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# Ethiopian Civil Service University

## Department of Accounting and Finance

Group Assignment
Submission date: may 31,2020
Bond Valuation
1. Is the yield to maturity on a bond the same thing as the required return? Is YTM the same
thing as the coupon rate? Suppose today a 10 percent coupon bond sells at par. Two years
from now, the required return on the same bond is 8 percent. What is the coupon rate on the
bond then? The YTM?
2. Suppose you buy a 7 percent coupon, 20-year bond today when it’s ﬁrst issued. If interest
rates suddenly rise to 15 percent, what hap-pens to the value of your bond? Why?
3. Carpenter, Inc., has 8 percent coupon bonds on the market that have 10 years left to maturity.
The bonds make annual payments. If the YTM on these bonds is 9 percent, what is the
current bond price?
4. Linebacker Co. has 7 percent coupon bonds on the market with nine years left to maturity.
The bonds make annual payments. If the bond currently sells for \$1,080, what is its YTM?
5. Hawk Enterprises has bonds on the market making annual payments, with 16 years to
maturity, and selling for \$870. At this price, the bonds yield 7.5 percent. What must the
coupon rate be on the bonds?
6. Cutler Co. issued 11-year bonds a year ago at a coupon rate of 7.8 percent. The bonds make
semiannual payments. If the YTM on these bonds is 8.6 percent, what is the current bond
price?
7. Ngata Corp. issued 12-year bonds 2 years ago at a coupon rate of 9.2 percent. The bonds
make semiannual payments. If these bonds currently sell for 104 percent of par value, what is
the YTM?
8. Wimbley Corporation has bonds on the market with 14.5 years to maturity, a YTM of 6.8
percent, and a current price of \$1,136.50. The bonds make semiannual payments. What must
the coupon rate be on these bonds?

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9. The Mangold Corporation has two different bonds currently outstanding. Bond M has a face
value of \$20,000 and matures in 20 years. The bond makes no payments for the ﬁrst six
years, then pays \$1,100 every six months over the subsequent eight years, and ﬁnally pays
\$1,400 every six months over the last six years. Bond N also has a face value of \$20,000 and
a maturity of 20 years; it makes no coupon payments over the life of the bond. If the required
return on both these bonds is 9 percent compounded semiannually, what is the current price
of bond M? Of bond N?
Stock valuation

1. The Jackson–Timberlake Wardrobe Co. just paid a dividend of \$1.60 per share on its
stock. The dividends are expected to grow at a constant rate of 6 percent per year
indeﬁnitely. If investors require a 12 percent return on the Jackson–Timberlake Wardrobe
Co. stock, what is the current price? What will the price be in three years? In 15 years?
2. The next dividend payment by Top Knot, Inc., will be \$2.50 per share. The dividends are
anticipated to maintain a 5 percent growth rate forever. If the stock currently sells for
\$48.00 per share, what is the required return?
3. For the company in the previous problem, what is the dividend yield? What is the
expected capital gains yield?
4. Stairway Corporation will pay a \$3.60 per share dividend next year. The company
pledges to increase its dividend by 4.5 percent per year indeﬁnitely. If you require an 11
percent return on your investment, how much will you pay for the company’s stock
today?
5. Listen Close Co. is expected to maintain a constant 6.5 percent growth rate in its
dividends indeﬁnitely. If the company has a dividend yield of 3.6 percent, what is the
required return on the company’s stock?
6. Suppose you know that a company’s stock currently sells for \$60 per share and the
required return on the stock is 12 percent. You also know that the total return on the stock
is evenly divided between a capital gains yield and a dividend yield. If it’s the company’s
policy to always maintain a constant growth rate in its dividends, what is the current
dividend per share?

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7. No More Corp. pays a constant \$11 dividend on its stock. The company will maintain
this dividend for the next eight years and will then cease paying dividends forever. If the
required return on this stock is 10 percent, what is the current share price?
8. Ayden, Inc., has an issue of preferred stock outstanding that pays a \$6.50 dividend every
year in perpetuity. If this issue currently sells for \$113 per share, what is the required
return?
9. Great Pumpkin Farms just paid a dividend of \$3.50 on its stock. The growth rate in
dividends is expected to be a constant 5 percent per year indeﬁnitely. Investors require a
16 percent return on the stock for the ﬁrst three years, a 14 percent return for the next
three years, and an 11 percent return thereafter. What is the current share price?
10. Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the
stock over the next nine years because the ﬁrm needs to plow back its earnings to fuel
growth. The company will pay a \$10 per share dividend in 10 years and will increase the
dividend by 6 percent per year thereafter. If the required return on this stock is 13
percent, what is the current share price?
11. Spears, Inc., has an odd dividend policy. The company has just paid a dividend of \$7 per
share and has announced that it will increase the dividend by \$4 per share for each of the
next four years, and then never pay another dividend. If you require an 11 percent return
on the company’s stock, how much will you pay for a share today?
12. North Side Corporation is expected to pay the following dividends over the next four
years: \$8, \$7, \$5, and \$2. Afterward, the company pledges to maintain a constant 5
percent growth rate in dividends forever. If the required return on the stock is 11
percent, what is the current share price?
13. Rizzi Co. is growing quickly. Dividends are expected to grow at a 25 percent rate for the
next three years, with the growth rate falling off to a constant 7 percent thereafter. If the
required return is 13 percent and the company just paid a \$3.10 dividend, what is the
current share price?
14. Rebel, Inc., is proposing a rights offering. Presently there are 400,000 shares outstanding
at \$75 each. There will be 70,000 new shares offered at \$70 each.
a. What is the new market value of the company?
b. How many rights are associated with one of the new shares?

