Solution Manual for Principles of Finance, 6th Edition

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Principles of Finance6eChapter 1Besley/Brigham1-1CHAPTER 1ANSWERS1-1At the beginning of the twentieth century, the study of finance was mostly descriptive. As theproliferation of electronics and information technology has grown in recent decades, the study offinance has shifted toward more analytical methods.At the beginning of the century, managerial finance focused on mergers and acquisitions,investments were held mostly by powerful individuals or groups, and the banking system consistedof thousands of independent banking organizations that were primarily small, hometown banks.There was a shift toward greater regulation and control of financial services organizations after thefinancial disasters that occurred during the Depression era of the late 1920s and early 1930s. Atthat time, managerial finance was concerned with bankruptcy issues, the investments arenabecame substantially more regulated with the birth of the Securities and Exchange Commission(SEC), and the banking system went through significant restructuring with the failure of more than6,000 banks. Modern finance finds its roots in the second half of the century when increasedcompetition reduced the profit opportunities available to firms, so more emphasis was placed onevaluating the value of investment projects; small, individual investors became more active in thestock markets as mutual funds became popular; and, the restrictions on banking operations in theUnited States were eased as international competition increased in the banking industry.1-2Simply stated, finance deals with how firms generate and use funds. To do a good job, people inmarketing must understand how marketing decisions affect and are affected by funds availability, byinventory levels, by excess plant capacity, and so forth. Similarly, accountants must understandhow accounting data are used in corporate planning and are viewed by investors. Some knowledgeof the financial function is necessary to do a good job in other areas of the firm. At the same time,however, financial managers must have an understanding of marketing, accounting, and so forth, tomake more informed decisions about replacement or expansion of plant and equipment and abouthow to best finance their firms.1-3As we will show in later chapters, the financial decisions corporations make concern how to raisefunds (sources) when they are needed and how invest funds that are available. As an individual, wemake the same decisions—when we buy and car or a house, we search for the appropriate fundingsources (in most cases the cheapest), and when we have excess funds, we decide whatinvestments should be made. Although our discussions focus on corporations, the techniquesdescribed in this book can also be applied by individuals to make personal decisions.1-4As a general rule of thumb, the government is fairly friendly to business when economic conditionsare good and individuals are prospering because of the conditions. However, when an economicdisaster occurs, traditionally, there are cries for new, tougher regulations to rein in those individuals,organizations, and practices that are considered to have contributed to the downturn.1-5Value is measured as the present value of the cash flows that an investment is expected togenerate during its life. The three factors that determine value are: (1) the amount of the future cashflows, (2) the timing of the future cash flows, and (3) investors’ required rate of return. If the amountof the cash flows increases, the cash flows are received sooner, investors’ required rate of returndecreases, or any combination of these events occur, the value of an investment will increase.1-6The value of a firm can be measured by the market value of its stock. Thus, the firm maximizesvalue/wealth by maximizing the value of itsstock.

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Chapter 1Principles of Finance 6eBesley/Brigham1-21-7Sustainability refers to the process by which we live and interact with businesses, governments,other humans, and so forth, and how both the current environment and the future environment areaffected by the actions of all of these stakeholders.1-8A firm might be able to survive in the short term if it does not consider theeffectsits businessdecisions have on stakeholders, but it cannot survive in the long term unless its decisions help tosatisfy the needs of its stakeholders, including the environment.If customers are not treated“correctly,” they will become customers of the firm’s competitors; if employees are not treated“correctly,” they will go to work for other companies; if the local community is not treated “correctly,”legal action or legislation might restrict the company’s actions; and, if the environment is not treated“correctly,” future environmental factors or new government regulation might result in the ruin of thefirm.1-9Lean manufacturing refers tothe integration of the entire production process in an attempt to usethe least amount of resources needed to manufacture and sell products. Firms that adhere to theconcepts of lean manufacturing attempt to eliminate excesses (“fat”) so as to become as efficient aspossible.1-10Lean manufacturing and value maximization go hand-in-hand. To maximize value,a firm(investment) should maximize the net cash inflows generated during its life. A firm that follows leanmanufacturing techniques reduces waste, thus minimizes cash outflows associated with costs,which helps to maximize net cash inflows.──────────────────────────────────────SOLUTIONS1-1Integrative Problema.Finance deals with decisions about money—that is, how money is raised and used bycompanies and individuals.Because value is based on cash flows, finance is integral to thesuccessful operations of a firm. To be successful, a firm needs to understand how to raisefunds, how much it costs to use investors’ money, and how to appropriately invest funds.b.The general areas of finance include:Financial markets and institutions—includes the study of (1) financial markets, such as thestock markets and the bond markets and (2) participants in the markets, such as banks,insurance companies, pension funds, and so forth that “manufacture” various financialinstruments, including mortgages, auto loans, retirement funds, and savings plans.Investments—includes persons who determine (1) the values and risk and return relationshipsassociated with financial assets, such as stocks and bonds and (2)the best combination ofsecurities that should be held in a portfolio to meet specific investment goals.Financial services—refers to servicesprovided byorganizations such as brokerage firms,banks, insurance companies, and so forth. These services relate primarily to the financialstability of individuals both in the current period and in the future.Managerial finance—deals with the decisions that businesses make concerning their cashflows. Businesses make decisions about how to raise funds (financing) and what to do with thefunds that are raised (investments). The techniques used to make such decisions are partmanagerial finance.

