tb chapter20
TRANSCRIPT
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(Difficulty: E = Easy, M = Medium, and T = Tough)
Multiple Choice: Conceptual
Easy:
Lease cash flows Answer: c Diff: E
1. The riskiness of the cash flows to the lessee, with the possible exception
of residual value, is about the same as the riskiness of the lessee’s
a. Equity cash flows.
b. Capital budetin pro!ect cash flows.
c. "ebt cash flows.
d. #ension fund cash flows.
e. $one of the statements above is correct.
Operating lease Answer: e Diff: E
%. &peratin leases usually have terms that include
a. 'aintenance of the equipment.
b. &nly partial amorti(ation.
c. Cancellation clauses.
d. )tatements a and c are correct.
e. *ll of the statements above are correct.
Leasing Answer: c Diff: E N
+
. hich of the followin statements concernin leasin is most correct-
a. * sale and leaseback is a lease under which the lessor maintains and
finances the property also called a service lease.
b. The lessor is the party that uses the leased property.
c. * financial lease is a lease that does not provide for maintenance
services, is not cancelable, and is fully amorti(ed over its life also
called a capital lease.
d. *n important characteristic of operatin leases is the fact that they
are frequently fully amorti(ed in other words, the payments required
under the lease contract are sufficient to recover the full cost of the
equipment.
e. $one of the statements above.
Chapter 20 - Page 1
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Reporting earnings Answer: d Diff: E
/. hich of the followin are methods of reportin earnins when warrants or
convertibles are outstandin-
a. 0asic E#).
b. #rimary E#).
c. "iluted E#).d. *ll of the statements above are correct.
e. $one of the statements above is correct.
Reporting earnings Answer: d Diff: E
. hich of the followin methods of reportin earnins when warrants or
convertibles are outstandin are required under )EC rules-
a. 0asic E#).
b. #rimary E#).
c. "iluted E#).
d. )tatements a and c are correct.
e. *ll of the statements above are correct.
Warrants Answer: e Diff: E N
2. hich of the followin statements concernin warrants is most correct-
a. arrants cannot be traded separately from the bond with which they are
associated.
b. * warrant is a lon3term option to buy a stated number of shares of
common stock at a specified price.
c. arrants are lon3term call options that have value because holders can
buy the firm’s common stock at the exercise price reardless of how
hih the market price climbs.
d. )tatements a, b, and c are correct.
e. )tatements b and c are correct.
Medium:
Lease decision Answer: e Diff: M
4. 5n the lease versus buy decision, leasin is often preferable
a. )ince it does not limit the firm’s ability to borrow to make other
investments.
b. 0ecause, enerally, no down payment is required, and there are no
indirect interest costs.
c. 0ecause lease obliations do not affect the riskiness of the firm.
d. *ll of the statements above are correct.
e. $one of the statements above is correct.
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Capitalizing leases Answer: e Diff: M
6. 7inancial *ccountin )tandards 0oard 87*)09 )tatement :1+ requires that
for an unqualified audit report, financial 8or capital9 leases must be
included in the balance sheet by reportin the
a. ;alue of the leased asset as a fixed asset.
b. #resent value of future lease payments as an asset.c. #resent value of future lease payments as a liability.
d. )tatements a and b are correct.
e. )tatements a and c are correct.
Leasing Answer: e Diff: M
financin, such as leasin, will
show lower debt ratios once the effects of their leases are reflected
in their financial statements.
b. Capitali(in 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 obliation.
c. The fixed chares associated with a lease can be as hih as, but never
reater than, the fixed payments associated with a loan.
d. Capital, or financial, leases enerally provide for maintenance service
on the part of the lessor and can be refinanced at the discretion of
the lessee.
e. * key difference between a capital lease and an operatin lease is that
with a capital lease, the total lease payments on the asset are rouhly
equal to the full price of the asset plus a return on the investment in
the asset.
Leasing Answer: a Diff: M
1?
. hich of the followin statements is most correct-
a. 7inancial leases are fully amorti(ed.
b. 7inancial leases can be canceled.
c. 7inancial leases provide for maintenance services.
d. &peratin leases can never be canceled.
e. *ll of the statements above are correct.
Off-balance sheet leasing Answer: b Diff: M
11. @eavy use of off3balance sheet lease financin will tend to
a. 'ake a company appear more risky than it actually is because its stated
debt ratio will appear hiher.
b. 'ake a company appear less risky than it actually is because its stateddebt ratio will appear lower.
c. *ffect a company’s cash flows but not its deree of risk.
d. @ave no effect on either cash flows or risk because the cash flows are
already reflected in the income statement.
e. $one of the statements above is correct.