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c. What is the ex-rights price?
d. What is the value of a right?
e. Why might a company have a rights offering rather than a general cash offer?
15. The Clifford Corporation has announced a rights offer to raise \$50 million for a new
journal, the Journal of Financial Excess. This journal will review potential articles after
the author pays a nonrefundable reviewing fee of \$5,000 per page. The stock currently
sells for \$60 per share, and there are 5.2 million shares outstanding.
a. What is the maximum possible subscription price? What is the minimum?
b. If the subscription price is set at \$55 per share, how many shares must be sold?
c. How many rights will it take to buy one share?
d. What is the ex-rights price? What is the value of a right?
e. Show how a shareholder with 1,000 shares before the offering and no desire (or
money) to buy additional shares is not harmed by the rights offer.
16. Red Shoe Co. has concluded that additional equity financing will be needed to expand
operations and that the needed funds will be best obtained through a rights offering. It has
correctly determined that as a result of the rights offering, the share price will fall from
\$70 to \$62.75 (\$70 is the rights-on price; \$62.75 is the ex-rights price, also known as the
when-issued price). The company is seeking \$15 million in additional funds with a per-
share subscription price equal to \$40. How many shares are there currently, before the
offering? (Assume that the increment to the market value of the equity equals the gross
proceeds from the offering.)
17. The Woods Co. and the Mickelson Co. have both announced IPOs at \$40 per share. One
of these is undervalued by \$8, and the other is overvalued by \$5, but you have no way of
knowing which is which. You plan to buy 1,000 shares of each issue. If an issue is
underpriced, it will be rationed, and only half your order will be filled. If you could get
1,000 shares in Woods and 1,000 shares in Mickelson, what would your profit be? What
profit do you actually expect?
What principle have you illustrated?
18. The Educated Horses Corporation needs to raise \$40 million to finance its expansion into
new markets. The company will sell new shares of equity via a general cash offering to

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raise the needed funds. If the offer price is \$35 per share and the company’s underwriters
charge an 8 percent spread, how many shares need to be sold?
19. In the previous problem, if the SEC filing fee and associated administrative expenses of
the offering are \$900,000, how many shares need to be sold?

Capital Structure

1. Wild Side, Inc., has no debt outstanding and a total market value of \$200,000. Earnings
before interest and taxes, EBIT, are projected to be \$25,000 if economic conditions are
normal. If there is strong expansion in the economy, then EBIT will be 40 percent higher. If
there is a recession, then EBIT will be 60 percent lower. Wild Side is considering a \$70,000
debt issue with a 6 percent interest rate. The proceeds will be used to repurchase shares of
stock. There are currently 4,000 shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share (EPS) under each of the three economic scenarios
before any debt is issued. Also calculate the percentage changes in EPS when the
economy expands or enters a recession.
b. Repeat part (a) assuming that Wild Side goes through with recapitalization.
What do you observe?
2. Repeat parts (a) and (b) in Problem 1 assuming Wild Side has a tax rate of 35 percent.
3. Suppose the company in Problem 1 has a market-to-book ratio of 1.0.
a. Calculate return on equity (ROE) under each of the three economic scenarios before
any debt is issued. Also calculate the percentage changes in ROE for economic
expansion and recession, assuming no taxes.
b. Repeat part (a) assuming the firm goes through with the proposed recapitalization.
c. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35
percent.
4. Petty Corporation is comparing two different capital structures: an all-equity plan (Plan I)
and a levered plan (Plan II). Under Plan I, Petty would have 200,000 shares of stock
outstanding. Under Plan II, there would be 90,000 shares of stock outstanding and \$1.5
million in debt outstanding. The interest rate on the debt is 8 percent, and there are no taxes.
a. If EBIT is \$150,000, which plan will result in the higher EPS?

