4. Suppose Goodyear Tire and Rubber Company is considering divesting one of its
manufacturing plants. The plant is expected to generate free cash flows of $1.5 million per
year, growing at a rate of 2.5% per year. Goodyear has an equity cost of capital of 8.5%, a
debt cost of capital of 7%, a marginal corporate tax rate of 35%, and a debt-equity ratio of
2.6. If the plant has average risk and Goodyear plans to maintain a constant debt-equity ratio,
what after-tax amount must it receive for the plant for the divestiture to be profitable?
We can compute the levered value of the plant using the WACC method. Goodyear’s
WACC is
rwacc 
1
2.6
8.5% 
7%(1  0.35)  5.65%.
1  2.6
1  2.6
Therefore, VL =
1.5
= $47.6 million
0.0565 - 0.025
A divestiture would be profitable if Goodyear received more than $47.6 million after
tax.
5. Suppose Alcatel-Lucent has an equity cost of capital of 10%, market capitalization of
$10.8 billion, and an enterprise value of $14.4 billion. Suppose Alcatel-Lucent’s debt cost of
capital is 6.1% and its marginal tax rate is 35%.
•
a.What is Alcatel-Lucent’s WACC?
•
b.If Alcatel-Lucent maintains a constant debt-equity ratio, what is the value of a
project with average risk and the following expected free cash flows?
•
Year 0
1
2
3
FCF −100 50
100
70
•
c.If Alcatel-Lucent maintains its debt-equity ratio, what is the debt capacity of the
project in part b?
a. rwacc 
10.8
14.4  10.8
10% 
6.1%(1  0.35)  8.49%
14.4
14.4
b. Using the WACC method, the levered value of the project at date 0 is
VL 
50
100
70


 185.86.
2
1.0849 1.0849 1.08493
Given a cost of 100 to initiate, the project’s NPV is 185.86 – 100 = 85.86.
c. Alcatel-Lucent’s debt-to-value ratio is d = (14.4 – 10.8) / 14.4 = 0.25. The
project’s debt capacity is equal to d times the levered value of its remaining cash
flows at each date.
Year
FCF
VL
D = d*VL
0
–100
185.86
46.47
1
50
151.64
37.91
2
100
64.52
16.13
3
70
0
0.00
Corporate Governance and Agency Costs
1.What inherent characteristic of corporations creates the need for a system of checks on
manager behavior?
The corporation allows for the separation of management and ownership. Thus, those
who control the operations of the corporation and how its money is spent are not the
same who have invested in the corporation. This creates a clear conflict of interest and
this conflict between the investors and managers creates the need for investors to
devise a system of checks on managers—the system of corporate governance.
2.What are some examples of agency problems?
Examples of agency problems are excessive perquisite consumption (more company
jets/company jet travel than needed, nicer office than necessary, etc.). Others are
value-destroying acquisitions that nonetheless increase the pecuniary or nonpecuniary benefits to the CEO on net.
3.What are the advantages and disadvantages of the corporate organizational structure?
Managing Agency Conflict
The corporate organizational form allows those who have the capital to fund an
enterprise to be different from those who have the expertise to manage the enterprise.
This critical separation allows a wide class of investors to share the risk of the
enterprise. However, as mentioned in the answer to question 1, this separation comes
at a cost—the managers will act in their own best interests, not in the best interests of
the shareholders who own the firm.
10.Is it necessarily true that increasing managerial ownership stakes will improve firm
performance?
No. There are two counterarguments here. First, as Demsetz and Lehn (1985) argue,
there is no reason to expect a simple relation between ownership and performance.
There are many dimensions to the corporate governance system and a one-size-fits-all
approach is too simplistic; the correct ownership level for one firm may not be the
correct level for another. Second, some studies have shown a non-linear relationship
between firm valuation and ownership—specifically that increasing ownership is
good at first, but that in a certain range, managers can use their ownership level to
partially block efforts to constrain them, even though they still own a minority of the
shares. In this “entrenching” range, increasing ownership could reduce performance.
11.How can proxy contests be used to overcome a captured board?
Proxy contests are simply contested elections for directors. In a proxy contest, two
competing slates of directors rather than just one slate are proposed by the company.
If a board has become captured or unresponsive to shareholder demands, shareholders
can put their own slate of new directors up for election. If the dissident slate wins,
then shareholders will have succeeded in placing new directors, presumably not
beholden to the CEO, on the board.
12.What is a say-on-pay vote?
A say-on-pay vote is a nonbinding vote whereby the shareholders indicate whether
they approve of an executive’s pay package or not.
13.What are a board’s options when confronted with dissident shareholders?
When confronted with a dissident shareholder, a board can:
Ignore the shareholder, which will result in either the shareholder going away or
launching a proxy fight, in which case the board will need to expend resources in
an attempt to convince shareholders not to side with the dissident; or
Negotiate with the dissident shareholder to come to a solution on which the board
and the shareholder can agree.
