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Chapter 5: Q5-17-21BP-d (page 571)

Question: The treasurer of Kelly Bottling Company (a corporation) currently has \(150,000 invested in preferred stock yielding 8 percent. He appreciates the tax advantages of preferred stock and is considering buying \)150,000 more with borrowed funds. The cost of the borrowed funds is 13 percent. He suggests this proposal to his board of directors. They are somewhat concerned by the fact that the treasurer will be paying 5 percent more for funds than the company will be earning on the investment. Kelly Bottling is in a 35 percent tax bracket, with dividends taxed at 20 percent.

d. If interest rates and dividend yields in the market go up six months after a decision to purchase is made, what impact will this have on the outcome?

Short Answer

Expert verified

Answer

The increase in interest rate and dividend yield will reduce the portfolio’s value and increase the cost of borrowing.

Step by step solution

01

Step-by-step solutionStep 1: Meaning of bond yield

The bond yield refers to the return that the bondholder will generate from a bond. The bond yield can be calculated by using the coupon rate and face value of the bond.

02

Impact of interest rate and dividend yield

The increase in the dividend yield will reduce the value of the portfolio and the cost of borrowing can increase.The increase in the interest rates will reduce the price of the bonds as the bondholders will want to sell their bonds at high prices in the market and this will inversely impact its prices.

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Most popular questions from this chapter

Question: The management of Mitchell Labs decided to go private in 2002 by buying in all 2.80 million of its outstanding shares at \(24.80 per share. By 2006, management had restructured the company by selling off the petroleum research division for \)10.75 million, the fiber technology division for \(8.45 million, and the synthetic products division for \)20 million. Because these divisions had been only marginally profitable, Mitchell Labs is a stronger company after the restructuring. Mitchell is now able to concentrate exclusively on contract research and will generate earnings per share of $1.10 this year. Investment bankers have contacted the firm and indicated that if it reentered the public market, the 2.80 million shares it purchased to go private could now be reissued to the public at a P/E ratio of 15 times earnings per share.

b. What is the total value to the company from (1) the proceeds of the divisions that were sold, as well as (2) the current value of the 2.80 million shares (based on current earnings and an anticipated P/E of 15)?

American Health Systems currently has 6,400,000 shares of stock outstanding and will report earnings of \(10 million in the current year. The company is considering the issuance of 1,700,000 additional shares that will net \)30 per share to the corporation.

a. What is the immediate dilution potential for this new stock issue?

b. Assume that American Health Systems can earn 9 percent on the proceeds of the stock issue in time to include them in the current year’s results. Calculate earnings per share. Should the new issue be undertaken based on earnings per share?

Discuss the reason for the differences between underwriting spreads for stocks and bonds.

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

d. After the machinery and equipment are sold to partially cover the first lien secured claim, how much will be available from the remaining asset liquidation values to cover unsatisfied secured claims and unsecured debt?

Question: The management of Mitchell Labs decided to go private in 2002 by buying in all 2.80 million of its outstanding shares at \(24.80 per share. By 2006, management had restructured the company by selling off the petroleum research division for \)10.75 million, the fiber technology division for \(8.45 million, and the synthetic products division for \)20 million. Because these divisions had been only marginally profitable, Mitchell Labs is a stronger company after the restructuring. Mitchell is now able to concentrate exclusively on contract research and will generate earnings per share of $1.10 this year. Investment bankers have contacted the firm and indicated that if it re-entered the public market, the 2.80 million shares it purchased to go private could now be reissued to the public at a P/E ratio of 15 times earnings per share.

c. What is the percentage return to the management of Mitchell Labs from the restructuring? Use answers from parts a and b to determine this value
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