Finance Chapter 16

Chapter 16
Discussion Questions
16-1.
Corporate debt has been expanding very dramatically in the last three decades.
What has been the impact on interest coverage, particularly since 1977?
In 1977, the average U.S. manufacturing corporation had its interest covered
almost eight times. By the early 2000s, the ratio had been cut in half.
16-2.
What are some specific features of bond agreements?

The bond agreement specifies such basic items as the par value, the coupon
rate, and the maturity date.
16-3.
What is the difference between a bond agreement and a bond indenture?

The bond agreement covers a limited number of items, whereas the bond
indenture is a supplement that often contains over 100 pages of complicated
legal wording and specifies every minute detail concerning the bond issue. The
bond indenture covers such topics as pledged collateral, methods of repayment,
restrictions on the corporation, and procedures for initiating claims against the
corporation.
16-4.
Discuss the relationship between the coupon rate (original interest rate at time
of issue) on a bond and its security provisions.
The greater the security provisions afforded to a given class of bondholders, the
lower the coupon rate.
S16-1
16-5.
Take the following list of securities and arrange them in order of their priority
of claims:
Preferred stock
Subordinated debenture
Common stock
Senior debenture
Senior secured debt
Junior secured debt
The priority of claims can be determined from Figure 16-2:

senior secured debt,
junior secured debt,
senior debenture,
subordinated debenture,
preferred stock,
common stock.
16-6.
What method of "bond repayment" reduces debt and increases the amount of
common stock outstanding?
Conversion of bonds to common stock through either a convertible bond or an
exchange offer.
16-7.
What is the purpose of serial repayments and sinking funds?

The purpose of serial and sinking fund payments is to provide an orderly
procedure for the retirement of a debt obligation. To the extent bonds are paid
off over their life, there is less risk to the security holder.
16-8.
Under what circumstances would a call on a bond be exercised by a

corporation? What is the purpose of a deferred call?
A call provision may be exercised when interest rates on new securities are
considerably lower than those on previously issued debt. The purpose of a
deferred call is to insure that the bondholder will not have to surrender the
security due to a call for at least the first five or ten years.
S16-2
16-9.
Discuss the relationship between bond prices and interest rates. What
impact do changing interest rates have on the price of long-term bonds
versus short-term bonds?
Bond prices on outstanding issues and market interest rates move in
opposite directions. If interest rates go up, bond prices will go down and
vice versa. Long-term bonds are particularly sensitive to interest rate
changes because the bondholder is locked into the interest rate for an
extended period of time.
16-10.
What is the difference between the following yields: coupon rate, current yield,
yield to maturity?
The different bond yield terms may be defined as follows:
Coupon rate stated interest rate divided by par value.
Current yield stated interest rate divided by the current price of the bond.
Yield to maturity - the interest rate that will equate future interest payments
and payment at maturity to a current market price.
16-11.
How does the bond rating affect the interest rate paid by a corporation on
its bonds?
The higher the rating on a bond, the lower the interest payment that will be
required to satisfy the bondholder.
16-12.
Bonds of different risk classes will have a spread between their interest
rates. Is this spread always the same? Why?
The spread in the yield between bonds in different risk classes is not
always the same. The yield spread changes with the economy. If investors
are pessimistic about the economy, they will accept as much as 3% less
return to go into very high-quality securities-whereas, in more normal
times the spread may only be 1 %.
16-13.
Explain how the bond refunding problem is similar to a capital budgeting

decision.
The bond refunding problem is similar to a capital budgeting problem in
that an initial investment must be made in the form of redemption and
reissuing costs, and cash inflows will take place in the form of interest
savings. We take the present value of the inflows to determine if they equal
or exceed the outflow.
S16-3
16-14.
What cost of capital is generally used in evaluating a bond refunding

decision? Why?
We use the aftertax cost of new debt as the discount rate rather than the
more generalized cost of capital. Because the net cash benefits are known
with certainty, the refunding decision represents a riskless investment. For
this reason, we use a lower discount rate.
16-15.
Explain how the zero-coupon rate bond provides return to the investor.
What are the advantages to the corporation?
The zero-coupon-rate bond is initially sold at a deep discount from par
value. The return to the investor is the difference between the investor's
cost and the face value received at the end of the life of the bond. The
advantages to the corporation are that there is immediate cash inflow to the
corporation, without any outflow until the bond matures. Furthermore, the
difference between the initial bond price and the maturity value may be
amortized for tax purposes over the life of the bond by the corporation.
16-16.
Explain how floating rate bonds can save the investor from potential
embarrassments in portfolio valuations.
Interest payments change with changing interest rates rather than with the
market value of the bond. This means that the market value of a floating
rate bond is almost fixed. The one exception is when interest rates dictated
by the floating rate formula approach (or exceed) broadly defined limits.
16-17.
Discuss the advantages and disadvantages of debt.

The primary 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
dollars (the dollars have less purchasing power than when received).
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 common stock.
S16-4
16-18.
What is a Eurobond?
A Eurobond is a bond payable in the borrower's currency but sold outside
the borrower's country. It is usually sold by an international syndicate.
16-19.
What do we mean by capitalizing lease payments?

Capitalizing lease payments means computing the present value of future
lease payments and showing them as an asset and liability on the balance
sheet.
16-20.
Explain the close parallel between a capital lease and the borrow-purchase
decision from the viewpoint of both the balance sheet and the income
statement.
In both cases we create an asset and liability on the balance sheet.
Furthermore in both cases, for income statement purposes, we amortize the
asset and write off interest (implied or actual) on the debt.
S16-5
Appendix
16A-1.
What is the difference between technical insolvency and bankruptcy?

