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. The bond agreement specifies basic items such as the par value, the
coupon rate, and the maturity date.
3. The priority claims are:
Preferred Senior Secured Senior Subordinated
Share Debt Debenture Debenture
Subordinated Junior Secured Senior Secured Preferred
Debenture Debt Debt Share
Ordinary Senior Junior Secured Ordinary Equity
Equity Share Debenture Debt Share

4. The method of “bond repayment” reduces debt and increases the amount
of ordinary equity share outstanding is called bond conversion.
5. The purpose of serial and sinking fund payments is to provide an orderly
procedure for the retirement of a debt obligation. To the extent bonds are
paid off over their life, there is less risk to the security holder.
6. The different bond yield terms may be defined as follows:
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 will equate future interest
payments and payment at maturity to a current market price.
7. The higher the rating on a bond, the lower the interest payment that will
be required to satisfy the bondholder.
8. Refer to pages 636 through 637.

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9. Capitalizing lease payments means computing the present value of future

lease payments and showing them as an asset and liability on the
statement of financial position.
10. Founders’ share may carry special voting rights that allow the original
founders to maintain voting privileges in excess of their proportionate
ownership.
11. The preemptive right provides current shareholders with a first option to
buy new shares. In this fashion, their voting right and claim to earnings
cannot be diluted without their consent.
12. The actual owners have the last claim to any and all funds that remain. If
the firm is profitable, this could represent a substantial amount. Thus, the
residual claim may represent a privilege as well as a potential drawback.
Generally, other providers of capital may only receive a fixed amount.
13. Preferred share is a “hybrid” or intermediate form of security possessing
some of the characteristics of debt and ordinary equity share. The fixed
amount provision is similar to debt, but the noncontractual obligation is
similar to ordinary equity share. Though the preferred shareholder does
not have an ownership interest in the firm, the priority of claim is higher
than that of the ordinary shareholder.
14. Most corporations that issue preferred share do so to achieve a balance in
their capital structure. It is a means of expanding the capital base of the
firm without diluting the ordinary equity share ownership position or
incurring contractual debt obligations.
15. Preferred share may offer a slightly lower yield than bonds in spite of
greater risk because corporate recipients of preferred share dividends
must add only 30 percent of such dividends to its taxable income. Thus,
70 percent of such dividends are exempt from taxation.
16. With the cumulative feature, if preferred share dividends are not paid in
any one year, they accumulate and must be paid in total before ordinary
equity shareholders can receive dividends. Even though preferred share
dividends are not a contractual obligation as is true of interest debt, the
cumulative feature tends to make corporations very aware of obligations
to preferred shareholders. Preferred shareholders may even receive new
securities for forgiveness of missed dividend payments.

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II. Multiple Choice Questions

1. A 4. B 7. B 10. D
2. B 5. C 8. A
3. D 6. C 9. B

III. Problems

Problem 1

(a) Coupon rate P90 interest

= P1,000 par

= 9%

(b) Current P90 interest

rate/yield = P820 market price

= 10.98%

Approximate Annual Interest Principal Payment – Price of the Bond

(c) Payment + Number of Years to Maturity
Yield =
to Maturity .6 (Price of the Bond) + .4 (Principal Payment)

P1,000 − P820
P90 + 5
=
.6 (P820) + .4 (P1,000)

P180
P90 + 5
=
P492 + P400

P90 + P36
=
P892
P126
= P892

= 14.13%

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Problem 2
Bond A Bond B
(a)
Current P80 interest Current P85 interest
rate/yield = P800 market price rate/yield = P900 market price

= 10% = 9.44%

(b) The bond that the investor should select is Bond A because it has a higher
current yield.

Approximate Annual Interest Principal Payment – Price of the Bond

(c) = Payment + Number of Years to Maturity
Yield
to Maturity .6 (Price of the Bond) + .4 (Principal Payment)

P1,000 − P900
P85 + 2
=
.6 (P900) + .4 (P1,000)

P100
P85 + 2
=
P540 + P400

P85 + P50
=
P940
P135
= P940

= 14. 36%

(d) Yes. Bond B now has the higher yield to maturity. This is because the P100
discount will be recovered over only two years. With Bond A, there is a P200
discount, but a 10-year recovery period.

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Problem 3

(a) PV of P1,000 for: n = 20, i = 11%, PVIF = .124

P1,000
x .124
P 124

(b) PV of P1,000 for: n = 20, i = 9%, PVIF = .178

P1,000
x .178
P 178

(c) PV of P1,000 for: n = 20, i = 13%, PVIF = .087

P1,000
x .087
P 87

Problem 4

Note:
Life of the asset is 15 years, not 5 years.

Since one of the five criterias that is the length of the lease contract is 10 years
and the economic life of the asset is 15 years, the arrangement constitutes a major
part of the asset’s life, for compulsory treatment as a capital lease is indicated;
the transaction must be treated as a capital lease.

