tb chapter20

8/8/2019 TB Chapter20

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(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:

Lease cash flows Answer: c Diff: E

1. The riskiness of the cash flows to the lessee, with the possible exception

of residual value, is about the same as the riskiness of the lessee’s

a. Equity cash flows.

b. Capital budetin pro!ect cash flows.

c. "ebt cash flows.

d. #ension fund cash flows.

e. $one of the statements above is correct.

Operating lease Answer: e Diff: E

%. &peratin leases usually have terms that include

a. 'aintenance of the equipment.

b. &nly partial amorti(ation.

c. Cancellation clauses.

d. )tatements a and c are correct.

e. *ll of the statements above are correct.

Leasing Answer: c Diff: E N

+

. hich of the followin statements concernin leasin is most correct-

a. * sale and leaseback is a lease under which the lessor maintains and

finances the property also called a service lease.

b. The lessor is the party that uses the leased property.

c. * financial lease is a lease that does not provide for maintenance

services, is not cancelable, and is fully amorti(ed over its life also

called a capital lease.

d. *n important characteristic of operatin leases is the fact that they

are frequently fully amorti(ed in other words, the payments required

under the lease contract are sufficient to recover the full cost of the

equipment.

e. $one of the statements above.

Chapter 20 - Page 1

CHAPTE !"H#$%D &%'A'C%': PE&EED T*C+, EA%',-AA'T, A'D C*'.ET%$E


2/25

Reporting earnings Answer: d Diff: E

/. hich of the followin are methods of reportin earnins when warrants or

convertibles are outstandin-

a. 0asic E#).

b. #rimary E#).

c. "iluted E#).d. *ll of the statements above are correct.


Reporting earnings Answer: d Diff: E

. hich of the followin methods of reportin earnins when warrants or

convertibles are outstandin are required under )EC rules-

a. 0asic E#).

b. #rimary E#).

c. "iluted E#).

d. )tatements a and c are correct.


Warrants Answer: e Diff: E N

2. hich of the followin statements concernin warrants is most correct-

a. arrants cannot be traded separately from the bond with which they are

associated.

b. * warrant is a lon3term option to buy a stated number of shares of

common stock at a specified price.

c. arrants are lon3term call options that have value because holders can

buy the firm’s common stock at the exercise price reardless of how

hih the market price climbs.

d. )tatements a, b, and c are correct.

e. )tatements b and c are correct.

Medium:

Lease decision Answer: e Diff: M

4. 5n the lease versus buy decision, leasin is often preferable

a. )ince it does not limit the firm’s ability to borrow to make other

investments.

b. 0ecause, enerally, no down payment is required, and there are no

indirect interest costs.

c. 0ecause lease obliations do not affect the riskiness of the firm.

d. *ll of the statements above are correct.


Chapter 20 - Page 2


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Capitalizing leases Answer: e Diff: M

6. 7inancial *ccountin )tandards 0oard 87*)09 )tatement :1+ requires that

for an unqualified audit report, financial 8or capital9 leases must be

included in the balance sheet by reportin the

a. ;alue of the leased asset as a fixed asset.

b. #resent value of future lease payments as an asset.c. #resent value of future lease payments as a liability.

d. )tatements a and b are correct.

e. )tatements a and c are correct.

Leasing Answer: e Diff: M

financin, such as leasin, will

show lower debt ratios once the effects of their leases are reflected

in their financial statements.

b. Capitali(in a lease means that the firm issues equity capital in

proportion to its current capital structure, in an amount sufficient to

support the lease payment obliation.

c. The fixed chares associated with a lease can be as hih as, but never

reater than, the fixed payments associated with a loan.

d. Capital, or financial, leases enerally provide for maintenance service

on the part of the lessor and can be refinanced at the discretion of

the lessee.

e. * key difference between a capital lease and an operatin lease is that

with a capital lease, the total lease payments on the asset are rouhly

equal to the full price of the asset plus a return on the investment in

the asset.

Leasing Answer: a Diff: M

1?

. hich of the followin statements is most correct-

a. 7inancial leases are fully amorti(ed.

b. 7inancial leases can be canceled.

c. 7inancial leases provide for maintenance services.

d. &peratin leases can never be canceled.


Off-balance sheet leasing Answer: b Diff: M

11. @eavy use of off3balance sheet lease financin will tend to

a. 'ake a company appear more risky than it actually is because its stated

debt ratio will appear hiher.

b. 'ake a company appear less risky than it actually is because its stateddebt ratio will appear lower.

c. *ffect a company’s cash flows but not its deree of risk.

d. @ave no effect on either cash flows or risk because the cash flows are

already reflected in the income statement.


