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Managing Debt for Different Companies

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1. Delaware Steel Company has $100 million of 13 percent debentures outstanding. The indenture (loan covenants) limits additional borrowing such that the total interest coverage (EBIT/interest) is at least three times. Delaware's EBIT last year was $52 million. How much could Delaware borrow under a term loan at 13 percent interest without breaching the indenture restriction?

2. O'Dowell Tool and Machine Company is about to sell a $100 million issue of bonds. The covenants on the loan require that O'Dowell maintain a coverage of its interest plus sinking fund of 2.5 to 1 (remember, a sinking fund payment is the same as a principle payment). The bonds are to be retired over the next 20 years by equal yearly sinking-fund payments and carry an interest rate of 10% per year. What is the lowest level to which O'Dowell's EBIT can drop in the first year the bonds are issued without violating the covenants of the loan? O'Dowell's tax rate is 40%.
Remember, interest is paid in before-tax dollars while sinking fund payments are made in after-tax dollars. Each dollar of interest payment requires just one dollar of EBIT to cover it, but to pay a dollar in sinking-fund payment in after-tax dollars requires $1.67 of EBIT [before-tax dollars]. After paying 40% tax on $1.67, there will be $1.00 left to cover the sinking fund. Thus, to cover one dollar of interest plus one dollar of sinking fund would require $2.67 of EBIT ($1.00 for the interest plus $1.00 times 1.67 for the sinking fund payment); to cover one dollar of interest plus $0.50 of sinking fund payment would require $1.84 of EBIT.

3. Carter Manufacturing Company has outstanding an issue of 9 percent sinking-fund debentures which requires an annual sinking-fund payment of $4 million per year. This requirement may be met either by:
1. presenting to the trustee on or before a specified date each year cash in the amount of $4 million; or else
2. instructing the trustee to enter the financial markets and purchase for Carter's account enough bonds to equal a face value of $4 million, which it will then cancel and retire.
The same number of bonds will be retired in either case. In the first case, the bonds will be acquired and retired at face value. In the second, the bonds to be retired will be purchased from the market at market price.
A. Each bond has a face value of $1000, pays interest once per year, and has five years left to maturity. Presently, the bonds are trading in the market with a yield to maturity of 12.0 percent. What will the market price of the bonds be?

B. Enough bonds must be retired to satisfy the $4,000,000 sinking fund requirement― either by having the trustee acquire the 4,000 bonds to be retired at their $1,000 face value (par value) or else purchase the 4,000 bonds to be retired in the market at market price. Which of the two methods should Carter use to meet the current sinking-fund payment due shortly?

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Part I
Work out and submit problems 1, 2, and 3 below. Be sure to show all of your work.
1. Delaware Steel Company has $100 million of 13 percent debentures outstanding. The indenture (loan covenants) limits additional borrowing such that the total interest coverage (EBIT/interest) is at least three times. Delaware's EBIT last year was $52 million. How much could Delaware borrow under a term loan at 13 percent interest without breaching the indenture restriction?
Interest coverage = EBIT/Interest
With interest coverage of 3, and EBIT of $52 million
Maximum interest amount = 52/3 = 17.3 million
Current interest = 100 X 13 = $13 million
Additional interest that can be paid = 4.3 million
Given the interest rate of 13%
Amount that can be borrowed = 4.3/13% = $33.33 million
2. O'Dowell Tool and Machine Company is about to sell a $100 million issue of bonds. The covenants on the loan require that O'Dowell maintain a coverage of its interest plus sinking fund of 2.5 to 1 (remember, a sinking fund payment is the same as a principle payment). The bonds ...

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The solution explains some questions relating to managing the amount of debt.

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Financial Management Questions- Short answers and Multiple Choice

Short Answer

1. What is the difference between stock price maximization and profit maximization? Under what conditions might profit maximization not lead to stock price maximization?

2. Assume that you are serving on the board of directors of a medium-sized corporation and that you are responsible for establishing the compensation policies of senior management. You believe that the company's CEO is very talented, but your concerns is that she is always looking for a better job and may want to boost the company's short-run performance (perhaps at the expense of long-run profitability) to make herself more marketable to other corporations. What effect would these concerns have on the compensation policy you put in place

3. What is free cash flow? Why is it the most important measure of cash flow?

4. If you were starting a business, what tax considerations might cause you to prefer to set it up as a proprietorship or a partnership rather than as a corporation?

5. How does inflation distort ratio analysis comparisons, both for one company over time (trend analysis) and when different companies are compared? Are only balance sheet items of both balance sheet and income statement items affected?

6. Over the past year, my company has realized an increase in its current ratio and a drop in its total assets turnover ratio. However, the company's sales, quick ratio, and fixed assets turnover ratio have remained constant. What explains these changes?

