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essentials corporate finance
Corporate Finance 4th Edition David Hillier - Solutions
9 Coupon Rate How would Sacyr Vallehermoso decide on an appropriate coupon rate to set on its bonds given that the investment is in China? Is the coupon rate the same as the required rate of return on the bond?Explain.
10 Credit Ratings and Financial Markets Empirically, share prices and bond prices have been shown to react only to a small degree to credit rating changes, if at all. Why do you think this is?
11 Bond Ratings Governments, as well as companies, have credit ratings. What impact do you think a government’s credit rating has on a company that operates in that country?
12 Crossover Bonds Assume that Sacyr Vallehermoso had a bond issue and a credit rating from Moody’s and S&P. However, Moody’s has given a rating of Aaa and S&P has given a rating of BBB. What does this mean and why do you think it has happened? Explain.
13 Borrowing Choices Why might we expect firms with credit ratings in the middle of the spectrum to issue debt privately rather than publicly?
14 Bond Indentures Why do bonds have indentures? What, in your opinion, is the most important indenture for a bond? Are indentures more or less important for junk bond issues? Explain.
16 Bonds as Equity In 2018, Oxford University issued a 100-year bond. Critics charge that this issue is very similar to equity. Explain why critics would argue this is the case. Do you agree with the argument?What are the issues for Oxford to consider in this issue? Why would a for-profit company
19 Junk Bonds What is a ‘junk bond’? What are some of the controversies created by junk bond financing?By looking at the time series of bond defaults in Figure 16.3, can you think of a profitable trading strategy for junk bonds? Explain.
20 Sinking Funds What is a sinking fund covenant? Sinking funds have both positive and negative characteristics for bondholders. Why?
21 Mortgage Bonds Which is riskier to a prospective creditor – an open-end mortgage or closed-end mortgage? Why?
22 Public Issues versus Private Placements Which of the following are characteristics of public issues, and which are characteristics of private placements?(a) Stock exchange registration required(b) Higher interest cost(c) Higher fixed cost(d) Quicker access to funds(e) Active secondary market (f)
23 Bond Ratings In general, why don’t bond prices change when bond ratings change?
24 Accrued Interest You purchase an Asian Paints Ltd bond on the Bombay Stock Exchange with an invoice price of R9,342. The bond has a coupon rate of 6.45 per cent, and there are five months to the next semiannual coupon date. What is the clean price of the bond?
25 Accrued Interest You purchase a bond with a coupon rate of 5.2 per cent and a clean price of €865. If the next coupon payment is due in two months, what is the invoice price?
26 Bond Refunding Infineon AG plans to issue €500 million of bonds with a face value of €100,000, coupon rate of 3.5 per cent and 10 years to maturity. The current market interest rate on these bonds is 6 per cent.In one year, the interest rate on the bonds will be either 8 per cent or 5 per
27 Bond Refunding Parto SpA has an outstanding perpetual bond with a 4 per cent coupon rate that can be called in one year. The bonds make annual coupon payments. The call premium is set at 120 per cent of par value. There is a 40 per cent chance that the interest rate in one year will be 8 per
28 Bond Refunding Mobistar intends to issue callable, perpetual bonds with annual coupon payments.The bonds are callable at €12,500. One-year interest rates are 6 per cent. There is a 60 per cent probability that long-term interest rates one year from today will be 9 per cent, and a 40 per cent
29 Bond Refunding Heineken NV has decided to borrow money by issuing perpetual bonds with a coupon rate of 6 per cent, payable annually. The one-year interest rate is 6 per cent. Next year, there is a 35 per cent probability that interest rates will increase to 7 per cent, and there is a 65 per
30 Bond Refunding An outstanding issue of Jeronimo Martins bonds has a call provision attached. The total principal value of the bonds is €120 million, and the bonds have an annual coupon rate of 6.6 per cent.The total cost of refunding would be 12 per cent of the principal amount raised. The
31 Bond Refunding Charles River Associates is considering whether to refinance either of the two perpetual bond issues the company currently has outstanding. Here is information about the two bond issues:Bond A Bond B Coupon rate 8% 9%Value outstanding €75,000,000 €87,500,000 Call premium 8.5%
32 CoCo Bonds Consider convertible contingent bonds, also known as CoCo bonds. CoCo bonds have a strike price, which is set to be the cost of the issuing company’s equity when the bond is converted. Carry out research, and identify the strengths and weaknesses of CoCo bonds to the issuer and the
33 Valuing the Call Feature Consider the prices in the following three Treasury issues as of 24 February 2020:6.500 16 May 106:10 106:12 −13 5.28 8.250 16 May 103:14 103:16 .-3 5.24 12.000 16 May 134:25 134:31 −15 5.32 The bond in the middle is callable in February 2021. What is the implied
34 Negative Yields Over the past 10 years, some government bonds (for example, Switzerland and Japan)have traded at a negative yield to maturity. Why do you think investors are willing to buy bonds with a negative yield?