Chapter 20 - Page 3


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Lease analsis disco!nt rate Answer: a Diff: M

1%. The lease analysis should compare the cost of leasin to the

a. Cost of ownin usin debt.

b. Cost of ownin usin equity.

c. *fter3tax cost of debt to measure the effect of leasin on the cost of

equity.d. *verae cost of all fixed chares.

e. Cost of ownin usin the weihted averae cost of capital for the firm.

Con"ertibles Answer: e Diff: M

1+. hich of the followin statements about convertibles is correct-

a. The coupon interest rate on convertibles is enerally hiher than on

straiht debt.

b. $ew equity funds are raised by the issuer when convertibles are

converted.

c. 5nvestors are willin to accept lower interest rates on convertibles

because they are less risky than straiht debt.

d. *t issue, a convertible’s conversion 8exercise9 price is often set

equal to the current underlyin stock price.


Con"ertibles Answer: b Diff: M

1/. * 1?3year convertible bond has a face value of A1,??? and pays an annual

coupon of A?. The bond’s conversion price is A/?. The issuin company’s

stock currently trades at A+? a share. The company can issue straiht

8non3convertible9 debt with an 6 percent yield. hich of the followin

statements is most correct-

a. The bond’s conversion ratio is %?.

b. The bond’s conversion value is currently A4?.c. The bond’s straiht3debt value is A4?.

d. The bond’s straiht3debt value is A1,???.

e. The convertible bond should sell for less than A4?.

Warrants and con"ertibles Answer: c Diff: M

1. hich of the followin statements about warrants and convertibles is

incorrect-

a. 0oth warrants and convertibles are types of option securities.

b. &ne primary difference between warrants and convertibles is that

warrants brin in additional funds when exercised, while convertibles

do not.

c. The coupon rate on convertible debt is lower than the coupon rate onsimilar straiht debt because convertibles are less risky.

d. The value of a warrant depends on its exercise price, its term, and the

underlyin stock price.

e. arrants usually can be detached and traded separately from their

associated debt.

Chapter 20 - Page 4


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Warrants Answer: c Diff: M

12. hich of the followin statements is most correct-

a. * warrant is basically a lon3term option that enables the holder to

sell common stock back to the firm at an areed upon price, at a

specified time in the future.

b. Benerally, warrants are distributed alon with preferred stock in orderto make the preferred stock less risky.

c. 5f a company issuin coupon3payin debt wanted to reduce the cash

outflows associated with the coupon payments, it could issue warrants

with the debt to accomplish this.

d. &ne of the disadvantaes of warrants to the issuin firm is that they

are detachable and can be traded separately from the debt with which

they are issued.

e. arrants are attractive to investors because when they are issued with

stock investors receive dividends on the warrants they own, as well as

on the underlyin stock.

#ond with warrants Answer: e Diff: M

14. The straiht3debt value of a %?3year, 1? +6 annual coupon bond with +?

warrants is A42?.??, and the bond would sell at par of A1,??? with market

rates at 1/ percent. hich of the followin is most correct-

a. The total value of the warrants is A%/?.??.

b. The implied value of each warrant is A6.??.

c. The company will have a lower current cost of debt by usin the bond

with warrants than if it issued straiht debt.

d. )tatements a and b are correct.


$referred stoc% Answer: c Diff: M

16. hich of the followin statements concernin preferred stock is mostcorrect-

a. #referred stock enerally has a hiher component cost to the firm than

does common stock.

b. 0y law in most states, all preferred stock issues must be cumulative,

meanin that the cumulative, compounded total of all unpaid preferred

dividends must be paid before dividends can be paid on the firm’s

common stock.

c. 7rom the issuer’s point of view, preferred stock is less risky than

bonds.

d. #referred stock, because of the current tax treatment of dividends, is

bouht mostly by individuals in hih tax brackets.

e. Dnlike bonds, preferred stock cannot have a convertible feature.

Chapter 20 - Page 5


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$referred stoc% Answer: e Diff: M

1


7/25

Multiple Choice: P/o0lems

Easy:

Difference in lease and loan pa&ents Answer: c Diff: E

%%. )tanley Corporation is considerin a 3year, A2,???,??? bank loan to

finance service equipment. The loan has an interest rate of 1? percent

and is amorti(ed over five years with end3of3year payments. )tanley can

also lease the equipment for an end3of3year payment of A1,4


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Con"ertible bond analsis Answer: b Diff: E

%. $ewae )cientific Company is considerin issuin 13year convertible bonds

at a price of A1,??? each. The bonds would pay an 6 percent coupon, with

semiannual payments, and have a par value of A1,???. Each bond would be

convertible into % shares of $ewae’s common stock. ithout a conversion

feature, investors would require an annual nominal yield of 1? percent.

hat is the straiht3debt value of the bond at the time of issue-

a. A 6?

b. A 6/2

c. A1,???

