20-1. Leasing Connors Construction needs a piece of equipment that can either be leased or purchased. The equipment costs $100. One option is to borrow $100 from the local bank and use the money to buy the equipment. The other option is to lease the equipment. If Connors chooses to lease the equipment, it would not capitalize the lease on the balance sheet. Below is the company's balance sheet prior to the purchase or leasing of the equipment: Current assets $ 2 5 0 Debt $ 4 0 0 Fixed assets 5 5 0 Equity 4 0 0 Total assets $ 8 0 0 Total liabilities and equity $ 8 0 0 a. What would be the company's debt ratio if it chose to purchase the equipment? Round your answer to two decimal places. % b. What would be the company's debt ratio if it chose to lease the equipment? Round your answer to two decimal places. % c. Would the company's financial risk be different depending on whether the equipment was leased or purchased? _________________ I. The company's financial risk (assuming the implied interest rate on the lease is equivalent to the loan) is greater if the equipment is leased. II. The company's financial risk (assuming the implied interest rate on the lease is equivalent to the loan) is greater if the equipment is purchased. III. The company's financial risk (assuming the implied interest rate on the lease is greater than the interest rate on the loan) is no different whether the equipment is leased or purchased. IV. The company's financial risk (assuming the implied interest rate on the lease is less than the interest rate on the loan) is no different whether the equipment is leased or purchased. V. The company's financial risk (assuming the implied interest rate on the lease is equivalent to the loan) is no different whether the equipment is leased or purchased. -------------------------------------------------------------------------------- 2. Learning Objective 20-3 Problem 20-2. Warrants Gregg Company recently issued two types of bonds. The first issue consisted of 20-year straight (no warrants attached) bonds with an 8% annual coupon. The second issue consisted of 20-year bonds with a 6% annual coupon with warrants attached. Both bonds were issued at par ($1,000). What is the value of the warrants that were attached to the second issue? Round your answer to two decimal places. ________ -------------------------------------------------------------------------------- 3. Learning Objective 20-4 Problem 20-3. Convertibles Petersen Securities recently issued convertible bonds with a $1,000 par value. The bonds have a conversion price of $40 a share. What is the bonds' conversion ratio, CR? Round your answer to two decimal places. s h a r e s -------------------------------------------------------------------------------- 4. Learning Objective 20-2 Problem 20-4. Balance sheet effects of leasing Two textile companies, McDaniel-Edwards Manufacturing and Jordan-Hocking Mills, began operations with identical balance sheets. A year later, both required additional manufacturing capacity at a cost of $150,000. McDaniel-Edwards obtained a 5-year, $150,000 loan at an 9% interest rate from its bank. Jordan-Hocking, on the other hand, decided to lease the required $150,000 capacity from National Leasing for 5 years; an 9% return was built into the lease. The balance sheet for each company, before the asset increases, is as follows: Debt $ 2 0 0 , 0 0 0 Equity 2 0 0 , 0 0 0 Total assets $ 4 0 0 , 0 0 0 Total liabilities and equity $ 4 0 0 , 0 0 0 Show the McDaniel-Edwards' balance sheet after the asset increase. Round your answers to two decimal places. Debt 1. ________ Equity 2. ________ Total assets 3. ________ Total liabilities and equity 4. ________ Calculate McDaniel-Edwards' new debt ratio. Round your answer to two decimal places. 5. % Show the Jordan-Hocking's balance sheet after the asset increase. (Assume lease is kept off the balance sheet.) Round your answers to two decimal places. Debt 6. ________ Equity 7. ________ Total assets 8. ________ Total liabilities and equity 9. ________ Calculate Jordan-Hocking's new debt ratio. Round your answers to two decimal places. 10. % Show how Jordan-Hocking's balance sheet would have looked immediately after the financing if it had capitalized the lease. Round your answers to two decimal places. Assets 11. ________ Debt 12. ________ Value of leased asset 13. ________ PV of lease payments 14. ________ Equity 15. ________ Total assets 16. ________ Total liabilities and equity 17. ________ -------------------------------------------------------------------------------- 5. Learning Objective 20-2 Problem 20-5. Lease versus buy Morris-Meyer Mining Company must install $1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the required amount. Alternatively, a Nevada investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that the following facts apply: (1) The equipment falls in the MACRS 3-year class. The applicable MACRS rates are 33%, 45%, 15%, and 7%. (2) Estimated maintenance expenses are $75,000 per year. (3) Morris-Meyer's federal-plus-state tax rate is 40%. (4) If the money is borrowed, the bank loan will be at a rate of 15%, amortized in 4 equal installments to be paid at the end of each year. (5) The tentative lease terms call for end-of-year payments of $400,000 per year for 4 years. (6) Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance. (7) Morris-Meyer must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms, it can purchase the machinery at its fair market value at that time. The best estimate of this market value is the $250,000 salvage value, but it could be much higher or lower under certain circumstances. To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions. a. Assuming that the lease can be arranged, should Morris-Meyer lease, or should it borrow and buy the equipment? _________________ b. Consider the $250,000 estimated salvage value. Is it appropriate to discount it at the same rate as the other cash flows? (Hint: Riskier cash flows are normally discounted at higher rates, but when the cash flows are costs rather than inflows, the normal procedure must be reversed.) _________________ -------------------------------------------------------------------------------- 6. Learning Objective 20-3 Problem 20-6. Warrants Pogue Industries Inc. has warrants outstanding that permit its holders to purchase 1 share of stock per warrant at a price of $15. (Refer to Chapter 18 for parts a, b, and c.) Calculate the exercise value of Pogue's warrants if the common stock sells at each of the prices given below. Round your answers to two decimal places. Ps Exercise value $18 a. ________ 21 b. ________ 25 c. ________ 70 d. ________ At what price the warrants would actually sell under each