Buy or Lease Problem Walk-Through

 

1. International Machinery Company (IMC) is a Swedish multinational manufacturing company. Currently, IMC’s financial planners are considering undertaking a 1-year project in the United States. The project’s expected dollar-denominated cash flows consist of an initial investment of $2,900 and a cash inflow the following year of $3,400. IMC estimates that its risk-adjusted cost of capital is 16%. Currently, 1 U.S. dollar will buy 7.3 Swedish kronas. In addition, 1-year risk-free securities in the United States are yielding 6%, while similar securities in Sweden are yielding 5%.

If IMC undertakes the project, what is the net present value and rate of return of the project for IMC in home currency? Round your answer to 2 decimal places. Do not round intermediate calculations.

NPV:______

Swedish kronas

Rate of return:________

Layout time line with the U.S. dollar amounts given, but realize that these values need to be converted to Swedish kronas.

Use the spot rate given in the problem to convert the t = 0 U.S. dollar amount to Swedish kronas.

Use the 1 year forward rate calculated above to convert the t = 1 U.S. dollar amount to Swedish kronas.

Now calculate the NPV discounting the Swedish krona cash flows by the cost of capital given in the problem.

Calculate the rate of return using the Swedish krona cash flows as the t = 1 cash flow divided by the t = 0 cash flow, then subtracting one from this number.

 

2. Warrants

Gregg Company recently issued two types of bonds. The first issue consisted of 20-year straight (no warrants attached) bonds with an 5% annual coupon. The second issue consisted of 20-year bonds with a 2% annual coupon with warrants attached. Both bonds were issued at par ($900). What is the value of the warrants that were attached to the second issue? Round your answer to the nearest cent.

 

$________

 

3. As part of its overall plant modernization and cost reduction program, the management of Tanner-Woods Textile Mills has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was 15% versus a project required return of 15%.

 

The loom has an invoice price of $260,000, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4-year amortized loan at a 11% interest rate, with payments to be made at year-end. In the event the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $20,000 per year paid at year-end. The loom falls in the MACRS 5-year class, and Tanner-Woods’s marginal federal-plus-state tax rate is 40%. The applicable MACRS rates are 22%, 34%, 21%, 16%, 12%, and 6%.

 

United Automation Inc., maker of the loom, has offered to lease the loom to Tanner-Woods for $70,000 upon delivery and installation (at t = 0) plus 4 additional annual lease payments of $70,000 to be made at the end of Years 1 through 4. (Note that there are 5 lease payments in total.) The lease agreement includes maintenance servicing. Actually, the loom has an expected life of 10 years, at which time its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book value of $42,500. Tanner-Woods plans to build an entirely new plant in 4 years, so it has no interest in leasing or owning the proposed loom for more than that period. Round your answers to the nearest dollar.

 

Should the loom be leased or purchased?

 

PV cost of owning at 6.6% is $_____

 

PV cost of leasing at 6.6% is $______

 

The salvage value is clearly the most uncertain cash flow in the analysis. Assume that the appropriate salvage value pretax discount rate is 13%. What would be the effect of a salvage value risk adjustment on the decision? Round your answer to the nearest dollar.

 

NPV is $_______

 

4. Financing alternatives

The Howe Computer Company has growth rapidly during the past 5 years. Recently, its commercial bank urged the company to consider increasing its permanent financing. Its bank loan under a line of credit has risen to $160,000, carrying a 8% interest rate, and Howe has been 30 to 60 days late in paying trade creditors.

 

Discussions with an investment banker have resulted in the decision to raise $240,000, at this time. Investment bankers have assured Howe that the following alternatives are feasible (flotation costs will be ignored):

 

Alternative 1: Sell common stock at $10 per share.

Alternative 2: Sell convertible bonds at a 8% coupon, convertible into 80 shares of common stock for each $1000 bond (i.e., the conversion price is $12.50 per share).

Alternative 3: Sell debentures with a 8% coupon; each $1000 bond will have 80 warrants to buy 1 share of common stock at $12.50.

Keith Howe, the president, owns 75% of Howe’s common stock and wants to maintain control of the company; 60,000 shares are outstanding. The following are summaries of Howe’s latest financial statements:

 

Balance sheet

Current liabilities         $220,000

Common stock, $1 par            60,000

Retained earnings       $30,000

Total assets      $310,000         Total liabilities and equity       $310,000

 

Income Statement

Sales                $530,000

All costs except Interest                     487,600

EBIT               $42,400

Interest                        $17,000

EBT                 $25,400

Taxes               $10,160

Net income                  $15,240

 

Shares outstanding                  60,000

Earnings per share                   $0.25

Price/earnings ratio                  17

Market price of stock              $4.32

 

 

Show the new balance sheet under each alternative. For alternative 2 and 3, show the balance sheet after conversion of the debentures or exercise of the warrants. Assume that $160,000, of the funds raised will be used to pay off the bank loan and the rest used to increase total assets. Round your answers to the nearest dollar.

