Group 4:

● Anissa Dian Setyarani Wokas (20/470892/PEK/26619)

● Firza Syafira (20/470938/PEK/26665)
● Puspita Ramadhania (20/471001/PEK/26728)
● Raveena Fiarani (20/471005/PEK/26732)

Assignment 9

(18-1) Reynolds Construction needs a piece of equipment that costs $200. Reynolds can either lease
the equipment or borrow $200 from a local bank and buy the equipment. If the equipment is
leased, the lease would not have to be capitalized. Reynolds’s balance sheet prior to the
acquisition of the equipment is as follows:

Current assets $300 Debt $400

Net fixed assets 500 Equity 400
Total assets $800 Total claims $800

a. (1) What is Reynolds’s current debt ratio?

Reynolds’s current debt ratio can be found by dividing its total debt to its total
assets or its total claims. The calculation of the company’s debt ratio is as
following:

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

400
= 800

= 50%

From the calculations above, we can conclude that Reynolds’s current debt ratio
is 50%.

(2) What would be the company’s debt ratio if it purchased the equipment?

If the company decided to purchase the equipment by borrowing from the bank,
their balance sheet will look as followings:
 Current assets $300 Debt $600
Net fixed assets 700 Equity 400
Total assets $1000 Total claims $1000

Therefore, their debt ratio will be changed. The calculation of the debt ratio is as
followed:

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

600
= 1000

= 60%

From the calculations above, we can conclude that Reynolds’s debt ratio if it
purchased the equipment is 60%.

(3) What would be the debt ratio if the equipment were leased?

Since leasing is called the off-balance sheet financing, it won’t appear on the
balance sheet. Therefore, the calculation of its debt ratio will be as followed:

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

400
= 800

= 50%

From the calculations above, we can conclude that Reynolds’s debt ratio if the
equipment were leased will be the same with the current debt ratio, which is
50%.

b. Would the company’s financial risk be different under the leasing and
purchasing alternatives?

The risks considered will include whether the lease is an operating lease or a financial
lease. If the lease is an operating one, it means that all the cost including the
maintenance fee is covered and the lease can be canceled. On the other hand, if the
equipment is only needed for a short amount of time and the maintenance fee is
considerably high, then the company may want to purchase the equipment instead of
leasing them. Moreover, purchasing the equipment means that the company will be
responsible for all the cost, such as maintenance and service fee of the equipment.
(18-3) Two companies, Energen and Hastings Corporation, began operations with identical
balance sheets. A year later, both required additional fixed assets at a cost of $50,000.
Energen obtained a 5-year, $50,000 loan at an 8% interest rate from its bank. Hastings,
on the other hand, decided to lease the required $50,000 capacity for 5 years, and an 8%
return was built into the lease. The balance sheet for each company, before the asset
increases, follows:

Current assets $ 25,000 Debt $ 50,000

Fixed assets 125,000 Equity 100,000
Total assets $150,000 Total claims $150,000

a. Show the balance sheets for both firms after the asset increases, and calculate
each firm’s new debt ratio. (Assume that the lease is not capitalized.)

Energen’s
With the assumption that the lease is not capitalized, the company’s balance sheet that
purchase the equipment will look as following:

Current assets $ 25,000 Debt $ 100,000

Fixed assets 175,000 Equity 100,000
Total assets $200,000 Total claims $200,000

The calculation of the debt ratio is as followed:

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

100.000
= 200.000

= 50%

From the calculations above, we can conclude that Energen’s debt ratio after it
purchased the equipment is 50%.

Hasting’s
With the assumption that the lease is not capitalized, the company’s balance sheet that
lease the equipment will remain the same as it is before the lease of the equipment:
 Current assets $ 25,000 Debt $ 50,000
Fixed assets 125,000 Equity 100,000
Total assets $150,000 Total claims $150,000

The calculation of the debt ratio is as followed:

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

50.000
= 150.000

= 33, 33%

From the calculations above, we can conclude that Hasting’s debt ratio after it leased
the equipment will be 33,33%.

b. Show how Hastings’s balance sheet would look immediately after the financing if
it capitalized the lease.

