Finance

Question 1

(60 marks)

Ryan, the president of the Open Corporation, is considering leasing or purchasing equipment.

Microtech Corporation has offered to sell the Open Corporation the equipment at a price of

$6010,000. Following its usual practice, the equipment is depreciated over four years, at the rates

of 40% for the first year, and 20%for each of the remaining three years. The salvage value of this

equipment is expected to be 0.

Alternatively, the OpenCorporation can lease the equipment from ScottCorporation. Four annual

lease payments of $1.9 million settled at the beginning of each year. Open Corporation can

raise capital by issuing bonds with a yield of 12 percent, and the tax rate for OpenCorporation is

set to be 30 percent.

After comparing the above two options, the Chief Financial Officer of Open Corporation,

commented, “Scott’s offer is financially unreasonable due to a negative (i.e. net advantage

to leasing) to our company. Therefore, the annual lease payments should be curtailed. Meanwhile,

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we can pay a security deposit to Scott as an incentive. This deposit would be returned on the

expiration date of the lease contract.” In response to CFO’s comments, Ryan added,“If the leasing

term is acceptable to us, this will suggest that a negative should be brought to Scott. As far

as I know, leasing is a zero-sum game between the lessee and lessor. I believe Scottreject our

counter offer.” After several rounds of discussion, Ryan eventually determines to propose a

counteroffer to Scott, with a reduced lease payment of $1.8million on annual basis and a security

deposit of $1,000,000.

Required:

(a) In light of the NAL calculation, comment on the following remarks “Scott’s

offer is financially unreasonable due to a negative NAL (i.e.net advantage to

leasing) to our company.”

(12 marks)

(b) According to the counteroffer by the Open Corporation, evaluate the NAL

to Scott. What is the reaction of Scott to this counteroffer?The tax rate for

Scott is presumed to be 40%.

(14 marks)

(12 marks)

(12 marks)

(10 marks)

(c) Critically discuss Ryan’s remark “leasing is a zero-sum game between the

lessee and lessor”.

(d) Explain the rationale for lessees to accept a lease offer even if NALs are

negative.

(e) If the purchase of equipment is funded by bond issuance instead of own

capital, do you consider this factor in NAL analysis? Explain.

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Question 2 (40 Marks)

Great Car Company Limited, through its subsidiaries, manufactures and sells pick-up trucks

Asia market under branded names. The Company also researches, develops, and manufactures

principal automotive components for use in the assembly of pick-up trucks.

The company is considering a new investment project which has the same risks as existing

businesses. The initial outlay for the project is $55 million. The company expects that the project

will generate additional earnings of $10 million per year. The company currently has no debt. The

current annual earnings available to common stockholders are $80 million.

The company currently has 6 million shares outstanding. Currently, the required rate of return on

equity is 12%. Traditionally, the company has paid out all earnings to the stockholders as dividends

and financed capital expenditures with new issues of common stock.All earning streams are

assumed to be perpetuities. There are no taxes and no bankruptcy costs.

Required:

(a) Analyze the value of the firm if common stock is issued to finance the project. (6 marks)

(b) One of the banks suggests that the company can issue $55 million, 9%

perpetual bonds to finance the project. Advise the value of the company and

the rate of return required by stockholders.

(10 marks)

(c) TSL, another competitor firm, has a 8% coupon rate convertible bond due 20

years from now. The convertible bond has a par value of $1,000and is selling

at $970. The conversion price of the bond is $50 per share. A non-convertible

coupon bond of similar quality is currently yielding10%. The common stock

of TSL is selling at $40 per share. Assume that bond interest payments are

made annually.

i Determine the conversion ratio of the convertible bond.

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(4 marks)

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ii Calculate the conversion premium of the convertible bond.

iii Access the minimum price at which the convertible bond should sell.

iv Explain why a convertible bond sells at a premium above its value as a

bond or common stock.

(4 marks)

(10 marks)

(6 marks)

4

Requirements: 1200 words

Question 1

(60 imprints)

Ryan, the leader of the Open Corporation, is thinking about renting or buying hardware.

