Corporate Finance

Questions and Practice problems_Chapter 15

Chapter 15:
Concept questions (page 490 textbook): 2, 6, 12, 13
Questions and Problems (page 491 textbook): 1, 4

Concept questions

Question 1: What are the main features of a corporate bond that would be listed in the
indenture?
- The total amount of the bonds issued
- A description of the property used as security
- Repayment arrangements
- Call provisions
- Convertibility provisions
- Details of protective covenants

Question 2: Preferred Stock and Debt: What are the differences between preferred stock
and debt?
a. The dividends on preferred stock cannot be deducted as interest expense when determining
taxable corporate income. From the individual investor’s point of view, preferred dividends are
ordinary income for tax purposes. For corporate investors, 70% of the amount they receive as
dividends from preferred stock are exempt from income taxes.
b. In case of liquidation (at bankruptcy), preferred stock is junior to debt and senior to common
stock.
c. There is no legal obligation for firms to pay out preferred dividends as opposed to the
obligated payment of interest on bonds. Therefore, firms cannot be forced into default if a
preferred stock dividend is not paid in a given year. Preferred dividends can be cumulative or
non-cumulative, and they can also be deferred indefinitely (of course, indefinitely deferring the
dividends might have an undesirable effect on the market value of the stock).

Question 3: Preferred stock doesn’t offer a corporate tax shield on the dividends paid. Why
do we still observe some firms issuing preferred stock?
There are still advantages:
- Public utilities can pass the tax disadvantage of issuing preferred stock on to their customers, so
there is a substantial amount of straight preferred stock issued by utilities.
- When reporting losses to the IRS, firms don't have positive income for any tax deductions, so
they are not affected by the tax disadvantage of dividends vs. interest payments.
- Firms that issue preferred stock can avoid the threat of bankruptcy that exists with debt
financing b/c preferred divs are not a legal obligation like interest payments on corporate debt.

Question 4: The yields on nonconvertible preferred stock are lower than the yields on
corporate bonds. Why is there a difference? Which investors are the primary holders of
preferred stock? Why?
There are two reasons the return is lower:
1) Corporate investors receive 70% tax deductibility on dividends if they hold the stock.
Therefore, they are willing to pay more for the stock; that lowers its return.
2) Issuing corporations are willing and able to offer higher returns on debt since the interest on
the debt reduces their tax liabilities. Preferred divs are paid out of net income, hence they provide
no tax shield.

Question 5: What are the main differences between corporate debt and equity? Why do
some firms try to issue equity in the guise of debt?
1) Repayment is an obligation of the firm: (Debt=yes, Equity=No)
2) Grants ownership of the firm: (Debt=No, Equity=Yes)
3) Provides a tax shield (Debt=Yes, Equity=No)
4) Liquidation will result if not paid (Debt=Yes, Equity=No

Question 6: Call Provisions: A company is contemplating a long-term bond issue. It is

debating whether to include a call provision. What are the benefits to the company from
including a call provision? What are the costs? How do these answers change for a put
provision?
- There are two benefits. First, the company can take advantage of interest rate declines by
calling in an issue and replacing it with a lower coupon issue. Second, a company might
wish to eliminate a covenant for some reason. Calling the issue does this. The cost to the
company is a higher coupon. A put provision is desirable from an investor’s standpoint,
so it helps the company by reducing the coupon rate on the bond. The cost to the
company is that it may have to buy back the bond at an unattractive price.

Question 7: What is a proxy?

It is the grant of authority by a shareholder to someone else to vote his or her shares.

Question 8: Do you think a preferred stock is more like debt or equity? Why?
Preferred stock is similar to both. Preferred shareholders get a stated dividend only, and if the
corporation is liquidated, preferred stockholders get a stated value. However, unpaid preferred
dividends are not debts of a company and preferred dividends are not a tax-deductible business
expense.

Question 9: New equity issues are generally only a small portion of all new issues. At the
same time, companies continue to issue new debt. Why do companies tend to issue little
new equity but continue to issue new debt?
In order to maintain it's capital structure, a company has to issue more debt to replace the old
debt that comes due.
There is a possibility that the MV of a company continues to increase. Which means that to
maintain a specific capital structure on a MV basis the company has to issue new debt since the
MV of existing debt generally does not increase as the value of the company increases.

