Assignment 1 Question 1 (25 marks) Armstrong Inc. has an outstanding issue of convertible bonds with par value of $1,000. The bonds pay interest semi-annually and are convertible into 80 shares of common stock. The coupon rate of this bond issue is 2% p.a. with exactly 3 years to maturity. The yield-to-maturity of a similar straight bond with similar risk is 5% p.a. i. Calculate the straight bond value of this convertible bond. (6 marks) ii. Calculate the conversion value of the bond when the share price of Armstrong Inc. is currently $14.20 per share. (4 marks) iii. What is the lowest price that you would expect the convertible bond to sell for if Armstrong Inc.’s current share price were $11.50 per share instead? (9 marks) iv. If the convertible bonds are selling at $930 and explain why this convertible bond is selling at a price higher than its value as a bond or common stock. (6 marks) Question 2 (25 marks) Best Corporation is working with TAG Aviation (consultant) in considering leasing or purchasing a Bombardier Challenger 605 private jet to commute top executives between manufacturing facilities in Shanghai, China and the headquarters in Hong Kong. The price of the private jet plane is USD 14 million with zero scrap value in six years. If Best Corporation buys the plane, it can pay using the company’s own reserves or borrow the money from Bank of Canton at 12% p.a. If utilizing the lease option, the company can lease the jet from Leasing Capital with before-tax payment of USD 2.5 million per year, payable at year’s end for the next six years. Best Corporation is in the 40% tax bracket. i. Given the above information, calculate the net advantage to leasing (NAL) for Best Corporation to obtain the private jet, assuming the company will use its own reserves rather than borrow from the bank. Which alternative would you recommend? Why? (17 marks) ii. Suppose the entire $14M purchase price of the private jet is borrowed from Bank of Canton. Without any calculation, should Best Corporation change its buy or lease decision on the private jet? Please explain. (8 marks) Question 3 (50 marks) You are recently employed as a financial analyst of ABC firm and a quick study of the capital structure of the firm makes you think that the firm may be under utilizing its debt capacity as currently the firm contains 10% debt and 90% equity. To evaluate the firm’s capital structure, You have gathered the data summarized in the following table. Scenario I is 30% debt and Scenario II is 60% debt. These two scenarios are the choices which the CFO would like to consider. Capital Structure Analysis Source of Capital Current (10% debt) Scenario I (30% debt) Scenario II (60% debt) Common Stock outstanding 300,000 shares 201,000 shares 80,000 shares Equity required return 10% 12% 16% Long -term debt $3,000,000 $9,000,000 $18,000,000 Coupon rate 5% 6% 10% The current level of total financing is $30 million which is calculated by $3,000,000 / 0.1 = $30,000,000. Therefore, at 30% debt and 60% debt level, the long-long debt for scenario I and II is $9 million and $18 million respectively. The money raised by debts under both scenarios is used for repurchase of shares. The number of common stock outstanding in each scenario is determined by the CFO and presented in the above table. The firm’s current earnings before interest and taxes (EBIT) is $2.8 million and will be stable in the foreseeable future. The company is subject to the 40% tax rate. Please answer the following questions: i. Using the current level of EBIT $2.8 million to calculate the times interest earned (TIE) ratio for each capital structure. Then, evaluate the three capital structure scenarios using the times interest earned and debt ratio. (13 marks) ii. Use EPS equal to zero, and EBIT equal to $1,800,000 and $2,800,000 to draw an EBIT-EPS graph. In your graph, please include the current and the two proposed capital structures (Scenario I and II). Show your EPS calculation clearly. (12 marks) iii. According to your findings in part (b), which capital structure will maximize ABC’s earnings per share (EPS) with its EBIT of $2,800,000? Why might this not be the best capital structure? (8 marks) iv. Using the zero growth rate dividend discount valuation model (g = 0), find out the share price of ABC under each of the three capital structures assuming all aftertax earnings will be distributed to shareholders as dividends. (8 marks) v. Which capital structure would you recommend to the CFO on the basis of your findings in part (c) and (d), Why? (9 marks) Requirements: 1000 words
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