Technical insolvency refers to the circumstances where a firm is unable to pay its bills
as they come due. A firm may be technically insolvent even though it has a positive net
worth. Bankruptcy, on the other hand, indicates that the market value of a firm's assets
is less than its liabilities and the firm has a negative net worth. Under the law, either
technical insolvency or bankruptcy may be adjudged as a financial failure of the
business firm.
16A-2.
16A-3.
What are the four types of out-of-court settlements? Briefly describe each.
Extension -
Creditors agree to allow the firm more time to meet its

financial obligations.
Composition -
Creditors agree to accept a fractional settlement on their

original claims.
Creditor committee -
A creditor committee is set up to run the business because it is

believed that management can no longer conduct the affairs of
the firm.
Assignment -
Liquidation of assets takes place without going through formal

court action.
What is the difference between an internal reorganization and an external

reorganization under formal bankruptcy procedures?
An internal reorganization calls for an evaluation and restricting of the current affairs
of the firm. Current management may be replaced and a redesign of the capital
structure may be necessary. An external reorganization means that an actual merger
partner will be found for the firm.
16A-4.
What are the first three priority items under liquidation in bankruptcy?
(1)
Cost of administering the bankruptcy procedures.
(2)
Wages due workers if earned within three months of filing the bankruptcy
petition. The maximum amount is $600 per worker.
(3)
Tax due at the federal, state or local level.
S16-6
Chapter 16
Problems
(Assume the par value of the bonds in the following problems is $1,000 unless otherwise
specified.)
1.
The Pioneer Petroleum Corporation has a bond outstanding with an $85 annual interest
payment, a market price of $800, and a maturity date in five years. Find the following:
a.
b.
c.
The coupon rate.

The current rate.
The approximate yield to maturity.
16-1. Solution:
The Pioneer Petroleum Company
a. $85 interest/$1,000 par = 8.5% coupon rate
b. $85 interest/$800 market price = 10.625% current yield
c. Approximate yield to maturity = (Y')
Principal payment Price of the bond
Number of years to maturity
.6 (Price of the bond) .4 (Principal payment)
Annual interest payment

(Y' )
$1,000 $800
5
.6($800) .4($1,000)
$85
$200
5
$480 $400
$85
$85 $40 $125
14.20%
$880
$880
S16-7
2.
Harold Reese must choose between two bonds:

Bond X pays $95 annual interest and has a market value of $900. It has 10 years
to maturity.
Bond Z pays $95 annual interest and has a market value of $920. It has two years
to maturity.
a.
b.
c.
d.
Compute the current yield on both bonds.

Which bond should he select based on your answer to part a?
A drawback of current yield is that it does not consider the total life of the bond. For
example, the approximate yield to maturity on Bond X is 11.17 percent. What is
the approximate yield to maturity on Bond Z?
Has your answer changed between parts b and c of this question?
16-2. Solution:
a. Bond X
$95 interest/$900 market price = 10.56% current yield
Bond Z
b. He should select Bond X. It has a higher current yield.
S16-8
16-2. (Continued)
c. Approximate yield to maturity = (Y')

(Y' )
$1,000 $920
2
.6($920) .4($1,000)
$95
$80
2
.6($920) .4($1,000)
$95
$95 $40 $135
14.18%
$552 400 $952
d. Yes. Bond Z has the higher yield to maturity. This is because

the discount will be recovered over only two years. With
Bond X there is a $100 discount, but a 10-year recovery
period.
S16-9
3.
An investor must choose between two bonds:

Bond A pays $90 annual interest and has a market value of $850. It has 10 years to
maturity.
Bond B pays $80 annual interest and has a market value of $900. It has two years to
maturity.
a.
b.
c.
d.
Compute the current yield on both bonds.

Which bond should he select based on your answer to part a?
A drawback of current yield is that it does not consider the total life of the bond. For
example, the approximate yield to maturity on Bond A is 11.54 percent. What is the
approximate yield to maturity on Bond B?
Has your answer changed between parts b and c of this question in terms of which
bond to select?
16-3. Solution:
a. Bond A
Bond B
b. Bond A. It has a higher current yield.
S16-10
16-3. (Continued)
c.
Approximate yield to maturity = (Y')
Bond B


(Y' )
$1,000 $900
2
.6($900) .4($1,000)
$80
$100
2
$540 $400)
$80
$80 $50 $130
13.83%
$940
$940
d. Yes. Bond B now has the higher yield to maturity. This is

because the $100 discount will be recovered over only two
years. With Bond A there is a $150 discount, but a 10-year
recovery period.
S16-11
4.
Match the yield to maturity in column 2 with the security provisions (or lack thereof) in
column 1. Higher returns tend to go with greater risk.
(1)
Security Provision
a. Debenture
b. Secured debt
c. Subordinated debenture
(2)
Yield to Maturity
a. 6.85%
b. 8.20%
c. 7.76%
16-4. Solution:
Security Provision
Yield to Maturity
a. Debenture
b. Security debt
c. Subordinated debenture
a. 7.76%
b. 6.85%
c. 8.20%
The greater the risk, the higher the yield.
5.
The Southeast Investment Fund buys 70 bonds of the Hillary Bakery Corporation through
its broker. The bonds pay 9 percent annual interest. The yield to maturity (market rate of
interest) is 12 percent. The bonds have a 25-year maturity. Using an assumption of
semiannual interest payments:
a. Compute the price of a bond (refer to semiannual interest and bond prices in
Chapter 10 for review if necessary).
b. Compute the total value of the 70 bonds.
S16-12
16-5. Solution:
The Southeast Investment Fund
a. Present value of interest payments
PVA = A PVIFA (n = 50, i = 6%)
PVA = $45 15.762 = $709.29
Appendix D
Present value of principal payment at maturity

