International Tile Importers, Inc., is a rapidly growing firm that imports and markets floor tiles from around the world that are used in the construction of custom homes and commercial buildings. The firm has grown so fast that its management is considering the issuance of a five-year interest-only note. The notes would have a principal amount of $1,000 and pay 12% interest each year, with the principal amount due at the end of Year 5. The firm's investment banker has agreed to help the firm place the notes and has estimated that they can be sold for $800 each under today's market conditions. a) What is the promised yield to maturity based on the terms suggested by the investment banker? b) The firm's management looked at the yield to maturity estimated above with dismay, for it was much higher than the 12% coupon rate, which is much higher than current yields on investment-grade debt. The investment banker explained that for a small firm such as International Tile, the bond rating would probably be in the middle of the speculative grades, which requires a much higher yield to attract investors. It even suggested that the firm recalculate the expected yield to maturity on the debt under the following assumptions: The risk of default in Years 1 through 5 is 5% per year, and the recovery rate in the event of default is only 50%. What is the expected yield to maturity under these conditions? Use tab 4-5

PROBLEM 4-1 Given Solution Legend Cost of debt Tax Rate Cost of equity Debt/EV 6% 30% 14% 20% = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output Solution Source Debt Equity Proportion After-tax cost WACC Product PROBLEM 4-2 Given MCD beta risk free rate MRP MCD debt MCD Ent Value MCD Debt beta Solution Legend 0.56 4.20% 5% 15% 80% 0.2 Solution MCD Ke a. Unlevered Beta b. = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output PROBLEM 4-3 Given Analysis of unlevered equity beta with risky debt beta = .30 Company Name Eastman Chemical Co. (EMN) Celanese Corp. (CE) Dow Chemical Company (DOW) a. Solution: Tax Rate Levered Debt/Equity Assumed Equity Betas Capitalization Debt Betas 2.0200 42.69% 0.30 2.6300 82.93% 0.30 2.5000 29.07% 0.30 Unlevered Equity Betas Average b. Solution Analysis of Sterling Analysis based on simple average of unlevered equity betas beta unlevered D/E 20.00% beta debt 0.30 Solution Legend 38% D/E 20.00% beta levered Total Debt 1,844,000 3,674,000 9,496,000 Market Cap 4,320,000 4,430,000 32,670,000 = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output PROBLEM 4-4 Given Liabilities and Owner's Capital December 31, 2006 Balance Sheet Invested Capital (Book Values) (Market Values) Solution Legend Current liabilities Accounts payable Notes payable Other current liabilities` Total current liabilities $8,250,000 7,266,000 $15,516,000 Long-term debt (8.5% interest paid semi-annually, due in 2015) Total liabilities $- $420,000,000 $434,091,171 $435,516,000 Owners' capital Common stock ($1 par value per share) Paid-in-capital Accumulated earnings Total owners' capital Total liabilities and owners' capital = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input $434,091,171 = Crystal Ball Output $40,000,000 100,025,000 255,000,000 $395,025,000 $830,541,000 Capital Market Data Treasury Bond Yield Market Risk Premium Unlevered equity beta (SIC 4924) Stock price Market capitalization Yield on debt Bond beta Short-term interest bearing debt New long-term debt total Tax Rate $900,000,000 $1,334,091,171 5.42% 5.00% 0.90 $22.50 8.00% 0.30 $40.00% Solution Step 1: Evaluate the capital structure weights Enterprise Value = Market Capitalization + Debt Debt / Enterprise Value Equity / Enterprise Value Step 2: Estimate the costs of Financing Debt (after taxes) Equity Levered equity beta Step 3: Calculate the WACC WACC Source of Capital Debt Equity Capital Structure Weight (Proportion) After-Tax Cost WACC Weighted After-Tax Cost PROBLEM 4-5 Given Maturity Terms Face value Coupon rate Offering price 5 years Interest only $1,000 12.00% $800 Solution Solution Legend a. Promised YTM = = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output b. (Note: the discussion of this analysis is found in the Appendix to the chapter) Bond Rating Caa/CCC 10 Year Treasury Yield = 5.02% Coupon 12.00% Principal $1,000.00 Price $800.00 Maturity 5 years Recovery Rate 50.00% Default Probability 5.00% Default Cash Flows Year 0 1 2 3 4 5 1 2 3 4 5 Promised Cash Flow Promised YTM Expected yield to maturity if default occurs in this year Probability of default in each year Weighted YTM = E(YTM) x Pb of default Average YTM based on Expected Cash Flows YTM Spread Cost of Debt Spread Expected YTM = Cost of debt PROBLEM 4-6 Given Face value Current price Maturity Terms Coupon rate $1,000.00 $1,081.26 8 years semi-annual interest only 7.25% Solution Legend = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output Solution Semi-annual YTM Annual YTM Note: The Effective Annual YTM accounts for semi-annual compounding, i.e., (1 + .0298)^2 - 1. PROBLEM 4-7 Given Solution Legend Today's Date Feb-05 Ford Motor Co. Coupon: Maturity: Term to Maturity Rating: Price: 6.375% 2/1/2029 24 years Baa1/BBB$927.84 General Motors Corp. Coupon: Maturity: Term to Maturity Rating: Price: 8.375% 7/15/2033 28.5 years Baa2 /BBB$1,061.25 Solution Ford Motor Co. Semi-annual YTM Annualized