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Principles of Finance6eChapter 1Besley/Brigham1-3c.One of the most important changes in finance during the past century has been that thetechniques used to make financial decisions have become much more sophisticated. Theelectronic revolution, especially with respect to computers, has fueled this change. In addition,financial decision making has become much more concerned with value, especially with how afirm can maximize its value.d.During the past couple of decades, Congress has been fairly “business friendly,” which has ledto more deregulation than regulation. Industries such as financial services, transportation, andutilities havebecome much less regulated and thus much more competitive than previously.However, Congress typically is reactive rather than proactive when passing legislation thataffects business. As a result, we generally expect that new legislation will be passed orreregulation will be imposed when Congress believes particular events harm the economy andbusiness. For example, the Sarbanes Oxley Act of 2002 was passed in response to thedownfall of Enron, WorldCom, and others that resulted from unethical, and in some casesillegal, accounting actions. As the time we write this book, the economy is performing poorly,which some believe is the direct result of unethical practices that occurred in the real estate andmortgage markets during the past few years. Congress is currently considering legislation thatwill restrict how mortgage companies originate mortgages for individuals.e.Value refers to the amount that should be paid for an asset (investment) today, and it isdetermined by computing the amount an investor must invest today at a particular rate of returnto generate the same cash flows that the asset is expected to generate during its life. In otherwords, an investor should never pay more for an investment than what he or she would needtoday to produce the same cash flow pattern that the investment is expected to produce in thefuture.f.Firms focus on the values of their common stocks; thus, they maximize value bymaximizingthemarket prices of theirstocks.Individuals maximize value in a similar fashion—that is,individuals maximize the total values of the combinations of investments that they hold.g.Sustainability refers to the process by which we live and interact with businesses, governments,other humans, and so forth, and how both the current environment and the future environmentare affected by the actions of all of these stakeholders. To remain a going concern, a firm mustbe concerned with sustainability. If a firm does not consider the effects of its decisions onsustainability, then it might find itself in bankruptcy in the future because one or more of thestakeholder groups (employees, customers, environment, and so forth) was irreparablyharmed.h.Firms that adhere to the concepts of lean manufacturing attempt to eliminate excesses (“fat”)so as to become as efficient as possible. To maximize value, a firm (investment) shouldmaximize the net cash inflows generated during its life. A firm that follows lean manufacturingtechniques reduces waste, thus minimizes cash outflows associated with costs, which helps tomaximize net cash inflows.ETHICAL DILEMMAWho Hasthe Money—The DemocratorThe Republican?Ethical dilemma:There are a few of factors that should be considered here. First, Sunflower Manufacturing has applied for a

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Chapter 1Principles of Finance 6eBesley/Brigham1-4$10 million working capital loan at The Democrat Federal Bank (known as The Democrat). But the personwho is evaluating the loan application, Sheli, has determined that the bank should lend the company only$2 million. Sheli’s analysis of Sunflower suggests that the company doesnot have the financial strength tosupport the higher loan. Second, if Sunflower is not granted the loan for the requested amount, thecompany might take its banking business to a competitor of The Democrat. Third, The Democrat is havingfinancial difficulties that might result in future layoffs. Sheli might be affected by the bank’s layoffs if herdivision does not meet its quota of loans. As a result, it might be in her best interest to grant Sunflower theloan it requested even though her analysis suggests that such an action is not rational.Discussion questions:•What is the ethical dilemma?In this case, the ethical dilemma is whether Sheli should grant Sunflower a loan for the amount thatwas requested even though she believes that the company’s existing credit position is not strongenough for such a loan. It appears that Sheli would be making a decision that she does not favor in aneffort to help her division meet its loan quota and perhaps to save her job with the bank. If Sheli basesher decision on her own best interests—that is, keeping her job—at the expense of the bank, then sheprobably is making an unethical decision. If, on the other hand, her decision is based on the bestinterests of the bank, then her decision is justified.•Do you agree with Sheli or Henry concerning the importance of loyalty as a factor in loan decisions?To answer this question, other questions should be asked. Do you believe that customer loyalty is animportant factor when making financial decisions? If so, how important of an input should loyalty be insuch decisions?It appears that Henry believes loyalty is a very important factor that should be considered when makingdecisions about loans. Thus, Henry considers intangibles when making loan decisions. On the otherhand, it seems that Sheli would prefer to rely strictly on her analyses to make decisions; she doesn’tseem to be keen on considering intangibles when making such decisions. How should such factors asloyalty and previous business relationships be incorporated into financial decisions? How important arethese factors?Most people would agree that loyalty and previous credit history are important factors to consider whenmaking loan decisions. The fact that Sunflower Manufacturing has been a loyal customer of TheDemocrat for many years must be considered when making the decision about how much the companyshould be allowed to borrow. But, is the company’s loyalty sufficient to increase the amount of the loanfrom the $2 million that Sheli’s analysis indicates the company should be granted to the $10 million thatSunflower requested? Perhaps. Because one of the most important inputs to a loan decision is thecharacter of the borrower, loyalty should be considered when deciding how much to lend to Sunflower.•Should The Democrat lend Sunflower the $10 million was requested?On the positive side, if The Democrat lends Sunflower the amount that was requested, then it appearsthat Sheli and Henry will meet their loan quotas and their jobs will be secure for a while. On the otherhand, if Sheli is right and Sunflower’s financial position is not sufficient to handle a $10 million loan,there is a good likelihood that the loan will not be repaid, which would exacerbate The Democrat’s poorfinancial position. In this case, both the lender and the borrower might go bankrupt.Like any other investment, lending money is risky. In this case, Henry is convinced that Sunflower willtake its business to a competing bank if the entire $10 million loan is not granted. Because TheDemocrat has been losing business to competing banks, Henry would like to find a way to lendSunflower the money it has requested. It appears that Sheli is amenable to lending the money to