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Lease analsis disco!nt rate Answer: a Diff: M
1%. The lease analysis should compare the cost of leasin to the
a. Cost of ownin usin debt.
b. Cost of ownin usin equity.
c. *fter3tax cost of debt to measure the effect of leasin on the cost of
equity.d. *verae cost of all fixed chares.
e. Cost of ownin usin the weihted averae cost of capital for the firm.
Con"ertibles Answer: e Diff: M
1+. hich of the followin statements about convertibles is correct-
a. The coupon interest rate on convertibles is enerally hiher than on
straiht debt.
b. $ew equity funds are raised by the issuer when convertibles are
converted.
c. 5nvestors are willin to accept lower interest rates on convertibles
because they are less risky than straiht debt.
d. *t issue, a convertible’s conversion 8exercise9 price is often set
equal to the current underlyin stock price.
e. $one of the statements above is correct.
Con"ertibles Answer: b Diff: M
1/. * 1?3year convertible bond has a face value of A1,??? and pays an annual
coupon of A?. The bond’s conversion price is A/?. The issuin company’s
stock currently trades at A+? a share. The company can issue straiht
8non3convertible9 debt with an 6 percent yield. hich of the followin
statements is most correct-
a. The bond’s conversion ratio is %?.
b. The bond’s conversion value is currently A4?.c. The bond’s straiht3debt value is A4?.
d. The bond’s straiht3debt value is A1,???.
e. The convertible bond should sell for less than A4?.
Warrants and con"ertibles Answer: c Diff: M
1. hich of the followin statements about warrants and convertibles is
incorrect-
a. 0oth warrants and convertibles are types of option securities.
b. &ne primary difference between warrants and convertibles is that
warrants brin in additional funds when exercised, while convertibles
do not.
c. The coupon rate on convertible debt is lower than the coupon rate onsimilar straiht debt because convertibles are less risky.
d. The value of a warrant depends on its exercise price, its term, and the
underlyin stock price.
e. arrants usually can be detached and traded separately from their
associated debt.
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Warrants Answer: c Diff: M
12. hich of the followin statements is most correct-
a. * warrant is basically a lon3term option that enables the holder to
sell common stock back to the firm at an areed upon price, at a
specified time in the future.
b. Benerally, warrants are distributed alon with preferred stock in orderto make the preferred stock less risky.
c. 5f a company issuin coupon3payin debt wanted to reduce the cash
outflows associated with the coupon payments, it could issue warrants
with the debt to accomplish this.
d. &ne of the disadvantaes of warrants to the issuin firm is that they
are detachable and can be traded separately from the debt with which
they are issued.
e. arrants are attractive to investors because when they are issued with
stock investors receive dividends on the warrants they own, as well as
on the underlyin stock.
#ond with warrants Answer: e Diff: M
14. The straiht3debt value of a %?3year, 1? +6 annual coupon bond with +?
warrants is A42?.??, and the bond would sell at par of A1,??? with market
rates at 1/ percent. hich of the followin is most correct-
a. The total value of the warrants is A%/?.??.
b. The implied value of each warrant is A6.??.
c. The company will have a lower current cost of debt by usin the bond
with warrants than if it issued straiht debt.
d. )tatements a and b are correct.
e. *ll of the statements above are correct.
$referred stoc% Answer: c Diff: M
16. hich of the followin statements concernin preferred stock is mostcorrect-
a. #referred stock enerally has a hiher component cost to the firm than
does common stock.
b. 0y law in most states, all preferred stock issues must be cumulative,
meanin that the cumulative, compounded total of all unpaid preferred
dividends must be paid before dividends can be paid on the firm’s
common stock.
c. 7rom the issuer’s point of view, preferred stock is less risky than
bonds.
d. #referred stock, because of the current tax treatment of dividends, is
bouht mostly by individuals in hih tax brackets.
e. Dnlike bonds, preferred stock cannot have a convertible feature.
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$referred stoc% Answer: e Diff: M
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Multiple Choice: P/o0lems
Easy:
Difference in lease and loan pa&ents Answer: c Diff: E
%%. )tanley Corporation is considerin a 3year, A2,???,??? bank loan to
finance service equipment. The loan has an interest rate of 1? percent
and is amorti(ed over five years with end3of3year payments. )tanley can
also lease the equipment for an end3of3year payment of A1,4
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Con"ertible bond analsis Answer: b Diff: E
%. $ewae )cientific Company is considerin issuin 13year convertible bonds
at a price of A1,??? each. The bonds would pay an 6 percent coupon, with
semiannual payments, and have a par value of A1,???. Each bond would be
convertible into % shares of $ewae’s common stock. ithout a conversion
feature, investors would require an annual nominal yield of 1? percent.
hat is the straiht3debt value of the bond at the time of issue-
a. A 6?
b. A 6/2
c. A1,???