d. A 6


9/25

Lease analsis Answer: b Diff: M

%6. Fedstone Corporation is considerin a leasin arranement to finance some

special manufacturin tools that it needs for production durin the next

three years. * planned chane in the firm’s production technoloy will

make the tools obsolete after + years. The firm will depreciate the cost

of the tools on a straiht3line basis. The firm can borrow A/,6??,???, the

purchase price, at 1? percent to buy the tools or make three equal end3of3

year lease payments of A%,1??,???. The firm’s tax rate is /? percent and

the firm’s before3tax cost of debt is 1? percent. *nnual maintenance costs

associated with ownership are estimated at A%/?,???. hat is the net

advantae to leasin 8$*L9-

a. A ?

b. A1?2,%??

c. A+2%,6??

d. A/++,1??

e. A2/4,


10/25

#ond with warrants Answer: b Diff: M

+?. )hearson #LC’s stock sells for A/% per share. The company wants to sell

some %?3year, annual interest, A1,??? par value bonds. Each bond will

have attached 4 warrants, each exercisable into one share of stock at an

exercise price of A/4. )hearson’s straiht bonds yield 1? percent. The

warrants will have a market value of A% each when the stock sells for A/%.

hat coupon interest rate must the company set on the bonds3with3warrants

if the bonds are to sell at par-

a. 6.??M

b. 6.%/M

c. 6.


11/25

Warrants and ield on straight debt Answer: b Diff: M

++. @imes 0everae Co. recently issued 1?3year bonds at par 8A1,???9 with a

2 percent annual coupon. The bonds also have 1 warrants attached, and

each warrant is worth A1?. 5f @imes were to instead issue 1?3year

straiht debt with no warrants attached, what would be the yield-

a. 2.??Mb. 6.%2M

c. 6.46M

d.


12/25

Con"ertibles Answer: e Diff: M

+2. Nohnson 0everae’s common stock sells for A%4.6+, pays a dividend of

A%.1?, and has an expected lon3term rowth rate of 2 percent. The firm’s

straiht3debt bonds pay 1?.6 percent. Nohnson is plannin a convertible

bond issue. The bonds will have a %?3year maturity, pay A1?? interest

annually, have a par value of A1,???, and a conversion ratio of % shares

per bond. The bonds will sell for A1,??? and will be callable after 1?

years. *ssumin that the bonds will be converted at Hear 1?, when they

become callable, what will be the expected return on the convertible when

it is issued-

a. 1/.??M

b. 1%.??M

c. 1?.6?M

d. 1%.12M

e. 11.//M

Co&parati"e after-ta' ields Answer: c Diff: M

+4

. "eep Fiver #ower Corporation recently sold an issue of preferred stockthat had an after3tax yield of


13/25

(al!e of warrants Answer: c Diff: M

+


14/25

Lease analsis Answer: b Diff: )

/%. Carolina Truckin Company 8CTC9 is evaluatin a potential lease areement

on a truck that costs A/?,??? and falls into the '*CF) +3year class. The

applicable '*CF) depreciation rates are ?.++, ?./, ?.1, and ?.?4. The

loan rate would be 1? percent, if CTC decided to borrow money and buy the

asset rather than lease it. The truck has a /3year economic life, and its

estimated residual value is A1?,???. 5f CTC buys the truck, it would

purchase a maintenance contract that costs A1,??? per year, payable at the

end of each year. The lease terms, which include maintenance, call for a

A1?,??? lease payment at the beinnin of each year. CTC’s tax rate is /?

percent. )hould the firm lease or buy-

a. Lease it costs A6/% less than buyin.

b. Lease it costs A


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Chapter 20 - Page 15


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Chapter 20 - Page 16

CHAPTE !"A'-E A'D *1T%*'


17/25

1+ Lease cash flows Answer: c Diff: E

%+ Operating lease Answer: e Diff: E

++ Leasing Answer: c Diff: E N

)tatement a is the definition of an operatin lease. )tatement b is the

definition of the lessee. )tatement d is incorrect an important

characteristic of an operatin lease is that they are frequently not fully

amorti(ed. Therefore, the correct statement is c.

/+ Reporting earnings Answer: d Diff: E

+ Reporting earnings Answer: d Diff: E

2+ Warrants Answer: e Diff: E N

)tatement a is not correct. arrants can be detached from the bonds with which

they are associated and can be traded separately from the bond.

4+ Lease decision Answer: e Diff: M

6+ Capitalizing leases Answer: e Diff: M


18/25

%1+ $referred stoc% Answer: d Diff: E N

)tatements a, b, and c are correct therefore, statement d is the correct

answer.

