## Question

1) Data Corporation’s president, George Unkelos, believes that his firm’s market, data collection and analysis, can be expanded. To exploit the situation, he needs to get his hands on a new computer hardware and software system. He has been looking at two computer systems, one owned by IBM, the other by Honeywell. Honeywell’s system will cost the firm $12 million. IBM’s system will cost $24 million. Honeywell’s system operate for 6 years whereas IBM’s system will operate 12 years. The salvage value of each system is zero. Depreciation expense is on a straight-line basis. Marc Nadav, senior vice president of marketing has estimated the sales for two systems to be:

YEAR IBM HONEYWELL

1 – 3 $15mm $10mm

4 – 6 10mm 10mm

7 – 12 10mm -

Edward Klar, senior accountant. has established the following rules of thumb for estimating other relevant data:

Cost 30% of sales

Accounts Receivables 30% of next year’s sales

Inventory 25% of next year’s sales

Cash 5% of next year’s sales

Accounts Payable 20% of next year’s sales

The firm’s financial structure according to the balance sheet is:

Security Book Value Coupon Rate # of Securities Maturity Price per unit

Outstanding

Bonds 10,000,000 6% 10,000 10 yrs. $1000

Debentures 20,000,000 9% 20,000 10 yrs. $1100

Common Stock 50,000,000 - 1,000,000 - $50

Retained

Earnings 25,000,000 - - -

The annual dividend payment that was just paid is $5 and it is expected to grow by 8% for five years and then 2% (starting in year 6) thereafter. The tax rate is 45%. Which system would you take? (25 points)

2) Assume that the annual sales of the firm of problem 1 are $250 million. Let fixed costs equal $30 million and variable costs equal 30% of sales.

a) Determine the Degree of Operating Leverage of the firm

b) Determine the Degree of Financial Leverage of the firm

c) Determine the percentage increase in earnings if sales were to increase by 40% (10 points)

3) Go back to question 2, and assume that if you increase the leverage ratio to 50%, the average cost of debt will increase by 75 basis points. Assume that the unlevered cash flow is a perpetuity. Determine the new ATWACOC and the new value of the firm. (15 points)

4) Assume now that Honeywell withdraws its proposal and you can only buy the IBM system. Assume that you can lease the IBM assets of the project described in problem 1. The terms of the lease are that you can lease the assets for 6 years. The annual lease payment is $3.5 million per year. At the end of year 6, the repurchase price or salvage value is the book value of the asset. Would you lease or buy? (15 points)

5) Assume that if you purchase the IBM asset, it will allow you to borrow $20 million dollars for 10 years at an annual coupon rate of 4%. Assume that the asset secures the loan. Assume that the principal is repaid at the end of the tenth year. Now what would you recommend? (10 points)

6) Assume that the bonds of Problem 1 have a call price of $1,080 per $1,000 par bond. Interest rates suddenly drop to 4.5%. Transaction costs to refund the bond equal $900,000. Is it profitable to refund the bond? (10 points)

7) A corporation borrows $10 million for 8 years. The annual coupon rate is 12%. The balloon payment at the end of year 8 is $4 million and the firm is expected to make quarterly payments. Assume a 40% tax rate. If the expected EBIT in year 6 is $10 million, determine the expected Fixed Coverage Ratio for year 6. Fixed Coverage Ratio equals (where T = the corporate tax rate):. (15 points)

__________EBIT _____________

Interest Payment + Principal Payment

(1-T)

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