PV = FV PVIF (n = 50, i = 6%)
PV = $1,000 .054 = $54.00
Appendix B
Total present value

Present value of interest payments
Present value of payment at maturity
Total present value or price of the bond
b. Value of 70 bonds
$
763.29
70
$53,430.30
S16-13
$709.29
54.00
$763.29
6.
Sanders & Co. pays a 12 percent coupon rate on debentures that are due in 20 years.
The current yield to maturity on bonds of similar risk is 10 percent. The bonds are currently
callable at $1,060. The theoretical value of the bonds will be equal to the present value of
the expected cash flow from the bonds. This is the normal definition we use.
a. Find the theoretical market value of the bonds using semiannual analysis.
b. Do you think the bonds will sell for the price you arrived at in part a? Why?
16-6. Solution:
Sanders & Co.
PVA = A PVIFA (n = 40, i = 5%)
PVA = $60 17.159 = $1,029.54
Appendix D

PV = FV PVIF (n = 40, i = 5%)
PV = $1,000 .142 = $142.00
Appendix B
Total present value

$1,029.54
142.00
$1,171.54
b. No. The call price of $1,060 will keep the bonds from getting
much over $1,060. Since the bonds are currently callable,
investors will not want to buy the bonds at almost $1,171 and
risk having them called away at $1,060.
S16-14
7.
The yield to maturity for 25-year bonds is as follows for four different bond rating
categories:
Aaa
9.4%
Aa2
10.0%
Aal
9.6%
Aa3
10.2%
The bonds of Evans Corporation were rated as Aal and issued at par a few weeks ago.
The bonds have just been downgraded to Aa2. Determine the new price of the bonds,
assuming a 25-year maturity and semiannual interest payments. As a first step, use the data
above as a guide to appropriate interest rates for bonds with different ratings.
16-7. Solution:
Evans Corporation
With a Aal rating at issue, the coupon rate is 9.6% annually or
4.8% semiannually. With a downgrading to Aa2, the new yield to
maturity is 10% or 5% semiannually.
PVA = A PVIFA (n = 50, i = 5%)
PVA = $48 18.256 = $876.29
Appendix D

PV = PV PVIF (n = 50, i = 5%)
PV = $1,000 .087 = $87.00
Total present value of the bond
S16-15
Appendix B
$876.29
87.00
$963.29
8.
Twenty-five-year B-rated bonds of Parker Optical Company were initially issued at a

12 percent yield. After 10 years the bonds have been upgraded to Aa2. Such bonds are
currently yielding 10 percent to maturity. Use Table 163 to determine the price of the
bonds with 15 years remaining to maturity. (You do not need the bond ratings to enter the
table; just use the basic facts of the problem.)
16-8. Solution:
Parker Optical Company
Using Table 16-3:
12% initial coupon rate, 10% yield to maturity,
15 years remaining to maturity:
9.
= $1,153.32
A previously issued Aal, 20-year industrial bond provides a return one-fourth higher than
the prime interest rate assumed to be at 8 percent. Previously issued public utility bonds
provide a yield of three-fourths of a percentage point higher than previously issued
industrial bonds of equal quality. Finally, new issues of Aal public utility bonds pay
one-fourth of a percentage point more than previously issued public utility bonds. What
should the interest rate be on the newly issued Aa1 public utility bond?
16-9. Solution:
Interest rate on previously issued
Aal 20-year industrial bonds
8% 1.25 =
Additional return on Aal 20-year
public utility bond
Additional return on new issues
Anticipated return on newly issued
Aal public utility bonds
S16-16
10.00%
+ .75%
+ .25%
11.00%
10.
A 15-year, $1,000 par value zero-coupon rate bond is to be issued to yield 10 percent.
a. What should be the initial price of the bond? (Take the present value of $1,000 to be
received after 15 years at 10 percent, using Appendix B at the back of the text.)
b. If immediately upon issue, interest rates dropped to 8 percent, what would be the
value of the zero-coupon rate bond?
c. If immediately upon issue, interest rates increased to 12 percent, what would be the
value of the zero-coupon rate bond?
16-10. Solution:
a. PV of $1,000 for n = 15, i = 10%, PVIF = .239
$1,000
.239
$ 239
b. PV of $1,000 for n = 15, i = 8%, PVIF = .315
$1,000
.315
$ 315
c. PV of $1,000 for n = 15, i = 14%, PVIF = .183
$1,000
.183
$ 183
S16-17
11.
What is the effective yield to maturity on a zero-coupon bond that sells for $131 and will
mature in 30 years at $1,000? (Compute PVIF and go to Appendix B for the 30-year figure
to find the answer or compute FVIF and go to Appendix A for the 30-year figure to find the
answer. Either approach will work.)
16-11. Solution:
PVIF
PV
$131
.131
FV $1,000
Using Appendix B for n = 30, the yield is 7 percent

or
FVIF
FV $1,000
7.634
PV
$131
Using Appendix A for n = 30, the yield is approximately