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Principles of Finance6eChapter 1Besley/Brigham1-5Sunflower, but her motives might not be appropriate. At least she is willing to reconsider her initialrecommendation. Perhaps Sheli could sit down with Sunflower’s executives and “map out” a plan thatwill improve the company’s financial strength and permit The Democrat to approve the $10 million loanwithout further harming its own financial.•What would you do if you were Sheli?Commercial lending is a very competitive business. Sheli would be wise to thoroughly examineSunflower’s existing financial position and project what its financial position will be during the life of theloan. If the financial position does not warrant granting the loan in the amount of $10 million, Shelishould determine how Sunflower can improve its financial position so that the firm can borrow what itneeds to continue successful operations. Because Sunflower has been a loyal customer of the bank,The Democrat should be a loyal lender. But the bank’s loyalty can only go so far—that is, the bankshould not substantially jeopardize own operations/life.References:“Banks Take a New Tack On Mortgage Lending,”The Wall Street Journal Online, November 1, 2006.(http://online.wsj.com/)Karen E. Klein, “Building Customer Relations by Listening.” BusinessWeek.com,June 1, 2007.

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Principles of Finance 6eChapter 2Besley/Brigham2-1CHAPTER 2ANSWERS2-1Preferred stocks are similar to bonds because the preferred dividends that a company pays areconstant like the interest it pays on its outstanding bonds. Preferred stock is similar to commonstock because the firm cannot be forced into bankruptcy if it fails to pay a preferred dividend. Inaddition, like common stock, preferred stock has no maturity.2-2A bond represents a loan contract between the firm that issued the bond and the investors thatpurchased the bond. The bond contract, which is called an indenture, specifies the amount ofinterest that must be paid each year to ensure that the bond issuer is not in default of the contract.On the other hand, there is no legal contract associated with a stock issue. Equity issuers are notlegally bound to pay dividends; the decision as to whether dividends are paid to stockholders isbased on the firm’s financial position, plans for future growth, and so forth. Factors that affect thedecision to pay dividends are discussed in detail later in the text.2-3The dividend that is paid to preferred stockholders generally is stated as a percentage of thepreferred stock’s par value. The preferred stocks’ par value also represents the per share dollaramount that will be paid to preferred stockholders in the event the firm is liquidated (assuming thatall debt obligations are satisfied first). On the other hand, the par value of common stock has littlesignificance to common stockholders. The par value of common stock represents the minimumliability of a common stockholder in the event the firm goes bankrupt. Generally, common stock issold for greater than its par value, which means that common stockholders have no additionalfinancial liability if the firm goes bankrupt.2-4a.0Bonds and term loans are equivalent debt instruments and should have about the sameinterest rate.b.+Debentures are riskier than mortgage bonds and, hence, would require a higher interestrate.c.–This would allow bondholders to reap the benefits of a stock price increase, so they wouldaccept a lower interest rate.d.(1)+Because the debentures will be subordinated to its bank debt, the debentures will havea higher interest rate.(2)–Because the debentures will be subordinated to the bank debt, the bank debt will havea lower interest rate.(3)0The net effect of (1) and (2) is indeterminant.e.+Because income bonds are riskier, they would carry a higher rate of interest.f.(1)–The more of the property that is mortgaged the weaker the claim of the debentureholders. Thus, going from $75 million to $50 million of first mortgage debt willstrengthenthe debentures and lower their interest rate.(2)–The property will have a smaller mortgage; hence, each individual first mortgage bondwill be better secured, less risky, and have a lower interest rate.(3)0Debentures will cost less, as will mortgage bonds, but theaverage costprobably willbe about the same—at least, it is not obvious that the cost will be higher or lower. Thisoccurs because the rate on the mortgage bonds is lower than that on debentures, butthe weights are shifting toward the riskier, higher rate debentures.g.+A call provision increases the risk to the bondholders, so a higher rate would be required.

