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CORPORATE FINANCE: CORE PRINCIPLES & APPLICATIONS, FIFTH EDITION Ross, Stephen A. The activities for this course are taken from the Concept Questions that are located at the end of each chapter of your textbook. For this unit please complete three questions of your choice from each chapter covered in this unit. The questions can be found for Chapter 5 on pages 158-159, for Chapter 6 on page 189. Chapter 5 1. Treasury Bonds Is it true that a U.S. Treasury security is risk free? 2. Interest Rate Risk Which has greater interest rate risk, a 30-year Treasury bond or a 30-year BB corporate bond? 3. Treasury Pricing With regard to bid and ask prices on a Treasury bond, is it possible for the bid price to be higher? Why or why not? Chapter 6 1. Stock Valuation Why does the value of a share of stock depend on dividends? 2. Stock Valuation A substantial percentage of the companies listed on the NYSE and the NASDAQ don’t pay dividends, but investors are nonetheless willing to buy shares in them. How is this possible given your answer to the previous question? 3. Dividend Policy Referring to the previous questions, under what circumstances might a company choose not to pay dividends? Each unit two closing cases will need to be completed. For Unit 2 please complete: Financing East Coast Yacht’s Expansion Plans with a Bond Issue, beginning on page 163 Stock Valuation at Ragan Engines, beginning on page 194 www.mhhe.com/RossCore5e CHAPTER 5 Interest Rates and Bond Valuation 163 EXCEL MASTER IT! PROBLEM Companies often buy bonds to meet a future liability or cash outlay. Such an investment is called a dedicated portfolio because the proceeds of the portfolio are dedicated to the future liability. In such a case, the port- folio is subject to reinvestment risk. Reinvestment risk occurs because the company will be reinvesting the coupon payments it receives. If the YTM on similar bonds falls, these coupon payments will be reinvested at a lower interest rate, which will result in a portfolio value that is lower than desired at maturity. Of course, if interest rates increase, the portfolio value at maturity will be higher than needed. Suppose Ice Cubes, Inc., has the following liability due in five years. The company is going to buy five-year bonds today to meet the future obligation. The liability and current YTM are below: Amount of liability: Current YTM: $100,000,000 8% a. At the current YTM, what is the face value of the bonds the company has to purchase today to meet its future obligation? Assume that the bonds in the relevant range will have the same coupon rate as the current YTM and these bonds make semiannual coupon payments. b. Assume the interest rates remain constant for the next five years. Thus, when the company reinvests the coupon payments, it will reinvest at the current YTM. What is the value of the portfolio in five years? c. Assume that immediately after the company purchases the bonds, interest rates either rise or fall by 1 percent. What is the value of the portfolio in five years under these circumstances? One way to eliminate reinvestment risk is called immunization. Rather than buying bonds with the same maturity as the liability, the company instead buys bonds with the same duration as the liability. If you think about the ded- icated portfolio, if the interest rate falls, the future value of the reinvested coupon payments decreases. However, as interest rates fall, the price of bonds increases. These effects offset each other in an immunized portfolio. Another advantage of using duration to immunize a portfolio is that the duration of a portfolio is the weighted average of the duration of the assets in the portfolio. In other words, to find the duration of a portfo- lio, you simply take the weight of each asset multiplied by its duration and then sum the results. d. What is the duration of the liability for Ice Cubes, Inc.? e. Suppose the two bonds shown below are the only bonds available to immunize the liability. What face amount of each bond will the company need to purchase to immunize the portfolio? FINANCING EAST COAST YACHTS’ EXPANSION PLANS WITH A BOND ISSUE After Dan’s EFN analysis for East Coast Yachts (see the Closing Case in Chapter 3), Larissa has decided to expand the company’s operations. She has asked Dan to enlist an underwriter to help sell $45 million in new 30-year bonds to finance new construction. Dan has entered into discussions with Renata Harper, an underwriter from the firm of Crowe & Mallard, about which bond features East Coast Yachts should consider and also what coupon CLOSING CASE BOND A BOND B Settlement Maturity Coupon rate YTM Coupons per year 1/1/2000 1/1/2003 7.00% 7.50% 2 1/1/2000 1/1/2008 8.00% 9.00% 2 PART 2 Valuation and Capital Budgeting164 rate the issue will likely have. Although Dan is aware of bond features, he is uncertain as to the costs and benefits of some of them, so he isn’t clear on how each feature would affect the coupon rate of the bond issue. 