Corporate Finance Review

Lowes Corporation is expecting to have EBIT next year of $10 million, with a standard deviation of $5 million. Lowes has $40 million in bonds with coupon of 8%, selling at par, which are being retired at the rate of $3 million annually. Lowes also has 200,000 shares of preferred stock, which pays annual dividend of $4 per share. The tax rate of Lowes is 35%. Calculate the probability that Lowes will not be able to pay interest, sinking fund, and preferred dividends, out of its current income, next year. So I began by finding the valuation of the bonds. Then finding the preferred stock dividends. I need to find the probability (z table) of the ability for Lowes to pay interest, retire the bonds (sinking fund), preferred dividends out of it’s current net income (EBIT - interest - tax). Please advise, there is bonds, quant, and corp fin all wrapped in 1 question.

A spot check on this problem would be helpful. Amazing how quick it gets rusty when you don’t visit it. McDonald Corporation needs $20 million in new capital, which it may acquire by selling bonds at par with coupon of 11% or by selling stock at $40 (net) per share. The current capital structure of McDonald consists of $200 million (face value) of 10% coupon bonds selling at 90, and 10 million shares of stock selling at $42 apiece. After the new financing, the EBIT of McDonald is expected to be $80 million with a standard deviation of $30 million. Which method of financing do you recommend? What is the probability that you are right? Use bonds, 67.72% First, determine the critical EBIT, where the debt financing and equity financing provide equal EPS, by using E* = I + r(NP + F) (10.7) In this equation, I = interest on existing debt = .1(200) = $20 million r = coupon rate on new debt = .11 N = number of shares of stock at present = 10 million P = price per share of new equity = $40 F = amount of new financing needed = $20 million E* = 20 + .11(10*40 + 20) = $66.20 million Since the company expects to make $80 million in EBIT, which is more than E*, it is better to sell bonds. To find the probability that you have made the right decision, find z as z = (66.2 – 80)/30 = −0.46 Draw the normal probability distribution curve, with z = 0 in the middle. The required z = −.4533 is to the left of center. The area on the right of z = −.4533 represents the probability of making the right decision. From the tables, we get the probability of being right P(being right) = .5 + .1772 = 67.72%