Question

Question 5 (a) Modigliani and Miller showed that when firms have to pay taxes, a firm’s value increases with leverage. Briefly discuss what prevents a firm from taking on high levels of debt. (b) Maturity Rating Features Bond A 10 years AA Put provision Bond B 10 years A Call provision Appraise which bond has the higher yield to maturity. (c) Your company buys from a supplier who offers credit terms of 3/10 net 130. Discuss whether your company should or should not pay cash for the goods it buys if it can borrow funds from the bank at 10% per annum. (Use a 360-day year for your computations.)

Answer 1

Answer of a) -

Taking too much debt can restrict company's flexibility leading to financial problems & revenue drop. A downturn in the market or wider global recession could impede trade & increases the likelihood of the company defaulting on its debt repayment. Generally high level of debt is risky as investors will become hesitant to invest in company . This prevents a firm from taking high level of debt.

Answer of b) -

yield to maturity- YTM is the total return anticipated on a bond if the bond is held until it matures.

bond call option- this gives holder right to buy a bond by a particular date for a predetermined price.

bond put option- The buyer of bond put is expecting an increase in interest rates & decrease in bond prices. This gives investor right to sell bonds before maturity.

Here, Bond B with A rating call option will have high YTM than Bond A with AA rating put option .

Answer of c) -

Here credit term 3/10 net 130 means that it the bill is paid within 10 days, there is discount of 3%. Otherwise, the total amount is due within 130 days.

If it borrows money from bank at 10% per annum. then for every Rs.100 , Rs.110 to be given to bank for year 1 and onwards. But payment to be given to bank is after 360 days.

So its good to go for suppliers plan credit as it provides discount with half credit term than banks term.