1. You are Renata’s assistant, and she has asked you to prepare a memo to Dan describing the effect of each of the following bond features on the coupon rate of the bond. She would also like you to list any advantages or disadvantages of each feature. a. The security of the bond, that is, whether or not the bond has collateral. b. The seniority of the bond. c. The presence of a sinking fund. d. A call provision with specified call dates and call prices. e. A deferred call accompanying the above call provision. f. A make-whole call provision. g. Any positive covenants. Also, discuss several possible positive covenants East Coast Yachts might consider. h. Any negative covenants. Also, discuss several possible negative covenants East Coast Yachts might consider. i. A conversion feature (note that East Coast Yachts is not a publicly traded company). j. A floating rate coupon. Dan is also considering whether to issue coupon-bearing bonds or zero coupon bonds. The YTM on either bond issue will be 5.5 percent. The coupon bond would have a 5.5 percent coupon rate. The company’s tax rate is 35 percent. 2. How many of the coupon bonds must East Coast Yachts issue to raise the $45 million? How many of the zeroes must it issue? 3. In 30 years, what will be the principal repayment due if East Coast Yachts issues the coupon bonds? What if it issues the zeroes? 4. What are the company’s considerations in issuing a coupon bond compared to a zero coupon bond? 5. Suppose East Coast Yachts issues the coupon bonds with a make-whole call provision. The make-whole call rate is the Treasury rate plus .40 percent. If East Coast calls the bonds in seven years when the Treasury rate is 4.8 percent, what is the call price of the bond? What if it is 6.2 percent? 6. Are investors really made whole with a make-whole call provision? 7. After considering all the relevant factors, would you recommend a zero coupon issue or a regular coupon issue? Why? Would you recommend an ordinary call feature or a make-whole call feature? Why? PART 2 Valuation and Capital Budgeting194 STOCK VALUATION AT RAGAN ENGINES Larissa has been talking with the company’s directors about the future of East Coast Yachts. To this point, the company has used outside suppliers for various key components of the company’s yachts, including engines. Larissa has decided that East Coast Yachts should consider the purchase of an engine manufacturer to allow East Coast Yachts to better integrate its supply chain and get more control over engine features. After investi- gating several possible companies, Larissa feels that the purchase of Ragan Engines, Inc., is a possibility. She has asked Dan Ervin to analyze Ragan’s value. Ragan Engines, Inc., was founded nine years ago by a brother and sister—Carrington and Genevieve Ragan—and has remained a privately owned company. The company manufactures marine engines for a vari- ety of applications. Ragan has experienced rapid growth because of a proprietary technology that increases the fuel efficiency of its engines with very little sacrifice in performance. The company is equally owned by Carrington and Genevieve. The original agreement between the siblings gave each 125,000 shares of stock. Larissa has asked Dan to determine a value per share of Ragan stock. To accomplish this, Dan has gathered the following information about some of Ragan’s competitors that are publicly traded: EPS DPS STOCK PRICE ROE R Blue Ribband Motors Corp. Bon Voyage Marine, Inc. Nautilus Marine Engines Industry average $1.24 1.55 −.25 $ .85 $.39 .47 ������ .67 $.51 $20.10 16.85 ������ 31.60 $22.85 11.00% 14.00 ���� ��N/A������ � 12.50% 14.00% �17.00 �13.00 14.67% Nautilus Marine Engines’ negative earnings per share (EPS) was the result of an accounting write-off last year. Without the write-off, EPS for the company would have been $1.93. Last year, Ragan had an EPS of $3.65 and paid a dividend to Carrington and Genevieve of $195,000 each. The company also had a return on equity of 18 percent. Larissa tells Dan that a required return for Ragan of 13 percent is appropriate. 1. Assuming the company continues its current growth rate, what is the value per share of the company’s stock? 2. Dan has examined the company’s financial statements, as well as examining those of its competitors. Although Ragan currently has a technological advantage, Dan’s research indicates that Ragan’s competitors are investigating other methods to improve efficiency. Given this, Dan believes that Ragan’s technological advantage will last only for the next five years. After that period, the company’s growth will likely slow to the industry average. Additionally, Dan believes that the required return the company uses is too high. He believes the industry average required return is more appropriate. Under Dan’s assumptions, what is the estimated stock price? 3. What is the industry average price−earnings ratio? What is Ragan’s price−earnings ratio? Comment on any differences and explain