APPENDIX 2
FIN/571 – WEEK 5 HOMEWORK
Chapter 17
Problem 1
(Choosing financial targets) Bixton Company’s new chief financial officer is evaluating Bixton’s capital structure. She is concerned that the firm might be underleveraged, even though the firm has larger-than-average research and development and foreign tax credits when compared to other firms in its industry. Her staff prepared the industry comparison shown here.
a. Bixton’s objective is to achieve a credit standing that falls, in the words of the chief financial officer, “comfortably within the ‘A’ range.” What target range would you recommend for each of the three credit measures?
Answer:
To land comfortably within the ‘A’ range, the firm should better stay off the lower end of the ratings. i.e.
Fixed Charge Coverage: 4.30 – 5.20
Total Debt: 60 – 70%
Long-Term Debt / Total Capitalization: 26 – 32%
b. Before settling on these target ranges, what other factors should Bixton’s chief financial officer consider?
Answer:
The CFO Should firstly consider the firm’s ability to fully utilize the non-interest tax credits and debt management tactics. She should also take into account that the firm’s research and development is intangible asset and the firm may not be able to get loans on the same percentage of debt as its competitors
c. Before deciding whether the target ranges are really appropriate for Bixton in its current financial situation, what key issues specific to Bixton must the chief financial officer resolve?
Answer:
The CFO needs to consider R&D and foreign tax credits. The additional tax shield from additional debt may not have significant effects when R&D and foreign tax credits are taken into account.
FUNDS FROM
RATING
FIXED CHARGE
OPERATIONS/
LONG-TERM DEBT/
CATEGORY
COVERAGE
TOTAL DEBT
CAPITALIZATION
Aa
5.00–6.25x
70 / 85%
15–20%
A
4.00–5.20
50 / 70%
21–35
Baa
2.95–4.35
35 / 60%
29–38
Chapter. 18
Problem 2: (Dividend adjustment model) Regional Software has made a bundle selling spreadsheet software and has begun paying cash dividends. The firm’s chief financial officer would like the firm to distribute 24% of its annual earnings (POR = 0.24) and adjust the dividend rate to changes in earnings per share at the rate ADJ = 0.75. Regional paid $1.25 per share in dividends last year. It will earn at least $11.00 per share this year and each year in the foreseeable future.
Use the dividend adjustment model, Equation (18.1), to calculate projected dividends per share for this year and the next four.
Answer:
D1= ADJ [POR (EPS1) - D0] + D0
D1= 0.75 [0.24 x $11.00 - $1.25] + $1.25 = $2.29
D2= 0.75 [0.24 x $11.00 - $2.29] + $2.29 = $2.55
D3= 0.75 [0.24 x $11.00 - $2.55] + $2.55 = $2.62
D4= 0.75 [0.24 x $11.00 - $2.62] + $2.62 = $2.63
D5= 0.75 [0.24 x $11.00 - $2.63] + $2.63 = $2.637
Problem 3: (Dividend policy) A firm has 25 million common shares outstanding. It currently pays out $1.70 per share per year in cash dividends on its common stock. Historically, its payout ratio has ranged from 31% to 35%. Over the next five years it expects the earnings and discretionary cash flow shown below in millions.
a) Over the five-year period, what is the maximum overall payout ratio the firm could achieve without triggering a securities issue?
Answer:
Total discretionary cash flow = $49 + $69 + $65 + $27 + $29 = $239
Total earnings = $107 + $132 + $137 + $134 + $144 = $654
Maximum Payout Ratio = $239 / $654 = 36.54%
b) Recommend a reasonable dividend policy for paying out discretionary cash flow in years 1 through 5.
Answer:
Current dividend = $1.70 x 25 million shares = $42.5 million
The firm could gradually increase the dividend from $42.5million to $53 million.
D1 = $43 / 25 = $1.72
D2 = $45 / 25 = $1.8
D3 = $48 / 25 = $1.92
D4 = $50 / 25 = $2.00
D5 = $53 / 25 = $2.12
Note that $43 + $45 + $48 + $50 + $53 = $239, equals the total discretionary cash flow. This also indicates that there is zero probability of occurrence of any discretionary cash deficit.
1
2
3
4
5
THEREAFTER
Earnings
107
132
137
134
144
152+ per year
Discretionary cash flow
49
69
65
27
29
54+ per year
Chapter 20
Problem 4
(Comparing borrowing costs) Stephens Security has two financing alternatives:
(1) A publicly placed $80 million bond issue. Issuance costs are $1.2 million, the bond has a 7.5% coupon paid semiannually, and the bond has a 16-year life.