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Chapter 2Principles of Finance 6eBesley/Brigham1-2h.–The sinking fund calls for repayment over the life of the bond. This lowers somewhat therisk of the issue, hence leads to lower rates.i.+This would raise the interest rate because a lower rating implies greater risk.2-5Safety Ranka.Income bond7b.Subordinated debenture—noncallable5c.First mortgage bond—no sinking fund3d.Common stock8e.U.S. Treasury bond1f.First mortgage bond—with sinking fund2g.Subordinated debentures—callable6i.Term loan42-6From the corporation's viewpoint, one important factor in establishing a sinking fund is that its ownbonds generally have a higher yield than do government bonds; hence, the company saves moreinterest by retiring its own bonds than it could earn by buying government bonds. This factor causesfirms to favor the second procedure. Investors also would prefer the annual retirement procedure ifthey thought that interest rates were more likely to rise than to fall, but they would prefer thegovernment bond purchases program if they thought rates were likely to fall. In addition,bondholders recognize that, under the government bond purchase scheme, each bondholder wouldbe entitled to a given amount of cash from the liquidation of the sinking fund if the firm should gointo default, whereas under the annual retirement plan, some of the holders would receive a cashbenefit while others would benefit only indirectly from the fact that there would be fewer bondsoutstanding.On balance, investors seem to have little reason for choosing one method over the other, whilethe annual retirement method is clearly more beneficial to the firm. The consequence has been apronounced trend toward annual retirement and away from the accumulation scheme.2-7($ million)Common stock (42 million shares outstandingAt $1 par)[$40 million + $2 million]$ 42Additional paid-in capital = $120 + $48168Retained earnings170Total common stockholders' equity$380Total value of the issue = 2 million sharesx$25 = $50 millionAdded to Common stock account = 2 million sharesx$1 par = $2 millionAdded to Additional paid-in capital account = $50 million-$2 million=$48 million2-8a.The average investor in a listed firm is not really interested in maintaining his or herproportionate share of ownership and control. An investor could increase ownership by simplybuying more stock on the open market. Consequently, most investors are not concerned withwhether new shares are sold directly (at about market prices) or through rights offerings.However, if a rights offering is being used to effect a stock split, or if it is being used to reducethe underwriting cost of an issue (by substantial underpricing), the preemptive right might wellbe beneficial to the firm and its stockholders.b.Clearly, the preemptive right is important to the stockholders of closely-held firms whoseowners are interested in maintaining their relative control positions.

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Principles of Finance 6eChapter 2Besley/Brigham2-32-9Preferred stock can be classifiedonlywhen the one doing the classification is considered. From thestandpoint of the firm, preferred stock is like equity in that it cannot force the firm into bankruptcy,but it is like debt in that it causes fluctuations in earnings available to the common stockholders.Consequently, if the firm is concerned primarily with survival, it probably would classify preferredstock as equity. However, if there is essentially no danger of bankruptcy, management would viewpreferred stock as simply another fixed charge security and treat it internally as debt. Equityinvestors would have a similar viewpoint, and in general they should treat preferred stock in muchthe same manner as debt. For creditors, the position is reversed. They take preference overpreferred stockholders, and the preferred issues act as a cushion. Consequently, a bond analystprobably would want to treat preferred as equity. Obviously, in all these applications, there wouldhave to be some qualifications; in a strict sense, preferred stock is neither debt nor equity, but ahybrid.2-10When the price of its stock is temporarily depressed and a firm wishes to raise funds via an equityissue, the company’s investment banker probably will recommend convertible debt be issued. Thefirm can use convertible bonds if it is believed that the price of the stock will rise sufficiently in thefuture to make conversion attractive. Then, if conversion takes place when the stock price is higher,the firm will have essentially issued its stock at a price higher than existed when the convertiblebond was issued.2-11The convertible bond has an expected return that consists of an interest yield (9 percent) plus anexpected capital gain. We know the expected capital gain must be at least 3 percent, because thetotal expected return on the convertible must be at least equal to that on the nonconvertible bond,12 percent. In all likelihood, the expected return on the convertible would be higher than that on thestraight bond, because a capital gains yield is riskier than an interest yield. The convertible would,therefore, probably be regarded as being riskier than the straight bond. However, the convertible,with its interest yield, probably would be regarded as being less risky than common stock.2-12a.Most firms have a continuing need for long-term debt to finance operations (at least as long asthey are still in business). It would make sense for a firm to issue bonds like the Canadianbonds. If you think about it, the most significant difference between a 30—year bond and aperpetual bond that is callable is that there is a refinancing requirement for the regular bond atthe end of 30 years. This refinancing requirement probably will change the cost of the bond,because refinancing takes place at existing market rates.b.The default risk will be negligible for each bond. The interest rate risk, however, will be greatestfor the bond with the longest term to maturity. As a result, the perpetual bonds’ interest rate riskwill be greater than for the 5-year bond (which will have the lowest interest rate risk) and the50-year bond. Because the Canadian bond will be called only if interest rates decline, it isconsidered the riskiest, and thus will have the highest expected interest rate. The order of theexpected interest rate from lowest to highest would be:5-year bond50-year bondregular perpetual bondCanadian perpetual bondc.Probably not. If rates had dropped so that bonds with a coupon rate equal to 3 percent could besold, the Canadian government probably would have issued the 3-percent bonds to replace themore expensive bonds.d.If the information bondholders used to reach their conclusion that the bonds would be calledwas unfounded, then there should be no reason to expect the Canadian government to foot thebill for investors’ mistakes. At the same time, some might argue that the Canadian governmenthas a moral obligation to ensure that any false information that it knows about is not passed onto investors. If the Canadian government originally sold the bonds to naïve investors and hadsomehow led them to think that the bonds would be called, the fairness might indicate thatretirement is appropriate. But, if you think about it, the original investors probably sold the

