1. KIC, Inc., plans to issue $5 million of bonds with a coupon rate of 8 percent and 30 years to maturity. The current market interest rates on these bonds are 7 percent. In one year, the interest rate on the bonds will be either 10 percent or 6 percent with equal probability. Assume investors are risk-neutral.
a. If the bonds are noncallable, what is the price of the bonds today?
b. If the bonds are callable one year from today at $1,080, will their price be greater or less than the price you computed in (a)? Why?
2. Illinois Industries has decided to borrow money by issuing perpetual bonds with a coupon rate of 7 percent, payable annually. The one-year interest rate is 7 percent. Next year, there is a 35 percent probability that interest rates will increase to 9 percent, and there is a 65 percent probability that they will fall to 6 percent.
a. What will the market value of these bonds be if they are noncallable?
b. If the company decides instead to make the bonds callable in one year, what coupon will be demanded by the bondholders for the bonds to sell at par? Assume that the bonds will be called if interest rates rise and that the call premium is equal to the annual coupon.
c. What will be the value of the call provision to the company?
3. Janetta Corp. has an EBIT rate of $975,000 per year that is expected to continue in perpetuity. The unlevered cost of equity for the company is 14 percent, and the corporate tax rate is 35 percent. The company also has a perpetual bond
issue outstanding with a market value of $1.9 million.
a. What is the value of the company?
b. The CFO of the company informs the company president that the value of the company is $4.8 million. Is the CFO correct?
4. Tom Scott is the owner, president, and primary salesperson for Scott Manufacturing. Because of this, the company's profits are driven by the amount of work Tom does. If he works 40 hours each week, the company's EBIT will be $550,000 per year; if he works a 50-hour week, the company's EBIT will be $625,000 per year. The company is currently worth $3.2 million. The company needs a cash infusion of $1.3 million, and it can issue equity or issue debt with an interest rate of 8 percent. Assume there are no corporate taxes.
a. What are the cash flows to Tom under each scenario?
b. Under which form of financing is Tom likely to work harder?
c. What specific new costs will occur with each form of financing?
5. Edwards Construction currently has debt outstanding with a market value of $85,000 and a cost of 9 percent. The company has EBIT of $7,650 that is expected to continue in perpetuity. Assume there are no taxes.
a. What is the value of the company's equity? What is the debt-to-value ratio?
b. What are the equity value and debt-to-value ratio if the company's growth rate is 3 percent?
c. What are the equity value and debt-to-value ratio if the company's growth rate is 7 percent?
6. Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies' economists agree that the probability of the continuation of the current expansion is 80 percent for the next year, and the probability of a recession is 20 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $2.7 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.1 million. Steinberg's debt obligation requires the firm to pay $900,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.2 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 13 percent.
a. What is the value today of Steinberg's debt and equity? What about that for Dietrich's?
b. Steinberg's CEO recently stated that Steinberg's value should be higher than Dietrich's because the firm has less debt and therefore less bankruptcy risk. Do you agree or disagree with this statement?
7. Overnight Publishing Company (OPC) has $2.5 million in excess cash. The firm plans to use this cash either to retire all of its outstanding debt or to repurchase equity. The firm's debt is held by one institution that is willing to sell it back to OPC for $2.5 million. The institution will not charge OPC any transaction costs. Once OPC becomes an all-equity firm, it will remain unlevered forever. If OPC does not retire the debt, the company will use the $2.5 million in cash to buy back some of its stock on the open market. Repurchasing stock also has no transaction costs. The company will generate $1,300,000 of annual earnings before interest and taxes in perpetuity regardless of its capital structure.
The firm immediately pays out all earnings as dividends at the end of each year.
OPC is subject to a corporate tax rate of 35 percent, and the required rate of return on the firm's unlevered equity is 20 percent. The personal tax rate on interest income is 25 percent, and there are no taxes on equity distribution. Assume there are no bankruptcy costs.
a. What is the value of OPC if it chooses to retire all of its debt and become an unlevered firm?
b. What is the value of OPC if is decides to repurchase stock instead of retiring its debt?
( Hint: Use the equation for the value of a levered firm with personal tax on interest income from the previous question.)
c. Assume that expected bankruptcy costs have a present value of $400,000. How does this influence OPC's decision?
8. 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?
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?