Fundamentals of Corporate Finance with Connect Access Card
11th Edition
ISBN: 9781259418952
Author: Stephen A. Ross Franco Modigliani Professor of Financial Economics Professor, Randolph W Westerfield Robert R. Dockson Deans Chair in Bus. Admin., Bradford D Jordan Professor
Publisher: McGraw-Hill Education
expand_more
expand_more
format_list_bulleted
Question
Chapter 16, Problem 2M
Summary Introduction
Case synopsis:
Company S is a real estate firm, whose CEO (chief executive officer) is Person R. The firm buys a real estate and rents it to the tenants. The firm gains profit every year. Before the foundation of Company S, Person R was the CEO and the founder of Company A, which is a farming operation. Company A was a failure firm, which ends up with bankruptcy. This situation made Person R to be extremely averse towards debt financing.
Hence, the company is completely financed through equity. Company S is assessing a plan to buy a huge tract of land, which would be leased to the tenant farmers. This purchase is predicted to raise the annual earnings before tax in perpetuity. Person J is the new CFO (chief financial officer) of Company S, who has found the present capital cost of the company.
Person J felt that the company will be very valuable if it adds debt in its capital structure. While evaluating whether the company could issue debt to completely finance the project, she found that it can issue bonds at a par value with the coupon rate. She also found an optimal range of capital structure between 70% equity and 30% debt to maximize its value.
Characters in the case:
- Company S
- Company A
- Person S
- Person J
Adequate information:
- If Company S moves beyond the 30% debt, the bonds issued by the company will have a lower rating and a greater coupon, as the possibility of financial distress and the associated cost will increase.
- Company S also has a corporate rate of tax.
To construct: The
Expert Solution & Answer
Want to see the full answer?
Check out a sample textbook solution
Students have asked these similar questions
Terence Breezeway, the CEO of Prairie Home Stores, wondered what retirement would be like. It was almost 20 years to the day since his
uncle Jacob Breezeway, Prairie Home's founder, had asked him to take responsibility for managing the company. Now it was time to spend
more time riding and fishing on the cld Lazy Beta Ranch.
U'nder Mr. Breezeway's leadership, Prairie Home had grown slowty but steadily and was solidly profitable. (E Table 7.6 shows earnings.
dividends, and book asset values for the last 5 years.) Most of the company's supermarkets had been modernized, and its brand name was
well known.
Table 7.6 Financial data for Prairie Home Stores, 2019-2023 (figures in millions)
2019
2020
2021
2022
2023
Book value, start of year
$62.7
$73.9
$66.1
$69.0
$76.5
Earnings
9.7
9.5
11.8
11.0
11.2
Dividends
6.3
6.6
6.9
7.4
7.7
Retained earnings
3.4
2.9
4.9
2.6
3.5
Book value, end of year
66.1
69.0
73.9
76.5
80.0
Note
1. Prairie Home Stores has 400,000 common shar
2. The company's poley ia…
6
Scenario
Several years ago, Carlson Manufacturing moved to a larger production facility to accommodate its growing business. Instead of selling their old facility, they rented it to another firm and have been receiving rental income from the tenant. The tenant’s lease is getting ready to expire but instead of renewing the lease, Carlson has decided to take the building back and use it to manufacture a new product. Carlson will continue to depreciate the building on a straight-line basis as they have done in prior years, so there will be no change in depreciation expense. The old building is large enough to house the majority of operations, but they will need to rent a small storage building for raw materials. They have also decided that instead of purchasing the machinery necessary for production, they will rent the equipment on a monthly basis. Their existing workforce is unable to accommodate the production of the new product so Carlson will hire new workers and a supervisor to…
Chapter 16 Solutions
Fundamentals of Corporate Finance with Connect Access Card
Ch. 16.1 - Why should financial managers choose the capital...Ch. 16.1 - What is the relationship between the WACC and the...Ch. 16.1 - What is an optimal capital structure?Ch. 16.2 - Prob. 16.2ACQCh. 16.2 - Prob. 16.2BCQCh. 16.2 - Prob. 16.2CCQCh. 16.3 - What does MM Proposition I state?Ch. 16.3 - What are the three determinants of a firms cost of...Ch. 16.3 - Prob. 16.3CCQCh. 16.4 - What is the relationship between the value of an...