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Chapter 2Principles of Finance 6eBesley/Brigham1-4bonds many years ago, so there no longer would be such an obligation to them. Educatedinvestors should know that the government would not call the bonds when the interest rateswere so high—in effect, the government would be wasting constituents’ money.─────────────────────────────────────────────────SOLUTIONS2-1a.The conversion price simply is the face (par) value of the bond divided by the conversionratio—the conversion price for this issue is $1,000/25 = $40. Therefore, it would be beneficialfor investors to convert their bonds into common stock when the price of the stock is greaterthan $40 per share.b.The conversion feature would add some flexibility to the bonds as an investment. Investorsmight find it attractive to buy the bonds because they can later decide whether they prefer toremain bondholders or to convert and become stockholders.Adding a call provision will helpthe firm, because the firm can “force” bondholders to convert by calling the bond when thestock price is greater than $40. For example, if the stock price is $45 and the bond’s call priceis $1,100 when the firm calls the bond, it would be better for bondholders to convert the bondinto common stock because the value of the common stock would be $1,125 = 25 x $45, whichis greater than the $1,100 call price.2-2a.Dividend = $50(0.08) =$4b.Conversion price = $50/4 = $12.50; an investor should consider converting when the price ofthe stock exceeds this price.c.Shares currently outstanding = ($2.5 million)/$50 = 50,000 sharesNew sharesof common stockif all preferred stockholders convert = 4(50,000) = 200,000shares2-3a.Number of zeros= Amount needed/Price per bond= $4,500,000/$567.44 = 7,930.35= 7,931 bonds.b.Filkins will have to repay $4.5 million when the bond maturesin five years. But because thedebt is a zero-coupon bond, there will no interest payments in the meantime. Thus, the annualdebt service costs are $0.2-4a.If P0= $18, the option is exercised, and the stock is sold immediately, the gain would be ($18-$15)x100 = $300. Therefore, it would be beneficial to exercise the option.b.If P0= $13, the option is exercised, and the stock is sold immediately, the loss would be ($13-$15)x100 =-$200. Therefore, it would not be beneficial to exercise the option.c.The answers in part (a) and part (b) would be reversed if the option were a put with the sameexercise price:If the stock is purchased for $18 and sold to the option writer by exercising the option, the losswould be ($15-$18)x100 =-$300. The option holder would have to buy the stock at $18 pershare to exercise the put and sell the stock at $15 to the option writer. Therefore, it would notbe beneficial to exercise the option.

