Solution

Cost of debt using both methods Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30 per bond will be incurred in this process. The firm is in the 40% tax bracket.

a) Find the net proceeds from sale of the bond, Nd.

b) Show the cash flows from the firm’s point of view over the maturity of the bond.

c) Use the IRR approach to calculate the before-tax and after-tax costs of debt.

d) Use the approximation formula to estimate the before-tax and after-tax costs of debt.

e) Compare and contrast the costs of debt calculated in parts c and d. Which approach do you prefer? Why?

EPS and optical debt ratio: Williams glassware has estimated at various debt ratio the expected earnings per share and the standard deviation of the earnings per share as shown in the following table:

a) Estimate the optimal debt ratio on the basis of the relationship between earnings per share and the debt ratio. You will probably find it helpful to graph the relationship.

b) Graph the relationship between the coefficient of variation and the debt ratio. Label the areas associated with business risk and financial risk.

Dividend constraints The Howe Company’s stockholders’ equity account follows:

The earnings available for common stockholders from this period’s operations are $100,000, which have been included as part of the $1.9 million retained earnings.

a) What is the maximum dividend per share that the firm can pay? (Assume that legal capital includes all paid-in capital.)

b) If the firm has $160,000 in cash, what is the largest per-share dividend it can pay without borrowing?

c) c. Indicate the accounts and changes, if any, that will result if the firm pays the dividends indicated in parts a and b.

d) Indicate the effects of an $80,000 cash dividend on stockholders’ equity.

Cost of debt using both methods Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result of current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30 per bond will be incurred in this process. The firm is in the 40% tax bracket.

a) Find the net proceeds from sale of the bond, Nd.

b) Show the cash flows from the firm’s point of view over the maturity of the bond.

c) Use the IRR approach to calculate the before-tax and after-tax costs of debt.

d) Use the approximation formula to estimate the before-tax and after-tax costs of debt.

e) Compare and contrast the costs of debt calculated in parts c and d. Which approach do you prefer? Why?

EPS and optical debt ratio: Williams glassware has estimated at various debt ratio the expected earnings per share and the standard deviation of the earnings per share as shown in the following table:

Debt ratio | Earnings per share (EPS) | Standard Deviation of EPS |

0% | $2.30 | $1.15 |

20% | $3.00 | $1.80 |

40% | $3.50 | $2.80 |

60% | $3.95 | $3.95 |

80% | $3.80 | $5.53 |

b) Graph the relationship between the coefficient of variation and the debt ratio. Label the areas associated with business risk and financial risk.

Dividend constraints The Howe Company’s stockholders’ equity account follows:

Common Stock (400,000 shares at $4 par) | $16,00,000 |

Paid in capital in excess of par | $10,00,000 |

Retained earnings | $19,00,000 |

Total Stockholder’s Equity | $45,00,000 |

a) What is the maximum dividend per share that the firm can pay? (Assume that legal capital includes all paid-in capital.)

b) If the firm has $160,000 in cash, what is the largest per-share dividend it can pay without borrowing?

c) c. Indicate the accounts and changes, if any, that will result if the firm pays the dividends indicated in parts a and b.

d) Indicate the effects of an $80,000 cash dividend on stockholders’ equity.