The Benly Company needs to raise funds for a major expansion. The company is debating whether to issue stock or to issue bonds. If the company issues bonds, then its debts will increase and it will be...

Melissa Buehrlen
Instructor Somers
Business Economics
06/13/2013
Chp. 17; Exercise Questions
1.) The Benly Company needs to raise funds for a major expansion. The company is
debating whether to issue stock or to issue bonds. If the company issues bonds,
then its debts will increase and it will be under additional stress to ensure that its
evenues can cover the costs of its debt. If it issues stock, the cu
ent owners will
lose power and influence. What should the company do? Explain your answer.
If the company decides to roll out a secondary stock offering, it means the board has chosen
to issue more shares. This increases the total number of shares available for trading. It goes
to the company as usable funds. There is no obligation to pay timely interest or repay the
amount after a fixed period of time. On the flip side, since more shares are rolled out it
dilutes the control thereby the influence of cu
ent shareholders. Moreover, equity is more
costly as the return expected includes a component of market risk premium over and above
the risk free rate.
Bonds on the other hand, are to be repaid with interest. Since interest is a tax deductible
expense, which lowers the cost of bo
owing. The interest rate that the company will pay will
also depend on its creditworthiness. If Benly Company has a good credit history, as
determined by credit rating agencies, it can raise debt by bonds at a lower rate of interest.
The question then becomes how long should the bond’s term be. By issuing long term
onds, the company gets immediate cash but has long time before it is to be repaid. Also,
inflation works in company’s favour since the amount that is paid back will be worth much
less than what it was bo
owed at. The only drawback is long-term bonds are issued at a
higher rate of interest than short-term bonds.
Thus, it is advisable for Benly Company to choose the option that satisfies their
equirements as each of the alternative has its own advantages and disadvantages.
2.) What is the creditor-owner conflict? Explain why 100 percent equity might be
inefficient. Explain why 100 percent debt might be inefficient.
Company’s owners and managers need creditors for bo
owing funds. The funds bo
owed
y owners will be invested where they expect returns to be higher than interest to be paid on
the debt. Creditors on the other hand expect the return according to their own perception of
isk. The conflict arises when managers take up more risky ventures than anticipated by
creditors to earn maximum return.
If the firm takes up very risky ventures it greatly increases risk of bankruptcy. It makes the
creditors jittery as their assets are at stake. It might also make the creditors feel mislead and
they might chose not to work with the firm again. This adds to the moral hazard and thus
causes the cost of capital to rise for the firm.
Usually, as stockholders decisions are to suit their own best interest, the chances of agency
problem increases between the stockholders and creditors.
100% debt is inefficient because it increases interest expense which call for more cash flows
to cover them up. Rise in interest leads to fall in EPS, and eventually leads to decrease in
stock price. Higher debt adds to risk of bankruptcy. Though it lowers tax payments, but adds
to riskiness of a firm.
100% equity is inefficient as it leads to dilution of control from the existing shareholders.
Besides, it proves to be costly than debt. To optimize the total cost of capital, a firm should
have both debt and equity in appropriate proportions. This will lead to lowering cost of
capital and maximizing shareholder’s wealth.
3.) The marketing director of National Midland Mortgage has been arguing with senior
management about building a $50 million publishing facility. Other managers
wo
ied about the assumptions in the analysis that support the investment-an
increase in the number of mortgages processed and a reduction in processing costs.
What if the mortgage market did not grow as expected?

If the assumption of increase in mortgages does not turn out as expected, it will cause the
analysis to crumble. This will jeopardize the feasibility of the investment, leading to losses.
The best way is to keep a buffer of fluctuations in the investment analysis proposal so as
much if any changes occur, the buffer is able to abso
the variations and the projects long-
term feasibility is not affected.

4.) Bob Davies must decide whether to invest $100,000 in his own business or in another
local business. Both investment projects have an expected life of five years. The
cash flow of each is as follow:

To
Year Davies Other
1 $20,000 $10,000
2 $30,000 $10,000
3 $40,000 $30,000
4 $10,000 $40,000
5 $5,000 $50,000
Suppose the risk of the projects is the same and is accounted for by a risk premium
of 6 percent per year. Would either investment make sense? Which would be better?
NPV of cash flows
For Davies’ own business:
= -100,000+20,000/ (1+0.06)1 + 30,000/ (1+0.06)2 + 40,000/ (1+0.06)3 + 10,000/
(1+0.06)4 + 5,000/ (1+0.06)5
= -5454
IRR = 3.7%
For Other business
= -100,000+10,000/ (1+0.06)1 + 10,000/ (1+0.06)2 + 30,000/ (1+0.06)3 + 40,000/ (1+0.06)4
+ 50,000/ (1+0.06)5
= 12, 569
IRR = 9.5%
Since NPV is greater than zero, the option to invest in other business is a better one.
5.) An oil company recently evaluated a proposed investment for improvements in a
particular type of refining equipment. According to the analysis, such improvements
would require an investment of $15 million and would result in an incremental after-
tax cash flow of $2 million per year for nine years following the year of the
investment.
a.) If the discount rate is 10 percent, what is the net present value of this
project?
.) If the discount rate is 15 percent, what is the net present value of this
project?
c.) What discount rate would you argue makes most sense in evaluating this
project?
(a) NPV at discount rate 10% is
= -15+2/ (1+0.1)1 +2/ (1+0.1)2+ 2/ (1+0.1)3+ 2/ (1+0.1)4+ 2/ (1+0.1)5+ 2/ (1+0.1)6+ 2/
(1+0.1)7+ 2/ (1+0.1)8 + 2/ (1+0.1)9
= -3.48
(b) NPV at discount rate 15% is
= -15+2/ (1+0.15)1 +2/ (1+0.15)2+ 2/ (1+0.15)3+ 2/ (1+0.15)4+ 2/ (1+0.15)5+ 2/
(1+0.15)6+ 2/ (1+0.15)7+ 2/ (1+0.15)8 + 2/ (1+0.15)9
= -5.46
(c) IRR = 3.8%
Since the rate of return for the given set of cash glows is 3.8%, the cost of capital should
e less than that to make the investment profitable. Analysis will make sense at anything
elow 3.8%.
6.) What is the effect on a firm’s cost of capital when a CEO is found to have engaged in
unethical behavior? Explain.
CEOs are the key management people who are responsible for running the business. They
are the face of a company. It is based on a CEOs competence that investors judge the...