Corporate Finance 9th edition Solutions ManualCHAPTER 15 LONG-TERM FINANCING: AN INTRODUCTION Answers to Concepts Review and Critical Thinking Questions 1. The indenture is a legal contract and can run into 100 pages or more. Bond features which would be included are: the basic terms of the bond, the total amount of the bonds issued, description of the property used as security, repayment arrangements, call provisions, convertibility provisions, and details of protective covenants. 2. The differences between preferred stock and debt are: a. The dividends on preferred stock cannot be deducted as interest expense when determining taxable corporate income. From the individual investor’s point of view, preferred dividends are ordinary income for tax purposes. For corporate investors, 70% of the amount they receive as dividends from preferred stock are exempt from income taxes. b. In case of liquidation (at bankruptcy), preferred stock is junior to debt and senior to common stock. c. There is no legal obligation for firms to pay out preferred dividends as opposed to the obligated payment of interest on bonds. Therefore, firms cannot be forced into default if a preferred stock dividend is not paid in a given year. Preferred dividends can be cumulative or non-cumulative, and they can also be deferred indefinitely (of course, indefinitely deferring the dividends might have an undesirable effect on the market value of the stock). 3. Some firms can benefit from issuing preferred stock. The reasons can be: a. Public utilities can pass the tax disadvantage of issuing preferred stock on to their customers, so there is a substantial amount of straight preferred stock issued by utilities. b. Firms reporting losses to the IRS already don’t have positive income for any tax deductions, so they are not affected by the tax disadvantage of dividends versus interest payments. They may be willing to issue preferred stock. c. Firms that issue preferred stock can avoid the threat of bankruptcy that exists with debt financing because preferred dividends are not a legal obligation like interest payments on corporate debt. 4. The return on non-convertible preferred stock is lower than the return on corporate bonds for two reasons: 1) Corporate investors receive 70 percent tax deductibility on dividends if they hold the stock. Therefore, they are willing to pay more for the stock; that lowers its return. 2) Issuing corporations are willing and able to offer higher returns on debt since the interest on the debt reduces their tax liabilities. Preferred dividends are paid out of net income, hence they provide no tax shield. Corporate investors are the primary holders of preferred stock since, unlike individual investors, they can deduct 70 percent of the dividend when computing their tax liabilities. Therefore, they are willing to accept the lower return that the stock generates. 317 and 3) The availability of positive NPV projects. the company can take advantage of interest rate declines by calling in an issue and replacing it with a lower coupon issue. 13. unpaid preferred dividends are not debts of a company and preferred dividends are not a tax deductible business expense. since the market value of existing debt generally does not increase as the value of the company increases (at least by not as much). The three basic factors that affect the decision to issue external equity are: 1) The general economic environment. a company might wish to eliminate a covenant for some reason. First. external financing requires the firm to issue new securities. the bondholder has the obligation to surrender their bonds when the call option is exercised by the bond issuer. the firm can use it as a tax shield. There is also the possibility that the market value of a company continues to increase (we hope). It is the grant of authority by a shareholder to someone else to vote his or her shares. Preferred stock is similar to both debt and common equity. Second. If the IRS accepts the security as debt. A put provision is desirable from an investor’s standpoint. The cost to the company is that it may have to buy back the bond at an unattractive price. preferred stockholders get a stated value. 6. Often. 10.e. Preferred shareholders receive a stated dividend only. The statement is true. 7. 2) The level of stock prices. 8. other things being equal. business cycles. In contrast. 