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Principles of Finance 6eChapter 2Besley/Brigham2-5If the stock is purchased for $13 and sold to the option writer by exercising the option, the gainwould be ($15-$13)x100 = $200. In this case, the option holder would be able to buy thestock at $13 per share and then sell it to the option writer at $15 by exercising the option.Therefore, it would be beneficial to exercise the option.2-5a.If the stock is purchased for $26 per share and sold to the option writer by exercising theoption, the gain/loss would be ($25-$26)x200 =–$200.b.If the stock is purchased for $30 per share and sold to the option writer by exercising theoption, the loss would be ($25-$30)x200 =–$1,000. Therefore, it would not be beneficial toexercise the option.c.If the stock is purchased for $20 per share and sold to the option writer by exercising theoption, the loss would be ($25-$20)x200 = $1,000. Therefore, it would be beneficial toexercise the option.2-6a.Balance sheets:Meyer Balance Sheet ($ thousands):Debt$400Equity200Total assets$600Total liabilities and equity$600Haugen Balance Sheet ($ thousands):Debt$200Equity400Total assets$600Total liabilities and equity$600b.Haugen sold $200,000/$50 = 4,000 shares to raise the funds needed to purchase the newmachine. Therefore, because the stock issue increased the number of existing shares by 20percent, the number of shares Haugen had outstanding before the issue wasshares020,00=0.20sharesnew4,000=issuethebeforesharesgoutstandinofNumbersharesnew4,000=issuethebeforesharesgoutstandinofNumber0.20Thus, the number of shares that are outstanding after the stock issue equal 24,000.c.Income Statement for Meyer Manufacturing ($ thousands):ΔEBIT$100.0ΔInterest = $200x0.08( 16.0)ΔEarnings before taxes84.0ΔTaxes (40%)( 33.6)ΔNet income (earnings availableto pay to common stockholders)$ 50.4Income Statement for Haugen Mills ($ thousands):

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Chapter 2Principles of Finance 6eBesley/Brigham1-6ΔEBIT$100.0ΔInterest = $0x0.08( 0.0)ΔEarnings before taxes100.0ΔTaxes (40%)( 40.0)ΔNet income (earnings available to pay to common stockholders$ 60.0d.Meyerissued bonds, not stock, so it has 20,000 shares of common stock outstanding.Therefore, Meyer’s earnings per share, EPS, is$2.52=20,000$50,400=EPSMey erHaugen issued stock and its shares outstanding increased to 24,000. Therefore, Haugen’searnings per share, EPS, is$2.50=24,000$60,000=EPSHaugenIf we use the EPS to evaluate both companies, we would conclude Meyer’s decision to issuedebt was better than Haugen’s decision to issue stock. We will discuss this concept further inlater chapters in the book.2-7a.Cox Computer Company Balance Sheet:Alternative 1:Short-term debt$ 25,000Long-term debt25,000Common stock, par $175,000*Paid-in capital225,000*Retained earnings25,000Total assets$375,000Total liabilities and equity$375,000*At $10 per share, $250,000/$10 = 25,000 shares would have to be sold to raise the $250,000.Therefore, at $1 par value, the Common stock account will increase by $1x25,000 = $25,000,and the remaining $225,000 is Paid-in capital. Because $150,000 is used to pay some of thebank debt, assets increase by only $100,000. Total shares outstanding after the issue: 75,000= 50,000 + 25,000.Alternative 2:Short-term debt$ 25,000Long-term debt25,000Common stock, par $170,000*Paid-in capital230,000*Retained earnings25,000Total assets$375,000Total liabilities and equity$375,000*To raise $250,000, the firm would have to sell $250,000/$1,000 = 250 bonds. Each bond isconvertible into 80 shares of common stock; thus, conversion will increase the number ofshares outstanding by 20,000= 80 x 250. Therefore, at $1 par value, the Common stockaccount will increase by $1x20,000 = $20,000, and the remaining $230,000 is Paid-in capital.Total shares outstanding after the conversion: 70,000 = 50,000 + 20,000.

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Principles of Finance 6eChapter 2Besley/Brigham2-7Alternative 3:Short-term debt$25,000Long-term debt275,000Common stock, par $150,000Retained earnings25,000Total assets$ 375,000Total liabilities and equity$ 375,000b.OriginalAlt.1Alt.2Alt.3_____________________________Number of CharlesCox's shares40,00040,00040,00040,000Total shares50,00075,00070,00050,000Percent ownership80%53%57%80%c.OriginalAlt.1Alt. 2Alt.3__________________________________Total assets$275,000$375,000$375,000$375,000EBIT$ 55,000$ 75,000$ 75,000$ 75,000Interest*( 17,500)( 2,500)( 2,500)( 32,500)EBT$ 37,500$ 72,500$ 72,500$ 42,500Taxes (40%)( 15,000)( 29,000)( 29,000)( 17,000)Net income$ 22,500$ 43,500$ 43,500$ 25,500Number of shares50,00075,00070,00050,000Earnings per share$0.45$0.58$0.62$0.51*Both the bank loans and the long-term debt require interest payments; the amount of short-term debt that is not a bank loan does not require interest payments. Before new financing isobtained, the amount of the bank loan is $150,000 and the amount of long-term debt is$25,000—at 10 percent, the total interest is ($150,000 + $25,000)x0.10 = $17,500. Thefinancing plans eliminate the bank loans, so the interest payment for each plan is: (1)Alternative 1 has $25,000 long-term debt with interest payments equal to $2,500; (2) Alternative2 has $25,000 long-term debt with interest payments equal to $2,500; and, (3) Alternative 3 has$275,000 long-term debt with interest payments equal to ($25,000x0.10) + ($250,000x0.12)= $$32,500.d.Each alternative permits Charles Cox to maintain control of the firm (more than 50 percentownership). In addition, each alternative results in an increase in EPS. But, becausePlan2results in the greatest increase in EPS, it would be preferred.2-8a.Book value per share = ($364,000 + $336,000)/20,000 = $35.00b.Total amount of issue= 10,000x$32.55 = $325,500Book value after issue= ($364,000 + $336,000) + $325,500= $1,025,500Book value per share = $1,025,500/30,000 = $34.182-9a.Today, the amount Fibertech has to pay today is known with certainty because the currentexchange rate is known. In other words, if Fibertech decides to pay the bill today, it needs$500,000 to purchase 5,500,000 yen. However, if Fibertech waits to pay the bill when it is due

