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Chapter 5: Q13DQ. (page 565)

Put an X by the security that has the feature best related to the following considerations. You may wish to refer to Table 17-4.

Common stock

Preferred stock

Bonds

  1. Ownership and control of the firm
  1. Obligation to provide return
  1. Claims to assets in bankruptcy
  1. High cost of distribution
  1. Highest return
  1. Highest risk
  1. Tax-deductible payment
  1. Payment partially tax-exempt to corporate recipient

Short Answer

Expert verified

The common stock is best in case of ownership and control of the firm, the highest cost of the return, highest return, highest risk, and partially tax-exempt payment. The preferred stock is best in regard that the payment is partially tax-exempt. The bond is best as the obligation to provide a return, claim to the assets in case of bankruptcy, and tax-deductible payment.

Step by step solution

01

Types of financial instruments

The different financial instruments are cash instruments, derivative instruments, and foreign exchange instruments.The different instruments can also be categorized based on the asset class based on whether these instruments are equity or debt based.

02

Table showing the best security to be selected for a particular reason

Common stock

Preferred stock

Bonds

  1. Ownership and control of the firm

X

  1. Obligation to provide return

X

  1. Claims to assets in bankruptcy

X

  1. High cost of distribution

X

  1. Highest return

X

  1. Highest risk

X

  1. Tax-deductible payment

X

  1. Payment partially tax-exempt to corporate recipient

X

X

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Most popular questions from this chapter

Louisiana Timber Company currently has 5 million shares of stock outstanding and will report earnings of \(9 million in the current year. The company is considering the issuance of 1 million additional shares that will net \)40 per share to the corporation.

a. What is the immediate dilution potential for this new stock issue?

b. Assume the Louisiana Timber Company can earn 11 percent on the proceeds of the stock issue in time to include it in the current year鈥檚 results. Should the new issue be undertaken based on earnings per share?

The Ellis Corporation has heavy lease commitments. Prior to SFAS No. 13, it merely footnoted lease obligations in the balance sheet, which appeared as follows:

In \( millions

In \) millions

Current assets

\(70

Current liabilities

\)30

Fixed assets

\(70

Long-term liabilities

\)30

Total liabilities

\(60

Stockholder鈥檚 equity

\)80

Total assets

\(140

Total stockholder鈥檚 equity and liabilities

\)140

The footnotes stated that the company had $14 million in annual capital lease obligations for the next 20 years.

e. In an efficient capital market environment, should the consequences of SFAS No. 13, as viewed in the answers to parts c and d, change stock prices and credit ratings?

Question: Barton Simpson, the chief financial officer of Broadband Inc. could hardly believe the change in interest rates that had taken place over the last few months. The interest rate on A2 rated bonds was now 6 percent. The $30 million, 15-year bond issue that his firm has outstanding was initially issued at 9 percent five years ago. Because interest rates had gone down so much, he was considering refunding the bond issue. The old issue had a call premium of 8 percent. The underwriting cost on the old issue had been 3 percent of par, and on the new issue it would be 5 percent of par. The tax rate would be 30 percent and a 4 percent discount rate would be applied for the refunding decision. The new bond would have a 10-year life. Before Barton used the 8 percent call provision to reacquire the old bonds, he wanted to make sure he could not buy them back cheaper in the open market.

c. Now do the standard bond refunding analysis as discussed in this chapter. Is the refunding financially feasible?

Question: The Bowman Corporation has a \(18 million bond obligation outstanding, which it is considering refunding. Though the bonds were initially issued at 10 percent, the interest rates on similar issues have declined to 8.5 percent. The bonds were originally issued for 20 years and have 10 years remaining. The new issue would be for 10 years. There is a 9 percent call premium on the old issue. The underwriting cost on the new \)18,000,000 issue is \(530,000, and the underwriting cost on the old issue was \)380,000. The company is in a 35 percent tax bracket, and it will use an 8 percent discount rate (rounded after-tax cost of debt) to analyze the refunding decision.

b. Calculate the present value of total inflows.

The trustee in the bankruptcy settlement for Titanic Boat Co. lists the following book values and liquidation values for the assets of the corporation. Liabilities and stockholders鈥� claims are also shown.

Assets

Book value

Liquidation value

Accounts receivables

\(1,400,000

\)1,200,000

Inventory

\(1,800,000

\)900,000

Machinery and equipment

\(1,100,000

\)600,000

Building and plant

\(4,200,000

\)2,500,000

Total assets

\(8,500,000

\)5,200,000

Liabilities and stockholder鈥檚 claims

Liabilities

Accounts payable

\(2,800,000

First lien, secured by machinery and equipment

\)900,000

Senior unsecured debt

\(2,200,000

Subordinated debenture

\)1,700,000

Total liabilities

\(7,600,000

Stockholder鈥檚 claims

Preferred stock

\)250,000

Common stock

\(650,000

Total stockholder鈥檚 claims

\)900,000

Total liabilities and stockholder鈥檚 claims

$8,500,000

f. Compute a ratio of your answers in part d and e. This will indicate the initial allocation ratio.
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