condition given below? Round your answers to two decimal places. Ps Warrant Premium $18 e. ________ $4.50 21 f. ________ 3.00 25 g. ________ 1.50 70 h. ________ 1.00 How would each of the following factors affect your estimates of the warrants' prices and premiums in previous part? i. The life of the warrant is lengthened. _________________ j. The expected variability ( ? p) in the stock's price decreases. _________________ k. The expected growth rate in the stock's EPS increases. _________________ l. Assume Pogue's stock now sells for $18 per share. The company wants to sell some 20-year, annual interest, $1,000 par value bonds. Each bond will have 100 warrants, each exercisable into 1 share of stock at an exercise price of $21. Pogue's pure bonds yield 11%. Assume that the warrants will have a market value of $2.00 when the stock sells at $18. What annual dollar coupon must the company set on the bonds with warrants if they are to clear the market? Round your answer to two decimal places. m. What annual coupon interest rate must the company set on the bonds with warrants if they are to clear the market? Round your answer to two decimal places. % -------------------------------------------------------------------------------- 7. Learning Objective 20-4 Problem 20-7. Convertibles The Hadaway Company was planning to finance an expansion in the summer of 2008 with a convertible security. They considered a convertible debenture but feared the burden of fixed interest charges if the common stock did not rise enough to make conversion attractive. They decided on an issue of convertible preferred stock, which would pay a dividend of $1.05 per share. The common stock was selling for $21 a share at the time. Management projected earnings for 2008 at $1.50 a share and expected a future growth rate of 10% a year in 2009 and beyond. It was agreed by the investment bankers and management that the common stock would continue to sell at 14 times earnings, the current price/earnings ratio. a. What conversion price should be set by the issuer? The conversion rate will be 1.0; that is, each share of convertible preferred can be converted into 1 share of common. Therefore, the convertible's par value (as well as the issue price) will be equal to the conversion price, which, in turn, will be determined as a percentage over the current market price of the common. In recent years there has been heavy use of 20% to 30% premiums. Use the midpoint of the range to answer the question. ________ b. Should the preferred stock include a call provision? _________________ -------------------------------------------------------------------------------- 8. Learning Objective 20-2 Problem 20-8. Lease analysis As part of its overall plant modernization and cost reduction program, the management of Tanner-Woods Textile Mills has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was found to be 20% versus a project required return of 12%. The loom has an invoice price of $250,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 10% interest rate, with payments to be made at the end of each year. In the event that the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $20,000 per year paid at the end of each year. The loom falls in the MACRS 5-year class, and Tanner-Woods's marginal federal-plus-state tax rate is 40%. The applicable MACRS rates are 20%, 32%, 19%, 12%, 11%, and 6%. United Automation Inc., maker of the loom, has offered to lease the loom to Tanner-Woods for $70,000 upon delivery and installation (at t = 0) plus 4 additional annual lease payments of $70,000 to be made at the end of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance and servicing. Actually, the loom has an expected life of 8 years, at which time its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book value of $42,500. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no interest in either leasing or owning the proposed loom for more than that period. a. Should the loom be leased or purchased? _________________ b. The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pre-tax discount rate is 15%. Should the loom in this case be leased or purchased? _________________ c. The original analysis assumed that Tanner-Woods would not need the loom after 4 years. Now assume that the firm will continue to use it after the lease expires. Thus, if it leased, Tanner-Woods would have to buy the asset after 4 years at the then existing market value, which is assumed to equal the book value. What effect would this requirement have on the basic analysis? _________________ -------------------------------------------------------------------------------- 9. Learning Objective 20-3 Learning Objective 20-4 Problem 20-9. Financing alternatives The Howe Computer 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 $150,000, carrying a 10% interest rate, and Howe has been 30 to 60 days late in paying trade creditors. Discussions with an investment banker have resulted in the decision to raise $250,000 at this time. Investment bankers have assured Howe that the following alternatives are feasible (flotation costs will be ignored): Alternative 1: Sell common stock at $10 per share. Alternative 2: Sell convertible bonds at a 10% coupon, convertible into 80 shares of common stock for each $1,000 bond (that is, the conversion price is $12.50 per share). Alternative 3: Sell debentures with a 10% coupon; each $1,000 bond will have 80 warrants to buy 1 share of common stock at $12.50. Keith Howe, the president, owns 80% of Howe's common stock and wishes to maintain control of the company; 50,000 shares are outstanding. The following are summaries of Howe's latest financial statements: Balance Sheet -------------------------------------------------------------------------------- Current liabilities $ 2 0 0 , 0 0 0 Common stock, $1 par 5 0 , 0 0 0 Retained earnings 2 5 , 0 0 0 Total assets $ 2 7 5 , 0 0 0 Total liabilities and equity $ 2 7 5 , 0 0 0 Income Statement -------------------------------------------------------------------------------- Sales $ 5 5 0 , 0 0 0 All costs except interest 4 9 5 , 0 0 0 EBIT $ 5 5 , 0 0 0 Interest 1 5 , 0 0 0 EBT $ 4 0 , 0 0 0 Taxes (40%) 1 6 , 0 0 0 Net income $ 2 4 , 0 0 0 Shares outstanding 5 0 , 0 0 0 Earnings per share $ 0 . 4 8 Price/earnings ratio 1 8 x Market price of stock $ 8 . 6 4 Show the new balance sheet under each alternative. For Alternatives 2 and 3, show the balance sheet after conversion of the debentures or exercise of the warrants. Assume that $150,000 of the funds raised will be used to pay off the bank loan and the rest to increase total assets. Round your answers to two decimal places. Alternative 1: Total current liabilities 1. ________ Long-term debt