Question 1

To ensure the fund needed for operation, along with spontaneous financing from accounts
payable and accruals, adequate short-term financing will be available. Milestone plans to
establish an unsecured short-term borrowing arrangement with its local bank, Mourinho bank.
The bank has offered either a line-of-credit agreement or a revolving credit agreement. Mourinho
Bank’s terms for a line of credit are an interest rate of 2.50% above the prime rate. On an
equivalent revolving credit agreement, the interest rate would be 3.00% above prime with a
commitment fee of 0.50% on the average unused balance. Under both loans, a compensating
balance equal to 20% of the amount borrowed would be required. The prime rate is currently 7%.
Both the line-of-credit agreement and the revolving credit agreement would have borrowing
limits of $1,000,000. For purposes of his analysis, it was estimated that Milestone will borrow
$600,000 on the average during the year, regardless which loan arrangement it chooses.
Find the effective annual rate under:
(1) The line-of-credit agreement.
(2) The revolving credit agreement.
If the firm does expect to borrow an average of $600,000, which borrowing arrangement would
you recommend to the firm? Explain why!

Question 2
Miles, the financial manager for Milestone Corporation, wishes to evaluate three prospective
investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk
index of 6%. The expected return and expected risk of the investments are as follows:

Investment Expected return Expected risk

X 14% 7%
Y 12% 8%
Z 10% 9%

a. If Miles were risk-indifferent, which investments would she select? Explain why.
b. If he were risk-averse, which investments would she select? Why?
c. If he were risk-seeking, which investments would she select? Why?
d. Given the traditional risk preference behavior exhibited by financial managers, which
investment would be preferred? Why?
Question 3
Miles Co is considering a bid for Stone Co. Both companies are stock-market listed and are in
the same business sector. Financial information on Stone Co, which is shortly to pay its annual
dividend, is as follows:
Number of ordinary shares 5 million
Ordinary share price $3.30
Earnings per share 40 cents
Proposed payout ratio 60%
Dividend per share one year ago 23.3 cents
Dividend per share two years ago 22 cents
Average sector price/earnings ratio 10

a. Calculate the value of Stone Co using the price/earnings ratio method.

b. Using a cost of equity of 13% and a dividend growth rate of 4.5%, calculate the value of
Stone Co using the dividend growth model.
c. Calculate the market capitalization of Stone Co.

Question 4
Milestone Company has an outstanding issue of convertible bonds with a $1,000 par value.
These bonds are convertible into 50 shares of common stock. They have a 10% annual coupon
interest rate and a 20-year maturity. The interest rate on a straight bond of similar risk is
currently 12%.

a. Calculate the straight bond value of the bond.

b. Calculate the conversion (or stock) value of the bond when the market price of the common
stock is $15, $20, $23, $30, and $45 per share.
c. For each of the stock prices given in part b, at what price would you expect the bond to sell?
Why?
d. What is the least you would expect the bond to sell for, regardless of the common stock price
behavior?