Name ___________________________________
Name ___________________________________
Finance Capital Markets
INSTRUCTIONS: You may refer to any published source of information to formulate our
esponses. Please answer all questions legibly in the space provided. Explicitly show
your solutions and all calculations and circle your final answer in the problems. Make
assumptions and state them where necessary. Please limit your solution to the space
provided and submit your responses in hard copy only. Calculate to at least four decimal
places of accuracy.
(7 pts.)
1a. Suppose you are given the following rates:
Maturity (years XXXXXXXXXX
Zero-coupon YTM 3.5% 4.5% 4.5% 4.0% 5.5%
You want to lock in an interest rate for an investment that begins in one year and matures
in five years. What rate (call this rate f1,5) would you obtain if there are no a
itrage
opportunities?
No a
itrage means this must equal the amount we would earn investing at the cu
ent five year spot
ate.
2
(8 pts.)
1b. Suppose the yield on a one-year, zero-coupon bond is 6%. The forward rate for year 2 is
4%, and the forward rate for year 3 is 5%. What is the yield to maturity of a zero-coupon
ond that matures in three years?
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(21 pts.: XXXXXXXXXX)
2. You are the financial vice-president of the Burke Dance Corporation. Management
is questioning whether the existing capital structure is optimal, so you have been asked to
consider the possibility of issuing $1 million of additional debt and using the proceeds to
epurchase stock. The following data reflect the cu
ent financial conditions of the Burke Dance
Corporation:
Value of debt (book = market) $1,000,000
Market value of equity $5,257,143
Sales, last 12 months $16,000,000
Variable operating costs (50% of sales) $8,000,000
Fixed operating costs $7,000,000
Tax rate, T (federal-plus-state) 40%
At the cu
ent level of debt, the cost of debt, kd, is 8 percent and the cost of equity, ke, is 8.5
percent. It is estimated that if the leverage were increased by raising the level of debt to $2
million, the interest rate on new debt would rise to 9 percent and the cost of equity would rise to
11 percent. The old 8 percent debt is senior to the new debt, and it would remain outstanding,
continue to yield 8 percent, and have a market value of $1 million. The firm is a zero-growth
firm, with all its earnings paid out as dividends.
a. Should the firm increase its debt to $2 million?
Hint: Find the new value of the firm using the following equation: V = D + E
= D + [{(EBIT – Int) (1 – T)}/ke] and compare it with the existing value of the firm.
4
. If the firm decided to increase its level of debt to $3 million, its cost of the additional $2
million of debt would be 12 percent and ke would rise to 14 percent. The original 8
percent of debt would again remain outstanding, and its market value would remain $1
million. What level of debt should the firm choose: $1 million, $2 million, or $3 million?
5
c. The market price of the firm’s stock was originally $20 per share. Calculate the new
equili
ium stock prices at debt levels of $2 million and $3 million.
(Hint: Shares outstanding = Value of Equity / Price. Note that the repurchase price is the
equili
ium price that would prevail after the repurchase transaction. Original
shareholders would sell only at a price which incorporated any increased value resulting
from the repurchase.)
d. What would happen to the value of the old bonds if Burke Dance Corporation uses more
leverage and the old bonds are not senior to the new bonds? What would happen to the
value of equity? Explain.
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(20 pts)
3. Campiseland Co. is considering increasing the amount of debt in its capital structure.
The treasurer is wo
ied about the ramifications of that action on the firm’s cost of funds.
The following information may be relevant to your analysis.
- The company’s capital structure is as follows (figures are in book values):
Short-Term Bank Debt $ XXXXXXXXXXmillion
Long-Term Bond XXXXXXXXXX
Prefe
ed Stock XXXXXXXXXX
Common Equity (8.60 million shares XXXXXXXXXX
Total $178.8 million
- The bank debt is cu
ently costing 9.2%.
- The bonds have a fixed 11% annual coupon and mature in fourteen years. The price of the
bonds is $109 (based on $100 par value).
- The prefe
ed stock has 100 par value, pays an annual dividend of 6% of par, and is selling
for $63¼ per share.
- The common stock is selling for $19 per share.
- The company’s marginal tax rate is 34%.
- The beta of the firm’s stock, given its cu
ent capital structure, is 0.9.
- Treasury bonds are cu
ently yielding 7.1%.
- The market has historically earned 8.3% more than Treasury bonds.
If the company sells $10 million in bonds (at the prevailing market rate), and uses the
proceeds to repurchase common stock, what will be Campiseland’s weighted-average cost of
funds?
i) Use the Beta (Unlevered) = E/V x Beta (Levered) relationship.
ii) Treat prefe
ed stock as debt when calculating the weight of equity (E/V) for un-levering
and re-levering the Beta.
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8
(12 pts.: 4 pts each)
4. Do you agree or disagree with the following statements? Briefly explain why.
(a) “In a world of no corporate or personal taxes, no agency costs or information
asymmetries, a lower dividend payout will reduce a firm’s cost of capital.”
(b) “Unlike new capital, which needs a stream of new dividends to service it, retained
earnings have zero cost.”
(c) “If a company repurchases stock instead of paying a dividend, the number of
shares falls and earnings per share rise. For this reason alone, stock repurchase
must always be prefe
ed to paying dividends.”