Fin571_Week_5_Problem_Sets

Week 5 Text Problem Sets Felicia N. Lamar September 19, 2010 FIN/571 University of Phoenix Denny Frischkorn Week 5 Text Problem Sets Exercises Chapter 17 B1: (Choosing Financial Targets) Bixton Company’s new chief financial officer is evaluating Bixton’s capital structure. She is concerned that the firm might be underleveraged, even though the firm has larger-than-average research and development and foreign tax credits when compared to other firms in its industry. Her staff prepared the industry comparison shown here. A. Bixton’s objective is to achieve a credit standing that falls, in the words of the chief financial officer, “comfortably within the ‘A’ range.” What target range would you recommend for each of the three credit measures' Since the CFO wants to be “comfortably within the ‘A’ range”, then the ideal target range for each credit measure should be off of the low end of the credit ratings. Fixed Charge Coverage = 3.40-4.30 range Funds from Operations/Total Debt = 55-65 Long-term Debt/Capitalization = 25-30 B. Before settling on these target ranges, what other factors should Bixton’s chief financial officer consider' The CFO should consider how fully the company uses its non-interest tax credits and manages other debts like insurance costs. Also, they need to examine their assets that are intangible in nature. These intangible assets can lead to lenders not being willing to loan to Bixton like other companies C. Before deciding whether the target ranges are really appropriate for Bixton in its current financial situation, what key issues specific to Bixton must the chief financial officer resolve' Before deciding whether the target ranges are appropriate, the CFO should resolve the use of foreign tax credits and research and design. When these two factors are considered the CFO may find that other tax shields are not as valuable as believed. Chapter 18 A10: (Dividend Adjustment Model) Regional Software has made a bundle selling spreadsheet software and has begun paying cash dividends. The firm’s chief financial officer would like the firm to distribute 25% of its annual earnings (POR = 0.25) and adjust the dividend rate to changes in earnings per share at the rate ADJ = 0.75. Regional paid $1.00 per share in dividends last year. It will earn at least $8.00 per share this year and each year in the foreseeable future. Use the dividend adjustment model, to calculate projected dividends per share for this year and the next four. The dividend adjustment model D1 =ADJ [POR (EPS1) – D0] + D0 D1= 0.75[0.25 x 8.00 – 1.00] + 1.00 = 1.00 D2= 0.75[0.25 x 8.00 – 1.75] + 1.75 = 1.94 D3= 0.75[0.25 x 8.00 – 1.94] + 1.94 = 1.985 D4= 0.75[0.25 x 8.00 – 1.98] + 1.98 = 2.00 D5= 0.75[0.25 x 8.00 – 2.00] + 2.00 = 2.00 Chapter 18 B2: (Dividend Policy) A firm has 20 million common shares outstanding. It currently pays out $1.50 per share per year in cash dividends on its common stock. Historically, its payout ratio has ranged from 30% to 35%. Over the next five years it expects the earnings and discretionary cash flow shown below in millions. A. Over the five-year period, what is the maximum overall payout ratio the firm could achieve without triggering a securities issue' Discretionary Cash Flow Total= $50 + $70 + $60 + $20 + $15 = $215 Total Earnings = $100 + $125 + $150 + $120 + $140 = $635 Maximum Payout Ratio = $215 / $635 = 33.86% B. Recommend a reasonable dividend policy for paying out discretionary cash flow in years 1 through 5. To recommend a reasonable policy for paying out discretionary cash flow we have to take the current dividend 1.50 x 20 milling shares = $30 million The company could have a slow gradual increase from 30 to 50 D1= 35/20 = 1.75 D2= 39/20=1.95 D3= 43/20= 2.15 D4= 48/20 = 2.40 D5= 50/20= 2.50 The total discretionary cash flow is 215, and there is never a discretionary cash deficit since cash flows occur in the initial. Chapter 20 A2: (Comparing Borrowing Costs) Stephens Security has two financing alternatives: (1) A publicly placed $50 million bond issue. Issuance costs are $1 million, the bond has a 9% coupon paid semiannually, and the bond has a 20-year life. (2) A $50 million private placement with a large pension fund. Issuance costs are $500,000, the bond has a 9.25% annual coupon, and the bond has a 20-year life. Which alternative has the lower cost (annual percentage yield)' Alternative 1 Alternative 2 N=40 N = 20 R= R = PV = -(50 – 1) = -49 PV = -(50 -0.5) =49.5 PMT= 9 / 2 x 50 = 2.25 PMT = 9.25 x 50 = 4.625 FV = 50 FV = 50 R =4.61 R= 9.36 APY = (1+0.0461)² - 1 = 9.4334 APY= (1 +0.0936)² - 1= 9.36 Alternative 2 has the lower cost in terms of annual percentage yield. Chapter 21 C2: (Leasing, taxes, and the time value of money) The lessor can claim the tax deductions associated with asset ownership and realize the leased asset’s residual value. In return, the lessor must pay tax on the rental income. A. Explain why a financial lease represents a secured loan in which the lender’s entire debt service stream is taxable as ordinary income to the lessor/lender. A financial lease is a form of secured debt that when made in payments include the interest and principle repayment components. The lease payment is taxable to the lessor as an ordinary income, so that makes the entire debt stream ordinary income which is taxable. B. In view of this tax cost, what tax condition must hold in order for a financial lease transaction to generate positive net-present-value tax benefits for both the lessor and lessee' In order for a financial lease transaction to generate positive net-present-value tax for the lessor and lessee then the lessee’s payment tax shield plus the lessor’s depreciation tax shields plus any other credits have to be greater than the lessor’s lease payment tax liability plus the lessee’s depreciation tax shields plus any other credits. Keep in mind that this condition must hold in order to benefit both the lessee and lessor. C. Suppose the lease payments in Table 21-2 must be made in advance, not arrears. (Assume that the timing of the lease payment tax deductions/obligations changes accordingly but the timing of the depreciation tax deductions does not change). Show that the net advantage to leasing for NACCO must decrease as a result. Explain why this reduction occurs. The after tax lease payment is 1,745,000 – 698,000 = 1,047,000. It seems that the net advantage to leasing for NAACO should decrease because the payments are accelerated by a year NAL = 10,000,000 -7,810,789 -2,644,460 -123,592 -578,841 The lease payments are more than 500,000 lower than the net advantage to leasing that is shown in the text. That net advantage was -54,236. (I think) D. Show that if NACCO is nontaxable, the net advantage to leasing is negative and greater in absolute value than the net advantage of the lease to the lessor. If NAACO is nontaxable, the net advantage to leasing will be -1,142,472. The net advantage to the lessor will be 578,841. The net advantage to the lessor is smaller than the net advantage to the lessee in absolute value. E. Either find a lease rate that will give the financial lease a positive net advantage for both lessor and lessee, or show that no such lease rate exists. I don’t think that a lease rate that will give the financial lease a positive net advantage for both the lessor and lessee exists. For this condition a lease rate must have advantages for both parties and given the net advantage to leasing for both parties they cannot end up having benefits for both. F. Explain what your answer to part e implies about the tax costs and tax benefits of the financial lease when lease payments are made in advance. My answer to part E implies that the tax costs and tax benefits of the financial lease when payments are made in advance can impose a net tax cost when the lessor pays their income tax at a higher rate than the lessee.