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Question 1: Bonds (5 marks total) Two outstandin...

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Question 1: Bonds (5 marks total) Two outstanding government bond issues are identical except that one has 2 years to maturity and the other has 5 years to maturity. Each bond has a face value of $100, an AAA credit rating, fixed semi-annual coupons, a current price of $100 and a yield to maturity of 12% p.a. Based on this data, answer each of the following: (a) What is the annual coupon rate on each of these bonds? Explain. (0.5 marks) (b) The Reserve Bank of Australia announces a decrease in the cash rate and as a result interests rates fall market wide. If the required yield to maturity for the two government bonds falls to 10% p.a., what will be the price of each bond? (2 marks) (c) The Reserve Bank of Australia announces an increase in the cash rate and as a result interests rates rise market wide. If the required yield to maturity for the two government bonds rises to 14% p.a., what will be the price of each bond? (1 mark) (d) Explain, with reference to relevant bond valuation concepts, the relative changes in price of the two bonds in response to changing interest rates. (1.5 marks) Question 2: Woolworths Cost of Capital (8 marks) You are to estimate the cost of capital for Woolworths Ltd, an Australian listed company, at the end of its last financial year (24 June 2012). Before you can undertake this task, you will need to collect some actual finance data. The ?External Links? section of this unit?s MySCU web site contains links to Internet sources of information that you might find useful for this assignment. Amongst other sources, you should consider the Bulletin Statistical Tables F2 (daily) and F3 available through the RBA website. Note also that 24 June 2012 was a Sunday so some market data you will require is unavailable for that date. Use 22 June 2012 or June averages as appropriate. Woolworths Ltd uses a number of sources of debt and equity. You can make the following assumptions: ? Borrowings on the Woolworths Balance Sheet in their annual report reflect market value. ? All borrowings can be classified as debt. ? Woolworths aims to maintain its current A credit rating.1 An average yield on corporate bonds with an A rating can therefore be used in this analysis.2 ? The CAPM is used to estimate the cost of ordinary equity. ? The 10-year Australian Treasury bond rate is an appropriate proxy for the risk-free rate. ? The beta for Woolworths has not varied significantly in the past 5 years and is not expected to change in the near future. ? The market risk premium (also called equity risk premium) is 6%. ? Woolworths calculates its WACC assuming a classical tax system. ? The company?s tax rate is 30%. Ensure that you set out full workings in a clear and logical fashion. Label all input figures, state any assumptions necessary for their use and reference their source. Marks for this question will be awarded for: correct choice of input figures; correct choice and application of method; and referencing of data sources. Question 33: Capital Structure (7 marks total) Harry Real Estate Company was founded 25 years ago by the current CEO, Harry Lantern. The company purchases real estate, including land and buildings, and rents the property to tenants. The company has shown a profit every year for the past 18 years, and the shareholders are satisfied with the company?s management. Prior to founding Harry Real Estate, Harry was the founder and CEO of a failed alpaca farming operation. The resulting bankruptcy made him extremely averse to debt financing. As a result, Harry Real Estate is entirely equity financed, with 15 million ordinary shares outstanding. The shares currently trade at $35.20 each. Harry Real Estate is evaluating a plan to purchase a huge piece of land in Queensland for $110 million. The land will subsequently be leased to tenant farmers. This purchase is expected to increase Harry Real Estate?s annual pre-tax earnings by $27 million in perpetuity. You, the company?s new CFO, have been put in charge of the project. You have determined that the company?s cost of capital is 12.5%. You feel that the company would be more valuable if it included debt in its capital structure, so you are evaluating whether the company should issue debt to finance the project in its entirety. Based on some conversations with investment banks, you think that the company can issue bonds at par value with an 8% coupon rate. From your analysis, you also think that a capital structure around 70% equity and 30% debt would be optimal. The company has a 40% corporate tax rate. Based on this data, answer each of the following questions, assuming that the only market imperfections are corporate taxes and financial distress costs: (a) Construct Harry Real Estate?s market value balance sheet before it announces the investment project. (0.5 marks) (b) Suppose the company decides to issue equity to finance the project. (2.5 marks) i) Construct Harry Real Estate?s market value balance sheet after it announces the project to the market and says it will finance the land purchase by a new share issue. [Hint: First calculate the NPV of the project.] ii) What would be the new price per share after the announcement in (i)? iii) How many shares will Harry Real Estate need to issue to finance the land purchase? iv) Construct Harry Real Estate?s market value balance sheet after the equity issue but before the land purchase has been made. How many shares does the company now have outstanding and what is the price per share? v) Construct Harry Real Estate?s market value balance sheet after the land purchase has been made. (c) Suppose the company decides to issue bonds to finance the project. (1.5 marks) i) What will the market value of Harry Real Estate be if the land purchase is financed with bonds? ii) Construct Harry Real Estate?s market value balance sheet after both the bond issue and the land purchase. What is the price per share? (d) If Harry Real Estate Company aims to maximise firm value and share price, which method of financing the new project (bonds or shares) should be used? Explain. (0.75 marks) (e) If your estimate of the optimal capital structure is correct, what else should the company consider doing? (0.5 marks) (f) With reference to appropriate theory and assuming your estimate of the optimal capital structure is correct, explain what is likely to happen if the company changes to a capital structure with a debt to equity ratio of 1? (1.25 marks)

 

Paper#1850 | Written in 18-Jul-2015

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