A2. (Comparing borrowing costs) Stephens Security has two financing alternatives: (1) A publicly placed $50 million bond issue. Issuance costs are $1 million, the bond has a 9% coupon paid semiannually, and the bond has a 20-year life. (2) A $50 million private placement with a large pension fund. Issuance costs are $500,000, the bond has a 9.25% annual coupon, and the bond has a 20-year life. Which alternative has the lower cost (annual percentage yield)?
1.n = 40 r = ? PV = -($50 - $1) = -$49 PMT = 9% / 2 x $50 = $2.25 FV = $50 r = 4.61%
APY = (1 + 0.0461)2 -1 = 9.4334%
2.n = 20 r = ? PV = -($50 - $0.5) = -$49.5 PMT = 9.25% x $50 = $4.625 FV = $50 r = 9.36%
APY = 9.36%
Choice 2 has the lower APY.
United Hospital has received a leasing proposal from Leasing, Inc., for a Siemens cardiac cath unit. The terms are: **Five-year lease **Annual payments of $200,000 payable one year in advance **Payment of property tax estimated to be $23,000 annually **Renewal at end of year 5 at fair market value Alternatively, UnitedHospital can buy the cath unit for $725,000. This purchase would require UnitedHospital to debt-finance this equipment. It anticipates a bank loan with an initial down payment of $125,000 and a three-year term loan at 16 percent with equal principal payments. The residual value of the equipment at year 5 is estimated to be $225,000. The lease is treated as an operating lease. Depreciation is calculated on a straight-line basis. Assuming a discount rate of 14 percent, what financing option should UnitedHospital select? Assume that there is no reimbursement of capital cost.
Write a summary of 350 words or more-after completing the problem sets-that explains the types and features of long-term debt and the advantages and disadvantages of leasing with debt versus equity financing.
As stated in the book, all types of long-term debt share some common features: 1) Stated Maturity: Which is the date at which the borrower must repay the funds it has borrowed, 2) Stated Principle Amount: That is the amount the borrower must repay at maturity, 3) Stated Coupon Rate of Interest: which is usually a fixed rate that the borrower must repay through the period the debt is outstanding, 4) Mandatory Redemption (sinking fund) Schedule: Bonds are redeemed at face value at a certain date, a Sinking Fund is a fund that is created for the purpose of spreading out the redemption value of the bonds over time to decrease the likelihood of default, and 5) Optional Redemption Provision: when this provision exists, the issuer states that it has the right to call the issue (or part of it) for early redemption. A schedule of optional redemption prices is specified at the time of issue. Callable bonds usually provide for a grace period immediately following issuance.
Bonds are noncallable during this period.
There are four main types of long-term debt; 1) Secured Debt: which are bonds are secured by specific assets such as Mortgage Bonds (bonds that are secured by a specific asset; if the issuer fails to make the required repayments, lenders can seize the assets), Collateral Trust Bonds (similar to mortgage bonds except that they are secured by equity rather than real property), Equipment Trust Certificates, and Conditional Sales Contracts (usually issued to finance the purchase of aircrafts, railroad engines, and cars).; 2) Unsecured Debt: this consists of notes (unsecured debt with original maturities of ten years or less) and debentures (unsecured debt with original maturities greater than ten years).; 3) Tax-Exempt Corporate Debt: Sometimes, to encourage investments in certain industries, Congress grants firms to issue tax-exempt bonds; and 4) Convertible Bonds: Bonds that can be converted into common stock shares at the bondholder’s option.
The advantages of leasing (Debt Financing) are efficient use of tax deductions and tax credits, reduced risk, reduced costs of borrowing, flexibility under bankruptcy, circumvention of debt covenants, and off balance sheet financing. The disadvantages of leasing are that the lessee forfeits the tax deductions associated with ownership and usually forgoes the residual value. The advantages of leasing that are of dubious value are trying to fool investors through accounting games, achieving “100% financing”, and circumventing debt covenants.