CHAPTER 31 CASE  C­33  

And the value today is:

PVConservation = –$169,509.87/(1 + .0659)35
PVConservation = –$17,950.88

So, the NPV of a 55-year harvest schedule is:

NPV = $2,403,388 + 202,995.97 + 97,575.62 – 17,950.88

NPV = $2,686,008.85

The company should use a 40-year harvest schedule since it has the highest NPV. Notice that when
the NPV began to decline, it continued declining. This is expected since the growth in the trees
increases at a decreasing rate. So, once we reach a point where the increased growth cannot
overcome the increased effects of compounding, harvesting should take place. There is no point
further in the future which will provide a higher NPV.

CHAPTER 8
FINANCING EAST COAST YACHT’S
EXPANSION PLANS WITH A BOND
ISSUE
1. A rule of thumb with bond provisions is to determine who the provisions benefit. If the
company benefits, the bond will have a higher coupon rate. If the bondholders benefit, the bond
will have a lower coupon rate.

a. A bond with collateral will have a lower coupon rate. Bondholders have the claim on the
collateral, even in bankruptcy. Collateral provides an asset that bondholders can claim, which
lowers their risk in default. The downside of collateral is that the company generally cannot sell
the asset used as collateral, and they will generally have to keep the asset in good working
order.

b. The more senior the bond is, the lower the coupon rate. Senior bonds get full payment in
bankruptcy proceedings before subordinated bonds receive any payment. A potential problem
may arise in that the bond covenant may restrict the company from issuing any future bonds
senior to the current bonds.

c. A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. The
problem with a sinking fund is that the company must make the interim payments into a sinking
fund or face default. This means the company must be able to generate these cash flows.
 d. A provision with a specific call date and prices would increase the coupon rate. The call
provision would only be used when it is to the company’s advantage, thus the bondholder’s
disadvantage. The downside is the higher coupon rate. The company benefits by being able to
refinance at a lower rate if interest rates fall significantly, that is, enough to offset the call
provision cost.

e. A deferred call would reduce the coupon rate relative to a call provision without a deferred call.
The bond will still have a higher rate relative to a plain vanilla bond. The deferred call means
that the company cannot call the bond for a specified period. This offers the bondholders
protection for this period. The disadvantage of a deferred call is that the company cannot call
the bond during the call protection period. Interest rates could potentially fall to the point where
it would be beneficial for the company to call the bond, yet the company is unable to do so.

f. A make-whole call provision should lower the coupon rate in comparison to a call provision
with specific dates since the make-whole call repays the bondholder the present value of the
future cash flows. However, a make-whole call provision should not affect the coupon rate in
comparison to a plain vanilla bond. Since the bondholders are made whole, they should be
indifferent between a plain vanilla bond and a make-whole bond. If a bond with a make-whole
provision is called, bondholders receive the market value of the bond, which they can reinvest
in another bond with similar characteristics. If we compare this to a bond with a specific call
price, investors rarely receive the full market value of the future cash flows.

g. A positive covenant would reduce the coupon rate. The presence of positive covenants protects
bondholders by forcing the company to undertake actions that benefit bondholders. Examples
of positive covenants would be: the company must maintain audited financial statements; the
company must maintain a minimum specified level of working capital or a minimum specified
current ratio; the company must maintain any collateral in good working order. The negative
side of positive covenants is that the company is restricted in its actions. The positive covenant
may force the company into actions in the future that it would rather not undertake.

h. A negative covenant would reduce the coupon rate. The presence of negative covenants protects
bondholders from actions by the company that would harm the bondholders. Remember, the
goal of a corporation is to maximize shareholder wealth. This says nothing about bondholders.
Examples of negative covenants would be: the company cannot increase dividends, or at least
increase beyond a specified level; the company cannot issue new bonds senior to the current
bond issue; the company cannot sell any collateral. The downside of negative covenants is the
restriction of the company’s actions.

i. Even though the company is not public, a conversion feature would likely lower the coupon
rate. The conversion feature would permit bondholders to benefit if the company does well and
also goes public. The downside is that the company may be selling equity at a discounted price.

j. The downside of a floating rate coupon is that if interest rates rise, the company has to pay a
higher interest rate. However, if interest rates fall, the company pays a lower interest rate.

2. Since the coupon bonds will have a coupon rate equal to the YTM, they will sell at par. So, the
number of coupon bonds to sell will be: (NOTE: The text has a typo. The coupon rate on the coupon
bonds should be 7.5 percent.)

