Solution to questions - Assignment Example

Question REQUIRED TASK: Referring to the financial ments below, apply the Altmans Z-score model to predict ELVAs likelihood of financial distress. Interpret your results, including a comment on the change between 2006 and 2007.Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1X5X1 = Net Working Capital/Total AssetsAs calculated in excel 20072006Total Assets1,650,8001468800Net Working Capital749,800642,400Retained Earnings225,988203,768 EBIT149.70209.10Market Value of All Assets16508001468800Sales3,850.003,432.

00Book Value of Total Liabilities964,812805,032 20072006x10.4542040220.437364x20.136896050.138731x39.06833E-050.000142x41.7110069111.824524x50.0023322030.002337Multiplying the above by the coefficient gives 20072006 0.5450450.524837 0.1916540.194223 0.0002990.00047 1.0266041.094714 0.0023320.002337   z-score 1.7659351.816581Comment The Altman Z-score calculation shows that the company falls below the cutoff point of 2.675 in its z-score, for both years. This insinuates that the firm was predicted to experience severe financial distress and possibly bankruptcy in 2008.

However, comparing the two years shows that in the year 2007, the z-score predicted more severe bankruptcy and financial distress than in 2006. This is because the z-score for 2007 was less than 1.81 while that for 2006 was more than 1.81 but less than 2.675.Mini-case 1: Estimating Interest Rate using Risk PremiumsRequired Task: Complete the Solution Table below, which is presented in form of a formula required to determine Rd.Solution to Mini-Case 1 (show your work below the table, as appropriate):r*rf+ IRP+ DRP+ MRP+ LRP=rd= 1.29%3.60%= 0.86%= 0.49%0.03%6.27%Working r*rf = average yield on 3-month Treasury bills - the inflation rate= 4.89 – 3.60= 1.

29%IRP = Rate of inflation = 3.60%DRP = average yield on Aaa-rated bonds - average yield on 30-year Treasury bonds= 6.24 – 5.38= 0.86%MRP = average yield on 30-year Treasury bonds - 3-month Treasury bills5.38 – 4.89 = 0.49%LRP = basis point x one hundrendth of 1 percent = 3 x 0.01 = 0.03%Hence rd:rd = r*rf + IRP + DRP + MRP + LRP 1.29% + 3.60% + 0.86% + 0.49%= 6.27%The calculations shows that the reasonable estimate of the nominal interest rate (nominal yield), rd, for a new issue of Aaa-rated bonds to be offered by Binghamton Truck is 6.27%. This means that the case above requires Binghamton to offer a nominal yield of 6.

27% on the Aaa-rated bond to the investors. Mini-case 2: Using Term Structure of Interest Rates to make Investment decision.a) Why might you choose to make the investment in the 1-year security that pays an interest rate of only 6 percent, as opposed to investing in the 2-year security paying 8 percent? Provide a numerical support for your answer.For the 2 year security:20000(1 + 0.08)2$23328In which case, savings in 2 years is $23328For the 1 year deal20000(1 + 0.06)$22472Therefore interest needed in year 2 for the 1 year security to give $23328:$23328 - $22472= $856Consequently, in the 2nd year investment I would expect a rate of:856/22472 = 3.

81%In which case, I only need 3.81% interest rate to reach the savings for the 2 year investment at the end of two years. This is even a lesser rate than the original rate which was 6%. Consequently, I would have more savings when I choose the 6% interest rate. b) Which Theory of term structure have you supported in your answer?Unbiased expectation theoryc) Assume your required rate of return on the second-year investment is 11 percent; otherwise, you will choose to go with the 2-year security.

What rationale you offer for your preference? I will choose the 2- year security given the rationale that I am risk averse; in which case, 11% rate is far much more than 6. Since I am afraid of risks, I would not subject myself to a higher required rate of return which usually bears much risk. Mini-Case 3: Bootstrapping ProcedureTable 2: Implied Zeroes and Spot Rates. (Answers for maturity 1 are already given to you.)Maturity (Years)Implied Zero (zi)Spot Rate (yi)1z1 = 0.9476y1 = 5.53%2z2 = 0.

9551 y2 = 4.70% ?3z3 = 0.9369 Y3 = 6.73%% Z2Formula used = z2 = P2 = 101.25 C2 = 6Hence plugging the values = 0.9551 Y2y2 = 1 – x 100% ( 1 - 1/0.9551)* 100% = 4.70% Z3 = P3 = 100.25c2 = 7 = 0.9369 Y3 = 1 – x 100%= ( 1 - 1/0.9369)* 100% = 6.73%