– Recommended textbook for the subject: Ross, Stephen A., Westerfield, Randolph W., Jordan, Bradford D. Essentials of Corporate Finance. (CHAPTERS 6 & 7)
– Answer the following essay questions:
1. Mark Sexton and Todd Story, the owners of S&S Air introduced in Module 3, have decided to expand their operations. They instructed their newly hired financial analyst, Chris Guthrie, to enlist an underwriter to help sell $20 million in new 10-year bonds to finance construction. Chris has entered into discussions with Renata Harper, an underwriter from the firm of Crowe & Mallard, about which bond features S&S Air should consider and what coupon rate the issue will likely have.
Although Chris is aware of the bond features, he is uncertain as to the costs and benefits of some features, so he isn’t clear on how each feature would affect the coupon rate of the bond issue. You are Renata’s assistant, and she has asked you to prepare a memo to Chris describing the effect of each of the following bond features on the coupon rate of the bond. She would also like you to list any advantages or disadvantages of each feature.
a. The security of the bond, that is, whether the bond has collateral.
b. The seniority of the bond.
c. The presence of a sinking fund.
d. A call provision with specified call dates and call prices.
e. A deferred call accompanying the above call provision.
f. A make-whole call provision.
g. Any positive covenants. Also, discuss several possible positive covenants S&S Air might consider.
h. Any negative covenants. Also, discuss several possible negative covenants S&S Air might consider.
i. A conversion feature (note that S&S Air is not a publicly traded company).
j. A floating rate coupon.
2. Holding Period Yield. The YTM on a bond is the interest rate you earn on your investment if interest rates don’t change. If you actually sell the bond before it matures, your realized return is known as the holding period yield (HPY).
a. Suppose that today you buy an annual coupon bond with a coupon rate of 7 percent for $875. The bond has 10 years to maturity. What rate of return do you expect to earn on your investment?
b. Two years from now, the YTM on your bond has declined by 1 percent, and you decide to sell. What price will your bond sell for? What is the HPY on your investment? Compare this yield to the YTM when you first bought the bond. Why are they different?
3. According to the Value Line Investment Survey, the growth rate in dividends for Duke Energy for the previous 10 years has been 1.5%.
If investors feel this growth rate will continue, what is the required return for Duke Energy stock?
4. Stock Valuation. Most corporations pay quarterly dividends on their common stock rather than annual dividends. Barring any unusual circumstances during the year, the board raises, lowers, or maintains the current dividend once a year and then pays this dividend out in equal quarterly installments to its shareholders.
a. Suppose a company currently pays an annual dividend of $3.20 on its common stock in a single annual installment, and management plans on raising this dividend by 6 percent per year indefinitely. If the required return on this stock is 12 percent, what is the current share price?
b. Now suppose the company in (a) actually pays its annual dividend in equal quarterly installments; thus, the company has just paid a dividend of $.80 per share, as it has for the previous three quarters. What is your value for the current share price now? (Hint: Find the equivalent annual end-of-year dividend for each year.) Comment on whether you think this model of stock valuation is appropriate.
5. How does a stock trade take place? Go to www.nyse.com, click on “The Trading Floor” and “Anatomy of a Trade.” Based on this information, describe the process of a trade on the NYSE.
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