1. Shanken Corp. issued a 30-year, 6.2 percent semiannual bond 7 years ago. The bond currently sells for 108 percent of its face value.
The company's tax rate is 35 percent. (Assume that the face value of one coupon bond is $1,000.)
a. What is the pretax cost of debt?
b. What is the aftertax cost of debt?
c. Which is more relevant, the pretax or the aftertax cost of debt? Why?
2. For the firm in the previous problem, suppose the book value of the debt issue is $70 million. In addition, the company has a second debt issue on the market, a zero coupon bond with 12 years left to maturity; the book value of this issue is $100 million and the bonds sell for 61 percent of par. What is the company's total book value of debt? The total market value? What is your best estimate of the aftertax cost of debt now? (Assume that semi-annual compounding is used for the zero-coupon bond.)
3. Suppose your company needs $20 million to build a new assembly line. Your target debt-equity ratio is .75. The flotation cost for new equity is 7 percent, but the flotation cost for debt is only 3 percent. Your boss has decided to fund the project by borrowing money because the flotation costs are lower and the needed funds are relatively small.
a. What do you think about the rationale behind borrowing the entire amount?
b. What is your company's weighted average flotation cost, assuming all equity is raised externally?
c. What is the true cost of building the new assembly line after taking flotation costs into account? Does it matter in this case that the entire amount is being raised from debt?
4. Och, Inc., is considering a project that will result in initial aftertax cash savings of
5. $3.5 million at the end of the first year, and these savings will grow at a rate of 4 percent per year indefinitely. The firm has a target debt-equity ratio of .55, a cost of equity of 13 percent, and an aftertax cost of debt of 5.5 percent. The cost-saving proposal is somewhat riskier than the usual projects the firm undertakes; management uses the subjective approach and applies an adjustment factor of +2 percent to the cost of capital for such risky projects. Under what circumstances should Och take on the project?
6. The Saunders Investment Bank has the following financing outstanding. What is the WACC for the company? (Assume that the face value of one bond (for both coupon and zero-coupon bonds) is $1,000, and that semi-annual compounding is used for the zero-coupon bond.)
7. Debt: 60,000 bonds with a coupon rate of 6 percent and a current price quote of 109.5; the bonds have 20 years to maturity. 230,000 zero coupon bonds with a price quote of 17.5 and 30 years until maturity.
8. Preferred stock: 150,000 shares of 4 percent preferred stock with a current price of
1. $79, and a par value of $100.
9. Common stock: 2,600,000 shares of common stock; the current price is $65, and the beta of the stock is 1.15.
10. Market: The corporate tax rate is 40 percent, the market risk premium is 7 percent, and the risk-free rate is 4 percent.
11. Goodbye, Inc., recently issued new securities to finance a new TV show. The project cost $19 million, and the company paid $1,150,000 in flotation costs. In addition, the equity issued had a flotation cost of 7 percent of the amount raised, whereas the debt issued had a flotation cost of 3 percent of the amount raised. If Goodbye issued new securities in the same proportion as its target capital structure, what is the company's target debt-equity ratio?
a. The shareholders of the Stackhouse Company need to elect seven new directors. There are 850,000 shares outstanding currently trading at $43 per share. You would like to serve on the board of directors; unfortunately no one else will be voting for you. How much will it cost you to be certain that you can be elected if the company uses straight voting? How much will it cost you if the company uses cumulative voting?
12. New Business Ventures, Inc., has an outstanding perpetual bond with a 10 percent coupon rate that can be called in one year. The bond makes annual coupon payments. The call premium is set at $150 over par value. There is a 60 percent chance that the interest rate in one year will be 12 percent, and a 40 percent chance that the interest rate will be 7 percent. If the current interest rate is 10 percent, what is the current market price of the bond? (Assume that the face value of the bond is $1,000)
13. Bowdeen Manufacturing intends to issue callable, perpetual bonds with annual coupon payments. The bonds are callable at $1,175. One-year interest rates are 9 percent. There is a 60 percent probability that long-term interest rates one year from today will be 10 percent, and a 40 percent probability that they will be 8 percent. Assume that if interest rates fall the bonds will be called. What coupon rate should the bonds have in order to sell at par value? (Assume that the face value of the bond is $1,000.)
14. 12. The following Treasury bond quote appeared in The Wall Street Journal on May 11, 2004:
a. 9.125 May 09 100.09375 100.12500 ... -2.15
15. Why would anyone buy this Treasury bond with a negative yield to maturity? How is this possible?