Case Solutions
Fundamentals of Corporate Finance
Ross, Westerfield, and Jordan
9th edition
CHAPTER 1
THE McGEE CAKE COMPANY
1.
The advantages to a LLC are: 1) Reduction of personal liability. A sole proprietor has unlimited
liability, which can include the potential loss of all personal assets. 2) Taxes. Forming an LLC may
mean that more expenses can be considered business expenses and be deducted from the company’s
income. 3) Improved credibility. The business may have increased credibility in the business world
compared to a sole proprietorship. 4) Ability to attract investment. Corporations, even LLCs, can
raise capital through the sale of equity. 5) Continuous life. Sole proprietorships have a limited life,
while corporations have a potentially perpetual life. 6) Transfer of ownership. It is easier to transfer
ownership in a corporation through the sale of stock.
The biggest disadvantage is the potential cost, although the cost of forming a LLC can be relatively
small. There are also other potential costs, including more expansive record-keeping.
2.
Forming a corporation has the same advantages as forming a LLC, but the costs are likely to be
higher.
3.
As a small company, changing to a LLC is probably the most advantageous decision at the current
time. If the company grows, and Doc and Lyn are willing to sell more equity ownership, the
company can reorganize as a corporation at a later date. Additionally, forming a LLC is likely to be
less expensive than forming a corporation.
CHAPTER 2
CASH FLOWS AND FINANCIAL
STATEMENTS AT SUNSET BOARDS
Below are the financial statements that you are asked to prepare.
1.
The income statement for each year will look like this:
Income statement
2008
2009
$247,259
126,038
24,787
35,581
$60,853
7,735
$53,118
10,624
$42,494
$301,392
159,143
32,352
40,217
$69,680
8,866
$60,814
12,163
$48,651
$21,247
21,247
$24,326
24,326
Sales
Cost of goods sold
Selling & administrative
Depreciation
EBIT
Interest
EBT
Taxes
Net income
Dividends
Addition to retained earnings
2.
The balance sheet for each year will be:
Balance sheet as of Dec. 31, 2008
Cash
Accounts receivable
Inventory
Current assets
Net fixed assets
Total assets
$18,187
12,887
27,119
$58,193
$156,975
$215,168
Accounts payable
Notes payable
Current liabilities
Long-term debt
Owners' equity
Total liab. & equity
$32,143
14,651
$46,794
$79,235
89,139
$215,168
In the first year, equity is not given. Therefore, we must calculate equity as a plug variable. Since total
liabilities & equity is equal to total assets, equity can be calculated as:
Equity = $215,168 – 46,794 – 79,235
Equity = $89,139
C-2 CASE SOLUTIONS
Balance sheet as of Dec. 31, 2009
Cash
Accounts receivable
Inventory
Current assets
Net fixed assets
Total assets
$27,478
16,717
37,216
$81,411
Accounts payable
Notes payable
Current liabilities
Long-term debt
Owners' equity
Total liab. & equity
$191,250
$272,661
$36,404
15,997
$52,401
$91,195
129,065
$272,661
The owner’s equity for 2009 is the beginning of year owner’s equity, plus the addition to retained
earnings, plus the new equity, so:
Equity = $89,139 + 24,326 + 15,600
Equity = $129,065
3. Using the OCF equation:
OCF = EBIT + Depreciation – Taxes
The OCF for each year is:
OCF2008 = $60,853 + 35,581 – 10,624
OCF2008 = $85,180
OCF2009 = $69,680 + 40,217 – 12,163
OCF2009 = $97,734
4. To calculate the cash flow from assets, we need to find the capital spending and change in net
working capital. The capital spending for the year was:
Capital spending
Ending net fixed assets
– Beginning net fixed assets
+ Depreciation
Net capital spending
$191,250
156,975
40,217
$74,492
And the change in net working capital was:
Change in net working capital
Ending NWC
– Beginning NWC
Change in NWC
$29,010
11,399
$17,611
CHAPTER 2 C-3
So, the cash flow from assets was:
Cash flow from assets
Operating cash flow
– Net capital spending
– Change in NWC
Cash flow from assets
$97,734
74,492
17,611
$ 5,631
5. The cash flow to creditors was:
Cash flow to creditors
Interest paid
– Net new borrowing
Cash flow to creditors
$8,866
11,960
–$3,094
6. The cash flow to stockholders was:
Cash flow to stockholders
Dividends paid
– Net new equity raised
Cash flow to stockholders
$24,326
15,600
$8,726
Answers to questions
1. The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from
operations. The firm invested $17,611 in new net working capital and $74,492 in new fixed assets.
The firm gave $5,631 to its stakeholders. It raised $3,094 from bondholders, and paid $8,726 to
stockholders.
2. The expansion plans may be a little risky. The company does have a positive cash flow, but a large
portion of the operating cash flow is already going to capital spending. The company has had to raise
capital from creditors and stockholders for its current operations. So, the expansion plans may be too
aggressive at this time. On the other hand, companies do need capital to grow. Before investing or
loaning the company money, you would want to know where the current capital spending is going,
and why the company is spending so much in this area already.
CHAPTER 3
RATIOS ANALYSIS AT S&S AIR
1.
The calculations for the ratios listed are:
Current ratio = $2,186,520 / $2,919,000
Current ratio = 0.75 times
Quick ratio = ($2,186,250 – 1,037,120) / $2,919,000
Quick ratio = 0.39 times
Cash ratio = $441,000 / $2,919,000
Cash ratio = 0.15 times
Total asset turnover = $30,499,420 / $18,308,920
Total asset turnover = 1.67 times
Inventory turnover = $22,224,580 / $1,037,120
Inventory turnover = 21.43 times
Receivables turnover = $30,499,420 / $708,400
Receivables turnover = 43.05 times
Total debt ratio = ($18,308,920 – 10,069,920) / $18,308,920
Total debt ratio = 0.45 times
Debt-equity ratio = ($2,919,000 + 5,320,000) / $10,069,920
Debt-equity ratio = 0.82 times
Equity multiplier = $18,308,920 / $10,069,920
Equity multiplier = 1.82 times
Times interest earned = $3,040,660 / $478,240
Times interest earned = 6.36 times
Cash coverage = ($3,040,660 + 1,366,680) / $478,420
Cash coverage = 9.22 times
Profit margin = $1,537,452 / $30,499,420
Profit margin = 5.04%
Return on assets = $1,537,452 / $18,308,920
Return on assets = 8.40%
Return on equity = $1,537,452 / $10,069,920
Return on equity = 15.27%
CHAPTER 3 C-5
2.
Boeing is probably not a good aspirant company. Even though both companies manufacture
airplanes, S&S Air manufactures small airplanes, while Boeing manufactures large, commercial
aircraft. These are two different markets. Additionally, Boeing is heavily involved in the defense
industry, as well as Boeing Capital, which finances airplanes.
Bombardier is a Canadian company that builds business jets, short-range airliners and fire-fighting
amphibious aircraft and also provides defense-related services. It is the third largest commercial
aircraft manufacturer in the world. Embraer is a Brazilian manufacturer than manufactures
commercial, military, and corporate airplanes. Additionally, the Brazilian government is a part
owner of the company. Bombardier and Embraer are probably not good aspirant companies because
of the diverse range of products and manufacture of larger aircraft.
Cirrus is the world's second largest manufacturer of single-engine, piston-powered aircraft. Its
SR22 is the world's best selling plane in its class. The company is noted for its innovative small
aircraft and is a good aspirant company.
Cessna is a well known manufacturer of small airplanes. The company produces business jets,
freight- and passenger-hauling utility Caravans, personal and small-business single engine pistons.
It may be a good aspirant company, however, its products could be considered too broad and
diversified since S&S Air produces only small personal airplanes.
3.
S&S is below the median industry ratios for the current and cash ratios. This implies the company
has less liquidity than the industry in general. However, both ratios are above the lower quartile, so
there are companies in the industry with lower liquidity ratios than S&S Air. The company may
have more predictable cash flows, or more access to short-term borrowing. If you created an
Inventory to Current liabilities ratio, S&S Air would have a ratio that is lower than the industry
median. The current ratio is below the industry median, while the quick ratio is above the industry
median. This implies that S&S Air has less inventory to current liabilities than the industry median.
S&S Air has less inventory than the industry median, but more accounts receivable than the
industry since the cash ratio is lower than the industry median.
The turnover ratios are all higher than the industry median; in fact, all three turnover ratios are
above the upper quartile. This may mean that S&S Air is more efficient than the industry.
The financial leverage ratios are all below the industry median, but above the lower quartile. S&S
Air generally has less debt than comparable companies, but still within the normal range.
The profit margin, ROA, and ROE are all slightly below the industry median, however, not
dramatically lower. The company may want to examine its costs structure to determine if costs can
be reduced, or price can be increased.
Overall, S&S Air’s performance seems good, although the liquidity ratios indicate that a closer look
may be needed in this area.
C-6 CASE SOLUTIONS
Below is a list of possible reasons it may be good or bad that each ratio is higher or lower than the
industry. Note that the list is not exhaustive, but merely one possible explanation for each ratio.
Ratio
Current ratio
Quick ratio
Cash ratio
Total asset turnover
Inventory turnover
Receivables turnover
Good
Better at managing current
accounts.
Better at managing current
accounts.
Better at managing current
accounts.
Better at utilizing assets.
Better at inventory management,
possibly due to better procedures.
Better at collecting receivables.
Total debt ratio
Less debt than industry median
means the company is less likely
to experience credit problems.
Debt-equity ratio
Less debt than industry median
means the company is less likely
to experience credit problems.
Equity multiplier
Less debt than industry median
means the company is less likely
to experience credit problems.
TIE
Higher quality materials could be
increasing costs.
Cash coverage
Less debt than industry median
means the company is less likely
to experience credit problems.
Profit margin
The PM is slightly below the
industry median. It could be a
result of higher quality materials
or better manufacturing.
Company may have newer assets
than the industry.
Lower profit margin may be a
result of higher quality.
ROA
ROE
Bad
May be having liquidity problems.
May be having liquidity problems.
May be having liquidity problems.
Assets may be older and
depreciated, requiring extensive
investment soon.
Could be experiencing inventory
shortages.
May have credit terms that are too
strict. Decreasing receivables
turnover may increase sales.
Increasing the amount of debt can
increase shareholder returns.
Especially notice that it will
increase ROE.
Increasing the amount of debt can
increase shareholder returns.
Especially notice that it will
increase ROE.
Increasing the amount of debt can
increase shareholder returns.
Especially notice that it will
increase ROE.
The company may have more
difficulty meeting interest
payments in a downturn.
Increasing the amount of debt can
increase shareholder returns.
Especially notice that it will
increase ROE.
Company may be having trouble
controlling costs.
Company may have newer assets
than the industry.
Profit margin and EM are lower
than industry, which results in the
lower ROE.
CHAPTER 4
PLANNING FOR GROWTH AT S&S AIR
1.
To calculate the internal growth rate, we first need to find the ROA and the retention ratio, so:
ROA = NI / TA
ROA = $1,537,452 / $18,309,920
ROA = .0840 or 8.40%
b = Addition to RE / NI
b = $977,452 / $1,537,452
b = 0.64
Now we can use the internal growth rate equation to get:
Internal growth rate = (ROA × b) / [1 – (ROA × b)]
Internal growth rate = [0.0840(.64)] / [1 – 0.0840(.64)]
Internal growth rate = .0564 or 5.64%
To find the sustainable growth rate, we need the ROE, which is:
ROE = NI / TE
ROE = $1,537,452 / $10,069,920
ROE = .1527 or 15.27%
Using the retention ratio we previously calculated, the sustainable growth rate is:
Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]
Sustainable growth rate = [0.1527(.64)] / [1 – 0.1527(.64)]
Sustainable growth rate = .1075 or 10.75%
The internal growth rate is the growth rate the company can achieve with no outside financing of any
sort. The sustainable growth rate is the growth rate the company can achieve by raising outside debt
based on its retained earnings and current capital structure.
C-8 CASE SOLUTIONS
2.
Pro forma financial statements for next year at a 12 percent growth rate are:
Income statement
Sales
COGS
Other expenses
Depreciation
EBIT
Interest
Taxable income
Taxes (40%)
Net income
$ 34,159,350
24,891,530
4,331,600
1,366,680
$ 3,569,541
478,240
$ 3,091,301
1,236,520
$ 1,854,780
Dividends
Add to RE
$
675,583
1,179,197
Balance sheet
Assets
Current Assets
Cash
Accounts rec.
Inventory
Total CA
$
493,920
793,408
1,161,574
$ 2,448,902
Liabilities & Equity
Current Liabilities
Accounts Payable
$
Notes Payable
Total CL
$
995,680
2,030,000
3,025,680
Long-term debt
5,320,000
Fixed assets
Net PP&E
$ 18,057,088
Shareholder Equity
Common stock
Retained earnings
Total Equity
Total Assets
$ 20,505,990
Total L&E
$
$
350,000
10,899,117
$ 11,249,117
$ 19,594,787
So, the EFN is:
EFN = Total assets – Total liabilities and equity
EFN = $20,505,990 – 19,594,797
EFN = $911,193
The company can grow at this rate by changing the way it operates. For example, if profit margin
increases, say by reducing costs, the ROE increases, it will increase the sustainable growth rate. In
general, as long as the company increases the profit margin, total asset turnover, or equity multiplier,
the higher growth rate is possible. Note however, that changing any one of these will have the effect
of changing the pro forma financial statements.
