# Bonds, Returns, Growth, Dividends and Percentage of Sales

Question One: Bond Returns. You buy an 8 percent coupon, 20-year maturity bond when its yield to maturity is 9 percent. A year later, the yield to maturity is 10 percent. What is your rate of return over the year?

Question Two: Rate of Return. A bond that pays coupons annually is issued with a coupon rate of 4 percent, maturity of 30 years, and a yield to maturity of 7 percent. What rate of return will be earned by an investor who purchases the bond and holds it for 1 year if the bond's yield to maturity at the end of the year is 8 percent?

Question Three: Constant-Growth Model. Eastern Electric currently pays a dividend of about $1.64 per share and sells for $27 a share.

a. If investors believe the growth rate of dividends is 3 percent per year, what rate of return do they expect to earn on the stock?

b. If investors' required rate of return is 10 percent, what must be the growth rate they expect of the firm?

c. If the sustainable growth rate is 5 percent, and the plowback ratio is .4, what must be the rate of return earned by the firm on its new investments?

Question Four: Dividends and Taxes. Investors require an after-tax rate of return of 10 percent on their stock investments. Assume that the tax rate on dividends is 30 percent while capital gains escape taxation.

A firm will pay a $2 per share dividend 1 year from now, after which it is expected to sell at a price of $20.

a. Find the current price of the stock.

b. Find the expected before-tax rate of return for a 1-year holding period.

c. Now suppose that the dividend will be $3 per share. If the expected after-tax rate of return

is still 10 percent, and investors still expect the stock to sell at $20 in 1 year, at what price

must the stock now sell?

d. What is the before-tax rate of return? Why is it now higher than in part (b)?

Question Five: Dividends and Repurchases. While dividend yields in the United States in the late 1990s were at historically low levels, share repurchases were at historical highs. Was this a coincidence?

Question Six: Sustainable Growth. Plank's Plants had net income of $2,000 on sales of $50,000 last year. The firm paid a dividend of $500. Total assets were $100,000, of which $40,000 was financed by debt.

a. What is the firm's sustainable growth rate?

b. If the firm grows at its sustainable growth rate, how much debt will be issued next year?

c. What would be the maximum possible growth rate if the firm did not issue any debt next year?

Question Seven: Using Percentage of Sales. The 2003 financial statements for Growth Industries are presented below. Sales and costs in 2004 are projected to be 20 percent higher than in 2003. Both current assets and accounts payable are projected to rise in proportion to sales. The firm is currently operating at full capacity, so it plans to increase fixed assets in proportion to sales. What external financing will be required by the firm? Interest expense in 2004 will equal 10 percent of long-term debt outstanding at the start of the year. The firm will maintain a dividend payout ratio of .40. - see attached.

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#### Solution Summary

Answers questions on Bonds, Returns, Growth, Dividends and Percentage of Sales.

30 Problems: After tax returns, constant growth stock, NPV, cash budget, payback, WACC

1

EQ 2. (TCO D) After-tax returns

West Corporation has $50,000, which it plans to invest in marketable securities. The corporation is choosing between the following three equally risky securities: Alachua County tax-free municipal bonds yielding 6 percent; Exxon bonds yielding 9.5 percent; GM preferred stock with a dividend yield of 9 percent. West's corporate tax rate is 35 percent. What is the after-tax return on the best investment alternative? (Assume the company chooses on the basis of after-tax returns.)

2

EQ 2. (TCO D) After-tax returns

The XYZ Corporation has $1000,000 which it plans to invest in marketable securities. The corporation is choosing between the following three equally risky securities: Greenville County tax-free municipal bonds yielding 7 percent; AB corp. bonds yielding 11.5 percent; XZ corp. preferred stock with a dividend yield of 10 percent. XYZ's corporate tax rate is 35 percent. What is the after-tax return on the best investment alternative? (Assume the company chooses on the basis of after-tax returns.)

3

EQ 4. (TCO E) Constant growth stock

The last dividend paid by ABC Company was $2.00. ABC's growth rate is expected to be a constant 4 percent. ABC's required rate of return on equity (ks) is 9 percent. What is the current price of ABCs common stock?

4

EQ 4. (TCO E) Constant growth stock

The last dividend paid by XYZ Company was $1.00. XYZs growth rate is expected to be a constant 5 percent. XYZ's required rate of return on equity (ks) is 10 percent. What is the current price of XYZ's common stock?

5

EQ 4. (TCO E) Constant growth stock

The last dividend paid by Klein Company was $1.00. Klein's growth rate is expected to be a constant 4 percent. Klein's required rate of return on equity (ks) is 12 percent. What is the current price of Klein's common stock?

6

EQ 5. (TCO B, F) NPV

As the director of capital budgeting for Bingo Corporation, you are evaluating two mutually exclusive projects with the following net cash flows:

A B

-$150,000 -$225,000

1 $55,000 $85,000

2 $70,000 $55,000

3 $70,000 $65,000

4 $75,000 $55,000

5 $80,000 $65,000

If Bingo Corporation's cost of capital is 10 percent, defend which project would you choose.