7 percent.
12.
You buy an 8 percent, 25-year, $1,000 par value floating rate bond in 1999. By the year
2004, rates on bonds of similar risk are up to 11 percent. What is your one best guess as to
the value of the bond?
16-12. Solution:
With a floating rate bond, the rate the bond pays changes with
interest rates in the market. Therefore, the price of the bond
stays constant. The one best guess is $1,000.
S16-18
13.
Fourteen years ago, the U.S. Aluminum Corporation borrowed $9.9 million. Since then,
cumulative inflation has been 98 percent (a compound rate of approximately 5 percent
per year).
a. When the firm repays the original $9.9 million loan this year, what will be the
effective purchasing power of the $9.9 million? (Hint: Divide the loan amount by one
plus cumulative inflation.)
b. To maintain the original $9.9 million purchasing power, how much should the lender
be repaid? (Hint: Multiply the loan amount by one plus cumulative inflation.)
c. If the lender knows he will receive only $9.9 million in payment after 14 years, how
might he be compensated for the loss in purchasing power? A descriptive answer is
acceptable.
16-13. Solution:
U.S. Aluminum Corporation
a.
Loan amount
$9,900,000
$5,000,000
1 Cumulative inflation
1.98
b. $9,900,000 1.98
$19,602,000
A $19,602,000 loan repayment in a 98% cumulative

inflationary environment will provide $9,000,000 in
purchasing power to the original lender.
c. Charge a high enough interest rate to not only provide an
adequate annual return on the borrowed funds, but also
compensate for the loss of purchasing power.
S16-19
14.
A $1,000 par value bond was issued 25 years ago at a 12 percent coupon rate. It currently
has 15 years remaining to maturity. Interest rates on similar obligations are now 8 percent.
a. What is the current price of the bond? (Look up the answer in Table 16-3 on page ___.)
b. Assume Ms. Bright bought the bond three years ago when it had a price of $1,050.
What is her dollar profit based on the bonds current price?
c. Further assume Ms. Bright paid 30 percent of the purchase price in cash and borrowed
the rest (known as buying on margin). She used the interest payments from the bond
to cover the interest costs on the loan. How much of the purchase price of $1,050 did
Ms. Bright pay in cash?
d. What is Ms. Brights percentage return on her cash investment? Divide the answer to
part b by the answer to part c.
e. Explain why her return is so high.
16-14. Solution:
Ms. Bright
a. The original bond was issued at 12%
Yield to maturity is now 8%
15 years remain to maturity
The bond price is $1,345.52
b. $1,345.52
1,050.00
$ 295.52
c. Purchase Price
30% Margin
d.
Current price
Purchase price
Dollar profit
$1,050.00
$ 315.00 Purchase price paid in cash
Dollar profit
$295.52
Purchase price paid in cash

$315.00
93.82%
93.82% represents Ms. Brights return on her investment.
S16-20
16-14. (Continued)
e. Ms. Bright has not only benefited from an increase in the
price of the bond (due to lower interest rates), but she also
has benefited from the use of leverage by buying on margin.
She has controlled a $1,070 initial investment with only
$315 in cash. The low cash investment tends to magnify
gains (as well as losses).
15.
A $1,000 par value bond was issued 25 years ago at a 8 percent coupon rate. It currently
has 15 years remaining to maturity. Interest rates on similar debt obligations are now
14 percent.
a. Compute the current price of the bond using an assumption of semiannual payments.
b. If Mr. Mitchell initially bought the bond at par value, what is his percentage loss
(or gain)?
c. Now assume Mrs. Gordon buys the bond at its current market value and holds it to
maturity, what will her percentage return be?
d. Although the same dollar amounts are involved in part b and c, explain why the
percentage gain is larger than the percentage loss.
S16-21
16-15. Solution:
Mr. Mitchell Mrs. Gordon
PVA = A PVIFA (n = 30, i = 7%)
PVA = 40 12.409 = $496.36
Appendix D

PV = FV PVIF (n = 30, i = 7%)
PV = $1,000 .131 = $131.00
Total present value
b. Purchase price
Current value
Dollar loss
Appendix B
$496.36
131.00
$627.36
$1,000.00
627.36
$ 372.64
Dollar loss
Investment
$372.64
37.26%
$1,000.00
c. Maturity value
Purchase price
Dollar gain
Dollar gain
Investment
$1,000.00
627.36
$ 372.64
$372.64
59.40%
$627.36
d. The percentage gain is larger than the percentage loss

because the investment is smaller ($627.36 vs. $1,000).
The gain/loss is the same ($372.64).
S16-22
16.
The Delta Corporation has a $20 million bond obligation outstanding, which it is
considering refunding. Though the bonds were initially issued at 13 percent, the interest
rates on similar issues have declined to 11.5 percent. The bonds were originally issued for
20 years and have 16 years remaining. The new issue would be for 16 years. There is a
9 percent call premium on the old issue. The underwriting cost on the new $20 million
issue is $560,000, and the underwriting cost on the old issue was $400,000. The company
is in a 40 percent tax bracket, and it will use a 7 percent discount rate (rounded after-tax
cost of debt) to analyze the refunding decision. Should the old issue be refunded with new
debt?
16-16. Solution:
The Delta Corporation
Outflows
1. Payment of call premium
$20,000,000 9% = $1,800,000
$1,800,000 (1 .4) = $1,080,000
Aftertax cost of call
2. Underwriting cost on new issue

Amortization of costs ($560,000/16) (.4)
$35,000 (.4) = $14,000 tax savings per year
Actual expenditure
PV of future tax savings $14,000 9.447*
Net cost of underwriting expense on new issue
$560,000
132,258
$427,742
*PVIFA for n = 16, i = 7% (Appendix D)