Microtech Corporation has offered to sell the Open Corporation the hardware at a cost of

$6010,000. Following its typical practice, the gear is devalued over fouryears, at the rates

of 40% for the firstyear, and 20%for every one of the excess three years. The salvagevalue of this

hardware is relied upon to be 0.

On the other hand, the OpenCorporation can rent theequipment from ScottCorporation. Four yearly

rent installments of $1.9 millionare settled toward the start of every year. Open Corporation can

raise capital by giving securities with a yield of 12%, and the duty rate for OpenCorporation is

set to be 30%.

Subsequent to contrasting the over two choices, the Chief Financial Officer of Open Corporation,

remarked, “Scott’s offer is monetarily irrational because of a negativeNAL (for example net benefit

to renting) to our organization. Consequently, the yearly leasepayments ought to be reduced. In the interim,

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we can pay a security depositto Scott as a motivation. This store wouldbe returned on the

termination date of the leasecontract.” because of CFO’s remarks, Ryan added,”If the renting

term is worthy to us, this will suggestthat a negativeNAL ought to be brought to Scott. As far

as I probably am aware, leasingis a lose-lose situation between the resident and lessor. I trust Scottreject our

counter offer.” After a few roundsof conversation, Ryaneventually decides to propose a

counter proposal to Scott, witha decreased leasepayment of $1.8million on annualbasis and a security

store of $1,000,000.

Required:

(a) considering the NAL count, commenton the accompanying comments “Scott’s

offer is monetarily preposterous because of a negative NAL (i.e.net benefit to

renting) to our organization.”

(12 imprints)

(b) According to the counteroffer by the Open Corporation, assess the NAL

to Scott. What is the response of Scott to this counter offer?The charge rate for

Scott is dared to be 40%.

(14 imprints)

(12 imprints)

(12 imprints)

(10 imprints)

(c) Critically examine Ryan’s comment “renting is a lose-lose gamebetween the

renter and lessor”.

(d) Explain the reasoning for lesseesto acknowledge a rent offereven if NALs are

negative.

(e) If the acquisition of hardware is supported by bond issuance rather than own

capital, do you think about this factor in NAL investigation? Clarify.

2

indistinct

Question 2 (40 Marks)

Extraordinary Car Company Limited, throughits auxiliaries, makes and sells get trucksin

Asia market underbranded names. The Companyalso investigates, creates, and makes

head auto parts for use in the get together of get trucks.

The organization is thinking about another speculation project which has the equivalent riskas existing

organizations. The initialoutlay for the task is $55 million. The organization expectsthat the task

will create extra income of $10 millionper year. The organization at present has no debt.The

current yearly profit accessible to regular investors are $80 million.

The organization as of now has 6 million sharesoutstanding. At present, the necessary pace of return on

value is 12%. Generally, the organization has paidout all profit to the investors as profits

furthermore, financed capitalexpenditures with new issuesof basic stock.All procuring streams are

thought to be interminabilities. There are no duties and no liquidation costs.

Required:

(a) Analyze the valueof the firm if regular stockis gave to back the task. (6 imprints)

(b) One of the bankssuggests that thecompany can issue $55 million, 9%

unending bonds to fund the venture. Advisethe estimation of the organization and

the pace of return needed by investors.

(10 imprints)

(c) TSL, another contender firm, has a 8% couponrate convertible security due 20

a long time from now.The convertible bond has a parvalue of $1,000and is selling

at $970. The transformation cost of thebond is $50 per share. A non-convertible

coupon obligation of comparative qualityis at present yielding10%. The commonstock

of TSL is selling at $40 pershare. Expect thatbond interest installments are

made every year.

I Determine the transformation proportion of the convertible bond.

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(4 imprints)

vague

ii Calculate the change premium of the convertible bond.

iii Access the base cost at which the convertible bond should sell.

iv Explain why a convertible bond sells at a higher cost than normal over its incentive as a

bond or basic stock.

(4 imprints)

(10 imprints)

(6 imprints)

4

Prerequisites: 1200 words

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