Question: The Howland Carpet Company has grown rapidly
The Howland Carpet Company has grown rapidly during the past 5 years. Recently, its commercial bank urged the company to consider increasing its permanent financing. Its bank loan under a line of credit has risen to $250,000, carrying an 8% interest rate. Howland has been 30 to 60 days late in paying trade creditors.
Discussions with an investment banker have resulted in the decision to raise $500,000 at this time. Investment bankers have assured the firm that the following alternatives are feasible (flotation costs will be ignored).
â— Alternative 1: Sell common stock at $8.
â— Alternative 2: Sell convertible bonds at an 8% coupon, convertible into 100 shares of common stock for each $1,000 bond (i.e., the conversion price is $10 per share).
◠Alternative 3: Sell debentures at an 8% coupon, each $1,000 bond carrying 100 warrants to buy common stock at $10. John L. Howland, the president, owns 80% of the common stock and wishes to maintain control of the company. There are 100,000 shares outstanding. The following are extracts of Howland’s latest financial statements:
a. Show the new balance sheet under each alternative. For Alternatives 2 and 3, show the balance sheet after conversion of the bonds or exercise of the warrants. Assume that half of the funds raised will be used to pay off the bank loan and half to increase total assets.
b. Show Mr. Howland’s control position under each alternative, assuming that he does not purchase additional shares.
c. What is the effect on earnings per share of each alternative, assuming that profits before interest and taxes will be 20% of total assets?
d. What will be the debt ratio (TL/TA) under each alternative?
e. Which of the three alternatives would you recommend to Howland, and why?
Transcribed Image Text:
Balance Sheet Current liabilities $400,000 Common stock, par $1 100,000 Retained earnings 50,000 Total assets $550,000 Total claims $ 550,000 Income Statement Sales $1,100,000 All costs except interest 990,000 EBIT $ 110,000 Interest 20,000 Pre-tax earnings $ 90,000 Taxes (40%) 36,000 Net income 54,000 Shares outstanding 100,000 Earnings per share $0.54 Price/earnings ratio 15.83 Market price of stock $8.55 %24
> a. Synergy; merger b. Horizontal merger; vertical merger; congeneric merger; conglomerate merger c. Friendly merger; hostile merger; defensive merger; tender offer; target company; breakup value; acquiring company d. Operating merger; financial merger e.
> What are the two principal reasons for holding cash? Can a firm estimate its target cash balance by summing the cash held to satisfy each of the two reasons?
> Discuss this statement: “Firms can control their accruals within fairly wide limits.”
> Is it true that, when one firm sells to another on credit, the seller records the transaction as an account receivable while the buyer records it as an account payable and that, disregarding discounts, the receivable typically exceeds the payable by the
> What is a convertible? If a company decides to raise capital by issuing convertible bonds, how would the terms on the bond be set? Consider specifically the maturity, coupon rate, and call features of the bond, as well as the conversion price (or convers
> What is a warrant? If a company decides to raise capital by issuing bonds with warrants, how would the terms on both the bond and the warrant be set? Consider in particular how the coupon rate and maturity of the bond would be related to the exercise pri
> If a company is thinking about issuing preferred stock to raise capital, what are some factors that it should consider? What factors should an investor consider before buying preferred stock?
> Suppose you just bought a convertible bond at its par value. Your broker gives you information on the bond’s conversion ratio, coupon rate, maturity, years of call protection, and the yield on nonconvertible bonds of similar risk and maturity. The compan
> Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is rethinking her company’s working capital policy in light of a recent scare she faced when RR’s corporate banker, citing a nationwide cre
> Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. The firm was founded 5 years ago to provide educational software for the rapidly expanding primary and secondary school markets. Although EduSoft has done well, the firm’s founder belie
> Define each of the following terms: a. Lessee; lessor b. Operating lease; financial lease; sale-and-leaseback; combination lease; synthetic lease; SPE c. Off–balance sheet financing; capitalizing d. FASB Statement 13 e. Guideline lease f. Residual value
> Distinguish between the APV, FCFE, and corporate valuation models.
