B1. (Choosing financial targets) Bixton Company's new chief financial officer is evaluating
Bixton's capital structure. She is concerned that the firm might be underleveraged, even
though the firm has larger-than-average research and development and foreign tax credits
when compared to other firms in its industry. Her staff prepared the industry comparison
shown here.
a. Bixton's objective is to achieve a credit standing that falls, in the words of the chief
financial officer, "comfortably within the ‘A' range." What target range would you recommend
for each of the three credit measures?
b. Before settling on these target ranges, what other factors should Bixton's chief financial
officer consider?
c. Before deciding whether the target ranges are really appropriate for Bixton in its current
financial situation, what key issues specific to Bixton must the chief financial officer
resolve?
a.To be “comfortably” within the range, the firm should stay off the low end of the ratings.
Fixed Charge Coverage = 3.40 - 4.30
Cash Flow / Total Debt = 55 - 65
Long-Term Debt / Total Capitalization = 25 - 30
b.Ability to use fully non-interest tax credits and debt management considerations such as issuance costs. The CFO should also consider that the firm’s R&D is an intangible asset and that lenders may not be willing to loan the same percentage of debt to Bixton as to its competitors.
c. The CFO needs to consider R&D and foreign tax credits. The additional tax shield from additional debt may not be valuable when R&D and foreign tax credits are taken into consideration.
A10. (Dividend adjustment model) Regional Software has made a bundle selling spreadsheet software and has begun paying cash dividends. The firm’s chief financial officer would like the firm to distribute 25% of its annual earnings (POR = 0.25) and adjust the dividend rate to changes in earnings per share at the rate ADJ = 0.75. Regional paid $1.00 per share in dividends last year. It will earn at least $8.00 per share this year and each year in the foreseeable future. Use the dividend adjustment model, Equation (18.1), to calculate projected dividends per share for this year and the next four.
D1 = ADJ [POR(EPS1) - D0] + D0
D1 = 0.75 [0.25 x $8.00 - $1.00] + $1.00 = $1.75
D2 = 0.75 [0.25 x $8.00 - $1.75] + $1.75 = $1.94
D3 = 0.75 [0.25 x $8.00 - $1.94] + $1.94 = $1.985
D4 = 0.75 [0.25 x $8.00 - $1.98] + $1.98 = $2.00
D5 = 0.75 [0.25 x $8.00 - $2.00] + $2.00 = $2.00
B2. (Dividend policy) A firm has 20 million common shares outstanding. It currently pays out $1.50 per share per year in cash dividends on its common stock. Historically, its payout ratio has ranged from 30% to 35%. Over the next five years it expects the earnings and discretionary cash flow shown below in millions.
a.Over the five-year period, what is the maximum overall payout ratio the firm could achieve without triggering a securities issue?
Total discretionary cash flow = $50 + $70 + $60 + $20 + $15 = $215
Total earnings = $100 + $125 + $150 + $120 + $140 = $635
Maximum Payout Ratio = $215 / $635 = 33.86%
b. Recommend a reasonable dividend policy for paying out discretionary cash flow in years 1 through 5.
Current dividend = $1.50 x 20 million shares = $30 million
The firm could gradually increase the dividend from $30 million to $50 million.
D1 = $35 / 20 = $1.75
D2 = $39 / 20 = $1.95
D3 = $43 / 20 = $2.15
D4 = $48 / 20 = $2.40
D5 = $50 / 20 = $2.50
Note that $35 + $39 + $43 + $48 + $50 = $215, the total discretionary cash flow and since large discretionary cash flows occur at the beginning, there is never a discretionary cash deficit.
A2. (Comparing borrowing costs) Stephens Security has two financing alternatives: (1) A publicly placed $50 million bond issue. Issuance costs are $1 million, the bond has a 9% coupon paid semiannually, and the bond has a 20-year life. (2) A $50 million private placement with a large pension fund. Issuance costs are $500,000, the bond has a 9.25% annual coupon, and the bond has a 20-year life. Which alternative has the lower cost (annual percentage yield)?
1.n = 40 r = ? PV = -($50 - $1) = -$49 PMT = 9% / 2 x $50 = $2.25 FV = $50 r = 4.61%
APY = (1 + 0.0461)2 -1 = 9.4334%
2.n = 20 r = ? PV = -($50 - $0.5) = -$49.5 PMT = 9.25% x $50 = $4.625 FV = $50 r = 9.36%
APY = 9.36%
Choice 2 has the lower APY.
TABLE 21-2 Direct cash flow consequences to NACCO of lease financing an electric shovel
(amounts in thousands).
YEAR0 1 2 3 4 5 6 7 8 9 10
Benefits of Leasing:
Initial outlay (avoided) +10,000 (this is under year 0)
Costs of Leasing:
Lease payments:-1,745 (its the same from year 1 to 10)
Lease payment tax credit:+698 (year 1-10)
Depriciation tax credit fargone: -380(year 1-10)
Salvage value fargone:-500(only under year 10)
Net cash flow to lease:+10,000 -1,427 -1,427 -1,427 -1,427 -1,427 -1,427 -1,427 -1,427 -1,427 -1,927 This represents year 0 through 10
C2. (Leasing, taxes, and the time value of money) The lessor can claim the tax deductions associated with asset ownership and realize the leased asset’s residual value. In return, the lessor must pay tax on the rental income.
a. Explain why a financial lease represents a secured loan in which the lender’s entire debt service stream is taxable as ordinary income to the lessor/lender.
A lease represents a form of secured debt. Each lease payment includes an interest
component and a principal repayment component. Because the lease payment is
taxable as ordinary income to the lessor, in
effect, the entire debt service stream (i.e., the interest component and the principal
component) is taxable as ordinary income.
b. In view of this tax cost, what tax condition must hold in order for a financial lease transaction to generate positive net-present-value tax benefits for both the lessor and lessee?
The following condition must hold:
PV(lessee's lease payment tax shields) + PV(lessor's depreciation tax shields + other tax credits)
<is greater than>
PV(lessor's lease payment tax liability) + PV(lessee's depreciation tax shields + other taxcredits) in order for a financial lease transaction to generate positive net present value benefits for lessor and lessee combined.
c. Suppose the lease payments in Table 21-2 must be made in advance, not arrears.
(Assume that the timing of the lease payment tax deductions/obligations changes
accordingly but the timing of the depreciation tax deductions does not change). Show that the net advantage to leasing for NACCO must decrease as a result. Explain why this reduction occurs.
Each after-tax lease payment is $1,047,000 (= 1,745,000 - 698,000). The net
advantage to leasing for NACCO must decrease because the lease payments
are accelerated by 1 year:
which is more than $500,000 lower than the net advantage to leasing calculated in the text, which was -$54,236.
d. Show that if NACCO is nontaxable, the net advantage to leasing is negative and greater in absolute value than the net advantage of the lease to the lessor.
If NACC) is nontaxable, its net advantage to leasing is:
The net advantage of the lease to the lessor is:
which is smaller than NAL in absolute value.
e. Either find a lease rate that will give the financial lease a positive net advantage for both lesser and lessee, or show that no such lease rate exists.
A mutually advantageous lease rate, L, must satisfy the following two conditions simultaneously:
The two conditions cannot be satisfied simultaneously; a mutually beneficial lease rate therefore does not exist.
f. Explain what your answer to part e implies about the tax costs and tax benefits of the financial lease when lease payments are made in advance.
Making the lease payments in advance imposes a net tax cost when the lessor pays income tax at a higher rate than the lessee.