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Chapter 5: 7DQ (page 471)
Explain the role of financial intermediaries in the flow of funds through the three-sector economy.
Financial intermediaries invest excess funds in the economy’s needed areas.
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Question: Barton Simpson, the chief financial officer of Broadband Inc. 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 6 percent. The $30 million, 15-year bond issue that his firm has outstanding was initially issued at 9 percent five years ago. Because interest rates had gone down so much, he was considering refunding the bond issue. The old issue had a call premium of 8 percent. The underwriting cost on the old issue had been 3 percent of par, and on the new issue it would be 5 percent of par. The tax rate would be 30 percent and a 4 percent discount rate would be applied for the refunding decision. The new bond would have a 10-year life. Before Barton used the 8 percent call provision to reacquire the old bonds, he wanted to make sure he could not buy them back cheaper in the open market.
d. In terms of the refunding decision, how should Barton be influenced if he thinks interest rates might go down even more?
Question: The trustee in the bankruptcy settlement for Titanic Boat Co. lists the following book values and liquidation values for the assets of the corporation. Liabilities and stockholders’ claims are also shown.
| Assets | ||
Book value | Liquidation value | |
Accounts receivables | \(1,400,000 | \)1,200,000 |
Inventory | \(1,800,000 | \)900,000 |
Machinery and equipment | \(1,100,000 | \)600,000 |
Building and plant | \(4,200,000 | \)2,500,000 |
Total assets | \(8,500,000 | \)5,200,000 |
| Liabilities and stockholder’s claims | |
Liabilities | |
Accounts payable | \(2,800,000 |
First lien, secured by machinery and equipment | \)900,000 |
Senior unsecured debt | \(2,200,000 |
Subordinated debenture | \)1,700,000 |
Total liabilities | \(7,600,000 |
Stockholder’s claims | |
Preferred stock | \)250,000 |
Common stock | \(650,000 |
Total stockholder’s claims | \)900,000 |
Total liabilities and stockholder’s claims | $8,500,000 |
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 Table16A-3.
How might a leveraged buyout eventually lead to high returns for a company?
Discuss the benefits accruing to a company that is traded in the public securities markets.
Richmond Rent-A-Car is about to go public. The investment banking firm of Tinkers, Evers & Chance is attempting to price the issue. The car rental industry generally trades at a 20 percent discount below the P/E ratio on the Standard & Poor’s 500 Stock Index. Assume that index currently has a P/E ratio of 25. The firm can be compared to the car rental industry as follows:
Richmond | Car Rental Industry | |
Growth rate in earnings per share..... | 15% | 10% |
Consistency of performance............. | Increased earnings 4 out of 5 years | Increased earnings 3 out of 5 years |
Debt to total assets..................... | 52% | 39% |
Turnover of product......................... | Slightly below average | Average |
Quality of management.................. | High | Average |
Assume, in assessing the initial P/E ratio, the investment banker will first determine the appropriate industry P/E based on the Standard & Poor’s 500 Index. Then a half point will be added to the P/E ratio for each case in which Richmond Rent-A-Car is superior to the industry norm, and a half point will be deducted for an inferior comparison. On this basis, what should the initial P/E be for the firm?
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