35 Sukuk Medhat International is a manufacturing firm operated along Islamic principles. It wishes to raise 20 billion Bahrain dinars and pay this back in equal instalments over six years. Comparable Western bonds have 8 per cent coupons. Construct a sukuk that is competitive with Western bonds.
1 If the bonds are non-callable, what is the price of the bonds today? (30 marks)Stature Technologies plans to issue £100 million of bonds with a face value of £100,000, coupon rate of 4.125 per cent and 10 years to maturity. The current yield to maturity of these bonds is 4 per cent. In one
2 If the bonds are callable one year from today at 115 per cent of face value, will their price be greater than or less than the price you computed in (1)? Why? (30 marks)Stature Technologies plans to issue £100 million of bonds with a face value of £100,000, coupon rate of 4.125 per cent and 10
3 If Stature Technologies wished to issue the bond (without call option) in Abu Dhabi as a sukuk, explain, using a diagram, how you would construct the Islamic bond. (40 marks)Stature Technologies plans to issue £100 million of bonds with a face value of £100,000, coupon rate of
4.125 per cent and 10 years to maturity. The current yield to maturity of these bonds is 4 per cent. In one year, the yield to maturity on the bonds will be either 6 per cent or 3.75 per cent with equal probability. Assume investors are risk-neutral.
2 How many of the coupon bonds must West Coast Yachts issue to raise the £30 million? How many of the zeros must it issue?Larissa Warren, the owner of West Coast Yachts, has decided to expand her operations. She asked her newly hired financial analyst, Dan Ervin, to enlist an underwriter to help
3 In 20 years, what will be the principal repayment due if West Coast Yachts issues the coupon bonds?What if it issues the zeros?Larissa Warren, the owner of West Coast Yachts, has decided to expand her operations. She asked her newly hired financial analyst, Dan Ervin, to enlist an underwriter to
4 What are the company’s considerations in issuing a coupon bond compared to a zero coupon bond?Larissa Warren, the owner of West Coast Yachts, has decided to expand her operations. She asked her newly hired financial analyst, Dan Ervin, to enlist an underwriter to help sell £30 million in new
5 Suppose West Coast Yachts issues the coupon bonds with a make-whole call provision. The make-whole call rate is the Treasury rate plus 0.40 per cent. If West Coast calls the bonds in seven years when the Treasury rate is 5.6 per cent, what is the call price of the bond? What if it is 9.1 per
6 Are investors really made whole with a make-whole call provision?Larissa Warren, the owner of West Coast Yachts, has decided to expand her operations. She asked her newly hired financial analyst, Dan Ervin, to enlist an underwriter to help sell £30 million in new 20-year bonds to finance new
7 After considering all the relevant factors, would you recommend a zero coupon issue or a regular coupon issue? Why? Would you recommend an ordinary call feature or a make-whole call feature? Why?Larissa Warren, the owner of West Coast Yachts, has decided to expand her operations. She asked her
1 Look up the websites and financial reports for Société Générale, Crédit Agricole, Enel SpA and ING Group, and find the credit rating for each firm. For some of these companies, you will need to search closely for the information. While it may seem a bit of a bore to do this, searching for
2 The most important accounting standard for bonds is IAS 39 Financial Instruments: Recognition and Measurement. However, you should also know IAS 23 Borrowing Costs, which deals with the way interest payments and other charges are presented in the financial accounts. Visit the IASPlus website
1 Types of Lease Financing What is a lease, and what are the different types of lease financing available to firms?
2 Accounting and Leasing What is meant by ‘off-balance-sheet financing’? Why has leasing historically been been viewed as off-balance-sheet funding when it appears in the financial statements? Is this term now a misnomer? Explain.