Ch. 16.4 - If we consider only the effect of taxes, what is...Ch. 16.5 - Prob. 16.5ACQCh. 16.5 - What are indirect bankruptcy costs?Ch. 16.6 - Can you describe the trade-off that defines the...Ch. 16.6 - What are the important factors in making capital...Ch. 16.7 - Prob. 16.7ACQCh. 16.7 - What is the difference between a marketed claim...Ch. 16.7 - What does the extended pie model say about the...Ch. 16.8 - Prob. 16.8ACQCh. 16.8 - Why might firms prefer not to issue new equity?Ch. 16.8 - Prob. 16.8CCQCh. 16.9 - Do U.S. corporations rely heavily on debt...Ch. 16.9 - What regularities do we observe in capital...Ch. 16.10 - Prob. 16.10ACQCh. 16.10 - Prob. 16.10BCQCh. 16 - Maximizing what will maximize shareholder value?Ch. 16 - What is most closely related to a firms use of...Ch. 16 - Give an example of a direct cost of bankruptcy.Ch. 16 - Prob. 16.7CTFCh. 16 - Prob. 1CRCTCh. 16 - Prob. 2CRCTCh. 16 - Optimal Capital Structure [LO1] Is there an easily...Ch. 16 - Observed Capital Structures [LO1] Refer to the...Ch. 16 - Financial Leverage [LO1] Why is the use of debt...Ch. 16 - Homemade Leverage [LO1] What is homemade leverage?Ch. 16 - Prob. 7CRCTCh. 16 - Prob. 8CRCTCh. 16 - Prob. 9CRCTCh. 16 - Prob. 10CRCTCh. 16 - Prob. 1QPCh. 16 - Prob. 2QPCh. 16 - Prob. 3QPCh. 16 - Prob. 4QPCh. 16 - MM and Stock Value [LO1] In Problem 4, use MM...Ch. 16 - Prob. 6QPCh. 16 - Prob. 7QPCh. 16 - Prob. 8QPCh. 16 - Homemade Leverage and WACC [LO1] ABC Co. and XYZ...Ch. 16 - Prob. 10QPCh. 16 - MM and Taxes [LO2] In the previous question,...Ch. 16 - Calculating WACC [LO1] Twice Shy Industries has a...Ch. 16 - Calculating WACC [LO1] Braxton Corp. has no debt...Ch. 16 - MM and Taxes [LO2] Meyer Co. expects its EBIT to...Ch. 16 - Prob. 15QPCh. 16 - MM [LO2] Tool Manufacturing has an expected EBIT...Ch. 16 - Prob. 17QPCh. 16 - Homemade Leverage [LO1] The Day Company and the...Ch. 16 - Weighted Average Cost of Capital [LO1] In a world...Ch. 16 - Cost of Equity and Leverage [LO1] Assuming a world...Ch. 16 - Business and Financial Risk [LO1] Assume a firms...Ch. 16 - Stockholder Risk [LO1] Suppose a firms business...Ch. 16 - Prob. 1MCh. 16 - Prob. 2MCh. 16 - Prob. 3MCh. 16 - Stephenson Real Estate Recapitalization Stephenson...Ch. 16 - Stephenson Real Estate Recapitalization Stephenson...
Knowledge Booster
Similar questions
- Malone Industries has been in business for five years and has been very successful. In the past year, it expanded operations by buying Hot Metal Manufacturing for a price greater than the value of the net assets purchased. In the past year, the customer base has expanded much more than expected, and the companys owners want to increase the goodwill account. Your CPA firm has been hired to help Malone prepare year-end financial statements, and your boss has asked you to talk to Malones managers about goodwill and whether an adjustment can be made to the goodwill account. How do you respond to the owners and managers?arrow_forwardTom purchased the following assets for use in his business during the current year: Date Asset Cost 12-Jan Car 24,000 4-Feb Equipment 36,000 15-Mar Qualified leasehold improvement 40,000 24-Apr Computers 10,000 Total 110,000 Tom has $50,000 in profits before depreciation expense and has no other sources of income. Tom does not expect to purchase any new assets next year and hopes to grow sales, but who knows for sure? Give Tom two options as to how to depreciate the assets for tax. Select one option to recommend and justify your answer.arrow_forwardTom purchased the following assets for use in his business during the current year: Date Asset Cost 12 - Jan Car 24,000 4 - Feb Equipment 36,000 15 - Mar Qualified leasehold improvement 40,000 24 - Apr Computers 10, 000 Total 110, 000 Tom has $50,000 in profits before depreciation expense and has no other sources of income. Tom does not expect to purchase any new assets next year and hopes to grow sales, but who knows for sure? Give Tom two options as to how to depreciate the assets for tax. Select one option to recommend and justify your answer.arrow_forward
- Read the scenario and associated questions below. Research the pertinent issues and write a three-to-four-page paper to explain the accounting options for the scenario. AT & T company was depreciating its antennas over 20 years. The total cost of the antennas accounted for 20 million dollars. It was recently discovered that the antennas useful life is only seven years due to new technological development. With reference to the above scenario answer the following questions. What is the accounting implication in this situation and why? What promulgated Accounting Standards should be followed? Provide your rationale. How and why should this discovery be recorded in the financial statements of the company? Explain your response. If the company issues quarterly financial statements and the discovery is made in the third quarter, should this impact be shown prospectively or retroactively and in what specific time period? Explain your response. As the accountant, what could you…arrow_forwardSubject: accountingarrow_forwardRon Swanson owns Swanson’s Woodcraft Connection, a store dedicated to woodworking tools, supplies, and design plans. On May 1, Year One, Swanson’s purchased a new warehouse to store additional inventory to help meet customer demand. Ron paid $50,000 for the warehouse and estimates that it will be used for twenty years. Salvage value is $5,000 and Swanson uses the straight-line method of depreciation. Swanson’s Woodcraft Connection has a December 31st year-end. What is the amount of depreciation to be taken in Year One? The amount of depreciation to be taken in Year One is: $ Question 2 The amount of depreciation to be taken in Year Two is:$ Question 3 Now, assume that Swanson’s Woodcraft Connection applies the half-year convention. The amount of depreciation expense to be taken in Year One is: $ Question 4 Assuming that Swanson’s Woodcraft Connection applies the half-year convention. The amount of depreciation expense to be…arrow_forward
