Five years ago, Shaffer’s Recliners issued $10,000,000 of corporate bonds with a 30-year maturity. The bonds have a coupon rate of 10.125%, pay interest semiannually, and have a par value of $1,000 per bond. The bonds are currently trading at a price of $879.625 per bond. A 25-year Treasury bond with a 6.825% coupon rate (paid semiannually) and $1,000 par is currently selling for $975.42.

Part 2: Case Analysis

1) Determine the yield spread between the corporate bond and the Treasury bond. If you are considering the investment in Shaffer’s bonds (that will be held to maturity) and require an 11% rate of return, would you purchase the bonds? Give reasons for your answer.

2) Alternatively, you could consider purchasing Shaffer’s preferred stock. Assume that the preferred stock has a current market price of $42, a par value of $50, and a dividend amounting to 10% of par. Would you be willing to buy the firm’s preferred stock? Why or why not? Your required rate of return for investments of this type is 12.5%.

3) Now assume that Shaffer’s Recliners has earnings per share (EPS) of $1.89, has 750,000 common shares outstanding, and has recently paid a dividend of $0.65 per share. Additionally, the firm has generated a net income of $1,417,500 and has common shareholders’ equity of $6,000,000 (book value). You believe the firm is in a constant state of growth, and your required rate of return for investments of this risk level is 18%. The firm’s common stock is currently trading for $45 per share. Based upon this information, would you be willing to purchase shares of common stock in the firm? Why or why not? Use both the present value of cash flows model and the free cash flow (FCF) approach to determine your answer. The firm’s current FCF is $109,237. Use the firm’s weight average cost of capital, which is currently at 15.83%, as the appropriate discount rate.