Problem 83.

For each of the following situations, the present value concept

should be applied:
1. Your wealthy aunt has just established a trust fund for you that will
accumulate to a total of $100,000 in 1 years. !nterest on the trust fund is
compounded annually at an " percent interest rate. #ow much is in your trust fund
today$
. %n &anuary 1, you will purchase a new car. 'he automobile dealer will
allow you to ma(e increasing annual )ecember *1 payments over the following
four years. 'he amounts of these payments are $+,000, $+,-00, $-,000, $.,000. %n
this same &anuary 1, your mother will lend you just enough money to enable you to
meet these payments. !nterest rates are e/pected to be " percent for the ne/t five
years. 0ssuming that you can earn annual compounding interest by depositing the
loan from your mother in a ban(, what is the minimum amount your mother must
loan you to enable you to meet the car payments$
*. !n settlement of a claim for your recently wrec(ed car, your insurance
company will pay you either a lump sum today or three annual payments of $*,100
starting one year from now. !nterest rates are e/pected to be . percent for the ne/t
five years. 1hat is the least amount of money that you should be willing to accept
today$
+. 1hat is the present value of $*,000 a year to be received in years *
through 11, assuming a 1 percent discount rate$
Problem 87. )uring the year, 2hor 3ompany issued several series of bonds. For
each bond, record the journal entry that must be made upon the issuance date. 45ound
to the nearest dollar, a calculator is needed for and *.6
1. %n 7arch 1-, a 08year, $-,000 par value bond series with annual interest
of 9 percent was issued. 'hree thousand of these bonds were issued at a price of 9".
!nterest is paid semiannually.
. %n &anuary 0, a series of 1-8year, $1,000 par value bonds with annual
interest of " percent was issued at a price giving a current yield to maturity of ..-
percent. !ssuance costs for the :,000 bonds issued were $-0,000. !nterest is paid
annually.
*. %n %ctober *1, a 108year, $1,000 par value bond series with annual
interest of : percent was issued at a price to give a current yield to maturity of "
percent. !nterest on the -,000 bonds issued is paid semiannually.
Problem 95. 'he %wner;s <=uity section of the balance sheet of %vlov
3orporation on )ecember *1, 009, was as follows:
'he board of directors too( the following actions:
)ecember *1, 010:
1. 0 8for81 stoc( split of common stoc( was declared.
. 1,000 shares of its outstanding preferred stoc( were purchased by %vlov
at $11+ per share.
&anuary 1, 011:
1. 'he preferred dividend of $".00 was declared.
. 0 cash dividend of $.1- a share on common stoc( outstanding on &anuary
1 was declared.
*. 0 stoc( dividend of of a share was declared on common stoc(,
effective February 1.
February 1, 011: 'he dividends declared in &anuary were paid.
Required:
>repare journal entries to record the transactions.
Case 92: Innovative Engineering Company*
!nnovative <ngineering 3ompany was founded by two partners, 7eredith ?ale and 2helley
Yeaton, shortly after they had graduated from engineering school. 1ithin five years, the
partners had built a thriving business, primarily through the development of a product line
of measuring instruments based on the laser principle. 2uccess brought with it the need for
new permanent capital. 0fter careful calculation, the partners placed the amount of this
need at $1. million. 'his would replace a term loan that was about to mature and provide
for plant e/pansion and related wor(ing capital.
0t first, they sought a wealthy investor, or group of investors, who would provide the $1.
million in return for an interest in the partnership. 'hey soon discovered, however, that
although some investors were interested in participating in new ventures, none of them was
willing to participate as partner in an industrial company because of the ris(s to their
personal fortunes that were inherent in such an arrangement. ?ale and Yeaton therefore
planned to incorporate the !nnovative <ngineering 3ompany, in which they would own all
the stoc(.
0fter further investigation, they learned that 0rbor 3apital 3orporation, a venture capital
firm, might be interested in providing permanent financing. !n thin(ing about what they
should propose to 0rbor, their first idea was that 0rbor would be as(ed to provide $1.
million, of which $1.1 million would be a long8term loan. For the other $100,000, 0rbor
would receive 10 percent of the !nnovative common stoc( as a @sweetener.A !f 0rbor would
pay $100,000 for 10 percent of the stoc(, this would mean that the 90 percent that would be
owned by ?ale and Yeaton would have a value of $900,000. 0lthough this was
considerably higher than !nnovative;s net assets, they thought that this amount was
appropriate in view of the profitability of the product line that they had successfully
developed.
0 little calculation convinced them, however, that this idea 4hereafter, proposal 06 was too
ris(y. 'he resulting ratio of debt to e=uity would be greater than 100 percent, which was
considered unsound for an industrial company.
'heir ne/t idea was to change the debtBe=uity ratio by using preferred stoc( in lieu of most
of the debt. 2pecifically, they thought of a pac(age consisting of $00,000 debt, $900,000
preferred stoc(, and $100,000 common stoc( 4proposal C6. 'hey learned, however, that
0rbor 3apital 3orporation was not interested in accepting preferred stoc(, even at a
dividend that e/ceeded the interest rate on debt. 'hereupon, they approached 0rbor with a
proposal of $.00,000 debt and $.00,000 e=uity 4proposal 36. For the $.00,000 e=uity,
0rbor would receive 4i.e., +0 percent6 of the common stoc(.
'he 0rbor representative was considerably interested in the company and its prospects but
e/plained that 0rbor ordinarily did not participate in a major financing of a relatively new
company unless it obtained at least -0 percent e=uity as part of the deal. 'hey were
interested only in a proposal for $*00,000 debt and $900,000 for half of the e=uity
4proposal )6. 'he debtBe=uity ratio in this proposal was attractive, but ?ale and Yeaton
were not happy about sharing control of the company e=ually with an outside party.
Cefore proceeding further, they decided to see if they could locate another venture capital
investor who might be interested in one of the other proposals. !n calculating the
implications of these proposals, ?ale and Yeaton assumed an interest cost of debt of "
percent, which seemed to be the rate for companies similar to !nnovative, and a dividend
rate for preferred stoc( of 10 percent. 'hey assumed, as a best guess, that !nnovative would
earn $*00,000 a year after income ta/es on operating income but before interest costs and
the ta/ savings thereon. 'hey included their own common stoc( e=uity at $900,000.
'hey also made pessimistic calculations based on income of $100,000 4instead of
$*00,0006 per year and optimistic calculations based on income of $-00,000 a year. 'hey
realiDed, of course, that the $100,000 pessimistic calculations were not necessarily the
minimum amount of income, it was possible that the company would lose money. %n the
other hand, $-00,000 was about the ma/imum amount of income that could be e/pected
with the plant that could be financed with the $1. million. 'he applicable income ta/ rate
was *+ percent.
Euestions
1. For each of the four proposals, calculate the return on common shareholders;
e=uity 4net income after preferred dividends F common shareholders; e=uity6 that
would be earned under each of the three income assumptions. 5ound calculations to
the nearest $1,000 and percent.
. 3alculate the preta/ earnings and return on its $1. million investment to 0rbor
3apital 3orporation under each of the four proposals. 0ssume that 0rbor receives a
dividend e=ual to its portion of common stoc( ownership times !nnovative;s net
income after preferred dividends 4if any6, assume a @negative dividendA if !nnovative
has a net loss.
*. 1ere the partners correct in rejecting proposals 0 and C$
+. 3omment on the li(elihood that !nnovative <ngineering 3ompany could find a
more attractive financing proposal than proposal ).