7

EQ 5. (TCO B, F) NPV

As the director of capital budgeting for ABC Corporation, you are evaluating two mutually exclusive projects with the following net cash flows:

A B

-$200,000 -$125,000

1 $65,000 $60,000

2 $60,000 $40,000

3 $50,000 $40,000

4 $65,000 $35,000

5 $50,000 $45,000

8

EQ 5. (TCO B, F) NPV

As the director of capital budgeting for Denver Corporation, you are evaluating two mutually exclusive projects with the following net cash flows:

A B

-$100,000 -$125,000

1 $25,000 $25,000

2 $30,000 $35,000

3 $30,000 $35,000

4 $25,000 $35,000

5 $30,000 $45,000

If Denver's cost of capital is 15 percent, defend which project would you choose.

9

EQ 6. (TCO G) Cash budget

XYZ Corporation's budgeted monthly sales are $4,500. Forty percent of its customers pay in the first month and take the 1 percent discount. The remaining 60 percent pay in the month following the sale and do not receive a discount. XYZ's bad debts are very small and are excluded from this analysis. Purchases for next month's sales are constant each month at $1,200. Other payments for wages, rent, and taxes are constant at $800 per month. Construct a single month's cash budget with the information given. What is the average cash gain or (loss) during a typical month for XYZ Corporation?

10

EQ 6. (TCO G) Cash budget

ABC Corporation's budgeted monthly sales are $4,000. Forty percent of its customers pay in the first month and take the 3 percent discount. The remaining 60 percent pay in the month following the sale and do not receive a discount. ABC's bad debts are very small and are excluded from this analysis. Purchases for next month's sales are constant each month at $2,000. Other payments for wages, rent, and taxes are constant at $500 per month. Construct a single month's cash budget with the information given. What is the average cash gain or (loss) during a typical month for ABC Corporation?

11

EQ 9. (TCO D)

Which of the following Treasury bonds will have the largest amount of interest rate risk (price risk) and why?

A. A 7% coupon bond which matures in 12 years.

B. A 9% coupon bond which matures in 10 years.

C. A 12% coupon bond which matures in 7 years.

D. A 7% coupon bond which matures in 9 years.

E. A 10% coupon bond which matures in 10 years.

12

EQ 9. (TCO D)

All treasury securities have a yield to maturity of 7%-- so the yield curve is flat. If the yield to maturity on all Treasuries were to decline to 6%, which of the following bonds would have the largest percentage increase in price and why?

A. 15 year zero coupon Treasury bond.

B. 12 year Treasury bond with a 10% annual coupon.

C. 15 year Treasury bond with a 12 percent annual coupon.

D. 2 year zero coupon Treasury bond.

E. 2 year Treasury bond with a 15% annual coupon.

13

EQ 9. (TCO D)

Which of the following statements is most correct and why?

A. If a bond sells for less than par, and then its yield to maturity is less than its coupon rate.

B. If a bond sells at par, and then its current yield will be less than its yield to maturity.

C. Assuming that both bonds are held to maturity and are of equal risk, a bond selling for more than par with ten years to maturity will have a lower current yield and higher capital gain relative to a bond that sells at par.

D. Answers A and C are correct.

E. None of the answers above is correct.

14

EQ 10. (TCO C) Payback period

The ABC Corporation is considering a project which has an up-front cost paid today at t = 0. The project will generate positive cash flows of $70,000 a year at the end of each of the next five years. The project's NPV is $90,000 and the company's WACC is 12 percent. What is the project's simple, regular payback?

15

EQ 10. (TCO C) Payback period

The Bingo Corporation is considering a project which has an up-front cost paid today at t = 0. The project will generate positive cash flows of $85,000 a year at the end of each of the next five years. The project's NPV is $100,000 and the company's WACC is 10 percent. What is the project's simple, regular payback?

16

EQ 10. (TCO C) Payback period

Haig Aircraft is considering a project which has an up-front cost paid today at t = 0. The project will generate positive cash flows of $60,000 a year at the end of each of the next five years. The project's NPV is $75,000 and the company's WACC is 10 percent. What is the project's simple, regular payback?

17

EQ 11. (TCO H) WACC

A company has determined that its optimal capital structure consists of 30 percent debt and 70 percent equity. Given the following information, calculate the firm's weighted average cost of capital.

Rd = 6%

Tax rate = 35%

P0 = $35

Growth = 0%

D0 = $3.00

18

EQ 11. (TCO H) WACC

A company has determined that its optimal capital structure consists of 50 percent debt and 50 percent equity. Given the following information, calculate the firm's weighted average cost of capital.

Rd = 7%

Tax rate = 40%

P0 = $30

Growth = 0%

D0 = $2.50

19

EQ 11. (TCO H) WACC

A company has determined that its optimal capital structure consists of 40 percent debt and 60 percent equity. Given the following information, calculate the firm's weighted average cost of capital.

rd= 6%

Tax rate = 40%

P0 = $25

Growth = 0%

D0 = $2.00

20

(12.3) Sunk costs

Which of the following statements is CORRECT?

a. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

b. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.

c. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.

d. Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the PV.

e. A good example of a sunk cost is a situation where a retailer opens a new store, and that leads to a decline in sales of some of the firm's existing stores.

