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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. 4