Inflows
3. Cost savings in lower interest rates
13% (interest on old bond) $20,000,000 = $2,600,000/year
11.5% (interest on new bond) $20,000,000 = $2,300,000/year
Savings per year
$ 300,000
Savings per year $300,000 (1 .4)
= $ 180,000 aftertax
S16-23
16-16. (Continued)
$ 180,000
9.447
$1,700,460
PVIFA (n = 16, i = 7%)
Appendix D
4. Underwriting cost on old issue

Original amount
Amount written off over 4 years
at $20,000 per year
Unamortized old underwriting cost
Present value of deferred future write-off
$20,000 9.447 (n = 16, i = 7%)
Immediate gain in old underwriting
cost write-off
Tax rate
Aftertax value of immediate gain in old
underwriting cost write-off
$400,000
80,000
$320,000
188,940
$131,060
40
$ 52,424
Summary
Outflows
1.
2.
Inflows
$1,080,000
427,742
$1,507,742
3.
4.
PV of inflows
PV of outflows
Net present value
$1,700,460
52,424
$1,752,884
$1,752,884
1,507,742
$ 245,142
Refund the old issue (particularly if it is perceived that

interest rates will not go down even more).
S16-24
17.
The Sunbelt Corporation has $40 million of bonds outstanding that were issued at a coupon
rate of 12 percent seven years ago. Interest rates have fallen to 12 percent. Mr. Heath, the
vice-president of finance, does not expect rates to fall any further. The bonds have 18 years
left to maturity, and Mr. Heath would like to refund the bonds with a new issue of equal
amount also having 18 years to maturity. The Sunbelt Corporation has a tax rate of
36 percent. The underwriting cost on the old issue was 2.5 percent of the total bond value.
The underwriting cost on the new issue will be 1.8 percent of the total bond value. The
original bond indenture contained a five-year protection against a call, with an 8 percent
call premium starting in the sixth year and scheduled to decline by one-half percent each
year thereafter (consider the bond to be seven years old for purposes of computing the
premium). Assume the discount rate is equal to the aftertax cost of new debt rounded up
to the nearest whole number. Should the Sunbelt Corporation refund the old issue?
16-17. Solution:
The Sunbelt Corporation
First compute the discount rate
12% (1 .36) = 12% .64 = 7.68%. Round up to 8%.
Outflows
1. Payment on call provision
$40,000,000 7.5%
= $3,000,000
$3,000,000 (1 .36)
= $1,920,000
Actual expenditure
1.8% $40,000,000 =
Amortization of costs ($720,000/18) (.36) =
Tax savings per year = $40,000 (.36)
=
Actual expenditure
PV of future tax savings $ 14,400 9.372*
Net cost of underwriting expense on new issue
S16-25
$720,000
$ 14,400
$720,000
134,957
$585,043
16-17. (Continued)
Inflows
12 7/8% (interest on old bond) $40,000,000 = $5,150,000
12% (interest on new bond) $40,000,000 =
4,800,000
Savings per year
$ 350,000
Savings per year $350,000 (1 .36) = $224,000 Aftertax
$ 224,000
9.372
$2,099,328
PVIFA (n = 18, i = 8%)

Present value of savings
Appendix D

Original amount (2.5% $40,000,000)
Amount written off over last 7 years at
$40,000 per year ($1,000,000/25) 7
Present value of deferred future write off:
$40,000 9.372 (n = 18, i = 8%)
Immediate gain in old underwriting write-off
Tax rate
Aftertax value of immediate gain in old
S16-26
$1,000,000
280,000
$ 720,000
374,880
$ 345,120
.36
$ 124,243
16-17. (Continued)
Summary
Outflows
1.
2.
Inflows
$1,920,000
585,043
$2,505,043
3.
4.
PV of inflows
PV of outflows
Net present value
$2,099,328
124,243
$2,223,571
$2,223,571
2,505,043
$ (281,472)
Based on the negative net present value, the Sunbelt

Corporation should not refund the issue.
18.
In problem 17, what would be the aftertax cost of the call premium at the end of year 11
(in dollar value)?
16-18. Solution:
The Sunbelt Corporation (Continued)
Call premium (aftertax cost)
5 years of 1/2% deductions (7th through 11th year) = 2 1/2%
8%
2 1/2%
5 1/2%
Call premiums
Call premiums at the end of the 11th year
$40,000,000 5 1/2% = $2,200,000

$ 2,200,000 (1 .36) = $1,408,000 aftertax cost of call premium
S16-27
19.
The Richmond Corporation has just signed a 144-month lease on an asset with an 18-year
life. The minimum lease payments are $3,000 per month ($36,000 per year) and are to be
discounted back to the present at an 8 percent annual discount rate. The estimated fair value
of the property is $290,000. Should the lease be recorded as a capital lease or an operating
lease?
16-19. Solution:
Richmond Corporation
Using criteria 3 and 4
The lease is less than 75% of the estimated life of the leased
property.
144 months
12/18
= 12 years
= 67%
However, the present value of the lease payments is greater than

90% of the fair value of the property.
$ 36,000
7.536
$271,296
annual lease payments

