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Finma

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- INTERMEDIATE FINANCIAL MANAGEMENT
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A. Given the following information, calculate the weighted average cost of capital for the Holy

Corporation:

Percent of Capital Structure:

Preference shares 10%

Ordinary equity 60%

Debt 30%

Additional information:

Corporate Tax rate 34%

Dividend, preference P9.00

Dividend, expected, ordinary P3.50

Price, preference P102.00

Growth rate 6%

Bond yield 10%

Flotation cost, preference P3.20

Price, Ordinary P70.00

B. Compute the cost for the following sources of long term financing:

a. A P1,000 par value bond with a market price of P970 and a coupon interest rate of

10 percent. Flotation costs for a new issue would be approximately 5 percent. The

bonds mature in ten years and the corporate tax rate is 34 percent.

b. A preference share selling for P100 with annual dividend payment of P8. If the

company sells a new issue, the flotation cost will be P9 percent. The companys

marginal tax rate is 30 percent.

c. Internal ordinary equity where the current market price of the ordinary share is P38.

The expected dividend this coming year should be P3, increasing thereafter at a 4

percent annual growth rate. The corporate tax rate is 34 percent.

d. New ordinary share where the most recent dividend was P2.80. The companys

dividend per share should continue to increase at an 8 percent growth rate into the

indefinite future. The market price of the ordinary share is currently P53; however,

flotation costs of P6 per share are expected if the new stock is issued.

C. Happy Gilmore Co. is trying to calculate its cost of capital for use in capital budgeting decisions.

Mr. Shooter, the vice president for finance, has given you the following information and has

asked you to compute the weighted average cost of capital.

The company currently has outstanding bond with an 11.2 percent coupon rate and another

bond with a 7.5 percent rate. The firm has been informed by its investment banker that the

bonds of equal risk and credit ratings are now selling to yield 12.4 percent.

The ordinary share has a price of P54 and an expected dividend of P2.70 per share. The firms

historical growth rate of earnings and dividends per share has been 14.5 percent, but security

analysts expect this growth rate to slow to 12 percent in future years.

The preference share is selling at P50 per share and carries a dividend of P4.75 per share. The

corporate tax rate is 35 percent. The flotation cost is 2.8 percent of the selling price for

preference share. The optimum capital structure for the firm seems to be 35 percent debt, 10

percent preference shares, and 55 percent ordinary equity in the form of retained earnings.

Required: Compute the cost of capital for the individual components in the capital

structure and then calculate the weighted average cost of capital.

The companys cost of capital structure is 70 percent equity, and 30 percent debt.

The yield to maturity on the companys bonds is 9 percent.

The companys year-end dividend is forecasted to be $0.80

The company expects that its dividend will grow at a constant rate of 9 percent a year.

The companys stock price is $25.

The companys tax rate is 40 percent.

The company anticipates that it will need to raise new common stock this year. Its

investment bankers anticipate that the total flotation cost will equal 10 percent of the

amount issued. Assume the company accounts for flotation costs by adjusting the cost

of capital.

E. Jefferson Corp. requires a $15 million to fund its current year capital projects. Jefferson will

finance part of its needs with $9 million in internally generated funds. The firms common

stock market price is $120 per share. The firms last dividend was $5 per share and is

expected to grow at a rate of 11 percent annually for the foreseeable future. Another portion

of the required funds will come from the issue of 9,375 shares of 12 percent $100 par

preferred stock that will be privately placed. The firm will net $96 per share form the sale

these shares. The remainder of the funding needs will be met with debt. Five thousand 10-

year $1,000 bonds with a coupon rate of 15 percent will be issued to net the firm $1,020 each.

Interest will be paid annually on the bonds.

Required: The firms tax rate is 30 percent. What is Jeffersons weighted average cost of capital?

F. Zenon Co. recently issued 10-year 12 3/4 percent coupon bonds at face value. Zenon's beta is

.62, its target debt/equity ratio is .60, and the tax rate is 34 percent. If the market risk

premium is 8 percent and the risk-free rate is 10 percent, estimate Zenon's weighted average

required return?

8% long-term debt due 1999 $ 2,000,000

8% cumulative preferred stock $ 2,000,000

Common stock $6,000,000

Beta of Argon stock 1.5

Tax rate 34%

Market rate of return 12%

Risk-free rate 6%

Market cost of debt 10%

H. Assume the risk-free rate is 8 percent, beta is 1.5, and the return on the market is 12

percent. The firm has a D/A ratio of .4. The cost of debt is 10 percent and the tax rate

is 34 percent.

What is the weighted average required return?

Debt $ 18,000,000

Equity $ 27,000,000

Total $ 45,000,000

Given KM of 15%, KRF of 8%, beta of 0.875, a before-tax cost of debt of 11%, and a tax

rate of 34%, calculate Druid's weighted average required return assuming that the firm

intends to use only retained earnings and debt?

