Management consultancy by cabrera chapter 19 answer

The priority of claims can be determined as follows: senior secured debt, junior secured debt, senior debenture, subordinated debenture, preference shares, ordinary shares.. Debt, utiliz

CHAPTER 19

SOURCES OF INTERMEDIATE AND LONG-TERM FINANCING: DEBT AND EQUITY

I Questions

1 The bond agreement specifies such basic items as the par value, the coupon rate, and the maturity date

2 The priority of claims can be determined as follows:

senior secured debt,

junior secured debt,

senior debenture,

subordinated debenture,

preference shares,

ordinary shares

3 Bond conversion

4 The advantages of debt are:

a Interest payments are tax deductible

b The financial obligation is clearly specified and of a fixed nature

c In an inflationary economy, debt may be paid back with cheaper pesos

d The use of debt, up to a prudent point, may lower the cost of capital

to the firm

The disadvantages are:

a Interest and principal payment obligations are set by contract and must be paid regardless of economic circumstances

b Bond indenture agreements may place burdensome restrictions on the firm

c Debt, utilized beyond a given point, may serve as a depressant on outstanding ordinary shares

II Multiple Choice

Supporting computations:

16

Px =

where Px = value of a share ex-rights

Po = market value of share rights-on

N = number of rights required to purchase one share

S = subscription price per share

18 The following schedule applies for the term loan:

Year

Beginning Balance

Interest

x (1 – T c )

Principal Payment

Ending Balance

(Po x N) + 5

N + 1

(P75 x 4) + P60

5

360 5

2 4000 156 1000 3000

-0-The present value of interest after taxes at 12% is calculated to be P453.49

19 After the tax benefit, the annual cost of leasing is P1,400 (1 – 35) = P910 The present value annuity factor for four years at 12% is 3.0373 The present value cost of the lease is the cost of the first payment plus the present value of the four future payments, or P910 + P910 (3.0373)

= P3,673.94

20 The present value annuity factor for five years at 12% is 3.6048 Therefore, the present value of principal payments is P1,000 (3.6048) = P3,604.80 The present value cost of the purchase option is the present value of principal payments or P3,604.80 plus P453.49 which equals P4,058.29

III Problems

PROBLEM 1 (CAM FURNITURE COMPANY)

a Proposal 1: 10 year 12 percent bonds

CAM FURNITURE COMPANY

Income Statement For the Year Ended December 31, 2005

Estimated sales levels

Sales P400,000 P600,000 P800,000 Operating costs 360,000 540,000 720,000 Operating income 40,000 60,000 80,000 Interest charges 14,000 14,000 14,000 Net income before taxes 26,000 46,000 66,000 Income taxes 13,000 23,000 33,000 Net income P 13,000 P 23,000 P 33,000 Outstanding shares = = 10,000

* EPS (P36 market value – price earnings ratio of 12)

Proposal 2: Ordinary share issue to yield P33-1/3

CAM FURNITURE COMPANY

Income Statement For the Year Ended December 31, 2005

Estimated sales levels

Sales P400,000 P600,000 P800,000 Operating costs 360,000 540,000 720,000 Operating income 40,000 60,000 80,000 Interest charges 2,000 2,000 2,000 Net income before taxes 38,000 58,000 78,000 Income taxes 19,000 29,000 39,000 Net income P 19,000 P 29,000 P 39,000 Outstanding shares = + 10,000 = 13,000 shares

P30,000 3*

P100,000

33 - 1/3

b Within the constraints of this problem, two possible objectives emerge: profit maximization as measured by earnings per share and wealth maximization as measured by the price of the ordinary shares If profit maximization is used, the firm should choose to finance the new product

by selling bonds, since earnings per share is higher for each of the three levels of sales On the other hand, wealth maximization would require the sale of new ordinary shares because share price is higher at each sales level

Wealth maximization is the preferred criterion for financial decision making Unlike profit maximization, it represents a measure of the total benefits stream to be enjoyed by the shareholders, adjusted for both the timing of benefits and the risk associated with the receipt thereof A criterion that ignores these two important determinants of value cannot

be expected to provide a proper guide to decision making

Because wealth maximization is the preferred objective, the sale of ordinary shares is the recommended financing technique

c Proposal 2 would still be the choice, because the market value remains above that of Proposal 1 The difference is getting smaller, however, which means that Proposal 1 would become attractive if sales reached a higher level (approximately P1.6 million)

d The investment banker would suggest that lower price-earnings ratio with debt financing is a reflection of the greater returns demanded by shareholders in compensation for the variability in earnings and higher risk of bankruptcy created by the fixed commitment to pay debt interest and principal

PROBLEM 2 (FAYE INDUSTRIES, INC.)

Faye Industries Inc.

Pro Forma Consolidated Income Statement Including Earnings per Common Share

and Return on Average Common Shareholders’ Equity For the Year Ending November 30, 2006 (P000 omitted except per share amounts)

(1) Issuing Long-term

(2) Selling Preference

(3) Selling Ordinary

Bonds Shares Shares

Interest on

1,658

Average common shares outstanding (in thousands)

Pro forma earnings per share

Estimated return on average common shareholders’

equity