Question 1 (23 marks)

a. After completing its capital spending for the year, HSU Manufacturing has $1,000 extra cash. HSU's managers must choose between investing the cash in Treasury bonds that yield 8% or paying the cash out to investors who would invest in the bonds themselves.

i. If the corporate tax rate is 35%, what personal tax rate would make the investors equally willing to receive the dividend or to let HSU invest the money? (10 marks)

ii. Is the answer to part i) reasonable? Explain. (2 marks)

b. The desire for high current income is a valid explanation of preference for high current dividend policy. Comment on the validity of this statement. (11 marks)

Question 2 (9 marks)

HSU Corporation has an EBIT of $975,000 per year that is expected to continue in perpetuity. The unlevered cost of equity for the company is 14% and the corporate tax rate is 35%. The company also has a perpetual bond issue outstanding with a market value of $1.9 million.

a. What is the value of the company if M&M propositions hold? (5 marks)

b. The CFO of the company informs the company president that the value of company

is $4.5 million. Is the CFO necessarily wrong? Explain using the trade-off model. (4 marks)

Question 3 (9 marks)

Firm X and Firm Y are identical in every way except their capital structure. Firm X is an all-equity firm and has 15,000 shares of stock outstanding with a market value of $30 per share. Firm Y uses leverage in its capital structure. The market value of Firm Y's debt is $65,000 and its cost of debt is 9%. Each firm is expected to have earnings before interest of $75,000 in perpetuity. Neither firm pays taxes.

a. What is the value of Firm X? (3 marks)

b. What is the value of Firm Y? (3 marks)

c. What is the market value of Firm Y's equity? (3 marks)

Question 4 (15 marks)

XYZ Corporation plans to issue perpetual bonds (par value = $1,000) with a coupon rate of 8% paid annually. The current market interest rates on these bonds are 7%. In one year, the interest rate on the bonds will be either 10% or 4% with equal probability.

a. If the bonds are non-callable, what is the price of the bonds today? (5 marks)

b. If the bonds are callable one year from now at $1,100, what is the price of the bonds today? (7 marks)

c. What is the compensation for bearing the call risk of XYZ's callable bonds? (3 marks)

Question 5 (14 marks)

HKW Corporation is considering buying a machine that costs $540,000. The machine will be depreciated over 5 years by the straight-line method and will have zero salvage value. The company can also lease the machine with year-end payments of $145,000. The company can issue bonds at 9% interest rate. If the corporate tax rate is 35%, should the company buy or lease? Explain. (14 marks)