problem 1: Valuing Callable Bonds
Bowdeen Manufacturing intends to issue callable, perpetual bonds with annual coupon payments. The bonds are callable at $1,350. One-year interest rates are 12 percent. There is a 40 percent probability that long-term interest rates one year from today will be 17 percent, and a 60 percent probability that they will be 7 percent. Assume that if interest rates fall the bonds will be called.
What coupon rate should the bonds have in order to sell at par value?
problem 2: Interest on Zeroes
Tesla Corporation needs to raise funds to finance a plant expansion, and it has decided to issue 25-year zero coupon bonds to raise the money. The required return on the bonds will be 8 percent. Assume semiannual compounding.
a) What will these bonds sell for at issuance?
b) Using the IRS amortization rule, what interest deduction can the company take on these bonds in the first year? In the last year?
c) Repeat part (b) using the straight-line method for the interest deduction.
d) Based on your answers in (b) and (c), which interest deduction method would Tesla Corporation prefer?
problem 3: Firm Value
Old School Corporation expects an EBIT of $9,000 every year forever. Old School currently has no debt, and its cost of equity is 18 percent. The firm can borrow at 11 percent. The corporate tax rate is 35 percent.
a) What is the value of the firm?
b) What will the value be if Old School converts to 50 percent debt and 100 percent debt?
problem 4: Break-Even EBIT
Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Rolston would have 162,000 shares of stock outstanding. Under Plan II, there would be 108,000 shares of stock outstanding and $1.62 million in debt outstanding. The interest rate on the debt is 10 percent, and there are no taxes.
A) If EBIT is $292,000, find out the EPS for each plan.
B) If EBIT is $1,264,000, find out the EPS for each plan.
C) find out the break-even EBIT?
problem 5: Agency Costs
Tom Scott is the owner, president, and primary salesperson for Scott Manufacturing. Because of this, the company’s profits are driven by the amount of work Tom does. If he works 40 hours each week, the company’s EBIT will be $405,000 per year; if he works a 50-hour week, the company’s EBIT will be $505,000 per year. The company is currently worth $2.7 million. The company needs a cash infusion of $1.32 million, and it can issue equity or issue debt with an interest rate of 9.5 percent. Assume there are no corporate taxes.
A) What are the cash flows to Tom under each scenario?
B) Under which form of financing is Tom likely to work harder?
problem 6: Costs of Financial Distress
Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies' economists agree that the probability of the continuation of the current expansion is 75 percent for the next year, and the probability of a recession is 25 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $2.42 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $913,000. Steinberg's debt obligation requires the firm to pay $813,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.15 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 11 percent.
A) What is the value today of Steinberg's debt and equity? What about that for Dietrich's?
B) Steinberg's CEO recently stated that Steinberg's value should be higher than Dietrich's because the firm has less debt and therefore less bankruptcy risk. Do you agree or disagree with this statement?