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Chapter 2Principles of Finance 6eBesley/Brigham2-8in 90 days, the exchange rate might be different and thus the company might have to pay morethan $510,000 to purchase the 5,500,000 yen (it also might be able to pay less). The primaryadvantage to waiting to pay the bill is that Fibertech can use the funds for other purposes. Inaddition, it can avoid the high cost of borrowing funds to pay the bill today.b.Cost to Fibertech = 5,500,000 x $0.095 = $522,500 in 90 days when the bill is due.c.At $0.100 per yen, the cost to purchase the needed amount of yen would be:5,500,000 x $0.100 = $550,000At $0.085 per yen, the cost to purchase the needed amount of yen would be:5,500,000 x $0.085 = $467,500d.The primary benefit Fibertech would receive by entering a futures contract is that it would beable to “lock in” today the price of the yen needed in 90 days. For example, if the futurescontract in part (b) was entered, then Fibertech knows that it needs $522,500 in 90 days to paythe debt it owes the Japanese manufacturer, regardless of what the actual exchange rate is atthat time—the futures contract has “locked in” the price today.2-10Integrative ProblemPart I: Initial Expansiona.Financing with stock offers several advantages over debt, but there are also disadvantages.The major advantages and disadvantages are discussed below.ADVANTAGES:(1)Common stock will not obligate Gonzales to make fixed payments. Gonzales’s managerscan choose to pay dividends if earnings are sufficient. If Gonzales sells bonds, it will berequired to make interest payments on fixed dates.(2)Common stock never matures and never has to be repaid.(3)The use of common stock will improve Gonzales’s debt ratio and increase its future ability touse debt.DISADVANTAGES:(1)The Gonzales family might have to give up some voting control if it sells common stock.(2)The Gonzales family will have to share the earnings of the business with the newstockholders.(3)Because common stock is riskier than debt, the issuing cost will be higher than it would beif debt were used.(4)Common stock dividends are not tax deductible, as are interest payments.b.Because all of Gonzales’s stock is owned by family members, the stock is said to be privatelyowned, or closely held. If some stock is sold to the public, the stock will then be publicly held.c.Classified stock is stock that is given some special designation. Those designations typicallyare Class A, ClassB, and so on, but any designation can be used. “founders’ shares” is thename given to classified stock that is owned by the firm’s founders. Founders’ shares generallyhave sole voting rights, but restricted dividends for a number of years. Because the Gonzalesfamily wants to maintain control of its company, the firm might designate the shares owned byfamily members as founders’ shares. Then,ClassBstock, which would have the right toreceive dividends but not to vote, would be sold to the public.

