Meng 85176800

Yanru Meng

85176800

Econ 134A

Jan 11 2016

Question:
1-2 Why is it important for business students to study finance even if the topic is not
their major?
The reason why students need to study finance is the finance is related to money and it can help
people to earn more money after they take the finance course. When people need to find a job
which is related to the economics or finance, studying finance can make them more competitive and
they will do better job. Being able to analyze data and know about the market can help workers and
managers make better decisions.

1-3 How can knowledge of financial decision making by corporate financial

managers help you make personal financial decisions?
The financial managers can help you to find a better way to raise funds and make an investment. It
can help you to better decide which investment to choose and the techniques they use are pretty
similar to you. As a result, you might get some suggestions from them about investment.

1-5 In general, how is value measured? What general factors determine value?
How does each factor affect value?
The value is measured based on the cash flow of the asset which is expected to generate during its
life. The amount, the timing of the cash flow and r determine the value.
The amount of cash flow increases—the rate to return decreases—the value of investment increases.

2-1 In what respect is preferred stock similar to bonds, and in what respect is it
similar
to common stock?
Preferred stock is between bonds and common stock. When it is used to pay fixed dividends, it likes
a bond but it takes lower precedence. When the interest rates rise, the bonds and preferred stocks
price will fall.
Both of preferred stock and common stock give stockholders partial ownership in the company. The
company can buy the stock back at any time so it can not make the company become bankrupt.

2-2 Explain the following statement: “Whereas a bond contains a promise to pay
interest, common stock provides an expectation but no promise of dividends.”
“Whereas a bond contains a promise to pay interest” means that the firm will get the interest after
they purchase the bond because the bond is an instrument of the bond issuer to raise money and
they pay the holders with the interests.
“Common stock provides an expectation but no promise of dividends” tells that there is no contract
issued to promise that the common stock holders will get dividends.
When the firm purchase the bond, they will have a bond contract. However, there is no legal
contract for purchasing common stock.
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2-5 Rank the following securities from lowest (1) to highest (8) in terms of their
riskiness
for an investor. All securities (except the Treasury bond) are for a given
firm. If you think two or more securities are equally risky, indicate so.
1. U.S. Treasury bond
2. First mortgage bond—with sinking fund
3. First mortgage bond—no sinking fund
4. Term loan
5. Subordinated debentures—noncallable
6. Subordinated debentures—callable
7. Income bond
8. Common stock

2-6 A sinking fund can be set up in one of two ways:

(1) The corporation makes annual payments to the trustee, who invests the proceeds
in securities (frequently government bonds) and uses the accumulated
total to retire the bond issue at maturity.
The advantage: If the interest rate will not fall, the trustee will be favor to keep the bonds from the
corporation because they will have higher profits.
The disadvantage: If the interest rate might fall, firms will prefer to keep the bonds from the
government because it is much safer to buy the bonds from the government.

(2) The trustee uses the annual payments to retire a portion of the issue each
year, either by calling a given percentage of the issue through a lottery and paying a
specified price per bond or by buying bonds on the open market,
whichever is cheaper.
Discuss the advantages and disadvantages of each procedure from the viewpoint
of both the firm and its bondholders.
The advantage: The bondholders will keep their bonds when the stock price gets higher and the
company will not call the bond. Instead, the firm might buy the bonds from the open market
The disadvantage: Each shareholder will have a limited amount of cash be given from the
liquidation of the sinking fund. Firm might go into default and it will cost longer time.

2-10 Evaluate the following statement: “Issuing convertible securities represents a

means
by which a firm can sell common stock at a price above the existing market price.”
When the price of the common stock stays low, the firms will be depressed and they will consider
about purchasing the convertible securities. The firm who purchasing for convertible securities
believes that the price will rise again and it will above the existing market price so that they will
make profits from it.

Problem
2-1 The Swift Company is planning to finance an expansion. The principal executives
of the company agree that an industrial company such as theirs should finance
growth by issuing common stock rather than by taking on additional debt.
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Because they believe that the current price of Swift’s common stock does not
reflect its true worth, however, they have decided to sell convertible bonds. Each
convertible bond has a face value equal to $1,000 and can be converted into
25 shares of common stock.
a. What would be the minimum price of the stock that would make it beneficial for
bondholders to convert their bonds? Ignore the effects of taxes or other costs.
$1,000 / 25 = $40
So, the minimum price of the stock that would make it beneficial for bondholders to convert their
bonds is $40 per share.

b. What would be the benefits of including a call provision with these bonds?
The benefits for the call provision is the firm can choose be bondholders or stockholders. When the
stock price is higher enough and it is more than the call price of the bond, the firm can convert to be
the stockholders and hold the common stock.

2-2 Four years ago, Ideal Solutions issued convertible preferred stock with a par
value
of $50 and a stated dividend of 8 percent. Each share of preferred stock can be
converted to four shares of common stock at the option of the investor. When
issued, the preferred stock was sold at par value such that Ideal raised $2.5 million
to fund expansion of its operations.
a. What is the annual dividend per share on the preferred stock?
$50*0.08= $4
The annual dividend is $4.

b. What is the conversion price of the preferred stock? When should an investor
consider converting into common stock? (Ignore taxes and other costs that
might be associated with conversion.)
$50 / $4 = $12.5
The conversion price is $12.5. The investor should consider converting into common stock when
the price is over $12.5.

c. If all investors convert their preferred stock to common stock, how many
new shares of common stock will Ideal have outstanding?
preferred stock $2.5million / $50 = 50,000 shares
new common stock 50000 * 4 = 200,000 shares

2-3 Filkins FarmEquipment needs to raise $4.5 million for expansion, and it expects
that
five-year zero coupon bonds can be sold at a price of $567.44 for each $1,000 bond.
a. How many $1,000 par value, zero coupon bonds would Filkins have to sell
to raise the needed $4.5 million?
$4.5 million / $567.44 = 7930.35
so Filkins should sell 7931 bonds.

b. What will be the burden of this bond issue on the future cash flows generated
by Filkins? What will be the annual debt service costs?
The burden of this bond issue on the future cash flow is $4.5 million. The annual debt service cost
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is 0 since it is a zero coupon bond.

2-4 Suppose you own a call option that permits you to purchase 100 shares of the
stock of Silicon Graphics for $15 per share any time during the next three
months. Silicon Graphics has a current market price of $12 per share.
a. Should you exercise the option and purchase the stock if its price increases to
$18? What would be your gain (loss) if you exercised the option and then
immediately sold the stock?
100*($18 - $15) = $300
Yes, I should exercise the option and purchase the stock if its price increases to $18. I will gain
$300.

b. Should you exercise the option and purchase the stock if its price increases to
$13? What would be your gain (loss) if you exercised the option and then
immediately sold the stock?
100*($13 - $15) = $-200
No, I shouldn’t exercise the option and purchase the stock. The loss that I will have is about $200.

c. Would your answer to part (b) change if the option were a put rather than a
call? Remember, a put gives you the right to sell stock at a predetermined price.
Yes, the answer to (b) would change if the option were a put.
I would gain ($15 - $13) * 100 = $200.