d. A 6
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Lease analsis Answer: b Diff: M
%6. Fedstone Corporation is considerin a leasin arranement to finance some
special manufacturin tools that it needs for production durin the next
three years. * planned chane in the firm’s production technoloy will
make the tools obsolete after + years. The firm will depreciate the cost
of the tools on a straiht3line basis. The firm can borrow A/,6??,???, the
purchase price, at 1? percent to buy the tools or make three equal end3of3
year lease payments of A%,1??,???. The firm’s tax rate is /? percent and
the firm’s before3tax cost of debt is 1? percent. *nnual maintenance costs
associated with ownership are estimated at A%/?,???. hat is the net
advantae to leasin 8$*L9-
a. A ?
b. A1?2,%??
c. A+2%,6??
d. A/++,1??
e. A2/4,
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#ond with warrants Answer: b Diff: M
+?. )hearson #LC’s stock sells for A/% per share. The company wants to sell
some %?3year, annual interest, A1,??? par value bonds. Each bond will
have attached 4 warrants, each exercisable into one share of stock at an
exercise price of A/4. )hearson’s straiht bonds yield 1? percent. The
warrants will have a market value of A% each when the stock sells for A/%.
hat coupon interest rate must the company set on the bonds3with3warrants
if the bonds are to sell at par-
a. 6.??M
b. 6.%/M
c. 6.
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Warrants and ield on straight debt Answer: b Diff: M
++. @imes 0everae Co. recently issued 1?3year bonds at par 8A1,???9 with a
2 percent annual coupon. The bonds also have 1 warrants attached, and
each warrant is worth A1?. 5f @imes were to instead issue 1?3year
straiht debt with no warrants attached, what would be the yield-
a. 2.??Mb. 6.%2M
c. 6.46M
d.
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Con"ertibles Answer: e Diff: M
+2. Nohnson 0everae’s common stock sells for A%4.6+, pays a dividend of
A%.1?, and has an expected lon3term rowth rate of 2 percent. The firm’s
straiht3debt bonds pay 1?.6 percent. Nohnson is plannin a convertible
bond issue. The bonds will have a %?3year maturity, pay A1?? interest
annually, have a par value of A1,???, and a conversion ratio of % shares
per bond. The bonds will sell for A1,??? and will be callable after 1?
years. *ssumin that the bonds will be converted at Hear 1?, when they
become callable, what will be the expected return on the convertible when
it is issued-
a. 1/.??M
b. 1%.??M
c. 1?.6?M
d. 1%.12M
e. 11.//M
Co¶ti"e after-ta' ields Answer: c Diff: M
+4
. "eep Fiver #ower Corporation recently sold an issue of preferred stockthat had an after3tax yield of
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(al!e of warrants Answer: c Diff: M
+
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Lease analsis Answer: b Diff: )
/%. Carolina Truckin Company 8CTC9 is evaluatin a potential lease areement
on a truck that costs A/?,??? and falls into the '*CF) +3year class. The
applicable '*CF) depreciation rates are ?.++, ?./, ?.1, and ?.?4. The
loan rate would be 1? percent, if CTC decided to borrow money and buy the
asset rather than lease it. The truck has a /3year economic life, and its
estimated residual value is A1?,???. 5f CTC buys the truck, it would
purchase a maintenance contract that costs A1,??? per year, payable at the
end of each year. The lease terms, which include maintenance, call for a
A1?,??? lease payment at the beinnin of each year. CTC’s tax rate is /?
percent. )hould the firm lease or buy-
a. Lease it costs A6/% less than buyin.
b. Lease it costs A
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Chapter 20 - Page 15
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Chapter 20 - Page 16
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1+ Lease cash flows Answer: c Diff: E
%+ Operating lease Answer: e Diff: E
++ Leasing Answer: c Diff: E N
)tatement a is the definition of an operatin lease. )tatement b is the
definition of the lessee. )tatement d is incorrect an important
characteristic of an operatin lease is that they are frequently not fully
amorti(ed. Therefore, the correct statement is c.
/+ Reporting earnings Answer: d Diff: E
+ Reporting earnings Answer: d Diff: E
2+ Warrants Answer: e Diff: E N
)tatement a is not correct. arrants can be detached from the bonds with which
they are associated and can be traded separately from the bond.
4+ Lease decision Answer: e Diff: M
6+ Capitalizing leases Answer: e Diff: M
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%1+ $referred stoc% Answer: d Diff: E N
)tatements a, b, and c are correct therefore, statement d is the correct
answer.