As we have seen previously, if the company decided to lease the equipment, it will not
be seen on the company’s balance sheet, thus it could deceive the investors by making
them believe that the company is in a better position compared to the company who
chose to own the equipment. When in fact, the risk between leasing and purchasing
the equipment using debt is relatively the same. Therefore, to show the company’s
true financial position, the lease has to be capitalized by reporting the leased assets as
a fixed asset and the present value of the future lease payments as a liability.

The balance sheet of Hasting after the lease is capitalized will be as following:

Current assets $ 25,000 Debt $ 100,000

Fixed assets 175,000 Equity 100,000
Total assets $200,000 Total claims $200,000

(18-4) Big Sky Mining Company must install $1.5 million of new machinery in its Nevada
mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the
machinery. Assume that the following facts apply.

1. The machinery falls into the MACRS 3-year class

2. Under either the lease or the purchase, Big Sky must pay for insurance, property
taxes and maintenance
 3. The firm’s tax rate is 40%
4. The loan would have an interest rate of 15%
5. The lease terms call for $400.000 payments at the end of each of the next 4 years
6. Big Sky Mining has no use for the machine beyond the expiration of the lease
and the machine has an estimated residual value of $250.000 at the end of the 4th
year.

What is the NAL of the lease?

(19-3) Maese Industries Inc. has warrants outstanding that permit the holders to purchase 1
share of stock per warrant at a price of $25.

a. Calculate the exercise value of the firm’s warrants if the common sells at each of
the following prices: (1) $20, (2) $25, (3) $30, (4) $100. (Hint: A warrant’s
exercise value is the difference between the stock price and the purchase price
specified by the warrant if the warrant were to be exercised).

S.No Stock Price Purchase Price Exercise Value

1 $25 $20 ($5) or 0

 2 $25 $25 $0

3 $25 $30 $5

4 $25 $100 $75

b. Assume the firm’s stock now sells for $20 per share. The company wants to sell
some 20 year, $1.000 par value bonds with interest paid annually. Each bond will
have attached 50 warrants, each exercisable into 1 share of stock at an exercise
price of $25. The firm’s straight bonds yield 12%. Assume that each warrant will
have a market value of $3 when the stock sells at $20. What coupon interest rate
and dollar coupon, must the company set on the bonds with warrants if they are
to clear the market? (Hint: The convertible bond should have an initial price of
$1.000).

Value of warrants + Value of bond =$1,000

Value of warrants: Value of bond:

No of warrants = 50 n = 20 Years

Warrant Value = $3 r = 12% per year

Thus, Total value = $150 PVIF = 0.10367

PVIFA = 7.46944

Redemption value = Par value = $1,000

● Present value of Redemption Value = PVIF*Redemption value

Present value of Redemption Value = $103.67

● Present value of Interest Payment = PVIFA*Interest payment per

period

Present value of Interest Payment =

 7.46944 × Interest payment per period

$150 + 103.67 + 7.46944 × Interest payment per period $1,000Interest

7.46944 ×Interest Payment per Period =$746.33

Interest Payment per Period =$99.92

Interest Payment per Period = $100 (Rounded off)

Therefore, the annual dollar coupon payment = 10%

Therefore, the coupon rate =10%

(19-5) Fifteen years ago, Roop Industries sold $400 million of convertible bonds. The bonds had a
40-year maturity, a 5.75% coupon rate, and paid interest annually. They were sold at their
$1,000 par value. The conversion price was set at $62.75, and the common stock price was
$55 per share. The bonds were subordinated debentures and were given an A rating; straight
nonconvertible debentures of the same quality yielded about 8.75% at the time Roop’s bonds
were issued.

a. Calculate the premium on the bonds—that is, the percentage excess of the
conversion price over the stock price at the time of issue.

