Nealon Energy Corporation engages in the acquisition, exploration, development, and production of natural gas and oil in the continental United States. The company has grown rapidly over the last 5 years as it has expanded into horizontal drilling techniques for the development of the massive deposits of both gas and oil in shale formations. The company’s operations in the Haynesville shale (located in northwest Louisiana) have been so significant that it needs to construct a natural gas gathering and processing center near Bossier City, Louisiana, at an estimated cost of $70 million. To finance the new facility, Nealon has $20 million in profits that it will use to finance a portion of the expansion and plans to sell a bond issue to raise the remaining $50 million. The decision to use so much debt financing for the project was largely due to the argument by company CEO Douglas Nealon Sr. that debt financing is relatively cheap relative to common stock (which the firm has used in the past). Company CFO Doug Nealon Jr. (son of the company founder) did not object to the decision to use all debt but pondered the issue of what cost of capital to use for the expansion project. There was no doubt that the out-of-pocket cost of financing was equal to the new interest that must be paid on the debt. However, the CFO also knew that by using debt for this project the firm would eventually have to use equity in the future if it wanted to maintain the balance of debt and equity it had in its capital structure and not become overly dependent on borrowed funds. The following balance sheet reflects the mix of capital sources that Nealon has used in the past. Although the percentages would vary over time, the firm tended to manage its capital structure back toward these proportions: SOURCE OF FINANCING TARGET………….CAPITAL STRUCTURE WEIGHTS bonds…………………………………………………………………………….40% Common Stock……………………………………………………………….60% The firm currently has one issue of bonds outstanding. The bonds have a par value of $1,000 per bond, carry an 8 percent coupon rate of interest, have 16 years to maturity, and are selling for $1,035. Nealon’s common stock has a current market price of $35, and the firm paid a $2.50 dividend last year that is expected to increase at an annual rate of 6 percent for the foreseeable future. a. What is the yield to maturity for Nealon’s bonds under current market conditions? b. What is the cost of new debt financing to Nealon based on current market prices after both taxes (you may use a 34 percent marginal tax rate for your estimate) and flotation costs of $30 per bond have been considered? c. What is the investor’s required rate of return for Nealon’s common stock? If Nealon were to sell new shares of common stock, it would incur a cost of $2.00 per share. What is your estimate of the cost of new equity financing raised from the sale of common stock? d. Compute the weighted average cost of capital for Nealon’s investment using the weights reflected in the actual financing mix (that is, $20 million in retained earnings and $50 million in bonds). e. Compute the weighted average cost of capital for Nealon where the firm maintains its target capital structure by reducing its debt offering to 40 percent of the $70 million in new capital, or $28 million, using $20 million in retained earnings and raising $22 million through a new equity offering. f. If you were the CFO for the company, would you prefer to use the calculation of the cost of capital in part (d) or (e) to evaluate the new project? Why?
> From an investor’s standpoint, what are the key differences between Treasury and agency issues?
> What is a bond refunding? Is it the same thing as a call?
> What is the difference between gross margin and operating margin? What do they tell us? Generally speaking, are larger or smaller values better?
> Both ROA and ROE measure profitability. Which one is more useful for comparing two companies? Why?
> Why do you think most long-term financial planning begins with sales forecasts? Put differently, why are future sales the key input?
> A put and a call option have the same maturity and strike price. If both are at the money, which is worth more? Prove your answer and then provide an intuitive explanation.
> Recall the option strategies of a protective put and covered call discussed in the text. Suppose you have sold short some shares of stock. Discuss analogous option strategies and how you would implement them. (Hint: They’re called protective calls and co
> A put and a call option have the same maturity and strike price. If they also have the same price, which one is in the money?
> Are the put options in the money? What is the intrinsic value of a Milson Corp. put option? Calls Puts Option & Strike N.Y. Close Price Expiration Vol. Last Vol. Last Milson 59 55 Mar 98 3.50 66 1.06 59 55 Apr 54 6.25 40 1.94 59 55 Jul 25 8.63 17 3.