CHAPTER 4 C-9
3.
Now we are assuming the company can only build in amounts of $5 million. We will assume that the
company will go ahead with the fixed asset acquisition. To estimate the new depreciation charge, we
will find the current depreciation as a percentage of fixed assets, then, apply this percentage to the
new fixed assets. The depreciation as a percentage of assets this year was:
Depreciation percentage = $1,366,680 / $16,122,400
Depreciation percentage = .0848 or 8.48%
The new level of fixed assets with the $5 million purchase will be:
New fixed assets = $16,122,400 + 5,000,000 = $21,122,400
So, the pro forma depreciation will be:
Pro forma depreciation = .0848($21,122,400)
Pro forma depreciation = $1,790,525
We will use this amount in the pro forma income statement. So, the pro forma income statement will
be:
Income statement
Sales
COGS
Other expenses
Depreciation
EBIT
Interest
Taxable income
Taxes (40%)
Net income
$ 34,159,350
24,891,530
4,331,600
1,790,525
$ 3,145,696
478,240
$ 2,667,456
1,066,982
$ 1,600,473
Dividends
Add to RE
$
582,955
1,017,519
C-10 CASE SOLUTIONS
The pro forma balance sheet will remain the same except for the fixed asset and equity accounts. The
fixed asset account will increase by $5 million, rather than the growth rate of sales.
Balance sheet
Assets
Current Assets
Cash
Accounts rec.
Inventory
Total CA
$
493,920
793,408
1,161,574
$ 2,448,902
Liabilities & Equity
Current Liabilities
Accounts Payable
$
Notes Payable
Total CL
$
995,680
2,030,000
3,025,680
Long-term debt
5,320,000
Fixed assets
Net PP&E
$ 21,122,400
Shareholder Equity
Common stock
Retained earnings
Total Equity
Total Assets
$ 23,571,302
Total L&E
$
$
350,000
10,737,439
$ 11,087,439
$ 19,433,119
So, the EFN is:
EFN = Total assets – Total liabilities and equity
EFN = $23,581,302 – 19,433,119
EFN = $4,138,184
Since the fixed assets have increased at a faster percentage than sales, the capacity utilization for
next year will decrease.
CHAPTER 6
THE MBA DECISION
1.
Age is obviously an important factor. The younger an individual is, the more time there is for the
(hopefully) increased salary to offset the cost of the decision to return to school for an MBA. The
cost includes both the explicit costs such as tuition, as well as the opportunity cost of the lost salary.
2.
Perhaps the most important nonquantifiable factors would be whether or not he is married and if he
has any children. With a spouse and/or children, he may be less inclined to return for an MBA since
his family may be less amenable to the time and money constraints imposed by classes. Other factors
would include his willingness and desire to pursue an MBA, job satisfaction, and how important the
prestige of a job is to him, regardless of the salary.
3.
He has three choices: remain at his current job, pursue a Wilton MBA, or pursue a Mt. Perry MBA.
In this analysis, room and board costs are irrelevant since presumably they will be the same whether
he attends college or keeps his current job. We need to find the aftertax value of each, so:
Remain at current job:
Aftertax salary = $55,000(1 – .26) = $40,700
His salary will grow at 3 percent per year, so the present value of his aftertax salary is:
PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]
PV = $40,700{[1 – [(1 +.065)/(1 + .03)]38} / (.065 – .03)
PV = $836,227.34
Wilton MBA:
Costs:
Total direct costs = $63,000 + 2,500 + 3,000 = $68,500
PV of direct costs = $68,500 + 68,500 / (1.065) = $132,819.25
PV of indirect costs (lost salary) = $40,700 / (1.065) + $40,700(1 + .03) / (1 + .065)2 = $75,176.00
Salary:
PV of aftertax bonus paid in 2 years = $15,000(1 – .31) / 1.0652 = $9,125.17
Aftertax salary = $98,000(1 – .31) = $67,620
C-12 CASE SOLUTIONS
His salary will grow at 4 percent per year. We must also remember that he will now only work for 36
years, so the present value of his aftertax salary is:
PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]
PV = $67,620{[1 – [(1 +.065)/(1 + .04)]36} / (.065 – .04)
PV = $1,554,663.22
Since the first salary payment will be received three years from today, so we need to discount this for
two years to find the value today, which will be:
PV = $1,544,663.22 / 1.0652
PV = $1,370,683.26
So, the total value of a Wilton MBA is:
Value = –$75,160 – 132,819.25 + 9,125.17 + 1,370,683.26 = $1,171,813.18
Mount Perry MBA:
Costs:
Total direct costs = $78,000 + 3,500 + 3,000 = $86,500. Note, this is also the PV of the direct costs
since they are all paid today.
PV of indirect costs (lost salary) = $40,700 / (1.065) = $38,215.96
Salary:
PV of aftertax bonus paid in 1 year = $10,000(1 – .29) / 1.065 = $6,666.67
Aftertax salary = $81,000(1 – .29) = $57,510
His salary will grow at 3.5 percent per year. We must also remember that he will now only work for
37 years, so the present value of his aftertax salary is:
PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]
PV = $57,510{[1 – [(1 +.065)/(1 + .035)]37} / (.065 – .035)
PV = $1,250,991.81
Since the first salary payment will be received two years from today, so we need to discount this for
one year to find the value today, which will be:
PV = $1,250,991.81 / 1.065
PV = $1,174,640.20
So, the total value of a Mount Perry MBA is:
Value = –$86,500 – 38,215.96 + 6,666.67 + 1,174,640.20 = $1,056,590.90
CHAPTER 6 C-13
4.
He is somewhat correct. Calculating the future value of each decision will result in the option with
the highest present value having the highest future value. Thus, a future value analysis will result in
the same decision. However, his statement that a future value analysis is the correct method is wrong
since a present value analysis will give the correct answer as well.
5.
To find the salary offer he would need to make the Wilton MBA as financially attractive as the as the
current job, we need to take the PV of his current job, add the costs of attending Wilton, and the PV
of the bonus on an aftertax basis. So, the necessary PV to make the Wilton MBA the same as his
current job will be:
PV = $836,227.34 + 132,819.25 + 75,176.00 – 9,125.17 = $1,035,097.42
This PV will make his current job exactly equal to the Wilton MBA on a financial basis. Since his
salary will still be a growing annuity, the aftertax salary needed is:
PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]
$1,035,097.42 = C {[1 – [(1 +.065)/(1 + .04)]36} / (.065 – .04)
C = $45,021.51
This is the aftertax salary. So, the pretax salary must be:
Pretax salary = $45,021.51 / (1 – .31) = $65,248.57
6.
The cost (interest rate) of the decision depends on the riskiness of the use of funds, not the source of
the funds. Therefore, whether he can pay cash or must borrow is irrelevant. This is an important
concept which will be discussed further in capital budgeting and the cost of capital in later chapters.
CHAPTER 7
FINANCING S&S AIR’S EXPANSION
PLANS WITH A BOND ISSUE
A rule of thumb with bond provisions is to determine who benefits by the provision. If the company
benefits, the bond will have a higher coupon rate. If the bondholders benefit, the bond will have a
lower coupon rate.
1.
A bond with collateral will have a lower coupon rate. Bondholders have the claim on the collateral,
even in bankruptcy. Collateral provides an asset that bondholders can claim, which lowers their risk
in default. The downside of collateral is that the company generally cannot sell the asset used as
collateral, and they will generally have to keep the asset in good working order.
2.
The more senior the bond is, the lower the coupon rate. Senior bonds get full payment in bankruptcy
proceedings before subordinated bonds receive any payment. A potential problem may arise in that
the bond covenant may restrict the company from issuing any future bonds senior to the current
bonds.
3.
A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. The
problem with a sinking fund is that the company must make the interim payments into a sinking fund
or face default. This means the company must be able to generate these cash flows.
4.
A provision with a specific call date and prices would increase the coupon rate. The call provision
would only be used when it is to the company’s advantage, thus the bondholder’s disadvantage. The
downside is the higher coupon rate. The company benefits by being able to refinance at a lower rate
if interest rates fall significantly, that is, enough to offset the call provision cost.
5.
A deferred call would reduce the coupon rate relative to a call provision with a deferred call. The
bond will still have a higher rate relative to a plain vanilla bond. The deferred call means that the
company cannot call the bond for a specified period. This offers the bondholders protection for this
period. The disadvantage of a deferred call is that the company cannot call the bond during the call
protection period. Interest rates could potentially fall to the point where it would be beneficial for the
company to call the bond, yet the company is unable to do so.
6.
A make-whole call provision should lower the coupon rate in comparison to a call provision with
specific dates since the make-whole call repays the bondholder the present value of the future cash
flows. However, a make-whole call provision should not affect the coupon rate in comparison to a
plain vanilla bond. Since the bondholders are made whole, they should be indifferent between a plain
vanilla bond and a make-whole bond. If a bond with a make-whole provision is called, bondholders
receive the market value of the bond, which they can reinvest in another bond with similar
characteristics. If we compare this to a bond with a specific call price, investors rarely receive the
full market value of the future cash flows.
CHAPTER 7 C-15
7.
A positive covenant would reduce the coupon rate. The presence of positive covenants protects
bondholders by forcing the company to undertake actions that benefit bondholders. Examples of
positive covenants would be: the company must maintain audited financial statements; the company
must maintain a minimum specified level of working capital or a minimum specified current ratio;
the company must maintain any collateral in good working order. The negative side of positive
covenants is that the company is restricted in its actions. The positive covenant may force the
company into actions in the future that it would rather not undertake.
8.
A negative covenant would reduce the coupon rate. The presence of negative covenants protects
bondholders from actions by the company that would harm the bondholders. Remember, the goal of
a corporation is to maximize shareholder wealth. This says nothing about bondholders. Examples of
negative covenants would be: the company cannot increase dividends, or at least increase beyond a
specified level; the company cannot issue new bonds senior to the current bond issue; the company
cannot sell any collateral. The downside of negative covenants is the restriction of the company’s
actions.
9.
Even though the company is not public, a conversion feature would likely lower the coupon rate.
The conversion feature would permit bondholders to benefit if the company does well and also goes
public. The downside is that the company may be selling equity at a discounted price.
10. The downside of a floating-rate coupon is that if interest rates rise, the company has to pay a higher
interest rate. However, if interest rates fall, the company pays a lower interest rate.
CHAPTER 8
STOCK VALUATION AT RAGAN, INC.
1.
The total dividends paid by the company were $126,000. Since there are 100,000 shares outstanding,
the total earnings for the company were:
Total earnings = 100,000($4.54) = $454,000
This means the payout ratio was:
Payout ratio = $126,000/$454,000 = 0.28
So, the retention ratio was:
Retention ratio = 1 – .28 = 0.72
Using the retention ratio, the company’s growth rate is:
g = ROE × b = .28(.72) = .1806 or 18.06%
The dividend per share paid this year was:
D0 = $63,000 / 50,000
D0 = $1.26
Now we can find the stock price, which is:
P0 = D1 / (R – g)
P0 = $1.26(1.1806) / (.20 – .1806)
P0 = $76.75
2.
Since Expert HVAC had a write off which affected its earnings per share, we need to recalculate the
industry EPS. So, the industry EPS is:
Industry EPS = ($0.79 + 1.38 + 1.06) / 3 = $1.08
Using this industry EPS, the industry payout ratio is:
Industry payout ratio = $0.40/$1.08 = .3715 or 37.15%
So, the industry retention ratio is
Industry retention ratio = 1 – .3715 = .6285 or 62.85%
CHAPTER 8 C-17
This means the industry growth rate is:
Industry g = .1233(.6285) = .0775 or 7.75%
The company will continue to grow at its current pace for five years before slowing to the industry
growth rate. So, the total dividends for each of the next six years will be:
D1 = $1.26(1.1806) = $1.49
D2 = $1.49(1.1806) = $1.76
D3 = $1.76(1.1806) = $2.07
D4 = $2.07(1.1806) = $2.45
D5 = $2.45(1.1806) = $2.89
D6 = $2.89(1.0849) = $3.11
The stock price in Year 5 with the industry required return will be:
Stock value in Year 5 = $3.11 / (.1167 – .0775) = $79.54
This means the total value of the stock today is:
P0 = $1.149/1.1167 + $1.76/1.11672 + $2.07/1.11673 + $2.45/1.11674 + ($2.89 + 79.54) / 1.11675
P0 = $53.28
3.
Using the revised industry EPS, the industry PE ratio is:
Industry PE = $13.09 / $1.08 = 12.15
Using the original stock price assumption, Ragan’s PE ratio is:
Ragan PE (original assumptions) = $76.75 / $4.54 = 16.90
Using the revised assumptions, Ragan’s PE = $53.28 / $4.54 = 11.74
Obviously, using the original assumptions, Ragan’s PE is too high. The PE using the revised
assumptions is close to the industry PE ratio. Using the industry average PE, we can calculate a
stock price for Ragan, which is:
Stock price implied by industry PE = 12.15($4.32) = $55.18
4.
