the percentage of the company’s stock you need is:

Percent of stock needed = 1/(N + 1)

Percent of stock needed = 1/(3 + 1)

3. If the company uses cumulative voting, the directors are all elected at once. You will need 1/(N + 1)

percent of the stock (plus one share) to guarantee election, where N is the number of seats up for

election. So, the percentage of the company’s stock you need is:

Percent of stock needed = 1/(N + 1)

Percent of stock needed = 1/(4 + 1)

Percent of stock needed = .20, or 20%

So, the number of shares you need to purchase is:

4. Under cumulative voting, she will need 1/(N + 1) percent of the stock (plus one share) to guarantee

election, where N is the number of seats up for election. So, the percentage of the company’s stock she

needs is:

Percent of stock needed = 1/(N + 1)

Percent of stock needed = 1/(12 + 1)

Percent of stock needed = .0769, or 7.69%

5. We first need to find the market value of equity, which is:

Market value of equity = $43(1,600,000)

6. To find the price of the company’s bonds, we need to find the present value of the bond’s cash flows.

So, the price of the bond is:

P = $30(PVIFA2.80%,26) + $1,000(PVIF2.80%,26)

P = $1,036.59

7. a. The debt-equity ratio based on the book value of debt and equity is:

D/E = Book value of debt/Book value of equity

D/E = $185,000,000/$210,000,000

8. a. The price of the bond today is the present value of the expected price in one year. So, the price

of the bond in one year if interest rates increase will be:

P1 = $35(PVIFA4.5%,58) + $1,000(PVIF4.5%,58)

P1 = $795.08

9. The price of the bond today is the present value of the expected price in one year. The bond will be

called whenever the price of the bond is greater than the call price of $1,150. First, we need to find the

expected price in one year. If interest rates increase next year, the price of the bond will be the present

value of the perpetual interest payments, so:

10. If interest rates rise, the price of the bonds will fall. If the price of the bonds is low, the company will

not call them. The firm would be foolish to pay the call price for something worth less than the call

price. In this case, the bondholders will receive the coupon payment, C, plus the present value of the

remaining payments. So, if interest rates rise, the price of the bonds in one year will be:

P1 = C + C/.10

If interest rates fall, the assumption is that the bonds will be called. In this case, the bondholders will

receive the call price, plus the coupon payment, C. So, the price of the bonds if interest rates fall will

be:

11. a. The price of the bond today is the present value of the expected price in one year. So, the price

of the bond in one year if interest rates increase will be:

P1 = $65 + $65/.08

P1 = $877.50

If interest rates fall, the price of the bond in one year will be:

b. If interest rates rise, the price of the bonds will fall. If the price of the bonds is low, the company

will not call them. The firm would be foolish to pay the call price for something worth less than

the call price. In this case, the bondholders will receive the coupon payment, C, plus the present

value of the remaining payments. So, if interest rates rise, the price of the bonds in one year will

be:

If interest rates fall, the assumption is that the bonds will be called. In this case, the bondholders

will receive the call price, plus the coupon payment, C. The call premium is not fixed, but it is

the same as the coupon rate, so the price of the bonds if interest rates fall will be:

P1 = ($1,000 + C) + C

P1 = $1,000 + 2C

c. To the company, the value of the call provision will be given by the difference between the value

of an outstanding, non-callable bond and the call provision. So, the value of a non-callable bond

with the same coupon rate would be:

12. In general, this is not likely to happen, although it can (and did). The reason that this bond has a

negative YTM is that it is a callable U.S. Treasury bond. Market participants know this. Given the