7. If investors' aversion to risk increased, would the risk premium on a high-beta stock increase more or less than that on a low-beta stock? Explain.

8. If a company's beta were to double, would its expected return double?

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True/False

1. If a firm's managers want to maximize stock price it is in their best interests to operate efficient, low-cost plants, develop new and safe products that consumers want, and maintain good relationships with customers, suppliers, creditors, and the communities in which they operate.

a. True
b. False

2. An agency relationship exists when one or more persons hire another person to perform some service but withhold decision-making authority from that person.

a. True
b. False

3. Financial Managers and accountants perform the same functions in a firm.

a. True
b. False

4. Which of the following statements is true?

a. One of the benefits of incorporating your business is that you become entitled to receive unlimited liability.
b. Sole proprietorships are subject to more regulations than corporations.
c. Sole proprietorships do not have to pay corporate tax.
d. All of the above are correct.
e. None of the answers above is correct.

5. Which of the following actions are likely to reduce the agency problem between stockholders and managers?

a. Congress passes a law that severely restricts hostile takeovers.
b. A manager receives a lower salary but receives additional shares of the company's stock.
c. The board of directors has become more vigilant in its oversight of the company's management.
d. Statements b and c are correct.
e. All of the statements above are correct.

6. The annual report contains four basic financial statements: the income statement; balance sheet; statement of cash flows; and statement of retained earnings.

a. True
b. False

7. Taxes, payment patterns, and reporting considerations, as well as credit sales and non-cash costs, are reasons why operating cash flows can differ from accounting profits.

a. True
b. False

8. Net operating working capital is equal to the operating current assets minus the operating current liabilities.

a. True
b. False

9. Which of the following statements is most correct?

a. Indexing tax brackets reduces the extent of "bracket creep."
b. Bonds issued by a municipality such as the city of Miami would carry a lower interest rate than bonds with the same risk and maturity issued by a private corporation such as Florida Power & Light.
c. Our federal tax laws tend to encourage corporations to finance with debt rather than with equity securities.
d. Our federal tax laws encourage the managers of corporations with surplus cash to invest it in stocks rather than in bonds. However, other factors may offset tax considerations.
e. All of the statements above are true.

10. Which of the following best describes free cash flow?

a. Free cash flow is the amount of cash flow available for distribution to all investors after all necessary investments in operating capital have been made.
b. Free cash flow is the amount of cash flow available for distribution to shareholders after all necessary investments in operating capital have been made.
c. Free cash flow is the net change in the cash account on the balance sheet.
d. Free cash flow is equal to net income plus depreciation.
e. Free cash flow is equal to the cash flow from non-taxable transactions.

11. The current ratio and inventory turnover ratio measure the liquidity of a firm. The current ratio measures the relationship of a firm's current assets to its current liabilities and the inventory turnover ratio measures how rapidly a firm turns its inventory back into a "quick" asset or cash.

a. True
b. False

12. The degree to which the managers of a firm attempt to magnify the returns to owners' capital through the use of financial leverage is captured in debt management ratios.

a. True
b. False

13. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operations.

a. True
b. False

14. Determining whether a firm's financial position is improving or deteriorating requires analysis of more than one set of financial statements. Trend analysis is one method of measuring a firm's performance over time.

a. True
b. False

15. Which of the following statements is most correct about Economic Value Added (EVA)?

a. If a company has no debt, its EVA equals its net income.
b. If a company has positive ROE, its EVA must also be positive.
c. A company's EVA will be positive whenever the cost of equity exceeds the ROE.
d. All of the statements above are correct.
e. None of the statements above is correct.

16. Which of the following alternatives could potentially result in a net increase in a company's free cash flow for the current year?

a. Reducing the days-sales-outstanding ratio.
b. Increasing the number of years over which fixed assets are depreciated.
c. Decreasing the accounts payable balance.
d. All of the answers above are correct.
e. Answers a and b are correct.

17. Which of the following statements is most correct?

a. Many large firms operate different divisions in different industries, and this makes it hard to develop a meaningful set of industry benchmarks for these types of firms.
b. Financial ratios should be interpreted with caution because there exist seasonal and accounting differences that can reduce their comparability.
c. Financial ratios should be interpreted with caution because it may be difficult to say with certainty what is a "good" value. For example, in the case of the current ratio, a "good" value is neither high nor low.
d. Ratio analysis facilitates comparisons by standardizing numbers.
e. All of the statements above are correct.

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a. True
b. False

19. The tighter the probability distribution of expected future returns, the smaller the risk of a given investment as measured by the standard deviation.

a. True
b. False

20. If investors become more averse to risk, the slope of the Security Market Line (SML) will increase.

a. True
b. False

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