Question

Please complete the following problems in Microsoft Word / Excel document and post to the drop box.

1) Interest rates and bond ratings (LO16-2) A previously issued A2, 15-year industrial bond provides a return three-fourths higher than the prime interest rate of 11 percent. Previously issued A2 public utility bonds provide a yield of three-fourths of a percentage point higher than previously issued A2 industrial bonds of equal quality. Finally, new issues of A2 public utility bonds pay three-fourths of a percentage point more than previously issued A2 public utility bonds.What should be the interest rate on a newly issued A2 public utility bond?

2) Fourteen years ago, the U.S. Aluminum Corporation borrowed $6.5 million. Since then, cumulative inflation has been 98 percent (a compound rate of approximately 65 percent per year). a. When the firm repays the original $6.5 million loan this year, what will be the effective purchasing power of the $6.5 million? (Hint: Divide the loan amount by one plus cumulative inflation.) b. To maintain the original $6.5 million purchasing power, how much should the lender be repaid? (Hint: Multiply the loan amount by one plus cumulative inflation.) c. If the lender knows he will receive $6.5 million in payment after 14 years, how might he be compensated for the loss in purchasing power? A descriptive answer is acceptable.

3)Tobacco Company of America is a very stable billion-dollar company with sales growth of about 5 percent per year in good or bad economic conditions. Because of this stability (a correlation coefficient with the economy of +.3 and a standard deviation of sales of about 5 percent from the mean), Mr. Weed, the vice-president of finance, thinks the company could absorb some small risky company that could add quite a bit of return without increasing the company’s risk very much. He is trying to decide which of the two companies he will buy. Tobacco Company of America’s cost of capital is 10 percent.

Computer Whiz Company (CWC) (cost $75 million)			American Micro-Technology (AMT) (cost $75 million)
Probability	Aftertax Cash Flows for 10 Years ($ millions)		Probability	Aftertax Cash Flows for 10 Years ($ millions)
0.3	$ 6		0.2	$(1)
0.3	10		0.2	3
0.2	16		0.2	10
0.2	25		0.3.	25
			0.1	31

a. What is the expected cash flow for each company?

b. Which company has the lower coefficient of variation?

c. Compute the net present value of each company.

d. Which company would you pick, based on net present values

Answer 1

1.

Interest rate on previously issue A2 15-year industrial bonds = 11% × 1.75 =          19.250

Additional return on A2 15-year public utility bond + .750

Additional return on new issues                                                     + .750%

Anticipated return on newly issue A2 public utility bonds 20.750%

2. a. Loan amount/(1 + Cumulative inflation) = $6,500,000/(1+0.98)=$6,500,000/1.98 = $ 3,282,828

b.   Loan amount * (1 + Cumulative inflation) = $6,500,000 * (1+0.98) = $ 12,870,000

c. We need to charge an interest rate which is pretty high so that it is able to to provide an adequate annual return on the borrowed funds and also compensate for the loss of purchasing power.

  A loan repayment of 12,870,000 in a 98 percent cumulative inflationary environment will provide $6,500,000 in purchasing power to the original lender.

3.

a)         Expected for CWC is 0.3 * 6 + 0.3 * 10 + 0.2 * 16 + 2 * 0.25 = 13 million

AMT is 0.2 * -1 + .2 * 3 + .2 * 10 + .3 *25 + .1 * 31 = 13 million

b)         Lower variation is for CWC

c)         NPV is -75 + 13/1.1 + ... 13/1.1^10 = $4,879,372.37

d)         Both companies are the same when compared on basis of NPV

e)         Yes, if risk is to be considered I would pick CWC as it has lesser variation

f)         AMT will be picked in this case as it can be used as a hedge against the primary business during bad market conditions.

g) Tobacco company's stock's market value might increase as the investment has positive NPV