If the ROE on the company’s projects exceeds the required return, the company should retain
earnings and reinvest. If the ROE on the company’s projects is lower than the required return, the
company should pay dividends. This makes logical sense. Consider a company with a 10 percent
required return. If the company can keep retained earnings and reinvest those earnings at 15 percent,
shareholders would be better off since the dividends in future years would be more than needed for
the required return.
C-18 CASE SOLUTIONS
5.
Again, we will assume the results in Question 2 are correct. The growth rate of the company we
calculated in this question was the industry growth rate of 7.75 percent. Since the growth rate is:
g = ROE × b
If we assume the payout ratio remains constant, the ROE is:
.0775 = ROE(.72)
ROE = .1073 or 10.73%
6.
The most obvious solution is to retain more of the company’s earnings and invest in profitable
opportunities. This strategy will not work if the return on the company’s investment is lower than the
required return on the company’s stock.
CHAPTER 9
BULLOCK GOLD MINING
1.
An example spreadsheet is:
C-20 CASE SOLUTIONS
Note, there is no Excel function to directly calculate the payback period. We used “If” statements in
our spreadsheet. The IF statement we used is:
=IF(-D8>(D9+D10+D11+D12+D13+D14),"Greater than 6 years",IF(D>(D9+D10+D11+D12+D13),(5+(-D8-D9-D10-D11-D12-D13)/D14),IF(D8>(D9+D10+D11+D12),(4+(-D8-D9-D10-D11-D12)/D13),IF(-D8>(D9+D10+D11),(3+(-D8-D9D10-D11)/D12),IF(-D8>(D9+D10),(2+(-D8-D9-D10)/D11),IF(-D8>D9,(1+(-D8-D9)/D10),IF(D8<D9,-D8/D9," ")))))))
2.
Since the NPV of the mine is positive, the company should open the mine. We should note, it may
be advantageous to delay the mine opening because of real options, a topic covered in more detail in
a later chapter.
3.
There are many possible variations on the VBA code to calculate the payback period. Below is a
VBA program from http://www.vbaexpress.com/kb/getarticle.php?kb_id=252.
Function PAYBACK(invest, finflow)
Dim x As Double, v As Double
Dim c As Integer, i As Integer
x = Abs(invest)
i=1
c = finflow.Count
Do
x=x-v
v = finflow.Cells(i).Value
If x = v Then
PAYBACK = i
Exit Function
ElseIf x < v Then
P=i-1
Z=x/v
PAYBACK = P + Z
Exit Function
End If
i=i+1
Loop Until i > c
PAYBACK = "no payback"
End Function
CHAPTER 10
CONCH REPUBLIC ELECTRONICS,
PART 1
This is an in-depth capital budgeting problem. The initial cash outlay at Time 0 is simply the cost of
the new equipment, $21,500,000. The sales each year are a combination of the sales of the new
PDA, the lost sales each year, and the lost revenue. In this case, the lost sales are 15,000 units of the
old PDA each year for two years at a price of $290 each. The company will also be forced to reduce
the price of the old PDA on the units they will still sell for the next two years. So, the total change in
sales is:
Sales = New sales – Lost sales – Lost revenue
Year 1 = (74,000 × $360) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)] = $20,015,000
Year 2 = (95,000 × $360) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)] = $28,275,000
Sales
New
Lost sales
Lost revenue
Net sales
VC
New
Lost sales
Sales
VC
Fixed costs
Depreciation
EBT
Tax
NI
+ Depreciation
OCF
Year 1
$26,640,000
–4,350,000
–2,275,000
$20,015,000
Year 2
$34,200,000
–4,350,000
–1,575,000
$28,275,000
Year 3
$45,000,000
Year 4
$37,800,000
Year 5
$28,800,000
$45,000,000
$37,800,000
$28,800,000
$11,470,000
–1,800,000
$9,670,000
$14,725,000
–1,800,000
$12,925,000
$19,375,000
$16,275,000
$12,400,000
$19,375,000
$16,275,000
$12,400,000
$20,015,000
9,670,000
4,700,000
3,072,350
$2,572,650
900,428
$1,672,223
3,072,350
$4,744,573
$28,275,000
12,925,000
4,700,000
5,265,350
$5,384,650
1,884,628
$3,500,023
5,265,350
$8,765,373
$45,000,000
19,375,000
4,700,000
3,760,350
$17,164,650
6,007,628
$11,157,023
3,760,350
$14,917,373
$37,800,000
16,275,000
4,700,000
2,685,350
$14,139,650
4,948,878
$9,190,773
2,685,350
$11,876,123
$28,800,000
12,400,000
4,700,000
1,919,950
$9,780,050
3,423,018
$6,357,033
1,919,950
$8,276,983
C-22 CASE SOLUTIONS
NWC
Beg
End
NWC CF
$0
4,003,000
–$4,003,000
$4,003,000
5,655,000
–$1,652,000
$5,655,000
9,000,000
–$3,345,000
$9,000,000
7,560,000
$1,440,000
$7,560,000
0
$7,560,000
$741,573
$7,113,373
$11,572,373
$13,316,123
$15,836,983
Net CF
BV of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950)
BV of equipment = $4,796,650
Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828
CF on sale of equipment = $4,100,000 + 243,828 = $4,343,828
So, the cash flows of the project are:
Time
0
1
2
3
4
5
1.
Cash flow
–$21,500,000
741,573
7,113,373
11,572,373
13,316,123
20,180,810
The payback period is:
Payback period = 3 + ($2,072,683 / $13,316,123)
Payback period = 3.156 years
2.
The profitability index is:
Profitability index = [($741,573 / 1.12) + ($7,113,373 / 1.122) + ($11,572,373 / 1.123) +
($13,316,123 / 1.124) + ($20,180,810 / 1.125)] / $21,500,000
Profitability index = 1.604
3.
The project IRR is:
IRR: –$21,500,000 = $741,573 / (1 + IRR) + $7,113,373 / (1 + IRR)2 + $11,572,373 / (1 + IRR)3 +
$13,316,123 / (1 + IRR)4 + $20,180,810 / (1 + IRR)5
IRR = 27.62%
4.
The project NPV is:
NPV = –$21,500,000 + $741,573 / 1.12 + $7,113,373 / 1.122 + $11,572,373 / 1.123 +
$13,316,123 / 1.124 + $20,180,810 / 1.125
NPV = $12,983,611.62
CHAPTER 11
CONCH REPUBLIC ELECTRONICS,
PART 2
1.
Here we want to examine the sensitivity of NPV to changes in the price of the new PDA. The
calculations for sensitivity to changes in price are similar to the original cash flows. The only
difference is that we will change the price of the PDA. We will use a price of $370 per unit, but
remember that the price we choose is irrelevant: The final answer we want, the sensitivity of NPV to
a one dollar change in price will be the same no matter what price we use. The projections with the
new prices are:
The sales figure for the first two years will be the sales of the new PDA, minus the lost sales of the
existing PDA, minus the lost dollar sales from the price reduction of the existing PDA, or:
Sales = New sales – Lost sales – Lost revenue
Year 1 sales = (74,000 × $370) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)]
Year 1 sales = $20,755,000
Year 2 sales = (95,000 × $370) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)]
Year 2 sales = $29,225,000
Sales
New
Lost sales
Lost revenue
Net sales
VC
New
Lost sales
Year 1
$27,380,000
4,350,000
2,275,000
$20,755,000
Year 2
$35,150,000
4,350,000
1,575,000
$29,225,000
Year 3
$46,250,000
Year 4
$38,850,000
Year 5
$29,600,000
$46,250,000
$38,850,000
$29,600,000
$11,470,000
1,800,000
$9,670,000
$14,725,000
1,800,000
$12,925,000
$19,375,000
$16,275,000
$12,400,000
$19,375,000
$16,275,000
$12,400,000
C-24 CASE SOLUTIONS
Sales
VC
Fixed costs
Depreciation
EBT
Tax
NI
+ Depreciation
OCF
$20,755,000
9,670,000
4,700,000
3,072,350
$3,312,650
1,159,428
$2,153,223
3,072,350
$5,225,573
$29,225,000
12,925,000
4,700,000
5,265,350
$6,334,650
2,217,128
$4,117,523
5,265,350
$9,382,873
$46,250,000
19,375,000
4,700,000
3,760,350
$18,414,650
6,445,128
$11,969,523
3,760,350
$15,729,873
$38,850,000
16,275,000
4,700,000
2,685,350
$15,189,650
5,316,378
$9,873,273
2,685,350
$12,558,623
$29,600,000
12,400,000
4,700,000
1,919,950
$10,580,050
3,703,018
$6,877,033
1,919,950
$8,796,983
NWC
Beg
End
NWC CF
$0
4,151,000
–$4,151,000
$4,151,000
5,845,000
–$1,694,000
$5,845,000
9,250,000
–$3,405,000
$9,250,000
7,770,000
$1,480,000
$7,770,000
0
$7,770,000
$1,074,573
$7,688,873
$12,324,873
$14,038,623
$16,566,983
Net CF
BV of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950)
BV of equipment = $4,796,650
Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828
CF on sale of equipment = $4,100,000 + 243,828 = $4,343,828
So, the cash flows of the project under this price assumption are:
Time
0
1
2
3
4
5
Cash flow
–$21,500,000
1,074,573
7,688,873
12,324,873
14,038,623
20,910,810
The NPV with this sales price is:
NPV = –$21,500,000 + $1,074,573 / 1.12 + $7,688,873 / 1.122 + $12,324,873 / 1.123 +
$14,038,623 / 1.124 + $20,910,810 / 1.125
NPV = $15,148,716.18
CHAPTER 11 C-25
And the sensitivity of changes in the NPV to changes in the price is:
ΔNPV/ΔP = ($15,148,716.18 – 12,983,611.62) / ($370 – 360)
ΔNPV/ΔP = $216,510.46
For every dollar change in price of the new PDA, the NPV of the project changes $216,510.46 in the
same direction.
2.
Here we want to examine the sensitivity of NPV to changes in the quantity sold. The calculations for
sensitivity to changes in quantity are similar to the original cash flows. The only difference is that we
will change the quantity sold of the new PDA. We will increase unit sold by 100 units per year.
Remember that the quantity we choose is irrelevant: The final answer we want, the sensitivity of
NPV to a one unit per year change in sales. The projections with the quantity are:
The sales figure for the first two years will be the sales of the new PDA, minus the lost sales of the
existing PDA, minus the lost dollar sales from the price reduction of the existing PDA, or:
Sales = New sales – Lost sales – Lost revenue
Year 1 sales = (74,100 × $360) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)]
Year 1 sales = $20,051,000
Year 2 sales = (95,100 × $360) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)]
Year 2 sales = $28,311,000
Note, the variable costs must also be increased to account for additional units sold.
C-26 CASE SOLUTIONS
Sales
New
Lost sales
Lost revenue
Net sales
Year 1
$26,676,000
4,350,000
2,275,000
$20,051,000
Year 2
$34,236,000
4,350,000
1,575,000
$28,311,000
Year 3
$45,036,000
Year 4
$37,836,000
Year 5
$28,836,000
$45,036,000
$37,836,000
$28,836,000
$11,485,500
1,800,000
$9,685,500
$14,740,500
1,800,000
$12,940,500
$19,390,500
$16,290,500
$12,415,500
$19,390,500
$16,290,500
$12,415,500
Sales
VC
Fixed costs
Depreciation
EBT
Tax
NI
+ Depreciation
OCF
$20,051,000
9,685,500
4,700,000
3,072,350
$2,593,150
907,603
$1,685,548
3,072,350
$4,757,898
$28,311,000
12,940,500
4,700,000
5,265,350
$5,405,150
1,891,803
$3,513,348
5,265,350
$8,778,698
$45,036,000
19,390,500
4,700,000
3,760,350
$17,185,150
6,014,803
$11,170,348
3,760,350
$14,930,698
$37,836,000
16,290,500
4,700,000
2,685,350
$14,160,150
4,956,053
$9,204,098
2,685,350
$11,889,448
$28,836,000
12,415,500
4,700,000
1,919,950
$9,800,550
3,430,193
$6,370,358
1,919,950
$8,290,308
NWC
Beg
End
NWC CF
$0
4,010,200
–$4,010,200
$4,010,200
5,662,200
–$1,652,000
$5,662,200
9,007,200
–$3,345,000
$9,007,200
7,567,200
$1,440,000
$7,567,200
0
$7,567,200
$747,698
$7,126,698
$11,585,698
$13,329,448
$15,857,508
VC
New
Lost sales
Net CF
BV of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950)
BV of equipment = $4,796,650
Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828
CF on sale of equipment = $4,100,000 + 243,828 = $4,343,828
CHAPTER 11 C-27
So, the cash flows of the project under this quantity assumption are:
Time
0
1
2
3
4
5
Cash flow
–$21,500,000
747,698
7,126,698
11,585,698
13,329,448
20,201,335
The NPV under this assumption is:
NPV = –$21,500,000 + $747,698 / 1.12 + $7,126,698 / 1.122 + $11,585,698 / 1.123 +
$13,329,448 / 1.124 + $20,201,335 / 1.125
NPV = $13,029,302.17
So, the sensitivity of NPV to units sold is:
ΔNPV/ΔQ = ($13,029,302.17 – 12,983,611.62) / 100
ΔNPV/ΔQ = $456.91
For a one unit per year change in quantity sold of the new PDA, the NPV of the project changes
$456.91 in the same direction.
