The University of Rochester Simon School of Business EXP482 ford W, Smith Corporate Financial Policy Fall 2014 Problem Set 2 Due Monday, November 17 by 9:00 a.m. e-mail (0: ceil. hook@simon.rochester.edu 1. The Browning Machine Tool Company currently has 100,000 common shares and $1,200,000 (face value) of debt outstanding, They are currently considering issuing an additional $800,000 worth of debt. The new debt would have the same seniority and maturity as the existing debt. The new debt, however, would be convertible, Holders of the new bonds could exchange each $1000 of face value for 100 new shares of the company. a, Graph the value of the new bonds as a function of the value of the firm at the maturity date of the bond issues. Label enough points to demonstrate that the graph is consistent with the specific numerical parameters in the problem. b, All other things equal, what will happen to the value of the convertible bonds if the variance of firm value increases unexpectedly’? Why? ¢. All other things equal, what will happen to the value of the convertible bonds ifthe risk- free rate of interest increases unexpectedly? Why? 4d, Suppose the new bonds were issued with a shorter time to maturity than the old bonds. How would this affect the value of both the old and the new bonds? Why? . Suppose the new bonds subordinated to the old bonds. How would this affect the value of both the old and the new bonds? Why? 2. Your boss tells you that the company is undertaking a $100 million pollution abatement project ‘She says that there are three sources of funds that are being considered: (1) Sell ordinary debt with 10% COUPON, (2) Sell “pollution control bonds” with a 6% coupon (the interest is tax exempt). (3) Sell common stock with a current dividend yield of 4%, a, Your boss says that one of the directors suggests equity, since it carries the lowest rate among the alternatives. What do you say” b, Another director argues that debt has a tax advantage over equity and that the interest tax shield from the ordinary bond will be greater than that of the pollution control bond. What do you say? 3. You have been retained by Merck’s CFO to determine target leverage. Before your initial meeting, you need to prepare a memo (no more than two-page) providing an overview of the methods you plan to employ. Including pretiminary data may be useful in making your methods more understandable, Page 1 of 1