problem 1: Assume that your company requires to raise $30 million and you want to issue 30-year bonds for this purpose. Assume the required return on your bond issue will be 8 %, and you are evaluating two issue alternatives: an 8 percent semiannual coupon bond and a zero coupon bond. Your company’s tax rate is 35 percent.
a) How many of the coupon bonds would you need to issue to raise the $30 million? How many of the zeroes would you need to issue?
b) In 30 years, what will your company’s repayment be if you issue the coupon bonds? What if you issue the zeroes?
problem 2: Most of the corporations pay quarterly dividends on their common stock instead of annual dividends. Barring any unusual circumstances during the year, the board raises, lowers, or maintains the current dividend once a year and then pays this dividend out in equal quarterly installments to its shareholders.
a) Assume that a company currently pays a $3.20 annual dividend on its common stock in a single annual installment, and management plans on raising this dividend by 6 percent per year, indefinitely. When the required return on this stock is 12 %, what is the current share price?
b) Now assume that that the company in (a) actually pays its annual dividend in equal quarterly installments; thus, this company has just paid a $.8 dividend per share, as it has for the prior three quarters. What is your value for the current share price now? (Hint: Find out the equivalent annual end-of year dividend for each year.) Comment on whether or not you think that this model of stock valuation is suitable.
problem 3: Consider the given two mutually exclusive projects: Whichever project you select, if any, you need a 15 percent return on your investment.
Year Cash Flow (A) Cash Flow (B)
0 -$300,000 -$40,000
1 20,000 19,000
2 50,000 12,000
3 50,000 18,000
4 390,000 10,500
a) If you apply the payback criterion, which investment will you select? Why?
b) If you apply the discounted payback criterion, which investment will you select? And Why?
c) If you apply the NPV criterion, which investment will you select? And Why?
d) If you apply the IRR criterion, which investment will you select? And Why?
e) If you apply the profitability index criterion, which investment will you select? And Why?
f) Based on your answers in (a) through (e), which project will you finally select? And Why?
problem 4: An investment under consideration has a payback of 7-years and a cost of $724,000. If the required return is 12 percent, what is the worst-case NPV? The best-case NPV? describe. Assume the cash flows are conventional.
problem 5: AOL is considering two proposals to overhaul its network infrastructure. They have received two bids. The first bid, from Huawei, will require a $20 million upfront investment and will generate $20 million in savings for AOL each year for the next three years. The second bid, from Cisco, requires a $100 million upfront investment and will generate $60 million in savings each year for the next three years.
a) What is the IRR for AOL associated with each bid?
b) If the cost of capital for this investment is 12%, what is the NPV for AOL of each bid? Suppose Cisco modifies its bid by offering a lease contract rather. Under the terms of the lease, AOL will pay $20 million upfront, and $35 million per year for the next three years.
AOL’s savings will be the same as with Cisco’s original bid.
c) Comprising its savings, what are AOL’s net cash flows under the lease contract? What is the IRR of Cisco bid now?
d) Is this new bid a better deal for AOL than Cisco’s original bid? Describe.
problem 6: Andrew Industries is contemplating issuing a 30-year bond with a coupon rate of 7% (annual coupon payments) and a face value of $1000. Andrew believes it can get a rating of A from Standard and Poor’s. Though, due to recent financial difficulties at the company, Standard and Poor’s is warning that it may downgrade Andrew Industries bonds to BBB. Yields on A-rated, long-term bonds are presently 6.5%, and yields on BBB-rated bonds are 6.9%.
a) What is the price of bond if Andrew maintains the A rating for the bond issue?
b) What will the price of bond be if it is downgraded?
problem 7: The Isabelle Corporation rents prom dresses in its stores across the southern United States. It has merely issued a 5-year, zero-coupon corporate bond at a price of $74.
You have purchased this bond and intend to hold it until maturity.
a) Determine the yield to maturity of the bond?
b) What is the expected return on your investment (expressed as an EAR) if there is no chance of default?
c) What is the expected return (expressed as an EAR) if there is a 100% probability of default and you will recover 90% of the face value?
d) Find out the expected return (expressed as an EAR) if the probability of default is 50%, the likelihood of default is higher in bad times than the good times, and in the case of default, you will recover 90% of the face value?
e) For parts (b–d), what can you state regarding the five-year, risk-free interest rate in each
case?
problem 8: Cooperton Mining just announced it will cut its dividend from $4 to $2.50 per share and use the extra funds to expand. Prior to the announcement, Cooperton’s dividends were expected to grow at a 3% rate, and its share price was $50. With the new expansion, Cooperton’s dividends are expected to grow at a 5% rate. What share price would you predict after the announcement? (Suppose Cooperton’s risk is unchanged by the new expansion.) Is the expansion a positive NPV investment?