3 The Cash Flows of Leasing If you did not have the financing to purchase an asset, would you compare it to the buy decision in your leasing analysis? Explain.
4 Discounting and Taxes In a world with taxes, why is WACC not appropriate for discounting cash flows in a lease-versus-buy decision? What is the appropriate discount rate when evaluating a lease? Explain.
5 Leasing You have recently joined the finance department of a large retail company, and your manager tells you that the company’s policy is to lease its assets, instead of buying them outright. He explains that because leasing reduces risk it will reduce the firm’s cost of capital. Do you
6 Does Leasing Ever Pay? Explain why the reservation payment of a lease is the amount that makes the lessee indifferent between buying an asset and leasing it.
7 Reasons for Leasing Review the reasons why firms undertake leasing. Explain why some of these reasons are not beneficial for shareholders.
8 Unanswered Questions Why do some firms lease and others do not? What are some of the reasons why firms may or may not lease?REGULAR
9 Accounting for Leases Discuss how IFRS 16 treats finance and operating leases in the financial statements. In what ways does this impact the decision between debt financing and leasing?
10 Accounting for Leases In 2019, IFRS 16 changed the way leases were treated in the financial statements.Carry out your own research on the new standard and discuss what progress has been made. What impact have the changes had on the lessee? Explain your answer.
11 Sale and Leaseback Why might a firm choose to engage in a sale and leaseback transaction?Give two reasons. Is a sale and leaseback good for firms in financial distress? What does the empirical evidence say? Explain.
12 Lease or Buy A company could purchase a machine for £100,000. The machine has annual maintenance costs of £10,000 and an anticipated useful life of five years, after which it will have zero salvage value.Tax depreciation can be claimed on a straight line basis. Assume all cash flows occur at
13 Leasing Cash Flows You work for an airline that is contemplating leasing a new-design plane geonavigational system. The system costs €22 million and will be depreciated using the straight line method.At the end of four years, the geo-navigational system will have zero value. You can lease it
14 Finding the Break-even Payment Using the information from question 13, what would the lease payment have to be for the lessee to be indifferent buying or leasing the system? Assume that the tax rate is 23 per cent. The lessee can borrow at 5 per cent before taxes.
15 Taxes and Leasing Cash Flows Using the information in question 13, assume your company does not contemplate paying taxes for the next several years. What are the annual cash flows to the lessee from leasing in this case?
16 Setting the Lease Payment In the previous question, over what range of lease payments will the lease be profitable for both parties? What are the minimum and maximum amounts?
17 Lease or Buy Super Sonics Entertainment is considering buying a machine that costs NKr3,500,000.The machine will be depreciated straight line to zero over 4 years. The company can lease the machine with year-end payments of NKr942,000 and a balloon payment of NKr500,000 at the end of the lease
18 Lease or Buy What is the net advantage to leasing (NAL) for Wildcat?
19 Reservation Payment What is the maximum lease payment that would be acceptable to Wildcat Oil Company?
20 Reservation Payment What is the minimum lease payment that would be acceptable to Lambert Leasing Company?
21 Setting the Lease Price An asset costs £360,000 and will be depreciated using the straight line method.At the end of its three-year life it will be worthless. The corporate tax rate is 18 per cent and the appropriate pre-tax interest rate is 10 per cent. What set of lease payments will make the
22 Lease or Buy Wolfson plc has decided to purchase a new machine that costs £4.2 million. The machine will be depreciated on a straight line basis and will be worth nothing at the end of four years. The corporate tax rate is 18 per cent. The Sur Bank has offered Wolfson a four-year loan for £4.2
23 Lease or Buy High electricity costs have made Farmer Corporation’s chicken-plucking machine economically worthless. Only two machines are available to replace it. The International Plucking Machine (IPM) model is available only on a lease basis, but has a notional price of £8,000 for tax
24 Debt Capacity Many researchers are now coming to the conclusion that leasing has benefits from increasing the debt capacity of financially constrained firms. Explain why this is so and provide a review of the literature that proposes this idea. Present your own views on the purpose of leasing,
25 Moral Hazard Schneider (2010) argues that moral hazard in leasing is a major contributor to the level of accidents that New York taxi drivers experience. Explain what is meant by moral hazard and present a case for or against Schneider’s findings.