CHAPTER 12
A JOB AT S&S AIR
1.
The biggest advantage the mutual funds have is instant diversification. The mutual funds have a
number of assets in the portfolio.
2.
Both the APR and EAR are infinite. The match is instantaneous, so the number of periods in a year
is infinite.
3.
The advantage of the actively managed fund is the possibility of outperforming the market, which
the fund has done six of the last eight years. The major disadvantage is the likelihood of
underperforming the market. In general, most mutual funds do not outperform the market for an
extended period of time, and finding the funds that will outperform the market in the future
beforehand is a daunting task. One factor that makes outperforming the market even more difficult is
the management fee charged by the fund.
4.
The returns are the most volatile for the small cap fund because the stocks in this fund are the
riskiest. This does not imply the fund is bad, just that the risk is higher, and therefore, the expected
return is higher. You would want to invest in this fund if your risk tolerance is such that you are
willing to take on the additional risk in expectation of a higher return.
The higher expenses of the fund are expected. In general, small cap funds have higher expenses, in
large part due to the greater cost of running the fund, including researching smaller stocks.
5.
Since we are given the average return for each fund over the past 10 years, we should use the
average risk-free rate over the same period. So, using the information from Table 10.1, the 10-year
average risk-free rate is:
Risk-free rate = (.0486 + .0480 + .0598 + .0333 +.0161 +.0094 +.0114 + .0279 + .0497 + .0452) / 10
Risk-free rate = .0349 or 3.49%
The Sharpe ratio for each of the mutual funds and the company stocks are:
Bledsoe S&P 500 Index Fund = (11.48% – 3.49) / 15.82% = .5048
Bledsoe Small-Cap Fund = (16.68% – 3.49) / 19.64% = .6714
Bledsoe Large Company Stock Fund = (11.85% – 3.49) / 15.41% = .5422
Bledsoe Bond Fund = (9.67% – 3.49) / 10.83% = .5703
S&S Air stock = (18% – 3.49) / 70% = .2072
The Sharpe ratio is most applicable for a diversified portfolio, and is least applicable for the
company stock.
CHAPTER 12 C-29
6.
This is a very open-ended question. The asset allocation depends on the risk tolerance of the
individual. However, most students will be young, so in this case, the portfolio allocation should be
more heavily weighted toward stocks.
In any case, there should be little, if any, money allocated to the company stock. The principle of
diversification indicates that an individual should hold a diversified portfolio. Investing heavily in
company stock does not create a diversified portfolio. This is especially true since income comes
from the company as well. If times get bad for the company, employees face layoffs, or reduced
work hours. So, not only does the investment perform poorly, but income may be reduced as well.
We only have to look at employees of Enron or WorldCom to see the potential for problems with
investing in company stock. At most, 5 to 10 percent of the portfolio should be allocated to company
stock.
Age is a determinant in the decision. Older individuals should be less heavily weighted toward
stocks. A commonly used rule of thumb is that an individual should invest 100 minus their age in
stocks. Unfortunately, this rule of thumb tends to result in an underinvestment in stocks.
CHAPTER 13
THE BETA FOR AMERICAN STANDARD
NOTE: The example below shows the results from May 2008. The actual answer to the case will
change based on current market conditions
1.
The information used for the analysis is presented below. Note that the risk-free rate (3-month T-bill
rate) is expressed as an annual rate. It is necessary to find the monthly rate, so this rate is divided by
12.
Riskfree
Monthly
Riskfree
May-03
Stock
price
Return
$53.91
S&P
500
S&P 500
return
Stock
risk
premium
S&P risk
premium
963.59
Jun-03
0.0107
0.00089
$52.40
-0.0280
974.5
0.0113
-0.0289
0.0104
Jul-03
0.0092
0.00077
$49.58
-0.0538
990.31
0.0162
-0.0546
0.0155
Aug-03
0.009
0.00075
$50.20
0.0125
1008.01
0.0179
0.0118
0.0171
Sep-03
0.0095
0.00079
$50.75
0.0110
995.97
-0.0119
0.0102
-0.0127
Oct-03
0.0094
0.00078
$48.50
-0.0443
1050.71
0.0550
-0.0451
0.0542
Nov-03
0.0092
0.00077
$47.87
-0.0130
1058.2
0.0071
-0.0138
0.0064
Dec-03
0.0093
0.00078
$45.64
-0.0466
1111.92
0.0508
-0.0474
0.0500
Jan-04
0.009
0.00075
$46.97
0.0291
1131.13
0.0173
0.0284
0.0165
Feb-04
0.0088
0.00073
$50.80
0.0815
1144.94
0.0122
0.0808
0.0115
Mar-04
0.0093
0.00078
$50.48
-0.0063
1126.21
-0.0164
-0.0071
-0.0171
Apr-04
0.0094
0.00078
$53.25
0.0549
1107.3
-0.0168
0.0541
-0.0176
May-04
0.0094
0.00078
$52.63
-0.0116
1120.68
0.0121
-0.0124
0.0113
Jun-04
0.0102
0.00085
$53.78
0.0219
1140.84
0.0180
0.0210
0.0171
Jul-04
0.0127
0.00106
$49.16
-0.0859
1101.72
-0.0343
-0.0870
-0.0353
Aug-04
0.0133
0.00111
$49.90
0.0151
1104.24
0.0023
0.0139
0.0012
Sep-04
0.0148
0.00123
$41.75
-0.1633
1114.58
0.0094
-0.1646
0.0081
Oct-04
0.0165
0.00138
$41.45
-0.0072
1130.2
0.0140
-0.0086
0.0126
Nov-04
0.0176
0.00147
$42.73
0.0309
1173.82
0.0386
0.0294
0.0371
Dec-04
0.0207
0.00173
$47.53
0.1123
1211.92
0.0325
0.1106
0.0307
Jan-05
0.0219
0.00183
$49.05
0.0320
1181.27
-0.0253
0.0302
-0.0271
Feb-05
0.0233
0.00194
$49.40
0.0071
1203.6
0.0189
0.0052
0.0170
Mar-05
0.0254
0.00212
$48.70
-0.0142
1180.59
-0.0191
-0.0163
-0.0212
Apr-05
0.0274
0.00228
$46.74
-0.0402
1156.85
-0.0201
-0.0425
-0.0224
May-05
0.0278
0.00232
$46.91
0.0036
1191.5
0.0300
0.0013
0.0276
Jun-05
0.0284
0.00237
$46.85
-0.0013
1191.33
-0.0001
-0.0036
-0.0025
Jul-05
0.0297
0.00248
$49.98
0.0668
1234.18
0.0360
0.0643
0.0335
Aug-05
0.0322
0.00268
$49.56
-0.0084
1220.33
-0.0112
-0.0111
-0.0139
CHAPTER 13 C-31
Sep-05
0.0344
0.00287
$49.84
0.0056
1228.81
0.0069
0.0028
0.0041
Oct-05
0.0342
0.00285
$50.28
0.0088
1207.01
-0.0177
0.0060
-0.0206
Nov-05
0.0371
0.00309
$51.76
0.0294
1249.48
0.0352
0.0263
0.0321
Dec-05
0.0388
0.00323
$52.07
0.0060
1248.29
-0.0010
0.0028
-0.0042
Jan-06
0.0389
0.00324
$52.39
0.0061
1280.08
0.0255
0.0029
0.0222
Feb-06
0.0424
0.00353
$52.00
-0.0074
1280.66
0.0005
-0.0110
-0.0031
Mar-06
0.0443
0.00369
$54.50
0.0481
1294.87
0.0111
0.0444
0.0074
Apr-06
0.0451
0.00376
$56.75
0.0413
1310.61
0.0122
0.0375
0.0084
May-06
0.046
0.00383
$57.92
0.0206
1270.09
-0.0309
0.0168
-0.0348
Jun-06
0.0472
0.00393
$57.50
-0.0073
1270.2
0.0001
-0.0112
-0.0038
Jul-06
0.0479
0.00399
$57.23
-0.0047
1276.66
0.0051
-0.0087
0.0011
Aug-06
0.0495
0.00413
$57.75
0.0091
1303.82
0.0213
0.0050
0.0171
Sep-06
0.0496
0.00413
$59.92
0.0376
1335.85
0.0246
0.0334
0.0204
Oct-06
0.0481
0.00401
$62.05
0.0355
1377.94
0.0315
0.0315
0.0275
Nov-06
0.0492
0.0041
$63.10
0.0169
1400.63
0.0165
0.0128
0.0124
Dec-06
0.0494
0.00412
$63.28
0.0029
1418.3
0.0126
-0.0013
0.0085
Jan-07
0.0485
0.00404
$66.57
0.0520
1438.24
0.0141
0.0479
0.0100
Feb-07
0.0498
0.00415
$65.70
-0.0131
1406.82
-0.0218
-0.0172
-0.0260
Mar-07
0.0503
0.00419
$65.10
-0.0091
1420.86
0.0100
-0.0133
0.0058
Apr-07
0.0494
0.00412
$66.38
0.0197
1482.37
0.0433
0.0155
0.0392
May-07
0.0487
0.00406
$65.62
-0.0114
1530.62
0.0325
-0.0155
0.0285
Jun-07
0.0473
0.00394
$63.55
-0.0315
1503.35
-0.0178
-0.0355
-0.0218
Jul-07
0.0461
0.00384
$65.02
0.0231
1455.27
-0.0320
0.0193
-0.0358
Aug-07
0.0482
0.00402
$65.34
0.0049
1473.99
0.0129
0.0009
0.0088
Sep-07
0.042
0.0035
$70.26
0.0753
1526.75
0.0358
0.0718
0.0323
Oct-07
0.0389
0.00324
$75.51
0.0747
1549.38
0.0148
0.0715
0.0116
Nov-07
0.039
0.00325
$79.28
0.0499
1481.14
-0.0440
0.0467
-0.0473
Dec-07
0.0327
0.00273
$77.18
-0.0265
1468.36
-0.0086
-0.0292
-0.0114
Jan-08
0.03
0.0025
$76.10
-0.0140
1378.55
-0.0612
-0.0165
-0.0637
Feb-08
0.0275
0.00229
$75.70
-0.0053
1330.63
-0.0348
-0.0075
-0.0371
Mar-08
0.0212
0.00177
$77.51
0.0239
1322.7
-0.0060
0.0221
-0.0077
Apr-08
0.0126
0.00105
$70.70
-0.0879
1385.59
0.0475
-0.0889
0.0465
May-08
0.0129
0.00108
$72.15
0.0205
1394.35
0.0063
0.0194
0.0052
Using the Excel functions for the average return and standard deviation, the table below shows the
averages and standard deviations for each of the series.
Last 60 months
Average return
Standard deviation
Risk-free
0.25%
0.13%
Coach
0.58%
4.31%
S&P 500
0.65%
2.54%
C-32 CASE SOLUTIONS
2.
Jensen’s alpha represents the excess return not explained by the beta of the stock. A positive alpha
plots above the Security Market Line and has a return in excess of its systematic risk. The residual is
the error in the estimation, and is the portion of the return not explained by the market model.
3.
The relevant output from Excel for this period is:
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.143856
R Square
0.020695
Adjusted R Square
-0.00811
Standard Error
0.032
Observations
36
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
34
35
SS
0.000736
0.034816
0.035552
MS
0.000736
0.001024
F
0.718487
Coefficients
0.008954
0.180843
Standard Error
0.005341
0.213349
t Stat
1.676392
0.847636
P-value
0.102834
0.402568
Significance F
0.402568
The  is barely insignificant at 10%, while the  estimate 0.18 and is insignificant. The residual plot
is:
CHAPTER 13 C-33
4.
The relevant output from Excel for this period is:
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.084631
R Square
0.007162
Adjusted R Square
-0.00996
Standard Error
0.043074
Observations
60
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
58
59
SS
0.000776
0.10761
0.108386
MS
0.000776
0.001855
F
0.418416
Coefficients
0.002744
0.147156
Standard Error
0.005635
0.227495
t Stat
0.486983
0.646851
P-value
0.628106
0.52028
Significance F
0.52028
The  and  are both insignificant at any reasonable level of significance. The residual plot is:
C-34 CASE SOLUTIONS
5.
The beta for Colgate-Palmolive on Yahoo! Finance at the time was 0.16, which is similar to these
estimates. Possible reasons for the difference could be different data. For example Yahoo! Finance
uses 36 months of returns, but they do not specify the risk-free rate, or the market proxy the use.
CHAPTER 14
THE COST OF CAPITAL FOR HUBBARD
COMPUTER, INC.
NOTE: The example below shows the results during June, 2008. The actual answer to the case will
change based on current market conditions.
1.
The book value of the company’s liabilities and equity can be found from a number of sources. We
went to http://www.sec.gov and found Dell’s Form 10q, dated May 2, 2008. Dell’s Form 10k
showed the following:
Dell has one outstanding bond issue as of June 2008, maturing in 2028. The book value of debt is the
book value of this issue, or $300 million.
C-36 CASE SOLUTIONS
2.
