Instructor: Prof. Neil G. Cohen
Prepared by: Jin Yikai
Oct 27 2014
1. What are the annual cash outlays associated with the bond issue and the stock issue?
Sheen’s idea (finance with bond) is to issue $125M bond with an annual interest rate of 6.5% and mature in 15 years. Annual principal repayment is $6.25M and leave $37.5M outstanding at maturity. The cash outlay is $6.25M every year besides the interest. See graph below.
If finance by equity, Winfield would issue 7.5M new shares @ $17.75 and keep a constant dividend policy of $1.00/Share. The actual cash outlay is $7.5M every year.
2. Respond to each director 's assessment of the…show more content… 3. Interpret the EBIT Chart shown in the case - explain what it means. See Chapter 7 where it is explained.
The debt line is steeper than the equity line because use of debt financing causes EPS to change at a greater rate as EBIT changes – the essence of financial leverage. The double-edged sword aspect of financial leverage – as the lines diverge from the indifference level the gap between EPS with debt and EPS with equity widens. The right-hand divergence is good - financial leverage helps. The left-hand divergence is bad – financial leverage hurts. The EBIT Chart helps display the EBIT-EPS relationship for any level of EBIT in any year.
4. Recommend the financing choice, using the Income, Risk, Control, Marketability, Flexibility, Timing grid as explained in Chapter 7 of the Cohen Finance Book.
Suppose I have four alternatives totally:
a) Debt with Fixed Principal Repayments
b) Debt without Fixed Principal Repayments
d) Debt & Equity (75% debt & 25% equity)
Firstly I calculate the cost of financing, the assumptions are as following:
Marginal Tax Rate
Market Risk Premium
Risk-free Rate (Rf)
Cost of Equity (Ke)
Cost of Debt (Kd)
Time horizon (Years)
Dividend per share
I get the NPV of the cost of financing, from which I can see that among all the financing options considered, Debt (with no principal repayments) has the lowest NPV cost whereas Equity has the highest NPV cost.