Question 1.Both Berkley and Oakley are large public corporations with subsidiaries throughout the world. Berkley uses a centralized approach and makes most of the decisions for its subsidiaries. Oakley uses a decentralized approach and its subsidiaries make many of their own decisions.
a. Would the agency problem be more pronounced for Berkley or for Oakley? Explain.
b. Would agency costs likely be higher for Berkley or Oakley? Why?
c. Discuss a major advantage and a major disadvantage to a centralized approach such as Berkley uses.
d. Discuss a major advantage and a major disadvantage to a centralized approach such as Oakley uses.
e. Which is better, a centralized or decentralized approach? Explain.
Question 2. Assume the firm's stock now sells for $30 per share. The company wants to raise $20 million by issuing 20-year, annual interest, $1,000 par value bonds. Each bond will have 40 warrants attached, each exercisable into 1 share of stock at an exercise price of $36. The firms straight bonds yield 8%. Each warrant is expected to have a market value of $0.75 when the stock sells at $30. The company wants to establish a coupon interest rate and dollar coupon to ensure that the bonds will clear the market.
a. Calculate the value of the debt portion of the bonds with warrants.
Stock price $30
Bonds-life and par value 20
Par value $1,000
# of warrants per bond 40
Exercise price $36
Warrant market value @ P=$30) $0.75
Yield on straight bonds 8%
b. Calculate the dollar coupon amount per bond with warrants.
c. Calculate the coupon interest rate that should be set on the bonds with warrants.
d. Identify 2 or 3 advantages to the company of issuing a bond with warrants instead of straight bonds.
e. Identify 2 or 3 advantages to the investor of buying a bond with warrants instead of straight bonds.
Question 3. Mantra Corporation is interested in acquiring Corlos Corporation. Corlos has 10 million shares outstanding and a target capital structure consisting of 30 percent debt and 70 percent equity. The debt interest rate is 8%. Assume that the risk-free rate of interest is 3% and the market risk premium is 7%. Corlos' free cash flow (FCF0) is $5 million per year and is expected to grow at a constant rate of 6 percent a year; its beta is 1.2. Corlos has $5 million in debt. The tax rate for both companies is 30%.
| Shares outstanding |
10,000,000 |
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FCF0 |
5,000,000 |
| Target debt in capital structure |
30% |
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Constant growth rate |
6% |
| Debt interest rate |
8% |
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Beta |
1.2 |
| rRF |
3% |
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Amount of debt |
5,000,000 |
| Market risk premium |
7% |
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| Tax rate |
30% |
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| a. Calculate the required rate of return on equity using equation: rs= rRF + RPM(b) |
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b. Calculate weighted average cost of capital, using equation: WACC = Wdrd(1-%) + wsrs
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c. Calculate the value of operations, using equation: Vops = FCF0(1+g)/WACC - g)
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d. Calculate the value of the company's equity, using equation: Vs = Vops - debt
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e. Calculate the current value of the company's stock.
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Question 4: A Treasury bond futures contract settled at 97'16.
a. Calculate the present value of one futures contract?
b. Are current market interest rates higher or lower than the standardized rate on a futures contract? Explain.
c. Calculate the implied annual interest rate on the futures contract.
d. Calculate the new value of the futures contract if interest rates increase by 1 percentage point annually.
e. Why do companies enter into futures contracts? Provide a specific example.
Question 5. Corizon Company's balance sheet and income statement are shown below (in millions of dollars). Corizon and its creditors have agreed upon a voluntary reorganization plan. In this plan, each share of the $5 preferred will be exchanged for one share of $2.00 preferred with a par value of $50 plus one 10% subordinated income debenture with a par value of $50. The $8 preferred issue will be retired with cash. The company's tax rate is 30%.
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| Balance Sheet prior to Reorganization (in millions) |
| Current Assets |
200 |
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Current liabilities |
175 |
| Net fixed assets |
225 |
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Advance payments |
10 |
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$5 preferred stock, $100 par value (1,000,000) shares |
100 |
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$8 preferred stock, no par, callable at 100 (80,000 shares) |
8 |
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Common stock, $1.00 par value (5,000,000) shares |
25 |
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Retained earnings |
107 |
| Total assets |
425 |
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Total claims |
425 |
a. Construct the pro forma balance sheet after reorganization takes place. Show the new preferred at its par value.
b. Construct the pro forma income statement after reorganization takes place. How does the recapitalization affect net income available to common stockholders?
| Income Statement (in millions) |
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| Prior to Reorganization |
After Reorganization |
| Net sales |
700.0 |
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| Operating expense |
630.0 |
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| Net operating income |
70.0 |
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| Other income |
7.0 |
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| EBT |
77.0 |
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| Taxes |
23.1 |
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| Net income |
53.9 |
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| Dividends on $5 PS |
5.0 |
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| Dividends on $8 PS |
0.6 |
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| Income to Common SHs |
48.3 |
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c. Calculate the required pre-tax earnings before and after the recapitalization?
d. Calculate the debt ratio before and after the reorganization?
e. Would the common stockholders be in favor of the reorganization? Why or why not?
Question 6. Your portfolio is diversified. It has an expected return of 10.0% and a beta of 1.10. You want to add 500 shares of Tundra Corporation at $30 a share to your portfolio. Tundra has an expected return of 14.0% and a beta of 1.30. The total value of your current portfolio is $50,000.
a. Calculate the expected return on the portfolio after the purchase of the Tundra stock?
b. Calculate the expected beta on the portfolio after you add the new stock?
c. Is your portfolio less risky or more risky than average? Explain.
d. Will your portfolio likely outperform or underperform the market in a period when stocks are rapidly falling in value? Explain.
e. Is beta always an accurate predictor of a portfolio's performance? Explain?