> Are the call options in the money? What is the intrinsic value of a Milson Corp. call option? Calls Puts Option & Strike N.Y. Close Price Expiration Vol. Last Vol. Last Milson 59 55 Mar 98 3.50 66 1.06 59 55 Apr 54 6.25 40 1.94 59 55 Jul 25 8.63 17
> How many option contracts on Milson stock were traded with an expiration date of July? How many underlying shares of stock do these option contracts represent? Calls Puts Option & Strike N.Y. Close Price Expiration Vol. Last Vol. Last Milson 59 55 M
> Regarding Ms. Smith’s and Mr. Van Eaton’s statements made about the competitive strategy of the South Winery: a. Both are incorrect. b. Both are correct. c. Only one is correct.
> Two of the options are clearly mispriced. Which ones? At a minimum, what should the mispriced options sell for? Explain how you could profit from the mispricing in each case. Calls Puts Option & Strike N.Y. Close Price Expiration Vol. Last Vol. Last
> Mr. Van Eaton tells Ms. Smith that he likes the fact that the conclusions in her report are backed up with facts, but he tells her that he is concerned about the section concerning the bargaining power of buyers. He says that while all of the points she
> Ms. Smith would likely categorize the French wine industry into which of the following life cycle phases? a. Decline phase b. Pioneer phase c. Mature phase
> If the French home currency were to greatly appreciate in value compared to the English currency, what is the likely impact on the East Winery? a. Make the firm less competitive in the English market. b. No impact since the major market for East Winery i
> Explain why the right to prepay a mortgage is similar to the call feature contained in most corporate bonds.
> What does it mean for a mortgage pool to be fully modified?
> From an investor’s point of view, what is the difference between mortgage pools backed by GNMA, FNMA, and FHLMC?
> All else the same, will the payments be higher on a 15-year mortgage or a 30-year mortgage? Why?
> How does mortgage securitization benefit mortgage originators?
> How does mortgage securitization benefit borrowers?
> Why is inflation associated with lower values of real GDP and wages?
> What is the impact of lengthening the time to expiration on an option’s value? Explain.
> What is a call option? A put option? Under what circumstances might you want to buy each? Which one has greater potential profit? Why?
> Zenith Co.’s bonds mature in 12 years and pay 7 percent interest annually. If you purchase the bonds for $1,150, what is your expected rate of return?
> Citigroup issued bonds that pay a 5.5 percent coupon interest rate. The bonds mature in 5 years. They are selling for $1,076. What would be your expected rate of return (yield to maturity) if you bought the bonds? What would the current yield be?
> Time Warner has bonds that are selling for $1,371. The coupon interest rate on the bonds is 9.15 percent, and they mature in 21 years. What is the yield to maturity on the bonds? What is the current yield?
> You own a bond that has a par value of $1,000 and matures in 5 years. It pays a 5 percent annual coupon rate. The bond currently sells for $1,100. What is the bond’s expected rate of return?
> The market price is $900 for a 10-year bond ($1,000 par value) that pays 6 percent interest (6 percent semiannually). What is the bond’s expected rate of return?
> The Latham Corporation is planning on issuing bonds that pay no interest but can be converted into $1,000 at maturity, 7 years from their purchase. To price these bonds competitively with other bonds of equal risk, it is determined that they should yield
> ExxonMobil 20-year bonds pay 6 percent interest annually on a $1,000 par value. If the bonds sell at $945, what is the bonds’ expected rate of return?
> At the beginning of the year, you bought a $1,000 par value corporate bond with a 6 percent annual coupon rate and a 10-year maturity date. When you bought the bond, it had an expected yield to maturity of 8 percent. Today the bond sells for $1,060. a. W
> You purchased a bond for $1,100. The bond has a coupon rate of 8 percent, which is paid semiannually. It matures in 7 years and has a par value of $1,000. What is your expected rate of return?
> You own a 10-year bond that pays 6 percent interest annually. The par value of the bond is $1,000, and the market price of the bond is $900. What is the yield to maturity of the bond?
> Assume you own a bond with a market value of $820 that matures in 7 years. The par value of the bond is $1,000. Interest payments of $30 are paid semiannually. What is your expected rate of return on the bond?
