## 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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