Homework: Finance Mangers
Part 1
I. Mark Sexton and Todd Story, the owners of S&S Air introduced in Module 3, have decided to expand their operations. They instructed their newly hired financial analyst, Chris Guthrie, to enlist an underwriter to help sell $20 million in new 10-year bonds to finance construction. Chris has entered into discussions with Renata Harper, an underwriter from the firm of Crowe & Mallard, about which bond features S&S Air should consider and what coupon rate the issue will likely have.
Although Chris is aware of the bond features, he is uncertain as to the costs and benefits of some features, so he isn't clear on how each feature would affect the coupon rate of the bond issue. You are Renata's assistant, and she has asked you to prepare a memo to Chris describing the effect of each of the following bond features on the coupon rate of the bond. She would also like you to list any advantages or disadvantages of each feature.
i. The security of the bond, that is, whether the bond has collateral.
ii. The seniority of the bond.
iii. The presence of a sinking fund.
iv. A call provision with specified call dates and call prices.
v. A deferred call accompanying the above call provision.
vi. A make-whole call provision.
vii. Any positive covenants. Also, discuss several possible positive covenants S&S Air might consider.
viii. Any negative covenants. Also, discuss several possible negative covenants S&S Air might consider.
ix. A conversion feature (note that S&S Air is not a publicly traded company).
x. A floating rate coupon.
II. Holding Period Yield. The YTM on a bond is the interest rate you earn on your investment if interest rates don't change. If you actually sell the bond before it matures, your realized return is known as the holding period yield (HPY).
i. Suppose that today you buy an annual coupon bond with a coupon rate of 7 percent for $875. The bond has 10 years to maturity. What rate of return do you expect to earn on your investment?
ii. Two years from now, the YTM on your bond has declined by 1 percent, and you decide to sell. What price will your bond sell for? What is the HPY on your investment? Compare this yield to the YTM when you first bought the bond. Why are they different?
III. According to the Value Line Investment Survey, the growth rate in dividends for Duke Energy for the previous 10 years has been 1.5%. If investors feel this growth rate will continue, what is the required return for Duke Energy stock?
IV. Stock Valuation. Most corporations pay quarterly dividends on their common stock rather than annual dividends. Barring any unusual circumstances during the year, the board raises, lowers, or maintains the current dividend once a year and then pays this dividend out in equal quarterly installments to its shareholders.
i. Suppose a company currently pays an annual dividend of $3.20 on its common stock in a single annual installment, and management plans on raising this dividend by 6 percent per year indefinitely. If the required return on this stock is 12 percent, what is the current share price?
ii. Now suppose the company in (a) actually pays its annual dividend in equal quarterly installments; thus, the company has just paid a dividend of $.80 per share, as it has for the previous three quarters. What is your value for the current share price now? (Hint: Find the equivalent annual end-of-year dividend for each year.) Comment on whether you think this model of stock valuation is appropriate.
Part 2
I. The DRK Corporation recently developed a dividend reinvestment plan (DRIP). The plan allows investors to reinvest cash dividends automatically in DRK in exchange for new shares of stock. Over time, investors in DRK will be able to build their holdings by reinvesting dividends to purchase additional shares of the company. Over 1,000 companies offer dividend reinvestment plans. Most companies with DRIPs charge no brokerage or service fees. In fact, the shares of DRK will be purchased at a 10 percent discount from the market price. A consultant for DRK estimates that about 75 percent of DRK's shareholders will take part in this plan. This is somewhat higher than the average. Evaluate DRK's dividend reinvestment plan. Will it increase shareholder wealth? Discuss the advantages and disadvantages involved here.
II. STEPHENSON REAL ESTATE RECAPITALIZATION
Robert Stephenson founded Stephenson Real Estate Company years ago and is its current CEO. The company purchases real estate, including land and buildings, and rents the property to tenants. The company has shown a profit every year for the past 18 years, and the shareholders are satisfied with the company's management. Prior to founding Stephenson Real Estate, Robert was the founder and CEO of a failed alpaca farming operation. The resulting bankruptcy made him extremely averse to debt financing. As a result, the company is entirely equity financed, with 9 million shares of common stock outstanding. The stock currently trades at $42.50 per share. Stephenson is evaluating a plan to purchase a huge tract of land in the southeastern United States for $50 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Stephenson's annual pretax earnings by $12 million in perpetuity. Kim Weyand, the company's new CFO, has been put in charge of the project. Kim has determined that the company's current cost of capital is 12.5 percent. She feels that the company would be more valuable if it included debt in its capital structure, so she is evaluating whether the company should issue debt to entirely finance the project. Based on some conversations with investment banks, she thinks that the company can issue bonds at par value with an 8 percent coupon rate. From her analysis, she also believes that a capital structure in the range of 70 percent equity/30 percent debt would be optimal. If the company goes beyond 30 percent debt, its bonds would carry a lower rating and a much higher coupon because the possibility of financial distress and the associated costs would rise sharply. Stephenson has a 40 percent corporate tax rate (state and federal).