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Principles of Finance 6eChapter 2Besley/Brigham2-9d.Yes, it would, although this might make the selling job more difficult both because more shareswould be involved and also because some potential investors might be concerned to see familymembers unloading shares. Still, it is not at all uncommon for founding stockholders to sellsome of their shares as a part of the initial offering in order to diversify their personal holdings.Indeed, some companies go public using only already-issued shares, that is, where thecompany receives none of the money raised.Part II: Subsequent Expansionsa.Bonds and term loans both are long-term debt contracts under which a borrower agrees tomake a series of interest and principal payments on specified dates to the lender(s). The maindifference is that a term loan usually is placed with one or more financial institutions (a bank, aninsurance company, or a pension fund), while a bond typically is sold to the public. Term loansoften are used (1) by financially weaker companies or (2) to finance specialized projects,because in both cases the borrower must tell a relatively complicated “story” as to why thelender should make the loan, and it is more difficult and expensive “to tell the story” to a largenumber of lenders, as would be necessary in a bond issue.b.(1) If Gonzales uses the manufacturing facility as collateral for its debt, the bonds would bemortgage bonds, and presumably first mortgage bonds. Because this is secured debt, theinterest rate on mortgage bonds is lower than on most other types of long-term debt. (Theexception is floating rate debt.) (2) Had Gonzales used unsecured debentures, the risk toinvestors would have been higher; consequently, the interest rate required on debentureswould have been higher.c.A bond indenture is a formal agreement between the issuer of the bond and the investors whobuy the bonds. It is designed to keep the issuing firm from doing something to cause the qualityof the bonds to deteriorate after they have been sold. Atrusteeis assigned to insure that theprovisions of the indenture are carried out and that the interests of the bondholders areprotected.Indentures containrestrictive covenantsthat constrain the actions of the issuing firm. Includedare such points as (1) the conditions under which the issuer can refund or call the issue (callprovisions), (2) whether the firm is required to set up a sinking fund to retire a portion of theissue each year, (3) the levels at which key financial ratios must be maintained, and (4) thelevel of earnings that must be met before dividends can be paid to stockholders.d.A company will only call a bond issue if interest rates have fallen, and, if the bond is called, thebondholders will have to reinvest their money at the then prevailing lower interest rate.Therefore, the inclusion of a call provision increases thereinvestment riskthat the bondholdersface, and this increased risk causes them to raise their required return on the bond, which inturn raises the interest rate the company must pay.If Gonzales did not include a call provision, it would be able to sell the issue at a rate somewhatbelow 12 percent. By delaying the call, Gonzales guarantees investors the promised rate for atleast 3 years, so the interest rate is lower than it would have been if the issue is immediatelycallable.The advantage to Gonzales of including a call provision is that if interest rates should fallafter 3years, the company would be able to refund the issue and sell a new issue at the lower interestrate.e.(1)If Gonzales included a sinking fund provision in the contract, the interest rate woulddecline. A sinking fund protects the bondholders by insuring that the firm will be able toretire the issue in an orderly manner when the maturity date is reached. This lowers thebond’s riskiness and, consequently, the required interest rate.

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Chapter 2Principles of Finance 6eBesley/Brigham2-10(2)A sinking fund provision generally requires the firm to retire a specified percentage of thebond issue each year. Gonzales would probably be given the option of purchasing bondson the open market at the prevailing market price or calling in randomly selected bonds atpar. Because the sinking fund is designed to protect the bondholders, Gonzales would notpay a premium to the holders of the called bonds. The company would choose the method(call or market purchase) that had the lowest cost. Therefore, if interest rates had fallen,and the bonds were selling at a premium, Gonzales would call bonds. However, if interestrates had increased, the bonds would be selling at a discount, and Gonzales would buybonds in the open market.(3)The longer the maturity of a bond, the more logical it is to include a sinking fund provision,and the more likely one is to be found on a bond. Thus, “sinkers” are common on 30-yearbonds but rare on 5-year issues. The reason is that the longer the maturity, the greater theprobability that something will go wrong, hence the greater the need to assure orderlyrepayment.(4)Because Gonzales’s bond matures in only 10 years, itis not likely to include a sinking fund.Note also that the money raised will be used to build and “break in” a new manufacturingfacility. Because properties do not generate cash until they are operational, and sinkingfunds normally are paid out of operating cash, there is further reason to doubt that asinking fund would be used in this instance.f.If Gonzales’s bond rating were lowered by various bond rating agencies (such as Moody’s andstandard & Poor’s), investors would demand a higher return on its debt. This would (1) raise thecost of new debt and (2) lower the value of Gonzales’s outstanding debt. An increase inGonzales’s bond rating to double-A would lower the rate required on Gonzales’s debt andincrease the market value of the outstanding debt.Note these additional points regarding bond ratings:(1)Moody’s and standard & Poor’s are the major rating agencies.Corporations pay theagencies to have their debt rated prior to a new offering, and to have a continuingevaluation after the issuance.(2)Investment bankers (firms that help issue stocks and bonds) generally insist that bonds berated as a condition for selling new bonds, because (a) purchasers want to know how riskya bond is, (b) investors don’t want to try to analyze the bond’s risk, so (c) it is more efficientto have the agencies rate the bond and then provide this information to investors(economies of scale).(3)The ratings serve as a qualitative guide to the probability of default.In a sense, ratingsreflect the probability distribution of the expected rate of return for the remaining life of thebond. Bond rating analysts do not use a strict formula when they make ratings, but peoplehave used statistical techniques to predict (a) bond ratings, (b) changes in ratings, and (c)actual probabilities of bankruptcy.g.Here are some factors that influence financing decisions:(1)The target capital structure(2)Maturity matching: use debt that has a maturity equal to the asset’s life.(3)Interest rate levels and the yield curve(4)Relative costs of different types of securities(5)Restrictive covenants that would be required(6)The firm’s financial condition, especially the tie ratio(7)The firm’s investment opportunities (asymmetric information and signaling effects)(8)The availability of collateralNote that if markets were truly efficient, and conditions were stable, the type of security usedwould be immaterial, because the cost of each security would be commensurate with its risk.

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