# Week 5 Assignment 3: Final Exam

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FINANCE

Part A Suppose Floyd Motor Company sold an issue of bonds on January 1, 2001. The bonds were sold for $1,000 per unit (i.e., they were issued at par), had a 10 percent coupon rate payable semi-annually, and matures in 15 years, i.e., on December 31, 2015. a) If you bought the bond on the issue date at the issue price and expected to hold it until it matures on December 31, 2015, what would be your average annual rate of return on the investment? [5 points] b) Two years after the bonds were issued, the going rate of interest on similar bonds fell to 8 percent. At what price would the bonds sell? [5 points] c) Six years after the initial offering, the going interest rate on similar bonds rose to 12 percent. At what price would the bonds sell? [5 points] d) Eight years after the issue, the bonds were selling for $925. What is the bond’s yield to maturity at this point? What is the current yield? What is the capital gains yield? [10 points]

Part B Explain the difference between interest rate risk and reinvestment rate risk. Which of the following bonds has the most interest rate risk and why? Which has the most reinvestment rate risk and why? [20 points] a) A 5-year bond with a 9% annual coupon b) A 5-year bond with a zero coupon c) A 10-year bond with a 9% coupon d) A 10-year bond with a zero coupon

Part C

a) Explain three differences between equity and debt [15 points]

b) Microtech Corporation is expanding rapidly, and it currently needs to retain all of its earnings, hence it does not pay any dividends. However, investors expect Microtech to begin paying dividends, with the first dividend of $1.00 coming 3 years from today. The dividend should grow rapidly – at a rate of 50 percent per year – during Years 4 and 5. After Year 5, the company’s dividend is expected to grow at a constant rate of 8 percent per year indefinitely. If the required return on the stock is 15 percent, what is the intrinsic value of the stock today? [20 points]

Part D Clyne Industries is considering whether it should produce its newly invented Slammin Jammin Basketball Goal Set. To bring this product to the market will require the purchase of equipment costing $600,000. Shipping and installation expenses associated with the equipment are estimated to be $50,000. In addition, net working capital investments of $50,000 will be required to get production started. No additional investments in net working capital will be required in subsequent years. Revenues are expected to be $250,000 in the first year and grow at a rate of $25,000 per year until the project is terminated at the end of the fourth year. Annual operating expenses (excluding depreciation) are expected to be $80,000 in the first year and to grow at a rate of $10,000 per year until the end of the project’s life. Depreciation will be under MACRS for a 3-year class asset, with depreciation rates of 33 percent, 45 percent, 15 percent, and 7 percent. The salvage value of the equipment at the end of four years is expected to be $50,000. Clyne Industries pays taxes at the 40 percent rate, and its cost of capital is 15 percent. Based on its Net Present Value (NPV), should the Goal Set be produced? [30 points]

Part E Explain how each of the following actions is likely to affect each of accounts receivable, sales, and profit. In your answer, explain whether the action will increase or decrease each variable or have an indeterminate effect. [20 points] a) The firm loosens its credit standards. b) The terms of trade are changed from 3/10, net 30 to 2/10, net 30. c) The terms of trade are changed from 3/10, net 40 to 3/10, net 30. d) The credit manager gets tough with past due accounts.

Part F The Thompson Corporation projects an increase in sales from $18 million to $25 million, but it needs an additional $500,000 of current assets to support this expansion. Thompson purchases under terms of 2/10, net 60 and currently pays on the 10th day, taking discounts. The CFO is considering using trade credit to finance the additional working capital required. Alternatively, Thompson can finance its expansion with a one-year loan from its bank. The bank has quoted the following alternative loan terms: [30 points] a) 12 percent rate on a simple interest loan, with monthly interest payments. b) 10 percent annual rate on a discount interest basis with no compensating balance. c) 8.75 percent annual rate on a discount interest basis, with a 10 percent compensating balance. d) 8 percent add-on interest, with monthly payments. Based strictly on cost considerations only, what should Thompson do to finance its expansion?

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