11. specifically. The following table summarizes the main difference between debt and equity: Repayment is an obligation of the firm Grants ownership of the firm Provides a tax shield Liquidation will result if not paid Debt Yes No Yes Yes Equity No Yes No No Companies often issue hybrid securities because of the potential tax shield and the bankruptcy advantage. taken public. In an efficient market. Dual share classes allow minority shareholders to retain control of the company even though they do not own a majority of the total shares outstanding. the firm has the best of both worlds. A company has to issue more debt to replace the old debt that comes due if the company wants to maintain its capital structure.) 318 . and if the corporation is liquidated.Corporate Finance 9th edition Solutions Manual 5. If the security maintains the bankruptcy and ownership advantages of equity. Since the issuer holds the right to call the bonds. Internal financing comes from internally generated cash flows and does not require issuing securities. The cost to the company is a higher coupon. However. 9. This is because the holder of callable bonds effectively sold a call option to the bond issuer. 12. Calling the issue does this. the price of the bonds will reflect the disadvantage to the bondholders and the advantage to the bond issuer (i.. the callable bonds will be sold at a lower price than that of the non-callable bonds. There are two benefits. This also means that to maintain a specific capital structure on a market value basis the company has to issue new debt. the difference in the share classes are the voting rights. When a company has dual class stock. but the founders want to retain control of the company. dual share companies were started by a family. so it helps the company by reducing the coupon rate on the bond. where N is the number of seats up for election. Many problems require multiple steps. the price of non-callable bonds will move higher than that of the callable bonds. the firm may satisfy its sinking fund obligation by buying bonds in the open market.001 And the total cost to you will be the shares needed times the price per share. depending on the specific terms). Since the non-callable bonds do not have such a drawback. However. Basic 1. Those bonds being repurchased are chosen through a lottery.001 × $39 Total cost = $11. or: Total cost = 300. You will need to own one-half of the shares.50% 319 . You will need 1/(N + 1) percent of the stock (plus one share) to guarantee election. the number of shares needed to guarantee election under straight voting will be: Shares needed = (600. the sinking fund provides an early warning system to the bondholders about the quality of the bonds. If the company uses straight voting. the call option on the callable bonds is more likely to be exercised by the bond issuer. So. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. 15. If bond prices are high though. the board of directors is elected one at a time. the value of the bond will go up to reflect the decrease in the market rate of interest.039 If the company uses cumulative voting. it is likely to have trouble making its sinking fund payments. Thus. rounding may appear to have occurred. the firm may satisfy its obligation by purchasing bonds at face value (or other fixed price. the board of directors are all elected at once. If a firm is experiencing financial difficulty. Due to space and readability constraints. the percentage of the company’s stock you need is: Percent of stock needed = 1/(N + 1) Percent of stock needed = 1 / (7 + 1) Percent of stock needed = .1250 or 12. Thus. the final answer for each problem is found without rounding during any step in the problem.000 shares / 2) + 1 Shares needed = 300. So. plus one share. when these intermediate steps are included in this solutions manual. As the interest rate falls. Sinking funds provide additional security to bonds. If bond prices are low. in order to guarantee enough votes to win the election.700.Corporate Finance 9th edition Solutions Manual 14. A drawback to sinking funds is that they give the firm an option that the bondholders may find distasteful. So.20) + 1 Number of shares to purchase = 300. or: Total cost = 75.Corporate Finance 9th edition Solutions Manual So. the percentage of the company’s stock you need is: Percent of stock needed = 1/(N + 1) Percent