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Complete the review problems listed below in either one word or excel document. Be sure to show your computations where applicable.
Consider the following three bonds with $1,000 face value
Bond A: 10-year, 10 percent coupon bond
Bond B: 10-year, zero-coupon bond
Bond C: 20-year, 10 percent coupon bond
Compute the market values of each of the three bonds when the market interest rate varies from 0 to 14 percent. What is your interpretation of the decreasing relationship between bond market prices and interest rates?
Consider the following four bonds
Coupon Issue Zero Coupon Perpetual Convertible
Maturity 5 Years 5 Years Infinity 5 Years
Coupon Rate 6 Percent Zero 6 Percent 5 Percent
a. If the market yield is 7 percent, what are the values of the three first bonds (assume a face value of $1,000)?
b. Why are the values of the bonds lower than their face value?
c. Why is the coupon rate for the convertible bond lower than that for the non-convertible, coupon issue?
d. Given that the convertible bond is trading at $1,040, what is the value of the option to convert?
e. Suppose that the market yield rises to 7.5 percent. What are the bond values at that yield? Explain why the change in the value of the bonds is different.
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Calculating the weighted average cost of capital.
Suppose that Tale Inc. has the following target capital structure: 50 percent stock, 40 percent debt and 10 percent preferred stock. Its cost of equity is estimated at 10 percent, that of debt 6 percent, and that of preferred stock 4.5 percent. The tax rate is 35 percent.
a. What is Tale’s cost of capital?
b. Should Tale use more preferred stock financing than debt financing since it is cheaper?
The cost of equity, the weighted average cost of capital, and financial leverage.
Albarval Co. expects its return on assets to be stable at 12 percent, assuming a target capital structure of 80 percent equity and 20 percent debt. Suppose that the firm’sborrowing rate is 8 percent, for a wide range of capital structures.
a. Suppose that Albarval does not pay any tax. What’s Albarvals’ cost of equity?What would Albarval’s cost of equity be if the target capital structure is 50 percent equity, 50 percent debt? Show that under both Structures the firm’s weighted average capital cost is the same and that it is equal to 12 percent.
b. Suppose now that the firm’s tax rate is 40 percent. What is the cost of equity and the WACC under the two capital structures? Why are the cost of equity and the WACC different under the two capital structures?
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