A convertible security is a bond or preferred stock that under specified conditions of

issue can be converted into common stocks by the holder. The difference between a
convertible and a warrant is that no new capital is generated and it is only the change
in the form of instrument that takes place.

The premium percentage excess of the conversion price of stock over the stock price
at the time of issue and is calculated by the following formule:

𝐶𝑃−𝑀𝑃
𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑀𝑃
𝑥 100

Where:

MP (Market Price of the Common Stock) = $55 per share

CP (Conversion Price of the Common Stock) = $62.75 per share

Substituting the values in the equation:

 62.75 − 55
𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = 55
𝑥 100 = 14. 09%

b. What is Roop’s annual before-tax interest savings on the convertible issue versus
a straight-debt issue?

The savings in the interest would be the difference in the interest paid on the
convertible bond and the interest payable if straight bonds would have been issued.

The interest paid on convertible bond by R industry is calculated:

Interest = Total Bond Value x Interest Rate

= 400 million x 5.75

= $23 million

The interest payable on straight bonds can be calculated:

Interest = Total Bond Value x Interest Rate

= 400 million x 8.75

= $35 million

Savings difference = 35 million - 23 million = $12 million

c. At the time the bonds were issued, what was the value per bond of the conversion
feature?

The value of convertible feature of a bond is the value of the common stock that
would be received by the bondholder on the conversion of the bond.

Conversion Ratio can be calculated:

𝐵𝑜𝑛𝑑 𝑉𝑎𝑙𝑢𝑒
𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑃𝑟𝑖𝑐𝑒

1000
= 62.75
= 16: 1

Thus, 16 shares will be issued against 1 bond on conversion, the current value of
share being $55. The convertible value of the bond would be the current value of 16
shares.
 Current Value of Shares = 55 x 16 = $880

The value is $880 per Bond

d. Suppose the price of Roop’s common stock fell from $55 on the day the bonds
were issued to $32.75 now, 15 years after the issue date (also assume the stock
price never exceeded $62.75). Assume interest rates remained constant. What is
the current price of the straight-bond portion of the convertible bond? What is
the current value if a bondholder converts a bond? Do you think it is likely that
the bonds will be converted?

The value of the straight bond portion can be calculated as the present value of the
cash flows of the remaining portion of the bond maturity, using the formula:

𝑅𝑉
𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐵𝑜𝑛𝑑 = 𝐶 𝑥 𝑃𝑉𝐼𝐹(𝑖, 𝑛) + 𝑛
(1+𝑖)

Where,

C = Coupon Payment

PVIF (i,n) = Interest factor of the present value of dollar at i interest and for n
periods

RV = Redemption Value of Bond

i = Rate of Interest

The following are calculated with the formula:

C = (5.75 x 1,000) = $57.5

PVIF = (8.75 x 25) = 10.02

As obtained from the table against 25 years and at 8.75%:

RV = $1,000

i = 8.75%

n = 25 years

Substituting the values in the formula:

 𝑅𝑉
𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐵𝑜𝑛𝑑 = 𝐶 𝑥 𝑃𝑉𝐼𝐹(𝑖, 𝑛) + 𝑛
(1+𝑖)

1,000
= 57. 5 𝑥 10. 02 + 25
(1+0.0875)

= $699.25

The value of straight bond is $699.25

The conversion ratio of the bond is 16:1. The value of the bond holder on conversion
would be = 32.75 x 16 = $524

The bondholders would not go for conversion as the value of $524 on conversion
would be lower than the value of holding the bond of $699.25

e. The bonds originally sold for $1,000. If interest rates on A-rated bonds had
remained constant at 8.75% and if the stock price had fallen to $32.75, then what
do you think would have happened to the price of the convertible bonds?
(Assume no change in the standard deviation of stock returns.)

The Bond price follows the performance of the underlying security. However, after
substantial decrease in the underlying shares, the price of the convertible bond is the
value of the straight-portion of the bond. The solution of point (d) shows that the
value of conversion being lower than the straight portion of the bond value. Thus, the
price of the bond would be $699.25.

f. Now suppose that the price of Roop’s common stock had fallen from $55 on the
day the bonds were issued to $32.75 at present, 15 years after the issue. Suppose
also that the interest rate on similar straight debt had fallen from 8.75% to
5.75%. Under these conditions, what is the current price of the straight-bond
portion of the convertible bond? What is the current value if a bondholder
converts a bond? What do you think would have happened to the price of the
bonds?

The value of the straight bond portion can be calculated as the present value of the
cash flows of the remaining portion of the bond maturity, using the formula:

𝑅𝑉
𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐵𝑜𝑛𝑑 = 𝐶 𝑥 𝑃𝑉𝐼𝐹(𝑖, 𝑛) + 𝑛
(1+𝑖)
 Where,

C = Coupon Payment

PVIF (i,n) = Interest factor of the present value of dollar at i interest and for n
periods

RV = Redemption Value of Bond

i = Rate of Interest

n = Period of Investment

Calculated as follows:

C = (5.75 x 1,000) = $57.5

PVIF = (5.75 x 25) = 13.09

As obtained from the table against 25 years and at 8.75%

RV = $1,000

i = 5.75%

n = 25 years

1,000
Calculated with the same formula = (5. 75 𝑥 13. 09) + 25 = $1,000
(1+0.0575)

The value of straight bond is $1,000

The conversion ratio of the bond is 16:1. The value of the bond holder on conversion
would be = 32.75 x 16 = $524

The Bond price follows the performance of the underlying security. However, after
substantial decrease in the underlying shares, the price of the convertible bond is the
value of the straight-portion of the bond. The price of the Bond would be $1,000.

(19-6) The Howland Carpet Company has grown rapidly during the past 5 years. Recently, its
commercial bank urged the company to consider increasing its permanent financing. Its bank
loan under a line of credit has risen to $250,000, carrying an 8% interest rate. Howland has
been 30 to 60 days late in paying trade creditors. Discussions with an investment banker have
resulted in the decision to raise $500,000 at this time. Investment bankers have assured the
firm that the following alternatives are feasible (flotation costs will be ignored).

● Alternative 1: Sell common stock at $8.

● Alternative 2: Sell convertible bonds at an 8% coupon, convertible into 100 shares of
common stock for each $1,000 bond (i.e., the conversion price is $10 per share).
● Alternative 3: Sell debentures at an 8% coupon, each $1,000 bond carrying 100
warrants to buy common stock at $10.

a. Show the new balance sheet under each alternative. For Alternatives 2 and 3, show
the balance sheet after conversion of the bonds or exercise of the warrants. Assume
that half of the funds raised will be used to pay off the bank loan and half to increase
total assets.

Balance sheet for Alternative 1: Sale of Common Stock @ $8

Balance sheet for Alternative 2: Sale convertible bonds at an 8% coupon, convertible into
100 shares of common stock for each $1000 bond.
 Balance sheet for Alternative 3: Sale debentures at an 8% coupon, each $1000 bond
carrying 100 warrants to buy common stock at $10

b. Show Mr. Howland’s control position under each alternative, assuming that he does
not purchase additional shares.

c. What is the effect on earnings per share of each alternative, assuming that profits
before interest and taxes will be 20% of total assets?
d. What will be the debt ratio (TL/TA) under each alternative?

Alternative 1: (150,000/800,000) = 18.75%

Alternative 2: (150,000/800,000) = 18.75%

Alternative 3: (500,000+150,000)/1,300,000 = 50.00%

e. Which of the three alternatives would you recommend to Howland, and why?

Of the three alternatives, I would recommend alternative 3. Because it retains the highest
amount of control for Mr. Howland as well as the maximum EPS.