 

Total assets for Alternative 1  $_______

 

Total assets for Alternative 2  $_______

 

Total assets for Alternative 3  $_______

 

 

Show Keith Howe’s control position under of each alternative, assuming that the does not purchase additional shares. Round your answers to the whole number.

 

Original                                               Plan 1              Plan 2              Plan 3

Percent ownership       75%

%_____          %_____           %_____

 

What is the affect on earnings per share of each alternative if it is assumed that earnings before interest and taxes will be 16% of total assets? Round your answers to the nearest cent.

Original                                               Plan 1              Plan 2              Plan 3

Earnings per share       $0.25               $____              $____              $_____

 

That will be the debt ratio under each alternative? Round your answers to the whole number.

 

Original                                   Plan 1  Plan 2              Plan 3

Debt/assets ratio          71%        %____          %____            %_____

Warrants

 

Srorm Software wants to issue $130 million ($1,300 x 100,000 bonds) in new capital to fund new opportunities. If Storm raised the $130 million of new capital in a straight-debt 20-year bond offering, Storm would have to offer an annual coupon rate of 12%. However, Storm’s advisers have suggested a 20-year bond offering with warrants. According to the advisers, Storm could issue 10% annual coupon-bearing debt with 30 warrants per $1,300 face value bond. Storm has 10 million shares of stock outstanding at a current price of $30. The warrants can be exercised in 10 years (on December 31, 2025) at an exercise price of $35. Each warrant entitles its holder to buy one share of Storm Software stock. After issuing the bonds with warrants, Storm’s operations and investments are expected to grow at a constant rate of 11.2% per year.

 

If investors pay $1,300 for each bond, what is the value of each warrant attached to the bond issue? Round your answer to the nearest cent.

 

$____

 

 

What is the component cost of these bonds with warrants? Round your answer to two decimal places.

 

%____

 

What premium is associated with the warrants? Round your answer to two decimal places.

 

%_____

 

 

 

Buy or Lease Problem Walk-Through

> In this video we will learn how to make a buy or lease decision. We are given the value of a machine to be purchased by Morris Meyer Mining Company and the values of the parameters that will effect leasing and owning costs. Leasing is a contractual agreement between the owner of the asset, the lesser, and the user of the asset, the lessee. The lessee makes periodic payments to the lessor for using the asset. In this case Morris is deciding on whether to buy or lease equipment that costs $2.5 million. We will calculate the net present value of owning and net present value of leasing to arrive at the decision. In this case the after tax cost of borrowing rate will be used as the discounting rate. The tax rate is 40 percent; so the after tax rate is 60 percent. We will calculate the after tax borrowing rate by multiplying 15 percent by 60 percent, the after tax rate, and we arrive at 9 percent. Also note that the maintenance expense is excluded from the analysis since Morris Meyer will have to bear the cost whether it buys or leases the machinery. First, let us calculate the cost of owning. Owning an asset will give a tax saving benefit from depreciation tax and will also give a positive cash flow if the machine is sold at salvage value at the end of its use. Now let us calculate the depreciation tax savings for Morris. The MACRS rate of depreciation is given for four years. We calculate the depreciation expense for year one by multiplying the MACRS rate for year one, 33 percent, by the value of the machine, $2,500,000, and the depreciation expense for year one can be calculated as $825,000. To determine the depreciation tax savings we will multiply the depreciation expense for year one, $825,000, by the tax rate of 40 percent. Thus we arrive at the value of depreciation savings for year one as $330,000. Similarly, we can calculate that the depreciation tax savings for year two, year three and year four calculated as $450,000, $150,000 and $70,000. The residual value of the machine is $250,000, and the after tax inflow of cash is $150,000. To calculate the cost of owning we will first calculate the net cash flows and discount the cash flows at the appropriate discount rate. The cost of equipment, $2,500,000, is the initial cash outflow in the year zero. The depreciation tax savings from year one to four and the after tax residual value of the equipment, $150,000, are the cash inflows. Note that the year four cash inflow will be $220,000, which is the sum of depreciation savings at year four and the residual value. Now let us calculate the cost of owning at the after tax discount rate of 9 percent. We will use Excel’s built in NPV function. Note that the NPV function in Excel calculates the present value of cash flows from year one and excludes the cash flow at year zero. So we will enter rate as nine and select all the cash flows from year one to year four and subtract the initial outlay of 2,500,000. Thus we calculate the cost of owning as negative $1,546,811. The negative sign denotes a cash outflow. Now let us calculate the cost of leasing. The leasing expense is $500,000 for four years. We will calculate the after tax leasing expense by multiplying $500,000 by the after tax rate, 60 percent, and arrive at the after tax lease expense for all the four years, $300,000. Using Excel’s built in NPV function we can determine the cost of leasing has $971,916. Note that in case of leasing there is no initial outlay for calculating the cost of leasing. To arrive at the lease or buy decision let us compare the cost of borrowing and leasing. From our calculations we can see that the cost of leasing is less than the cost of owning. The net advantage to leasing can be calculated as $574,895 by subtracting the cost of leasing from the cost of owning. We assume that Morris Meyer does not plan to continue using the equipment; so the after tax salvage value of $250,000 is a cash inflow and the cost of owning analysis. When we analyze the cash flows, it can be noticed that most cash flows are certain in the purchase or lease of equipment. The lease certain cash flow is the terminal cash flow or specifically the cash flow of salvage value. Since the cash flow is under both the lease and the borrow and purchase alternatives are reasonably certain they should be discounted at a relatively low rate. To make a better estimation the terminal cash flow should be discounted at a rate more than 9 percent. The cash flows for borrowing and leasing, except for the residual value cash flow, are relatively certain because they are fixed by contract and thus not very risky. Thus we can conclude that leasing the equipment is a better option for Morris Meyer.