i. If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.
ii. Construct Stephenson's market value balance sheet before it announces the purchase.
iii. Suppose Stephenson decides to issue equity to finance the purchase.
o What is the net present value of the project?
o Construct Stephenson's market value balance sheet after it announces that the firm will finance the purchase using equity. What would be the new price per share of the firm's stock? How many shares will Stephenson need to issue to finance the purchase?
o Construct Stephenson's market value balance sheet after the equity issue but before the purchase has been made. How many shares of common stock does Stephenson have outstanding? What is the price per share of the firm's stock?
iv. Construct Stephenson's market value balance sheet after the purchase has been made.
v. Suppose Stephenson decides to issue debt to finance the purchase.
o What will the market value of the Stephenson Company be if the purchase is financed with debt?
o Construct Stephenson's market value balance sheet after both the debt issue and the land purchase. What is the price per share of the firm's stock?
vi. Which method of financing maximizes the per-share stock price of Stephenson's equity?
III. COST OF CAPITAL FOR HUBBARD COMPUTER, INC.
Hubbard Computer, Inc. (HCI) has recently hired you in its relatively new treasury management department. HCI was founded eight years ago by Bob Hubbard and currently operates 74 stores in the Southeast. HCI is privately owned by Bob and his family, and had sales of $97 million last year. HCI primarily sells to in-store customers who come to the store and talk with a sales representative. The sales representative assists the customer in determining the type of computer and peripherals that are necessary for the individual customer's computing needs. After the order is taken, the customer pays for the order immediately, and the computer is made to fill the order. Delivery of the computer averages 15 days, and it is guaranteed in 30 days.
QUESTIONS
HCI's growth to date has been financed by its profits. When the company had sufficient capital, it would open a new store. Other than scouting locations, relatively little formal analysis has been used in its capital budgeting process. Bob has just read about capital budgeting techniques and has come to you for help. For starters, the company has never attempted to determine its cost of capital, and Bob would like you to perform the analysis. Since the company is privately owned, it is difficult to determine the cost of equity for the company. Bob wants you to use the pure play approach to estimating the cost of capital for HCI, and he has chosen Dell as a representative company. The following steps will allow you to calculate this estimate.
i. Most publicly traded corporations are required to submit quarterly (10Q) and annual reports (10K) to the SEC detailing the financial operations of the company over the past quarter or year, respectively. These corporate filings are available on the SEC website at www.sec.gov. Go to the SEC website and search for SEC filings made by Dell. Find the most recent 10Q or 10K and download the form. Look on the balance sheet to find the book value of debt and the book value of equity. If you look further down the report, you should find a section titled "Long-term Debt and Interest Rate Risk Management" that will provide a breakdown of Dell's long-term debt.
ii. To estimate the cost of equity for Dell, go to finance.yahoo.com and enter the ticker symbol DELL. Follow the various links to answer the following questions: What is the most recent stock price listed for Dell? What is the market value of equity, or market capitalization? How many shares of stock does Dell have outstanding? What is the most recent annual dividend? Can you use the dividend discount model in this case? What is the beta for Dell? Now go back to finance.yahoo.com and find the "Bonds" link. What is the yield on 3-month Treasury bills? Using the historical market risk premium, what is the cost of equity for Dell using the CAPM?
iii. You now need to calculate the cost of debt for Dell. The following table provides the yield to maturity for each of Dell's bonds. What is the weighted aver-age cost of debt for Dell using the book value weights and the market value weights? Does it make a difference in this case if you use book value weights or market value weights?
iv. You now have all the necessary information to calculate the weighted average cost of capital for Dell. Calculate the weighted average cost of cap-ital for Dell using book value weights and market value weights. Assume Dell has a 35 percent marginal tax rate. Which cost of capital number is more relevant?
v. You used Dell as a pure play company to estimate the cost of capital for HCI. Are there any potential problems with this approach in this situation?
IV. What was the largest IPO? Go to hoovers website and find out. In what country was the company located? What was the largest IPO in the United States?
