Microsoft Word - Document1 Assignment 08 – Capital Structure Directions: Unless otherwise stated, answer in complete sentences, and be sure to use correct English spelling and grammar. Sources must be...

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Microsoft Word - Document1 Assignment 08 – Capital Structure Directions: Unless otherwise stated, answer in complete sentences, and be sure to use correct English spelling and grammar. Sources must be cited in APA format. Your response should be four (4) pages in length Respond to the items below. Part A: Cash Flow of Accounts Receivable Myers and Associates, a famous law office in California, bills its clients on the first of each month. Clients pay in the following way:  40% pay at the end of the first month  30% pay at the end of the second month  20% pay at the end of the third month  5% pay at the end of the fourth month  5% default on their bills The actual and anticipated billings are as follows: Give the anticipated cash flow for the first quarter of 2018 if the past billings and anticipated billings follow this same pattern. Show your work. Part B: Straight Bank Loan Right Bank offers EAR loans of 9.38% and requires a monthly payment on all loans. a. What is the APR for these monthly loans? Show your work. b. What is the monthly payment for the following? Show your work. 1. A loan of $200,000 for six years 2. A loan of $450,000 for twelve years 3. A loan of $1,250,000 for thirty years Part C: Selling Bonds Astro Investment Bank has the following bond deals under way: The bond yield in the table is the market yield before the commission is charged. Assume that all bonds are semiannual and issued at a par value of $1,000. Determine the net proceeds of each bond and the cost of the bonds for each company in terms of yield. Show your work. Chapter 16.pdf Financial Management: Core Concepts Fourth Edition Chapter 16 Capital Structure Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Learning Objectives (1 of 2) 16.1 Explain why borrowing rates are different based on ability to repay loans. 16.2 Demonstrate the benefits of borrowing. 16.3 Calculate the break-even EBIT for different capital structures. 16.4 Explain the appropriate borrowing strategy under the pecking order hypothesis. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Learning Objectives (2 of 2) 16.5 Develop the arguments for the optimal capital structure in a world of no taxes and no bankruptcy and in a world of corporate taxes with no bankruptcy costs. 16.6 Understand the static theory of capital structure and the trade-off between the benefits of the tax shield and the cost of bankruptcy. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.1 Capital Markets: A Quick Review (1 of 3) • Companies raise funds for growth in debt and equity markets. • Investors have different risk preferences and companies have varying risk profiles. • The cost that a firm pays for its debt or the rate of return that investors demand to purchase equity in a firm depends largely on the firm’s debt rating and its beta or systematic risk measure. • Riskier firms end up paying higher yields on debt securities and are expected to pay a higher rate of return on their equity, thereby raising their average cost of capital. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.1 Capital Markets: A Quick Review (2 of 3) Example 1: Effect of Risk on Borrowing Rates Mike and Agnes are two venture capitalists with fairly different risk profiles. On average, both investors are willing to commit $1,000,000 per project to cutting-edge ideas and products that they think will fly. However, Mike is more conservative in that he tends to select low-risk projects that he thinks have at least a 50% chance of being successful. While Agnes selects high-risk projects that have at least 20% chance of doing well. Their success rates have tended to be right in line with their expectations. Based on their track records, what is the minimum rate that each investor is willing to lend $1,000,000 at? Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.1 Capital Markets: A Quick Review (3 of 3) Example 1: Answer Mike’s success rate = 5 ÷ 10 projects; Agnes’ success rate = 2 ÷ 10 projects So, if they each lend $1,000,000 → 10 projects @ $100,000 each  For Mike, each successful project must return $1,000,000 ÷ 5 = $200,000 For Agnes, each successful project must return $1,000,000 ÷ 2 = $500,000  Mike’s loan rate → ($200,000 − $100,000) ÷ $100,000 = 100%  Agnes’s loan rate → ($500,000 − $100,000) ÷ $100,000 = 400%  So Agnes (being more of a risk-taker) has a loan rate that is four times higher than that of Mike. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.2 Benefits of Debt • Financial leverage is the ability that owners have to use other people’s money at fixed rates to make higher rates of return than would have been possible by using all of one’s own money. It represents one of the main benefits of taking on debt. • Firms that take on debt as part of their capital structure are therefore known as leveraged firms while those that do not are known as unlevered firms. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.2 (A) Earnings per Share as a Measure of the Benefits of Borrowing (1 of 4) • One way to measure the benefits of leverage is by comparing the EPS of firms with different capital structures under good and bad economic conditions. • Table 16.1 presents three equal-sized firms, one with no debt, one with 50% debt, and the last one with 99.75% debt. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.2 (A) Earnings per Share as a Measure of the Benefits of Borrowing (2 of 4) Table 16.1 Capital Structure of Three Identical Firms Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.2 (A) Earnings per Share as a Measure of the Benefits of Borrowing (3 of 4) • Assuming a cost of debt of 10% for all firms and identical EBIT ($2000), EPS is calculated and shown in Table 16.2. Table 16.2 Earnings per Share of Firms with Different Funding Structures • If the firm’s EBIT covers its interest cost, higher leverage benefits the stockholders with a higher EPS. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.2 (A) Earnings per Share as a Measure of the Benefits of Borrowing (4 of 4) • However, if the firm’s EBIT does not cover its interest cost, the reverse is true, as shown in Table 16.3. Table 16.3 Earnings per Share of Firms with Different Funding Structures • So leverage is a two-edged sword, benefiting firms in good times and hurting them in bad times. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.3 Break-Even Earnings for Different Capital Structures (1 of 4) • At a certain level of EBIT, known as the break-even EBIT, all three firms will have the same EPS as shown in Table 16.4. Table 16.4 Earnings per Share of Firms with Different Capital Structures Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.3 Break-Even Earnings for Different Capital Structures (2 of 4) To calculate the break-even EBIT we use the following method: 1) We first calculate the EPS of two firms, → Company 1 and Company 2; set them equal; and solve for the EBIT. EPS = (EBIT − I) ÷ # of shares EPS1 = (EBIT − 0) ÷ 400 = (EBIT − $500) ÷ 200 → 400 (EBIT − $500) = 200(EBIT − 0) → 2EBIT − $1,000 = EBIT → EBIT = $1,000 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.3 Break-Even Earnings for Different Capital Structures (3 of 4) 2) Next, we calculate each firm’s EPS at the break-even EBIT, i.e., $1,000: Company 1’s EPS = 1,000 ÷ 400 = $2.50 Company 2’s EPS = (1,000 − 500) ÷ 200 = $2.5 Company 3’s EPS = (1,000 − 997.5) ÷ 1 = $2.5 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.3 Break-Even Earnings for Different Capital Structures (4 of 4) 3) Below an EBIT of $1000, e.g. $800: leverage hurts and vice-versa as shown in Figure 16.1. Figure 16.1 Earnings per share and earnings for three different capital structures. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.4 Pecking Order • The pecking order hypothesis is based on the notion that firms have a preferred order of raising capital. • Accordingly, it states that: 1. Firms prefer internal financing (retained earnings) first. 2. If external financing is required, firms will choose to issue the safest or cheapest security first, starting with debt financing and using equity as a last resort. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.4 (A) Firms Prefer Internal Financing First • Why do firms prefer internal financing first? – It typically requires less effort, – Avoids transactions cost, – Avoids loss of secrecy. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. 16.4 (B) Firms Choose to Issue Cheapest Security First and Use Equity as a Last Resort (1 of 2) • Retained earnings being limited, firms have to use other external sources such as debt and equity. • When they do tap the capital markets, firms tend to issue debt first, → less costly, and leads to less loss of control, and equity last, → too much debt can put the firm into a risk of bankruptcy. Copyright © 2019, 2016, 2013 Pearson
Answered 2 days AfterAug 23, 2021

Answer To: Microsoft Word - Document1 Assignment 08 – Capital Structure Directions: Unless otherwise stated,...

Akshay Kumar answered on Aug 26 2021
134 Votes
Answers
Part A
Anticipated cash flows:
    
    January
    February
    March
    Total
    Cash collections
:
    
    
    
    
    40% of current month billing
    40%*(340,000)
= 136,000
    40%*(360,000)
=144,000
    40%*(408,000)
=163,200
    443,200
    30% of previous month billing
    30%*(296,000)
= 88,800
    30%*(340,000)
= 102,000
    30%*(360,000)
=108,000
    298,800
    20% of two months back billing
    20%*(323,000)
=64,600
    20%*(296,000)
=59,200
    20%*(340,000)
=68,000
    191,800
    5% of three months back billing
    5%*(392,000)
=19,600
    5%*(323,000)
=16,150
    5%*(296,000)
=14,800
    50,550
    
    309,000
    321,350
    354,000
    984,350
Part B
a – APR = m x [(1 + EAR) ^1/m - 1]
= 12 x [(1.0938^1/12) - 1] = 9%
b. Monthly Payment = [PVA x r] / [1 - (1 + r)^-n]
1. A loan of $200,000 for six years
Monthly Payment = [$200,000 x...
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