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Case Studies in Finance

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Case Studies in Finance

Table of Contents

Case Studies in Finance

Table of Contents

Case 1: Insider Trading

Case Studies in Finance

Case 2: The Tobacco Industry

Written by

Case 3: Connect Cable Contractors

Dr. Michael J. Seiler Associate Professor of Finance Hawaii Pacific University

Case 4: IBP Case 5: Chrysler Case 6: Moog Case 7: Kate Myers Case 8: Quilici Family

Chapter 1: Case 1: Insider Trading Case 2. The Tobacco Industry Case 3. Connect Cable Contractors

Case 10: Intel

Chapter 2: Case 4. IBP Case 5. Chrysler

Case 11: Amber Plank

Chapter 3: Case 6. Moog

Case 9: Wal-Mart

Case 12: Fruit of the Loom Case 13: Nations Bank Case 14: AMR American Airlines Case 15: Mirage Resorts Case 16: eBay Case 17: Aether Systems Case 18: NetJ.com Case 19: OTCBB

Chapter 4: Case 7. Kate Myers Case 8. Quilici Family Chapter 5: Case 9. Wal-Mart Case 10. Intel Chapter 6: Case 11. Amber Plank  Case 12. Fruit of the Loom Case 13. Nations Bank  Case 14. AMR - American Airlines Case 15. Mirage Resorts Chapter 7:

Chapter 9: Case 23. Southwest Airlines Case 24. Acclaim Entertainment Chapter 10: Case 25. Philip Morris Chapter 11: Case 26. Computerized Business Systems Chapter 12: Case 27. McLeodUSA Chapter 13: Case 28. Lancaster Colony Chapter 14: Case 29. Anheuser-Busch Case 30. Pepsi Case 31. Inn-Room Safe Chapter 15: Case 32. Home Depot Chapter 16: Case 33. Hasbro Case 34. Microsoft Case 35. REITs

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Case Studies in Finance

Case 20: Pittston Case 21: Vanguard Case 22: Florida Power & Light Case 23: Southwest Airlines Case 24: Acclaim Entertainment

Case 16. eBay Case 17. Aether Systems Case 18. NetJ.com Case 19. OTCBB Case 20. Pittston Case 21. Vanguard

Case 36. HOLDRs Chapter 17: Case 37. Reynolds Case 38. Adaptec Case 39. Roxio

Chapter 8: Case 22. Florida Power & Light

Chapter 18: Case 40. Tyco

Case 25: Philip Morris Case 26: Computerized Business Systems

Copyright © 1995-2003 by Addison Wesley A division of Pearson Education Legal Disclaimer

Case 27: McLeodUSA Case 28: Lancaster Colony Case 29: AnheuserBusch Case 30: Pepsi Case 31: Inn-Room Safe Case 32: Home Depot Case 33: Hasbro Case 34: Microsoft Case 35: REITs Case 36: HOLDRs Case 37: Reynolds Case 38: Adaptec Case 39: Roxio Case 40: Tyco

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Principles of Managerial Finance, 10e

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Addison Wesley Companion Website

Principles of Managerial Finance, 10e Welcome to the Companion Web site for Principles of Managerial Finance  by Lawrence J. Gitman. Click on any of the links below to enter the site: Student Resources Case Studies in Finance Student Software Instructor Resources

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Home > Case Studies in Finance > Table of Contents >

Case Studies in Finance

Table of Contents Case Studies in Finance Written by Dr. Michael J. Seiler Associate Professor of Finance Hawaii Pacific University Chapter 1:

Chapter 9:

Case 1: Insider Trading Case 2. The Tobacco Industry Case 3. Connect Cable Contractors

Case 23. Southwest Airlines Case 24. Acclaim Entertainment Chapter 10:

Chapter 2:

Case 25. Philip Morris

Case 4. IBP Case 5. Chrysler

Chapter 11:

Case 26. Computerized Business Systems Chapter 3:

Case 6. Moog

Chapter 12:

Case 27. McLeodUSA Chapter 4:

Case 7. Kate Myers Case 8. Quilici Family

Chapter 13:

Chapter 5:

Chapter 14:

Case 9. Wal-Mart Case 10. Intel

Case 29. Anheuser-Busch Case 30. Pepsi Case 31. Inn-Room Safe

Case 28. Lancaster Colony

Chapter 6:

Case 11. Amber Plank  Case 12. Fruit of the Loom Case 13. Nations Bank  Case 14. AMR - American Airlines Case 15. Mirage Resorts

Chapter 15:

Case 32. Home Depot Chapter 16:

Case 33. Hasbro Case 34. Microsoft

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Chapter 7:

Case 16. eBay Case 17. Aether Systems Case 18. NetJ.com Case 19. OTCBB Case 20. Pittston Case 21. Vanguard

Case 35. REITs Case 36. HOLDRs Chapter 17:

Case 37. Reynolds Case 38. Adaptec Case 39. Roxio

Chapter 8:

Chapter 18:

Case 22. Florida Power & Light

Case 40. Tyco

Copyright © 1995-2003 by Addison Wesley A division of Pearson Education Legal Disclaimer

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aw_gitman_pmf_10|Case Studies in Finance|Case 1: Insider Trading

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Case Studies in Finance

Case 1: Insider Trading Ethics: Insider Trading over the Internet

You don't have to be a member of the Board of Directors to engage in illegal insider trading. John J. Freeman, a part-time temporary word processor at two investment houses, learned all he needed to know from the desks of co-workers, garbage cans, and from making copies of documents that discussed impending mergers and acquisitions. Even though the documents referred to the companies involved by code, Freeman was able to learn their true identity by piecing together their industry, historical stock prices, names of officers, and geographic location. Once Freeman knew who and when, he disseminated the information to friends, family, and anyone who would listen via an Internet chat room under the name "TheBren." What Freeman did not know is that among his many listeners were members of the Securities and Exchange Commission (SEC), the FBI, and federal prosecutors. In fact, at any given time, 100 specially trained SEC employees are surfing the Net, visiting chat rooms, and reading message boards looking for illegal inside traders. When they identify a red flag, they forward the information to the Office of Internet Enforcement, a special division of the SEC who helps build cases to pursue criminal charges and/or civil lawsuits. The SEC is not the only surveillance group out in cyberspace. The exchanges monitor trading activity as well. In fact, the American Stock Exchange was the organization who originally identified a problem when they noticed unusual trading patterns prior to the public announcement of these mergers and acquisitions. Once the SEC was notified, it was only a matter of time. Freeman directly told at least 10 people, but as with any valuable secret, the information spread like wildfire. A friend of Freeman's, a waiter at a New York restaurant, made over $285,000. He told a patron who profited by at least $445,000, which was certainly more than he earned in his former career as a school teacher. While his friends made millions of dollars, Freeman was more conservative and profited by only $70,000-$110,000, plus various non-pecuniary benefits such as cases of wine. This seems to be a small gain given the hefty fines and prison time that is certain to follow. It seems the Internet is affecting the stock market in all sorts of ways, both good and bad. It remains to be seen if the perceived anonymity of the Internet acts as a breeding ground for the conveying of private corporate information. One thing is for certain, however, the SEC is readying themselves by continual efforts and manpower devoted to policing cyberspace.

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aw_gitman_pmf_10|Case Studies in Finance|Case 1: Insider Trading

Questions

1. What is the definition of non-public, or private, information? 2. Who can come into contact with private, or inside, information? 3. When does private corporate information turn into illegal insider trading? 4. Why is the Internet such a high potential breeding ground for inside information? 5. What should you do if you learn of inside information?

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aw_gitman_pmf_10|Case Studies in Finance|Case 2: The Tobacco Industry

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Case Studies in Finance

Case 2: The Tobacco Industry Special Management Topics: Ethics

Cigarettes have long been known to cause cancer, lung diseases, and other related illnesses, but until recently, only minor steps have been taken to prevent this pernicious habit from reaching those who do not smoke. The government is strongly considering a ban on smoking in the work place. Offices, restaurants, sporting events, casinos, bars, and even construction sites are included in this definition of "work place." It has been argued that placing a ban on smoking in the work place will result in millions of dollars in savings by businesses through a lower rate of absenteeism, higher productivity, and an overall healthier work force. For those businesses that insist on providing on-site smoking facilities, smoking rooms would have to be established with ventilation systems separate from the rest of the building. Small firms have already complained that this would be detrimental to them due to the costs involved with installing such systems. Smokers argue that the necessity for smoking rooms would be so costly to businesses that they would find it too expensive to hire smokers. Thus, discrimination is also a key issue. The Food and Drug Administration (FDA) has also voiced complaints against the tobacco industry. Specifically, they accused the tobacco industry of increasing the amount of nicotine, a highly addictive narcotic, in its cigarettes. By increasing nicotine levels, tobacco firms are able to keep existing smokers addicted, while increasing their chances of hooking first time smokers. The tobacco industry has retaliated by stating they have not altered natural nicotine levels. Further, although the removal of nicotine is scientifically possible, just as caffeine can be removed from coffee, the industry refuses to reduce levels because nicotine gives cigarettes its flavor and feel. The FDA refuses to believe that tobacco companies do not boost nicotine levels. They cite three disturbing facts that support this contention. First, the tobacco industry has known through research conducted by its own scientists that nicotine causes cancer. This fact provides the tobacco industry's motive. Second, the tobacco industry holds several U.S. patents on technology that controls the amount of nicotine in cigarettes. Why would the tobacco industry spend millions of research and development dollars to develop technology that it did not intend to use? Finally, even the cigarettes that the industry claims are low in nicotine are still at levels that can induce addiction in the majority of smokers.

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aw_gitman_pmf_10|Case Studies in Finance|Case 2: The Tobacco Industry

It's only a matter of time before we find out which party is telling the truth. Meanwhile, the smoking ban becomes more and more realistic and within the next few years many experts feel that it will be in effect across the entire country. Questions

1. The Surgeon General has long since declared that cigarettes are hazardous to people's health. Since this is common knowledge, is it unethical for the tobacco industry to increase the level of nicotine in their cigarettes without informing consumers?

2. Is it unethical for the tobacco industry to increase the level of nicotine in their cigarettes if they do inform consumers?

3. If the tobacco industry decided voluntarily or otherwise to convey to consumers that nicotine levels are higher in a particular brand of cigarette, how should the message be conveyed? That is, is a fine print warning on the side of a pack of cigarettes ample warning?

4. Do you feel that the ban on smoking in all work places, such as those listed in the case, violates the civil rights of smokers? Does smoking in the work place violate the civil rights of non-smokers?

5. What can the government do to protect or help defray the costs of establishing smoke rooms in the work place for small businesses that cannot afford to install ventilation systems?

6. It can be argued that if the ban is implemented, businesses will find the costs associated with hiring smokers (due to having to establish smoke rooms) outweigh the benefits. What can the government do to prevent or mitigate the discrimination law suits that might result from a firm's hesitation to hire a smoker after the ban is implemented?