Part 3
I. PIEPKORN MANUFACTURING WORKING CAPITAL MANAGEMENT, PART A
You have recently been hired by Piepkorn Manufacturing to work in its newly established treasury department. Piepkorn Manufacturing is a small company that produces cardboard boxes in a variety of sizes. Gary Piepkorn, the owner of the company, works primarily in the sales and production areas. Currently, the company puts all receivables in one shoe box and all payables in another. Because of the disorganized system, the finance area needs work, and that's what you've been brought in to do. The company currently has a cash balance of $154,000 and plans to purchase new box folding machinery in the fourth quarter at a cost of $325,000. The purchase of the machinery will be made with cash because of the discount offered. The company's policy is to maintain a target cash balance of $100,000. All sales are in cash and all purchases are made on credit. Gary Piepkorn has projected the following gross sales for each of the next four quarters:
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Quarters
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01
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02
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03
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04
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Gross Sales
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$863,500
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$918,500
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$996,000
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$924,000
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Gross sales for the first quarter of next year are projected at $908,000. Piepkorn typically orders 50 percent of next quarter's projected gross sales in the current quarter, and suppliers are typically paid in 53 days. Wages, taxes, and other costs run about 30 percent of gross sales. The company has a quarterly interest payment of $115,000 on its long-term debt. The company uses a local bank for its short-term financial needs. It pays 1.5 percent per quarter on all short-term borrowing and maintains a money market account that pays 1 percent per quarter on all short-term deposits. Gary has asked you to prepare a cash budget and short-term financial plan for the company under the current policies. He has also asked you to prepare additional plans based on changes in several inputs.
QUESTIONS
i. Use the numbers given to complete the cash budget and short-term financial plan.
ii. Rework the cash budget and short-term financial plan assuming Piepkorn changes to a target balance of $80,000.
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PIEPKORN MANUFACTURING
Short-Term Financial Plan
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Q1
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Q2
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Q3
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Q4
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Beginning cash balance
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Net cash inflow
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Ending cash balance
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Minimum cash balance
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Cumulative surplus (deficit)
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PIEPKORN MANUFACTURING
Short-Term Financial Plan
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Q1
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Q2
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Q3
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Q4
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Target cash balance
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Net cash inflow
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New short-term investments
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Income from short-term investments
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Short-term investments sold
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New short-term borrowing
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Interest on short-term borrowing
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Short-term borrowing repaid
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Ending cash balance
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Minimum cash balance
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Cumulative surplus (deficit)
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Beginning short-term investments
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Ending short-term investments
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Beginning short-term debt
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Ending short-term debt
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II. PIEPKORN MANUFACTURING WORKING CAPITAL MANAGEMENT, PART B
After completing the short-term financial plan for next year (above part A), Gary Piepkorn approaches you and asks about the company's credit policy. In looking at the competition, most companies in the industry offer credit to customers, so Piepkorn Manufacturing appears to be one of the few companies that does not. Several customers have expressed the possibility of changing to a different supplier because of the lack of credit. Gary is interested in knowing how implementing a credit policy will affect the short-term financial plan for next year.
Additionally, he would like you to inquire as to the possibility of getting improved credit terms for the company's purchases. To analyze the possible switch to the new credit terms, Gary has asked you to investigate industry standard credit terms and rework the short-term financial plan assuming Piepkorn Manufacturing offers credit to its customers. He would also like to investigate how better credit terms from the company's suppliers would affect the short-term financial plan.
i. You have looked at the credit policy offered by your competitors and have determined that the industry standard credit policy is 1/10, net 45. The discount will begin to be offered on the first day of the year. You want to examine how this credit policy would affect the cash budget and short-term financial plan. If this credit policy is implemented, you believe that 60 percent of customers will take advantage of the credit offer and the accounts receivable period will be 24 days. Rework the cash budget and short-term financial plan under the new credit policy and a target cash balance of $80,000. What interest rate are you effectively offering customers?
ii. You have talked to the company's suppliers about the credit terms Piepkorn receives. Currently, the company receives terms of net 45. Your suppliers have stated that they would offer new credit terms of 2/25, net 40. The discount would begin to be offered on the first day of the year. What interest rate are the suppliers offering the company? Rework your cash budget and short-term financial plan from the previous question assuming you take advantage of the discount offered.
III. Suppose the rate of inflation in Russia will run about 3% higher than the U.S. inflation rate over the next several years. All other things being the same, what will happen to the ruble versus dollar exchange rate? What relationship are you relying on in answering?
IV. This question has to do with the Cash Account. Indicate the impact of the following corporate actions on cash, using the terms Increase, Decrease, or no change. For each, explain your conclusion.
o A dividend is paid with funds received from a sale of debt
o Real estate is purchased and paid for with short-term debt
o Inventory is bought on credit
o A short-term bank loan is repaid
o Next years' taxes are prepaid.
Format your homework according to the give formatting requirements:
a. The answer must be double spaced, typed, using Times New Roman font (size 12), with one-inch margins on all sides.
b. The response also includes a cover page containing the title of the homework, the course title, the student's name, and the date. The cover page is not included in the required page length.
c. Also include a reference page. The references and Citations should follow APA format. The reference page is not included in the required page length.