Problem 5

(a) Determine 10-year annuity that will yield 12%:

A = PVA/PVIFA (i = 12%, n = 10)

P900,000
= 5.650

= P159,292

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(b) The 10% deduction reduces the net cost to P810,000.

Original cost P900,000
10% 90,000
Net cost P810,000

Annual lease P810,000

payment = 5.650

= P143,362.80

Problem 6

Since the dividends grow at 9.8 percent, the next three annual dividends will be:

D1 = P1.68 (1.098) D2 = P1.84 (1.098) D3 = P2.03(1.098)

= P1.84 = P2.03 = P2.22

Discounting these cash flows results in a value of:

P1.84 P2.03 P2.22 + P72

Po = 1 + 0.135 + (1 + 0.135) 2 + (1 + 0.135) 3

= P1.63 + P1.58 + P50.76

= P53.96

At the current P54 per share price, the equity share does not appear undervalued.
It appears fairly valued.

Problem 7

It is not initially clear whether this will be good or bad news for the equity share
price. A rise in the growth rate increases the equity share’s value. But a higher
required return lowers the value. The two changes somewhat offset one another.
Since the current P70 equity share price is fair, investors require a return of 11.5
percent (1.75 ÷ 70 + 0.09) before the announcement. After the announcement,
investors will require a 12.7 percent return (0.115 + 0.012) and expect a 10
percent growth rate. Therefore, the new equity share price should be P64.81 per
share, a decline of P5.19 (− 7.4 percent).

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Po = P1.75
0.127 − 0.10

= P64.81

This was bad news for the equity share price.

Problem 8

Founder’s family votes = Shared owned x 10

= 51,325 (10)
= 513,250

Class B votes = Total votes – Founder’s family shares

= 1,200,000 – 51,325
= 1,148,675

Founder’s family votes 513,250

Class B votes = 1,148,675

= 44.68%

Problem 9

(a) Treasury bonds = 9% (1 − .35)

= 9% (.65)
= 5.85%

(b) Corporate bonds = 12% (1 − .35)

= 12% (.65)
= 7.80%

(c) Preferred share = Dividends reserved by a corporation from another

corporation is not taxable in the Philippines. The
yield is therefore 10% also.
The preferred share should be selected because it provides the highest after-
tax return.

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Problem 10

(a) Preferred share P100,000

Dividend yield 8%
Dividend P8,000
After-tax income P8,000

(b) Loan P100,000

Interest expense 10%
Interest P 10,000
x (1 – T) 66%
After-tax borrowing cost P 6,600

(c) Yes, the after-tax income exceeds the after-tax borrowing cost. Of course,
other factors may be considered as well.

Problem 11

Dividend P8,000
After-tax income P8,000

Interest P 10,000
x (1 – T) 85%
After-tax borrowing cost P 8,500

No, the after-tax income is now less than the after-tax borrowing.

Problem 12

The annual interest payment of P140 is computed by multiplying the coupon rate
of 14 percent by the P1,000 par value of the bond.

Problem 13

The bond will sell at a premium because the required rate of return is less than
the bond’s coupon rate. Thus, investors are willing to pay more for this bond
because it pays more interest than newly issued bonds with similar
characteristics.

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Problem 14

(a) Bond Y should have the greater price sensitivity to a change in the required
rate of return because of its longer maturity. That is, the present value of
future cash flows is more affected by changes in discount rates than less
distant cash flows.

(b) The intrinsic value of each bond is as follows:

For Bond X, when I = P80, kd = 9 percent, and n = 5

Po = (P80) (3.890) + (P1,000) (0.650)

= P311.20 + P650
= P961.20

For Bond Y, when I = P80, kd = 9 percent, and n = 15

Po = (P80) (8.060) + (P1,000) (0.275)

= P644.80 + P275
= P919.80

(c) Each bond sold for its par value of P1,000 before the change in the required
rate of return. Bond Y would decline in value by P80.20 (P1,000 – P919.80)
compared to a P38.80 (P1,000 – P961.20) decline for Bond X.

Problem 15

The required rate of return is:

Dp
Po = kp

Solve for kp:

kp Dp
= Po

P6.75
= P75.25

= 8.97%

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Problem 16

Substituting Dp = P2.60 and ks = 0.13, the current value is:

P2.60
Po = 0.13

= P20.00

Problem 17

Using the Gordon constant growth dividend model, the current value of a share
of Zeth Industries is:

(a) For D1 = P1.32 (P1.20 x 1.10), ks = 0.15, and g = 0.10

P1.32
Po = 0.15 – 0.10

= P26.40

(b) For D1 = P1.30 (P1.20 x 1.085), ks = 0.15, and g = 0.085

P1.30
Po = 0.15 – 0.085

= P20.00

(c) For D1 = P1.35 (P1.20 x 1.125), ks = 0.15, and g = 0.125

P1.35
Po = 0.15 – 0.125

= P54.00

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