1 under which of the following conditions whould a firm be least likely to issue variable rate debt. A the yield curve is slping sharply upward B operating Cash flows are negatively correlated with short term interest rate 2)8% semi annual pay, option free corporation bond that is selling at par has ten years to marturity. what is the effective duration of the bond based ona 75 basis point change in rates. A 10 B 6.8 3) Dagmar made $200 M in profits for the recent quarter, and since only 70% of these profits will be reinvested back into the company, the manager is considering repurchaseing $60,000,000 worth of stock. assumes the stock can berequrchased at the market price of $50, howevcer, after muchdiscussion dagmar decides to borrow $60 m that it will use to repurchased hsares. share price at time of buyback $50 share outsatrnding before buyback 41200000 EPS before buy back $10 earning yield $10/$50=20% after tax cost of borrowing 8% planning buyback 1.2m So what is the EPS after the buyback
- A. Issuing variable rate debt wouldn’t make a lot of sense if the firm expected interest rates to increase sharply. It also seems odd to issue variable rate debt if operating cash flows are negatively correlated with short-term interest rates, but if the correlation is weak and the coverage ratio is sufficient through peaks and troughs, perhaps doing so could make sense. 2. B. The price of the bond now is $1000. Let’s compute the price if the yield rises to 8.75%. The HP12C reveals that the new price is $950.69. That’s a difference of $49.31. Now let’s check the price at 7.25%. The new price is $1,052.70. That’s a difference of $52.70. The average is $51, which is a 5.1% change in price. Since the 5.1% change in price is caused by a .75% change in yield, the effective duration is 6.8. 3. We need to calculate earnings after the buyback and shares outstanding after the buyback. Earnings after the buyback = $412 million - $4.8 million = $407.2 million. The shares outstanding have declined from 41.2 million to 40 million. Thus I think the new EPS is 407.2/40 = $10.18.
- B Operating Cash flows are negatively correlated with short term interest rates - this is because if rates go up that would mean operating cash flows would be dropping and the firm would have trouble paying their interest expense and could result in defaulting on the debt. Hence this condition would not be favorable for a firm issuing variable rate debt 2. Effective Duration = the amount the price will change based on a 100 basis point change in rates. Duration = (Price when yield drops - Price when yield rises) / 2 (Price)(change in rates) Yield drop: FV = 1000 N = 20 I = 3.625 PMT: 40 solve for PV = 1052.70 Yield Rise: FV = 1000 N = 20 I = 4.375 PMT: 40 Solve for PV = 950.69 (1052.70 - 950.69) / 2(1000)(.0075) = 6.8
I’m with Chybychev on all of them…
1 B, 2 6.8 3 10.18 thank you thank you!!