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aw_gitman_pmf_10|Case Studies in Finance|Case 3: Connect Cable Contractors

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Case Studies in Finance

Case 3: Connect Cable Contractors Entrepreneurial Decision Making

Caldwell Cable Company is responsible for providing and maintaining cable services to Lexington County in South Carolina. To reduce expenses and remove the burden of providing insurance and company vehicles, Caldwell Cable hires outside contractors to perform installations and initial connection of cable service. Every three years the cable contract expires and anyone can submit a closed-bid in an attempt to get the contract. Until recently, P&R Cable, owned by Bob Martin, held the contract. Five years ago, Bob promoted an installer from within the company, named Steve Seiler, to run the business. Since then, Steve has taken on full responsibilities at P&R. On March 15, the contract came up for bid again. Over-burdened by the additional responsibilities and displeased with Bob's unwillingness to share in the profits of P&R, Steve decided to submit a closed bid under the company name "Connect Cable Contractors." Connect Cable underbid P&R by 2% (This figure was discovered later when all the bids became public record after the contract was awarded). This, coupled with Caldwell Cable's preference for working with Steve, caused Caldwell to award the contract to Connect Cable. Steve now faced several new obstacles. In the course of complying with industry regulations, Steve found that Bob's treatment of worker's compensation was not in compliance with IRS regulations. Under the previous contract, Bob had passed on worker's compensation premiums to his three sub-contractors by deducting 12% from their gross weekly paycheck. By law, Bob should have paid a fixed amount of approximately $6,000 a year. This amount is the responsibility of P&R, not of each sub-contractor. Steve now has to pay the $6,000 at the beginning of the year and cannot pass on the charges to his sub-contractors. Each sub-contractor is paid on a per job basis and Steve is given an override on each job. Exhibit 1 lists the various jobs that can be performed and the amount both Steve and his sub-contractors earned under the previous contract. Exhibit 1 Various jobs that can be performed and the price Bob paid for each under the previous contract Type of job

Bob's price

Overhead Install

$14.50

Underground Install

$14.50

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A/O(unwired-w/)

$5.50

A/O( wired-w/)

$5.50

VCR (w/ install)

$1.50

Long Drop

$10.00

Replace Drop

$14.50

Relocate; A/O Only: Wired

$10.00

Unwired

$10.00

Reconnect

$10.50

VCR (w/ reconnect)

$1.50

VCR Hook-Up Only

$6.50

Upgrades

$6.50

Trip Charge

$5.00

With the removal of the 12% charge, the current amounts that are paid to sub-contractors per  job are too high. Therefore, Steve must decide on a new level of prices to pay each person per job. His goal is to pay the sub-contractors more, in real  terms, but less in nominal  terms. For example, if Steve reduces the pay on a job by exactly 12%, this would be a decrease of 12% in nominal  terms, but no change in pay in real  terms because the 12% decrease is offset by the sub-contractors not having to pay 12% for worker's compensation. Steve would prefer to give them a raise of between 7%-8%, in real  terms. Furthermore, Bob's old prices are not commensurate with the level of difficulty each job entails. For example, "replacing a drop" is much easier than completely installing cable in a house for the first time, yet both jobs pay the same amount. This disparity in prices relative to the amount of time required to complete a job causes low morale and overall dissatisfaction. Steve, therefore, must revamp the pricing structure to reflect the level of time each job requires and include an increase in real  pay of approximately 7%-8%. The previous prices are consistent relative to each other with the following exceptions. First, overhead and underground installations are priced the same as replacing a drop. Because understanding the differences between the three requires a great familiarity with the cable industry, the analysis will be simplified by informing the reader that overhead installations require the most time, followed by underground installations, then finally replacing the drop. For this reason, Steve would like to pay a higher price for overhead installations, a lower price for underground installations, and an even lower price for replacing a drop. These prices should be altered only slightly as all three are still more time consuming than a basic reconnect. Second, the previous price structure paid the same amount for installing an additional cable outlet whether or not the outlet was already wired (Exhibit 1, lines 3 and 4. Also lines 8a and 8b.). From a sub-contractor's standpoint, installing cable wire for an additional outlet is not worth the small amount of revenue received, whereas activating an existing line is very quick

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aw_gitman_pmf_10|Case Studies in Finance|Case 3: Connect Cable Contractors

and easy. Since both jobs paid the same amount, many sub-contractors avoided installing unwired outlets. This caused Bob to lose revenue. Steve knew that something had to be done to entice sub-contractors to promote the installation of additional outlets. After deciding on the new prices, Steve wishes to demonstrate to his employees that in real  terms, they will be better off. To show the resulting increases in real  income, Steve asked each sub-contractor for a copy of their invoices since the "time window" system was initiated in January of this year. Steve felt that using records prior to January would be misleading since the time windows have caused a permanent decrease in everyone's income. Due to constraints, such as incompletely kept records and Bob's unwillingness to provide official records, Steve was able to gather only five weeks of records for one sub-contractor named Burt. A second subcontractor, Chris, provided Steve with nineteen weeks of financial records; Steve kept all twenty weeks worth of records on himself. From this data, Steve calculated a weekly average of the number of each job performed by each sub-contractor, including himself. These weekly averages are shown in Exhibit 2. Exhibit 2 Weekly averages of the number and type of job performed by each sub-contractor from January 1995 to the first week in March 1995

Type of job

Steve's Average number Burt's Average number of each job per week  of each job per week 

Chris' Average number of each job per week 

Overhead Install

5.5

11.8

8.1

Underground Install

6.9

1.6

7.6

A/O(unwired-w/)

17.8

17.6

18.5

A/O( wired-w/)

20.3

11.6

9.9

VCR (w/ install)

9.2

11.6

11.9

Long Drop

2.1

4.6

3.7

Replace Drop

3.0

2.8

0.9

Wired

2.0

0.4

0.8

Unwired

7.8

3.4

8.4

Reconnect

9.9

6.8

7.2

VCR (w/ reconnect)

9.9

2.8

3.8

VCR Hook-Up Only

0.0

0.0

0.0

Upgrades

1.0

1.0

1.0

Trip Charge

0.5

1.2

2.4

Relocate; A/O Only:

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aw_gitman_pmf_10|Case Studies in Finance|Case 3: Connect Cable Contractors

approximately 7%-8%? As you perform the analysis and answer the following questions, remember that Steve's employees will surely ask you to explain the assumptions you have made and where the calculations came from. Keep in mind that the purpose of the new pricing structure is to benefit the employees as well as Steve and to allow for a smooth transition in the transfer of the contract from Bob to Steve. Questions

1. Complete the following table. Be sure to reflect both adjustments for the time required to do different jobs and a 7%-8% increase in REAL pay for each sub-contractor. Table 1 Calculations Worksheet for New Prices

Type of job

(1) (2) (3) = {[(2)-(1)(1-.12)]/ (1)(1-.12)}*100 Bob's price Steve's price Percentage increase in pay

Overhead Install Underground Install A/O(unwired-w/) A/O( wired-w/) VCR (w/ install) Long Drop Replace Drop Relocate; A/O Only: Wired Unwired Reconnect VCR (w/ reconnect) VCR Hook-Up Only Upgrades Trip Charge

2. How much did Chris and Burt earn under Bob's old pricing per week? 3. How much more will they earn per week under Steve's new system? Table 2 Calculations Worksheet for Increases in Weekly Earnings Under the New Pricing System for Chris http://wps.aw.com/aw_gitman_pmf_10/0,6047,347186-,00.html (4 of 6) [11/27/2002 12:19:38 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 3: Connect Cable Contractors

Average number of  each job per week

Type of job

Dollar increase in pay per job

Total dollar increase In pay per type of job

Overhead Install Underground Install A/O(unwired-w/) A/O( wired-w/) VCR (w/ install) Long Drop Replace Drop Relocate; A/O Only: Wired Unwired Reconnect VCR (w/ reconnect) VCR Hook-Up Only Upgrades Trip Charge

Table 3 Calculations Worksheet for Increases in Weekly Earnings Under the New Pricing System for Burt

Type of job

Average number of  each job per week

Dollar increase in pay per job

Overhead Install Underground Install A/O(unwired-w/) A/O( wired-w/) VCR (w/ install) Long Drop Replace Drop Relocate; A/O Only: Wired

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Total dollar increase In pay per type of job

aw_gitman_pmf_10|Case Studies in Finance|Case 3: Connect Cable Contractors

Unwired Reconnect VCR (w/ reconnect) VCR Hook-Up Only Upgrades Trip Charge

4. How much MORE will EACH sub-contractor earn under the new pricing structure per year?

5. In question 3, you assumed that they will work the same number of each job in each of the 52 weeks throughout the year. How valid of an assumption is this? Is the assumption just as valid for each sub-contractor? Explain.

6. Based on your results from Question 2, can Steve hire another sub-contractor to help cope with the new time windows without cutting into the existing contractor's income too much? Explain.

7. The entire analysis is based on using data that dates back only to January of this year. What are the advantages and disadvantages of using such a period in the case?

8. In addition to the steps suggested in the case, what else can Steve do to increase his chances of renewing the contract three years from now? This may be the most important question in the case!

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aw_gitman_pmf_10|Case Studies in Finance|Case 4: IBP

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Case Studies in Finance

Case 4: IBP Financial Statement Construction: The Balance Sheet

IBP, Inc., now a division of Tyson Foods and a worldwide provider of various food products, had achieved record fourth quarter earnings. The company felt the results were due primarily to IBP's focus on the "home-meal replacement" market segment. For years the traditional family unit has undergone tremendous change. The "typical" American household no longer consists of a working father and a stay-at-home housewife mother who prepares four course meals for the family (which includes 2.4 children). Today, there is no one definition of a "family" or "household." Phrases used to describe life today include, duel family incomes, fast-food takeout, microwave cooking, etc. People just don't seem to have the time or are not willing to make the time to cook at home the way they used to. Forbes Magazine reports that a decade ago 70% of all purchases from the grocery store were for ingredients used to make meals in the home. Today, only 47 cents out of every dollar are spent on ingredients. What then are people spending their money on at the grocery store? They're buying meals that are prepared someplace else and only need to be heated up. The food industry refers to this as ready-to-cook or ready-to-eat meals. Examples include frozen pizzas, deli sandwiches, canned soup, frozen dinners, chicken pot pies, frozen sausage biscuits, and the list goes on and on. Industry experts predict this trend will continue for the foreseeable future. In fact, they say that within the next ten years, this market segment will represent over two-thirds of all grocery store purchases. Even in these exciting times of record earnings, IBP must be sure to keep track of their accounting. Below is a list of all the items found on their Balance Sheet. Reconstruct IBP's Balance Sheet by arranging the items in their correct order. An Alphabetical Listing of IBP's Balance Sheet Items

1.

Accounts payable and accrued expenses

2.

Accounts receivable

3.

Accumulated depreciation and amortization (843,937) 903,837

4.

Additional paid-in capital

5.

Assets

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$

565,517 599,999

405,278

aw_gitman_pmf_10|Case Studies in Finance|Case 4: IBP

6.

Buildings and stockyards

7.

Cash and cash equivalents

8.

Commitments and Contingencies Stockholders' Equity

9.

