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1)
Interest rates and bond ratings (LO16-2) A previously issued A2, 15-year industrial bond provides a return three-fourths higher than the prime interest rate of 11 percent. Previously issued A2 public utility bonds provide a yield of three-fourths of a percentage point higher than previously issued A2 industrial bonds of equal quality. Finally, new issues of A2 public utility bonds pay three-fourths of a percentage point more than previously issued A2 public utility bonds. What should be the interest rate on a newly issued A2 public utility bond?
2)
Fourteen years ago, the U.S. Aluminum Corporation borrowed $6.5 million. Since then, cumulative inflation has been 98 percent (a compound rate of approximately 65 percent per year). a. When the firm repays the original $6.5 million loan this year, what will be the effective purchasing power of the $6.5 million? (Hint: Divide the loan amount by one plus cumulative inflation.) b. To maintain the original $6.5 million purchasing power, how much should the lender be repaid? (Hint: Multiply the loan amount by one plus cumulative inflation.) c. If the lender knows he will receive $6.5 million in payment after 14 years, how might he be compensated for the loss in purchasing power? A descriptive answer is acceptable.
3)
Tobacco Company of America is a very stable billion-dollar company with sales growth of about 5 percent per year in good or bad economic conditions. Because of this stability (a correlation coefficient with the economy of +.3 and a standard deviation of sales of about 5 percent from the mean), Mr. Weed, the vice-president of finance, thinks the company could absorb some small risky company that could add quite a bit of return without increasing the company’s risk very much. He is trying to decide which of the two companies he will buy. Tobacco Company of America’s cost of capital is 10 percent.
| Computer Whiz Company (CWC) (cost $75 million) |
American Micro-Technology (AMT) (cost $75 million) | |||
| Probability | Aftertax Cash Flows for 10 Years ($ millions) |
Probability | Aftertax Cash Flows for 10 Years ($ millions) |
|
| 0.3 | $ 6 | 0.2 | $(1) | |
| 0.3 | 10 | 0.2 | 3 | |
| 0.2 | 16 | 0.2 | 10 | |
| 0.2 | 25 | 0.3. | 25 | |
| 0.1 | 31 | |||
a. What is the expected cash flow for each company?
b. Which company has the lower coefficient of variation?
c. Compute the net present value of each company.
d. Which company would you pick, based on net present values?
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