FIN B386F Newcastle College Financial Decision Making Questions
Question 1(60 marks)Ryan, the president of the Open Corporation, is considering leasing or purchasing equipment.Microtech Corporation has offered to sell the Open Corporation the equipment at a price of$6010,000. Following its usual practice, the equipment is depreciated over fouryears, at the ratesof 40% for the firstyear, and 20%for each of the remaining three years. The salvagevalue of thisequipment is expected to be 0.Alternatively, the OpenCorporation can lease theequipment from ScottCorporation. Four annuallease payments of $1.9 millionare settled at the beginning of each year. Open Corporation canraise capital by issuing bonds with a yield of 12 percent, and the tax rate for OpenCorporation isset to be 30 percent.After comparing the above two options, the Chief Financial Officer of Open Corporation,commented, “Scott’s offer is financially unreasonable due to a negativeNAL (i.e. net advantageto leasing) to our company. Therefore, the annual leasepayments should be curtailed. Meanwhile,1we can pay a security depositto Scott as an incentive. This deposit wouldbe returned on theexpiration date of the leasecontract.” In response to CFO’s comments, Ryan added,“If the leasingterm is acceptable to us, this will suggestthat a negativeNAL should be brought to Scott. As faras I know, leasingis a zero-sum game between the lessee and lessor. I believe Scottreject ourcounter offer.” After several roundsof discussion, Ryaneventually determines to propose acounter offer to Scott, witha reduced leasepayment of $1.8million on annualbasis and a securitydeposit of $1,000,000.Required:(a) In light of the NAL calculation, commenton the following remarks “Scott’soffer is financially unreasonable due to a negative NAL (i.e.net advantage toleasing) to our company.”(12 marks)(b) According to the counteroffer by the Open Corporation, evaluate the NALto Scott. What is the reaction of Scott to this counter offer?The tax rate forScott is presumed to be 40%.(14 marks)(12 marks)(12 marks)(10 marks)(c) Critically discuss Ryan’s remark “leasing is a zero sum gamebetween thelessee and lessor”.(d) Explain the rationale for lesseesto accept a lease offereven if NALs arenegative.(e) If the purchase of equipment is funded by bond issuance instead of owncapital, do you consider this factor in NAL analysis? Explain.2undefinedQuestion 2 (40 Marks)Great Car Company Limited, throughits subsidiaries, manufactures and sells pick-up trucksinAsia market underbranded names. The Companyalso researches, develops, and manufacturesprincipal automotive components for use in the assembly of pick-up trucks.The company is considering a new investment project which has the same riskas existingbusinesses. The initialoutlay for the project is $55 million. The company expectsthat the projectwill generate additional earnings of $10 millionper year. The company currently has no debt.Thecurrent annual earnings available to common stockholders are $80 million.The company currently has 6 million sharesoutstanding. Currently, the required rate of return onequity is 12%. Traditionally, the company has paidout all earnings to the stockholders as dividendsand financed capitalexpenditures with new issuesof common stock.All earning streams areassumed to be perpetuities. There are no taxes and no bankruptcy costs.Required:(a) Analyze the valueof the firm if common stockis issued to finance the project. (6 marks)(b) One of the bankssuggests that thecompany can issue $55 million, 9%perpetual bonds to finance the project. Advisethe value of the company andthe rate of return required by stockholders.(10 marks)(c) TSL, another competitor firm, has a 8% couponrate convertible bond due 20years from now.The convertible bond has a parvalue of $1,000and is sellingat $970. The conversion price of thebond is $50 per share. A non-convertiblecoupon bond of similar qualityis currently yielding10%. The commonstockof TSL is selling at $40 pershare. Assume thatbond interest payments aremade annually.i Determine the conversion ratio of the convertible bond.3(4 marks)undefinedii Calculate the conversion premium of the convertible bond.iii Access the minimum price at which the convertible bond should sell.iv Explain why a convertible bond sells at a premium above its value as abond or common stock.(4 marks)(10 marks)(6 marks)4Requirements: 1200 words