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MANAGEMENT CONSULTANCY - Solutions Manual

CHAPTER 19 SOURCES OF INTERMEDIATE AND LONG-TERM FINANCING: DEBT AND EQUITY
I. Questions 1. The bond agreement specifies such basic items as the par value, the coupon rate, and the maturity date. 2. The priority of claims can be determined as follows: senior secured debt, junior secured debt, senior debenture, subordinated debenture, preference shares, ordinary shares. 3. Bond conversion. 4. The advantages of debt are: a. Interest payments are tax deductible. b. The financial obligation is clearly specified and of a fixed nature. c. In an inflationary economy, debt may be paid back with cheaper pesos. d. The use of debt, up to a prudent point, may lower the cost of capital to the firm. The disadvantages are: a. Interest and principal payment obligations are set by contract and must be paid regardless of economic circumstances. b. Bond indenture agreements may place burdensome restrictions on the firm. c. Debt, utilized beyond a given point, may serve as a depressant on outstanding ordinary shares. 19-1

Chapter 19 Sources of Intermediate and Long-term Financing: Debt and Equity II. 39. 19. 8. 45. 10. Px = = = P72 360 (P75 x 4) + P60 5 the term loan: 5 18. 30. 24. 5. 23. 38. 37. Multiple Choice 1. Px = where Px Po N S = = = = value of a share5 (Po x N) + ex-rights market value of share rights-on N + 1 number of rights required to purchase one share subscription price per share Hence. 26. 7. 33. 17. 21. 42. The following schedule applies for Beginning Balance P5000 Interest x (1 – Tc ) P195 19-2 Principal Payment P1000 Ending Balance P4000 Year 1 . 12. 35. 43. 14. 13. 25. 15. 18. 9. 11. 20. 27. 3. D D D B A C C E D B C D D A D 16. 2. 40. 34. D C B A C A C B B B A A C C B 31. A C D A C C A A D C C A D B C Supporting computations: 16. 28. 4. 29. 6. 32. 44. 22. 36. 41.

058. The present value annuity factor for four years at 12% is 3.6048.0373) = P3. The present value cost of the lease is the cost of the first payment plus the present value of the four future payments.000 (3.49.35) = P910. III. After the tax benefit. The present value cost of the purchase option is the present value of principal payments or P3.29.94.49 which equals P4.6048) = P3.604.400 (1 – . the present value of principal payments is P1. Problems PROBLEM 1 (CAM FURNITURE COMPANY) a.80 plus P453. Proposal 1: 10 year 12 percent bonds CAM FURNITURE COMPANY 19-3 . the annual cost of leasing is P1.604.Sources of Intermediate and Long-term Financing: Debt and Equity Chapter 19 2 3 4 5 4000 3000 2000 1000 156 117 78 39 1000 1000 1000 1000 3000 2000 1000 -0- The present value of interest after taxes at 12% is calculated to be P453. 20. The present value annuity factor for five years at 12% is 3.80.673.0373. or P910 + P910 (3. 19. Therefore.

...000 540.........000 46..........Chapter 19 Sources of Intermediate and Long-term Financing: Debt and Equity Income P30.......000 Net income.. P 13...000 360....1/3 Proposal 2: Ordinary share issue to yield P33-1/3 P2......... Operating income .. Net income..................000 58......000 P 39..................... Outstanding shares = Estimated sales levels P400..... Operating costs ...000 720................ Interest charges .....000 + 10........000 Net income before taxes ......000 P600. 360....000 P 23... 40. 2005 Sales.000 60.000 P 33................000 Income taxes .30 Price-earnings ratio 10 times Estimated market value P100.000 720................30 10 times P33 CAM FURNITURE COMPANY Income Statement For the Year Ended December 31...... Income taxes ......76 P3.......46 12 times P17..000 * EPS (P36 market value – price earnings ratio of 12) Earnings per share P1.........000 14.............000 2.000 40....000 = 13....000 shares Earnings per share Price-earnings ratio Estimated market value P1.000 P 29...000 14....000 P800..52 19-4 P2.....000 29........00 12 times P36.........000 2....000 39....000 33......23 12 times P26.000 23............000 78....000 Operating costs ..... 13.....000 540. Net income before taxes .000 P600.. 2005 3* Estimated sales levels Sales........000 Interest charges .......000 P13 33 .....000 Operating income ...000 66...000 Outstanding shares = = 10.......000 80..........000 19...........000 38.....000 Statement For the Year Ended December 31..000 P 19......000 P800. 14...00 .000 2......30 10 times P23 P3....000 80.... P400.... 26......000 60.........

