chapter 7. Solution.

chapter 7. Solution. - Chapter 7: Capital...

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1. Income bonds are similar to preferred stock in several ways. Payment of interest on income bonds depends on the availability of sufficient earnings, just like preferred stock. However, income bonds would be paid ahead of preferred stock. On the other hand, both would be paid ahead of common stock. Missed payments are cumulated as with preferred stock. For purposes of analyzing debt, the major differences would be that payments on income bonds, while they can be deferred, must be paid contractually and are tax deductible. Failure to make payments can lead to default and bring on bankruptcy. This is not the case with preferred stock. 2. The contractual payments on a commodity bond depend directly on the price of a commodity. However, like a straight bond, the payments on the commodity bond are capped at some predetermined amount. The contractual payments on a straight bond do not depend on the price of the commodity. However, the ability of the company to make the payments might depend upon commodity prices. In the case of equity, there are no contractual payments at all, although the value of the equity could depend on commodity prices. From the point of view of analyzing capital structure, commodity bonds would qualify as debt, since the payments are contractual, and non-payment could bring on bankruptcy. However, since the amount that has to be paid is tied to commodity prices, the risk of bankruptcy is smaller. 3. This security resembles straight debt, except for two things: the “dividend” is not tax- deductible, and it is subordinated to all other debt. Alternatively, it could be compared to preferred stock with a finite life. I would classify this security as equity, since the payments are not contractual. Alternatively, it might be included in a special category like preferred debt. 4. If we assume that the straight preferred stock is trading at par, the return on the straight preferred = 9%. If the convertible preferred, which has a 6% dividend rate were evaluated as a straight preferred at this yield, we would get a price of 6/0.09 = $66.67. Since it is actually trading at $105, the equity component = 105 - 66.67 = $38.33 5. The convertible bond is a 10-year bond with a face value of $1000 and a coupon rate of 5%. If it yielded the same rate as the straight bond, i.e. 8%, its price would be equal to 25 04 1 1 104 1000 104 79615 20 20 . ( . ) . . - + = , assuming semi-annual coupons. Hence, the equity component of the convertible can be estimated as 1100 - 796.15 = 303.85. The total equity component of the firm’s asset value = 50(1 m.) + 303.85(20000) = $56.077m. The debt component = $25m. + 796.15(20000) = 40.923m. Hence, the debt ratio = 40.923/(40.923 + 56.077) = 42.19%
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This note was uploaded on 03/12/2012 for the course FINANCE 100 taught by Professor Aswath during the Fall '06 term at NYU.

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chapter 7. Solution. - Chapter 7: Capital...

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