Common stock, $.05 par value per share

544,711 $

10. Construction in progress

27,254

4,750 168,256

11. Current Assets 12. Current Liabilities 13. Deferred credits and other liabilities deferred income taxes other Total deferred credits and other liabilities 14. Deferred income tax benefits 15. Deferred income taxes 16. Equipment

17,037 148,811 165,848 51,781 1,818 1,096,571 1,747,774

17. Federal and State income taxes

152,122

18. Inventories

405,418

19. Land and improvements

106,492

20. Liabilities and Stockholder's Equity 21. Marketable securities 22. Net Property, plant, and equipment

1,400 1,072,093

23. Notes payable to banks

140,967

24. Other Total current liabilities

5,388 865,812

25. Other

(16,456)

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aw_gitman_pmf_10|Case Studies in Finance|Case 4: IBP

Treasury stock Total Stockholder's Equity 26. Other assets Goodwill Other Total other assets

(60,383) 1,400,914

724,089 115,099 839,096

27. Preferred stock 28. Prepaid expenses

0 10,983

29. Property, plant, and equipment 30. Retained earnings 31. Total Assets 32. Total Current Assets 33. Total Liabilities and Stockholder's Equity 34. Total Long-term Obligations

1,067,725 $3,008,096 1,096,815

$3,008,096 575,522

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aw_gitman_pmf_10|Case Studies in Finance|Case 5: Chrysler

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Case Studies in Finance

Case 5: Chrysler Ratio Analysis

Before Chysler merged to become DaimlerChrysler AG, they were presented with a takeover bid of $55 per share by MGM billionaire Kirk Kerkorian and former Chrysler chairman Lee Iacocca. Kirk Kerkorian was a stockholder in Chrysler and an experienced takeover financier who apparently found Chrysler to be a good buy. Chrysler rejected the offer, however, stating that the firm was not for sale. Further, many Wall Street experts felt that Kerkorian could not come up with the $20 billion necessary to complete the deal. After Chrysler rejected Kirk Kerkorian's bid of $55 per share, Kerkorian decided to have his people repeat the analysis of the firm's financial performance over the two most recent years to determine if he should increase his bid in this friendly takeover attempt. To measure the financial performance of Chrysler over the past two years, key financial ratios will have to be computed and compared with industry averages. To help in this endeavor, Chrysler's financial statements are found on the following pages. Chrysler Corporation's Balance Sheet for the year ending December 31 (in millions)

 Assets Current Assets Cash and cash equivalents Marketable securities Accounts receivable Inventories Prepaid taxes Finance receivables Total Current Assets Property & equipment Less: Accumulated Depreciation Net Plant & Equipment Other Assets Special tools Intangible assets Deferred tax assets

This year

Last year

$ 5,543 $ 2,582 $ 2,003 $ 4,448 $ 985 $13,623 $29,184 $20,468 $ 7,873 $12,595

$ 5,145 $ 3,226 $ 1,695 $ 3,356 $ 1,330 $12,433 $27,185 $18,281 $ 7,208 $11,073

$ 3,566 $ 2,082 $ 490

$ 3,643 $ 2,162 $ 395

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Other assets Total Assets

$ 5,839 $53,756

$ 5,081 $49,539

$ 8,290 $ 2,674 $ 7,032 $ 1,661 $19,657

$ 7,826 $ 4,645 $ 5,582 $ 811 $18,864

$ 9,858 $ 9,217 $ 4,065 $23,140 $42,797

$ 7,650 $ 8,595 $ 3,736 $19,981 $38,845

Stockholder's Equity Preferred stock Common stock (at $1 par) Additional paid-in capital Retained earnings Treasury stock Total Shareholder's Equity

$ 0 $ 408 $ 5,506 $ 6,280 ($1,235) $10,959

$ 2 $ 364 $ 5,536 $ 5,006 ($ 214) $10,694

Total Liabilities and Share. Equity

$53,756

$49,539

Liabilities Current Liabilities Accounts payable Short-term debt Accrued liabilities Other payments Total Current Liabilities Long-term Liabilities Long-term debt Accrued employee benefits Other non-current liabilities Total Long-term Liabilities Total Liabilities

Chrysler Corporation's Income Statement for the year ending December 31, (in millions)

Sales revenue Less: Cost of goods sold Gross profits Less: Operating expenses Selling & admin. $4,064 Pension $ 405 Nonpension post ret. $ 758 Depreciation $1,100 Amort. of tools $1,120 Total operating expenses Operating profits Less: Interest expenses

This year $53,195 $41,304 $11,891

Last year $52,235 $38,032 $14,203

$ 7,447 $ 4,444 $ 995

$ 7,436 $ 6,767 $ 937

$3,933 $ 714 $ 834 $ 994 $ 961

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aw_gitman_pmf_10|Case Studies in Finance|Case 5: Chrysler

Net profit before taxes Less: Taxes (40%) Net profit after taxes

$ 3,449 $ 1,380 $ 2,069

$ 5,830 $ 2,332 $ 3,498

Industry Average Financial ratios this year and last year This year Liquidity Net Working Capital Current Ratio Quick Ratio (Acid Test)  Activity Inventory Turnover Average Age of Inventory Average Collection Period Fixed Asset Turnover Total Asset Turnover

$5,056 1.78 1.55

$4,892 1.69 1.51

7.41 .021 22.8 1.54 .89

7.58 .021 23.4 1.62 .91

Debt Debt Times Interest Earned Profitability Gross Profit Margin Net Profit Margin Return on Total Assets Return on Equity

Last year

75% 6.4

77% 7.0

24% 4.7% 4.6% 20.7%

28% 4.9% 4.7% 33.8%

Questions

1. Compute Chrysler's financial ratios for the past two years. 2. Compare these ratios to the industry's average. Comment on Chrysler's strengths and weaknesses by ratio category.

3. Should Kerkorian have pursued the purchase of Chrysler? 4. If Kerkorian did not want to takeover Chrysler, what other reasons might he have had for trying to convince other people that Chrysler was a takeover candidate?

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aw_gitman_pmf_10|Case Studies in Finance|Case 5: Chrysler

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aw_gitman_pmf_10|Case Studies in Finance|Case 6: Moog

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Case Studies in Finance

Case 6: Moog Financial Statement Construction: Consolidated Statement of Earnings

The future of military warfare is being defined by innovations and advancements in technology. For example, Moog, Inc., has recently seen their flight control device installed in the V-22 Osprey, a wing-folding aircraft that is effectively both a helicopter and a fighter plane. But this is just the tip of the iceberg. Moog is in the process of creating technology that will allow unmanned vehicles and airplanes to be operated by remote control. Sound like futuristic science fiction? It really is not that far away. Think about the advantages of flying from a remote location. Today, it costs millions of dollars to train a single fighter pilot. When the pilot is lost in a war, a new pilot must be trained in his place. However, if the pilot is flying the plane from a remote, safe location, even when the plane is lost in a battle, the pilot will survive to flying again. Advancements are taking place in artillery as well. You may have heard of the expression, "I've got a bullet with your name on it." Well, this may be more true than you realize. Smart bullets are being developed that use the same technology as a guided missile. Instead of locking on a stationary target many miles away, this bullet will receive continually updated target location information that will enable it to follow a moving target even if that target goes around corners. No matter how good Moog's technology, they still need to construct their Consolidated Statement of Earnings to continue to be a successful company. Below is an alphabetical list of the items that appear on their Consolidated Statement of Earnings. Using these items, reconstruct the statement by putting all of the items in the correct order. Double check your answer to make sure the numbers add up. Items on the Consolidated Statement of Earnings Cost of Sales

$493,235

Earnings Before Income Taxes

$42,013

Income Taxes

$14,075

Interest

$32,054

Gross Profit Net Earnings

$211,143 $27,938

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aw_gitman_pmf_10|Case Studies in Finance|Case 6: Moog

Net Earnings Per Share Basic

$2.13

Diluted

$2.11

Net Sales

$704,378

Other

($64)

Research and Development

$26,461

Selling, general and administrative $110,679

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aw_gitman_pmf_10|Case Studies in Finance|Case 7: Kate Myers

Home > Case Studies in Finance > Case 7: Kate Myers >

Case Studies in Finance

Case 7: Kate Myers Basic Concepts: The Time Value of Money

After graduating from Ohio State University with a degree in Finance, Kate Myers took a position as a stock broker with Merrill Lynch in Cleveland. Although she had several college loans to make payments on, her goal was to set aside funds for the next eight years in order to make a down payment on a house. After considering the various suburbs of Cleveland, Kate chose Lakewood as her desired future residency. Based on median house price data, she learned that a three-bedroom, two-bath house currently costs $98,000. To avoid paying Private Mortgage Insurance (PMI), Kate wanted to make a down payment of 20%. Because it will be eight years before Kate buys a house, the $98,000 price will surely not be the same in the future. To estimate the rate at which the median house price will increase, she considered the historical price appreciation in Lakewood. In the past, homes appreciated by nearly 4% per annum. Kate was satisfied with this estimation. Merrill Lynch provides several opportunities for Kate to invest the funds that will be devoted to the purchase of her future home. She feels that a balanced account containing stocks, bonds, and government securities would realistically achieve an annual rate of return of 8%. Questions

1. Taking into consideration the fact that the $98,000 home price will grow at 4% per year, what will be the future median home selling price in Lakewood in eight years? What amount will Kate Myers have to accumulate as a down payment if she does decide to buy a house in Lakewood?

2. Based on your answer from number 1, how much will have to be deposited into the Merrill Lynch account (which earns 8% per year) at the end of each month to accumulate the required down payment?

3. If Kate decides to make end-of-the-year deposits into the Merrill Lynch account, how much would these deposits be? Why is this amount greater than twelve times the monthly payment amount?

4. If homes in Lakewood appreciate by 6% per annum over the next eight years instead of the assumed 4%, how much would Kate have to deposit at the end of each month to make the down payment? What if the appreciation is only 2% per year?

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aw_gitman_pmf_10|Case Studies in Finance|Case 7: Kate Myers

5. If Kate decided to deposit her down payment funds in less risky certificates of deposit (CDs) earning only 4%, how much would she have to deposit at the end of each month to make the down payment? What if she pursued a more risky investment of growth stocks that have an expected return of 12%?

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aw_gitman_pmf_10|Case Studies in Finance|Case 8: Quilici Family

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Case Studies in Finance

Case 8: Quilici Family Basic Concepts: The Time Value of Money

Greg and Debra Quilici own a four bedroom home in an affluent neighborhood just north of San Francisco, California. Greg is a partner in the family owned commercial painting business. Debra now stays home with their child, Brady, who is age 5. Until recently, the Quilicis have felt very comfortable with their financial position. After visiting Lawrence Krause, a family financial planner, the couple became concerned that they were spending too much and not putting enough funds aside for both their child's future education needs and their own retirement. Greg earns $85,000 per year, but with the rising costs of education, their past contribution efforts have left them short of their financial goals. To estimate the amount of money the Quilicis need to begin putting away for future security some general information was obtained by their financial planner. The couple felt that the amount of money they currently contribute to their Koegh plan would be sufficient for their retirement needs. What they had not accounted for was Brady's education. Greg is an alumni of Stanford University, a private school with an extremely high tuition of approximately $20,000 per year. Debra graduated from the University of North Carolina at Chapel Hill. The tuition expense there is only $2,500 per year. When Brady turns 18, the couple wishes to send him to either of these exceptional universities. They have a slight preference for the much more local Stanford University. The problem, however, is that with the rate at which tuition is increasing the Quilicis are not sure they can raise enough money. To assist in the calculations, assume the tuition at both universities will increase at an annual rate of 5%. Living expenses are currently estimated at $6,000 per year at both schools. This expense is expected to grow at only 3% per year. Further assume the Quilicis can deposit their money into a growth oriented mutual fund at Neuberger & Berman Management, Inc., which has historically earned a 12% return per annum (1% per month). The couple wishes to have a pre-determined monthly amount automatically drafted from their checking account. When Brady starts college they will slowly liquidate the account by making an annual payment to Brady to cover tuition and living expenses at the beginning of each year for the four years he will be in college. Questions

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aw_gitman_pmf_10|Case Studies in Finance|Case 8: Quilici Family

attend? Give an answer for each university.

