FINS3625 Applied Corporate Finance S2 2011
Solutions to Tutorial Problems - Week 2
1-1
a. Stockholder wealth maximization is the appropriate goal for management decisions. The
risk and timing associated with expected earnings per share and cash flows are considered
in order to maximize the price of the firm’s common stock.
b. Production opportunities are the returns available within an economy from investment in
productive assets. The higher the production opportunities, the more producers would be
willing to pay for required capital. Consumption time preferences refer to the preferred
pattern of consumption. Consumer’s time preferences for consumption establish how
much consumption they are willing to defer, and hence save, at different levels of interest.
c. A foreign trade deficit occurs when businesses and individuals in the U. S. import more
goods from foreign countries than are exported. Trade deficits must be financed, and the
main source of financing is debt. Therefore, as the trade deficit increases, the debt
financing increases, driving up interest rates. U. S. interest rates must be competitive
with foreign interest rates; if the Federal Reserve attempts to set interest rates lower than
foreign rates, foreigners will sell U.S. bonds, decreasing bond prices, resulting in higher
U. S. rates. Thus, if the trade deficit is large relative to the size of the overall economy, it
may hinder the Fed’s ability to combat a recession by lowering interest rates.
d. An agency relationship arises whenever one or more individuals, the principals, hire
another individual, the agent, to perform some service and then delegate decision-making
authority to that agent. Primary agency relationships exist between (1) stockholders and
managers, and (2) between debtholders and stockholders.
e. Agency costs include all costs borne by shareholders to encourage managers to maximize
a firm’s stock price rather than act in their own self-interests. The three major categories
of agency costs are (1) expenditures to monitor managerial actions, such as audit costs;
(2) expenditures to structure the organization in a way that will limit undesirable
managerial behavior, such as appointing outside investors to the board of directors; and
(3) opportunity costs which are incurred when shareholder-imposed restrictions, such as
requirements for stockholder votes on certain issues, limit the ability of managers to take
timely actions that would enhance shareholder wealth.
f.
An agency problem arises whenever a manager of a firm owns less than 100 percent of
the firm’s common stock, creating a potential conflict of interest called an agency
conflict. The fact that the manager will neither gain all the benefits of the wealth created
by his or her efforts nor bear all of the costs of perquisite consumption will increase the
incentive to take actions that are not in the best interests of the nonmanager shareholders.
In addition to conflicts between stockholders and managers, there can also be
conflicts between stockholders (through managers) and creditors. Creditors have a claim
on part of the firm’s earnings stream for payment of interest and principal on debt, and
they have a claim on the firm’s assets in the event of bankruptcy. However, stockholders
have control (through managers) of decisions that affect the riskiness of the firm.
g. A typical executive compensation program is structured in three parts: (1) a specified
annual salary; (2) a bonus paid at the end of the year, which depends on the company’s
profitability during the year; and (3) options to buy stock, or actual shares of stock, which
reward the executive for long-term performance. Economic Value Added (EVA) is a
method used to measure a firm’s true profitability. EVA is found by taking the firm’s
after-tax operating profit and subtracting the annual cost of all the capital a firm uses. If
the firm generates a positive EVA, its management has created value for its shareholders.
If the EVA is negative, management has destroyed shareholder value.
h. Executive stock options are performance-based incentive plans popular in the 1950s and
1960s which allowed managers to purchase stock at some time in the future at a given
price. This type of plan lost favor in the 1970s; they generally did not pay in the 1970s
because the stock market declined.
i.
A market is said to be transparent when reliable and accurate information is available to
all market participants.
j.
A conflict of interests arises for an accounting firm when it provides both consulting
services and auditing services to the same client. The accounting firm may be reluctant to
do a good job in auditing if it fears that in doing so it might lose consulting business.
k. The Sarbanes-Oxley Act of 2002 established increased requirements for corporate
accountability, and increased penalties for corporate fraud. It was enacted in response to
the widespread accounting scandals of the early 2000s.
1-2
Such factors as a compensation system that is based on management performance (bonuses
tied to profits, stock option plans) as well as the possibility of being removed from office
(voted out of office, an unfriendly tender offer by another firm) serve to keep management’s
focus on stockholders’ interests.
1-3
A firm’s fundamental, or intrinsic, value is the present value of its free cash flows when
discounted at the weighted average cost of capital. If the market price reflects all relevant
information, then the observed price is also the intrinsic price.
1-5
Earnings per share in the current year will decline due to the cost of the investment made in
the current year and no significant performance impact in the short run. However, the
company’s stock price should increase due to the significant cost savings expected in the
future.
1-6
The executive wants to demonstrate strong performance in a short period of time.
Strong performance can be demonstrated either through improved earnings and/or a
higher stock price. The current board of directors is well served if the manager works
to increase the stock price; however, the board is not well served if the manager takes
short-run actions which bump up short-run earnings, at the expense of long-run
profitability and the company’s stock price. Consequently, the board may want to
rely more on stock options and less on performance shares which are tied to
accounting performance.
1-7
As the stock market becomes more volatile, the link between the stock price and the ability of
senior management is weakened. Therefore, in this environment, companies may choose to
de-emphasize the awarding of stock and stock options, and rely more on bonuses and
performance shares which are tied to other performance measures besides the company’s
stock price. Moreover, in this environment, it may be harder to attract or retain top talent if
the compensation were tied too much to the company’s stock price.
