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Solutions Manual

CHAPTER 25 SOURCES OF LONG-TERM FINANCING


SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS I. Questions 1. In 1978, the average manufacturing corporation had its interest covered almost eight times. By the mid 1990s, the ratio had been cut in half. 2. !. he bond agreement specifies basic items such as the par value, the coupon rate, and the maturity date. he priority claims are" Senior Secured Debt Junior Secured Debt Senior Debenture Senior De#enture Senior Se$ure! De#t 'unior Se$ure! De#t Subordinated Debenture Preferred Share Ordinary Equity Share

Pre erre! S"are Su#or!inate! De#enture Or!inar% E&uit% S"are #. '.

he method of $bond repayment% reduces debt and increases the amount of ordinary e&uity share outstanding is called bond conversion. he purpose of serial and sinking fund payments is to provide an orderly procedure for the retirement of a debt obligation. o the e(tent bonds are paid off over their life, there is less ris) to the security holder. he different bond yield terms may be defined as follo+s" Coupon rate is the stated interest rate divided by par value. Current yield is the stated interest rate divided by the current price of the bond. Yield to maturity is the interest rate that +ill e&uate future interest payments and payment at maturity to a current mar)et price.

*.

7.

he higher the rating on a bond, the lo+er the interest payment that +ill be re&uired to satisfy the bondholder.

8. ,efer to pages *!* through *!7.

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Sources of Long-term Financing

9. Capitali ing lease payments means computing the present value of future lease payments and sho+ing them as an asset and liability on the statement of financial position. 10. -ounders. share may carry special voting rights that allo+ the original founders to maintain voting privileges in e(cess of their proportionate o+nership. 11. he preemptive right provides current shareholders +ith a first option to buy ne+ shares. In this fashion, their voting right and claim to earnings cannot be diluted +ithout their consent. 12. he actual o+ners have the last claim to any and all funds that remain. If the firm is profitable, this could represent a substantial amount. hus, the residual claim may represent a privilege as +ell as a potential dra+bac). /enerally, other providers of capital may only receive a fi(ed amount. 1!. Preferred share is a $hybrid% or intermediate form of security possessing some of the characteristics of debt and ordinary e&uity share. he fi(ed amount provision is similar to debt, but the noncontractual obligation is similar to ordinary e&uity share. hough the preferred shareholder does not have an o+nership interest in the firm, the priority of claim is higher than that of the ordinary shareholder. 1#. 0ost corporations that issue preferred share do so to achieve a balance in their capital structure. It is a means of e(panding the capital base of the firm +ithout diluting the ordinary e&uity share o+nership position or incurring contractual debt obligations. 1'. 1referred share may offer a slightly lo+er yield than bonds in spite of greater ris) because corporate recipients of preferred share dividends must add only !0 percent of such dividends to its ta(able income. hus, 70 percent of such dividends are e(empt from ta(ation. 1*. 2ith the cumulative feature, if preferred share dividends are not paid in any one year, they accumulate and must be paid in total before ordinary e&uity shareholders can receive dividends. 3ven though preferred share dividends are not a contractual obligation as is true of interest debt, the cumulative feature tends to ma)e corporations very a+are of obligations to preferred shareholders. 1referred shareholders may even receive ne+ securities for forgiveness of missed dividend payments.

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II. Multiple Choice Questions 1. 2. !. 4 B 5 #. '. *. B 6 6 7. 8. 9. B 4 B 10. 5

III. Problems Pro#le, 7a8


6oupon rate : : 190 interest 11,000 par 9; 190 interest 1820 mar)et price 10.98; 4nnual Interest = 1ayment 1rincipal 1ayment ? 1rice of the Bond @umber of 9ears to 0aturity

7b8

6urrent rate<yield

: :

7c8

4ppro(imate = 9ield to 0aturity

.* 71rice of the Bond8 = .# 71rincipal 1ayment8 190 = 11,000 > 1820 '

.* 718208 = .# 711,0008 190 = 1180 '

1#92 = 1#00 190 = 1892 112* 1892 1#.1!; 1!*

= =

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Pro#le, * 7a8
6urrent rate<yield Bon! A : : 180 interest 1800 mar)et price 10; 6urrent rate<yield Bon! B : : 18' interest 1900 mar)et price 9.##;

7b8

he bond that the investor should select is Bond 4 because it has a higher current yield.
4ppro(imate = 9ield to 0aturity 4nnual Interest = 1ayment 1rincipal 1ayment ? 1rice of the Bond @umber of 9ears to 0aturity

7c8

.* 71rice of the Bond8 = .# 71rincipal 1ayment8 18' = 11,000 > 1900 2

.* 719008 = .# 711,0008 18' = 1100 2

1'#0 = 1#00 18' = 19#0 11!' 19#0 1#. !*; 1'0

= =

7d8 9es. Bond B no+ has the higher yield to maturity. his is because the 1100 discount +ill be recovered over only t+o years. 2ith Bond 4, there is a 1200 discount, but a 10Ayear recovery period.

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Pro#le, . 7a8 1B of 11,000 for" n : 20, i : 11;, 1BI- : .12#

11,000 ( .12# 1 12#

7b8 1B of 11,000 for"

n : 20,

i : 9;,

1BI- : .178

11,000 ( .178 1 178

7c8 1B of 11,000 for"

n : 20,

i : 1!;,

1BI- : .087

11,000 ( .087 1 87

Pro#le, / @ote" Cife of the asset is 1' years, not ' years. Dince one of the five criterias that is the length of the lease contract is 10 years and the economic life of the asset is 1' years, the arrangement constitutes a maEor part of the asset.s life, for compulsory treatment as a capital lease is indicatedF the transaction must be treated as a capital lease. Pro#le, + 7a8 5etermine 10Ayear annuity that +ill yield 12;"
4 :
= =

1B4<1BI-4 7i : 12;, n : 108 1900,000 '.*'0 11'9,292

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7b8

he 10; deduction reduces the net cost to 1810,000.


