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Chapter 5: Q5-17-21BP-d (page 571)

Question: The treasurer of Kelly Bottling Company (a corporation) currently has \(150,000 invested in preferred stock yielding 8 percent. He appreciates the tax advantages of preferred stock and is considering buying \)150,000 more with borrowed funds. The cost of the borrowed funds is 13 percent. He suggests this proposal to his board of directors. They are somewhat concerned by the fact that the treasurer will be paying 5 percent more for funds than the company will be earning on the investment. Kelly Bottling is in a 35 percent tax bracket, with dividends taxed at 20 percent.

d. If interest rates and dividend yields in the market go up six months after a decision to purchase is made, what impact will this have on the outcome?

Short Answer

Expert verified

Answer

The increase in interest rate and dividend yield will reduce the portfolio鈥檚 value and increase the cost of borrowing.

Step by step solution

01

Step-by-step solutionStep 1: Meaning of bond yield

The bond yield refers to the return that the bondholder will generate from a bond. The bond yield can be calculated by using the coupon rate and face value of the bond.

02

Impact of interest rate and dividend yield

The increase in the dividend yield will reduce the value of the portfolio and the cost of borrowing can increase.The increase in the interest rates will reduce the price of the bonds as the bondholders will want to sell their bonds at high prices in the market and this will inversely impact its prices.

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Most popular questions from this chapter

The efficient market hypothesis is interpreted in a weak form, a semi strong form, and a strong form. How can we differentiate its various forms?

Question: The Bailey Corporation, a manufacturer of medical supplies and equipment, is planning to sell its shares to the general public for the first time. The firm鈥檚 investment banker, Robert Merrill and Company, is working with Bailey Corporation in determining a number of items. Information on the Bailey Corporation follows:

Bailey corporation

Income statement

For the year 20X1

Sales (all on credit)

\(42,680,000

Cost of goods sold

\)32,240,000

Gross profit

\(10,440,000

Selling and administrative expenses

\)4,558,000

Operating profit

\(5,882,000

Interest expense

\)600,000

Net income before taxes

\(5,282,000

Taxes

\)2,120,000

Net income

\(3,162,000

Bailey corporation

Balance sheet

As of December 31, 20X1

Assets

Current assets:

Cash

\)250,000

Marketable securities

\(130,000

Accounts receivables

\)6,000,000

Inventory

\(8,300,000

Total current assets

\)14,680,000

Net plant and equipment

\(13,970,000

Total assets

\)28,650,000

Liabilities and stockholders鈥� equity

Current liabilities:

Accounts payable

\(3,800,000

Notes payable

\)3,550,000

Total current liabilities

\(7,350,000

Long-term liabilities

\)5,620,000

Total liabilities

\(12,970,000

Stockholder鈥檚 equity:

Common stock (1,800,000 shares at \)1 par)

\(1,800,000

Capital in excess of par

\)6,300,000

Retained earnings

\(7,580,000

Total stockholder鈥檚 equity

\)15,680,000

Total liabilities and stockholder鈥檚 equity

$28,650,000

d. Now assume that, of the initial 800,000 share distribution, 400,000 belong to current stockholders and 400,000 are new shares, and the latter will be added to the 1,800,000 shares currently outstanding. What will earnings per share be immediately after the public offering? What will the initial market price of the stock be? Assume a price-earnings ratio of 12, and use earnings per share after the distribution in the calculation.

The Presley Corporation is about to go public. It currently has after-tax earnings of \(7,200,000, and 2,100,000 shares are owned by the present stockholders (the Presley family). The new public issue will represent 800,000 new shares. The new shares will be priced to the public at \)25 per share, with a 5 percent spread on the offering price. There will also be $260,000 in out-of-pocket costs to the corporation.

a. Compute the net proceeds to the Presley Corporation.

How would you define efficient security markets?

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.

d. In terms of the refunding decision, how should Barton be influenced if he thinks interest rates might go down even more?
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