Caselets-IPM

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Question No. 1

Fast and Loose Company has outstanding an 8 percent, four-year, $1,000-par-value bond on which interest is paid annually.

a.

If the market required rate of return is 15 percent, what is the market value of the bond?

b.

What would be its market value if the market required return dropped to 12 percent?

c.

If the coupon rate were 15 percent instead of 8 percent, what would be the market

value [under Part (a)]? If the required rate of return dropped to 8 percent, what would

happen to the market price of the bond?

Question No. 2

Gillis Manufacturing Company has in its capital structure $20 million of 13.5 percent sinking-fund debentures. The sinking-fund call price is $1,000 per bond, and sinking-fund payments of $1 million in face amount of bonds are required annually. At present, the yield to maturity on the debentures in the market is 12.21 percent. To satisfy the sinking fund payment, should the company deliver cash to the trustee or bonds? What if the yield to maturity were 14.60 percent?

Question No. 3

Gonzalez Electric Company has outstanding a 10 percent bond issue with a face value of

$1,000 per bond and three years to maturity. Interest is payable annually. The bonds are privately held by Suresafe Fire Insurance Company. Suresafe wishes to sell the bonds, and is negotiating with another party. It estimates that, in current market conditions, the bonds should provide a (nominal annual) return of 14 percent. What price per bond should Suresafe be able to realize on the sale?

Question No. 4

Tex Turner Telecommunications Company needs to raise $1.8 billion (face value) of debt funds over the next two years. If it were to use traditional (firm commitment) underwritings, the company would expect to have six underwritings over the two-year span. The underwriter spread would likely be $7.50 per bond, and out-of-pocket expenses paid by the company would total $350,000 per underwriting. With shelf registrations, the average size of offering would probably be $75 million. Here the estimated spread is $3 per bond, and out-of-pocket expenses of $40,000 per issue are expected.

a.

Ignoring interest costs and the time value of money, what are the total absolute costs of flotation over the two years for (1) the traditional underwriting method of offering securities? (2) the shelf registration method?

b.

Which method results in lower total costs?

Question No. 5

The O.K. Railroad needs to raise $9.5 million for capital improvements. One possibility is a new preferred stock issue – 8 percent dividend, $100 par value – stock that would yield

9 percent to investors. Flotation costs for an issue this size amount to 5 percent of the total amount of preferred stock sold. These costs are deducted from gross proceeds in determining the net proceeds to the company. (Ignore any tax considerations.)

a.

At what price per share will the preferred stock be offered to investors? (Assume that the issue will never be called.)

b.

How many shares must be issued to raise $9.5 million for the O.K. Railroad?

Question No. 6

Superior Cement Company has an 8 percent preferred stock issue outstanding, with each share having a $100 face value. Currently, the yield is 10 percent. What is the market price per share? If interest rates in general should rise so that the required return becomes

12 percent, what will happen to the market price per share?

Question No. 7

A share of preferred stock for the Baseball Bat Company just sold for $100 and carries an $8 annual dividend. a.

b.

What is the yield on this stock?

Now assume that this stock has a call price of $110 in five years, when the company intends to call the issue.

Question No. 8

Mel Content, a disgruntled stockholder of the Penultimate Corporation, desires representation on the board. The Penultimate Corporation, which has 10 directors, has 1 million shares outstanding.

a.

How many shares would Mel have to control to be assured of 1 directorship under a

plurality voting system?

b.

Re-compute Part (a), assuming a cumulative voting system.

c.

Re-compute Parts (a) and (b), assuming that the number of directors was reduced to 5.

Question No. 9

James Consol Company currently pays a dividend of $1.60 per share on its common stock.

The company expects to increase the dividend at a 20 percent annual rate for the next four years and then grow the dividend at a 7 percent rate thereafter. This phased-growth pattern is in keeping with the expected life cycle of earnings. You require a 16 percent return to invest in this stock. What value should you place on a share of this stock?

Question No. 10

Just today, Acme Rocket, Inc.’s common stock paid a $1 annual dividend per share and had a closing price of $20. Assume that the market expects this company’s annual dividend to grow at a constant 6 percent rate forever.

a.

Determine the implied

yield

on this common stock.

b.

What is the expected

dividend yield

?

c.

What is the expected

capital gains yield

?

Question No. 11

The stock of the Health Corporation is currently selling for $20 a share and is expected to pay a $1 dividend at the end of the year. If you bought the stock now and sold it for

$23 after receiving the dividend, what rate of return would you earn?

Question No. 12

Delphi Products Corporation currently pays a dividend of $2 per share, and this dividend is expected to grow at a 15 percent annual rate for three years, and then at a 10 percent rate for the next three years, after which it is expected to grow at a 5 percent rate forever.

What value would you place on the stock if an 18 percent rate of return was required?