1-8
a. No, the TIAA-CREF is not an ordinary shareholder. Because it is the largest institutional
shareholder in the United States and it controls over $400 billion in pension funds, its
voice carries a lot of weight. This “shareholder” in effect consists of many individual
shareholders whose pensions are invested with this group.
b. The owners of TIAA-CREF are the individual teachers whose pensions are invested with
this group.
c. For the TIAA-CREF to be effective in yielding its weight, it must act as a coordinated
unit. In order to do this, the fund’s managers should solicit from the individual
shareholders their “votes” on the fund’s practices, and from those “votes” act on the
majority’s wishes. In so doing, the individual teachers whose pensions are invested in the
fund have in effect determined the fund’s voting practices.
9-7
a. AFN = (A*/S)(S) – (L*/S)(S) – MS1(1 – d)
=
$122.5
$17.5
$10.5
($70) ($70) ($420)(0.6) = $13.44 million.
$350
$350
$350
b.
Upton Computers
Pro Forma Balance Sheet
December 31, 2010
(Millions of Dollars)
Cash
Receivables
Inventories
Total current
assets
Net fixed assets
Total assets
Accounts payable
Notes payable
Accruals
Total current
liabilities
Mortgage loan
Common stock
Retained earnings
Total liab.
and equity
AFN =
2009
$ 3.5
26.0
58.0
$ 87.5
35.0
$122.5
$ 9.0
18.0
8.5
$ 35.5
6.0
15.0
66.0
$122.5
Forecast
Basis %
2010 Sales Additions Pro Forma Financing
0.0100
$ 4.20
0.0743
31.20
0.1660
69.60
$105.00
42.00
$147.00
0.100
0.0257
$ 10.80
18.00
10.20
0.0243
7.56*
Pro Forma
after
Financing
$ 4.20
31.20
69.60
$105.00
42.00
$147.00
+13.44
$ 10.80
31.44
10.20
$ 39.00
6.00
15.00
73.56
$ 52.44
6.00
15.00
73.56
$133.56
$147.00
$ 13.44
*PM = $10.5/$350 = 3%.
Payout = $4.2/$10.5 = 40%.
NI = $350  1.2  0.03 = $12.6.
Addition to RE = NI - DIV = $12.6 - 0.4($12.6) = 0.6($12.6) = $7.56.
9-8
Stevens Textiles
Pro Forma Income Statement
December 31, 2010
(Thousands of Dollars)
Sales
Operating costs
EBIT
Interest
EBT
Taxes (40%)
Net income
2009
$36,000
$32,440
$ 3,560
460
$ 3,100
1,240
$ 1,860
Dividends (45%)
Addition to RE
$ 837
$ 1,023
Forecast
Basis
1.15  Sales09
0.9011  Sales10
0.10 × Debt09
Pro Forma
2010
$41,400
37,306
$ 4,094
560
$ 3,534
1,414
$ 2,120
$ 954
$ 1,166
Stevens Textiles
Pro Forma Balance Sheet
December 31, 2010
(Thousands of Dollars)
Cash
Accts receivable
Inventories
Total curr.
assets
Fixed assets
Total assets
Accounts payable
Accruals
Notes payable
Total current
liabilities
Long-term debt
Total debt
Common stock
Retained earnings
Total liabilities
and equity
2009
$ 1,0800
6,480
9,000
$16,560
12,600
$29,160
$ 4,320
2,880
2,100
$ 9,300
3,500
$12,800
3,500
12,860
$29,160
AFN =
*From income statement.
Forecast
Basis %
2010 Sales Additions Pro Forma
0.0300
$ 1,242
0.1883
7,452
0.2005
10,350
0.3500
0.1200
0.0800
1,166*
Financing
Pro Forma
after
Financing
$ 1,242
7,452
10,350
$19,044
14,490
$33,534
$19,044
14,490
$33,534
$ 4,968
3,312
2,100
$ 4,968
3,312
4,228
+2,128
$10,380
3,500
$13,880
3,500
14,026
$12,508
3,500
$16,008
3,500
14,026
$31,406
$33,534
$ 2,128
9-9
Garlington Technologies Inc.
Pro Forma Income Statement
December 31, 2010
Sales
Operating costs
EBIT
Interest
EBT
Taxes (40%)
Net income
2009
$3,600,000
3,279,720
$ 320,280
18,280
$ 302,000
120,800
$ 181,200
Dividends:
Addition to RE:
$ 108,000
$ 73,200
Forecast
Basis
1.10  Sales09
0.911  Sales10
Additions
2010
$3,960,000
3,607,692
$ 352,308
0.13 × Debt09
20,280
$ 332,028
132,811
$ 199,217
Set by management
$ 112,000
$ 87,217
Garlington Technologies Inc.
Pro Forma Balance Statement
December 31, 2010
Cash
Receivables
Inventories
Total current
assets
Fixed assets
Total assets
2009
$ 180,000
360,000
720,000
$1,260,000
1,440,000
$2,700,000
Accounts payable $ 360,000
Notes payable
156,000
Accruals
180,000
Total current
liabilities
$ 696,000
Common stock
1,800,000
Retained earnings
204,000
Total liab.
and equity
$2,700,000
Forecast
Basis %
2010 Sales
0.05
0.10
0.20
Additions
AFN
2010
Effects
$ 198,000
396,000
792,000
$1,386,000
1,584,000
$2,970,000
0.40
0.10
0.05
87,217*
With AFN
2010
$ 198,000
396,000
792,000
$1,386,000
1,584,000
$2,970,000
$ 396,000
156,000 +128,783
198,000
$ 396,000
284,783
198,000
$ 750,000
1,800,000
291,217
$ 878,783
1,800,000
291,217
$2,841,217
$2,970,000
AFN =
$ 128,783
Cumulative AFN =
$ 128,783
*See income statement.