(PVIFA (n = 12, i = 8%)
present value of lease payments
$271,296
$290,000
= 93.6%
Since one of the four criteria for compulsory treatment as a

capital lease is indicated, the transaction must be treated as a
capital lease.
S16-28
20.
The Bradley Corporation has heavy lease commitments. Prior to SFAS No. 13, it merely
footnoted lease obligations in the balance sheet, which appeared as follows:
BRADLEY CORPORATION
($ millions)
Current assets.....................................
$150
Fixed assets........................................
250
Total assets.........................................
$400
Current liabilities...............................
$ 50
Long term liabilities...........................
100
Total liabilities................................
150
Stockholders equity...........................
250
Total liabilities and
stockholders equity.......................
$400
The footnotes stated that the company had $22 million in annual capital lease obligations
for the next 20 years.
a.
b.
c.
d.
e.
f.
Discount these annual lease obligations back to the present at a 7 percent discount rate
(round to the nearest million dollars).
Construct a revised balance sheet that includes lease obligations, as in Table 168.
Compute total debt to total assets on the original and revised balance sheets.
Compute total debt to equity on the original and revised balance sheets.
In an efficient capital market environment, should the consequences of SFAS No. 13,
as viewed in the answers to parts c and d, change stock prices and credit ratings?
Comment on managements perception of market efficiency (the viewpoint of the
financial officer).
S16-29
16-20. Solution:
The Bradley Corp.
a.
$22
10.594
$233.068
million annual lease payments

(PVIFA forn n = 20, i = 7%)
million (round to $233 million)
b. Current assets $150 million

Fixed assets
250 million
Leased property
under capital
lease233 million
Total assets
c.
$633 million
Current liabilities $ 50 million

Long-term liabilities 100 million
Obligations under
capital lease
233 million
Total liabilities 383 million
Stockholders' equity 250 million
Stockholders'
equity
$633 million
Original
Revised
Total debt $150 million

$383 million
37.5%
= 60.5%
Total assets $400 million
$633 million
d.
Original
Revised
Total debt $150 million
60%
Equity
$250 million
$383 million
=153.2%
$250 million
e. No, the information was already known by financial

analysts before it was brought into the balance sheet.
f.
Management is concerned about whether the market is as

efficient as academics generally believe. They feel that
newly presented information may make their performance
look questionable.
S16-30
21.
The Lollar Corporation plans to lease an $800,000 asset to the Pierce Corporation. The
lease will be for 12 years.
a. If the Lollar Corporation desires a 10 percent return on its investment, how much
should the lease payments be?
b. If the Lollar Corporation is able to generate $120,000 in immediate tax shield benefits
from the asset to be purchased for the lease arrangement and will pass the benefits
along to the Pierce Corporation in the form of lower lease payments, how much
should the revised lease payments be? Continue to assume the Lollar Corporation
desires a 10 percent return on the 12-year lease.
16-21. Solution:
Lollar Corporation
a. Determine 12-year annuity that will yield 10%.
A = PV / PVIFA (i = 10%, n = 12)
Appendix D
=
$800,000
$117,405
6.814
b. Original amount
Tax Benefits
Net cost
A=
$800,000
120,000
$680,000
$680,000
$99,795
6.814
S16-31
COMPREHENSIVE PROBLEM
Comprehensive Problem 1.
Mike Garcia, the chief financial officer of Endicott Publishing Co., could hardly believe the
change in interest rates that had taken place over the last few months. The interest rate on
A2 rated bonds was now 8 percent. The $30 million, 15-year bond issue that his firm has
outstanding was initially issued at 11 percent five years ago.
Because interest rates had gone down so dramatically, he was considering refunding the bond
issue. The old issue had a call premium of 10 percent. The underwriting cost on the old issue had
been 3 percent of par and on the new issue, it would be 4 percent of par. The tax rate would be 40
percent and a 5 percent discount rate will be applied for the refunding decision. The new bond
would have a 10-year life.
Before Mike used the 10 percent call provision to reacquire the old bonds, he wanted to make
sure he could not buy them back cheaper in the open market.
a. First compute the price of the old bonds in the open market. Use the valuation procedures for
a bond that were discussed in Chapter 10 (use the annual analysis). Determine the price of a
single $1,000 par value.
b. Compare the price in part a to the 10 percent call premium over par value. Which appears to
be more attractive in terms of reacquiring the old bonds?
c. Now do the standard bond refunding analysis as discussed in this chapter. Is the refunding
financially feasible?
d In terms of the refunding decision, how should Mike be influenced if he thinks interest rates
might go down even more?
S16-32
CP 16-1. Solution:
Endicott Publishing Co.
a. Price of Old Bond
Present Value of Interest Payments
PVA
= A PVIFA (n = 10, i = 8%)
PVA = $100 6.710 = $738.10
Appendix D
Present Value of Principal Payment at Maturity

PV = FV x PVIF (n = 10, i = 6%)
Appendix D
PV = $1,000 x .558 = $558
Total present value
Present Value of Interest Payments
Present Value of Principal Payment
$738.10
463.00
$1,201.10
b. The price of $1,201.10 is more than 20 percent over par.

The Call price is only 10 percent over par. Clearly, calling
in the bonds is more attractive than repurchasing them in
the open market.
c. Refunding Decision
S16-33
CP 16-1. (Continued)
Outflows
1. Payment of call premium
$30,000,000 10% = $3,000,000
$3,000,000 x (1 .30) = $1,800,000
Actual expenditure $30,000,000 4%
Amortization of cost = ($1,200,000/10)
Tax savings per year 120,000 .40
PV of future tax savings $48,000 7.722*
= $1,200,000
= $120,000
=
$48,000
= $370,656
Actual expenditure
PV of future tax savings
New cost of underwriting expense
on new issue
11% (interest on old bonds) $30,000,000
8% (interest on new bonds) $30,000,000
Savings per year
$1,200,000
370,656
$ 829,344
= $3,300,000
2,400,000
$900,000
Savings per year $900,000 (1 40) = $540,000 after tax