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b. If EBIT is \$300,000, which plan will result in the higher EPS?
c. What is the break-even EBIT?
5. In Problem 4, use M&M Proposition I to find the price per share of equity under each of the
two proposed plans. What is the value of the firm?
6. Kolby Corp. is comparing two different capital structures. Plan I would result in 1,500
shares of stock and \$20,000 in debt. Plan II would result in 1,100 shares of stock and \$30,000
in debt. The interest rate on the debt is 10 percent.
a. Ignoring taxes, compare both of these plans to an all-equity plan assuming that
EBIT will be \$12,000. The all-equity plan would result in 2,300 shares of stock
outstanding. Which of the three plans has the highest EPS? The lowest?
b. In part (a), what are the break-even levels of EBIT for each plan as compared to
that for an all-equity plan? Is one higher than the other? Why?
c. Ignoring taxes, when will EPS be identical for Plans I and II?
d. Repeat parts (a), (b), and (c) assuming that the corporate tax rate is 40 percent.
Are the break-even levels of EBIT different from before? Why or why not?
7. Ignoring taxes in Problem 6, what is the price per share of equity under Plan I? Plan II? What
8. Home Body, Inc., a prominent consumer products firm, is debating whether to convert its all-
equity capital structure to one that is 50 percent debt. Currently, there are 5,000 shares
outstanding, and the price per share is \$60. EBIT is expected to remain at \$28,000 per year
forever. The interest rate on new debt is 8 percent, and there are no taxes.
a. Allison, a shareholder of the firm, owns 100 shares of stock. What is her cash flow
under the current capital structure, assuming the firm has a dividend payout rate of
100 percent?
b. What will Allison’s cash flow be under the proposed capital structure of the firm?
Assume she keeps all 100 of her shares.
c. Suppose Home Body does convert, but Allison prefers the current all-equity capital
structure. Show how she could unlever her shares of stock to recreate the original
capital structure.
d. Using your answer to part (c), explain why Home Body’s choice of capital structure
is irrelevant.

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9. ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure.
ABC is all equity financed with \$800,000 in stock. XYZ uses both stock and perpetual debt;
its stock is worth \$400,000 and the interest rate on its debt is 10 percent. Both firms expect
EBIT to be \$90,000. Ignore taxes.
a. Rico owns \$30,000 worth of XYZ’s stock. What rate of return is he expecting?
b. Show how Rico could generate exactly the same cash flows and rate of return by
investing in ABC and using homemade leverage.
c. What is the cost of equity for ABC? What is it for XYZ?
d. What is the WACC for ABC? For XYZ? What principle have you illustrated?
10. Lamont Corp. uses no debt. The weighted average cost of capital is 11 percent. If the current
market value of the equity is \$25 million and there are no taxes, what is EBIT?
11. In the previous question, suppose the corporate tax rate is 35 percent. What is EBIT in this
case? What is the WACC? Explain.
12. Maxwell Industries has a debt– equity ratio of 1.5. Its WACC is 11 percent, and its cost of
debt is 8 percent. The corporate tax rate is 35 percent.
a. What is Maxwell’s cost of equity capital?
b. What is Maxwell’s unlevered cost of equity capital?
c. What would the cost of equity be if the debt– equity ratio were 2? What if it were
1.0? What if it were zero?
13. Second Base Corp. has no debt but can borrow at 7.5 percent. The firm’s WACC is currently
10 percent, and the tax rate is 35 percent.
a. What is Second Base’s cost of equity?
b. If the firm converts to 25 percent debt, what will its cost of equity be?
c. If the firm converts to 50 percent debt, what will its cost of equity be?
d. What is Second Base’s WACC in part (b)? In part (c)?
14. Bruce & Co. expects its EBIT to be \$85,000 every year forever. The firm can borrow at 11
percent. Bruce currently has no debt, and its cost of equity is 18 percent. If the tax rate is 35
percent, what is the value of the firm? What will the value be if Bruce borrows \$60,000 and
uses the proceeds to repurchase shares?
15. In Problem 14, what is the cost of equity after recapitalization? What is the WACC? What
are the implications for the firm’s capital structure decision?

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16. Tool Manufacturing has an expected EBIT of \$45,000 in perpetuity and a tax rate of 35
percent. The firm has \$80,000 in outstanding debt at an interest rate of 9 percent, and its
unlevered cost of capital is 14 percent. What is the value of the firm according to M&M
Proposition I with taxes? Should Tool change its debt– equity ratio if the goal is to maximize
the value of the firm? Explain
17. Firm Value Old School Corporation expects an EBIT of \$12,000 every year forever. Old
School currently has no debt, and its cost of equity is 16 percent. The firm can borrow at 9
percent. If the corporate tax rate is 35 percent, what is the value of the firm? What will the
value be if Old School converts to 50 percent debt? To 100 percent debt?
18. The Veblen Company and the Knight Company are identical in every respect except that
Veblen is not levered. Financial information for the two firms appears in the following table.
All earnings streams are perpetuities, and neither firm pays taxes. Both firms distribute all
earnings available to common stockholders immediately.

a. An investor who can borrow at 6 percent per year wishes to purchase 5 percent of
Knight’s equity. Can he increase his dollar return by purchasing 5 percent of Veblen’s
equity if he borrows so that the initial net costs of the strategies are the same?
b. Given the two investment strategies in (a), which will investors choose? When will
this process cease?