Hriginal cost 10; @et cost 4nnual lease payment
= =

1900,000 90,000 1810,000 1810,000 '.*'0 11#!,!*2.80

Pro#le, 0 Dince the dividends gro+ at 9.8 percent, the ne(t three annual dividends +ill be"
51 : 11.*8 71.0988 : 11.8# 52 : 11.8# 71.0988 : 12.0! 5! : 12.0!71.0988 : 12.22

5iscounting these cash flo+s results in a value of"


1o =
= =

11.8# 1 = 0.1!' +

12.0! 71 = 0.1!'8 2

12.22 = 172 71 = 0.1!'8 !

11.*! = 11.'8 = 1'0.7* 1'!.9*

4t the current 1'# per share price, the e&uity share does not appear undervalued. It appears fairly valued. Pro#le, 1 It is not initially clear +hether this +ill be good or bad ne+s for the e&uity share price. 4 rise in the gro+th rate increases the e&uity share.s value. But a higher re&uired return lo+ers the value. he t+o changes some+hat offset one another. Dince the current 170 e&uity share price is fair, investors re&uire a return of 11.' percent 71.7' G 70 = 0.098 before the announcement. 4fter the announcement, investors +ill re&uire a 12.7 percent return 70.11' = 0.0128 and e(pect a 10 percent gro+th rate. herefore, the ne+ e&uity share price should be 1*#.81 per share, a decline of 1'.19 7> 7.# percent8.

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Sources of Long-term Financing 1o =


=

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11.7' 0.127 > 0.10 1*#.81

his +as bad ne+s for the e&uity share price. Pro#le, 2 -ounder.s family votes : Dhared o+ned ( 10 : '1,!2' 7108 : '1!,2'0 6lass B votes : otal votes ? -ounder.s family shares

: 1,200,000 ? '1,!2' : 1,1#8,*7'


-ounder.s family votes 6lass B votes : : '1!,2'0 1,1#8,*7' ##.*8;

Pro#le, 3 7a8 reasury bonds : 9; 71 > .!'8 : 9; 7.*'8 : '.8'; 7b8 6orporate bonds : 12; 71 > .!'8 : 12; 7.*'8 : 7.80; 7c8 1referred share : 5ividends reserved by a corporation from another corporation is not ta(able in the 1hilippines. he yield is therefore 10; also.

he preferred share should be selected because it provides the highest afterA ta( return.
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Pro#le, -4 7a8 1referred share 5ividend yield 5ividend 4fterAta( income 7b8 Coan Interest e(pense Interest ( 71 ? 8 4fterAta( borro+ing cost 1100,000 8; 18,000 18,000 1100,000 10; 1 10,000 **; 1 *,*00

7c8 9es, the afterAta( income e(ceeds the afterAta( borro+ing cost. Hf course, other factors may be considered as +ell. Pro#le, -5ividend 4fterAta( income Interest ( 71 ? 8 4fterAta( borro+ing cost 18,000 18,000 1 10,000 8'; 1 8,'00

@o, the afterAta( income is no+ less than the afterAta( borro+ing. Pro#le, -* he annual interest payment of 11#0 is computed by multiplying the coupon rate of 1# percent by the 11,000 par value of the bond. Pro#le, -. he bond +ill sell at a premium because the re&uired rate of return is less than the bond.s coupon rate. hus, investors are +illing to pay more for this bond because it pays more interest than ne+ly issued bonds +ith similar characteristics.

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Pro#le, -/ 7a8 Bond 9 should have the greater price sensitivity to a change in the re&uired rate of return because of its longer maturity. hat is, the present value of future cash flo+s is more affected by changes in discount rates than less distant cash flo+s. 7b8 he intrinsic value of each bond is as follo+s" -or Bond I, +hen I : 180, )d : 9 percent, and n : ' 1o : 71808 7!.8908 = 711,0008 70.*'08 : 1!11.20 = 1*'0 : 19*1.20 -or Bond 9, +hen I : 180, )d : 9 percent, and n : 1' 1o : 71808 78.0*08 = 711,0008 70.27'8 : 1*##.80 = 127' : 1919.80 7c8 3ach bond sold for its par value of 11,000 before the change in the re&uired rate of return. Bond 9 +ould decline in value by 180.20 711,000 ? 1919.808 compared to a 1!8.80 711,000 ? 19*1.208 decline for Bond I. Pro#le, -+ he re&uired rate of return is"
1o = 5p )p 5p 1o 1*.7' 17'.2' 8.97; 25-9

Dolve for )p"


)p
=

= =

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Pro#le, -0 Dubstituting 5p : 12.*0 and )s : 0.1!, the current value is"


1o =
=

12.*0 0.1! 120.00

Pro#le, -1 Jsing the /ordon constant gro+th dividend model, the current value of a share of Keth Industries is" 7a8 -or 51 : 11.!2 711.20 ( 1.108, )s : 0.1', and g : 0.10
1o =
=

11.!2 0.1' ? 0.10 12*.#0

7b8 -or 51 : 11.!0 711.20 ( 1.08'8, )s : 0.1', and g : 0.08'


1o =
=

11.!0 0.1' ? 0.08' 120.00

7c8 -or 51 : 11.!' 711.20 ( 1.12'8, )s : 0.1', and g : 0.12'


1o =
=

11.!' 0.1' ? 0.12' 1'#.00

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