2. Once Brady starts college what will his total expenses be in each of his four years? Again, give an answer for each university.

3. How much money will Greg and Debra have to deposit per month to allow Brady to attend Stanford University? How much money will have to be deposited per month to allow Brady to attend the University of North Carolina? (HINT: To answer this question you need to consider the costs of ALL four years.)

4. What if the Quilicis feel the Neuberger & Berman mutual fund will only yield 10%. How much will have to be deposited per month in order for Brady to attend each college?

5. What is the relationship between the amount that must be deposited monthly by the parents and the future increases in both tuition and living expenses?

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aw_gitman_pmf_10|Case Studies in Finance|Case 9: Wal-Mart

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Case Studies in Finance

Case 9: Wal-Mart Basic Concepts: Risk and Return Analysis

Marvin Brown is a savvy investor who is always looking for a sound company to include in his portfolio of stocks and bonds. Being somewhat risk-averse, his main objective is to buy stock in firms that are mature and well-established in their respective industries. Wal-Mart is one of the stocks Marv is currently considering for inclusion in his portfolio. Wal-Mart has four major areas of business: traditional Wal-Mart discount stores, Supercenters, Sam's Clubs, and international operations. Although Wal-Mart was established over 50 years ago, it continues to achieve growth through expansion. The Supercenter concept, which combines groceries and general merchandise, is extreme success as 75 new Supercenters were opened last year alone. Another 95 will be opening over the next two years. Sam's clubs have also seen success as 99 Pace stores (Pace is one of Sam's former Competitors) were converted to Sam's stores in 1995. In addition to taking over competitor stores, Sam's also opened 22 new stores of its own. Internationally, the picture is equally as rosy. In Canada, 122 former Woolco stores were converted to Wal-Mart discount stores. Expansion has reached Mexico and Hong Kong as well, as 24 Clubs and Supercenters and 3 "Value Clubs" were established, respectively. Wal-Mart plans to continue its reign as the world's largest retailer through expansion by developing the previously discussed 95 Wal-Mart discount stores, 12 new Supercenters and 9 new Sam's Clubs. Internationally, 20 to 25 new stores will be built in Hong Kong, China, Argentina, Brazil and Canada. In order to determine if Wal-Mart is a "good buy," Marv has to perform several analyses. First, he must calculate the returns on Wal-Mart's common stock over the past eight quarters as an indicator of how the stock might perform over the next year. He must then calculate the standard deviation of the stock as a proxy for its risk. To aid in his calculation, Marv has gathered the following stock price and dividend data. Table 1 Quarterly Stock Prices

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aw_gitman_pmf_10|Case Studies in Finance|Case 9: Wal-Mart

Quarter

Closing Stock Price

June 2002

$55.01

March 2002

$61.22

December 2001

$57.41

September 2001

$49.32

June 2001

$48.54

March 2001

$50.16

December 2000

$52.69

September 2000

$47.67

Table 2 Quarterly Dividend Payments Date

Dividend Payment

June 19, 2002

$0.08

March 20, 2002

$0.08

December 19, 2001

$0.07

September 19, 2001

$0.07

June 20, 2001

$0.07

March 21, 2001

$0.07

December 20, 2000

$0.06

September 13, 2000

$0.06

Questions

1. Calculate the returns for each of the seven  quarters. 2. Calculate the standard deviation of the returns from question 1. 3. Assume that Wal-Mart has a Beta of 1.2, the risk-free rate of interest (i.e. as proxied by the return on a 3-month treasury bill) is 5.25%, and the return on the market is 12.2% annually (as proxied by the return on the Standard & Poor's 500). Based on CAPM, what is the required rate of return on Wal-Mart's stock?

4. Using your answer from question 3, if Wal-Mart had an expected return of 14%, would Marv be well advised to purchase the stock? At what minimum expected rate of return would Marv be encouraged to buy the stock?

5. Marv has based his buy decision on quarterly data from the past two years. If the same analysis was performed five years ago or five years from now, do you think http://wps.aw.com/aw_gitman_pmf_10/0,6047,347188-,00.html (2 of 3) [11/27/2002 12:19:58 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 9: Wal-Mart

Marv might have come to a different conclusion? Discuss the effect that choosing this particular time period might have on Marv's results.

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aw_gitman_pmf_10|Case Studies in Finance|Case 10: In tel

Home > Case Studies in Finance > Case 10: Intel >

Case Studies in Finance

Case 10: Intel Basic Concepts: Portfolio Risk and Return Analysis

Michael Frank is an individual investor who is currently considering the purchase of $4,000 worth of Intel's common stock. Mike already has a significant amount invested in the computer industry, but he feels Intel will be one of the leading companies in the future. One of the reasons for this perceived future success is the Research and Development being done in the area of parallel supercomputers. Justin Rattner, Intel's former scientist of the year, is a leading researcher in parallel supercomputing. Parallel supercomputing breaks down a complex problem into many, easier to manage components. Further, all of these components can be manipulated simultaneously. It is analogous to Tom Sawyer getting all his friends to paint the fence. The speed of parallel computers is much faster than their larger and supposedly faster computers competitors. Computer chip manufacturers are concerned primarily with speed and the size of the components necessary to generate the speed. With Intel leading the way in this emerging area, Mike feels he should own their stock. One concern Mike has is how the inclusion of Intel's common stock will affect the overall return and risk of the computer stocks he currently owns. Presently, Mike holds $2,000 worth of IBM, $3,500 in Compaq, and $4,500 in Apple. To determine the impact of the purchase of $4,000 worth of Intel, Mike has calculated the expected annual returns over the next eight years for each of the four stocks. The expected returns for each are shown in the table below. Years into Expected Return for each Company (%) the future IBM Compaq Apple Intel 1

6.2

0.1

-4.2

4.8

2

7.8

2.8

6.6

10.2

3

6.9

-1.9

12.2

11.3

4

-4.1

2.9

7.8

18.1

5

8.9

7.7

4.3

6.6

6

10.2

15.1

-2.1

-1.8

7

15.3

19.3

8.4

2.7

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aw_gitman_pmf_10|Case Studies in Finance|Case 10: In tel

8

9.2

14.2

10.2

10.9

The beta of Intel is projected to be 1.1 over the next eight years. The betas of IBM, Compaq, and Apple assumed to be 0.7, 1.6, and 1.0, respectively. Mike wants to see what affect the purchase of Intel will have on the beta of his overall portfolio. He is assuming the beta of each firm will remain constant over the eight year period. Questions

1. Calculate the expected return for each of the next eight years without the inclusion of Intel.

2. Calculate the expected return for each of the next eight years with the inclusion of Intel.

3. Calculate the standard deviation for each of the next eight years without the inclusion of Intel.

4. Calculate the standard deviation for each of the next eight years with the inclusion of Intel.

5. Calculate the beta of the portfolio both with and without Intel. 6. We have assumed that beta will be constant over the next eight years. How realistic is this assumption. That is, does beta tend to remain constant over time?

7. Which measure of risk is more appropriate when considering Intel's inclusion into Mike Frank's portfolio, standard deviation or beta?

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aw_gitman_pmf_10|Case Studies in Finance|Case 11: Amber Plank 

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Case Studies in Finance

Case 11: Amber Plank Term Structure of Interest Rates

Amber Plank is a high school senior who plans to attend college next year and major in Astronomy. Her first choice is to attend the University of Charleston, which is highly regarded in her intended field. However, to do so she will have to take out a substantial amount of loans as this is a private university with high tuition costs. While loan rates today are not high by historical standards, Amber will be charged the one-year rate that exists at the time she takes out the loans. That is, each year when she borrows to pay for her tuition, she will be assessed interest at a rate consistent with the short-term rate that exists in the future. Amber's second collegiate choice is to attend the University of Florida. The benefit of doing so is that she will receive a full scholarship and thus will not have to borrow in order to attend this institution. The drawback is that while this is a fine university, it does not specialize in her major. Selecting which university to attend is an extremely important decision to make. In order to perform a complete cost comparison between the two universities, Amber must determine the future one-year interest rates that are likely to exist. Since they are the rates at which she will have to borrow in the future, accuracy is extremely important as these interest costs will eventually be used in a cost-benefit analysis. Table 1 lists today's rates that exist for U.S. Treasury securities of various maturities. Table 1 Time To Maturity Yield to Maturity 1 year

7.0%

2 years

7.5%

3 years

8.0%

4 years

8.5%

5 years

8.6%

Questions

1. What are the four most important variables that determine a bond's yield to maturity?

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aw_gitman_pmf_10|Case Studies in Finance|Case 11: Amber Plank 

2. Define a Yield Curve. 3. Explain the Expectations Hypothesis and use the theory to try to predict what the oneyear interest rates will be over the next five years.

4. Explain the Liquidity Preference Hypothesis and use the theory to try to predict what the one-year interest rates will be over the next five years.

5. Explain the Market Segmentation Hypothesis and use the theory to try to predict what the one-year interest rates will be over the next five years.

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aw_gitman_pmf_10|Case Studies in Finance|Case 12: Fruit of the Loom

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Case Studies in Finance

Case 12: Fruit of the Loom Bond Ratings

On August 5, 1999, the Standard & Poor's CreditWire reported that Fruit of the Loom's 8.875% senior notes, which mature in 2006, were downgraded from BB- to B. This downgrade came after the company recently amended its credit agreement on all other outstanding issues which effectively made the 8.875% notes subordinate to existing claims. Since this represented a mere shuffling of priority claims, Fruit of the Loom's overall corporate credit rating remained at BB- as did the rating of all but one other claim (an $850 million senior unsecured debt shelf filing was downgraded to B as well). The corporate BB- rating was justified by Standard & Poor's because while Fruit of the Loom still has strong brand name recognition and holds significant market share in underwear, imprinted T-shirt and fleece markets, they are having performance and operational difficulties. Below is a qualitative description of each of Standard & Poor's bond rating categories. Table 1 Standard & Poor's Bond Rating Scale

AAA - An obligor rated 'AAA' has EXTREMELY STRONG capacity to meet its financial commitments. AA - An obligor rated 'AA' has VERY STRONG capacity to meet its financial commitments. It differs from the highest rated obligors only in small degree. A - An obligor rated 'A' has STRONG capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher•rated categories. BBB - An obligor rated 'BBB' has ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments. BB - An obligor rated 'BB' is LESS VULNERABLE in the near term than other lower•rated obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions which could lead to the obligor's inadequate capacity to meet its financial commitments.

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aw_gitman_pmf_10|Case Studies in Finance|Case 12: Fruit of the Loom

B - An obligor rated 'B' is MORE VULNERABLE than the obligors rated 'BB', but the obligor currently has the capacity to meet its financial commitments. Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments. CCC - An obligor rated 'CCC' is CURRENTLY VULNERABLE, and is dependent upon favorable business, financial, and economic conditions to meet its financial commitments. CC - An obligor rated 'CC' is CURRENTLY HIGHLY VULNERABLE. R - An obligor rated 'R' is under regulatory supervision owing to its financial condition. During the pendency of the regulatory supervision the regulators may have the power to favor one class of obligations over others or pay some obligations and not others. Please see Standard & Poor's issue credit ratings for a more detailed description of the effects of regulatory supervision on specific issues or classes of obligations. SD and D - An obligor rated 'SD' (Selective Default) or 'D' has failed to pay one or more of its financial obligations (rated or unrated) when it came due. A 'D' rating is assigned when Standard & Poor's believes that the default will be a general default and that the obligor will fail to pay all or substantially all of its obligations as they come due. An 'SD' rating is assigned when Standard & Poor's believes that the obligor has selectively defaulted on a specific issue or class of obligations but it will continue to meet its payment obligations on other issues or classes of obligations in a timely manner. Please see Standard & Poor's issue credit ratings for a more detailed description of the effects of a default on specific issues or classes of obligations.