(2) An $80 million private placement with a large pension fund. Issuance costs are $400,000, the bond has a 6.75% annual coupon, and the bond has a 16-year life.
Which alternative has the lower cost (annual percentage yield)? Show how this is determined.
Answer:
Option 1.
n = 32
i = 7.5%
PV = - ($80,000,000 - $1,200,000) = -$78,800,000
PMT = 7.5% / 2 x $80,000,000 = $30000000
FV = $80,000,000
r = 3.85%
APY = (1 + 0.0385)2 -1 = 7.85%
(‘r’ calculated by hit and trial method
PV = PMT + )
Option 2.
n = 16
i = 6.75%
PV = - ($80,000,000 - $400,000) = -$49,500,000
PMT = 6.75% x $80,000,000 = $54, 00,000
FV = $80,000,000
r = 12.3%
APY = 12.3%
Option no 1, the publicity bond shows lower annual percentage yield, i.e. 7.85%
Chapter 21
Problem 5
(Leasing, taxes, and the time value of money) The lessor can claim the tax deductions associated with asset ownership and realize the leased asset’s residual value. In return, the lessor must pay tax on the rental income.
a. First, define the terms lease, lessor, and lessee and then explain the relationship between a lessor and a lessee?
Answer:
A rental agreement, whose tenure is for a year or more is called a Lease, this agreement may involve a series of fixed payments over the time. A lessor is the owner of the asset, whereas the user of the asset is called lessee.
A lease is just an extended rental contract. The owner of the equipment (the lessor) allows the user (the lessee) to operate the equipment in exchange of regular lease payments.
b. Next, list the principal advantages and principal disadvantages of lease financing? Which of the purported advantages are really of dubious value and why?
Answer:
Leasing offers a number of legitimate advantages, as for example, through a financial lease a firm can take more-efficient benefit of tax deductions and tax credits of ownership. The risk factors as well as cost of borrowing are reduced to a significant level. Leasing also offers opportunities to circumvent restrictive debt covenants or other restrictions.
There are two major disadvantages of lease financing, first, the lessee mislay the tax deductions associated with asset ownership. Second, the lessee cannot claim the residual value. Before opting for a leasing decision a lessee should take into account the cost of abandoning these benefits. Only then can he can be rational upon whether leasing is really cheaper than borrowing and buying.
Some dubious reasons of leasing could be,
a. It avoids capital expenditure controls
b. It preserves capital
c. Leasing may be done as off- balance sheet financing
d. It makes the balance sheet and income statement look better, since it increases the book income.
c. Explain why a dollar of lease financing displaces a dollar of conventional debt financing.
Answer:
When a firm borrows money, it pays the after tax rate on its debt. This is a hidden cost of leasing and the firm loses the tax shield. Surveys have shown that lease is substitute to debt rather than a compliment. Given below is a demonstration, picked from a lecture available on internet.
“In general, it could be assumed that every dollar of lease financing displaces
λ dollars of debt financing.
• If every dollar of lease financing exactly displaces $1 of debt financing, λ is one.
• If no debt is displaced because the firm could not have borrowed for some reason, then λ is zero.
• The appropriate discount rate is then
W ACC = λ(1 − tc )rD + (1 − λ)rE .
• Note that, when λ = 1, this is just the after-tax cost of debt that we used previously. Since this is usually what firm use, we keep using this rate in what follows.” (www.duke.edu)
d. Explain why a financial lease represents a secured loan in which the lender’s entire debt service stream is taxable as ordinary income to the lessor/lender.
Answer:
A lease is a form of secured debt. Each lease payment consists of two components, interest & principal repayment. As the lease payment is taxable as ordinary income to the lessor, as a consequence, the whole debt service stream becomes taxable as ordinary income.
e. In view of this tax cost, what tax condition must hold in order for a financial lease transaction to generate positive net-present-value tax benefits for both the lessor and lessee?
Answer:
The following Tax condition must hold for a financial transaction to generate positive NPV
tax benefit for both the lessor and the lessee.
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Principles of Corporate Finance. Richard A Brealey, Stewart C Myers, Franklin Allen, Pitabas Mohanty. (Tata McGraw-Hill Edition 2007)
Corporate Financial Management, Third Edition, by Douglas R.Emery, John D.Finnerty, and John D.Stowe.Published by Prentice Hall.Copyright ©2007 by Pearson Education, Inc.
