FIN-450 Week 6 Chapter 17 Practice Problems

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FIN-450 Week 6 Chapter 17 Practice Problems

Intermediate Finance - The Cost of Capital and Capital Structure

Grand Canyon University

Complete the following problems from Chapter 17 in the textbook:

1. P17-4

2. P17-6

3. P17-8

4. P17-14

5. P17-19

6. P17-21

1. Do all work in Excel. Do not submit Word files or *.pdf files.

2. Submit a single spreadsheet file for this assignment. Do not submit multiple files.

3. Place each problem on a separate spreadsheet tab.

You are not required to submit this assignment to Turnitin.

1. P17-4 Lease versus purchase JLB Corporation is attempting to determine whether to lease or purchase research equipment. The firm is in the 40% tax bracket, and its after-tax cost of debt is currently 8%. The terms of the lease and of the purchase are as follows: Lease Annual end-of-year lease payments of \$25,200 are required over the 3-year life of the lease. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for \$5,000 at termination of the lease.  Purchase The research equipment, costing \$60,000, can be financed entirely with a 14% loan requiring annual end-of-year payments of \$25,844 for 3 years. The firm in this case will depreciate the equipment under MACRS using a 3-year recovery period. (See Table 4.2 on page 120 for the applicable depreciation percentages.) The firm will pay \$1,800 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 3-year recovery period. a. Calculate the after-tax cash outflows associated with each alternative. b. b. Calculate the present value of each cash outflow stream, using the after-tax cost of debt. c. Which alternative—lease or purchase—would you recommend? Why?

2. P17-6 Lease-versus-purchase decision Joanna Browne is considering either leasing or purchasing a new Chrysler Sebring convertible that has a manufacturer’s suggested retail price (MSRP) of \$33,000. The dealership offers a 3-year lease that requires a capital payment of \$3,300 (\$3,000 down payment 1 \$300 security deposit) and monthly payments of \$494. Purchasing requires a \$2,640 down payment, sales tax of 6.5% (\$2,145), and 36 monthly payments of \$784. Joanna estimates that the value of the car will be \$17,000 at the end of 3 years. She can earn 5% annual interest on her savings and is subject to a 6.5% sales tax on purchases. Make a reasonable recommendation to Joanna using a lease-versus-purchase analysis that, for simplicity, ignores the time value of money.

a. Calculate the total cost of leasing.

b. Calculate the total cost of purchasing.

c. Which should Joanna do?

3. P17-8 Conversion price Calculate the conversion price for each of the following convertible bonds: a. A \$1,000-par-value bond that is convertible into 20 shares of common stock. b. A \$500-par-value bond that is convertible into 25 shares of common stock. c. A \$1,000-par-value bond that is convertible into 50 shares of common stock. 4.  P17-14 Determining values: Convertible bond Craig’s Cake Company has an outstanding issue of 15-year convertible bonds with a \$1,000 par value. These bonds are convertible into 80 shares of common stock. They have a 13% annual coupon interest rate, whereas the interest rate on straight bonds of similar risk is 16%.

a. Calculate the straight bond value of this bond.

b.  Calculate the conversion (or stock) value of the bond when the market price is \$9, \$12, \$13, \$15, and \$20 per share of common stock.

c.  For each of the common stock prices given in part b, at what price would you expect the bond to sell? Why?

d. Make a graph of the straight value and conversion value of the bond for each common stock price given. Plot the per-share common stock prices on the x axis and the bond values on the y axis. Use this graph to indicate the minimum market value of the bond associated with each common stock price.

4. P17-19 Common stock versus warrant investment Tom Baldwin can invest \$6,300 in the common stock or the warrants of Lexington Life Insurance. The common stock is currently selling for \$30 per share. Its warrants, which provide for the purchase of two shares of common stock at \$28 per share, are currently selling for \$7. The stock is expected to rise to a market price of \$32 within the next year, so the expected theoretical value of a warrant over the next year is \$8. The expiration date of the warrant is 1 year from the present.

a. If Mr. Baldwin purchases the stock, holds it for 1 year, and then sells it for \$32, what is his total gain? (Ignore brokerage fees and taxes.)

b. If Mr. Baldwin purchases the warrants and converts them to common stock in 1 year, what is his total gain if the market price of common shares is actually \$32? (Ignore brokerage fees and taxes.)

c.  Repeat parts a and b, assuming that the market price of the stock in 1 year is  (1) \$30 and (2) \$28. Discuss the two alternatives and the trade-offs associated with them.

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