Question

In: Finance

You start a corporation. Your idea will produce $100K at the end of each year for...

You start a corporation. Your idea will produce $100K at the end of each year for 20 years. After 20 years you will sell all assets – this will produce an additional $1.2 million at year 20. To begin production you need $500K immediately which you will raise by issuing bonds and stock. You issue a 20 year bond with 4% annual coupon and face value $1 million. YTM on bonds is 14%, stockholders also require 14% return. No cash is retained within the company. a) What are the cash flows produced by the company? What are these worth (assuming 14% annual rate)? b) What are cash flows to bondholders? What is the bond worth today? c) What are the cash flows to owners? What is ownership worth today? d) What percent of ownership in your company must you sell today?

Solutions

Expert Solution

From the question we have the following information:

- $100,000 will come at end of every year upto 20 years

- Initial capital requirement is $500,000

- Bond of $1,000,000 issued with coupon rate of 4% payable yearly

- Required rate of return is 14%

- sale of Assets at the end of year fecth $1.2 million

- YTM (Yield to Maturity) is 14%

Now we moving to answer part.

a.) Cash flow produced by company

figures in bracket is negative numbers

Particular's Amt
Initial capital(Stock & bond) (see note 1) $ 500,000
4% Bond(for 20 year) $ 1,000,000
Revenue of 20 years ($ 100,000 * 20) $ 2,000,000
Sale of asset at end of 20th year $ 1,200,000
Bond Redem (Both redem) $ 1,100,000
Interest payment 1 ( 4% * $ 1,000,000 * 20) ($ 800,000)
Interest Payment 2 (see note 2) ($ 80,000)
Paid to Onwers (see note 3) ($ 1,120,000)
Net cash generated after 20 year (Sum of above amt) $ 1,600,000

Note 1: Required rate of return is 14%. So owners should get 14% returns on their investment. Initial capital is $ 500,000 (which includes bond and stock). So in this $ 500,000 some part is bond and remaining part is stock. Revenue generated is $100,000 and interest payment on bond issue of $ 1,000,000 is $ 40,000 per year. So $ 100,000 - $ 40,000 = $ 60,000.

$ 60,000 is left for other bond and stock ($ 500,000 initial capital). So if owners want 14% returns they should use debt capital of $ 100,000 @ 4% coupon rate and share capital of $ 400,000. So from $ 60,000 - $ 4,000 ( 4% * $ 100,000) = $ 56,000.

This $ 56,000 belongs to stockholders and they invested $ 400,000. So the rate of return is ($ 56,000 *100 ) / $ 400,000 = 14%.

Total bond issue is $ 1.1 million (1.1 +0.1)

Note: 2 $ 4,000 * 20 = $ 80,000

Note 3: $ 56,000 * 20 = $ 1,120,000

Worth of cash generated by company at the end of 20 year today: ( Assuming rate of 14%)

$ 1,600,000 / (1+14%)^20 = $ 116,418.8

b.) Cash flow to bondholders

Interest payment to bondholders (see the above table) is $ 800,000 + $ 80,000 = $ 8,80,000

Today's worth of bond: It is calulated by discounted value of all the cash flow generated by bond till it's maturity. Present value of bond is the worht of bond. As YTM is 14% and coupon rate is 4%. Present value of bond calculated below.

Here the bond value is $ -728,544.

The present value calculated as follow as:

After this drag the cell in excel. The auto sum of discounted cash flow to get the bond value.

c.) Cash flow to the owners:

$ 56,000 * 20 = $ 1,120,000. This is the cash flow generated by owners.

The worth of ownership is the net cash flow generated by company after the years and this is discounted by 14%.

Net cash generated is $ 1,600,000 and discounted value is $ 1,600,000 / (1+14%)^20 = $ 116,418.8.

d.) Percent of onwership to sell:

If you see the note 1 you will get the answer of it. That is $ 100,000 is debt (bond issue) from initial capital and stockholder brings $ 400,000. So ($ 100,000 * 100) / $ 500,000 = 20%.

So 20% of the ownership should be sold by owner today.

Conculsion

So here owners brigns $ 400,000 capital and $ 100,000 via debt (bond). And Also company have been issuing $ 1,000,000. For the debt the coupon is 4%. So by generating revenue of $ 100,000 every year. Interest cost of $ 44,000 goes to bondholders every year. And $ 56,000 goes to the stockholder. As the their is no ploughing bank of profit.


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