%%+ Difference in lease and loan pa&ents Answer: c Diff: E

Time lineI?

kd J 1?M 1 % + / Hears

32,???,??? #'T J - #'T #'T #'T #'T

7inancial calculator solutionI

5nputsI $ J 5 J 1? #; J 32??????. &utputI #'T J A16%46/.66.

paymentsin"ifference

J A1,4


19/25

?k J 6M

1 % + / Hears

O O O O O O

1+4.4 1+4.4 1+4.4 1+4.4 1+4.4

$#; J -


0uyinI 5nputsI C7? J 31?????? C71 J 1?/??? C7% J 1%???, C7+ J 1?????

C7/ J 4%??? C7 J 1%6??? 5 J 6. &utputI $#; J 3A+,


20/25

55. Cost of leasin

69 Lease payment 8A%,1??9 8A%,1??9 8A%,1??9


21/25

A1,??? J ; K 48A%9

; J A6?.

Enter $ J %? 5 J 1? #; J 36? 7; J 1??? and then solve for #'T.

#'T J 5$T J A6%.+6 Coupon rate J???,1A

+6.6%A J 6.%/M.

+1+ #ond with warrants Answer: b Diff: M

Total value J )traiht3debt value K arrant value.

A1,??? J ; K %?8A1/.%?9

; J A412.

Enter $ J 2? 5 J #; J 3412 7; J 1??? and then solve for #'T.

#'T J 5$T% J A+.?? 5$T J A4?.?? Coupon rate J???,1A

4?A J 4.?M.

+%+ #ond with warrants Answer: d Diff: M

? 1 % + / %? 23month #eriods

O O O O O • • • O

#; J - /? /? /? /? /?

7; J 1,???

Calculate the value of the warrantsI

Total valuearrants Jwarranteach

value5mplied

× bondperwarrantsof$o.

%


22/25

C J -


Calculate the pure3bond value, 0t, at year I

5nputsI $ J 1 5 J 1% #'T J


23/25

worth A1?.%4 8A%?./4%?9.

/?

+ (al!e of warrants Answer: b Diff: M

;alue of the bond isI $ J %? 5HF J 11 #'T J 6? 7; J 1??? and then solve

for #; J A421.1?. The total value of the warrants must beI A1,??? 3 A421.1? J

%+6.


24/25

Time lineI

Leasin

?k J 6M

1 % + Hears

3%+,%?? 3%+,%?? 3%+,%??

#;Leasin J -


&wnin5nputsI C7? J 31?%/?? C71 J /%?? C7% J 22?? C7+ J %6/?? 5 J 6.

&utputI $#; J 3A4?,+?4.6/ ≈ 3A4?,+?6.

Leasin

5nputsI C7? J 3%+%?? C71 J 3%+%?? $! J % 5 J 6.

&utputI $#; J 3A2/,41.4/ ≈ 3A2/,4%.

$et advantae to leasin

#;Leasin 3 #;&wnin J 3A2/,4% 3 8A4?,+?69 J A,4+2.

/%

+ Lease analsis Answer: b Diff: )

Time lineI

&wnin

?k J 2M

1 % + / Hears

3/?,??? /,26? 2,2?? 1,6?? 2,%?

#;&wnin J -

"epreciation Table

'*CF)

Hear 7actor "epreciation

1 ?.++ A1+,%??

% ?./ 16,???

+ ?.1 2,??? / ?.?4 %,6??

1.?? A/?,???

Hear ? 1 % + /

5. 5nitial outlay

19 $ew asset cost 8A/?,???9

55. &peratin cash flows

%9 'aintenance 8A 1,???9 8A 1,???9 8A 1,???9 8A 1,???9

+9 'aintenance 8*fter3tax9

8Line % × 81 3 t99 J

8Line % × ?.29 82??9 82??9 82??9 82??9

/9 "epreciation new asset 1+,%?? 16,??? 2,??? %,6??

9 "epreciation tax savins

8Line + × ?./?9 ,%6? 4,%?? %,/?? 1,1%?

29 $et operatin C7s A /,26? A 2,2?? A 1,6?? A %?

555 Terminal year cash flows

49 Est. residual value 80efore3tax9 A1?,???

69 Tax on residual value 8?./? × A1?,???9 /,???


25/25

Time lineI

Leasin

?k J 2M

1 % + / Hears

32,??? 32,??? 32,??? 32,???

#;Leasin J -


&wninI 5nputsI C7? J 3/???? C71 J /26? C7% J 22?? C7+ J 16?? C7/ J 2%? 5J 2.

&utputI $#; J 3A%+,?+.12 ≈ 3A%+,?+.

LeasinI 5nputsI C7? J 32??? C71 J 32??? $! J + 5 J 2.

&utputI $#; J 3A%%,?+6.?4 ≈ 3A%%,?+6.

#;Leasin 3 #;&wnin J 3A%%,?+6 3 83A%+,?+9 J 3A

tb chapter20

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