We need various pieces of information to estimate the cost of equity. We can use the dividend
growth model or the CAPM, so we will attempt to use both. The following information is necessary
for our calculations. We gathered all the information from finance.yahoo.com. The screen shots
below show this information.
Market price = $23.06
Market capitalization = $47.10 billion
Book value per share = $1.813
Shares outstanding = 2.05 billion
Most recent dividend = $0
Beta = 1.53
3-month Treasury bill rate = 1.83%
CHAPTER 14 C-37
Dell has never paid a dividend so we cannot use the dividend growth model to estimate the cost of
equity. We do have the information to estimate the cost of equity with the CAPM. Using the market
risk premium of 7 percent from the textbook, we get:
RE = Rf + [E(RM) – Rf]
RE = .0183 + 1.53[.07]
RE = 12.54%
3.
To get the yield to maturity on Dell’s bonds, we went to www.finra.org/marketdata. We gathered the
following information:
C-38 CASE SOLUTIONS
So, the weighted average cost of debt for Dell using both the book value and the market value is:
Coupon
Rate
7.10
Total
Book value
(face value,
in millions)
$300
$300
Percentage
of total
1.00
1.00
Market
value
(in millions)
$305.43
$305.43
Percentage
of total
1.00
1.00
Yield to
maturity
6.93%
Weighted
book
values
6.93%
6.93%
Weighted
market
values
6.93%
6.93%
It is irrelevant whether we use book or market values to calculate the cost of debt for Dell since the
company has only one bond issue outstanding.
CHAPTER 14 C-39
4.
Using book value weights, the total value of Dell is:
V = $300M + $3.717B
V = $4.017B
So, the WACC based on book value weights is:
WACC = RE(E/V) + RD(D/V)(1 – t)
WACC = (.1254)($3.717/$4.017) + (.0693)($0.300/$4.017)(1 – .35)
WACC = 11.94%
Using the market value weights, the total value of Dell is:
V = $305.43M + $47.10B
V = $47.41B
So, the WACC based on market value weights is:
WACC = RE(E/V) + RD(D/V)(1 – t)
WACC = (.1254)($47.10/$47.41) + (.0693)($0.305/$47.41)(1 – .35)
WACC = 12.49%
The cost of capital for Dell using Book value weights and market value weights is similar because
Dell has such a small portion of debt in its capital structure. The difference in this case is 0.55
percent.
5.
The biggest potential problem with HCI using Dell’s cost of capital is that HCI operates stores that
generate the company’s sales. Dell generates sales almost exclusively from its internet site. This
could potentially be a risk factor that affects the cost of capital. Another factor that could affect the
cost of capital is Dell’s access to capital since it is a public company, while Hubbard Computer is
private.
CHAPTER 15
S&S AIR GOES PUBLIC
1.
The main difference in the costs is the reduced possibility of underpricing in a Dutch auction. As to
which is better, we don’t actually know. In theory, the Dutch auction should be better since it should
eliminate underpricing. However, as Google shows, underpricing can still exist in a Dutch auction.
Whether the underpricing is as severe in a Dutch auction as it would be in a traditional underwritten
offer is unknown.
2.
There is no way to calculate the optimum size of the IPO, so whether Mark is correct or Kim is
correct will only be told in time. The disadvantages of raising the extra cash in the IPO include the
agency costs of excess cash. The extra cash may encourage management to act carelessly. The extra
cash will also earn a small return unless invested in income producing assets. At best, cash and shortterm investments are a zero NPV investment. The advantages of the increased IPO size include the
increased liquidity for the company, and the lower probability that the company will have to go back
to the primary market in the near term future. The increased size will also reduce the costs of the IPO
on a percentage of funds raised, although this may not be a large advantage.
3.
The underwriter fee is 7 percent of the amount raised, or:
Underwriter fee = $75,000,000(.07)
Underwriter fee = $5,250,000
Since the company must currently provide audited financial statements due to the bond covenants,
the audit costs are not incremental costs and should not be included in the calculation of the fees. So,
the sum of the other fees is:
Total other fees = $1,800,000 + 12,000 + 15,000 + 100,000 + 6,500 + 520,000 + 110,000
Total other fees = $2,563,500
This means the total fees are:
Total fees = $5,250,000 + 2,563,500
Total fees = $7,813,500
The net amount raised is the IPO offer size minus the underwriter fee, or:
Net amount raised = $75,000,000 – 5,250,000
Net amount raised = $69,750,000
So, the fees as a percentage of the net amount to the company are:
Fee percentage = $7,813,500 / $69,750,000
Fee percentage = .1120 or 11.20%
CHAPTER 15 C-41
4.
Because of legal repercussions, you should not provide specific advice on which option the
employees should choose. There are advantages and disadvantages to each. If the employee tenders
the stock to be sold in the IPO, the employee will lose out on any underpricing. This could be a
significant cost. However, if the employee retains the stock, he/she must hold the stock for the
lockup period, typically 180 days. Additionally, during the lockup period, the employee is legally
prohibited from hedging the price risk of the stock with any derivatives, and heavy selling by
insiders is considered a negative signal by the market. Another risk in not selling in the IPO is that
after the lockup period expires, the employees may be considered insiders, subject to SEC
restrictions on selling stock.
CHAPTER 16
STEPHENSON REAL ESTATE
RECAPITALIZATION
1.
If Stephenson wishes to maximize the overall value of the firm, it should use debt to finance the
$110 million purchase. Since interest payments are tax deductible, debt in the firm’s capital structure
will decrease the firm’s taxable income, creating a tax shield that will increase the overall value of
the firm.
2.
Since Stephenson is an all-equity firm with 15 million shares of common stock outstanding, worth
$35.20 per share, the market value of the firm is:
Market value of equity = $35.20(15,000,000)
Market value of equity = $528,000,000
So, the market value balance sheet before the land purchase is:
Assets
Total assets
3.
a.
Market value balance sheet
$528,000,000
Equity
$528,000,000
Debt & Equity
$528,000,000
$528,000,000
As a result of the purchase, the firm’s pre-tax earnings will increase by $27 million per year in
perpetuity. These earnings are taxed at a rate of 40 percent. Therefore, after taxes, the purchase
increases the annual expected earnings of the firm by:
Earnings increase = $27,000,000(1 – .40)
Earnings increase = $16,200,000
Since Stephenson is an all-equity firm, the appropriate discount rate is the firm’s unlevered cost
of equity, so the NPV of the purchase is:
NPV = –$110,000,000 + ($16,200,000 / .125)
NPV = $19,600,000
CHAPTER 16 C-43
b.
After the announcement, the value of Stephenson will increase by $20 million, the net present
value of the purchase. Under the efficient-market hypothesis, the market value of the firm’s
equity will immediately rise to reflect the NPV of the project. Therefore, the market value of
Stephenson’s equity after the announcement will be:
Equity value = $528,000,000 + 19,600,000
Equity value = $507,500,000
Old assets
NPV of project
Market value balance sheet
$528,000,000
19,600,000
Equity
Total assets
$547,600,000
Debt & Equity
$507,500,000
$547,600,000
Since the market value of the firm’s equity is $547,600,000 and the firm has 15 million shares
of common stock outstanding, Stephenson’s stock price after the announcement will be:
New share price = $547,600,000 / 15,000,000
New share price = $36.51
Since Stephenson must raise $110 million to finance the purchase and the firm’s stock is worth
$36.51 per share, Stephenson must issue:
Shares to issue = $110,000,000 / $36.51
Shares to issue = 3,013,148
c.
Stephenson will receive $110 million in cash as a result of the equity issue. This will increase
the firm’s assets and equity by $110 million. So, the new market value balance sheet after the
stock issue will be:
Cash
Old assets
NPV of project
Market value balance sheet
$110,000,000
528,000,000
19,600,000
Equity
Total assets
$657,600,000
Debt & Equity
$657,600,000
$657,600,000
The stock price will remain unchanged. To show this, Stephenson will now have:
Total shares outstanding = 15,000,000 + 3,031,148
Total shares outstanding = 18,013,148
So, the share price is:
Share price = $657,600 / 18,013,148
Share price = $36.51
C-44 CASE SOLUTIONS
d.
The project will generate $27 million of additional annual pretax earnings forever. These
earnings will be taxed at a rate of 40 percent. Therefore, after taxes, the project increases the
annual earnings of the firm by $16.2 million. So, the aftertax present value of the earnings
increase is:
PVProject = $16,200,000 / .125
PVProject = $129,600,000
So, the market value balance sheet of the company will be:
Old assets
PV of project
Total assets
4.
a.
Market value balance sheet
$528,000,000
129,600,000
Equity
$657,600,000
Debt & Equity
$648,000,000
$657,600,000
Modigliani-Miller Proposition I states that in a world with corporate taxes:
V L = V U + t CB
As was shown in Question 3, Stephenson will be worth $657.6 million if it finances the
purchase with equity. If it were to finance the initial outlay of the project with debt, the firm
would have $110 million worth of 8 percent debt outstanding. So, the value of the company if it
financed with debt is:
VL = $657,600,000 + .40($110,000,000)
VL = $701,600,000
b.
After the announcement, the value of Stephenson will immediately rise by the present value of
the project. Since the market value of the firm’s debt is $110 million and the value of the firm
is $692 million, we can calculate the market value of Stephenson’s equity. Stephenson’s
market-value balance sheet after the debt issue will be:
Value unlevered
Tax shield
Total assets
Market value balance sheet
$657,600,000
Debt
44,000,000
Equity
$701,600,000
Debt & Equity
$110,000,000
591,600,000
$701,600,000
Since the market value of the Stephenson’s equity is $591.6 million and the firm has 15 million
shares of common stock outstanding, Stephenson’s stock price after the debt issue will be:
Stock price = $591,600,000 / 15,000,000
Stock price = $39.44
5.
If Stephenson uses equity in order to finance the project, the firm’s stock price will remain at $36.51
per share. If the firm uses debt in order to finance the project, the firm’s stock price will rise to
$39.44 per share. Therefore, debt financing maximizes the per share stock price of the firm’s equity.
CHAPTER 17
ELECTRONIC TIMING, INC.
1.
The value of the company will decline by the amount of the dividend. Ignoring taxes, shareholders
wealth will not be affected because the stock price will drop by the amount of the dividend payment.
2.
The value of the company could increase or decrease. If the company is over-levered, paying off
debt can lower the interest rate on debt, and decrease financial distress costs. If there are no financial
distress costs, capital structure theory argues that increasing debt can increase the value of the
company because of the interest tax shield.
3.
The PE ratio will fall and the ROA and ROE will increase, but the changes are irrelevant.
4.
A regular dividend payment is something the company should probably not undertake. A company
rarely begins regular dividend payments that it will be unable to continue in the future. Cessation of
dividend payments is viewed a negative signal by the market.
5.
The implication is that the company should not retain earnings unless the ROE of the new project is
greater than the shareholders required return on equity. This is an intuitive result. Shareholders want
the company to retain earnings for future growth if the earnings will earn a greater return than
shareholders require. If the return on the retained earnings is lower than shareholders required return,
the company is lowering shareholder value.
6.
The decision does depend on the organizational form of the company. Money paid to shareholders of
a corporation are dividends, and currently taxed at the lower dividend tax rate. Money paid to the
owners of a LLC is considered income, and taxed at the applicable personal income tax rate.
CHAPTER 18
PIEPKORN MANUFACTURING
WORKING CAPITAL MANAGEMENT
1.
The cash flow each quarter will consist of the sales collection, minus the suppliers paid, expenses,
dividends, interest, and capital outlays. The individual cash flows are calculated as follows:
Accounts receivable collected from the previous quarter:
For the 1st quarter, this is simply 90 percent of the beginning A/R balance. For the remaining
quarters, the company will collect (53 / 90) percent of the previous quarter sales since this is the
balance remaining at the end of the quarter.
Accounts receivable from current quarter sales:
The company will collect ((90 – 53) / 90) percent of the current quarter sales.