> An 8-year bond for Rusk Corporation has a market price of $700 and a par value of $1,000. If the bond has an annual interest rate of 6 percent, but pays interest semiannually, what is the bond’s yield to maturity?
> Assume the market price of a 5-year bond for Margaret, Inc. is $900, and it has a par value of $1,000. The bond has an annual interest rate of 6 percent that is paid semiannually. What is the yield to maturity of the bond?
> Calculate the value of a bond that will mature in 14 years and has a $1,000 face value. The annual coupon interest rate is 5 percent, and the investor’s required rate of return is 7 percent.
> What are the markets and mechanics involved in generating simple arbitrage profits?
> What is meant by arbitrage profits?
> What different types of businesses operate in the international environment? Why are the techniques and strategies available to these firms different?
> How can we accommodate the effects of compounding in our calculation of the effective cost of short-term credit?
> How can the formula “interest = principle * rate * time” be used to estimate the cost of short-term credit?
> Define the following terms: a. Permanent asset investments b. Temporary asset investments c. Permanent sources of financing d. Temporary sources of financing e. Spontaneous sources of financing
> Define the hedging principle. How can this principle be used in the management of working capital?
> Explain what is meant by the statement “The use of current liabilities as opposed to long-term debt subjects the firm to a greater risk of illiquidity.”
> What advantages and disadvantages are generally associated with the use of short-term debt? Discuss.
> Discuss the risk–return relationship involved in the firm’s asset-investment decisions as that relationship pertains to its working capital management.
> Define and contrast the terms working capital and net working capital.
> Define the following: a. Line of credit b. Commercial paper c. Compensating balance d. Prime rate
> What is meant by the following trade credit terms: 2/10, net 30? 4/20, net 60? 3/15, net 45?
> There are three major sources of unsecured short-term credit other than accrued wages and taxes. List and discuss the distinguishing characteristics of each.
> Dell Computer Corporation (DELL) has long been recognized for its innovative approach to managing its working capital. Describe how Dell pioneered the management of net working capital to free up resources in the firm.
> What would be the probable effect on a firm’s cash position of each of the following events? a. Rapidly rising sales b. A delay in the payment of payables c. A more liberal credit policy on sales (to the firm’s customers) d. Holding larger inventories
> Discuss the shortcomings of the percent of sales method of financial forecasting.
> United Parcel Service (UPS) provides package delivery services throughout the United States and the world. Discuss the impact of seasonal variations in the delivery business for forecasting the firm’s financing requirements.
> What is the primary weakness of using EBIT-EPS analysis as a financing decision tool?
> Define the following terms: a. Financial structure b. Capital structure c. Optimal capital structure d. Debt capacity
> You have finally saved $10,000 and are ready to make your first investment. You have the three following alternatives for investing the money: • A Microsoft bond with a par value of $1,000 that pays 4.2 percent on its par value in interest, sells for $1,
> Break-even analysis assumes linear revenue and cost functions. In reality, these functions may not always be linear over large output and sales levels. Why?
> A manager in your firm decides to employ break-even analysis. Of what shortcomings should this manager be aware?
> Distinguish between business risk and financial risk. What each type of risk?
> Explain how the financial manager might use industry norms in the design of the company’s financing mix.
> Many CFOs believe that the firm’s composite cost of capital is saucer-shaped or U-shaped. What does this mean?
> Why might firms whose sales levels change drastically over time choose to use debt only sparingly in their capital structures?
> In the chapter introduction we learned that AT&T (T) borrowed $3 billion by issuing bonds in the public bond market. Although this may sound like a lot of money, AT&T owed almost $65 billion in corporate debt at the end of 2011. The company had over $27
> Explain how simulation works. What is the value in using a simulation approach?
> Use the concept of real options to explain why large restaurant chains often introduce new concept restaurants that have negative NPVs.
> How do sunk costs affect the determination of cash flows associated with an investment proposal?