 

Warrant Problem Walk-Through

>> In this video we will see how to calculate the exercise value of warrants and calculate their prices. We will also analyze how changes in different factors can affect warrant prices. In addition to this we will learn how to calculate the coupon rate for bonds issued with warrants. A warrant is a long-term option from a company which gives its holder the right to buy some of the shares of a company’s stock at a specified price. A warrant is valid for a specified length of time and are similar to a call option. Generally warrants are distributed with debt and are used to induce investors to buy long-term debt that carries a lower coupon rate than would otherwise be required. An investor with warrants would exercise the warrants or buy the stock at the exercise price when the market price of the stock is higher than the exercise price. This is when the warrant is said to be in the money. The value of the warrant is zero if the market price of the stock is less than the exercise price, and the warrant is said to be out of the money. In this part we will calculate the exercise value of the warrants assuming different market prices of the stock. Exercise value is calculated as the difference between the current market price of the stock and the strike price. When the current price is $15 and the strike price is $21 we subtract strike price from the current price to get the exercise value of negative $6. In this case the exercise value is minus $6. But the minimum value considered is zero. This is because the value of an asset can never be negative. Here the option is worthless since no rational investor will make transaction when a financial loss is 100 percent certain. Warrants like call options enable someone to have a high degree of personal leverage when buying securities. The huge capital gains potential combined with the loss limitation is clearly worth something. The exact amount it is worth to investors is the amount of the premium. So warrants will sell more than the exercise value to avoid any arbitrage opportunities. In this part we will try to estimate the possible warrant prices and premium though there are no precise answers. Let us first consider the situation when current market price of the stock is $15 and the strike price is $21. We can calculate the exercise value by subtracting strike price from current market price to calculate the exercise value which gives us negative $6. Now, as the warrant is out of the money, the warrant price will be the least. So we can assign a minimum value of $1.50 as warrant price. The warrant premium is calculated by subtracting exercise value from the warrant price, and we arrive at the value of premium as $7.50. Similarly we can calculate the premium for other values of stock price. In this part we will analyze the impact of factors like life of the warrant, expected variability, expected growth rate and a change in dividend policy on the price of a warrant. If the life of the warrant is longer then it increases the probability of an increase in the stock price which leads to better profit when the warrant is exercised. So we can conclude that longer the life of the warrant, higher the warrant value. If the expected variability in the stock’s price decreases then the probability of stock prices increase will also decrease. This reduces the chances of higher profits. So a decrease in the variability of the stock price will result in a decrease in the price of the warrant. EPS growth also affects the price of a warrant. If the EPS growth rate increases the stock price will increase. And the higher stock price will need to better profits if the warrant is exercised so the price of the warrant will increase. If the dividend payout goes from zero to 100 percent payout, it would have two possible effects. First, it might affect the stock price causing a change in the exercise value of the warrant. However, it is not necessary for the stock price to change. Second and more important here is that an increase in the payout ratio would drastically lower the expected growth rate. This reduces the potential future increase in stock’s price increasing. Therefore, the expected value or price of the warrant will decrease. In part D we will calculate the coupon rate of a bond issued with warrants. First we must calculate the straight debt value of the bond or the value of the bond without warrants. We know that the value of the bond with warrants is $1,000. The price of each warrant is $2.50, and 40 warrants are issued with each bond. By substituting values in the formula we know that $1,000 value of the bond equals the sum of straight debt of the bond and the value of warrants. By multiplying the number of warrants with the price of the warrant we calculated the value of warrants as $100. Now, by subtracting the $100 value of warrants from the price of the bond we calculate the straight value of debt in the bond to be $900. By substituting this information in the formula to calculate the future value we can derive the value of PMT or the coupon payment. From this we calculate the coupon payments to be $88.25. From this to calculate the interest rate we will divide the coupon payment by the par value of the bond, $1,000. So we determine the value of the coupon rate to be 8.83 percent.