> What is interest rate parity? How might the treasurer of a multinational firm use the interest rate parity concept: (a) when deciding how to invest the firm’s surplus cash and (b) when deciding where to borrow funds on a short-term basis?
> In our Anderson Company example, we assumed that the lease could not be canceled. What effect would a cancellation clause have on the lessee’s analysis? On the lessor’s analysis?
> Suppose Congress enacted new tax law changes that would: (1) permit equipment to be depreciated over a shorter period, (2) lower corporate tax rates, and (3) reinstate the investment tax credit. Discuss how each of these potential changes would affect
> Suppose there were no IRS restrictions on what constituted a valid lease. Explain, in a manner a legislator might understand, why some restrictions should be imposed. Illustrate your answer with numbers.
> One advantage of leasing voiced in the past is that it kept liabilities off the balance sheet, thus making it possible for a firm to obtain more leverage than it otherwise could have. This raised the question of whether or not both the lease obligation a
> Commercial banks moved heavily into equipment leasing during the early 1970s, acting as lessors. One major reason for this invasion of the leasing industry was to gain the benefits of accelerated depreciation and the investment tax credit on leased equip
> Are lessees more likely to be in higher or lower income tax brackets than lessors?
> Distinguish between operating leases and financial leases. Would you be more likely to find an operating lease employed for a fleet of trucks or for a manufacturing plant?
> Is it true that most firms are able to obtain some free trade credit and that additional trade credit is often available, but at a cost? Explain.
> From the standpoint of the borrower, is long-term or short-term credit riskier? Explain. Would it ever make sense to borrow on a short-term basis if short-term rates were above long-term rates?
> What are the advantages of matching the maturities of assets and liabilities? What are the disadvantages?
> What is a futures contract, and how are futures used to manage risk? What are you protecting against if you buy Treasury futures contracts? What if you sell Treasury futures short?
> What are the four elements of a firm’s credit policy? To what extent can firms set their own credit policies as opposed to accepting policies that are dictated by its competitors?
> Define each of the following terms: a. Working capital; net working capital; net operating working capital b. Relaxed policy; restricted policy; moderate policy c. Permanent operating current assets; temporary operating current assets d. Moderate (maturi
> What kinds of firms use commercial paper?
> The Thompson Corporation projects an increase in sales from $1.5 million to $2 million, but it needs an additional $300,000 of current assets to support this expansion. Thompson can finance the expansion by no longer taking discounts, thus increasing acc
> Suppose a firm makes purchases of $3.65 million per year under terms of 2/10, net 30, and takes discounts. a. What is the average amount of accounts payable net of discounts? (Assume the $3.65 million of purchases is net of discounts—that is, gross purc
> Dorothy Koehl recently leased space in the Southside Mall and opened a new business, Koehl’s Doll Shop. Business has been good, but Koehl frequently runs out of cash. This has necessitated late payment on certain orders, which is beginn
> Payne Products had $1.6 million in sales revenues in the most recent year and expects sales growth to be 25% this year. Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $1 million of fixe
> Strickler Technology is considering changes in its working capital policies to improve its cash flow cycle. Strickler’ss sales last year were $3,250,000 (all on credit), and its net profit margin was 7%. Its inventory turnover was 6.0 times during the ye
> Negus Enterprises has an inventory conversion period of 50 days, an average collection period of 35 days, and a payables deferral period of 25 days. Assume that cost of goods sold is 80% of sales. a. What is the length of the firm’s cash conversion cycle
> Grunewald Industries sells on terms of 2/10, net 40. Gross sales last year were $4,562,500 and accounts receivable averaged $437,500. Half of Grunewald’s customers paid on the 10th day and took discounts. What are the nominal and effective costs of trade
> What types of risks are interest-rate and exchange rate swaps designed to mitigate? Why might one company prefer fixed-rate payments while another company prefers floating-rate payments, or payments in one currency versus another?
> a. If a firm buys under terms of 3/15, net 45, but actually pays on the 20th day and still takes the discount, what is the nominal cost of its nonfree trade credit? b. Does it receive more or less credit than it would if it paid within 15 days?
