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Lease or buy / conversion price

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JLB Corporation is attempting to determing whether to lease or purchase research equipment. The firm is in the 40% tax
bracket, and its after-tax cost of debt is currently 8%. The terms of the lease and of the purchase are as follows:

Lease- Annual end-of-year lease payments of $25,200 are required over the 3-year life of the lease. All maintenance costs
will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase
the asset for $5,000 at termination of the lease.

Purchase- The research equipment costing $60,000, can be finance entirely with a 14% loan requiring annual end-of-year
payments of $25,844 for 3 years. The firm in this case will depreciate the equipment under the MACRS using the 3 year
recovery period. The firm will pay $1,800 per year for a service contract that covers all maintenance costs;insurance
and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 3-year recovery period.

A. Calculate the after-tax cash outflows associated with each alternative

B. Caluclate the present value of each cash outflow stream, using the after-tax cost of debt.

C. Which alternative-lease or purchase- would you recommend? Why?
Calculate the conversion price for each of the following convertible bonds:

A. A $1,000-par-value bond that is convertible into 20 shares of common stock.

B. A $500-par-value bond that is convertible into 25 shares of common stock

C. A $1,000 par-value bond that is convertible into 50 shares of common stock.

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Solution Summary

The solution explains two questions - lease vs buy analysis and calculating the conversion price of bonds

See Also This Related BrainMass Solution

Multiple Choice Questions: listing on a stock exchange, issuing securities, book value per share, after-tax cost of debt, Operating leases, financial lease, off-balance sheet lease financing, lease vs buy, conversion value of the bond, conversion price, before-tax yields, net advantage to leasing

1. Which of the following statements about listing on a stock exchange is most correct?

a. Listing is a decision of more significance to a firm than going public.
b. Any firm can be listed on the NYSE as long as it pays the listing fee.
c. Listing provides a company with some "free" advertising, and status as a listed company may enhance the firm's prestige.
d. Listing reduces the reporting requirements for firms, because listed firms file reports with the exchange rather than with the SEC.
e. Statements b and c are both correct.

2. Which of the following statements is most correct?

a. Flotation costs under a best-efforts arrangement are typically less for a given new equity issue than the costs associated with an underwritten offering, and the corporation is more certain of getting the needed funds under a best-efforts offering. This is why best efforts deals are most common.
b. If a firm decides to issue securities through a direct (or private) placement, then the underwriting syndicate that is formed to distribute the securities to the public may, at its discretion, decide either to guarantee or not to guarantee the sale of the securities.
c. If the demand curve for a firm's stock is relatively flat, the firm will have a more difficult time raising a large amount of new equity funds for expansion than would be true if this demand curve were steeper.
d. It is possible for a firm to go public, and yet not raise any additional capital.

3. Mesmer Analytic, a biotechnology firm, floated an initial public offering of 2,000,000 shares at a price of $5.00 per share. The firm's owner/managers held 60 percent of the company's $1.00 par value authorized and issued stock following the public offering. One month after the IPO, the firm's board of directors declared a one-time dividend of $0.50 per share payable to all stockholders, meaning that the owner/managers would receive an immediate dividend, in part out of the pockets of the new public stockholders. What was the book value per share of the firm before and after the special dividend was paid?

a. $2.60; $2.10
b. $2.60; $2.60
c. $2.60; $2.30
d. $1.60; $1.10
e. $1.60; $1.00

4. S. Claus & Company is planning a zero coupon bond issue. The bond has a par value of $1,000, matures in 2 years, and will be sold at a price of $826.45. The firm's marginal tax rate is 40 percent. What is the annual after-tax cost of debt to the company on this issue?

a. 4.0%
b. 6.0%
c. 8.0%
d. 10.0%
e. 12.0%

5. Operating leases usually have terms that include

a. Maintenance of the equipment.
b. Only partial amortization.
c. Cancellation clauses.
d. All of the above.
e. Only answers a and c above.

6. Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit report, financial (or capital) leases must be included in the balance sheet by reporting the

a. Value of the leased asset as a fixed asset.
b. Present value of future lease pay¬ments as an asset.
c. Present value of future lease pay¬ments as a liability.
d. Both a and b above.
e. Both a and c above.

7. Which of the following statements is most correct?

a. Firms which use "off balance sheet" financing, such as leasing, will show lower debt ratios once the effects of their leases are reflected in their financial statements.
b. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation.
c. The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan.
d. Capital, or financial, leases generally provide for maintenance service on the part of the lessor and can be refinanced at the discretion of the lessee.
e. A key difference between a capital lease and an operating lease is that with a capital lease, the total lease payments on the asset are roughly equal to the full price of the asset plus a return on the investment in the asset.

8. Heavy use of off-balance sheet lease financing will tend to

a. Make a company appear more risky than it actually is because its stated debt ratio will appear higher.
b. Make a company appear less risky than it actually is because its stated debt ratio will appear lower.
c. Affect a company's cash flows but not its degree of risk.
d. Have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.

9. The lease analysis should compare the cost of leasing to the

a. Cost of owning using debt.
b. Cost of owning using equity.
c. After-tax cost of debt to measure the effect of leasing on the cost of equity.
d. Average cost of all fixed charges.
e. Cost of owning using the weighted average cost of capital for the firm.

10. Stanley Corporation is considering a five-year, $6,000,000 bank loan to finance service equipment. The loan has an interest rate of 10 percent and is amortized over five years with end-of-year payments. Stanley can also lease the equipment for an end-of-year payment of $1,790,000. What is the difference in the actual out-of-pocket cash flows between the two payments, that is, by how much (in thousands of dollars) does one payment exceed the other?

a. $ 90.0
b. $125.5
c. $207.2
d. $251.0
e. $316.8

11. Reading Railroad's common stock is currently priced at $30, and its 8 percent convertible debentures (issued at par, or $1,000) are priced at $850. Each debenture can be converted into 25 shares of common stock at any time before 2005. What is the conversion price, CP, and the conversion value of the bond?

a. $25.00; $1,000
b. $25.00; $ 750
c. $40.00; $ 750
d. $40.00; $ 850
e. $40.00; $1,000

12. B&O Railroad's convertible debentures were issued at their $1,000 par value in 1993. At any time prior to maturity on February 1, 2013, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc?

a. $ 25
b. $1,000
c. $ 40
d. $1,025
e. $ 50

13. Deep River Power Corporation recently sold an issue of preferred stock that had an after-tax yield of 9.6 percent. The company's new bonds recently sold at par with an after-tax yield of 8.1 percent. Both issues were placed primarily with corporate investors in the 40 percent tax bracket. Given that the preferred stock enjoys a 70 percent dividend tax exclusion for corporate investors, what was the percentage point difference in the before-tax yields between the two issues?

a. 1.50%
b. 1.20%
c. 2.59%
d. 2.81%
e. 0.21%

14. Redstone Corporation is considering a leasing arrangement to finance some special manufacturing tools that it needs for production during the next three years. A planned change in the firm's production technology will make the tools obsolete after 3 years. The firm will depreciate the cost of the tools on a straight-line basis. The firm can borrow $4,800,000, the purchase price, at 10 percent on a simple interest loan to buy the tools, or it can make three equal end-of-year lease payments of $2,100,000. The firm's tax rate is 40 percent. Annual maintenance costs associated with ownership are estimated at $240,000. What is the net advantage to leasing (NAL)?

a. $ 0
b. $106,200
c. $362,800
d. $433,100
e. $647,900

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