Corporate Finance- Show how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage

Show how Rico could generate exactly the same cash

 Corporate Finance

 

Questions:

 CASE STUDY 1

Reliance company has a $ 1,000 face value convertible bond issue that is currently selling in the market for $950.Each bond is exchangeable at any time for 25 shares of the company’s stock. The convertible bond has a 7 percent coupon. Payable semi-annually. Similar non-convertible bonds are priced to yield 10 percent.The bond matures in 10 years stock in Reliance sells for $ 36 per share.

Q1. What are the conversion ratio, conversion price, and conversion premium?

Q2. What is the straight bond value?

Q3. What is the conversion value?

Q4. What is the option value of the bond?

CASE STUDY  2

Suppose your company needs $ 15 million to build a new assembly line. Your target debt equity ratio is 0.90. The flotation cost for new equity is 8 percent, but the flotation cost for debt is only 5%. Your boss has decided to fund the project by borrowing money because the flotation costs are lower and the needed funds are relatively small.

Q1. What do you think about the rationale behind borrowing the entire amount?

Q2. What is your company’s weighted average flotation cost, assuming all equity is raised externally?

Q3. What is the true cost of building the new assembly line after taking flotation costs into account?

Q4. Does it matter in this case that the entire amount is being raised from debt?

 CASE STUDY  3

ABC Co. & 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 stocks and perpetual debt, its stock is worth $ 400,000 and the interest rate on its debt is 10 per cent. Both firms expect EBIT to be $ 90000. Ignore taxes.

Q1. Rico owns $ 30,000 worth of XYZ’s stock. What rate of return is he expecting?

Q2. Show how Rico could generate exactly the same cash flows and rate of return by  investing in ABC and using homemade leverage?

Q3. What is the cost of equity for ABC? What is it for XYZ?

Q4. What is the WACC for ABC? For XYZ? What principle have you illustrated?

CASE STUDY  4

The Nike Company sells 3000 pairs of running shoes per month at a cash price of $88 per pair. The firm is considering a new policy that involves 30 days credit and an increase in price to $ 90.72 per pair on credit sales. The cash price will remain at $ 88 and the new policy is not expected to affect the quantity sold. The discount period will be 20 days. The required return is 1 percent per month.

Q1. How would be the new credit terms be quoted?

Q2. What investment is receivables is required under the new policy?

Q3. Explain why the variable cost of manufacturing the shoes is not relevant here?

Q4. If the default rate is anticipated to be 10 per cent, should the switch be made? What is the break even credit price?

 

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