of stock needed = 1 / (3 + 1) Percent of stock needed = .039 2.000 × . So.001 × $39 Total cost = $2. the board of directors are all elected at once.700. the number of shares you need to purchase is: Number of shares to purchase = (1.25 or 25% So.200. If the company uses cumulative voting. the number of shares you need to purchase is: Number of shares to purchase = (600. If the company uses cumulative voting.25 or 25% So. where N is the number of seats up for election.925. or: Total cost = 300.1250) + 1 Number of shares to purchase = 75. the number of additional shares you need to purchase is: New shares to purchase = 1. where N is the number of seats up for election. You will need 1/(N + 1) percent of the stock (plus one share) to guarantee election.001 × $9 Total cost = $2. the number of shares you need is: Number of shares to purchase = (5. the board of directors are all elected at once.25) + 1 Number of shares to purchase = 1.451 So.000 × .800 × .451 – 300 New shares to purchase = 1.001 And the total cost to you will be the shares needed times the price per share. the percentage of the company’s stock you need is: Percent of stock needed = 1/(N + 1) Percent of stock needed = 1 / (3 + 1) Percent of stock needed = .001 And the total cost will be the shares needed times the price per share. You will need 1/(N + 1) percent of the stock (plus one share) to guarantee election.009 320 .151 3. where N is the number of seats up for election.81 So. If the elections are staggered.81 – 179.05 Implied interest = $12.5%. 5. Zero coupon bonds are priced with semiannual compounding to correspond with coupon bonds. the implied interest.000(PVIF3.000(PVIF7%.97 If interest rates fall.1429 or 14.05 And the price at the end of one year is: P0 = $1.58) + $1.29% Her nominee is guaranteed election. the assumption of risk-neutrality implies that the forward rate is equal to the expected future spot rate.58) + $1. a.0552 P0 = $1. is: Implied interest = $191. which will be: P0 = [. which will be taxable as interest income.Corporate Finance 9th edition Solutions Manual 4.617. The price of the bond today is the present value of the expected price in one year.25 or 25% Her nominee is no longer guaranteed election.5%.16)] / 1.50($859.617. the price if the bond in one year will be: P1 = $60(PVIFA3. The price of the bond when purchased was: P0 = $1. Under cumulative voting.112.000 / (1 + .50($1. So. the percentage of the company’s stock she needs is: Percent of stock needed = 1/(N + 1) Percent of stock needed = 1 / (6 + 1) Percent of stock needed = .035)50 P0 = $179.000 / (1 + .16 Now we can find the price of the bond today.58) P1 = $1.97) + .035)48 P0 = $191.58) P1 = $859. she will need 1/(N + 1) percent of the stock (plus one share) to guarantee election.79 For students who have studied term structure. So. 321 .75 6. the price of the bond in one year if interest rates increase will be: P1 = $60(PVIFA7%. the percentage of the company’s stock needed is: Percent of stock needed = 1/(N + 1) Percent of stock needed = 1 / (3 + 1) Percent of stock needed = . 250 + C)] / 1. If the bond is callable. C. then the bond value will be less than the amount computed in part a. if interest rates rise.40($933.07) + $100 P1 = $1. If the interest rates fall next year. the price of the bond will be: P1 = ($100 / . The firm would be foolish to pay the call price for something worth less than the call price. 7.67 Intermediate 8. In this case. the price of the bonds if interest rates fall will be: P1 = $1.250 + C The selling price today of the bonds is the PV of the expected payoffs to the bondholders.63 So the coupon rate necessary to sell the bonds at par value will be: Coupon rate = $108. we find: P0 = $1. the price of the bonds will fall.528. First. the assumption is that the bonds will be called. If interest rates rise.150)] / 1. If the bond price rises above the call price. In this case.000 = [. the company will not call them. So. the price of the bond will be the present value of the perpetual interest payments.11 C = $108.60($1. the bondholders will receive the coupon payment.12) + $100 P1 = $933. If the price of the bonds is low. If interest rates increase next year.60(C + C / . plus the present value of the remaining payments. bondholders will not pay as much for a callable bond. the bondholders will receive the call price. The price of the bond today is the present