MANAGEMENT CONSULTANCY - Solutions Manual

CHAPTER 19 SOURCES OF INTERMEDIATE AND LONG-TERM FINANCING: DEBT AND EQUITY

I. Questions 1. The bond agreement specifies such basic items as the par value, the coupon rate, and the maturity date. 2. The priority of claims can be determined as follows: senior secured debt, junior secured debt, senior debenture, subordinated debenture, preference shares, ordinary shares. 3. Bond conversion. 4. The advantages of debt are: a. Interest payments are tax deductible. b. The financial obligation is clearly specified and of a fixed nature. c. In an inflationary economy, debt may be paid back with cheaper pesos. d. The use of debt, up to a prudent point, may lower the cost of capital to the firm. The disadvantages are: a. Interest and principal payment obligations are set by contract and must be paid regardless of economic circumstances. b. Bond indenture agreements may place burdensome restrictions on the firm. c. Debt, utilized beyond a given point, may serve as a depressant on outstanding ordinary shares. II. Multiple Choice 19-1

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Sources of Intermediate and Long-term Financing: Debt and Equity

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

D D D B A C C E D B C D D A D

16. 17. 18. 19. 20.

D C B A C 21. 22. 23. 24. 25. A C B B B

31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45.

A C D A C C A A D C C A D B C

26. 27. 28. 29. 30.

A A C C B

Supporting computations: 16. Px where Px Po N S Hence, Px = = = = = = value of a share ex-rights market value of share rights-on (Po x N) + 5 number of rights required to purchase one share subscription1 N + price per share = = P72

18. The following schedule applies for the term loan: (P75 x 4) + P60 360 5 5 Beginning Interest Principal Year Balance x (1 Tc ) Payment 1 P5000 P195 P1000 2 4000 156 1000 3 3000 117 1000 19-2

Ending Balance P4000 3000 2000

Sources of Intermediate and Long-term Financing: Debt and Equity

Chapter 19

4 5

2000 1000

78 39

1000 1000

1000 -0-

The present value of interest after taxes at 12% is calculated to be P453.49. 19. After the tax benefit, the annual cost of leasing is P1,400 (1 .35) = P910. The present value annuity factor for four years at 12% is 3.0373. The present value cost of the lease is the cost of the first payment plus the present value of the four future payments, or P910 + P910 (3.0373) = P3,673.94. 20. The present value annuity factor for five years at 12% is 3.6048. Therefore, the present value of principal payments is P1,000 (3.6048) = P3,604.80. The present value cost of the purchase option is the present value of principal payments or P3,604.80 plus P453.49 which equals P4,058.29.

III. Problems PROBLEM 1 (CAM FURNITURE COMPANY) a. Proposal 1: 10 year 12 percent bonds CAM FURNITURE COMPANY Income Statement For the Year Ended December 31, 2005 Estimated sales levels 19-3

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Sources of Intermediate and Long-term Financing: Debt and Equity

Sales........................................ P30,000 Operating costs........................ 3* Operating income..................... Interest charges........................ Net income before taxes........... Income taxes............................ Net income............................... Outstanding shares =

P400,000 360,000 40,000 14,000 26,000 13,000 P 13,000 = 10,000

P600,000 540,000 60,000 14,000 46,000 23,000 P 23,000

P800,000 720,000 80,000 14,000 66,000 33,000 P 33,000

* EPS (P36 market value price earnings ratio of 12) Earnings per share Price-earnings ratio Estimated market value P1.30 10 times P13 P2.30 10 times P23 P3.30 10 times P33

Proposal 2: Ordinary share issue to yield P33-1/3 CAM FURNITURE COMPANY P100,000 Statement Income For the33 - 1/3 Year Ended December 31, 2005 Sales........................................ Operating costs........................ Operating income..................... Interest charges........................ Net income before taxes........... Income taxes............................ Net income............................... Outstanding shares = Earnings per share Price-earnings ratio Estimated market value Estimated sales levels P400,000 P600,000 P800,000 360,000 540,000 720,000 40,000 60,000 80,000 2,000 2,000 2,000 38,000 58,000 78,000 19,000 29,000 39,000 P 19,000 P 29,000 P 39,000 + 10,000 = 13,000 shares P1.46 12 times P17.52 P2.23 12 times P26.76 P3.00 12 times P36.00

b. Within the constraints of this problem, two possible objectives emerge: profit maximization as measured by earnings per share and wealth maximization as measured by the price of the ordinary shares. If profit maximization is used, the firm should choose to finance the new product by selling bonds, since earnings per share is higher for each of the three 19-4

Sources of Intermediate and Long-term Financing: Debt and Equity

Chapter 19

levels of sales. On the other hand, wealth maximization would require the sale of new ordinary shares because share price is higher at each sales level. Wealth maximization is the preferred criterion for financial decision making. Unlike profit maximization, it represents a measure of the total benefits stream to be enjoyed by the shareholders, adjusted for both the timing of benefits and the risk associated with the receipt thereof. A criterion that ignores these two important determinants of value cannot be expected to provide a proper guide to decision making. Because wealth maximization is the preferred objective, the sale of ordinary shares is the recommended financing technique. c. Proposal 2 would still be the choice, because the market value remains above that of Proposal 1. The difference is getting smaller, however, which means that Proposal 1 would become attractive if sales reached a higher level (approximately P1.6 million). d. The investment banker would suggest that lower price-earnings ratio with debt financing is a reflection of the greater returns demanded by shareholders in compensation for the variability in earnings and higher risk of bankruptcy created by the fixed commitment to pay debt interest and principal. PROBLEM 2 (FAYE INDUSTRIES, INC.)
Faye Industries Inc. Pro Forma Consolidated Income Statement Including Earnings per Common Share and Return on Average Common Shareholders Equity For the Year Ending November 30, 2006 (P000 omitted except per share amounts) (1) Issuing Long-term Bonds P12,978 1,273 1,530 2,083 10,175 4,070 6,105 (2) Selling Preference Shares P12,978 1,273 1,273 11,705 4,682 7,023 (3) Selling Ordinary Shares P12,978 1,273 1,273 11,705 4,682 7,023

Earnings before interest and taxes Interest on Current debt (P13,395 x 9.5%) Alternative 1 (P15,300 x 10%) Total interest Income before income tax Income taxes (40%) Net income

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Sources of Intermediate and Long-term Financing: Debt and Equity

1,658 6,105 55,028 P61,133 5,365 55,028 P60,393 7,023 55,028 15,300 P77,351

Preference share dividends (P15,300,000 P120) x 13% Earnings available to common shareholders Add: Common shareholders equity December 1, 1999 Equity financing Common shareholders equity November 30, 2000 Average common shares outstanding (in thousands) December 1, 1999 balance Additional issued December 1 Total (and average) shares outstanding Pro forma earnings per share (P6,105 P0) 26,330 (P7,023 P1,658) 26,330 (P7.023 P0) 33,980

26,330 26,330

26,330 26,330

26,330 7,650 33,980

= = =

P0.2319

P0.2038

P0.2067

Estimated return on average common shareholders equity P6,105 [(P55,028 P61,133) 2] = P5,365 [(P55,028 P60,393) 2] = P7,023 [(P70,328 P77,351) 2] =

10.51%

9.30%

9.511%

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