YTM General Motors = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output PROBLEM 4-8 Given Levered equity beta Treasure bond yield Market risk premium Tax rate Debt as % of Capital Structure Solution Legend 1.25 4.28% 3.50% 25.00% 25.00% 7.00% Solution a. Cost of equity b. Low ERP High ERP WACC with Low ERP Cap Str After-Tax Weights Costs Product Debt 25.00% Equity 75.00% WACC with High MRP Cap Str After-Tax Weights Cost Product Debt 25.00% Equity 75.00% = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output PROBLEM 4-9 Given December 31, 2009 Balance Sheet Invested Capital (Book Values) (Market Values) Liabilities and Owners' Capital Current Liabilities Accounts payable Notes payable Other current liabilities` Total current liabilities Long-term debt (7.5% interest paid semianually, due in 2012) Total liabilities Owners' Capital Common stock ($1 par value per share) Paid-in-capital Accumulated earnings Total owners' capital Total liabilities and owners' capital $17,550,000 20,000,000 22,266,000 $59,816,000 $650,000,000 $709,816,000 $624,385,826 $644,385,826 $20,000,000 200,025,000 255,000,000 $475,025,000 $1,184,841,000 US Treasury Bond Yield Estimated Market or Equity Risk Premium Current Share Price Market value of owners' equity Current yield on the firm's long-term debt Current yield on the firm's short-term notes Dollar value of short term notes outstanding Corporate tax rate $20,000,000 $1,560,000,000 $2,204,385,826 20,000,000 Solution Legend = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output 5.42% 5.00% $78.00 8.50% 9.00% $20,000,000 35% Solution a. What are Harriston's capital structure weights? Enterprise value = Market capitalization + Debt Notes payable / Enterprise Value Long-Term Debt / Enterprise Value Equity / Enterprise Value b. What is Harriston's cost of equity capital using the CAPM? After-Tax Cost of Sources of Capital Notes Payable (after-taxes) Long-term Debt (after-taxes) Levered equity beta Equity (using the CAPM) 1.20 c. What is Harriston's WACC? Source of Capital Notes Payable Long-term Debt Equity Capital Structure Weight (Proportion) After-Tax Cost WACC Weighted AfterTax Cost PROBLEM 4-10 a. Analysis of airline carrier's unlevered beta Tax Rate 38% Levered Equity Betas Company Name American Airlines (AMR) 3.2400 Delta Airlines (DALR.PK) 4.0500 Jet Blue (JBLU) (0.1100) Southwest Airlines (LUV) (0.0100) Debt/Equity Assumed Debt Unlevered Capitalization Betas Equity Betas 205.16% 0.30 5663.67% 0.40 106.22% 0.30 14.93% 0.20 Average b. Analysis of Southwest Airlines Levered Beta Analysis based on simple average of unlevered equity betas beta unlevered D/E 14.93% c. Special concerns regarding estimation of cost of equity 1 - Tx Rate 62% beta debt beta levered 0.20 Solution Legend = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output PROBLEM 4-11 a. Fama French (FF) Coefficients Company Name SBC Communications (AT&T) Verizon Communications b 1.0603 1.1113 s -1.4998 -0.9541 FF Cost h of Equity 1.0776 0.639 CAPM Beta 0.62 0.79 CAPM CAPM minus FF Cost of Cost of Equity Equity SBC Communications (AT&T) Coefficients b s h Coefficient Estimates Risk Premia Product 5.00% 3.36% 4.40% Risk premium = + Risk free rate = 5.02% = Cost of equity Verizon Communications Coefficients b s h b. Coefficient Estimates Risk Premia Product 5.00% 3.36% 4.40% Risk premium = + Risk free rate = = Cost of equity Fama French estimate of the cost of equity CAPM estimate of the cost of equity Solution Legend = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output PROBLEM 4-12 Given Eastman Kodak Convertible Bonds Bond Facts Principal Amount Coupon Maturity Interest paid Conversion feature Price Information Current Bond Price Yield to Maturity Yield on Straight Debt Semi-Annual Yield Solution Legend = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output $1,000.00 6.750% 8 years 2 per year 32.2373 $1,277.20 This is the annual yield on convertible debt This is the effective annual yield found in Problem 4.3 This is the semi-annual yield from Problem 4.3 6.04% Solution $ Value % of Value Straight Bond Conversion Option Current Bond Price Estimate of the Cost of Convertible Bond Financing Marginal Tax Rate 0.0% Cost of Equity 13.5% % of Value Straight Bond Equity After Tax Cost of Convertible Bonds Before Tax cost of Convertible Bonds After Tax Cost Product PROBLEM 4-13 a. b. Solution Legend = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output PROBLEM 4-5 Given Maturity Terms Face value Coupon rate Offering price 5 years Interest only $1,000 12.00% $800 Solution a. Promised YTM = Solution Legend = Value given in problem = Formula/Calculation/Analysis required = Qualitative analysis or Short answer required = Goal Seek or Solver cell = Crystal Ball Input = Crystal Ball Output 18.46% b. (Note: the discussion of this analysis is found in the Appendix to the chapter) Bond Rating Caa/CCC 10 Year Treasury Yield = 5.02% Coupon 12.00% Principal $1,000.00 Price $800.00 Maturity 5 years Recovery Rate 50.00% Default Probability 5.00% Default Cash Flows Year 0 1 2 3 4 5 1 2 3 4 5 Promised Cash Flow Promised YTM Expected yield to maturity if default occurs in this year Probability of default in each year Weighted YTM = E(YTM) x Pb of default Average YTM based on Expected Cash Flows YTM Spread Cost of Debt Spread Expected YTM = Cost of debt