%%+ Difference in lease and loan pa&ents Answer: c Diff: E
Time lineI?
kd J 1?M 1 % + / Hears
32,???,??? #'T J - #'T #'T #'T #'T
7inancial calculator solutionI
5nputsI $ J 5 J 1? #; J 32??????. &utputI #'T J A16%46/.66.
paymentsin"ifference
J A1,4
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?k J 6M
1 % + / Hears
O O O O O O
1+4.4 1+4.4 1+4.4 1+4.4 1+4.4
$#; J -
7inancial calculator solutionI
0uyinI 5nputsI C7? J 31?????? C71 J 1?/??? C7% J 1%???, C7+ J 1?????
C7/ J 4%??? C7 J 1%6??? 5 J 6. &utputI $#; J 3A+,
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55. Cost of leasin
69 Lease payment 8A%,1??9 8A%,1??9 8A%,1??9
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A1,??? J ; K 48A%9
; J A6?.
Enter $ J %? 5 J 1? #; J 36? 7; J 1??? and then solve for #'T.
#'T J 5$T J A6%.+6 Coupon rate J???,1A
+6.6%A J 6.%/M.
+1+ #ond with warrants Answer: b Diff: M
Total value J )traiht3debt value K arrant value.
A1,??? J ; K %?8A1/.%?9
; J A412.
Enter $ J 2? 5 J #; J 3412 7; J 1??? and then solve for #'T.
#'T J 5$T% J A+.?? 5$T J A4?.?? Coupon rate J???,1A
4?A J 4.?M.
+%+ #ond with warrants Answer: d Diff: M
? 1 % + / %? 23month #eriods
O O O O O • • • O
#; J - /? /? /? /? /?
7; J 1,???
Calculate the value of the warrantsI
Total valuearrants Jwarranteach
value5mplied
× bondperwarrantsof$o.
%
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C J -
7inancial calculator solutionI
Calculate the pure3bond value, 0t, at year I
5nputsI $ J 1 5 J 1% #'T J
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worth A1?.%4 8A%?./4%?9.
/?
+ (al!e of warrants Answer: b Diff: M
;alue of the bond isI $ J %? 5HF J 11 #'T J 6? 7; J 1??? and then solve
for #; J A421.1?. The total value of the warrants must beI A1,??? 3 A421.1? J
%+6.
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Time lineI
Leasin
?k J 6M
1 % + Hears
3%+,%?? 3%+,%?? 3%+,%??
#;Leasin J -
7inancial calculator solutionI
&wnin5nputsI C7? J 31?%/?? C71 J /%?? C7% J 22?? C7+ J %6/?? 5 J 6.
&utputI $#; J 3A4?,+?4.6/ ≈ 3A4?,+?6.
Leasin
5nputsI C7? J 3%+%?? C71 J 3%+%?? $! J % 5 J 6.
&utputI $#; J 3A2/,41.4/ ≈ 3A2/,4%.
$et advantae to leasin
#;Leasin 3 #;&wnin J 3A2/,4% 3 8A4?,+?69 J A,4+2.
/%
+ Lease analsis Answer: b Diff: )
Time lineI
&wnin
?k J 2M
1 % + / Hears
3/?,??? /,26? 2,2?? 1,6?? 2,%?
#;&wnin J -
"epreciation Table
'*CF)
Hear 7actor "epreciation
1 ?.++ A1+,%??
% ?./ 16,???
+ ?.1 2,??? / ?.?4 %,6??
1.?? A/?,???
Hear ? 1 % + /
5. 5nitial outlay
19 $ew asset cost 8A/?,???9
55. &peratin cash flows
%9 'aintenance 8A 1,???9 8A 1,???9 8A 1,???9 8A 1,???9
+9 'aintenance 8*fter3tax9
8Line % × 81 3 t99 J
8Line % × ?.29 82??9 82??9 82??9 82??9
/9 "epreciation new asset 1+,%?? 16,??? 2,??? %,6??
9 "epreciation tax savins
8Line + × ?./?9 ,%6? 4,%?? %,/?? 1,1%?
29 $et operatin C7s A /,26? A 2,2?? A 1,6?? A %?
555 Terminal year cash flows
49 Est. residual value 80efore3tax9 A1?,???
69 Tax on residual value 8?./? × A1?,???9 /,???
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Time lineI
Leasin
?k J 2M
1 % + / Hears
32,??? 32,??? 32,??? 32,???
#;Leasin J -
7inancial calculator solutionI
&wninI 5nputsI C7? J 3/???? C71 J /26? C7% J 22?? C7+ J 16?? C7/ J 2%? 5J 2.
&utputI $#; J 3A%+,?+.12 ≈ 3A%+,?+.
LeasinI 5nputsI C7? J 32??? C71 J 32??? $! J + 5 J 2.
&utputI $#; J 3A%%,?+6.?4 ≈ 3A%%,?+6.
#;Leasin 3 #;&wnin J 3A%%,?+6 3 83A%+,?+9 J 3A