Note: Obligors rated 'BB', 'B', 'CCC', and 'CC' are regarded as having significant speculative characteristics. 'BB' indicates the least degree of speculation and 'CC' the highest. While such obligors will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions. Plus (+) or minus (•): Ratings from 'AA' to 'CCC' may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. Source: Standard & Poors Questions

1. Define what is meant by "a Pecking Order". 2. Why is it, specifically, that the 8.875% bond received a downgrading from BB- to B? 3. Should the stock price react to this bond's down rating? Why or why not? 4. Why is it that firms in different industries can have the same capital structure and the

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aw_gitman_pmf_10|Case Studies in Finance|Case 12: Fruit of the Loom

same Earnings Per Share (EPS), but still have a different bond rating?

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aw_gitman_pmf_10|Case Studies in Finance|Case 13: Nations Bank 

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Case Studies in Finance

Case 13: Nations Bank Valuation: Stock Valuation - the Gordon Growth model

Before Nations Bank was bought by Bank of America, Tina Brown was considering the purchase of Nations Bank's common stock. Given Nations Bank's recent merger with the Southeastern powerhouse, Bank South, and talks of penetration into the Florida market via a takeover of Barnett Bank, Tina felt Nations Bank would be a solid "buy and hold" as it continued to increase its market share through aggressive growth by acquisition. While Tina was convinced she wanted to own Nations Bank, with all the price volatility surrounding the recent speculations, she was not sure if the price was above or below the stock's intrinsic value. She decided to derive the price of Nations Bank's common stock by using the Gordon Growth Model (Constant Growth Model). To use the Gordon Growth Model, Tina had to first calculate Nations Bank's required rate of return on their common stock. The risk free rate, as proxied by the yield on a three month Treasury Bill, was 6%. The return on the market, as proxied by the return on the Standard and Poor's 500 (S&P 500), was 10%. Nations Bank had a beta of 1.75. Past dividend payments also had to be known. Tina was not sure how far back into the future she should go to retrieve the dividend payment information, so she arbitrarily stopped in 1987. Between 1987 and 1990, Nations Bank seemed to have very different payout amounts. Not fully understanding the reasons behind these differences, Tina decided to consider two periods for analysis: from 1987-1995 and from 1990-1995. The dividend information that Tina recovered is shown below in Table 1. Table 1 Year

Dividends

1995 $2.00 ($1.00 through June 1995) 1994 $1.88 1993 $1.64 1992 $1.51 1991 $1.48 1990 $1.42 1989 $1.10

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aw_gitman_pmf_10|Case Studies in Finance|Case 13: Nations Bank 

1988 $0.94 1987 $0.86

Questions

1. Using the Capital Asset Pricing Model (CAPM), what was Nations Bank's required rate of return on common stock?

2. Consider the first time period from 1987-1995. Use the Gordon Growth Model to determine the price of Nations Bank's common stock.

3. Consider the second time period from 1990-1995. Use the Gordon Growth Model to determine the price of Nations Bank's common stock.

4. The answers for questions 2 and 3 are very different. What does this indicate, in general, about the Gordon Growth Model? (Hint--The observed market price of Nations Bank's common stock is $70.25.)

5. What effect does the stock's required rate of return have on the calculation of its stock price when using the Gordon Growth Model?

6. If you felt that Nations Bank's last year dividend of $2.00 was going to be paid in that constant amount throughout the remainder of the company's life (i.e. zero growth), what would be the value of the stock today?

7. Based on your response to question 6, what is the relationship between the present value of a dividend paid one year from now, a dividend paid ten years from now and a dividend paid one hundred years from now?

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aw_gitman_pmf_10|Case Studies in Finance|Case 14: AMR - American Airlines

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Case Studies in Finance

Case 14: AMR - American Airlines Valuation: Valuing a Corporate Bond Issue

AMR is the parent company of American Airlines. In addition to its primary subsidiary, AMR also operates several airline support companies such as the SABRE group (reservations), the Management Services Group, and American Eagle (a regional carrier). American Airlines is currently considering the issuance of a series of $1,000 par bonds. The coupon rate offered, based on current market interest rates and the Standard & Poor's based AMR bond rating, will be 10%. The current interest rate is coincidentally 10% as well. Interest on the bonds will be paid semi-annually. However, American cannot decide on the maturity of the new issue. The life of the bonds will be 10, 20, or 30 years. Questions

1. Ignoring floatation costs, what will the bonds sell for today if American decides to issue the bonds with a maturity of 10 years? What will the price be if the bonds have a maturity of 20 years? 30 years?

2. If the bonds are issued with 10 years to maturity and the day after they are issued, the market interest rates increase to 12%, what will be the price of American Airline's bonds? What if interest rates drop to 8%?

3. If the bonds are issued with 20 years to maturity and the day after they are issued, the market interest rates increase to 12%, what will be the price of American Airline's bonds? What if interest rates drop to 8%?

4. If the bonds are issued with 30 years to maturity and the day after they are issued, the market interest rates increase to 12%, what will be the price of American Airline's bonds? What if interest rates drop to 8%?

5. Based on your answers to questions 2 through 4, what is the relationship between time to maturity and the price of the bond?

6. Based on your answer to question 1, what is the relationship between current interest rates, the coupon rate, and time to maturity?

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aw_gitman_pmf_10|Case Studies in Finance|Case 14: AMR - American Airlines

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aw_gitman_pmf_10|Case Studies in Finance|Case 15: Mirage Resorts

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Case Studies in Finance

Case 15: Mirage Resorts Refunding a Bond Issue

Las Vegas is the fastest growing and arguably the most exciting city in the United States. In fact, Las Vegas now has more visitors than Orlando or the entire state of Hawaii. The difference is, when people visit Orlando and Hawaii, they come to see theme parks and beaches and coincidentally stay in hotels. But, when people come to Las Vegas, they come to see its hotels. Mirage Resorts owns several hotels along the Las Vegas strip: The Mirage, Golden NuggetLas Vegas, and Treasure Island. Other hotels, not in Vegas include the Golden NuggetLaughlin and Casino Iguaza. When the Mirage hotel was first built, Mirage Resorts financed the project with 11% notes from the GNS Finance Corporation. These 20-year, $1,000 par, callable bonds had a face value of $40,000,000 and were issued in March of 1988. When they actually sold, they went at a discount at $970 each. The call price of each bond is $1,110. Further, when the bonds were originally issued, the floatation costs totaled $200,000. The unamortized debt discount is $39,065,000. Today, interest rates have dropped substantially. Mirage Resorts is considering the possibility that it might be able to refund the old bond issue and replace it with a new issue that has a much lower coupon rate. After meeting with several investment bankers, Mirage learned they could get new bonds at a much lower coupon rate. The new bonds are expected to sell at their par value of $1,000, have only an 8 1/2 coupon rate, and a 13-year maturity. Mirage estimates that there will be a two month overlapping period while it retires the old bond issue. Goldman Sachs was chosen to underwrite the issue because of their reputation and relatively low floatation costs. The deal held that Goldman Sachs would receive a fixed amount of $120,000 to cover administration expenses plus a variable amount equal to .4% of the par value of the offering. The selling group would receive another .3% of the par value upon the offering. Mirage Resorts has an after-tax cost of debt equal to 6% and their corporate tax rate is 35%. Questions

1. Calculate the total floatation costs associated with the new bond issue.

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aw_gitman_pmf_10|Case Studies in Finance|Case 15: Mirage Resorts

2. What is the initial investment required to issue the new debt? 3. What is the annual cash flow from the old bond issue? 4. What is the annual cash flow from the new bond issue? 5. Calculate the annual cash flow savings associated with the new bond issue. 6. What is the present value of the annual cash flow savings associated with the new bond issue? (Hint: these saving will occur every year until the bond issue matures.)

7. Should Mirage refund the bond issue? 8. Mirage issued the debt only seven years ago. Why is it that they are able to get such a lower interest rate today? Do you think Mirage Resorts should have waited until interest rates had decreased in the first place before building the Mirage hotel?

9. What factor(s) do you think were most responsible for the decision you made? That is, of all the factors that affect the refunding decision, which ones do you feel tend to have the greatest impact?

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aw_gitman_pmf_10|Case Studies in Finance|Case 23: Sou thwest Airlines

Home > Case Studies in Finance > Case 23: Southwest Airlines >

Case Studies in Finance

Case 23: Southwest Airlines Capital Budgeting: One Project - Accept/Reject Decision

The airline industry is extremely cyclical. That is, when the economy does well, so too do airlines. In recent years, the airline industry has found itself with too many seats and too few passengers. Some experts point to the past deregulation of the industry while others argue that technological advances such as teleconferencing are responsible. Several airlines such as Continental, America West, Eastern, and Trans World Airlines, have filed for Chapter 11 Bankruptcy. Some have fully recovered, while others have been forced to liquidate (Chapter 7). Narrowing profit margins have prompted airlines to develop creative survival tactics. Southwest Airlines has successfully found its niche in the industry by providing direct flight service to less traveled routes such as those to and from smaller cities. Since these routes do not generate nearly as much revenue as major city routes, Southwest has found ways to reduce its costs. Costs are reduced by following a no frills policy that the travelers refer to as "peanut flights." This means that instead of serving costly meals (the quality of which passengers have historically complained about anyway), Southwest serves just a bag of peanuts and a soft drink. With the recent success of short, direct flights, Southwest is considering the purchase of one such additional route. Before an airline applies to the federal government for a new route, a lengthy analysis is performed to determine the feasibility of the route. Expenses to consider include airport costs such as gate and landing fees and labor costs such as local baggage handlers and maintenance workers. Many times the airline will provide its own employees to load and unload luggage or to provide upkeep for their planes, but in the case of Southwest, they have so many small cities to service that the outsourcing of these jobs is not uncommon. Table 1 provides a summary of the after-tax cash flows associated with the acquiring of an additional small route. All costs and revenues are reflected by the following numbers. Table 1 Projected Net Cash flows (in Millions of Dollars) Year Net Cash flow 0

-$20.8

1

$4.5

2

$6.3

3

$5.2

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aw_gitman_pmf_10|Case Studies in Finance|Case 23: Sou thwest Airlines

4

$3.9

5

$2.1

6

$1.3

7

$0.5

Questions

1. What is the project's NPV assuming Southwest has a discount rate of 10%? How do we interpret the NPV?

2. What is the project's IRR? How is this measure different from the NPV? What is the interpretation of this number?

3. Calculate the project's Payback Period. 4. Assuming that Southwest has a required payback period of 5 years and a hurdle rate of 10%, should Southwest accept the additional route? Based on the project's NPV, should it be accepted? If conflicting conclusions occur, which criteria would you follow?

5. When will conflicts likely occur among the three criteria? 6. Calculate the project's Modified Internal Rate of Return (MIRR). What critical assumption does the MIRR make that differentiates it from the IRR?

