Question

1. In http://es.finance.yahoo.com/ search the Profile (Profile) of PepsiCo (PEP) and IBM (IBM), and then, examine the Balance and the Result Account of each company. Calculate the present value of the tax savings for interest that contributes to your long-term debt. Now suppose you each issue $ 3 trillion more of long-term debt and use the proceeds to buy back your own capital. What change would tax savings experience?

2. Scroll down and click on the word "Industry" in the left column. This will provide you with a table of financial ratios or ratios for different industries. Compare debt ratios between companies' equity. Can you explain the differences? Are these better explained according to the theory of equilibrium or according to that of the financial hierarchy?

3. What was Ryan's starting salary? How much could he have contributed to the voluntary savings plan in his first year of employment?

Answer 1

1.

Company Name	Debt	Interest Expense	Tax rate	Interest Rate
PepsiCo	$29,148,000	$1,135,000	36.7%	3.89% (Avg.)
IBM	$54,102,000	$1,344,000	23.1%	2.48% (Avg.)

 

Present Value of Interest Tax Shield for one year (PepsiCo) = (36.7%*$1,135,000)/(1+3.89%)^1

= $416,545/1.0389

= $400,948.12

 

Present Value of Interest Tax Shield for one year (IBM) = (23.1%*$1,344,000)/(1+2.48%)^1

=$310,464/1.0248

=$302,951

 

The value of PepsiCo exceeds the value of IBM by the present value of interest tax shield.According to M&M preposition, with taxes issuance of more debt will result more interest expense and reduction in taxable income. Both companies will attain more tax savings from interest expense on new debt.

Tax Savings (PepsiCo) = 36.7% * 3 Trillion = 1,101,000 million

Tax Savings (IBM) = 21.3% * 3 Trillion = 639,000 million

 

2.

Ratio	PepsiCo	IBM
Debt-to-equity	2.169	3.018

 

IBM having a higher debt-to-equity ratio indicates that it is leverage higher than PepsiCo with IBM using more creditor financing than investor financing. The higher ratio suggests IBM can easily serve its debt cost through cash flow and is using the advantage to increase return on equity and lower its cost of equity. However, PepsiCo having a higher tax rate has greater debt incentive and greater value of interest tax shield. The ratio for both the companies outline the theory of equilibrium of the capital structure. The choice of capital structure is a management decision where the firm’s capital structure is determined by its need for external financing to balance the benefit of debt against the costly equity cost.

 

The Value of Money over Time: Retirement Planning

 

3.

Current Salary	Growth Rate	Year	Previous Year's	Voluntary Savings
			Salary	Contributions
$70,000.00	5%	1	$54,846.83	$6,033.15
$70,000.00	5%	2	$57,589.17	$6,334.81
$70,000.00	5%	3	$60,468.63	$6,651.55
$70,000.00	5%	4	$63,492.06	$6,984.13
$70,000.00	5%	5	$66,666.67	$7,333.33
	Total			$33,336.97

 

Ryan’s first-year salary was $54,846.83 and he could have contributed $6,033.151 in his first year of employment. Additionally, if he has started the voluntary contribution saving plan five years ago with an 11% increase, the amount would have totaled $33,336.97 dollars.

 

If Ryan had taken advantage of the company's voluntary retirement plan to the maximum, each year for the past five years, how much money would he currently have accumulated in his retirement account, assuming monthly deposits and a nominal rate of return of 7 %? How much more would the value of his investment have been if he had opted for a higher risk alternative (for example, 100% in common shares), which are expected to yield an average rate of return of 12%?

Annual Rate	Monthly Rate	NPER	Contribution Amount	Future Value	Accumulated Amount
7%	0.583%	60	$33,337.00	$47,259	$13,922.37
12%	1.000%	60	$33,337.00	$60,563	$27,226.22

Had Ryan taken advantage of the voluntary retirement plan up to maximum with monthly deposits, every year for the past five year, he would currently have a balance of $47,259 at nominal rate of 7% or $60,563 with an average 12% rate of return in his retirement account. Comparing the two rates of return, there is a difference of $13,303.84 in the growth of the two options.

 

Monthly Deposits if compounded monthly

Year	Accumulated Amount
1	12,066.30
2	12,669.62
3	13,303.10
4	13,968.25
5	14,666.67
Total	66,673.94
NPV	$56,866.79

 

Rate	7%	12%
No of Periods	60	60
Future Value	$80,135.96	$102,694.79

 

With monthly deposits, compounded monthly at 7% nominal rate of return, he would have accumulated $80,136or $102,695 with compounded 12% rate of return. Comparing the two rates of return, there is a difference of $22,559 in the growth of the two options.

$102,694.79