Week_4

Lenders are more willing to lend a larger proportion of the market value of tangible assets than intangible assets. The reason is that the market for tangible assets is more liquid than the market for intangible and in the case of bankruptcy the lender would like to get the best price for the assets as fast as possible. The lender is therefore more willing to lend a higher percentage of the value of tangible than intangible assets 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' b. Before settling on these target ranges, what other factors should Bixton’s chief financial officer consider' 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' a. To be “comfortably” within the range, the firm should stay off the low end of the ratings. Fixed Charge Coverage = 3.40 - 4.30 Cash Flow / Total Debt = 45 - 65 Long-Term Debt / Total Capitalization = 22 - 32 b. Ability to use fully non-interest tax credits and debt management considerations such as issuance costs. The CFO should also consider that the firm’s R&D is an intangible asset and that lenders may not be willing to loan the same percentage of debt to Bixton as to its competitors. c. The CFO needs to consider R&D and foreign tax credits. The additional tax shield from additional debt may not be valuable when R&D and foreign tax credits are taken into consideration. Chapter 18 Extra Dividend = $3.80 x 0.40 - $1.20 = $0.32 D1 = ADJ [POR(EPS1) - D0] + D0 D1 = 0.75 [0.25 x $8.00 - $1.00] + $1.00 = $1.75 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 a. Total discretionary cash flow = $50 + $70 + $60 + $20 + $15 = $215 Total earnings = $100 + $125 + $150 + $120 + $140 = $635 Maximum Payout Ratio = $215 / $635 = 33.86% b. Current dividend = $1.50 x 20 million shares = $30 million The firm could gradually increase the dividend from $30 million to $50 million. 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 Note that $35 + $39 + $43 + $48 + $50 = $215, the total discretionary cash flow and since large discretionary cash flows occur at the beginning, there is never a discretionary cash deficit. Chapter 20 Debt covenants impose restrictions, intended to protect bondholders, on the firm that issued the bonds. Debt covenants may limit the issuance of additional debt, the payment of dividends, liens, subsidiary borrowing, asset disposition, mergers, and sale and leaseback. 1. Interest Coverage Ratio = EBIT / Interest Expense = $70 million / $14 million = 5 5 > 4, Dallas Instruments is in compliance. 2. Tangible Assets / Long-Term Debt = $400 million / $175 million = 2.29 2.29 > 1.5, Dallas Instruments is in compliance. 3. Cumulative Dividends and Share Repurchases = $40 million + $40 million = $80 million $80 million < $200 million x 60%, Dalals Instrument is in compliance. Dallas meets all of the covenants and is therefore in compliance. Chapter 21 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 lease represents a form of secured debt. Each lease payment includes an interest component and a principal repayment component. Because the lease payment is taxable as ordinary income to the lessor, in effect, the entire debt service stream (i.e., the interest component and the principal component) is taxable as ordinary income. 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' The following condition must hold: PV(lessee's lease payment tax shields) + PV(lessor's depreciation tax shields + other tax credits) PV(lessor's lease payment tax liability) + PV(lessee's depreciation tax shields + other tax credits) in order for a financial lease transaction to generate positive net present value benefits for lessor and lessee combined. 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. Each after-tax lease payment is $1,047,000 (= 1,745,000 - 698,000). The net advantage to leasing for NACCO must decrease because the lease payments are accelerated by 1 year: which is more than $500,000 lower than the net advantage to leasing calculated in the text, which was -$54,236. 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 NACC) is nontaxable, its net advantage to leasing is: The net advantage of the lease to the lessor is: which is smaller than NAL in absolute value. e. Either find a lease rate that will give the financial lease a positive net advantage for both lesser and lessee, or show that no such lease rate exists. A mutually advantageous lease rate, L, must satisfy the following two conditions simultaneously: The two conditions cannot be satisfied simultaneously; a mutually beneficial lease rate therefore does not exist. 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. Making the lease payments in advance imposes a net tax cost when the lessor pays income tax at a higher rate than the lessee.