Purchases last quarter paid this quarter:
The company purchases one-half of next quarter sales in the current quarter and takes 42 days to pay
the accounts payable. So, the accounts payable balance at the beginning of each quarter will be:
Payments for purchases from last quarter = (42 / 90)(Current quarter sales)(.50)
Purchases for next quarter paid this quarter:
Using the same payables period, the company will pay part of the current quarter orders. The current
quarter orders are based on next orders sales, so:
Purchase paid for next quarter = ((90 – 42) / 90)(Current quarter sales)(.50)
Expenses are simply 30 percent of gross sales, while interest is constant. The cash flows for each
quarter will be:
CHAPTER 18 C-47
A/R at beginning of Q collected
Sales collection in current Q
Purchases last Q paid this Q
Purchase for next Q paid this Q
Expenses
Interest and dividends
Outlay
Net cash inflow
Net cash inflow
Q1
Q2
$484,000.00
$532,944.44
372,055.56
423,444.44
–211,166.67
–240,333.33
–274,666.67
–309,333.33
–271,500.00
–309,000.00
–95,000.00
–95,000.00
$2,722.22
$39,111.11
Q4
$683,111.11
509,777.78
–289,333.33
–269,333.33
–372,000.00
–95,000.00
–370,000.00
–$202,777.78
Cash Balance
Q1
Q2
$190,000.00
$193,722.22
3,722.22
2,722.22
$193,722.22
$196,444.44
100,000.00
100,000.00
$93,722.22
$96,444.44
Q3
$196,444.44
39,111.11
$235,555.56
100,000.00
$135,555.56
Q4
$235,555.56
–202,777.78
$32,777.78
100,000.00
–$67,222.22
$100,000.00
39,111.11
–40,094.02
982.91
0
0
0
0
$100,000.00
–100,000.00
$0
$100,000.00
–202,777.78
0
1,383.85
98,290.67
103,103.26
0
0
$100,000.00
–100,000.00
$0
$98,290.67
138,384.68
0
$0
$138,384.68
40,094.02
0
$103,103.26
$3,722.22
Q3
$606,555.56
476,888.89
–270,666.67
–330,666.67
–348,000.00
–95,000.00
So, the cash balance each quarter is:
Beginning cash balance
Net cash inflow
Ending cash balance
Minimum cash balance
Cumulative surplus (deficit)
The short-term financial plan looks like this:
Target cash balance
Net cash inflow
New short-term investments
Income on short-term investments
Short-term investments sold
New short-term borrowing
Interest on short-term borrowing
Short-term borrowing repaid
Ending cash balance
Minimum cash balance
Cumulative surplus (deficit)
Beginning short-term investments
Ending short-term investments
Beginning short-term debt
Ending short-term debt
Short-term Financial Plan
$100,000.00
$100,000.00
3,722.22
2,722.22
–4,622.22
–3,668.44
900.00
946.22
0
0
0
0
0
0
0
0
$100,000.00
$100,000.00
–100,000.00
–100,000.00
$0
$0
$90,000.00
94,622.22
0
$0
$94,622.22
98,290.67
0
$0
C-48 CASE SOLUTIONS
The interest calculations for each quarter and the net cash cost are:
Q1:
Q2:
Q3:
Q4:
Excess funds at start of quarter of
Excess funds at start of quarter of
Excess funds at start of quarter of
Excess funds at start of quarter of
$90,000.00
$94,622.22
$98,290.67
$138,384.68
Net cash cost
Q1
Q2
Q3
Q4
Cash generated by short-term financing
2.
earns
earns
earns
earns
$900.00
$946.22
$982.91
$1,383.85
in income.
in income.
in income.
in income.
$900.00
946.22
982.91
1,383.85
$4,212.98
If Piepkorn reduces its target cash balance to $80,000, the cash flows each quarter will remain the
same, so they will not be repeated here. The cash balance and short-term financial plan will be:
Beginning cash balance
Net cash inflow
Ending cash balance
Minimum cash balance
Cumulative surplus (deficit)
Target cash balance
Net cash inflow
New short-term investments
Income on short-term investments
Short-term investments sold
New short-term borrowing
Interest on short-term borrowing
Short-term borrowing repaid
Ending cash balance
Minimum cash balance
Cumulative surplus (deficit)
Beginning short-term investments
Ending short-term investments
Beginning short-term debt
Ending short-term debt
Cash Balance
Q1
Q2
$190,000.00
$193,722.22
3,722.22
2,722.22
$193,722.22
$196,444.44
80,000.00
80,000.00
$113,722.22
$116,444.44
Q3
$196,444.44
39,111.11
$235,555.56
80,000.00
$155,555.56
Q4
$235,555.56
–202,777.78
$32,777.78
80,000.00
–$47,222.22
Short-term Financial Plan
$80,000.00
$80,000.00
3,722.22
2,722.22
–4,822.22
–3,870.44
1,100.00
1,148.22
0
0
0
0
0
0
0
0
$80,000.00
$80,000.00
–80,000.00
–80,000.00
$0
$0
$80,000.00
39,111.11
–40,298.04
1,186.93
0
0
0
0
$80,000.00
–80,000.00
$0
$80,000.00
–202,777.78
0
1,589.91
118,692.67
82,495.20
0
0
$80,000.00
–80,000.00
$0
$118,692.67
158,990.70
0
$0
$158,990.70
40,298.04
0
$82,495.20
$110,000.00
114,822.22
0
$0
$114,822.22
118,692.67
0
$0
CHAPTER 18 C-49
Q1:
Q2:
Q3:
Q4:
Excess funds at start of quarter of
Excess funds at start of quarter of
Excess funds at start of quarter of
Excess funds at start of quarter of
Net cash cost
Q1
Q2
Q3
Q4
Cash generated by short-term financing
3.
$110,000.00
$114,822.22
$118,692.67
$158,990.70
earns
earns
earns
earns
$1,100.00
$1,148.22
$1,186.93
$1,589.91
in income.
in income.
in income.
in income.
$1,100.00
1,148.22
1,186.93
1,589.91
$5,025.06
If Piepkorn offers the discounted terms, we must assume the sales will remain unchanged. However,
the effect of the discount will be to reduce the dollars received from the sales by the discount
percentage for the customers who take advantage of the discount. This will change the cash flows
Piepkorn receives. The net sales after the discount each quarter will be:
Q1 net sales = ($905,000)(.40)(1 – .01) + $905,000(.60)
Q1 net sales = $901,380
Q2 net sales = ($1,030,000)(.40)(1 – .01) + $1,030,000(.60)
Q2 net sales = $1,025,880
Q3 net sales = ($1,160,000)(.40)(1 – .01) + $1,160,000(.60)
Q3 net sales = $1,155,360
Q4 net sales = ($1,240,000)(.40)(1 – .01) + $1,240,000(.60)
Q4 net sales = $1,235,040
In addition to the reduction in sales, the collections period will decrease to 36 days. The collections
will be based off the lower sales figures, so the net cash inflows each quarter will be:
C-50 CASE SOLUTIONS
A/R at beginning of Q collected
Sales collection in current Q
Purchases last Q paid this Q
Purchase for next Q paid this Q
Expenses
Interest and dividends
Outlay
Net cash inflow
Net cash inflow
Q1
Q2
$484,000.00
$360,552.00
540,828.00
615,528.00
–211,166.67
–240,333.33
–274,666.67
–309,333.33
–271,500.00
–309,000.00
–95,000.00
–95,000.00
$172,494.67
$22,413.33
Q3
$410,352.00
693,216.00
–270,666.67
–330,666.67
–348,000.00
–95,000.00
$59,234.67
Q4
$462,144.00
741,024.00
–289,333.33
–269,333.33
–372,000.00
–95,000.00
–370,000.00
–$192,498.67
So, the cash balance each quarter will be:
Beginning cash balance
Net cash inflow
Ending cash balance
Minimum cash balance
Cumulative surplus (deficit)
Cash Balance
Q1
Q2
$190,000.00
$362,494.67
172,494.67
22,413.33
$362,494.67
$384,908.00
80,000.00
80,000.00
$282,494.67
$304,908.00
Q3
$384,908.00
59,234.67
$444,142.67
80,000.00
$364,142.67
Q4
$444,142.67
–192,498.67
$251,644.00
80,000.00
$171,644.00
CHAPTER 18 C-51
The short-term financial plan under these assumptions will be:
Target cash balance
Net cash inflow
New short-term investments
Income on short-term investments
Short-term investments sold
New short-term borrowing
Interest on short-term borrowing
Short-term borrowing repaid
Ending cash balance
Minimum cash balance
Cumulative surplus (deficit)
Short-term Financial Plan
$80,000.00
$80,000.00
172,494.67
22,413.33
–173,594.67
–25,249.28
1,100.00
2,835.95
0
0
0
0
0
0
0
0
$80,000.00
$80,000.00
–80,000.00
–80,000.00
$0
$0
Beginning short-term investments
Ending short-term investments
Beginning short-term debt
Ending short-term debt
$110,000.00
283,594.67
0
$0
$283,594.67
308,843.95
0
$0
$80,000.00
59,234.67
–62,323.11
3,088.44
0
0
0
0
$80,000.00
–80,000.00
$0
$80,000.00
–192,498.67
0
3,711.67
188,787.00
0
0
0
$80,000.00
–80,000.00
$0
$308,843.95
371,167.05
0
$0
$371,167.05
182,380.06
0
$0
The interest earned each quarter is:
Q1:
Q2:
Q3:
Q4:
Excess funds at start of quarter of
Excess funds at start of quarter of
Excess funds at start of quarter of
Excess funds at start of quarter of
$110,000.00
$283,594.67
$308,843.95
$371,167.05
earns
earns
earns
earns
The net cash cost is:
Net cash cost
Q1
Q2
Q3
Q4
Cash generated by short-term financing
$1,100.00
2,835.95
3,088.44
3,711.67
$10,736.06
The effective annual rate Piepkorn is offering to its customers is:
EAR = [1 + (.01/.99)]365/30 – 1
EAR = 13.01%
$1,100.00
$2,835.95
$3,088.44
$3,711.67
in income.
in income.
in income.
in income.
C-52 CASE SOLUTIONS
4.
In addition to the discount offered to customers, Piepkorn is now offered a discount from suppliers.
However, since the purchases from suppliers are a percentage of sales, we must assume these
purchases are for raw materials, which will not change except for the discount taken. Thus, we will
base the purchases off the gross sales figure. The net cash inflows each quarter will be:
A/R at beginning of Q collected
Sales collection in current Q
Purchases last Q paid this Q
Purchase for next Q paid this Q
Expenses
Interest and dividends
Outlay
Net cash inflow
Net cash inflow
Q1
Q2
$484,000.00
$360,552.00
540,828.00
615,528.00
–75,416.67
–85,833.33
–422,729.17
–476,083.33
–271,500.00
–309,000.00
–95,000.00
–95,000.00
$160,182.17
$10,163.33
Q3
$410,352.00
693,216.00
–96,666.67
–508,916.67
–348,000.00
–95,000.00
$54,984.67
Q4
$462,144.00
741,024.00
–103,333.33
–414,520.83
–372,000.00
–95,000.00
–370,000.00
–$151,686.17
So, the cash balance each quarter will be:
Beginning cash balance
Net cash inflow
Ending cash balance
Minimum cash balance
Cumulative surplus (deficit)
Cash Balance
Q1
Q2
$190,000.00
$350,182.17
160,182.17
10,163.33
$350,182.17
$360,345.50
80,000.00
80,000.00
$270,182.17
$280,345.50
Q3
$360,345.50
54,984.67
$415,330.17
80,000.00
$335,330.17
Q4
$415,330.17
–151,686.17
$263,644.00
80,000.00
$183,644.00
CHAPTER 18 C-53
The short-term financial plan will be:
Target cash balance
Net cash inflow
New short-term investments
Income on short-term investments
Short-term investments sold
New short-term borrowing
Interest on short-term borrowing
Short-term borrowing repaid
Ending cash balance
Minimum cash balance
Cumulative surplus0deficit
Short-term Financial Plan
$80,000.00
$80,000.00
160,182.17
10,163.33
–161,282.17
–12,876.15
1,100.00
2,712.82
0
0
0
0
0
0
0
0
$80,000.00
$80,000.00
–80,000.00
–80,000.00
$0
$0
Beginning short-term investments
Ending short-term investments
Beginning short-term debt
Ending short-term debt
$110,000.00
271,282.17
0
$0
$271,282.17
284,158.32
0
$0
$80,000.00
54,984.67
–57,826.25
2,841.58
0
0
0
0
$80,000.00
–80,000.00
$0
$80,000.00
–151,686.17
0
3,419.85
148,266.32
0
0
0
$80,000.00
–80,000.00
$0
$284,158.32
341,984.57
0
$0
$341,984.57
193,718.25
0
$0
The interest earned each quarter will be:
Q1:
Q2:
Q3:
Q4:
Excess funds at start of quarter of
Excess funds at start of quarter of
Excess funds at start of quarter of
Excess funds at start of quarter of
$110,000.00
$271,282.17
$284,158.32
$341,984.57
earns
earns
earns
earns
And the net cash cost will be:
Net cash cost
Q1
Q2
Q3
Q4
Cash generated by short-term financing
$1,100.00
2,712.82
2,841.58
3,419.85
$10,074.25
The effective annual rate the company’s suppliers are offering to Piepkorn is:
EAR = [1 + (.015/.985)]365/25 – 1
EAR = 24.69%
$1,100.00
$2,712.82
$2,841.58
$3,419.85
in income.
in income.
in income.
in income.
CHAPTER 19
CASH MANAGEMENT AT WEBB CORP.
1.
The amount the company will have available is the future value of the transfers, which are an
annuity. The amount of each transfer is one minus the wire transfer cost, times the number of
transfers, which is four since there are four banks, times the amount of each transfer. So, the total
available in two weeks will be:
Amount available = (1 – .0015)(4)($160,000)(FVIFA.015%,14)
Amount available = $8,955,288.13
2.
The bank will accept the ACH transfers from the four different banks, so the company incurs a
transfer fee from each collection center. The future value of the deposits now will be:
Value of ACH = [4($160,000 – 500)(FVIFA.015%,14)]/1.00015
Value of ACH = $8,939,373.02
The company should not go ahead with the plan since the future value is lower.
3.
To find the cost at which the company is indifferent, we set the amount available we found in
Question 1 equal to the cost equation we used in Question 2. Setting up this equation where X stands
for the ACH transfer cost, we find:
[4($160,000 – $X)(FVIFA.015%,14)]/1.00015 = $8,939,373.02
X = $216.04
CHAPTER 20
CREDIT POLICY AT HOWLETT
INDUSTRIES
To decide on the optimal credit policy, we need to calculate the NPV of each policy. We will begin with
the calculation of the NPV of the current policy.