value of the expected price in one year. so the bond will not be called.63 / $1.000 Coupon rate = . Therefore. plus the coupon payment. The present value of the expected value of the bond price in one year is: P0 = [.40($1. we can set the desired issue price equal to present value of the expected value of end of year payoffs.33 This is lower than the call price. the company will call it.10 P0 = $966. The bond will be called whenever the price of the bond is greater than the call price of $1. Doing so. the price of the bonds in one year will be: P1 = C + C / 0.13) + . plus the interest payment made in one year.Corporate Finance 9th edition Solutions Manual b.57 This is greater than the call price. C. we need to find the expected price in one year. so the bond will be called.86% 322 . so: P1 = ($100 / .1086 or 10.13 If interest rates fall. So.33) + .150. To find the coupon rate. and solve for C. 164.63 / 0.65($1. So. The firm would be foolish to pay the call price for something worth less than the call price. if interest rates rise.09) + . we can set the desired issue price equal to present value of the expected value of end of year payoffs.293. To find the coupon rate. C.08 P0 = $1. C. the bondholders will receive the call price. The call premium is not fixed. the price of the bonds in one year will be: P1 = C + C / . non-callable bond and the call provision. the price if the bond in one year will be: P1 = $80 + $80 / . plus the coupon payment. but it is the same as the coupon rate.76% c. plus the present value of the remaining payments.33 Now we can find the price of the bond today. the company will not call them. and solve for C.000 + C) + C P1 = $1.413. the price of the bonds will fall.0776 or 7.88 323 . In this case.000 + 2C)] / 1.08 C = $77.000 + 2C The selling price today of the bonds is the PV of the expected payoffs to the bondholders. To the company. So. the bondholders will receive the coupon payment.413.89) + .35($968. the value of the call provision will be given by the difference between the value of an outstanding.000 Coupon rate = .63 So the coupon rate necessary to sell the bonds at par value will be: Coupon rate = $77. so the price of the bonds if interest rates fall will be: P1 = ($1.06 P1 = $1. The price of the bond today is the present value of the expected price in one year. the value of a noncallable bond with the same coupon rate would be: Non-callable bond value = $77.09 If interest rates fall.000 = [. If interest rates rise. In this case. So.Corporate Finance 9th edition Solutions Manual 9.89 If interest rates fall. the price of the bond in one year if interest rates increase will be: P1 = $80 + $80 / .33)] / 1.65($1.09 P1 = $968. the assumption is that the bonds will be called.06 = $1. which will be: P0 = [.61 b. we find: P0 = $1.633 / $1. a. If the price of the bonds is low. Doing so.35(C + C / . In this case.714.000.08 – R) / R R = .0742 or 7.714.35)] / [.000.000.00 Note that the gain can be calculated using the pretax or aftertax cost of debt.500. The gain from refunding is the bond value times the difference in the interest rate.750. setting the NPV of refunding equal to zero.12)(1 – . 11.000 So. we find: Aftertax gain = $75.000(. the value of the call provision to the company is: Value = . we find: 0 = –$19.71 Assuming the call premium is tax deductible. so we need to find the interest rate that results in a zero NPV.07) / .000(.000. assuming either NPV is positive.000(. The NPV of each decision is the gain minus the cost. The NPV of the refunding is the difference between the gain from refunding and the refunding costs.07 Gain = $10.500.000 + $250.08 – R) / R Since refunding would cost money today.63) / 1. The company should refund when the NPV of refunding is greater than zero.42% Any interest rate below this will result in a positive NPV from refunding.35) Cost = $10. we need to find the NPV of each alternative and choose the option with the highest NPV.000.35) – .077. the aftertax cost of refunding this issue is: Cost = $75.88 – 1. So.Corporate Finance 9th edition Solutions Manual So. If we calculate the gain using the aftertax cost of debt. the NPV of refunding the 8 percent perpetual bond is: Bond A: Gain = $75.07(1 – .085)(1 – .000(.35) + $10.000.285.15 10.000. so the aftertax gain is: NPV = PV(Gain) – PV(Cost) The present value of the gain will be: Gain = $250.643.000[.293. We must also consider that the interest payments are tax deductible.71 324 .08 – .35)] Aftertax gain = $10. which will be: Aftertax cost = $250.000(1 – .285. we must determine the aftertax cost of refunding.08 Value = $130.000(.35) Aftertax cost = $19.08(1 – .07(1 – .65($1. discounted to the present value. 