7. Where does the value of MIRR fall relative to the discount rate and IRR?

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aw_gitman_pmf_10|Case Studies in Finance|Case 24: Acclaim Entertainment

Home > Case Studies in Finance > Case 24: Acclaim Entertainment >

Case Studies in Finance

Case 24: Acclaim Entertainment Capital Budgeting: Multiple Projects with Unequal Lives

Acclaim Entertainment, Inc. is a mass marketer of interactive entertainment software whose games can be played on such well known video game systems as Nintendo and Sega. Some of their more successful games include Mortal Kombat I and II, NBA Jam I and II, Maximum Carnage, Virtual Bart (Simpson), and NFL Quarterback. Acclaim has also obtained licenses from True Lies, Batman Forever, and Spiderman. The interactive entertainment industry is characterized by rapid technological change and as such, no single hardware system has achieved long-term dominance. Accordingly, Acclaim focuses its production efforts on the development of software for the hardware systems that dominate the interactive entertainment market at a given point in time or in the very near future. Presently, Acclaim has licensing agreements with three industry leaders: Sony Computer Entertainment of America (SCE), Nintendo, and Sega. Acclaim is currently in the design/production stage of a new version of Mortal Kombat. Since the previous versions of the game were extremely successful, Acclaim is not greatly concerned with the acceptance of the game by the general public. It is concerned, however, with the hardware platform that should be chosen to distribute the game. Since licensing agreements are extremely short term, Acclaim wonders which of the three hardware companies should carry Mortal Kombat. For example, the licensing agreement with SCE expires in December two years from now. The Nintendo agreement expires in December of this year and the Sega contract expires in December of next year. While these contracts expire and have traditionally been renewed every few years, there is no guarantee they will be successfully renewed or extended in the future. A further consideration involves the costs charged by each company. SCE, Nintendo, and Sega charge their licensees a fixed amount per unit based on chip configuration, memory capacity, and market price. This charge covers manufacturing, printing and packaging of the unit, as well as a royalty for the use of their respective names, proprietary information and technology. Furthermore, these charges are subject to adjustment at the discretion of SCE, Nintendo, and Sega. To offset the expenses of licensing fees, Acclaim must speculate on the ability of the three hardware platforms to access enough end-users to make their games profitable. Nintendo and Sega hold a grater share of the market, but SCE charges lower licensing fees. In general, the product life cycle in the interactive software business is from one month up to http://wps.aw.com/aw_git http://wps.aw.com/aw_gitman_pmf_10/0,6047,347 man_pmf_10/0,6047,347207-,00.html 207-,00.html (1 of 3) [11/27/2002 12:20:23 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 24: Acclaim Entertainment

eighteen months with the majority of sales occurring within the first three months after introduction. Although titles older than eighteen months may still be available for sale, Acclaim generally actively markets only its ten to fifteen most recently released titles. Mortal Kombat represents somewhat of an exception to the rule. Being one of the most successful products, Mortal Kombat's most feared competitor will be the prospect of the next version of Mortal Kombat. There has currently been no discussion of the number of games that will be produced in the series. Acclaim's management has assembled the following projected net cash flows associated with the distribution of Mortal Kombat. These net cash flows reflect all licensing fees, productions costs, advertising expenditures, revenues, etc. Table 1 Time Net cash flow (in millions) (end of year) SCE Nintendo Sega 0

-$40

-$40

-$40

1

$34

$44

$41

2

$10

$16

$18

3

$5

4

$1

$4

Questions

1. What is the Payback Period for Mortal Kombat when marketed under the three different hardware companies? Assuming a required payback period of 1 year, which company would you allow to carry the new product?

2. Assuming a discount rate of 10%, what is the Net Present Value (NPV) under each system? Under which system, if any, would you be willing produce Mortal Kombat?

3. What are the Internal Rates of Return (IRR) under each marketer? Which marketer(s) has/have acceptable IRRs?

4. Thus far we have assumed that Mortal Kombat will be marketed through only one hardware system. Under this assumption, the projects are mutually exclusive. If we explore the possibility of allowing more than one company to market Mortal Kombat, which company(ies) would you allow to market the product? Base your answer on the three criteria from the above questions.

5. Mortal Kombat will have a different life span depending on the hardware system Acclaim chooses. Since the lives of the three projects are not equal, can a comparison truly be made based on conventional NPV measures? Calculate the Annualized Net Present Value (ANPV) for each of the three alternatives. Based on

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aw_gitman_pmf_10|Case Studies in Finance|Case 24: Acclaim Entertainment

ANPV, which marketer would you choose to sell the product through if the projects were mutually exclusive? What if they were independent?

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aw_gitman_pmf_10|Case Studies in Finance|Case 25: Philip Morris

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Case Studies in Finance

Case 25: Philip Morris Capital Budgeting: Projects with Dissimilar Risks

When most people hear the name Philip Morris, they think of tobacco, or more specifically, Marlboro cigarettes. What most people do not realized is that the food products Philip Morris markets generate more sales revenue for the firm. Recognizable brand names include Kraft, Post, Maxwell House, and Entenmann's. Philip Morris is considering the introduction of two new products. The first product is a new breakfast cereal called Post Blueberry Morning. Post is an established name in the cereal market with a market share of 16.7%. Getting shelf space is extremely difficult and costly for most new products because grocery stores traditionally charge slotting fees. Slotting fees are fixed amounts that companies must pay to gain ideal shelf locations for their products. Post, however, feels less pressure from grocery stores because of the consumer demand for their products. With the consumer preference for Post brand cereal, Philip Morris feels that introducing Post Blueberry Morning will be a low risk venture. The second new product Philip Morris is considering the introduction of is a Gourmet Hazel Nut coffee that will be sold under the Maxwell House family of products. Maxwell House is also established in its market, but the coffee industry itself is more risky than the high profit margin breakfast cereal market. Coffee profits are strongly affected by the general swings in the commodity's price due to uncontrollable factors such as weather. From month to month the price of coffee fluctuates making profits from coffee sales fluctuate as well. In performing a capital budgeting analysis, Philip Morris recognizes that these two products should not be considered to be of equal risk. Therefore, traditional net present value analysis should not be used to decide which product, if any, to produce. To help the company decide how to handle the perspective investments, their finance department forecasted the projects' expected net cash flows. Both projects have an expected life of seven years. Table 1 shows the projected net cash flows associated with both projects. Table 1 Year

Net cash flow Net cash flow Gourmet Hazel Nut Post Blueberry Morning

0

-$4,000,000

-$2,500,000

1

$1,000,000

$803,000

2

$1,200,000

$521,000

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aw_gitman_pmf_10|Case Studies in Finance|Case 25: Philip Morris

3

$750,000

$235,000

4

$950,000

$400,000

5

$880,000

$498,000

6

$500,000

$612,000

7

$206,000

$519,000

Since the two projects have dissimilar risks, the finance department felt it would be appropriate to indicate how certain they were about their estimates of the net cash flows associated with each project. These certainty equivalents are shown in Table 2. Table 2 Year

C.E. Net cash flow Gourmet Hazel Nut Post Blueberry Morning

0

1.00

1.00

1

.80

.95

2

.70

.90

3

.60

.85

4

.50

.80

5

.40

.75

6

.30

.70

7

.20

.65

The appropriate discount rate for an average risk project for Philip Morris is 10%. They feel that because the Gourmet Hazel Nut project is more risky than average, a risk-adjusted discount rate of 12% should be used. Finally, the risk-free rate of return is currently 5%. Questions

1. If you assume the two projects are of equal risk, what is the net present value (NPV) of each project? Because the projects are independent, which project(s) would you accept?

2. Because the Gourmet Hazel Nut project is more risky, calculate its NPV using the Risk-Adjusted Discount Rate (RADR).

3. Using the certainty equivalents method, calculate the projects' NPV. Does your accept/reject decision change?

4. Explain the concept of certainty equivalents. Start with a definition and then explain fully.

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aw_gitman_pmf_10|Case Studies in Finance|Case 25: Philip Morris

5. How do certainty equivalents adjust cash flows for risk and time. How does this adjustment compare to the way RADRs treat risk and time?

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aw_gitman_pmf_10|Case Studies in Finance|Case 26: C omputerized Business Systems

Home > Case Studies in Finance > Case 26: Computerized Business Systems >

Case Studies in Finance

Case 26: Computerized Business Systems Capital Budgeting: Weighted Average Cost of Capital

Computerized Business Systems (CBS) transforms manual accounting and inventory systems into computerized, more efficient, systems. Many of their customers describe the transition as an overnight evolution from the dark ages to the 21st century. Manual systems are far too cumbersome with respects to both time and inventory control. CBS's computerized inventory systems, for example, allow every item in inventory, no matter how small, to be tracked at all points throughout the production process. Replenishing stock becomes an automatic process because the CBS system alerts the manager when supplies reach a pre-programmed level. Vicky Pagel has been a financial analyst with CBS for over five years. Although she normally does not get involved with sales, her most recent assignment was to assist Jack Ingram, a new sales representative. Jack is in the process of trying to sell a CBS system to Corbin Mills, a firm that does not know how to determine accurately its weighted average cost of capital (WACC). Corbin Mills, therefore, cannot determine whether the net present value (NPV) of the CBS system is positive or negative. To calculate Corbin Mills' WACC, Vicky first needed to gather information on the firm's cost of raising funds from various sources. As she proceeded with the analysis, she learned that Corbin Mills could issue 20-year corporate bonds at a coupon rate of 9%. As a result of current interest rates, the bonds could be sold for $1,005 each. These bonds have floatation costs of $35 per bond, pay interest semi-annually, and have a par value of $1,000. A corporate tax rate of 40% applies. Corbin Mills can raise additional funds through either retained earnings or new issues of common stock. Their common stock is currently selling for $68.25 per share. The most recent dividend paid was in the amount of $2.25. Corbin's dividends have previously grown at a rate of 4%, but this growth rate is expected to jump to 10% the year after and continue at this rate to infinity. If the firm wanted to sell new shares of common stock, after underpricing and floatation costs, they could do so for $62.75 per share. A final source from which funds could be raised is via preferred stock. $100-par preferred stock can be issued at an 11% annual dividend rate. After floatation costs, the preferred stock would sell for $95.50 per share. The final set of information needed to calculate the WACC is the proportion of total funds that each asset class represents. This information is given in Table 1. In performing the NPV http://wps.aw.com/aw_gitman_pmf_10/0,6047,347209-,00.html (1 of 3) [11/27/2002 12:20:30 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 26: C omputerized Business Systems

calculation, net after-tax cash flows must be known. These cash flows are given in Table 2. All variables such as improvements in efficiency, employee training costs, and salvage value are already incorporated in the cash flows. Put yourself in Vicky Pagel's position, and develop the WACC calculation that will be used in evaluating projects for Corbin Mills. Next, demonstrate whether the NPV for the proposed CBS system is positive or negative. The following questions will lead you step-by-step to complete the analysis. To perform this type of analysis you are implicitly making several assumptions. Since Jack will be the only one involved in communicating with Corbin Mills, he must completely understand all of the assumptions and calculations that will be made throughout the analysis. For this reason, the analysis must be clear as well as technically correct. Questions

Table 1 contains the market and book values of each asset class. Table 2 shows the after-tax cash flows associated with the CBS system. Use these tables to answer the questions which follow. Table 1 Asset Class

Book Value Market Value Target Ratio

Long-term Debt

$35,000,000

$33,400,000

35%

Preferred Stock

$5,000,000

$7,000,000

5%

Common Stock

$40,000,000

$42,000,000

40%

Retained Earnings $10,000,000

$10,000,000

20%

Table 2 Year After-tax net cash flow 0

-$480,000

1-10 $80,000 11

$10,000

1. What is the firm's cost of preferred stock? Is this the same as the after-tax cost of preferred stock?

2. What is the firm's cost of long-term debt? Is this the same as the after-tax cost of longterm debt?

3. What is the firm's cost of retained earnings? Is this the same as the after-tax cost of

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aw_gitman_pmf_10|Case Studies in Finance|Case 26: C omputerized Business Systems

retained earnings?