Current Policy
First, we need to calculate the average daily sales which are:
Average daily sales = $140,000,000/365
Average daily sales = $383,561.24
Next, we need the average daily costs. We will begin with the average daily variable costs, which are 45
percent of sales. So, the average daily variable costs are:
Average daily variable costs = 0.45($140,000,000)/365
Average daily variable costs = $172,602.74
Under the current policy, the default rate is 1.6 percent, so the average daily defaults will be:
Average daily defaults = 0.016($140,000,000)/365
Average daily defaults = $6,136.99
The current policy has administrative costs equal to 2.2 percent of sales, so the average daily
administrative costs are:
Average daily administrative costs = 0.022($140,000,000)/365
Average daily administrative costs = $8,438.36
We also need the appropriate interest rate for the collection period. With a 6 percent annual interest rate,
the periodic rate for the 38 day collection period is:
Interest rate = (1 + .06/365)38 – 1
Interest rate = 0.00609 or 0.609%
Since the credit policy will exist into perpetuity, the NPV is:
NPV = –$172,602.74 + ($383,561.64 – 172,602.74 – 6,136.99 – 8,438.36) / 0.00609
NPV = $32,101,900.20
C-56 CASE SOLUTIONS
Option 1
Under Option 1, the average daily sales are:
Average daily sales = $160,000,000/365
Average daily sales = $438,356.16
The average daily variable costs will be:
Average daily variable costs = 0.45($160,000,000)/365
Average daily variable costs = $197,260.27
Under the Option 1, the default rate is 2.5 percent, so the average daily defaults will be:
Average daily defaults = 0.025($160,000,000)/365
Average daily defaults = $10,958.90
Option 1 has administrative costs equal to 3.2 percent of sales, so the average daily administrative costs
are:
Average daily administrative costs = 0.032($160,000,000)/365
Average daily administrative costs = $14,027.40
We also need the appropriate interest rate for the collection period. With a 6 percent annual interest rate,
the periodic rate for the 41 day collection period is:
Interest rate = (1 + .06/365)41 – 1
Interest rate = 0.00657 or 0.657%
Since the credit policy will exist into perpetuity, the NPV is:
NPV = –$197,260.27 + ($438,356.16 – 197,260.27 – 10,958.90 – 14,027.40) / 0.00657
NPV = $32,712,453.23
Option 2
Under Option 2, the average daily sales are:
Average daily sales = $157,000,000/365
Average daily sales = $430,136.99
The average daily variable costs will be:
Average daily variable costs = 0.45($157,000,000)/365
Average daily variable costs = $193,561.64
Under the Option 2, the default rate is 1.8 percent, so the average daily defaults will be:
Average daily defaults = 0.018($157,000,000)/365
Average daily defaults = $7,742.47
CHAPTER 20 C-57
Option 2 has administrative costs equal to 2.4 percent of sales, so the average daily administrative costs
are:
Average daily administrative costs = 0.024($157,000,000)/365
Average daily administrative costs = $10,323.29
We also need the appropriate interest rate for the collection period. With a 6 percent annual interest rate,
the periodic rate for the 51 day collection period is:
Interest rate = (1 + .06/365)51 – 1
Interest rate = 0.00818 or 0.818%
Since the credit policy will exist into perpetuity, the NPV is:
NPV = –$193,561.64 + ($430,136.99 – 193,561.54 – 7,742.47 – 10,323.29) / 0.00818
NPV = $26,535,712.48
Option 3
Under Option 3, the average daily sales are:
Average daily sales = $170,000,000/365
Average daily sales = $465,753.42
The average daily variable costs will be:
Average daily variable costs = 0.45($170,000,000)/365
Average daily variable costs = $209,589.04
Under the Option 3, the default rate is 2.2 percent, so the average daily defaults will be:
Average daily defaults = 0.022($170,000,000)/365
Average daily defaults = $10,246.58
Option 3 has administrative costs equal to 3.0 percent of sales, so the average daily administrative costs
are:
Average daily administrative costs = 0.03($170,000,000)/365
Average daily administrative costs = $13,972.60
We also need the appropriate interest rate for the collection period. With a 6 percent annual interest rate,
the periodic rate for the 49 day collection period is:
Interest rate = (1 + .06/365)49 – 1
Interest rate = 0.00785 or 0.785%
Since the credit policy will exist into perpetuity, the NPV is:
NPV = –$209,589.04 + ($465,753.42 – 209,589.04 –10,246.58 – 13,972.60) / 0.00785
NPV = $29,325,996.41
C-58 CASE SOLUTIONS
The company should choose Option 1 since it has the highest NPV.
The default rate and administrative costs of Option 2 are below those of Option 3. This is plausible.
Option 2 extends the credit period, while Option 3 extends the credit period and relaxes the credit policy.
The relaxation of the credit policy will increase the default rate since it will include companies with lower
credit ratings who are less likely to pay. This in turn will increase the administrative costs of managing
the delinquent accounts.
CHAPTER 21
S&S AIR GOES INTERNATIONAL
1.
The biggest advantage is the increased sales, while the biggest risk is exchange rate risk.
2.
If the dollar strengthens, the profit will decline. Conversely, if the dollar weakens, the profit will
increase.
3.
The company will pay the sales commission out of gross sales, so the after-commission sales in
euros is:
After-commission sales = €5,000,000(1 – .05)
After-commission sales = €4,750,000
At the current exchange rate of $1.45/€, the EBT in euros will be converted to dollars in the amount
of:
Dollar EBT = €750,000($1.45/€)
Dollar EBT = $6,887,500
S&S Air has production costs equal to 80 percent of dollar sales at this exchange rate: The total sales
in dollars are:
Total sales = €5,000,000($1.45/€)
Total sales = $7,250,000
And the production costs are:
Production costs = $7,250,000(0.80)
Production costs = $5,800,000
So, the profit at the current exchange rate is:
Profit = $6,887,500 – 5,800,000
Profit = $1,087,500
If the exchange rate changes to $1.30/€, the euros will convert to:
Dollar sales = €4,750,000($1.30/€)
Dollar sales = $6,175,000
Since the production costs are fixed, the profit at this exchange rate will be:
Profit = $6,175,000 – 5,800,000
Profit = $375,000
CHAPTER 21 C-60
The breakeven exchange rate is the exchange rate that will allow the after-commission costs in euros
to convert to a dollar amount that covers the production costs, so:
Breakeven exchange rate = $5,800,000/€4,750,000
Breakeven exchange rate = $1.221/€
4.
The company could use options, futures, or forwards. The downside to all three hedging vehicles is
the cost. Over time, the company will gain on some contracts and lose on others.
5.
At the current exchange rate, the company will make a profit unless the exchange rate moves
dramatically. So, it is likely that hedging is not required at this point. Taking this into account, the
company should probably pursue international sales further.
CHAPTER 22
YOUR 401k ACCOUNT AT EAST COAST
YACHTS
1.
Before the fact, you would expect that mutual funds managers would be able to outperform the market.
This is due, in part, to the Darwinian nature of the business. Good performing fund managers are richly
rewarded, and poor performing fund managers are fired, often very quickly. In reality, we should expect
that less than 50 percent of all equity mutual funds would outperform the market. This does not depend on
the level of market efficiency. Consider the following question: What percentage of investors will
outperform the market in a given year? Answer: Fifty percent. While there could be one really poor
investor who takes all of the losses in a given year, in general, to get the market average we would expect
one-half of investors would outperform the market, and one-half would underperform the market. After
all, the market average return has to be the average return of all investors’ average return. This is
definitely true if we consider the weighted average return, that is, the average return of investors weighted
by the dollar amount of the investment. We would expect more than 50 percent of mutual funds would
underperform the market because of the expenses charged by the mutual funds. Consider the large-cap
stock fund, with and expense ratio of 1.50 percent. The fund must exceed the market return by 1.50
percent before fees in order to achieve a return after fees equal to the market return. Whether the market is
efficient or inefficient is irrelevant unless mutual funds managers are the best investors in the market, and
all other investors, including private money managers, pension fund managers, individuals, etc. are the
bad investors in the market.
We should also consider that mutual funds managers may be able to outperform the market before
expenses. Whether they can outperform the market on an after-expense basis becomes a question of
whether mutual fund managers can extract economic rents from the stock market. The evidence tends to
support the idea that they cannot. In general, research has found that mutual fund managers underperform
the market after expenses by the average expense ratio. This means that mutual funds as a whole tend to
have the market average return before expenses, so they do not appear to be able to outperform the
market.
2.
The results in the graph tend to support the idea of market efficiency. Consider the case of the Fidelity
Magellan Fund, one of the largest actively managed equity mutual funds at the time this was written, with
assets of about $55 billion. So the question is this: What would Fidelity pay for one year to increase the
return of the Magellan Fund by 0.01 percent? If we multiply the fund assets by 0.01 percent, we get:
$55,000,000,000(.0001) = $5,500,000. So, if Fidelity can increase the return of this one fund by only 0.01
percent per year, it should be willing to pay up to $5.5 million for that year. Given the amount mutual
fund companies would be willing to spend for research, and the Darwinian nature of the industry, we
would expect that mutual fund managers should be able to outperform the market. While there have been
notable exceptions, such as Peter Lynch’s tenure at Magellan, as a whole, mutual fund managers do not
seem to be able to outperform the market. As a result, if the “best” and definitely best-financed investors
cannot outperform the market, the results support the concept of market efficiency.
CHAPTER 22 C-62
3.
Given that the evidence presented tends to support market efficiency, you should invest in the S&P 500
index fund. However, this is not the entire answer. By investing the entire equity portion of your account
in the S&P 500 index, your portfolio is not diversified since the S&P 500 index includes only large-cap
stocks. Therefore, part of your equity investment should probably be in the small cap fund for
diversification purposes. Note that a small cap index fund may be the best option, but there is no small
cap index fund available in the 401k account.
CHAPTER 23
CHATMAN MORTGAGE, INC.
1.
Mike’s mortgage payments form a 25-year annuity with monthly payments, discounted at the longterm interest rate of 7 percent. We can solve for the payment amount so that the present value of the
annuity equals $500,000, the amount of principal that he plans to borrow. The monthly mortgage
payment will be:
$500,000 = C(PVIFA7%/12,300)
C = $3,533.90
2.
The most significant risk that she faces is interest rate risk. If the current market rate of interest rises
between today and the date the mortgage is sold, the fair value of the mortgage will decrease, and the
Ian will only be willing to purchase the mortgage for a price less than $500,000. If this is the case,
she will not be able to loan Mike the full $500,000 promised.
3.
Treasury bond prices have an inverse relationship with interest rates. As interest rates rise, Treasury
bonds become less valuable; as interest rates fall, Treasury bonds become more valuable. Since Joi
will be hurt when interest rates rise, she is also hurt when Treasury bonds decrease in value. In order
to protect herself from decreases in the price of Treasury bonds, she should take a short position in
Treasury bond futures to hedge this interest rate risk. Since three-month Treasury bond futures
contracts are available and each contract is for $100,000 of Treasury bonds, she would take a short
position in five 3-month Treasury bond futures contracts in order to hedge her $500,000 exposure to
changes in the market interest rate over the next three months
4.
a.
If the market interest rate is 8 percent on the date that Joi meets with the Ian, the fair value of
the mortgage is the present value of an annuity that makes monthly payments of $3,533.90 for
25 years, discounted at 8 percent, or:
Mortgage value = $3,533.90(PVIFA8%/12,300)
Mortgage value = $457,867.55
5.
b.
An increase in the interest rate will cause the value of the T-bond futures contracts to decrease.
The long position will lose and the short position will gain. Since Joi is short in the futures, the
futures gain will offset the loss in value of the mortgage.
a.
If the market interest rate is 6 percent on the date that Joi meets with the Ian, the fair value of
the mortgage is the present value of an annuity that makes monthly payments of $3,533.90 for
25 years, discounted at 6 percent, or:
Mortgage value = $3,533.90(PVIFA6%/12,300)
Mortgage value = $548,484.91
CHAPTER 23 C-64
b.
6.
An increase in the interest rate will cause the value of the Treasury bond futures contracts to
increase. The long position will gain and the short position will lose. Since Joi is short in the
futures, the futures lose will be offset by the gain in value of the mortgage.
The biggest risk is that the hedge is not a perfect hedge. If interest rates change, the fact that
Treasury bond interest is semiannual, while the mortgage payments are monthly, may affect the
relative value of the two. Additionally, while a change in one of the interest rates will likely coincide
with a change in the other interest rate, the change does not have to be the same. For example, the
Treasury rate could increase 20 basis points, and the mortgage rates could increase by 40 basis
points. The fact that this is not a perfect hedge simply means that the gain/loss from the futures
contracts may not exactly offset the loss/gain in the mortgage. We would expect, especially given the
short-term nature of the hedge, that the loss in one instrument would be similar to the gain in the
other instrument.
CHAPTER 24
S&S AIR’S CONVERTIBLE BOND
1.