Question 10: What is the difference between internal financing and external financing?
Internal financing comes from internally generated cash flows and does no require issuing
securities. External financing requires the firm to issue new securities.
Question 11: What factors influence a firm's choice of external versus internal equity
financing?
1) The general economic environment, specifically, business cycles
2) The level of stock prices
3) The availability of positive NPV projects

Question 12: Classes of Stock: Several publicly traded companies have issued more than
one class of stock. Why might a company issue more than one class of stock?
- When a company has dual class stock, the difference in the share classes are the voting
rights. Dual share classes allow minority shareholders to retain control of the company
even though they do not own a majority of the total shares outstanding. Often, dual share
companies were started by a family, and then taken public, but the founders want to
retain control of the company.

Question 13: Callable Bonds: Do you agree or disagree with the following statement: In an
efficient market, callable and noncallable bonds will be priced in such a way that there will
be no advantage or disadvantage to the call provision. Why?
- The statement is true. In an efficient market, the callable bonds will be sold at a lower
price than that of the non-callable bonds, other things being equal. This is because the
holder of callable bonds effectively sold a call option to the bond issuer. Since the issuer
holds the right to call the bonds, the price of the bonds will reflect the disadvantage to the
bondholders and the advantage to the bond issuer (i.e., the bondholder has the obligation
to surrender their bonds when the call option is exercised by the bond issuer.)

Question 14: If interest rates fall, will the price of noncallable bonds move up higher than
that of callable bonds? Why or why not?
They do. As the interest rates fall, the call option on the callable bond is more likely to be used
by the bond issuer. Since the non-callable bonds do not have this drawback, the value of the
bond will reflect the decrease in the market rate of interest by going up. Thus, the price of non-
callable bonds will move higher than that of the callable bonds.

Question 15: Sinking funds have both positive and negative characteristics for
bondholders. Why?
The sinking funds have both positive and negative characteristics for bondholders, as sinking
funds help the entity to repay its liability before the maturity of the debts. It leads to
improvement in the faith of the investors with the company through timely payment of a debt.

Questions and Problems

Question 1: The shareholders of the Stackhouse Company need to elect seven new directors.
There are 850,000 shares outstanding currently trading at $43 per share. You would like to serve
on the board of directors; unfortunately no one else will be voting for you. How much will it cost
you to be certain that you can be elected if the company uses straight voting? How much will it
cost you if the company uses cumulative voting?

=> Straight voting: (50%*850000*$43) + 1 = $18,275,001

 1
Cumulative voting: ( * 850000*$43) + 1 = $4,568,751
7+1

Question 2: An election is being held to fill three seats on the board of directors of a firm in
which you hold stock. The company has 7,600 shares outstanding. If the election is conducted
under cumulative voting and you own 300 shares, how many more shares must you buy to be
assured of earning a seat on the board?

=> The number of shares required as per cumulative voting is:

1 1
Shares = ( ∗S) + 1 = ( ∗¿ 7600) +1 = 1901
n+1 3+1
Extra shares required = 1901 – 300 = 1601

Question 3: The shareholders of Motive Power Corp. need to elect three new directors to the
board. There are 13,000,000 shares of common stock outstanding, and the current share price is
$10.50. If the company uses cumulative voting procedures, how much will it cost to guarantee
yourself one seat on the board of directors?

=> The number of shares required to guarantee one seat on the board of directors is given by this
formula:
S∗X 13000000∗1
N= +1= +1=3250001
D+ 1 3+1
Where: N stands for the number of shares
S stands for the number of outstanding shares
X stands for the number of seats to guarantee a seat
D stands for the number of directors to be elected

The amount it will cost to guarantee a directorial sea

= N * share price
= 3250001*$10.5 = $34125010.5

Question 4: Candle box Inc. is going to elect six board members next month. Betty Brown owns
17.4 percent of the total shares outstanding. How confident can she be of having one of her
candidate friends elected under the cumulative voting rule? Will her friend be elected for certain
if the voting procedure is changed to the staggering rule, under which shareholders vote on two
board members at a time?