> Snider Industries sells on terms of 2/10, net 45. Total sales for the year are $1,500,000. Thirty percent of customers pay on the 10th day and take discounts; the other 70% pay, on average, 50 days after their purchases. a. What is the days sales outstan
> What is the nominal and effective cost of trade credit under the credit terms of 3/15, net 30?
> Williams & Sons last year reported sales of $10 million and an inventory turnover ratio of 2. The company is now adopting a new inventory system. If the new system is able to reduce the firm’s inventory level and increase the firm’s inventory turnover ra
> The Raattama Corporation had sales of $3.5 million last year, and it earned a 5% return (after taxes) on sales. Recently, the company has fallen behind in its accounts payable. Although its terms of purchase are net 30 days, its accounts payable represen
> Why do companies use so many different types of instruments to raise capital? Why not just use debt and common stock?
> Define each of the following terms: a. Preferred stock b. Cumulative dividends; arrearages c. Warrant; detachable warrant d. Stepped-up price e. Convertible security f. Conversion ratio; conversion price; conversion value g. Sweetener
> Suppose a company simultaneously issues $50 million of convertible bonds with a coupon rate of 10% and $50 million of straight bonds with a coupon rate of 14%. Both bonds have the same maturity. Does the convertible issue’s lower coupon rate suggest that
> Evaluate the following statement: “Issuing convertible securities is a means by which a firm can sell common stock for more than the existing market price.”
> How does a firm’s dividend policy affect each of the following? a. The value of its long-term warrants b. The likelihood that its convertible bonds will be converted c. The likelihood that its warrants will be exercised
> What does it mean to “manage” risk? Should its stockholders want a firm to “manage” all of the risks it faces?
> If a firm expects to have additional financial requirements in the future, would you recommend that it use convertibles or bonds with warrants? What factors would influence your decision?
> What effect does the trend in stock prices (subsequent to issue) have on a firm’s ability to raise funds through: (a) convertibles and (b) warrants?
> Is preferred stock more like bonds or common stock? Explain.
> Fifteen years ago, Roop Industries sold $400 million of convertible bonds. The bonds had a 40-year maturity, a 5.75% coupon rate, and paid interest annually. They were sold at their $1,000 par value. The conversion price was set at $62.75, and the common
> The Tsetsekos Company was planning to finance an expansion. The principal executives of the company all agreed that an industrial company such as theirs should finance growth by means of common stock rather than by debt. However, they felt that the curre
> Maese Industries Inc. has warrants outstanding that permit the holders to purchase 1 share of stock per warrant at a price of $25. a. Calculate the exercise value of the firm’s warrants if the common sells at each of the following prices: (1) $20, (2) $2
> Neubert Enterprises recently issued $1,000 par value 15-year bonds with a 5% coupon paid annually and warrants attached. These bonds are currently trading for $1,000. Neubert also has outstanding $1,000 par value 15-year straight debt with a 7% coupon pa
> Niendorf Incorporated needs to raise $25 million to construct production facilities for a new type of USB memory device. The firm’s straight nonconvertible debentures currently yield 9%. Its stock sells for $23 per share, has an expected constant growth
> Stohs Semiconductor Corporation plans to issue $50 million of 20-year bonds in 6 months. The interest rate would be 9% if the bonds were issued today. How can Stohs set up a hedge against an increase in interest rates over the next 6 months? Assume that
> Big Sky Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply. 1. The machinery falls into the MACRS 3
> Two companies, Energen and Hastings Corporation, began operations with identical balance sheets. A year later, both required additional fixed assets at a cost of $50,000. Energen obtained a 5-year, $50,000 loan at an 8% interest rate from its bank. Hasti
> Consider the data in Problem 19-1. Assume that Reynolds’ tax rate is 40% and that the equipment’s depreciation would be $100 per year. If the company leased the asset on a 2-year lease, the payment would be $110 at the beginning of each year. If Reynolds
> Reynolds Construction needs a piece of equipment that costs $200. Reynolds can either lease the equipment or borrow $200 from a local bank and buy the equipment. If the equipment is leased, the lease would not have to be capitalized. Reynoldsâ€
> Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a bank loan for 100% of the required amount. Alternatively, a Texas investment banking firm that represents a group of investors believes it can arrange for a lea
> What are some reasons why companies decide to go public? If going public is a good idea, why don’t all companies do so?
