FIN B386F Newcastle College Financial Decision Making Questions

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 fouryears, at the rates

of 40% for the firstyear, and 20%for each of the remaining three years. The salvagevalue of this

equipment is expected to be 0.

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

lease payments of $1.9 millionare 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 negativeNAL (i.e. net advantage

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

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we can pay a security depositto Scott as an incentive. This deposit wouldbe returned on the

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

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

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

counter offer.” After several roundsof discussion, Ryaneventually determines to propose a

counter offer to Scott, witha reduced leasepayment of $1.8million on annualbasis and a security

deposit of $1,000,000.

Required:

(a) In light of the NAL calculation, commenton 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 counter offer?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 gamebetween the

lessee and lessor”.

(d) Explain the rationale for lesseesto accept a lease offereven 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, throughits subsidiaries, manufactures and sells pick-up trucksin

Asia market underbranded names. The Companyalso 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 riskas existing

businesses. The initialoutlay for the project is $55 million. The company expectsthat the project

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

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

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

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

and financed capitalexpenditures with new issuesof common stock.All earning streams are

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

Required:

(a) Analyze the valueof the firm if common stockis issued to finance the project. (6 marks)

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

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

the rate of return required by stockholders.

(10 marks)

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

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

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

coupon bond of similar qualityis currently yielding10%. The commonstock

of TSL is selling at $40 pershare. Assume thatbond 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)

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Requirements: 1200 words