$ 540,000
7,722 PVA (n = 10, i = 5%) (Appendix D)
$4,169,880 Present value of interest savings
S16-34
CP 16-1. (Continued)
Original amount (3% $30,000,000)
Amount written off over last 5 years at
$60,000 per year ($900,000/15)
Present value of deferred future write-off
$60,000 8.111 (n = 10, i = 4%)
Immediate gain in old underwriting writeoff tax rate
Tax rate
After tax value of immediate gain in old
$900,000
300,000
$600,000
463,320
$136,680
.40
$ 54,672
Summary
Outflows
1.
2.
Inflows
$1,800,000
829,344
$2,629,344
3.
4.
PV of inflows
PV of outflows
Net present value
$4,169,880
54,672
$4,224,552
$4,224,552
2,629,344
$1,595,208
The refunding is financially feasible.

d. If Mike thought interest rates were going down even more, he
might want to wait on the refunding because the net present
value would be even higher. Of course, if he were wrong and
interest rates went up, he might miss out on a highly
profitable opportunity.
S16-35
Appendix
16A1.
The trustee in the bankruptcy settlement for Immobile Corporation lists the book values and
liquidation values for the assets of the corporation. Also, liabilities and stockholders claims
are shown.
Book Value
Assets
Accounts receivable..............................
$1,000,000
Inventory........................................................1,100,000
Machinery and equipment.............................. 800,000
Building and plant..........................................3,000,000
$5,900,000
Liabilities and Stockholders Claims
Liabilities:
Accounts payable........................................
$2,000,000
First lien, secured by
machinery and equipment....................... 650,000
Senior unsecured debt.................................1,300,000
Subordinated debenture..............................1,450,000
Total liabilities........................................5,400,000
Stockholders claims:
Preferred stock............................................ 100,000
Common stock............................................ 400,000
Total stockholders claims...................... 500,000
stockholders claims.......................
$5,900,000
S16-36
Liquidation
Value
$ 700,000
600,000
400,000
1,800,000
$3,500,000
Appendix A-1 (Continued)

a.
Compute the difference between the liquidation value of the assets and the liabilities.
b.
Based on the answer to part a, will preferred stock or common stock participate in the
distribution?
c.
Assuming the administrative costs of bankruptcy, workers allowable wages, and unpaid
taxes add up to $300,000, what is the total of remaining asset value available to cover
secured and unsecured claims?
d.
After the machinery and equipment are sold to partially cover the first lien secured claim,
how much will be available from the remaining asset liquidation values to cover unsatisfied
secured claims and unsecured debt?
e.
List the remaining asset claims of unsatisfied secured debt holders and unsecured debt
holders in a manner similar to that shown at the bottom portion of Table 16A-3.
f.
Compute a ratio of your answers in part d and part e. This will indicate the initial allocation
ratio.
g.
List the remaining claims (unsatisfied secured and unsecured) and make an initial allocation
and final allocation similar to that shown in Table 16A-4. Subordinated debenture holders
may keep the balance after full payment is made to senior debt holders.
h.
Show the relationship of amount received to total amount of claim in a similar fashion to
that of Table 16A-5. (Remember to use the sales [liquidation] value for machinery and
equipment plus the allocation amount in part g to arrive at the total received on secured
debt.)
S16-37
16A-1.
Solution:
Immobile Corporation
a. Liquidation value of assets
Liabilities
Difference
$3,500,000
5,400,000
($1,900,000)
b. Preferred and common stock will not participate in the

distribution because the liquidation value of the assets does
not cover creditor claims.
c. Asset values in liquidation
Administrative costs, wages and taxes
Remaining asset values
$3,500,000
300,000
$3,200,000
d. Remaining asset value

$3,200,000
Payment to secured creditors
400,000
Amount available to unsatisfied secured
claims and unsecured debt
$2,800,000
e. Remaining claims of unsatisfied secured debt and
unsecured debt holder
Secured debt (unsatisfied first lien)
Accounts payable
Senior unsecured debt
Subordinated debentures
$ 250,000
2,000,000
1,300,000
1,450,000
$5,000,000
f. Amount available to unsatisfied

security claims and unsecured debt (part d) $2,800,000
56%
Remaining claims of unsatisfied secured
$5,000,000
debt and unsecured debt holders (part e)
S16-38
16A-1. (Continued)
g.
Allocation procedures for unsatisfied secured claims and

unsecured debt.
(1)
Category
Secured debt
(unsatisfied first lien)
Accounts Payable
Senior unsecured debt
Subordinated
debentures*
(2)
Amount of
Claim
(3)
Initial
Allocation
(56%)
(4)
Amount
Received
$ 250,000 $ 140,000 $ 140,000

2,000,000 1,120,000 1,120,000
728,000 1,300,000
1,300,000
1,450,000
812,000 240,000*
$5,000,000 $2,800,000 $2,800,000
* The subordinated debenture holders must transfer $572,000

of their initial allocation to the senior unsecured debt holders
to fully provide for their payment ($728,000 + $572,000 =
$1,300,000). This will leave $240,000 for subordinated
debentures ($812,000 $572,000).
S16-39
16A-1. (Continued)
h. Payments and percent of claims
Category
Secured debt
(first lien)
Accounts payable
Senior unsecured
debt
Subordinated
debentures
Percent of
claim
satisfied
Total amount
of claim
Amount
received
$ 650,000
2,000,000
1,300,000
*$ 540,000
1,120,000
1,300,000
83.1%
56.0%
100.0%
1,450,000
240,000
16.6%
* $400,000 from the sale of machinery and dequipment and