Coupon bonds to sell = $50,000,000 / $1,000 = 50,000

 CHAPTER 31 CASE  C­35  

The price of the 20-year, zero coupon bond when it is issued will be:

Zero coupon price = $1,000 / 1.037540 = $229.34

So, the number of zero coupon bonds the company will need to sell is:

Zero coupon bonds to sell = $50,000,000 / $229.34 = 218,016

3. At maturity, the principal payment for the coupon bonds will be:

Coupon bond principal payment at maturity = 50,000($1,000) = $50,000,000

The principal payment for the zero coupon bonds at maturity will be:

Zero coupon bond payment at maturity = 218,016($1,000) = $218,016,000

4. One of the main considerations is timing of the cash flows. The annual coupon payment on the
coupon bonds will be:

Annual coupon bond payments = 50,000($1,000)(.065) = $3,250,000

Since the interest payments are tax deductible, the aftertax cash flow from the interest payments will
be:

Aftertax coupon payments = $3,250,000(1 – .35) = $2,112,500

Even though interest payments are not actually made each year, the implied interest on the zero
coupon bonds is tax deductible. The value of the zero coupon bonds next year will be:

Value of zero in one year = $1,000/1.037538 = $246.86

So, the growth on the zero coupon bond was:

Zero coupon growth = $246.86 – 229.34 = $17.52

This increase in value is tax deductible, so it reduces taxes even though there is no cash flow for
interest payments. So, there is a positive cash flow created next year in the amount of:

Zero cash flow = 218,016($17.52)(.35) = $1,336,929.23

This cash flow will increase each year since the value of the zero coupon bond will increase by a
greater dollar amount each year.

5. If the Treasury rate is 4.80 percent, the make-whole call price in 7 years is:

P = $37.50({1 – [1/(1 + .026)]26 } / .026) + $1,000[1 / (1 + .026)26]

P = $1,215.38

And, if the Treasury rate is 8.20 percent, the make-whole call price in 7 years is:

P = $37.50({1 – [1/(1 + .043)]26 } / .043) + $1,000[1 / (1 + .043)26]

P = $914.90

6. The investor is not necessarily made whole with the make-whole call provision, but is made close to
whole. Assume a company issues a bond with a make-whole call of the Treasury rate plus .5 percent.
Further assume this is the correct average spread for the company’s bond over the life of the bond.
Although the spread is correct on average, it is not correct at every specific time. The spread over the
Treasury rate varies over the life of the bond, and is higher when the bond has a longer time to
maturity. To see this, consider, at the extreme, the spread for any bond above the Treasury yield at
maturity is zero. So, if the bond is called early in its life, the spread above the Treasury is likely to be
too low. This means the investor is more than made whole. If the bond is called late in its life, the
spread is too high. This means the interest rate used to calculate the present value of the cash flows is
too high, which results in a lower present value. Thus, the bondholder is made less than whole. In
practical terms, this difference is likely to be small, and it will almost always result in a higher price
paid to the bondholder when compared to a traditional call feature.
 CHAPTER 31 CASE  C­37  

7. There is no definitive answer to which type of bond the company should issue. If the intermediate
cash flows for the coupon payments will be difficult, a zero coupon bond is likely to be the best
solution. However, the zero coupon bond will require a larger payment at maturity.

As for the type of call provision, a make-whole call provision is generally better for bondholders,
therefore the coupon rate of the bond will likely be lower to sell the bond at par value. Again, there is
a tradeoff.

CHAPTER 9
STOCK VALUATION AT RAGAN THERMAL
SYSTEMS
1. The total dividends paid by the company were $640,000. Since there are 300,000 shares outstanding, the
total earnings for the company were:

Total earnings = 300,000($5.35) = $1,605,000

This means the payout ratio was:

Payout ratio = $640,000/$1,605,000 = .3988, or 39.88%

So, the retention ratio was:

Retention ratio = 1 – .3988 = .6012, or 60.12%

Using the retention ratio, the company’s growth rate is:

g = ROE × b = .21(.6012) = .1263, or 12.63%

Now we can value the company using the entire dividend payment. The total value of the company’s
equity under these assumptions is:

Total equity value = D1 / (R – g)

Total equity value = $640,000(1.1263) / (.18 – .1263)
Total equity value = $13,413,286.96

So, the value per share is:

Value per share = $13,413,286.96 / 300,000

Value per share = $44.71

2. Since Nautilus Marine Engines had a write off which affected its earnings per share, we need to
recalculate the industry EPS. So, the industry EPS is: