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APPLIED CORPORATE FINANCE - HW8

The document discusses the characteristics and implications of commodity bonds compared to straight bonds and equity, emphasizing the need for careful debt ratio analysis due to commodity price fluctuations. It also evaluates a new security with fixed dividends, classifying it as equity for debt ratio calculations, and examines the impact of venture capital on a firm's value. Additionally, it explores the effects of leverage on firm value and cost of capital in a tax-free environment, as well as the implications of interest tax savings from debt financing.

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Thanh Beo
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APPLIED CORPORATE FINANCE - HW8

The document discusses the characteristics and implications of commodity bonds compared to straight bonds and equity, emphasizing the need for careful debt ratio analysis due to commodity price fluctuations. It also evaluates a new security with fixed dividends, classifying it as equity for debt ratio calculations, and examines the impact of venture capital on a firm's value. Additionally, it explores the effects of leverage on firm value and cost of capital in a tax-free environment, as well as the implications of interest tax savings from debt financing.

Uploaded by

Thanh Beo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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2.

A commodity bond links interest and principal payments to the price of a


commodity. Differentiate a commodity bond from a straight bond and then
from equity. How would you factor these differences into your analysis of
the debt ratio of a company that has issued exclusively commodity bonds?
a. Commodity Bond vs. Straight Bond

Commodity Bond vs. Equity (Stock)

b. Impact on Debt Ratio Analysis


Debt Ratio = Total Debt / Total Assets
For businesses that only issue commodity bonds, debt ratio analysis needs to adjust some
important points:

- Flexibility of debt obligations


+) If commodity prices increase, the actual debt will be larger, increasing the debt ratio.
+) If commodity prices decrease, debt obligations decrease, making the company appear less
risky.
=> Need to assess the scenario of commodity price fluctuations to determine the actual debt
level.
- Commodity price fluctuation risk
The company may have a low debt ratio on paper, but if commodity prices increase suddenly, the
pressure to repay the debt will be greater.

- Impact on borrowing capacity


Because debt obligations change with commodity prices, investors and banks may assess higher
risks, affecting credit ratings.

- Compare with traditional debt


If you only look at the debt ratio on the balance sheet, the company may look less risky than it
actually is.
Contingent debt should be taken into account if commodity prices rise sharply.

3. You are analyzing a new security that has been promoted as equity, with
the following features:
• The dividend on the security is fixed in dollar terms for the life of the
security, which is 20 years.
• The dividend is not tax-deductible.
• In the case of default, the holders of this security will receive cash only after
all debt holders, secured, and unsecured, are paid.
• The holders of this security will have no voting rights.
On the basis of the description of debt and equity in the chapter, how would
you classify this security? If you were asked to calculate the debt ratio for this
firm, how would you categorize this security?

a.Classification of the Security

- Fixed Dividend Payments – Unlike common equity, which has variable


dividends, this security offers fixed dividend payments similar to bond coupon
payments.
- Non-Tax-Deductible Dividends – Unlike debt interest, which is tax-deductible,
the dividend payments on this security are not deductible, a key feature of equity.
- Lower Priority in Default – The security holders are paid after all debt holders
(secured and unsecured), placing them in a subordinate position similar to
preferred shareholders.
- No Voting Rights – Common shareholders typically have voting rights, but this
security does not, reinforcing its similarity to preferred stock.
b.Categorization for Debt Ratio Calculation
Since this security does not have tax-deductible payments and is subordinate to all
forms of debt, it would be classified as equity rather than debt when calculating the
debt ratio.
However, in some financial analyses, particularly for firms with a high proportion
of hybrid securities, analysts may include preferred stock in an adjusted debt-to-
capital ratio if the firm treats these payments as quasi-debt obligations.
5. You have been asked to calculate the debt ratio for a firm that has the
following components to its financing mix:
• The firm has 1 million shares outstanding, trading at $50 per share.
• The firm has $25 million in straight debt, carrying a market interest rate of
8%.
• The firm has 20,000 convertible bonds outstanding,with a face value of
$1,000, a market value of $1,100,and a coupon rate of 5%.
Estimate the debt ratio for this firm.

Convertible Bonds = 20,000 bonds × Market Price of $1,100 = $22 million

Total Debt=25M+22M=47M
Equity Value=Shares Outstanding×Market Price per Share
=1,000,000×50=50M

Debt Ratio=Total Debt+Total Equity


Total Debt=47/(47+50) =47 / 97 ≈ 48.45%

8. Office Helpers is a private firm that manufactures andsells office supplies.


The firm has limited capital and is estimated to have a value of $80 million
with the capital constraints. A venture capitalist is willing to contribute
$20 million to the firm in exchange for 30% of the value of the firm. With this
additional capital, the firm will be worth $120 million.
a. Should the firm accept the venture capital?
b. At what percentage of firm value would you (as the owner of the private
firm) break even on the venture capital financing?
(a) Should the firm accept the venture capital?

Current Ownership Value (Before Investment) = $80 million

New Ownership Value (After Investment) = 70% of $120 million = $84 million
Since the owner's stake increases from $80 million to $84 million, the firm should accept the
venture capital because the owner's wealth increases by $4 million.

X×120M=80M
X=80/120=66.67%
If the owner’s stake drops below 66.67%, they would be worse
off compared to not taking the venture capital.

18. MVP, a manufacturing firm with no debt outstanding and a market value
of $100 million, is considering borrowing $40 million and buying back stock.
Assuming that the interest rate on the debt is 9% and that the firm faces a tax
rate of 35%, answer the following questions:
a. Estimate the annual interest tax savings each year from the debt.
b. Estimate the present value of interest tax savings, assuming that the debt
change is permanent.
c. Estimate the present value of interest tax savings, assuming that the debt
will be taken on for 10 years only.
d. What will happen to the present value of interest tax savings if interest
rates drop tomorrow to 7% but the debt itself is fixed rate debt?

(a) Annual Interest Tax Savings

Interest Tax Savings=Interest Expense×Tax Rate


=(40M×9%)×35%
=3.6M×35%=1.26M

The firm will save $1.26 million in taxes annually due to the interest deduction.

(b) Present Value of Interest Tax Savings (Permanent Debt)

PV Tax Savings = Annual Tax Savings/Interest Rate


=1.26M/9%=14M

(c)

1/(1.09)^10≈0.422
(1−0.422)÷0.09=0.578/0.09≈6.42
PVTax Savings=1.26M×6.42≈8.08M
(d) What Happens If Interest Rates Drop to 7%?

(40M×7%)×35%=0.98M

 The present value of tax savings for permanent debt at 7%:

0.98M/7%=14M

 The present value for 10 years at 7%:

0.98M×(1−1/(1.07)^10)÷0.07
0.98M×7.02≈6.88

So, the value of the tax shield would decrease if the company refinanced at 7%, but the existing
tax shield remains the same as long as the firm sticks to the 9% fixed rate.

24. A firm that has no debt has a market value of $100 million and a cost of
equity of 11%. In the Miller–Modigliani world.
a. what happens to the value of the firm as the leverage is changed (assume no
taxes)?
b. what happens to the cost of capital as the leverage is changed (assume no
taxes)?
c. how would your answers to a and b change if there are taxes?

(a) Firm Value as Leverage Changes (No Taxes - MM Proposition I)

According to MM Proposition I (without taxes):

VL=VU

where:

 VL = Market value of a leveraged firm


 VU = Market value of an unlevered firm

This means leverage has no impact on firm value in a world without taxes.

 VL=100M, regardless of debt level.

b. Cost of capital remains unchanged at 11%.


c. VL=VU+PV of Interest Tax Shield
VL=100M+(D×T)

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