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    Capital Structure and Comparing Borrowing Costs

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    1. (Capital Structure) Sanderson Manufacturing Company would like to achieve a capital structure consistent with a Baa2/BBB senior debt rating. Sanderson has identified six comparable firms and calculated the credit statistics shown here.

    a. Sanderson's return on assets is 5.3%. It has a total capitalization of $600 million. What are reasonable targets for long-term debt/cap, funds from operations/LT debt, and fixed charge coverage?

    b. Are there any firms among the six who are particularly good or bad comparables? Explain.

    c. Suppose Sanderson's current ratio of long-term debt to total cap is 60% but its fixed charge coverage is 3.00. What would you recommend?

    FIRM A B C D E F
    Senior debt rating Baa2/BBB Baa3/BBB- Baa2/BBB Baa1/A- Baa1/BBB- Baa2/BBB+
    Return on assets 5.20% 5.00% 5.40% 5.70% 5.20% 5.30%
    Long-term debt/cap 38% 41% 45% 40% 25% 43%
    Total cap ($MM) 425 575 525 650 210 375
    Funds from
    operations/LT debt 39% 43% 28% 46% 57% 43%
    Fixed charge cov 2.57 2.83 2.75 2.38 3.59 2.15

    2. (Dividend adjustment model) Regional Software has made a bundle selling spreadsheet software and has begun paying cash dividends. The firm's chief financial officer would like the firm to distribute 25% of its annual earnings (POR = 0.25) and adjust the dividend rate to changes in earnings per share at the rate ADJ = 0.75. Regional paid $1.00 per share in dividends last year. It will earn at least $8.00 per share this year and each year in the foreseeable future. Use the dividend adjustment model, Equation (18.1), to calculate projected dividends per share for this year and the next four.

    3. (Dividend Policy) A firm has 20 million common shares outstanding. It currently pays out $1.50 per share per year in cash dividends on its common stock. Historically, its payout ratio has ranged from 30% to 35%. Over the next five years it expects the earnings and discretionary cash flow shown below in millions.

    a. Over the five-year period, what is the maximum overall payout ratio the firm could achieve without triggering a securities issue?

    b. Recommend a reasonable dividend policy for paying out discretionary cash flow in years 1 through 5.

    1 2 3 4 5 THEREAFTER
    Earnings 100 125 150 120 140 150+ per year
    Discretionary cash flow 50 70 60 20 15 50+ per year

    4. (Comparing Borrowing Costs) Stephens Security has two financing alternatives: (1) A publicly placed $50 million bond issue. Issuance costs are $1 million, the bond has a 9% coupon paid semiannually, and the bond has a 20-year life. (2) A $50 million private placement with a large pension fund. Issuance costs are $500,000, the bond has a 9.25% annual
    coupon, and the bond has a 20-year life. Which alternative has the lower cost (annual percentage yield)?

    5. (Leasing, taxes, and the time value of money) The lessor can claim the tax deductions associated with asset ownership and realize the leased asset's residual value. In return, the lessor must pay tax on the rental income.

    a. Explain why a financial lease represents a secured loan in which the lender's entire debt service stream is taxable as ordinary income to the lessor/lender.

    b. In view of this tax cost, what tax condition must hold in order for a financial lease transaction to generate positive net-present-value tax benefits for both the lessor and lessee?

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    Solution Preview

    1. a. Long-term Debt / Cap = 40% - 45%
    Cash Flow / LT Debt = 30% - 40%
    Fixed-Charge = 2.5 - 2.75
    Firms B and E should not be used in determining the range because their credit ratings are pretty low compared to the others
    b. The best firms for us to use to compare are A, C, and F because of excellent their credit ratings and ROA are close to what Sanderson's has. Firms B and D are not excellent examples because of their low credit rating compared to what Sanderson's had. E is out of question due to its size.
    c. Even though Sanderson has a strong ...