Download ECON366 - KONSTANTINOS KANELLOPOULOS

INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.
COURSE: FIN-210-50-S13 Finance
SEMESTER: I, 2013
Quiz - solutions
INSTRUCTIONS
Students are required to study the following questions and problems indicated and
to solve them in the class.
Although this is not a required part of a coursework, the purpose of this quiz is
twofold: to help the student understand the methodology for solving the problems
and to help him/her prepare for the courseworks and/or exams. The utilisation of
this resource can be maximised depending on the time and effort each individual
student devotes.
Konstantinos Kanellopoulos
23rd April 2013
1
1. You have just noticed in the financial pages of the local newspaper that you can buy a bond
($1,000 par) for $800. If the coupon rate is 10 percent, with annual interest payments, and
there are 10 years to maturity, you should make the purchase if your required return on
investments of this type is 12 percent.
Tabular solution:
Vd = $100 (PVIFA12%, 10) + $1,000 (PVIF12%, 10)
= $100 (5.6502) + $1,000 (0.3220) = $877.02.
Thus, the value is significantly higher than the market price and the bond should be
purchased.
2. You have just purchased a 10-year, $1,000 par value bond. The coupon rate on this bond is 8
percent annually, with interest being paid each 6 months. If you expect to earn a 10 percent
simple rate of return on this bond, how much did you pay for it?
Tabular solution:
Vd = $40 (PVIFA5%, 20) + $1,000 (PVIF5%, 20)
= $40 (12.4622) + $1,000 (0.3769) = $875.39.
3. Exercise 3 In order to accurately assess the capital structure of a firm, it is necessary to
convert its balance sheet figures to a market value basis. KJM Corporation's balance sheet as
of January 1, 2001, is as follows:
Long-term debt (bonds, at par)
Preferred stock
Common stock ($10 par)
Retained earnings
Total debt and equity
$10,000,000
2,000,000
10,000,000
4,000,000
$26,000,000
2
The bonds have a 4 percent coupon rate, payable semiannually, and a par value of
$1,000. They mature on January 1, 2011. The yield to maturity is 12 percent, so the
bonds now sell below par. What is the current market value of the firm's debt?
Tabular solution
Vd = $20 (PVIFA6%, 20) + $1,000 (PVIF6%, 20)
= $20 (11.4699) + $1,000 (0.3118) = $541.20 per bond.
Since there are 10,000 bonds outstanding the total value of debt is $541.20 (10,000) =
$5.412 million.
4. Copybold Corporation is a start-up firm considering two alternative capital structures--one is
conservative and the other aggressive. The conservative capital structure calls for a D/A ratio
= 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target
capital structure it envisions two possible scenarios for its operations: Feast or Famine. The
Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is
$60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to
be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will
be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The
firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the
book value of equity per share under either scenario is $10.00 per share.
What is the difference between the EPS forecasts for Feast and Famine under the aggressive
capital structure?
Debt = 75% = $300,000; Equity = 25% = $100,000; Total assets = $400,000.
Probability
EBIT
Interest
EBT
Taxes
NI
# shares
EPS
Feast
0.6
$60,000
(36,000)
$24,000
(9,600)
$14,400
10,000
$1.44
Famine
0.4
$20,000
(36,000)
($16,000)
6,400
($ 9,600)
10,000
-$0.96
Difference in EPS for aggressive capital structure:
EPSFeast - EPSFamine = $1.44 - ($0.96) = $2.40.
3
What is the difference between the EPS forecasts for Feast and Famine under the
conservative capital structure?
Debt = 25% = $100,000; Equity = 75% = $300,000; Total assets = $400,000.
Probability
EBIT
Interest
EBT
Taxes
NI
# shares
EPS
Feast
0.6
$60,000
(10,000)
$50,000
(20,000)
$30,000
30,000
$1.00
Famine
0.4
$20,000
(10,000)
$10,000
4,000
($6,000)
30,000
$0.20
Difference in EPS for conservative capital structure:
EPSFeast - EPSFamine = $1.00 - $0.20 = $0.80.
5. Howell Enterprises is forecasting EPS of $4.00 per share for next year. The firm has
10,000 shares outstanding, it pays 12 percent interest on its debt, and it faces a 40 percent
marginal tax rate. Its estimated fixed costs are $80,000 while its variable costs are estimated
at 40 percent of revenue. The firm's target capital structure is 40 percent equity and 60
percent debt and it has total assets of $400,000. On what level of sales is Howell basing its
EPS forecast?
EPS1 = (Sales - Variable costs - Fixed costs - Interest) (1 - T) / Shares outstanding.
Step 1:
Calculate interest expense
Debt = 0.60  $400,000 = $240,000.
Interest = 0.12  $240,000 = $28,800.
Step 2:
Solve for EPS
EPS1 = $4.00 = (S - 0.40S - $80,000 - $28,800)  (1 - 0.40) / 10,000
= (0.60S - $108,800) (0.6) / 10,000
$4.00 = (0.36S - $65,280) / 10,000
$105,280 = 0.36S
Sales = $292,444.44 $292,445.
Alternative method
EPS1 = (EBIT - Interest) (1 - T) / Shares outstanding.
Solve for EBIT
Net Income = EPS  Shares outstanding = $4.00  10,000 = $40,000.
EBT = NI / (1 - T) = $40,000 / (0.6) = $66,667.
Interest (from above) = $28,800.
EBIT = EBT + Interest = $66,667 + $28,800 = $95,467.
EBIT = EBT + Interest = $66,667 + $28,800 = $95,467.
S = 0.40S + $95,467 + 80,000
0.6S = $175,467
S = $175,467 / 0.6 = $292,445.
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