26 Asset Liquidity Gavazza (2010) finds that ‘more-liquid assets (1) make leasing, operating leasing in particular, more likely; (2) have shorter operating leases; (3) have longer capital leases; and (4) command lower markups of operating lease rates’. Explain Gavazza’s findings in the
27 Leasing and Accounting Quality Beatty et al. (2010) argue that low accounting quality firms increase the likelihood that a firm will lease assets instead of buying them. Provide a critique of this view and explain why accounting quality would have an impact on the lease-versus-buy decision.
28 Leasing and IFRS 16 The new leasing standard IFRS 16 made a number of fundamental changes in 2019 to the recording of leases in the financial statements. Review these changes. Do you think leasing will become more or less popular over the coming years as a result of these changes? Explain.
1 Andrew and Gilstad (2005) write that ‘business schools typically teach that leasing is a zero-sum game.However, the economic assumptions that lead to this belief often are not true. These incorrect assumptions have caused serious confusion and bias in lease evaluation for more than a
2 Parklead Leasing is a successful leasing company, specializing in the highest-quality excavation equipment.It has a fleet of 300 vehicles, and a repair and maintenance section. It purchases a new machine for €80,000 that it plans to lease for six years, after which time it will be worthless.
3 Ibro Tinmines plc requires the use of excavation machinery. It could lease the equipment for six years from Parklead Leasing for €22,000 per year, with a balloon payment at the end of the lease contract to offset any remaining financial liability. Evaluate the lease from the perspective of the
11 Warf Computers has decided to proceed with the manufacture and distribution of the virtual keyboard (VK)the company has developed. To undertake this venture, the company needs to obtain equipment for the production of the microphone for the keyboard. Because of the required sensitivity of the
11 Download the financial accounts of five companies in your country. Look for information on operating leases, financial leases, and sale and leasebacks. In each case, decide whether the financing is long term or short term and how it affects the debt to equity ratio of each firm. Do you see
12 Because of its importance, leasing has an accounting standard all to itself, titled IFRS 16 Leases. This is a new standard as of 2019 and should be consulted when considering the use of any type of lease.
1 Why should the shareholders in the firm care about maximizing the value of the entire firm? After all, the value of the firm is, by definition, the sum of both the debt and the equity. Instead, why should the shareholders not prefer the strategy that maximizes their interests only?
2 What ratio of debt to equity maximizes the shareholders’ interests?
3 Wasserprodukte GmbH has a corporate tax rate, tC, of 35 per cent and expected earnings before interest and taxes (EBIT) of €1 million each year. Its entire earnings after taxes are paid out as dividends.The firm is considering two alternative capital structures. Under Plan I, Wasserprodukte
1 Ignoring costs of financial distress, what is the firm’s optimal capital structure if dividends and interest are taxed at the same personal rate – that is, tE = tD?The firm should select the capital structure that gets the most cash into the hands of its investors. This is tantamount to
2 Under what conditions will the firm be indifferent between issuing equity or debt?The firm will be indifferent if the cash flow to shareholders equals the cash flow to bondholders. That is, the firm is indifferent when:( 1 − t c ) × ( 1 − t E ) = 1 − t D (18.7)
3 What should companies do in the real world?Although this is clearly an important question, it is, unfortunately, a hard one – perhaps too hard to answer definitively. Nevertheless, let us begin by working with the highest tax rates for a specific country, the UK. As of 2020, the corporate tax
1 We began our discussion of the capital structure decision by arguing that the particular capital structure that maximizes the value of the firm is also the one that provides the most benefit to the shareholders.
2 In a world of no taxes, the famous Proposition I of Modigliani and Miller proves that the value of the firm is unaffected by the debt–equity ratio. In other words, a firm’s capital structure is a matter of indifference in that world. The authors obtain their results by showing that either a
3 MM’s Proposition II in a world without taxes states that R E = R A + D __ E( R A − R D )This implies that the expected rate of return on equity (also called the cost of equity or the required return on equity) is positively related to the firm’s leverage. This makes
4 Although the above work of MM is quite elegant, it does not explain the empirical findings on capital structure very well. MM imply that the capital structure decision is a matter of indifference, whereas the decision appears to be a weighty one in the real world. To achieve real-world
5 In a world with corporate taxes but no bankruptcy costs, firm value is an increasing function of leverage.The formula for the value of the firm is V L = V U + t C D Expected return on levered equity can be expressed as R E = R A + ( 1 − t c ) × ( R A
1 Capital Structure, the Pie Theory and MM Use a pizza analogy to explain why capital structure should not influence firm value in a world with no taxes, transaction costs or financial distress costs. List three assumptions that lie behind the Modigliani–Miller theory in a world without taxes.