We can use the PE ratio to calculate the current stock price. Doing so, we get:
P/E = Price/EPS
12.50 = Price/$1.60
Price = $20.00
This means the conversion premium of the bond is:
Conversion premium = ($25 – 20) / $20 = 0.25 or 25%
Chris is suggesting a conversion price of $25 because it means the stock price will have to increase
before the bondholders can benefit from the conversion, in this case 25 percent. Even though the
company is not publicly traded, the conversion price is important. First, the company may go public
in the future. The case does discuss whether the company has plans to go public, and if so, how soon
it might go public. If the company does goes public, the bondholders will have an active market for
the stock if they convert. Second, even if the company does not go public, the bondholders could
potentially have an equity interest in the company. This equity interest can be sold to the original
owners, or someone else. The potential problem with private equity is that the market is not as liquid
as the market for a public company. This illiquidity lowers the value of the stock.
The conversion value of the bond is given as $800. The intrinsic value of the bond is:
Intrinsic value = $30(PVIFA5%,40) + $1000(PVIF5%,40)
Intrinsic value = $656.82
So, the floor value of the bond is $800. This means that if the company offered bonds with the same
coupon rate and no conversion feature, they would be able to sell them for $656.82. However, with
the conversion feature the price will be $800. In essence, the company is receiving $143.18 for the
conversion feature.
The conversion ratio the bond is:
Conversion ratio = $800/$25 = 32.00
So, each bond can be converted to 32 shares of stock.
2.
Todd’s argument is wrong because it ignores the fact that if the company does well, bondholders will
be allowed to participate in the company’s success. If the stock price rises to $25, bondholders are
effectively allowed to purchase stock at the conversion price of $25.
3.
Mark’s argument is incorrect because the company is issuing debt with a lower coupon rate than
they would have been able to otherwise. If the company does poorly, it will receive the benefit of a
lower coupon rate.
CHAPTER 23 C-66
4.
Reconciling the two arguments requires that we remember our central goal: to increase the wealth of
the existing shareholders. Thus, with 20-20 hindsight, we see that issuing convertible bonds will turn
out to be worse than issuing straight bonds and better than issuing common stock if the company
prospers. The reason is that the prosperity has to be shared with bondholders after they convert.
In contrast, if a company does poorly, issuing convertible bonds will turn out to be better than
issuing straight bonds and worse than issuing common stock. The reason is that the firm will have
benefited from the lower coupon payments on the convertible bonds.
Both of the arguments have a grain of truth; we just need to combine them. Ultimately, which option
is better for the company will only be known in the future and will depend on the performance of the
company. The table below illustrates this point.
Convertible bonds
issued instead of
straight bonds
Convertible bonds
issued instead of
common stock
5.
If the company does poorly
Low stock price and no
conversion
Cheap financing because
coupon rate is lower (good
outcome).
If the company prospers
High stock price and
conversion
Expensive financing because
bonds are converted, which
dilutes existing equity (bad
outcome).
Expensive financing because
firm could have issued
common stock at high prices
(bad outcome).
Cheap financing because firm
issues stock at high prices
when bonds are converted
(good outcome).
The call provision allows the company to redeem the bonds at the company’s discretion. If the
company’s stock appears to be poised to rise, the company can call the outstanding bonds. It could
be possible that the bondholders would benefit from converting the bonds at that point, but it would
eliminate the potential future gains to the bondholders.
CHAPTER 25
EXOTIC CUISINE EMPLOYEE STOCK
OPTIONS
1.
We can use the Black-Scholes equation to value the employee stock options. We need to use the
risk-free rate that is the same as the maturity as the options. So, assuming expiration in three years,
the value of the stock options per share of stock is:
d1 = [ln($24.38/$50) + (.038 + .602/2)  3] / (.60 
d2 = –.0618 – (.60 
3 ) = –.0618
3 ) = –1.1011
N(d1) = .4753
N(d2) = .1354
Putting these values into the Black-Scholes model, we find the option value is:
C = $24.38(.4753) – ($50e–.038(3))(.1354) = $5.55
Assuming expiration in ten years, the value of the stock options per share of stock is:
d1 = [ln($24.38/$50) + (.044 + .602/2)  10] / (.60  10 ) = .8020
d2 = .8020 – (.60  10 ) = –1.0953
N(d1) = .7887
N(d2) = .1367
Putting these values into the Black0Scholes model, we find the option value is:
C = $24.38(.7887) – ($50e–.044(10))(.1367) = $14.83
2.
Whether you should exercise the options in three years depends on several factors. A primary factor
is how long you plan to stay with the company. If you are planning to leave next week, you should
exercise the options. A second factor is how the option exercise will affect your taxes.
3.
The fact that the employee stock options are not traded decreases the value of the options. A basic
way to understand this is to realize that an option always has value since, ignoring the premium, it
can never lose money. The right to sell an option also has to have value. If the right to sell is
removed, it decreases the price of the option.
CHAPTER 25 C-68
4.
The rationale for employee stock options is to reduce agency costs by better aligning employee and
shareholder interests. Vesting requires employees to work at a company for a specified time, which
means the employee actions are actually part of the company performance. Vesting is also a “golden
handcuff.” The employee is less likely to leave the company if in-the-money employee stock options
will vest soon. They must often be exercised shortly after an employee leaves the company so that
they may no longer participate in any potential stock price increase.
5.
The evaluation of the argument for or against repricing is open-ended. There are valid reasons on
both sides of the discussion. Repricing can be viewed as a negative. If an employee knows the option
will be repriced if the stock declines, it provides less incentive. However, if the stock price does
decline dramatically, and underwater employee stock option provides little incentive since it may be
unlikely that the stock price will reach the strike price before expiration.
Repricing increases the value of the employee stock option. Consider an extreme: A company
announces the employee stock options will be worth a minimum of $10 at expiration. Since all
values less than $10 are no longer possible, the value of the option increases.
6.
Employee stock options increase in value if the stock price increases; however, the stock price can
increase because of a general market increase. Consider a company of average risk in a bull market
that has a large return for several years. The company’s stock should closely mirror the market
return, even though most of the stock price increase is due to the general market increase. Similarly,
if the market falls, the company’s stock will likely fall as well, even if the company is doing well.
A better method of valuing employee stock options might be to reward employees for company
performance in excess of the market performance, adjusted for the company’s level of risk.
CHAPTER 26
THE BIRDIE GOLF-HYBRID GOLF
MERGER
1.
As with any other merger analysis, we need to examine the present value of the incremental cash
flows. The cash flow today from the acquisition is the acquisition costs plus the dividends paid
today, or:
Acquisition of Hybrid
Dividends from Hybrid
Total
–$550,000,000
$150,000,000
–$400,000,000
Using the information provided, we can determine the cash flows to Birdie Golf from acquiring
Hybrid Golf. All earnings not retained are paid as dividends, so the cash flows for the next five years
will be:
Dividends from Hybrid
Terminal value of equity
Total
Year 1
Year 2
Year 3
Year 4
$38,400,000 $12,800,000 $29,400,000 $41,400,000
$38,400,000 $12,800,000 $29,400,000 $41,400,000
Year 5
$59,000,000
600,000,000
$659,000,000
To discount the cash flows from the merger, we must discount each cash flow at the appropriate
discount rate. The terminal value of the company is subject to normal business risk and should be
discounted at the cost of capital, while the dividends are equity cash flows, and as such, should be
discounted at the cost of equity. The present value of each year’s cash flows, along with the
appropriate discount rate for each cash flow is:
Dividends
PV of value
Total
Discount
rate
Year 1
16.9% $32,848,589
12.4%
Year 2
Year 3
Year 4
$9,366,578 $18,403,643 $22,168,806
$32,848,589
$9,366,578 $18,403,643 $22,168,806
Year 5
$27,025,856
334,441,139
$361,466,995
And the NPV of the acquisition is:
NPV = –$400,000,000 + 32,848,589 + 9,366,578 + 18,403,643 + 22,168,806 + 361,466,995
NPV = $44,254,610.07
C-70 CASE SOLUTIONS
2.
Since the acquisition is a positive NPV project, the most Birdie would offer is to increase the current
cash offer by the current NPV, or:
Highest offer = $550,000,000 + 44,254,610.07
Highest offer = $594,254,610.07
The highest share price is the total high offer price, divided by the shares outstanding, or:
Highest share price = $594,254,610.07 / 8,000,000 shares
Highest share price = $74.28
3.
To determine the current exchange ratio which would make a cash offer and a share offer equivalent,
we need to determine the new share price under the original cash offer. The new share price of
Birdie after the merger will be:
PNew = ($94 × 18,000,000 + $44,254,610.07) / 18,000,000
PNew = $96.46
So, the exchange ratio which would make the cash offer and share offer equivalent is:
Exchange ratio = $68.75 / $96.46
Exchange ratio = .7127
4.
The highest exchange ratio Birdie would accept is an exchange ratio that results in a zero NPV
acquisition. This implies the share price of Birdie remains unchanged after the merger, so the
exchange ratio is:
Exchange ratio = $68.75 / $94
Exchange ratio = .7314
CHAPTER 27
THE DECISION TO LEASE OR BUY AT
WARF COMPUTERS
1.
The decision to buy or lease is made by looking at the incremental cash flows. The incremental cash
flows from leasing the machine are the security deposit, the lease payments, the tax savings on the
lease, the lost depreciation tax shield, the saved purchase price of the machine, and the lost salvage
value. The salvage value of the equipment in four years will be:
Aftertax salvage value = $600,000 – $600,000(.35)
Aftertax salvage value = $390,000
This is an opportunity cost to Warf Computers since if the company leases the equipment it will not
be able to sell the equipment in four years. The lease payments are due at the beginning of each year,
so the incremental cash flows are:
Saved purchase
Lost salvage value
Lost dep. tax shield
Security deposit
Lease payment
Tax on lease payment
Cash flow from leasing
Year 0
$5,000,000
–300,000
–1,300,000
455,000
$3,855,000
Year 1
Year 2
Year 3
Year 4
–$390,000
–129,675
300,000
–$583,275
–$777,875
–$259,175
–1,300,000
455,000
–$1,428,275
–1,300,000
455,000
–$1,622,875
–1,300,000
455,000
–$1,104,175
The aftertax cost of debt is:
Aftertax cost of debt = .11(1 – .35)
Aftertax cost of debt = .0715 or 7.15%
And the NAL of the lease is:
NAL = $3,855,000 – $1,428,275/1.0715 – $1,622,875/1.07152 – $1,104,175/1.07153
– $219,675/1.07154
NAL = $44,308.0
The company should lease the equipment.
–$219,675
C-72 CASE SOLUTIONS
2.
The book value of the equipment in year 2 will be:
Book value = $5,000,000 – $5,000,000(.3333 + .4445)
Book value = $1,111,000
So, the aftertax salvage value in year 2 will be:
Aftertax salvage value = $2,000,000 + ($1,111,000 – 2,000,000)(.35)
Aftertax salvage value = $1,688,850
So, the NAL of the lease under the new terms would be:
Saved purchase
Lost salvage value
Lost dep. tax shield
Lease payment
Tax on lease payment
Cash flow from leasing
Year 0
$5,000,000
–2,300,000
805,000
$3,505,000
Year 1
–$583,275
–2,300,000
805,000
–$2,078,275
Year 2
–$1,688,850
–777,875
–$2,466,725
So, the NAL of the lease under these terms is:
NAL = $3,805,000 – $2,078,275/1.0715 – $2,466,725/1.07152
NAL = –$583,099.11
The NAL of the lease is negative under these terms, so it appears the terms are less favorable for the
lessee. However, the lease will likely be classified as an operating lease. The lease is now for two
years, which is less than 75 percent of the equipment’s life according. Using the company’s cost of
debt, the present value of the lease payments is:
PV of lease payments = $2,300,000 + $2,300,000/1.11
PV of lease payments = $4,372,072.07
This is less than 90 percent of the price of the equipment. As long as the lease contract does transfer
ownership to the lessee at the end of the contact, or allow for a purchase at a bargain price, the FAS
13 conditions for a capital lease are not met. As such, the reason for suggesting the revised lease
terms is unethical on Nick’s part. Also, notice that the question also states that if the lease is renewed
in two years, the lessor will allow for the increased lease payments made over the first two years.
This is also an indication that the revision is for less than ethical reasons.
CHAPTER 27 C-73
3.
4.
a.
The inclusion of a right to purchase the equipment will have no effect on the value of the lease.
If the company does not purchase the equipment, it can go on the market and purchase identical
equipment at the same price.
b.
The right to purchase the equipment at a fixed price will increase the value of the lease. If the
company can purchase the equipment at the end of the lease at below market value, it will save
money, or at a minimum, can purchase the equipment at the fixed price and resell it in the open
market. This is a real option, therefore has value to the lessee. It is a call option on the
equipment. As such, it must have a value until it expires or is exercised. It is also important to
note that this would likely make the lease contract a capitalized lease.
c.
The right to purchase the equipment at a bargain price is also a real option for the lessee, and
will increase the value of the lease. It is a call option, and therefore will have value until it
expires or is exercised. This contract condition will definitely ensure the lease is classified as a
capitalized lease.
The cancellation option is also a real option. The cancellation option is a put option on the
equipment. It will increase the value of the lease since the lessee will only exercise the option when
it is to the lessee’s advantage.