- Levi Ackerman decided to resign from his current job and start his own café. He is investing $50,000 of his own money and took out a business loan worth $100,000. Levi handed in his resignation in May 2021, purchased and fully paid for an established café costing $109,000 in June 2021, and plans to open shop on 1 July 2021. Additional information: • Annual depreciation for the non-current assets taken over from the previous owner totals $18,000. Additional equipment costing $5,000 were purchased and paid for in June. These equipment are depreciated on a straight-line basis and have an expected useful life of ten years with no residual value. Assume that monthly payment for the loan is $780, of which $240 relates to interest payment and the remainder relates to principal repayment. One month's credit is received from inventory suppliers and Levi will utilise this payment term, paying the amounts owed one day before it is due. Inventories costing $4,000 are acquired in June 2021.…arrow_forwardCreative Solutions purchased a patent from Russell Lazarus, an inventor. At the time of the purchase, the patent had two years remaining. The president of Creative Solutions decided to have the accountant amortize the cost of the patent, $200,000, over 10 years rather than two years. His reasoning was that the $200,000 has already been spent and stockholders might ask a lot of questions about a $100,000 expense showing up on the income statement but probably wouldn’t pay much attention to a $20,000 expense. What is Creative Solutions’ ethical responsibility to the company’s stockholders? According to GAAP, how should the amortization of patents be treated? Write a short paragraph explaining similarities and differences between plant assets and intangible assets. In groups of two or three, determine an appropriate method of depreciation, depletion, or amortization of the following assets for financial reporting purposes: (a) a car used as a taxi, (b) a parcel of land that will…arrow_forwardSweets Inc. made several capital purchases during the last month of the year. As part of the purchases the company sold some existing fixed assets. Yesterday, as you were walking to the compnay cafeteria, you saw the President of Sweets Inc. While walking the President you mentioned the recent capital purchases would significantly impact the financial statments. Today, the President called you directly and asked you to write a memorandum explaining the impact of the capital purchases (and related sales of some existing fixed assets) on each of the following financial statments; Income Statement, Balance Sheet, Statement of Cash Flows. Summary of December Capital Transactions On Dec 1, 2021 Sweets Inc purchased a new delivert truck for $100,000 The following additional information was provided: The truck was paid for with cash. The truck is expected to have a service life of 10 years. No salvage value is expected after the service life. The company uses straight line depreciation for…arrow_forward
- Sweets Inc. made several capital purchases during the last month of the year. As part of the purchases the company sold some existing fixed assets. Yesterday, as you were walking to the company cafeteria, you saw the President of Sweets Inc. While walking with the President you mentioned that recent capital purchases would significantly impact the financial statements. Today, the President called you directly and asked you to write a memorandum explaining the impact of the capital purchases (and related sale of some existing fixed assets) on each of the following financial statements; Income Statement Balance Sheet Statement of Cash Flows Summary of December Capital Transactions On Dec. 1, 2021 Sweets Inc. purchased a new delivery truck for $ 100,000 The following additional information was provided: The truck was paid for with cash. The truck is expected to have a service life of No salvage value is expected after the service life. The company uses straight-line depreciation for their…arrow_forwardSubject : Accountingarrow_forwardWant Answer of this Question on textarrow_forward
arrow_back_ios
SEE MORE QUESTIONS
arrow_forward_ios
Recommended textbooks for you
Financial Accounting: The Impact on Decision Make...AccountingISBN:9781305654174Author:Gary A. Porter, Curtis L. NortonPublisher:Cengage Learning
Financial AccountingAccountingISBN:9781337272124Author:Carl Warren, James M. Reeve, Jonathan DuchacPublisher:Cengage Learning
Financial AccountingAccountingISBN:9781305088436Author:Carl Warren, Jim Reeve, Jonathan DuchacPublisher:Cengage Learning
Financial Accounting: The Impact on Decision Make...
Accounting
ISBN:9781305654174
Author:Gary A. Porter, Curtis L. Norton
Publisher:Cengage Learning
Financial Accounting
Accounting
ISBN:9781337272124
Author:Carl Warren, James M. Reeve, Jonathan Duchac
Publisher:Cengage Learning
Financial Accounting
Accounting
ISBN:9781305088436
Author:Carl Warren, Jim Reeve, Jonathan Duchac
Publisher:Cengage Learning