# Optimal capital structure, yield to maturity, bonds, market

311. A taxpaying, levered firm's optimal capital structure:

is 100 percent equity financing.

consists of equal amounts of debt and equity financing.

is the mixture of debt and equity financing that minimizes the firm's aftertax cost of debt.

is the mixture of debt and equity financing that minimizes the weighted average cost of capital.

is 100 percent debt financing.

312. SmithKline Company's bonds are currently selling for $1,157.75 per $1000 par-value bond. The bonds have a 10 percent coupon rate and will mature in 10 years. What is the approximate yield to maturity?

6.96%

7.69%

11.0%

12.1%

313. Which of the following is true regarding bonds?

Most bonds do not carry default risk.

Municipal bonds are free of default risk.

Bonds are not sensitive to changes in the interest rates.

Moody's and Standard and Poor's provide information regarding a bondâ's interest rate risk.

None of the above is true

314. Two years ago, Maple Enterprises issued six percent, 20-year bonds and Temple Corp issued six percent, 10-year bonds. Since their time of issue, interest rates have increased. Which of the following statements is true of each firm's bond prices in the market, assuming they have equal risk?

Maple's decreased more than Temple's

Temple's decreased more than Maple's

Maple's increased more than Temple's

They are both priced the same

315. A call provision in a bond agreement grants the issuer the right to:

repurchase the bonds prior to maturity at a pre-specified price.

replace the bonds with equity securities.

repurchase the bonds after maturity at a pre-specified price.

change the coupon rate, provided the bondholders are notified in advance.

buy back the bonds on the open market prior to maturity.

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#### Solution Preview

311. A taxpaying, levered firm's optimal capital structure:

is the mixture of debt and equity financing that minimizes the weighted average cost of capital.

312. SmithKline Company's bonds are currently selling for $1,157.75 per $1000 par-value bond. The bonds have a ...

#### Solution Summary

Response discusses Optimal capital structure, yield to maturity, bonds, market risk

Required Interest Rates, Bonds and Yield to Maturity

1.

Assume Venture Healthcare sold bonds that have a 10-year maturity, a 12 percent coupon rate with annual payments, and a $1,000 par value.

a. Suppose that two years after the bonds were issued, the required interest rate fell to 7 percent. What would be the bonds' value?

b. Suppose that two years after the bonds were issued, the required interest rate rose to 13 percent. What would be the bonds' value?

c. What would be the value of the bonds three years after issue in each scenario above, assuming that interest rates stayed steady at either 7 percent or 13 percent?

2.

Twin Oaks Health Center has a bond issue outstanding with a coupon rate of 7 percent and four remaining until maturity. The par value of the bond is $1,000, and the bond pays interest annually.

a. Determine the current value of the bond if present market conditions justify a 14 percent required rate of return.

b. Now, suppose Twin Oaks' four-year bond had semiannual coupon payments. What would be its current value? (Assume a 7 percent semiannual required rate of return. However, the actual rate would be slightly less than 7 percent because a semiannual coupon bond is slightly less risky than an annual coupon bond.)

c. Assume that Twin Oaks' bond had a semiannual coupon but 20 years remaining to maturity. What is the current value under these conditions? (Again, assume a 7 percent semiannual required rate of return, although the actual rate would probably be greater than 7 percent because of increased price risk.

3.

Minneapolis Health System has bonds outstanding that have four years remaining to maturity, a coupon interest rate of 9 percent paid annually, and a $1,000 par value.

a. What is the yield to maturity on the issue if the current market price is $829?

b. If the current market price is $1,104?

c. Would you be willing to buy one of these bonds for $829 if you required a 12 percent rate of return on the issue? Explain your answer.

4.

A person is considering buying the stock of two home health companies that are similar in all respects except the proportion of earnings paid out as dividends. Both companies are expected to earn $6 per share in the coming year, but Company D (for dividends) is expected to pay out the entire amount as dividends, while Company G (for growth) is expected to pay out only one-third of its earnings, or $2 per share. The companies are equally risky, and their required rate of return is 15 percent. D's constant growth rate is zero and G's is 8.33 percent. What are the intrinsic values of stocks D and G?

5.

Medical Corporation of America (MCA) has a current stock price of $36 and its last dividend (D0) was $2.40. In view of MCA's strong financial position, its required rate of return is 12 percent. If MCA's dividends are expected to grow at a constant rate in the future, what is the firm's expected stock price in five years?

6.

A broker offers to sell you shares of Bay Area Healthcare, which just paid a dividend of $2 per share. The dividend is expected to grow at a constant rate of 5 percent per year. The stock's required rate of return is 12 percent.

a. What is the expected dollar dividend over the next three years?

b. What is the current value of the stock and the expected stock price at the end of each of the next three years?

c. What is the expected dividend yield and capital gains yield for each of the next three years?

d. What is the expected total return for each of the next three years?

e. How does the expected total return compare with the required rate of return on the stock? Does this make sense? Explain your answer.

7.

Seattle Health Plans currently uses zero-debt financing. Its operating income (EBIT) is 1 million, and it pays taxes at a 40 percent rate. It has $5 million in assets and, because it is all equity financed, $5 million in equity. Suppose the firm is considering replacing half of its equity financing with debt financing bearing an interest rate of 8 percent.

a. What impact would the new capital structure have on the firm's net income, total dollar return to investors, and ROE?

b. Redo the analysis, but now assume that the debt financing would cost 15 percent.

c. Return to the initial 8 percent interest rate. Now, assume that EBIT could be as low as $500,000 (with a probability of 20 percent) or as high as $1.5 million (with a probability of 20 percent). There remains a 60 percent chance that EBIT would be $1 million. Redo the analysis for each level of EBIT, and find the expected values for the firm's income, total dollar return to investors, ROE. What lesson about capital structure and risk does this illustration provide?

d. Repeat the analysis required for Part a, but now assume that Seattle Health Plans is a not-for-profit corporation and pays no taxes. Compare the results with those obtained in Part a

8.

Calculate the after-tax cost of debt for the Wallace clinic, a for-profit healthcare provider, assuming that the coupon rate set on its debt is 11 percent and its tax rate is

a. 0 percent

b. 20 percent

c. 40 percent

9.

St. Vincent's Hospital has a target capital structure of 35 percent debt and 65 percent equity. Its cost of equity (fund capital) estimate is 13.5 percent and its cost of tax-exempt debt estimate is 7 percent. What is the hospital's corporate cost of capital?

10.

Richmond Clinic has obtained the following estimates for its costs of debt and equity at various capital structures:

Percent Debt After-Tax Cost of Debt Cost of Equity

0% _ 16%

20 6.6% 17

40 7.8 19

60 10.2 22

80 14. 0 27

What is the firm's optimal capital structure? (Hint: Calculate its corporate cost of capital at each structure. Also, note that data on component costs at alternative capital structures are not reliable in real-world situations.)