Illustrate how management focus on forecasting, planning, and business strategy can create
wealth for a company in your industry.
We have talked about the forecasts that the firm makes as well as different approaches taken.
Do you have any good (or bad) examples of forecasting done by firms you are familiar with?
How would you use the firm's information (provided in different formats by both the firm and
other organizations) to determine if they seem to be reasonable in their statements?
Forecasting, planning, and business strategy can all create wealth for a company. I believe
strategy would be the most important as it gives the company focus on what they want to
accomplish. There are different types of strategies - however, the one I think of most often
when it comes to business is the type of business the company will conduct.
For example, will they be a cost leader and provide their goods/services at the lowest costs or
be a benefits leader and offer the best quality and/or best features for their product. You can
easily see how this can create wealth for the company as people value these things and will
build loyalty towards their brand.
Forecasting and planning may not seem something that builds wealth since it is something
you should do so you are prepared for the future. However, by planning ahead and
forecasting for the future, companies may be able to find out demand will increase/decrease
dramatically and make necessary changes to remain profitable during a recession or increase
production during an economic boom to do even better.
According to economic theory we might suspect that unemployment would lead housing
starts. In essence if unemployment increases then there will less consumer money floating
around causing fewer home purchases. Similarly an increasing unemployment is associated
with a slowing economy which should lead to decreased commercial construction. Housing
does tend to lag behind changes in the economy. The forecasts above both suggest that
unemployment is increasing and housing starts are decreasing. I would suspect that housing
starts are a better indicator of the housing industry which is the focus of your
project. Although unemployment, among other things certainly affects the housing industry.
As the financial manager in developing forecast for the firm, where would you go to in order
to start your forecast and refine it with more accurate future projections concerning interest
rates, raw material prices, and the like to build your estimates?
I think the scratch point to start forecasting will be form sales department that how much they
expect to sell next year, and while inquiring them there should not be a pushing attitude to
have big figure because if you get big figure by pushing them then you will also welcome big
problems in future when the warehouse will be filled up with finished goods due to low
demand.
Once you get the sales figure which is realistic now you need to consult the production
department, there can be certain situations where production could not produce that much, if
it is so then you may need to plan for an expansion plan.
After consulting the production department then we need to go to purchase department to
check and discuss quantity of stocks to produce the goods or services available space to stock
the materials, Economic order quantity etc.
After consulting all the departments, I need to calculate the Additional funds requirement for
coming period and forward the request to board of directors. There can be many other
variables and steps I just tried to make it short. Like you may need to consult Human
Resource department after meeting with production department who have discussed that they
will need more workers to produce more.
Explain how it's possible for sales growth to decrease the value of a profitable company.
A company can be profitable and yet have an Return on Invested Capital (ROIC) that is less
than the Weighted Average Cost of Capital (WACC), if the company has large capital
requirements. If, ROIC is less than the WACC, then the company is not earning enough on its
capital to satisfy investors. Growth adds even more capital that is not satisfying investors,
hence, growth decreases value.
It is thus clear that merely being a profit earning company is not enough. If the profit earnings
give a rate of return on Investable Capital / Funds that is less than the WACC deployed. This
will erode shareholder value and result in a decrease in value even of a profitable company.
Capital structure and WACC in reference to the rate of return, thus becomes a very
significant factor in valuation.
What are some actions an entrenched management might take that would harm shareholders?
If senior managers believe there is little chance they will be removed, we say that they
are entrenched. Such a company faces a high risk of being poorly run, because entrenched
managers are able to act in their own interests rather than in the interests of shareholders.
Entrenched managers consume too many perquisites, such as lavish offices , excessive staffs,
country club memberships, and corporate jets. They also invest in projects or acquisitions that
make the firm larger, even if they dont make the firm more valuable.
Singal Inc. is preparing its cash budget. It expects to have sales of $50,000 in January,
$60,000 in February, and $70,000 in March. If 50% of sales are for cash, 30% are credit sales
paid in the month after the sale, and another 20% are credit sales paid 2 months after the sale,
what are the expected cash receipts for March?
Expected cash receipts for March = 50% x 70,000 + 30% x 60,000 + 20% x 50,000 =
$63,000
The Chadmark Corporation's budgeted monthly sales are $10,000. In the first month, 20% of
its customers pay and take the 5% discount. The remaining 80% pay in the month following
the sale and don't receive a discount.
Chadmark's bad debts are very small and are excluded from this analysis. Purchases for next
month's sales are constant each month at $5,000.
Other payments for wages, rent, and taxes are constant at $1,000 per month. Construct a
single month's cash budget with the information given.
What is the average cash gain or (loss) during a typical month for the Chadmark
Corporation?
Current month sales collected: 10000 x 20% x (100%-5%) = $1900
ADD: Prior month sales collected: 10000 x 80% = $8000
LESS: purchases $5000
LESS: other expenses $1000
= $3900 average cash gain during a typical month.