> How do companies decide whether or not to refund their outstanding bonds? If the NPV as calculated in a bond refunding analysis is positive, does that mean that the company should call and refund the bond? What is the effect of calling a bond on its bond
> What’s the difference between an IPO and an SEO? Would you view purchasing a stock in an SEO to be more or less risky than purchasing a stock in an IPO? Would you expect the same first day returns for an SEO purchase as for an IPO purchase? Why?
> On the day an IPO comes out, the market price can rise above the offering price or fall below that price. Is it more common for the market price to close above or below the offering price on the day of an IPO? If a company’s market price rises above the
> Jan Volk, financial manager of Green Sea Transport (GST), has been asked by her boss to review GST’s outstanding debt issues for possible bond refunding. Five years ago, GST issued $40,000,000 of 11%, 25-year debt. The issue, with semiannual coupons, is
> Is bankruptcy a fairly common occurrence among large companies, or is it restricted primarily to small firms?
> Bynum and Crumpton Inc. (B&C), a small jewelry manufacturer, has been successful and has enjoyed a positive growth trend. Now B&C is planning to go public with an issue of common stock, and it faces the problem of setting an appropriate price for
> Benjamin Garcia’s start-up business is succeeding, but he needs $200,000 in additional funding to fund continued growth. Benjamin and an angel investor agree the business is worth $800,000 and the angel has agreed to invest the $200,000 that is needed. B
> Security Brokers Inc. specializes in underwriting new issues by small firms. On a recent offering of Beedles Inc., the terms were as follows: Price to public: ……………………………. $5 per share Number of shares: ………………………. 3 million Proceeds to Beedles: ……………………
> Mullet Technologies is considering whether or not to refund a $75 million, 12% coupon, 30-year bond issue that was sold 5 years ago. It is amortizing $5 million of flotation costs on the 12% bonds over the issue’s 30-year life. Mullet’s investment banks
> What is a synthetic lease? How are such leases structured, and what is their primary purpose? Is it likely that the use of synthetic leases will increase or decrease?
> Differentiate between an operating lease, a capital lease (also known as a financial lease), and a sale and leaseback arrangement. How might investors be misled by firms that use lease financing extensively, and what rules have accounts put in place in a
> Is leasing a zero sum game in the sense that any gain to the lessee is a cost to the lessor? If not, how might both parties gain from a lease transaction? In your answer, explain how the lessee and the lessor analyze the situation, why they might use dif
> Define the term NAL as it is used in lease analysis, and then explain how the NAL is calculated.
> Assuming that FASB Statement 13 is working as it is supposed to work, should traditional leasing arrangements enable a firm to use more financial leverage than it otherwise could? How do synthetic leases alter the situation? How do FASB Statement 13 and
> How do IRS regulations affect leasing decisions?
> In your answers to the following set of questions, assume that Ross Corporation has $200 million of assets at book value, $150 million of liabilities owed to 500 different creditors, and $50 million of common equity book value. Also, assume that Ross has
> Lewis Securities Inc. has decided to acquire a new market data and quotation system for its Richmond home office. The system receives current market prices and other information from several online data services and then either displays the information o
> The stockholders’ claim in a levered firm can be viewed as a call option; stockholders have the option to purchase the firm’s assets by paying off its debt. What incentives does this provide to stockholders and managers in choosing investment projects?
> How is the value of a financial option affected by: (a) the current price of the underlying asset, (b) the exercise (or strike) price, (c) the risk-free rate, (d) the time until expiration (or maturity), and (e) the variance of returns on the asset?