) Faye Industries Inc. the firm should choose to finance the new product by selling bonds. c. INC. d. Within the constraints of this problem. two possible objectives emerge: profit maximization as measured by earnings per share and wealth maximization as measured by the price of the ordinary shares. Unlike profit maximization. wealth maximization would require the sale of new ordinary shares because share price is higher at each sales level. The investment banker would suggest that lower price-earnings ratio with debt financing is a reflection of the greater returns demanded by shareholders in compensation for the variability in earnings and higher risk of bankruptcy created by the fixed commitment to pay debt interest and principal. adjusted for both the timing of benefits and the risk associated with the receipt thereof.6 million). If profit maximization is used. Proposal 2 would still be the choice. since earnings per share is higher for each of the three levels of sales. the sale of ordinary shares is the recommended financing technique. because the market value remains above that of Proposal 1. PROBLEM 2 (FAYE INDUSTRIES.Sources of Intermediate and Long-term Financing: Debt and Equity Chapter 19 b. however. The difference is getting smaller. Wealth maximization is the preferred criterion for financial decision making. Pro Forma Consolidated Income Statement Including Earnings per Common Share and Return on Average Common Shareholders’ Equity For the Year Ending November 30. which means that Proposal 1 would become attractive if sales reached a higher level (approximately P1. Because wealth maximization is the preferred objective. A criterion that ignores these two important determinants of value cannot be expected to provide a proper guide to decision making. 2006 (P000 omitted except per share amounts) (1) Issuing (2) Selling Long-term Preference (3) Selling Ordinary 19-5 . it represents a measure of the total benefits stream to be enjoyed by the shareholders. On the other hand.

330 (P7.133 7.978 1.Chapter 19 Sources of Intermediate and Long-term Financing: Debt and Equity Bonds P12.330 26.273 1.330 26.330 (P7.351 26.083 10.30% 9.028 ÷ P60.000 ÷ P120) x 13% Earnings available to common shareholders Add: Common shareholders’ equity December 1.023 ÷ [(P70.705 4.133) ÷ 2] = P5.530 2.978 1.393) ÷ 2] = P7.365 ÷ [(P55.682 7.980 6. 1999 balance Additional issued December 1 Total (and average) shares outstanding Pro forma earnings per share (P6.028 ÷ P61.395 x 9.2038 P0.330 26.658) ÷ 26.273 11.273 1.51% 9.300 x 10%) Total interest Income before income tax Income taxes (40%) Net income Preference share dividends (P15.330 7.300.300 P77.330 26.028 P61.978 1. 2000 Average common shares outstanding (in thousands) December 1.105 − P0) ÷ 26.5%) Alternative 1 (P15.365 55.511% 19-6 .105 Shares P12.105 ÷ [(P55.023 1.023 Earnings before interest and taxes Interest on Current debt (P13.650 33.028 15.2067 Estimated return on average common shareholders’ equity P6.175 4.023 55.273 1.2319 P0.351) ÷ 2] = 10.023 − P1.023 − P0) ÷ 33.273 11. 1999 Equity financing Common shareholders’ equity November 30.658 5.028 P60.105 55.070 6.980 = = = P0.682 7.393 Shares P12.328 ÷ P77.705 4.