Debt $ 2O,000,000

Equity $ 25,000,000

Tota l $ 45,000,000

Neon Corp.'s profit margin, payout ratio, and sales are expected to be 10%, 40%, and

$50 million respectively. If Neon does not wish to issue any new common stock, what

is the maximum amount of new capital that can be raised for investment projects?

K. CWF, Inc. had total earnings of $120,000 during the past year. The company pays out

60 percent of its earnings as dividends. CWF has determined that its optimal capital

structure is 40 percent debt and 60 percent equity. Given this information, how much

new capital (retained earnings plus new debt) can be raised before CWF is forced to

issue new common stock, assuming it stays at its target capital structure?

L. Zapata Enterprises is financed by two sources of funds: bonds and common stock. The

cost of capital for funds provided by bonds is ki, and ke is the cost of capital for equity

funds. The capital structure consists of B dollars worth of bonds and S dollars worth

of stock, where the amounts represent market values. Compute the overall weighted

average of cost of capital, ko.

M. Assume that B (in Problem L) is $3 million and S is $7 million. The bonds have a 14

percent yield to maturity, and the stock is expected to pay $500,000 in dividends this

year. The growth rate of dividends has been 11 percent and is expected to continue at

the same rate. Find the cost of capital if the corporation tax rate on income is 40

percent.

N. On January 1, 20X1, International Copy Machines (ICOM), one of the favorites of the

stock market, was priced at $300 per share. This price was based on an expected

dividend at the end of the year of $3 per share and an expected annual growth rate in

dividends of 20 percent into the future. By January 20X2, economic indicators have

turned down, and investors have revised their estimate for future dividend growth of

ICOM downward to 15 percent. What should be the price of the firms common stock

in January 20X2?

Assume the following:

a. A constant dividend growth valuation model is a reasonable representation

of the way the market values ICOM.

b. The firm does not change the risk complexion of its assets nor its financial

leverage.

c. The expected dividend at the end of 20X2 is $3.45 per share.

O. Far Stores has launched an expansion program that should result in the saturation

of the Bay Area marketing region of California in six years. As a result, the company is

predicting a growth in earnings of 12 percent for three years and 6 percent for the

fourth through sixth years, after which it expects constant earnings forever. The

company expects to increase its annual dividend per share, most recently $2, in

keeping with this growth pattern. Currently, the market price of the stock is $25 per

share. Estimate the companys cost of equity capital.

Q.The Manx Company was recently formed to manufacture a new product. It has the

following capital structure in market value terms:

Debentures $ 6,000,000

Preferred stock 2,000,000

Common stock (320,000 shares) 8,000,000

$16,000,000

The company has a marginal tax rate of 40 percent. A study of publicly held companies

in this line of business suggests that the required return on equity is about 17 percent.

(The CAPM approach was used to determine the required rate of return.) The Manx

Companys debt is currently yielding 13 percent, and its preferred stock is yielding 12

percent. Compute the firms present weighted average cost of capital.

R.The R-Bar-M Ranch in Montana would like a new mechanized barn, which will

require a $600,000 initial cash outlay. The barn is expected to provide after-tax annual

cash savings of $90,000 indefinitely (for practical purposes of computation, forever).

The ranch, which is incorporated and has a public market for its stock, has a weighted

average cost of capital of 14.5 percent. For this project, Mark O. Witz, the president,

intends to provide $200,000 from a new debt issue and another $200,000 from a new

issue of common stock. The balance of the financing would be provided internally by

retaining earnings.

The present value of the after-tax flotation costs on the debt issue amount to 2

percent of the total debt raised, whereas flotation costs on the new common stock

issue come to 15 percent of the issue. What is the net present value of the project

after allowance for flotation costs? Should the ranch invest in the new barn?

S. Cohn and Sitwell, Inc., is considering manufacturing special drill bits and other

equipment for oil rigs. The proposed project is currently regarded as complementary to

its other lines of business, and the company has certain expertise by virtue of its

having a large mechanical engineering staff. Because of the large outlays required to

get into the business, management is concerned that Cohn and Sitwell earn a proper

return. Since the new venture is believed to be sufficiently different from the

companys existing operations, management feels that a required rate of return other

than the companys present one should be employed.

The financial managers staff has identified several companies (with capital structures

similar to that of Cohn and Sitwell) engaged solely in the manufacture and sale of

oildrilling equipment whose common stocks are publicly traded. Over the last five

years, the median average beta for these companies has been 1.28. The staff believes

that 18 percent is a reasonable estimate of the average return on stocks in general

for the foreseeable future and that the risk-free rate will be around 12 percent. In

financing projects, Cohn and Sitwell uses 40 percent debt and 60 percent equity. The

after-tax cost of debt is 8 percent.

a. On the basis of this information, determine a required rate of return for the

project, using the CAPM approach.

b. Is the figure obtained likely to be a realistic estimate of the required rate of

return on the project?