> Define each of the following terms: a. MM Proposition I without taxes and with corporate taxes b. MM Proposition II without taxes and with corporate taxes c. Miller model d. Adjusted present value (APV) model e. Value of debt tax shield f. Equity as an o
> Your firm’s CEO has just learned about options and how your firm’s equity can be viewed as an option. Why might he want to increase the riskiness of the firm, and why might the bondholders be unhappy about this?
> Modigliani and Miller assumed that firms do not grow. How does positive growth change their conclusions about the value of the levered firm and its cost of capital?
> A utility company is allowed to charge prices high enough to cover all costs, including its cost of capital. Public service commissions are supposed to take actions that stimulate companies to operate as efficiently as possible in order to keep costs, an
> Explain, in your own words, how MM uses the arbitrage process to prove the validity of Proposition I. Also, list the major MM assumptions and explain why each of these assumptions is necessary in the arbitrage proof.
> Greene Sisters has a DSO of 20 days. The company’s average daily sales are $20,000. What is the level of its accounts receivable? Assume there are 365 days in a year.
> The Jimenez Corporation’s forecasted 2016 financial statements follow, along with some industry average ratios. Calculate Jimenez’s 2016 forecasted ratios, compare them with the industry average data, and comment brief
> How can a company use a bankruptcy to abrogate labor contracts? Has this occurred in certain industries in recent years?
> Data for Lozano Chip Company and its industry averages follow. a. Calculate the indicated ratios for Lozano. b. Construct the extended DuPont equation for both Lozano and the industry. c. Outline Lozano’s strengths and weaknesses as
> The Kretovich Company had a quick ratio of 1.4, a current ratio of 3.0, a days sales outstanding of 36.5 days (based on a 365-day year), total current assets of $810,000, and cash and marketable securities of $120,000. What were Kretovich’s annual sales?
> Complete the balance sheet and sales information in the table that follows for J. White Industries using the following financial data: Total assets turnover: 1.5 Gross profit margin on sales: (Sales 2 Cost of goods sold)/Sales 5 25% Total liabilities-
> The Morris Corporation has $600,000 of debt outstanding, and it pays an interest rate of 8% annually. Morris’ annual sales are $3 million, its average tax rate is 40%, and its net profit margin on sales is 3%. If the company does not maintain a TIE ratio
> You are considering an investment in either individual stocks or a portfolio of stocks. The two stocks you are researching, Stock A and Stock B, have the following historical returns: a. Calculate the average rate of return for each stock during the 5-ye
> Stock R has a beta of 1.5, Stock S has a beta of 0.75, the expected rate of return on an average stock is 13%, and the risk-free rate is 7%. By how much does the required return on the riskier stock exceed that on the less risky stock?
> You have a $2 million portfolio consisting of a $100,000 investment in each of 20 different stocks. The portfolio has a beta of 1.1. You are considering selling $100,000 worth of one stock with a beta of 0.9 and using the proceeds to purchase another sto
> Suppose you manage a $4 million fund that consists of four stocks with the following investments: If the market’s required rate of return is 14% and the risk-free rate is 6%, what is the fund’s required rate of return?
> Your retirement fund consists of a $5,000 investment in each of 15 different common stocks. The portfolio’s beta is 1.20. Suppose you sell one of the stocks with a beta of 0.8 for $5,000 and use the proceeds to buy another stock whose beta is 1.6. Calcul
> As an equity analyst you are concerned with what will happen to the required return to Universal Toddler Industries’ stock as market conditions change. Suppose rRF 5 5%, rM 5 12%, and bUTI 5 1.4. a. Under current conditions, what is rUTI, the required r
> Carter Enterprises can issue floating-rate debt at LIBOR + 2% or fixed-rate debt at 10%. Brence Manufacturing can issue floating-rate debt at LIBOR + 3.1% or fixed-rate debt at 11%. Suppose Carter issues floating-rate debt and Brence issues fixed-rate de
> Suppose rRF 5 5%, rM 5 10%, and rA 5 12%. a. Calculate Stock A’s beta. b. If Stock A’s beta were 2.0, then what would be A’s new required rate of return?
