Problems and Questions

1. An income bond holder receives interest payments only if the firm makes income. If the firm does not make interest payments in a year, the interest is cumulated and paid in the first year the firm makes income. A preferred stock receives preferred dividends only if the firm makes income. If a firm does not make preferred dividend payments in a year, the dividend is cumulated and paid in the first year the firm makes income. Are income bonds really preferred stock? What are the differences? For purposes of calculating debt how would you differentiate between income bonds and regular bonds?

2. A commodity bond links interest and principal payments to the price of a commodity. Differentiate a commodity bond from a straight bond, and then from equity. How would you factor these differences into your analysis of the debt ratio of a company that has issued exclusively commodity bonds?

3. You are analyzing a new security that has been promoted as equity, with the following features:

• The dividend on the security is fixed in dollar terms for the life of the security, which is 20 years.
• The dividend is not tax deductible.
• In the case of default, the holders of this security will receive cash only after all debt holders, secured as well as unsecured, are paid.
• The holders of this security will have no voting rights.

Based upon the description of debt and equity in the chapter, how would you classify this security? If you were asked to calculate the debt ratio for this firm, how would you categorize this security?

4. You are analyzing a convertible preferred stock, with the following characteristics for the security:

• There are 50,000 preferred shares outstanding, with a face value of \$ 100 and a 6% preferred dividend rate.
• The firm has straight preferred stock outstanding, with a preferred dividend rate of 9%.
• The preferred stock is trading at \$105.

Estimate the preferred stock and equity components of this preferred stock.

5. You have been asked to calculate the debt ratio for a firm that has the following components to its financing mix ñ

• The firm has 1 million shares outstanding, trading at \$ 50 per share.
• The firm has \$ 25 million in straight debt, carrying a market interest rate of 8%.
• The firm has 20,000 convertible bonds outstanding, with a face value of \$1000, a market value of \$1100, and a coupon rate of 5%.

Estimate the debt ratio for this firm.

6. You have been asked to estimate the debt ratio for a firm, with the following financing details:

• The firm has two classes of shares outstanding; 50,000 shares of class A stock, with 2 voting rights per share, trading at \$ 100 per share and 100,000 shares of class B stock, with 1/2 voting right per share, trading at \$ 90 per share.
• The firm has \$ 5 million in bank debt, and the debt was taken on recently.

Estimate the debt ratio. Why does it matter when the bank debt was taken on?

7. You are the owner of a small and successful firm with an estimated market value of \$ 50 million. You are considering going public.

a. What are the considerations you would have in choosing an investment banker?

b. You want to raise \$ 20 million in new financing, which you plan to reinvest back in the firm. (The estimated market value of \$ 50 million is based upon the assumption that this \$20 million is reinvested.) What proportion of the firm would you have to sell in the initial public offering to raise \$ 20 million?

c. How would your answer to (b) change if the investment banker plans to under price your offering by 10%?

d. If you wanted your stock to trade in the \$20-\$25 range, how many shares would you have to create? How many shares would you have to issue?

8. You have been asked for advice on a rights offering by a firm with 10 million shares outstanding, trading at \$ 50 per share. The firm needs to raise \$ 100 million in new equity. Assuming that the rights subscription price is \$ 25, answer the following questions:

a. How many rights would be needed to buy one share at the subscription price?

b. Assuming that all rights are subscribed to, what will the ex-rights price be?

c. Estimate the value per right.

d. If the price of a right were different (higher or lower) than the value estimated in (c), how would you exploit the difference?

9. American firms are heavily dependent upon debt for external financing, and they are over leveraged. Comment.

10. You are stockholder in a SmallTech Inc., a company which is planning to raise new equity. The stock is trading at \$ 15 per share, and there are 1 million shares outstanding. The firm issues 500,000 rights to buy additional shares at \$ 10 per share to its existing stockholders.

a. What is the expected stock price after the rights are exercised?

b . If the rights are traded, what is the price per right?

c. As a stockholder, would you be concerned about the dilution effect lowering your stock price? Why or why not?

11. There is evidience that initial public offerings are underpriced. Which of the following implications would you agree with?

a. This indiciates that investment bankers are making excess returns on initial public offerings.

b. Investors who subscribe to initial public offerings should make excess returns.

c. The companies issuing the stock in the initial public offering should try to find investment bankers who will over price their issues.

d. The underpricing is compensation for the risk that investment bankers take.

e. The underpricing operates as a promotional, encouraging investors to buy more stock in this company.

f. None of the above

g. All of the above.

12. Convertible bonds are often issued by small, high growth companies to raise debt. Why?

13. A manager of NoZone Inc., a company in urgent need of financing, is debating whether to issue straight debt at 11% or convertibe debt at 7%. He is tilting towards the convertible debt because it is cheaper? Is it? How would you check this proposition?

14. A company is trying to estimate its debt ratio. It has 1 million shares outstanding, trading at \$ 50 per share and had \$ 250 million in straight debt outstanding (with a market interest rate of 9%). It also has two other securities outstanding ñ

a. It has 200,000 warrants outstanding, conferring on its holders the right to buy stock in the Complex Inc, at \$ 65 per share. These warrants are trading at \$ 12 each.

b. It also has 10,000 convertible bonds outstanding, with a coupon rate of 6% and 10 years to maturity.

Estimate the debt ratio in market value terms.

15. Venture capitalists take advantage of small businesses by demanding a disproportionate share of the ownership of the company for their investment. Comment.

16. Firms generally can borrow money using bank debt or by issuing bonds. Why might a firm choose one method over the other?

17. Preferred stock is often considered as equity, when analysts calculate debt ratios. Is this appropriate? Under what conditions would you consider it to be more like debt?

18. Debt will always be cheaper than preferred stock, because of the tax advantage that it confers on the firm. What is the source of the tax advantage? Is this statement true?