> Here are data on $1,000 par value bonds issued by Microsoft, GE Capital, and Morgan Stanley. Assume you are thinking about buying these bonds. Answer the following questions. a. Assuming interest is paid annually, calculate the values of the bonds if you
> If a project requires an additional investment in working capital, how should this be treated when calculating the project’s cash flows?
> If depreciation is not a cash-flow expense, does it affect the level of cash flows from a project in any way? Why?
> Why do we focus on cash flows rather than accounting profits in making our capital-budgeting decisions? Why are we interested only in incremental cash flows rather than total cash flows?
> When might two mutually exclusive projects having unequal lives be incomparable? How should managers deal with this problem?
> What causes the time-disparity ranking problem? What reinvestment rate assumptions are associated with the NPV and IRR capital-budgeting criteria?
> What are common reasons for capital rationing? Is capital rationing rational?
> What are mutually exclusive projects? Why might the existence of mutually exclusive projects cause problems in the implementation of the discounted cash flow capital-budgeting criteria?
> Briefly compare and contrast the NPV, PI, and IRR criteria. What are the advantages and disadvantages of using each of these methods?
> In some countries, the expropriation (seizure) of foreign investments is a common practice. If you were considering an investment in one of these countries, would the use of the payback period criterion seem more reasonable than it otherwise might? Why o
> What are the disadvantages of using the payback period as a capital- budgeting technique? What are its advantages? Why is it so frequently used?
> This Mini Case is available in My Finance Lab. Note: Although not absolutely necessary, you are advised to use a computer spreadsheet to work the following problem. a. Use the price data from the table that follows for the Standard & Poorâ€
> Why is capital budgeting such an important process? Why are capital budgeting errors so costly?
> What might we expect to see in practice regarding the relative costs of different sources of capital?
> a. Distinguish between internal common equity and new common stock. b. Why is there a cost associated with internal common equity? c. Describe two approaches that could be used in computing the cost of common equity.
> How does a firm’s tax rate affect its cost of capital? What is the effect of the flotation costs associated with a new security issue on a firm’s weighted average cost of capital?
> In computing the cost of capital, which sources of capital should be considered?
> Why do firms calculate their weighted average cost of capital?
> In 2009, ExxonMobil (XOM) announced its intention to acquire XTO Energy for $41 billion. The acquisition provided ExxonMobil an opportunity to engage in the development of shale and unconventional natural gas resources within the continental United State
> Define the term cost of capital.
> The corporate treasurer of Aggieland Fireworks is considering the purchase of a BBB-rated bond that carries a 9 percent coupon. The BBB-rated security is taxable, and the firm is in the 46 percent marginal tax bracket. The face value of this bond is $1,0
> Compute the annual depreciation for an asset that costs $250,000 and is in the 5-year property class. Use the MACRS in your calculation.
> Interpret the following information regarding Westlake Corporation’s cash flows. Net income……………………………………………………$680 Depreciation expense………………………………………..125 Profits before depreciation………………………………..805 Increase in accounts receivable……………………... (200) I
> If the real risk-free rate of interest is 4.8% and the rate of inflation is expected to be constant at a level of 3.1%, what would you expect 1-year Treasury bills to return if you ignore the cross product between the real rate of interest and the inflat
> You are considering an investment in Minnix Petroleum’s preferred stock. The preferred stock pays a dividend of $2.31. Your required return is 12 percent. Value the stock.
> Explain the three factors that determine the intrinsic, or economic, value of an asset.
> Sarah Wiggum would like to make a single investment and have $2 million at the time of her retirement in 35 years. She has found a mutual fund that will earn 4 percent annually. How much will Sarah have to invest today? If Sarah were a finance major and
> Assume the expected inflation rate to be 4%. If the current real rate of interest is 6%, what ought the nominal rate of interest to be?
> What would you expect the nominal rate of interest to be if the real rate is 4% and the expected inflation rate is 7%?
> a. Compute an appropriate rate of return for Intel common stock, which has a beta of 1.2. The risk-free rate is 2 percent, and the market portfolio (NYSE stocks) has an expected return of 11 percent. b. Why is the rate you computed an appropriate rate?
