Chapter Review
14-9iCases & Projects
Ethics in Action
CEG Capital Inc. is a large holding company that uses long-term debt extensively to fund its operations. At December 31, the company reported total assets of $100 million, total debt of $55 million, and total equity of $45 million. In January, the company issued $11 billion in long-term bonds to investors at par value. This was the largest debt issuance in the company’s history, and it significantly increased the company’s ratio of total debt to total equity. Five days after the debt issuance, CEG filed legal documents to prepare for an additional $50 billion long-term bond issue. As a result of this filing, the price of the $11 billion in bonds that the company issued earlier in the week dropped to 94 because of the increased risk associated with the company’s debt. The investors in the original $11 billion bond issuance were not informed of the company’s plans to issue additional debt so quickly after the initial bond issue.
Did CEG Capital act unethically by not disclosing to initial bond investors its immediate plans to issue an additional $50 billion debt offering?
Team Activity
In teams, select a public company that interests you. Obtain the company’s most recent annual report on Form 10-K. The Form 10-K is a company’s annually required filing with the Securities and Exchange Commission (SEC). It includes the company’s financial statements and accompanying notes. The Form 10-K can be obtained either (a) by referring to the investor relations section of the company’s website or (b) by using the company search feature of the SEC’s EDGAR database service found at www.sec.gov/edgar/searchedgar/companysearch.html.
-
Based on the information in the company’s most recent annual report, answer the following questions:
-
How much long-term debt does the company report at the end of the most recent year presented?
-
Does the company have any bonds outstanding at the end of the most recent year? If so, read the supporting notes to the financial statements and determine the following:
- (1)
- (2)
The contract rate of interest on the bond issue(s).
- (3)
The face amount of the bond issue(s).
- (4)
The book value of the bond issue(s).
-
-
Based on your answers to the questions in requirement 1, evaluate the company’s debt position.
Communication
Nordbock Inc. reports the following outstanding bond issue on its December 31, 20Y1, balance sheet:
$1,000,000, 7%, 10-year bonds that pay interest semiannually. |
The bonds have been outstanding for five years and were originally issued at face amount. The company is considering redeeming these bonds on January 1, 20Y2, at 103 and issuing new $1,000,000, 5%, five-year bonds at their face amount. These bonds would pay interest semiannually on June 30 and December 31.
Write a brief memo to Liz Nolan, the chief financial officer, discussing the costs of redeeming the existing bonds, the proceeds from issuing the new bonds, and whether this is a good financial decision.
Present Values
Alex Kelton recently won the jackpot in the Colorado lottery while he was visiting his parents. When he arrived at the lottery office to collect his winnings, he was offered the following three payout options:
-
Receive $100,000,000 in cash today.
-
Receive $25,000,000 today and $9,000,000 per year for eight years, with the first payment being received one year from today.
-
Receive $15,000,000 per year for 10 years, with the first payment being received one year from today.
Assuming that the effective rate of interest is 7%, which payout option should Alex select? Use the present value tables in Appendix A. Explain your answer and provide any necessary supporting calculations.
Preferred Stock vs. Bonds
Xentec Inc. has decided to expand its operations to owning and operating golf courses. The following is an excerpt from a conversation between the chief executive officer, Peter Kilgallon, and the vice president of finance, Dan Baron:
Dan, have you given any thought to how we’re going to manage the acquisition of Sweeping Bluff Golf Course?
Well, the two basic options, as I see it, are to issue either preferred stock or bonds. The equity market is a little depressed right now. The rumor is that the Federal Reserve Bank’s going to increase the interest rates either this month or next.
Yes. I’ve heard the rumor. The problem is that we can’t wait around to see what’s going to happen. We’ll have to move on this next week if we want any chance to complete the acquisition of Sweeping Bluff Golf Course.
Well, the bond market is strong right now. Maybe we should issue debt this time around.
That’s what I would have guessed as well. Sweeping Bluff Golf Course’s financial statements look pretty good, except for the volatility of its income and cash flows. But that’s characteristic of the industry.
Discuss the advantages and disadvantages of issuing preferred stock versus bonds.
Financing Business Expansion
You hold a 25% common stock interest in YouOwnIt, a family-owned construction equipment company. Your sister, who is the manager, has proposed an expansion of plant facilities at an expected cost of $26,000,000. Two alternative plans have been suggested as methods of financing the expansion. Each plan is briefly described as follows:
Plan 1. | Issue $26,000,000 of 20-year, 8% notes at face amount |
Plan 2. | Issue an additional 550,000 shares of $10 par common stock at $20 per share, and $15,000,000 of 20-year, 8% notes at face amount |
The balance sheet as of the end of the previous fiscal year is as follows:
Net income has remained relatively constant over the past several years. The expansion program is expected to increase yearly income before bond interest and income tax from $2,667,000 in the previous year to $5,000,000 for this year. Your sister has asked you, as the company treasurer, to prepare an analysis of each financing plan.
-
Prepare a table indicating the expected earnings per share on the common stock under each plan. Assume an income tax rate of 40%. Round to the nearest cent.
-
-
Discuss the factors that should be considered in evaluating the two plans.
-
Which plan offers greater benefit to the present stockholders? Give reasons for your opinion.
-
Times Interest Earned
The following financial data (in thousands) were taken from recent financial statements of Office Depot, Inc.:
Year 3 | Year 2 | Year 1 | |
Interest expense | $121,000 | $ 62,000 | $ 80,000 |
Earnings before taxes | 158,000 | 299,000 | 459,000 |
-
Determine the times interest earned ratio for Office Depot in Year 3, Year 2, and Year 1? Round to one decimal place.
-
Evaluate this ratio for Office Depot.