$140,000 from the allocation process in part g.
16B-1. Edison Electronics is considering whether to borrow funds and purchase an asset or to
lease the asset under an operating lease arrangement. If it purchases the asset, the cost
will be $8,000. It can borrow funds for four years at 12 percent interest. The firm will
use the three-year MACRS depreciation category (with the associated four-year writeoff). Assume a tax rate of 35 percent.
The other alternative is to sign two operating leases, one with payments of $2,100 for
the first two years, and the other with payments of $3,700 for the last two years. In your
analysis, round all values to the nearest dollar.
a.
Compute the aftertax cost of the leases for the four years.
b.
c.
Compute the annual payment for the loan (round to the nearest dollar).
Compute the amortization schedule for the loan. (Disregard a small difference
from a zero balance at the end of the loan due to rounding.)
Determine the depreciation schedule (see Table 129 in Chapter 12).
Compute the aftertax cost of the borrowpurchase alternative.
Compute the present value of the aftertax cost of the two alternatives. Use a
discount rate of 8 percent.
Which alternative should be selected, based on minimizing the present value of
aftertax costs?
d.
e.
f.
g.
S16-40
16B-1.
Solution:
Edison Electronics
a.
(1)
Year
1
2
3
4
b. A =
c.
(2)
(3)
(4)
Payment
$2,100
$2,100
$3,700
$3,700
Tax Shield
35% of (1)
$ 735
735
1,295
1,295
After tax
Cost
$1,365
1,365
2,405
2,405
PV
$8,000
$2,634 (n = 4, i = 12%) Appendix D

PVIFA
3.037
(1)
(2)
Beginning Annual
Year Balance Payment
1
$8,000
$2,634
2
6,326
2,634
3
4,451
2,634
4
2,351
2,634
d.
Year
1
2
3
4
Depreciation
Base
$8,000
8,000
8,000
8,000
S16-41
(3)
(4)
Annual
Repayment
Interest
on Principal
12% of (1)
(2) (3)
$960
$1,674
759
1,875
534
2,100
282
2,352
Depreciation
Percentage Depreciation
.333
$2,664
.445
3,560
.148
1,184
.074
592
$8,000
(5)
Ending
Balance
(1) (4)
$6,326
4,451
2,351
(1)
16B-1. (Continued)
e.
(1)
(2)
(3)
(4)
(5)
(6)
Total Tax
Tax
Net After
Deductions
Shield
Tax Cost
Year Payment Interest Depreciation (2) + (3) 35% (4) (1) (5)
1
$2,634
$960
$2,664
$3,624
$1,268
$1,366
2
2,634
759
3,560
4,319
1,512
1,122
3
2,634
534
1,184
1,718
601
2,033
4
2,634
282
592
874
306
2,328
f.
Year
1
2
3
4
Aftertax
cost of
leasing
$1,365
1,365
2,405
2,405
PV
Factor
at 8%
.926
.857
.794
.735
Present
Value
$1,264
1,170
1,910
1,768
$6,112
Aftertax
cost of
BorrowPurchase
$1,366
1,122
2,033
2,328
PV
factor
at 8%
.926
.857
.794
.735
Present
Value
$1,265
962
1,614
1,711
$5,552
g. The borrow and purchase decision has a lower present value

and would be selected based on that criterion. Other factors
may also be considered.
S16-42

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Chapter 16

What are some specific features of bond agreements?

What is the difference between a bond agreement and a bond indenture?

The priority of claims can be determined from Figure 16-2:

What is the purpose of serial repayments and sinking funds?

Under what circumstances would a call on a bond be exercised by a

Explain how the bond refunding problem is similar to a capital budgeting

What cost of capital is generally used in evaluating a bond refunding

Discuss the advantages and disadvantages of debt.

What do we mean by capitalizing lease payments?

What is the difference between technical insolvency and bankruptcy?

Creditors agree to allow the firm more time to meet its

Creditors agree to accept a fractional settlement on their

A creditor committee is set up to run the business because it is

Liquidation of assets takes place without going through formal

What is the difference between an internal reorganization and an external

Cost of administering the bankruptcy procedures.

Tax due at the federal, state or local level.

The coupon rate.

Annual interest payment

$85 $40 $125

Harold Reese must choose between two bonds:

Compute the current yield on both bonds.

Annual interest payment

$95 $40 $135

d. Yes. Bond Z has the higher yield to maturity. This is because

An investor must choose between two bonds:

Compute the current yield on both bonds.

Approximate yield to maturity = (Y')

Principal payment Price of the bond

Annual interest payment

$80 $50 $130

d. Yes. Bond B now has the higher yield to maturity. This is

The greater the risk, the higher the yield.

Present value of principal payment at maturity

Total present value

Present value of principal payment at maturity

Total present value

Present value of principal payment at maturity

Twenty-five-year B-rated bonds of Parker Optical Company were initially issued at a

Using Appendix B for n = 30, the yield is 7 percent

Using Appendix A for n = 30, the yield is approximately

A $19,602,000 loan repayment in a 98% cumulative

Purchase price paid in cash

Present value of principal payment at maturity

d. The percentage gain is larger than the percentage loss

Aftertax cost of call

2. Underwriting cost on new issue

*PVIFA for n = 16, i = 7% (Appendix D)

PVIFA (n = 16, i = 7%)

4. Underwriting cost on old issue

Refund the old issue (particularly if it is perceived that

PVIFA (n = 18, i = 8%)

4. Underwriting cost on old issue

Based on the negative net present value, the Sunbelt

$40,000,000 5 1/2% = $2,200,000

However, the present value of the lease payments is greater than

annual lease payments

Since one of the four criteria for compulsory treatment as a

million annual lease payments

b. Current assets $150 million

Current liabilities $ 50 million

Total debt $150 million

Total debt $150 million