2 Maximizing Firm Value versus Maximizing Shareholder Interests Explain why, in a world with no taxes, transaction costs or financial distress costs, maximizing firm value is the same as maximizing share value. Are business risk and financial risk the same thing? If Firm A has greater business risk
3 Financial Leverage and Firm Value In a world with no taxes, no transaction costs and no costs of financial distress, is the following statement true, false or uncertain? If a firm issues equity to repurchase some of its debt, the share price of the firm’s equity will rise because the shares are
4 Financial Leverage and Firm Value: An Example In a world with no taxes, no transaction costs and no costs of financial distress, does moderate borrowing increase the required return on a firm’s equity? Does it necessarily follow that increases in debt increase the riskiness of the firm? Explain.
5 Corporate Taxes How do corporate taxes affect the Modigliani–Miller theory of capital structure?Illustrate your answer with a practical example.
6 Personal Taxes Show the impact of personal taxes on the firm value in an MM universe. When would a firm be indifferent between issuing debt or equity? Illustrate your answer with a practical example.REGULAR
7 Return on Equity Explain, using an example, how a change in the capital structure of a firm can affect the company’s return on equity.
8 Capital Structure What is the basic goal of financial management with respect to capital structure?Is there an easily identifiable capital structure that will maximize the value of the firm? Why, or why not?
9 Return on Equity Mayou plc currently has no debt in its capital structure but has decided to issue new debt to replace the equity so that the debt to equity ratio is 1:1. On the firm’s accounting statements, the total asset value is £120,000. Equity book and market values are the same and
10 EBIT and Gearing Penybont plc is planning to raise funds to finance a major new development, and its management is considering borrowing on a long-term basis for the first time. It has been established that it is possible to borrow £600 million at an interest rate of 8 per cent to meet its
11 EBIT, Taxes and Leverage Fresenius SE & Co has no debt outstanding and a total market value of€12.68 billion. Earnings before interest and taxes (EBIT) are projected to be €2.56 billion if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 per
12 ROE and Leverage Using the information in the question above on Fresenius SE & Co, suppose Fresenius has a book value of €12.68 billion.(a) Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued. Also calculate the percentage changes in ROE for
13 Break-even EBIT Hammerson plc is comparing two different capital structures: an all-equity plan(Plan I) and a levered plan (Plan II). Under Plan I, Hammerson would have 712 million shares of equity outstanding. Under Plan II, there would be 475 million shares of equity outstanding and £1
14 MM and Share Value In problem 13, use MM Proposition I to find the share price under each of the two proposed plans. What is the value of the firm?
15 Break-even EBIT and Leverage Taiyuan Coal Gasification Ltd is comparing two different capital structures. Plan I would result in 1.62 billion shares of equity and 798 million yuan in debt. Plan II would result in 1 billion shares of equity and 2.1 billion yuan in debt. The interest rate on the
16 Leverage and Share Value ABC plc is comparing two different capital structures. Plan I would result in 1,100 shares of stock and €16,500 in debt. Plan II would result in 900 shares of stock and €27,500 in debt, on which it would pay interest of 8 per cent. What is the price per share of
17 Homemade Leverage Star plc, a prominent consumer products firm, is debating whether or not to convert its all-equity capital structure to one that is 40 per cent debt. Currently there are 2,000 shares outstanding and the share price is £70. EBIT is expected to remain at £16,000 per year for
18 Homemade Leverage and WACC ABC AG and XYZ AG are identical firms in all respects except for their capital structure. ABC is all equity financed, with NKr600,000 in equity shares. XYZ uses both shares and perpetual debt; its equity is worth NKr300,000 and the interest rate on its debt is 10 per
19 MM Nina plc uses no debt. The weighted average cost of capital is 13 per cent. If the current market value of the equity is £35 million and there are no taxes, what is EBIT?
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