Case Study:
Company E is developing educational software for the primary and secondary school markets. In order to maintain the market place the owner entrusted the
To determine:
How convertible bonds reduce agency costs.
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Financial Management: Theory & Practice
- David Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: e. Suppose the expected free cash flow for Year 1 is 250,000 but it is expected to grow faster than 7% during the next 3 years: FCF2 = 290,000 and FCF3 = 320,000, after which it will grow at a constant rate of 7%. The expected interest expense at Year 1 is 128,000, but it is expected to grow over the next couple of years before the capital structure becomes constant: Interest expense at Year 2 will be 152,000, at Year 3 it will be 192,000 and it will grow at 7% thereafter. What is the estimated horizon unlevered value of operations (i.e., the value at Year 3 immediately after the FCF at Year 3)? What is the current unlevered value of operations? What is the horizon value of the tax shield at Year 3? What is the current value of the tax shield? What is the current total value? The tax rate and unlevered cost of equity remain at 25% and 14%, respectively.arrow_forwardYou heard about a company that is producing a product that you really believe in. You think you can scrape together some money to buy a couple of shares when you get paid next. First, you would like to make sure that the price seems fair so you will calculate its value. Analysts estimate that the price of the stock is likely to be $82.7 in one year. It is a young company, so they do not pay dividends yet. You estimated that the fair return on the stock is 11.2%. What is your best guess at the fair value of the stock given this information? Answer:arrow_forwardLarissa Warren and Dan Ervin have been discussing the future of East Coast Yachts. The companyhas been experiencing fast growth, and the future looks like clear sailing. However, the fast growthmeans that the company’s growth can no longer be funded by internal sources, so Larissa and Dan havedecided the time is right to take the company public. To this end, they have entered into discussionswith the investment bank of Crowe & Mallard. The company has a working relationship with Robin Perry,the underwriter who assisted with the company’s previous bond offering. Crowe & Mallard have helpednumerous small companies in the IPO process, so Larissa and Dan feel confident with this choice.Robin begins by telling Larissa and Dan about the process. Although Crowe & Mallard charged anunderwriter fee of 4 percent on the bond offering, the underwriter fee is 7 percent on all initial stockofferings of the size of East Coast Yachts’ initial offering. Robin tells Larissa and Dan that the…arrow_forward
- Consider the following thoughts of a manager at the end of the companys third quarter: If I can increase my reported profit by 2 million, the actual earnings per share will exceed analysts expectations, and stock prices will increase. The stock options that I am holding will become more valuable. The extra income will also make me eligible to receive a significant bonus. With a son headed to college, it would be good if I could cash in some of these options to help pay his expenses. However, my vice president of finance indicates that such an increase is unlikely. The projected profit for the fourth quarter will just about meet the expected earnings per share. There may be ways, though, that I can achieve the desired outcome. First, I can instruct all divisional managers that their preventive maintenance budgets are reduced by 25 percent for the fourth quarter. That should reduce maintenance expenses by approximately 1 million. Second, I can increase the estimated life of the existing equipment, producing a reduction of depreciation by another 500,000. Third, I can reduce the salary increases for those being promoted by 50 percent. And that should easily put us over the needed increase of 2 million. Required: Comment on the ethical content of the earnings management being considered by the manager. Is there an ethical dilemma? What is the right choice for the manager to make? Is there any way to redesign the accounting reporting system to discourage the type of behavior the manager is contemplating?arrow_forwardDavid Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: d. Suppose that Firms U and L have the same input values as in Part c except for debt of 980,000. Also, both firms have total net operating capital of 2,000,000 and both firms are expected to grow at a constant rate of 7%. (Assume that the EBIT in part c is expected at t = 1.) Use the compressed adjusted present value (APV) model to estimate the value of U and L. Also estimate the levered cost of equity and the weighted average cost of capital.arrow_forwardThe Boulder Brass Works Company (BBWC) is a small-capitalization machine shop that has found a rapidly growing niche market for its custom-machined brass parts. Its business is growing so fast that it has decided not to pay a dividend next year. However, in year 2 it expects its growth to decelerate and so plans to begin paying dividends at that time. At the end of year 2 it plans to pay a dividend of $5.00. At the end of year 3 it plays to pay a dividend of $15.00. Beginning in year 4, BBWC's management believes that the company will have entered its middle age. Management anticipates being able to sustain a dividend growth rate of 3% per year in year 4 and every year thereafter. Firms with similar growth and risk characteristics return 18% per year to their equity investors. What is BBWC's intrinsic value?arrow_forward
- A privately held corporation, is making plans for future investments that can increase growth. The company’s manager has recommended that the company “go public” by issuing common stock to raise the funds needed to support the growth. The current owners, who founded the firm, are worried that control of the firm will be diluted by this strategy. If the company undertakes an IPO, it is estimated that each share of stock will sell for $6.25, the investment banking fee will be 22 percent of the total value of the issue. The founders now hold all of the company’s stock: 8 million shares. If the company issues 8 million shares, what proportion of the stock will the founders own after the IPO?arrow_forwardA privately held corporation, is making plans for future investments that can increase growth. The company’s manager has recommended that the company “go public” by issuing common stock to raise the funds needed to support the growth. The current owners, who founded the firm, are worried that control of the firm will be diluted by this strategy. If the company undertakes an IPO, it is estimated that each share of stock will sell for $6.25, the investment banking fee will be 22 percent of the total value of the issue. If the founders must issue stock to finance the growth of the firm, what would you recommend they do to protect their controlling interest for at least a few years after the IPO?arrow_forwardYou are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can be sold for $30 million. If your research is unsuccessful, it will be worth nothing. To fund your research, you need to raise $2 million. Investors are willing to provide you with $2 million in initial capital in exchange for 50% of the unlevered equity in the firm. What is the total value of the firm without leverage?arrow_forward
- A friend has started a business. His product is a great success and the firm quickly grows large enough to be able to sell stock. The firm promises to pay a dividend of $8 per share every year for the next 53 years at which point the friend intends to shut down the business. The firm's stock is currently selling for $78 per share. If you believe that the company really will pay dividends as states and if you require a rate of return of 12% to make this investment, should you buy the stock? 1. No, according to the fundamental value equation, the price will be equal to $78 2. Yes, according to the fundamental value equation, the price will be more than $78 3. Yes, according to the fundamental value equation, the price will be less than $78 4. No, according to the fundamental value equation, the price will be less that $78 Please choose one of the options and explainarrow_forwardThe High-Flying Growth Company (HFGC) has been growing very rapidly in recent years, making its shareholders rich in the process. The average annual rate of return on the stock in the last few years has been 20%, and HFGC managers believe that 20% is a reasonable figure for the firm’s cost of capital. To sustain a high growth rate, the HFGC CEO argues that the company must continue to invest in projects that offer the highest rate of return possible. Two projects are currently under review. The first is an expansion of the firm’s production capacity, and the second project involves introducing one of the firm’s existing products into a new market. Cash flows from each project appear in the following table. a. Calculate the NPV, IRR, and PI for both projects. b. Rank the projects based on their NPVs, IRRs, and PIs. c. Do the rankings in part b agree or not? If not, why not? d. The firm can only afford to undertake one of these investments, and the CEO favors the product introduction…arrow_forwardNote:- Do not provide handwritten solution. Maintain accuracy and quality in your answer. Take care of plagiarism. Answer completely. You will get up vote for sure.arrow_forward
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