71 b.0725 Gain = $21. minus the price at the beginning of the year.09 – . The NPV of refunding this bond is: NPV = –$10. P0 = $1.500.00 + 21.35) + $12.689.689.00 + 10. so the price will be: P1 = $1.66 Assuming the call premium is tax deductible.125.35) Cost = $13.643.714.125.90 – 110.000.27 325 .04550 = $110.285. The price of a zero coupon bond is the PV of the par.000)(.000(1 – .203.66 Since the NPV of refunding both bonds is positive.000(.000/1. the inclusion of the tax rate in the calculation of the gains from refunding is irrelevant.90 The interest deduction is the price of the bond at the end of the year.71 = $10.917.535.203.Corporate Finance 9th edition Solutions Manual Thus. both bond issues should be refunded. so: Year 1 interest deduction = $120. 12.19 The price of the bond when it has one year left to maturity will be: P24 = $1.000/1. In one year.750.73 Year 24 interest deduction = $1.0452 = $915.564. so: a. the aftertax cost of refunding this issue is: Cost = ($87.71 The NPV of refunding the second bond is: Bond B: Gain = $87. the bond will have 24 years to maturity.120.66 NPV = $7.120.04548 = $120.71 NPV = $70.73 = $84.000/1.500.000 – 915.0725) / .00 The NPV of refunding this bond is: NPV = –$13.095)(1 – . 29 / 25 = $35.000.71 = $889.50 X + 12 – 12 X = 0. so the straight-line deduction is: Annual interest deduction = $889.25 X = C1 X + C3(1 – X) = 6.040) = $31. a.000 The repayment of the zero coupon bond will be the par value times the number of bonds issued. which means our investment in Bond 3 (the other noncallable bond) will be (1 – X).000 / $1.000) = $315.822 Challenge 14. Previous IRS regulations required a straight-line calculation of interest. We will invest X percent of our money in the first noncallable bond.57 d. The total interest received by the bondholder is: Total interest = $1. To calculate this.000 – 110. The equation is: C2 8. 13.06 Number of zero coupon bonds to sell = $30.0460 = $95.000 The number of zero coupon bonds to sell would be: Price of zero coupon bonds = $1. The repayment of the coupon bond will be the par value plus the last coupon payment times the number of bonds issued. so: Number of coupon bonds to sell = $30. The company will prefer straight-line methods when allowed because the valuable interest deductions occur earlier in the life of the bond. so: Zeroes: repayment = 315.000/1.50 X + 12(1 – X) = 6.000.29 The annual interest deduction is simply the total interest divided by the maturity of the bond.589($1.68182 326 .200.000 = 30.000 / $95.25 8. so they will sell at par. The number of bonds that must be sold is the amount needed divided by the bond price. So: Coupon bonds repayment = 30. we need to set up an equation with the callable bond equal to a weighted average of the noncallable bonds.Corporate Finance 9th edition Solutions Manual c.588. The coupon bonds have an 8% coupon which matches the 8% required return.589 b.000($1.06 = 315. Treasury bond. Given the high coupon rate of the bond.9730 Assuming $1. The reason that this bond has a negative YTM is that it is a callable U.Corporate Finance 9th edition Solutions Manual So.68182P1 + 0.73. but the number of periods is the number of periods until the call date.4730 – 103. 327 .31819(134. it is extremely likely to be called. although it can (and did). which means the bondholder will not receive all the cash flows promised. it would be positive. A better measure of the return on a callable bond is the yield to call (YTC). excluding the value of the call.96875) = 115. we invest about 68 percent of our money in Bond 1. the call value is: Call value = 115.31819P3 = 0.50 = 11. If the YTC were calculated on this bond.4730 The call value is the difference between this implied bond value and the actual bond price. the call value is $119. The YTC calculation is the basically the same as the YTM calculation. 15. this is not likely to happen. This combination of bonds should have the same value as the callable bond.S.68182(106. In general.000 par value.375) + 0. Market participants know this. So. So: P2 P2 P2 = 0. and about 32 percent in Bond 3.