4. What is the firm's cost of new common stock? Is this the same as the after-tax cost of new common stock?

5. Using market values, what is Corbin Mill's WACC? 6. Using book values, what is Corbin Mill's WACC? 7. Using target ratios, what is Corbin Mill's WACC? Explain why the target ratio will not always be maintained by a firm.

8. Which weights, market, book, or target, should be used in this analysis? Explain. 9. Would Corbin Mills be better off with the new CBS system (i.e. What is the NPV of the proposed system?)? Does the answer to this question depend upon which weight is used to calculate the WACC? Explain.

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aw_gitman_pmf_10|Case Studies in Finance|Case 27: McLeodUSA

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Case Studies in Finance

Case 27: McLeodUSA Long-Term Investment Decision: Optimal Capital Structure

The recent growth of McLeodUSA prompted the firm once again to go into the financial markets and file a registration statement for another $400 million in 10-year senior notes. This move represents the fifth time in the last 27 months that McLeod has borrowed in the private debt market raising over $1.125 billion. The reason for the offering was given as a need to raise capital to fund continued expansion in the area of intracity fiber optic networks. Acquisitions, joint ventures, and other strategic alliances have been the source of capital usage in the past and McLeod will certainly keep these types of options open in the future. With such a great need for outside capital, McLeod has decided to fully investigate their optimal capital structure. As such, they have decided to gather data to help analysts with the necessary calculations. Table 1 provides expected levels of earnings per share (EPS), standard deviation in EPS, and estimated required rates of return associated with each capital structure scenario. Table 1 Debt Expected Standard Deviation Estimated Required Rate Ratio EPS of EPS of Return 0%

$0.38

$0.21

10.3%

10%

$0.43

$0.26

10.6%

20%

$0.49

$0.33

11.4%

30%

$0.55

$0.45

12.2%

40%

$0.60

$0.62

13.4%

50%

$0.52

$0.84

16.7%

60%

$0.41

$1.08

20.6%

Questions

1. Calculate the coefficient of variation in EPS for each of the seven debt scenarios using the data in Table 1.

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aw_gitman_pmf_10|Case Studies in Finance|Case 27: McLeodUSA

2. Using the zero-growth valuation model, calculate the estimated stock price of McLeod under each of the seven debt scenarios.

3. What are the two simplifying assumptions that the zero-growth valuation model makes?

4. Based on the zero-growth valuation model, what is McLeod's optimal level of debt? 5. Note from Table 1 that expected EPS are maximized at a debt level of 40%. Does this optimum agree with the optimal capital structure derived from the zero-growth valuation model? Which of the two should McLeod be more concerned with maximizing? Explain.

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aw_gitman_pmf_10|Case Studies in Finance|Case 28: Lancaster Colony

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Case Studies in Finance

Case 28: Lancaster Colony Dividend Policy

Lancaster Colony, a diversified manufacturer and marketer, has increased its dividend payment to stockholders each year for the past 38 years. This impressive track record provides stockholders with a steady and predictable stream of income on which they can rely. Since sales and earnings have reached new highs for 10 consecutive years, and because Lancaster sees several investment opportunities in their Specialty Foods division, they are considering cutting their dividend next year and using the funds to invest more heavily in the lucrative Specialty Foods Group. The Board of Directors feel the rate of return Lancaster could earn by investing the funds internally is greater than the rate of return their stockholders could get if they invested the dividend payments in an equally risky venture outside the firm. To the Board, it seemed silly to pay out a dividend when they had a good use for the money internally. Still they recognized that cutting the dividend would stop their impressive 38 year streak and more importantly surprise investors in a negative way. Table 1 shows the earnings per share (EPS), dividends per share (DPS), and corresponding dividend payout ratio for Lancaster over the past eight years. Table 1 Year DPS

EPS Dividend Payout Ratio

1994 $0.29 $1.32

22.3%

1995 $0.37 $1.57

23.4%

1996 $0.44 $1.71

25.7%

1997 $0.48 $2.01

23.8%

1998 $0.54 $2.22

24.3%

1999 $0.59 $2.28

25.9%

2000 $0.63 $2.51

25.1%

2001 $0.67 $2.37

28.3%

Questions

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aw_gitman_pmf_10|Case Studies in Finance|Case 28: Lancaster Colony

1. Define the Residual Theory of Dividends. Does Lancaster appear to be employing this dividend policy alternative?

2. Define the Constant Payout Ratio policy. Does Lancaster appear to be employing this dividend policy alternative?

3. Define the Fixed-Dollar or "Regular" dividend policy. Does Lancaster appear to be employing this dividend policy alternative?

4. Define the Low-Regular-and-Extra Dividend policy. Does Lancaster appear to be employing this dividend policy alternative?

5. How would stockholders likely react if Lancaster decided to cut their dividend next year? (i.e. What would happen to the stock price and what would happen to investor composition?)

6. What could Lancaster's Board of Directors do to mitigate the reaction of its stockholders?

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aw_gitman_pmf_10|Case Studies in Finance|Case 29: Anh euser-Busch

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Case Studies in Finance

Case 29: Anheuser-Busch Short-term Asset Management: The Baumol Model

Brewing beer has always been the core business of Anheuser-Busch Companies, Inc. The industry leader since 1957, Anheuser-Busch currently owns 45% of the domestic beer market. This represents annual sales of 88.5 million barrels of beer. Market share has grown so much that Anheuser-Busch now has a larger portion of the market than their next four largest competitors combined. International sales are no different. Anheuser-Busch International remains the leading exporter of beer from the United States with sales in more than 65 countries. Microbreweries, or microbrews for short, have been gaining attention in recent years. Microbrews are defined as breweries that produce less than 15,000 barrels a year. The strength of microbrews is their philosophy that beer should be of the highest quality. Microbrews are only made with malted barley, hops, water, and yeast, the only four ingredients found in the purist German beers. Mass bottled beers usually add rice and corn to minimize costs. The drawback of microbrews is their cost. The more expensive ingredients make microbrews cost an average of 60% more than mass bottled beers. Beer is not like wine which gets better with age. Instead, it is a food that should be consumed as soon after production as possible. As such, beer pubs or microbrews that produce beer on the premises, are the hottest new trend with an average of four new pubs popping up every week. Sales have grown an average of 40% per year. This figure is extremely impressive when one considers that the beer market as a whole is shrinking. Even with this success, microbrew sales represent only two percent of the $50 billion dollar beer market. In their relentless pursuit to continue to dominate all sectors of the beer market, AnheuserBusch has tapped into the microbrewing trend. They have recently bought a stake in the Seattle based Red Hook Ale micro-brewery. The new products introduced into the regional and mainstream specialty beer segment include Red Wolf, Elk Mountain Red, Elk Mountain Amber Ale, and Elephant Red. Since microbrews are typically produced regionally, Anheuser-Busch is developing regional manufacturers and distributors. As such, they must decide on the best way to handle their short-term cash needs for purchasing inventory in these small plants. Anheuser-Busch has decided to use the Baumol model to determine the level of cash to keep on hand versus the amount to keep in marketable securities. Anheuser-Busch can earn 7% if they keep their funds in marketable securities. Every time http://wps.aw.com/aw_gitman_pmf_10/0,6047,347212-,00.html (1 of 2) [11/27/2002 12:20:39 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 29: Anh euser-Busch

they convert their marketable securities to cash, it costs them $25. Finally, they anticipate their total cash outlays over the next year to be $2,000,000. Questions

1. Using the Baumol Model, what is the economic conversion quantity (ECQ) that will maximize the firm's value given their short-term cash needs? Why is it important for a business to correctly determine their ECQ?

2. Based on your answer from question 1, how many times will Anheuser-Busch convert marketable securities into cash per year?

3. What is the average cash balance the firm will hold throughout the year, assuming the cash outflows will occur on a consistent or smooth basis?

4. What is the total cost associated with managing these short-term funds? How can you be sure this is the optimal ECQ?

5. In the above analysis, we have not considered a level of safety stock. Why is safety stock so important? What primary factor will determine the amount of safety stock for each specific firm?

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aw_gitman_pmf_10|Case Studies in Finance|Case 30: Pepsi

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Case Studies in Finance

Case 30: Pepsi Short-term Cash Management: Managing the Cash Conversion Cycle

Pepsi is a multinational company who operates within three primary industry segments: beverages, snack foods, and restaurants. The primary products sold in the beverage segment include Pepsi, Diet Pepsi, 7UP, and Mountain Dew. Frito-Lay represents the domestic snack food business, while PepsiCo's restaurant segment consists primarily of Taco Bell, Pizza Hut, and Kentucky Fried Chicken (KFC). Pepsi also engages in several joint ventures around the world, each within one of the three industry segments. Because Pepsi is such a large manufacturer and distributor, they spend millions of dollars each year on salaries trying to keep track of orders, payments, and receipts for each of their three lines of business. Todd Rovelstad, a manager in Financial Services at Pepsi's Phoenix plant, has discovered a way to reduce the time required to log orders, payments, and receipts. His idea is simple, yet innovative. Todd uses bar codes to sort paperwork. Just as bar codes are used in a grocery store to identify each item and its price, Todd can use bar codes to identify where orders are sent to and from, the product that is being referred to, and the amount of the product to be bought, sold, or shipped. This idea has several positive attributes. First, the Pepsi employees will be able to do their logging up to four times faster than they are able to under the current system. Today, receipts for payment are left stacked until a processor can get to them. This also allows employees to concentrate more on other ways in which the company can save money. Second, the accuracy rate under the bar code system is 99.99%. While keying in codes is relatively accurate also, Pepsi has been experiencing problems because their workers are putting in too much over time and fatigue has increased the error rate. Todd did not stop at bar codes for processing accounts receivables. He also saw the usefulness of bar codes for mail. The post office now sorts mail electronically by bar codes for those letters that have them. Pepsi can use coded envelopes to speed up the return time when its customers pay for shipments. These funds can then be deposited into PepsiCo's account much sooner than they currently can be. Even though interest is earned on only one to two additional days, when considering the size of Pepsi, this will translates into big savings. Pepsi wants to determine just how much these new programs will save the company. To determine the amount, they have disclosed the following information concerning the operating cycle. Pepsi's average payment period is 29 days. Their average age of inventory is 42 days. http://wps.aw.com/aw_gitman_pmf_10/0,6047,347213-,00.html (1 of 2) [11/27/2002 12:20:42 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 30: Pepsi

And the average collection period is 39 days. Pepsi feels that with the new system in place, it can speed up the average collection period by 12 days. This figure reflects the fact that the employees will not only receive the payments earlier, but more importantly, they will be able to start processing the receipts much sooner than they are currently able to do. The average age of the inventory and average payment period are assumed to remain unchanged. Pepsi currently spends $28,000,000 per year on its operating cycle investments. Funds used for financing the operating cycle cost 12% per annum. Todd feels the additional annual cost of $50,000 will be sufficient to pay for the added hardware necessary to use bar codes. This expense does not take into consideration the additional salary expenses that will be avoided due to a reduction in overtime costs. Questions

1. Calculate Pepsi's current operating cycle, cash conversion cycle, and need for shortterm financing of the cash conversion cycle (i.e. What is Pepsi's negotiated financing need?).