Bonds - $5 million face value, 10% coupon, annual interest payment

Common stock - 2,000,000 shares outstanding

The following is considering a $10 million expansion program which can be financed in

the following ways:

Plan A Issue a $10 million in new bonds. The bonds would be sold at par

value and would have a 12% annual coupon.

Plan B Issue $10 million in new common shares at $40 per share.

The companys marginal tax rate is 40%. Next year, the expected EBIT is $4 million if

the expansion program is expected.

U. David Ding Baseball Bat Company currently has $3 million in debt outstanding,

bearing

an interest rate of 12 percent. It wishes to finance a $4 million expansion program and

is considering three alternatives: additional debt at 14 percent interest (option 1),

preferred stock with a 12 percent dividend (option 2), and the sale of common stock at

$16 per share (option 3). The company currently has 800,000 shares of common stock

outstanding and is in a 40 percent tax bracket.

a. If earnings before interest and taxes are currently $1.5 million, what would

be earnings per share for the three alternatives, assuming no immediate

increase in operating profit?

b. Develop a break-even, or indifference, chart for these alternatives. What are

the approximate indifference points? To check one of these points,

mathematically determine the indifference point between the debt plan and

the common stock plan. What are the horizontal axis intercepts?

c. Compute the degree of financial leverage (DFL) for each alternative at the

expected EBIT level of $1.5 million.

d. Which alternative do you prefer? How much would EBIT need to increase

before the next alternative would be better (in terms of EPS)?

structure. It can issue 16 percent debt or 15 percent preferred stock. The total

capitalization of the company will be $5 million, and common stock can be sold at $20

per share. The company is expected to have a 50 percent tax rate (federal plus state).

Four possible capital structures being considered are as follows:

PLAN DEB T PREFERRED EQUITY

1 0% 0% 100%

2 30 0 70

3 50 0 50

4 50 20 30

a. Construct an EBIT-EPS chart for the four plans. (EBIT is expected to be $1 million.)

Be sure to identify the relevant indifference points and determine the horizontal-axis

intercepts.

b. Using Eq. (16.12), verify the indifference point on your graph between plans 1 and

3 and between plans 3 and 4.

c. Compute the degree of financial leverage (DFL) for each alternative at an expected

EBIT level of $1 million.

d. Which plan is best? Why?

outstanding with a market price of $60 per share. It also has $2 million in 6 percent

bonds. The company is considering a $3 million expansion program that it can finance

with all common stock at $60 a share (option 1), straight bonds at 8 percent interest

(option 2), preferred stock at 7 percent (option 3), and half common stock at $60 per

share and half 8 percent bonds (option 4).

a. For an expected EBIT level of $1 million after the expansion program, calculate the

earnings per share for each of the alternative methods of financing. Assume a tax

rate of 50 percent.

What is your interpretation of them?

X. Hi-Grade Regulator Company (see Problem W) expects the EBIT level after the

expansion program to be $1 million, with a two-thirds probability that it will be

between $600,000 and $1,400,000.

a. Which financing alternative do you prefer? Why?

b. Suppose that the expected EBIT level were $1.5 million and that there is a two-

thirds probability that it would be between $1.3 million and $1.7 million. Which

financing alternative would you prefer? Why?

Y. Fazio Pump Corporation currently has 1.1 million shares of common stock

outstanding and $8 million in debt bearing an interest rate of 10 percent on average. It

is considering a $5 million expansion program financed with common stock at $20 per

share being realized (option 1), or debt at an interest rate of 11 percent (option 2), or

preferred stock with a 10 percent dividend rate (option 3). Earnings before interest and

taxes (EBIT) after the new funds are raised are expected to be $6 million, and the

companys tax rate is 35 percent.

a. Determine likely earnings per share after financing for each of the three

alternatives.

b. What would happen if EBIT were $3 million? $4 million? $8 million?

c. What would happen under the original conditions if the tax rate were 46 percent? If

the interest rate on new debt were 8 percent and the preferred stock dividend rate

were 7 percent? If the common could be sold for $40 per share?

Z.. Boehm-Gau Real Estate Speculators, Inc., and the Northern California Electric Utility

Company have the following EBIT and debt-servicing burden:

NORTHERN

BOEHM-GAU CALIFORNIA

Expected EBIT $5,000,000 $100,000,000

Annual interest 1,600,000 45,000,000

Annual principal payments on debt 2,000,000 35,000,000

The tax rate for Boehm-Gau is 40 percent, and for Northern California Electric Utility is

36 percent. Compute the interest coverage and the debt-service coverage ratios for the two

companies. With which company would you feel more comfortable if you were a lender? Why?

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