=> Cumulative voting rule is a rule that applies to the process of voting in board members in
corporations that allow stockholders to vote proportionately to the number of shares they hold, in
essence, a stockholder with 1,000 shares of the company can cast 1,000 votes toward any single
issue or candidate.
% required to vote in her candidate=1/(1+N)
1 refers to her candidate
N=number of board members to be elected=6
% required to vote in her candidate=1/(1+6)=14.3%
The fact that Betty has 17.4% shareholding in the company, which is greater than the required
shareholding of 14.3% required to ensure her candidate success means that her friend will be
elected
% required for staggering rule=1/(1+N)
1 refers to her candidate
N=number of candidates that can be elected at a time=2
% required for staggering rule=1/(1+2)=33.3%
33.3% shareholding is needed to ensure her candidate success under the staggering rule, hence,
her friend may not likely be elected.

=> Cumulative voting, the percentage of company stock’s needed

= 1/N+1 = 1/6+1 = 14.3% < 17.4% => She can confident
Staggered voting, the percentage of company stock’s needed
= 1/2+1 = 33.3% > 17.4% => she cannot confident

Question 5: 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?
 Valuation of non-
a
callable bonds

Face Value of Bonds 5 mn

Face value of bond $ 1000

Number of bonds
0.005
(mn)

Coupon
8.00%
Rate

Interest 80.00

Market interest rate 7.00%

Maturity 30 Years

Period Particulars Amount $-mn Discounting @ 7% Value

1-30
Interest 12.409 992.72
Years 80.00

30th Redemption
1,000.00 131.00
Year value 0.13

Market value of the bond 1,123.72

Total value of bonds

5.62

Since market rate for these bonds is 7%, We have to discount the same @ 7% to get the
true value

b Callable one year from now @ $ 1080

Market Interest rate after one year(Equal probability)=10%*50%

+6%*50%=8%

Period Particulars Amount $-mn Discounting @ 8% Value

0-1 Interest 74.07

80.00 0.926
Question 6: 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? (facevalue = $1000)
=> The bond will be called whenever the price of bond higher than 1,000 + 150 = $1,150
Coupon payment = 1,000*10% = 100
- Scenario 1: 60% interest increase to 12%
P1 = 100/12% = 833.33 < 1,150 => the company will not call
- Scenario 2: 40% interest decrease to 7%
P2 = 100/7% = 1,428.57 > 1,150 => the company will call
The price of bond today is the PV of the expected price in one year + coupon payment madde in
1 year
P0 = [60%*833.33 + 40%*1,150]/(1+10%)^1 + 100/(1+10%) = 963.64

Question 9: An outstanding issue of Public Express Airlines debentures has a call provision
attached. The total principal value of the bonds is $250 million, and the bonds have an
annual coupon rate of 9 percent. The company is considering refunding the bond issue.
Refunding means that the company would issue new bonds and use the proceeds from the
new bond issuance to repurchase the outstanding bonds. The total cost of refunding would
be 10 percent of the principal amount raised. The appropriate tax rate for the company is
35 percent. How low does the borrowing cost need to drop to justify refunding with a new
bond issue?
The company should refund when the NPV of refunding is greater than zero, so we need to find
the interest rate that results in a zero NPV. The NPV of the refunding is the difference between
the gain from refunding and the refunding costs.

The gain from refunding is the bond value times the difference in the interest rate, discounted to
the present value. We must also consider that the interest payments are tax deductible, so the
aftertax gain is:

NPV = PV(Gain) – PV(Cost)

The present value of the gain will be:
Gain = $250,000,000(0.09 – R) / R
Since refunding would cost money today, we must determine the aftertax cost of refunding,
which will be:
Aftertax cost = $250,000,000(0.10)(1 – .35)= $16,250,000
So, setting the NPV of refunding equal to zero, we find:
0 = –$16,250,000 + $250,000,000(.09 – R) / R
=> R=8.45%
Any interest rate below this will result in a positive NPV from refunding.