21

(12.3) Externalities

Which of the following statements is CORRECT?

a. An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline.

c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.

d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.

e. The identification of an externality can never lead to an increase in the calculated NPV.

22

(Comp: 12.1-12.4) Ann. op. CFs, depr'n and int. given

As a member of Midwest Corporation's financial staff, you must estimate the Year 1 operating cash flow for a proposed project with the following data. What is the Year 1 operating cash flow?

Sales revenues, each year $35,000

Depreciation $10,000

Other operating costs $17,000

Interest expense $4,000

Tax rate 35.0%

a. $12,380

b. $13,032

c. $13,718

d. $14,440

e. $15,200

23

(Comp: 12.1-12.4) Ann. op. CFs, depr'n and int. given

You work for the Sing Oil Company, which is considering a new project whose data are shown below. What is the project's operating cash flow for Year 1?

Sales revenues, each year $55,000

Depreciation $8,000

Other operating costs $25,000

Interest expense $8,000

Tax rate 35.0%

a. $21,185

b. $22,300

c. $23,415

d. $24,586

e. $25,815

24

(Comp: 12.1-12.4) NPV, SL, constant CFs, cannibalization

TexMex Products is considering a new salsa whose data are shown below. The equipment that would be used would be depreciated by the straight-line method over its 3-year life, would have zero salvage value, and no new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other TexMex products and would reduce their pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.)

WACC 10.0%

Pre-tax cash flow reduction in other products (cannibalization) $5,000

Investment cost (depr'ble basis) $65,000

Straight-line depr'n rate 33.333%

Sales revenues, each year $75,000

Annual operating costs, ex. depr'n $25,000

Tax rate 35.0%

a. $25,269

b. $26,599

c. $27,929

d. $29,325

e. $30,792

25

(14.3) Additional funds needed

Jefferson City Computers has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)?

a. A sharp increase in its forecasted sales.

b. A sharp reduction in its forecasted sales.

c. The company reduces its dividend payout ratio.

d. The company switches its materials purchases to a supplier that sells on terms of 1/5,

net 90, from a supplier whose terms are 3/15, net 35.

e. The company discovers that it has excess capacity in its fixed assets.

26 (14.3) Additional funds needed

Which of the following statements is CORRECT?

a. Since accounts payable and accrued liabilities must eventually be paid off, as these

accounts increase, AFN as calculated by the AFN equation must also increase.

b. Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess current assets. Based on the AFN equation, its AFN will be larger than if it had been operating with excess capacity in both fixed and current assets.

c. If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth.

d. Additional funds needed (AFN) are typically raised using a combination of notes payable,

Long-term debt and common stock. Such funds are non-spontaneous in the sense that they

require explicit financing decisions to obtain them.

e. If a firm has a positive free cash flow, then it must have either a zero or a negative AFN.

27

(14.3) Additional funds needed--positive AFN

Clayton Industries is planning its operations for next year, and Ronnie Clayton, the CEO, wants you to forecast the firm's additional funds needed (AFN). Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year? Dollars are in millions.

Last year's sales = S0 $350 Last year's accounts payable $40

Sales growth rate = g 30% Last year's notes payable (to bank) $50

Last year's total assets = A0 $500 Last year's accruals $30

Last year's profit margin = M 5% Target payout ratio 60%

a. $102.8

b. $108.2

c. $113.9

d. $119.9

e. $125.9

28

(14.5) Finding the target fixed assets/sales ratio

Last year Emery Industries had $450 million of sales and $225 million of fixed assets, so its FA/Sales ratio was 50%. However, its fixed assets were used at only 65% of capacity. If the company had been able to sell off enough of its fixed assets at book value so that it was operating at full capacity, with sales held constant at $450 million, how much cash (in millions) would it have generated?

a. $74.81

b. $78.75

c. $82.69

d. $86.82

e. $91.16

29

(14.5) Forecasting financial requirements

Which of the following statements is CORRECT?

a. When we use the AFN formula, we assume that the ratios of assets and liabilities to

sales (A*/S0 and L*/S0) vary from year to year in a stable, predictable manner.

b. When fixed assets are added in large, discrete units as a company grows, the

c. assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow.

c. Firms whose fixed assets are 'lumpy' frequently have excess capacity, and this should be accounted for in the financial forecasting process.

d. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets.

e. A graph showing the relationship between assets and sales is always linear if economies of scale exist.

30

(14.3) AFN formula method

Which of the following statements is CORRECT?

a. Inherent in the basic, unmodified AFN formula are these two assumptions: (1) each asset item must grow at the same rate as sales, and (2) spontaneous liability accounts must also grow at the same rate as sales.

b. If a firm's assets are growing at a positive rate, but its retained earnings are not increasing, then it would be impossible for the firm's AFN to be negative.

c. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually decrease, then the firm's actual AFN must, mathematically, exceed the previously calculated AFN.

d. Higher sales usually require higher asset levels, and this leads to what we call AFN. However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to have a zero dividend payout ratio.

e. Dividend policy does not affect the requirement for external funds based on the AFN formula method.