Question No. 13

North Great Timber Company will pay a dividend of $1.50 a share next year. After this, earnings and dividends are expected to grow at a 9 percent annual rate indefinitely.

Investors currently require a rate of return of 13 percent. The company is considering several business strategies and wishes to determine the effect of these strategies on the market price per share of its stock.

a.

Continuing the present strategy will result in the expected growth rate and required rate of return stated above.

b.

Expanding timber holdings and sales will increase the expected dividend growth rate to 11 percent but will increase the risk of the company. As a result, the rate of return required by investors will increase to 16 percent.

c.

Integrating into retail stores will increase the dividend growth rate to 10 percent and increase the required rate of return to 14 percent.

From the standpoint of market price per share, which strategy is best?

Question No. 14.

Just today, Fawlty Foods, Inc.’s common stock paid a $1.40 annual dividend per share and had a closing price of $21. Assume that the market’s required return, or capitalization rate, for this investment is 12 percent and that dividends are expected to grow at a constant rate forever.

a.

Calculate the implied growth rate in dividends.

b.

What is the expected

dividend yield

?

c.

What is the expected

capital gains yield

?

Question No. 15

Burp-Cola Company just finished making an annual dividend payment of $2 per share on its common stock. Its common stock dividend has been growing at an annual rate of

10 percent. Kelly Scott requires a 16 percent annual return on this stock. What intrinsic value should Kelly place on one share of Burp-Cola common stock under the following three situations?

a.

Dividends are expected to continue growing at a constant 10 percent annual rate.

b.

The annual dividend growth rate is expected to decrease to 9 percent and to remain

constant at that level.

c.

The annual dividend growth rate is expected to increase to 11 percent and to remain

constant at the level.

Question No. 16

The Lex Dictionary Company has net operating income of $10 million and $20 million of debt with a 7 percent interest rate. The earnings of the company are not expected to grow, and all earnings are paid out to shareholders in the form of dividends. In all cases, assume no taxes.

a.

Using the net operating income approach with an equity capitalization rate of 12.5

Percent at the $20 million debt level, compute the total value of the firm and the implied overall capitalization rate,

k

o.

b.

Next, assume that the firm issues an additional $10 million in debt and uses the proceeds to retire common stock. Also, assume that the interest rate and overall capitalization rate remain the same as in Part (a). Compute the new total value of the firm and the new implied equity capitalization rate.

Question No. 17

The Maiwand Company and the Afghan Company are identical in every respect except that the Maiwand Company is not financially levered, whereas the Afghan Company

has $2 million in 12 percent bonds outstanding. There are no taxes, and capital markets are assumed to be perfect. The earnings of both companies are not expected to grow, and all earnings are paid out to shareholders in the form of dividends. The valuation of the two firms is shown as follows:

O

Net operating income

I

Interest on debt

MAIWAND

$ 600,000

0

E

Earnings available to common shareholders (

O

I

) $ 600,000

k

e Equity capitalization rate ÷0.15

$4,000,000

0

$4,000,000

AFGHAN

$ 600,000

240,000

$ 360,000

÷0.16

$2,250,000

S

Market value of stock (

E

/

k

e)

B

V

Market value of debt

Total value of firm (

B

+

S

)

k

o Implied overall capitalization rate [

k

i(

B

/

V

) +

k

e(

S

/

V

)] 0.15

B

/

S

Debt-to-equity ratio 0

2,000,000

$4,250,000

0.1412

0.89

a.

You own $22,500 worth of Afghan stock. Show the process and the amount by which

you could reduce your outlay through the use of arbitrage.

b.

When will this arbitrage process cease?

Question No. 18

Cybernauts, Ltd., is a new firm that wishes to determine an appropriate capital 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 DEBT PREFERRED EQUITY

1

2

3

4

0%

30

50

50

0%

0

0

20

100%

70

50

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.

Which plan is best? Why?

Question No. 19

Hi-Grade Regulator Company currently has 100,000 shares of common stock 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. Calculate the indifference points between alternatives.

Question No. 20

Currently, the risk-free rate is 10 percent and the expected return on the market portfolio is 15 percent. Market analysts’ return expectations for four stocks are listed here, together with each stock’s expected beta.

STOCK EXPECTED RETURN EXPECTED BETA

1. Stillman Zinc Corporation

2. Union Paint Company

17.0%

14.5

3. National Automobile Company 15.5

1.3

0.8

1.1

4. Parker Electronics, Inc.

a.

18.0 1.7

If the analysts’ expectations are correct, which stocks (if any) are overvalued?

Which (if any) are undervalued?

b.

If the risk-free rate were suddenly to rise to 12 percent and the expected return on the

market portfolio to 16 percent, which stocks (if any) would be overvalued? Which (if

any) undervalued? (Assume that the market analysts’ return and beta expectations for

our four stocks stay the same.)

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