2. Calculate the operating cycle, cash conversion cycle, and need for short-term financing of the cash conversion cycle if Pepsi decides to implement the use of bar codes.

3. If the bar codes are used in the future, what will be the annual savings stemming specifically from the cash conversion cycle financing reduction?

4. Considering the annual costs associated with implementing the bar code system, should Pepsi change their logging systems?

5. Assume the cost of implementing the bar code system exceeds the savings in reduction of short-term financing needs. Should Pepsi decide not to change systems? Discuss.

6. Define the cash conversion cycle and explain why it is so important. Do you think cash conversion cycles should be different for different industries (HINT - consider a manufacturer versus a retailer).

7. What are the three ways to speed up the cash conversion cycle?

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aw_gitman_pmf_10|Case Studies in Finance|Case 31: Inn-Room Safe

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Case Studies in Finance

Case 31: Inn-Room Safe Managing Accounts Receivable

Mass media news programs have made travelers aware, via hidden video cameras, of how common it is for hotel employees and outsiders posing as hotel guests to gain access to your room and steal your valuables right off the night stand. Of course, by the time you find out something is missing there is no way to figure out who did it. And housekeeping never seems to keep track of who cleaned your room. To combat this problem, most hospitality establishments provide, at a nominal fee, an in-room safe that can only be accessed by the guest and the top manager of the hotel. Inn-Room Safe is a manufacturer and wholesaler of the most popular and secure in-room safes on the market, the "Interchangeable Lock Block." Inn-Room specializes by manufacturing and distributing only this one product which comes in four different sizes to fit almost all hotel spaces. Currently, Inn-Room provides shipping credit terms of net 30 days to top qualifying customers and those paying by bank wire transfer. For other, less credit worthy customers, net terms of 10 and 15 days are required. Inn-Room does not allow for a discount for early accounts receivable collections. Recognizing that sales volume should increase and that bad debt expenses should decrease, Inn-Room is considering offering a 2% discount to those hotels who pay for shipments within 10 days. Today, Inn-Room's average collection period is 23 days. With the proposed discount offering, this number is expected to reduce to 14 days. Bad debt expense is expected to decrease from 0.8% to 0.5%. Inn-Room now sells 1,700 safes on credit at an average price of $234 and a variable cost of $157 per unit. After the discount, Inn-Room forecasts that sales will increase by 7% and that 70% of all credit sales will be by hotels that take the 2% discount. Finally, Inn-Room's required rate of return on a similar risk investment is 12% under both account receivable options. Questions

1. If Inn-Room decides to implement the newly proposed discount, what will be the additional profit contribution from an increase in sales?

2. If Inn-Room decides to implement the newly proposed discount, what will be the cost of the marginal investment in accounts receivable?

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aw_gitman_pmf_10|Case Studies in Finance|Case 31: Inn-Room Safe

3. If Inn-Room decides to implement the newly proposed discount, what will be the marginal benefit of reducing the bad debt expense?

4. If Inn-Room decides to implement the newly proposed discount, what will be the marginal cost of paying the cash discount to early paying customers?

5. If Inn-Room decides to implement the newly proposed discount, what will be the net profit from implementing the proposed plan?

6. What additional factors should Inn-Room consider when making such an important decision?

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aw_gitman_pmf_10|Case Studies in Finance|Case 32: Home Depot

Home > Case Studies in Finance > Case 32: Home Depot >

Case Studies in Finance

Case 32: Home Depot Working Capital and Short-Term Management: The Cost of Taking a Cash Discount on Accounts Payable

Home Depot, the largest home improvement retailer in the world, is on the cutting edge of retail innovations. Much of their quick and steady rise to success is attributed to their approach to creating new customers and cultivating future customers. Through an idea called Home Depot University, adults take a four week comprehensive course in home improvement techniques which, of course, illustrate how the products sold by Home Depot can be used to enhance and modernize homes. The potential of kids as customers has not slipped their attention either. A program, known as "Our Kids Workshops," teaches children not only safety and creativity, but also plants a loyalty seed for the future. Another means by which Home Depot has differentiated themselves from their competition is by marketing what are called proprietary brands. This simply means that the product lines are only offered at Home Depot. Once customers adopt the product, they cannot buy it elsewhere. This is a way for Home Depot to protect their customer base from discount retailers who compete purely on price and drive down profit margins. One of Home Depot's proprietary brands is RIDGID who produce everything from power tools to wet/dry vacuums and air filtration systems. When Home Depot buys products from RIDGID, they use credit and have 45 days to make full payment on these accounts payable. However, if Home Depot wants to take advantage of RIDGID's 2% cash discount offer, they must pay within 15 days. To simplify record keeping, RIDGID uses the end-of-month (EOM) method when determining the beginning of the credit period. This simply means that any sales made throughout the month will have a starting credit period beginning on the first day of the next month. For example, Home Depot recently purchased a shipment of stationary bench-top power tools from RIDGID on December 23. Since RIDGID follows the EOM method, Home Depot's credit period does not start until January 1. If Home Depot wishes to take the 2% cash discount offered, they must make full payment by January 15. If not, they must pay the entire amount by February 14. Questions

1. Calculate the exact cost of giving up the discount. 2. Home Depot's risk-free required rate of return is currently 7%. The firm's Weighted Average Cost of Capital (WACC) is 13.4%. Finally, the rate at which the company can http://wps.aw.com/aw_gitman_pmf_10/0,6047,347215-,00.html (1 of 2) [11/27/2002 12:20:48 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 32: Home Depot

borrow from a bank is 9.7%. Should Home Depot take the cash discount or should they wait until the full credit period is up? On which of the above three figures did you base your comparison? Explain.

3. Calculate the approximate cost of giving up the discount. 4. Perform a sensitivity analysis using both the actual and the approximation formulas with cash discounts of 1%, 2%, and 3% and credit periods of 30 days, 45 days, and 60 days. What is the relationship between these two variables and the error yielded by the approximation formula?

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aw_gitman_pmf_10|Case Studies in Finance|Case 33: Hasbro

Home > Case Studies in Finance > Case 33: Hasbro >

Case Studies in Finance

Case 33: Hasbro Leasing versus Buying

Hasbro, Inc., is a multinational parent company who is in the primary business of designing, manufacturing, and marketing toys, games, puzzles, etc. Their subsidiary companies include such household names as Parker Brothers, Milton Bradley, Tonka, Kenner, and Playschool. These companies produce some of the most easily recognized products in the world: Monopoly, Mr. Potato Head, G.I. Joe, The Game of Life, Scrabble, Lincoln Logs, Twister, Operation, Yahtzee, Candy Land, Pictionary, Trivial Pursuit, and Scattergories, to name a few. Hasbro is currently trying to pick-up ground in the doll market by directly competing with Mattel's Barbie, a front runner in the doll market segment for decades. To do so, Hasbro has proposed the sale of their own teenage doll, Maxie. To produce Maxie, Hasbro must acquire several new pieces of equipment. As part of the production process, Hasbro currently occupies certain manufacturing facilities and sales offices and uses certain equipment under various operating leases. Now that they need to acquire more machinery, they must decide whether to buy or lease the new equipment. Hasbro can purchase the machinery for $30,000 by financing over a five year period at 8% interest. The corresponding annual payment would be $7,514. Buying the machinery has an advantage in that the machine can be depreciated using the MACRS five year recovery system. Depreciation rates are given below. Table 1 Percent that can Year be depreciated 1

20

2

32

3

19

4

12

5

12

The drawback to purchasing the machinery, however, is that the maintenance duties are http://wps.aw.com/aw_gitman_pmf_10/0,6047,347216-,00.html (1 of 2) [11/27/2002 12:20:51 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 33: Hasbro

borne by the owner. To maintain the machinery will cost Hasbro $1,000 each year for five years. If Hasbro decides to lease the machinery, they will have to pay the lessor $7,000 per year for the next five years. As with most operating leases, the lessor will pay for all maintenance necessary. At the end of the five year period, Hasbro will have the option to buy the machinery at a cost of $6,000. The tax rate for Hasbro is 40%. Questions

1. Find the after-tax cash flows associated with the lease payments. Assume Hasbro will agree to purchase the machinery at the end of the five year period for the agreed upon $6,000.

2. If the machinery is purchased, the interest paid from financing it is tax deductible. Since this is the case, find the amount of interest paid each year.

3. Depreciation is also tax deductible if the machinery is purchased. Calculate the depreciation expenses over the five year period.

4. Knowing that depreciation, interest expenses, and maintenance costs are tax deductible, calculate the total tax shield associated with purchasing the machinery.

5. What are the total net after-tax cash outflows associated with purchasing the machinery?

6. Using your answers from questions 1 and 5, should Hasbro lease or buy the machinery? (i.e. What is the present value of the costs associated with both options?)

7. In general, what are the advantages and disadvantages to leasing? 8. In question 1, we assumed Hasbro would purchase the machinery for $6,000 at the end of the five year lease period. In practice, Hasbro will want to wait the full five years before they make that decision. What will their decision be based on at that time? That is, if Hasbro decides to lease the machinery, what factors will determine their decision of whether or not to buy the machinery at the end of the lease?

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aw_gitman_pmf_10|Case Studies in Finance|Case 34: Microsoft

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Case Studies in Finance

Case 34: Microsoft Special Topics: Options

Chris Jubran is an avid follower of technology stocks. He currently owns 500 shares of Microsoft's common stock. Today the price of each share is $89. Tomorrow, Microsoft will announce whether a much anticipated business deal with long-distance phone service giant, AT&T, will go through. If the deal is made, the stock price of both firms should increase substantially. While most of the investment community believes the agreement will occur, Chris feels otherwise. Chris is very concerned that the value of his holdings, $44,500($89 x 500 shares), will greatly decrease if the Microsoft/AT&T deal does not pan out. One way out of this predicament is to sell off his Microsoft holdings, wait for the announcement and the corresponding decrease in the stock price, then repurchase the shares at a lower rate. Although this would not result in a profit, Chris would avoid the loss associated with holding the shares. After calling his discount broker at Charles Schwab to determine the transaction costs associated with selling off the 500 shares, Chris found that the round trip transaction costs would be far too expensive. Instead, his broker recommended the use of put options. The following information is a reprint from a recent edition of the Wall Street Journal on December 15: Table 1 Microsoft Call (MSFT) Strike Expiration Stock Price Price Date Vol. Last

Put Vol.

Last

89

75

Jan

11 17 7/8

118

1/2

89

75

Apr

17 17 1/2

62

2 1/4

89

80

Jan -----

----- 1475

1 1/4

89

85

Dec

813

3 7/8

253

1 1/4

89

85

Jan

147

7

430

2 5/8

89

85

Apr

75 11 1/8

28

4 7/8

89

90

Dec 2221

3/8 1684

1 1/2

89

90

Jan 1373

4

641

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4 3/4

aw_gitman_pmf_10|Case Studies in Finance|Case 34: Microsoft

89

90

Apr

71

7 5/8

16

7

89

90

Jul

50 10 1/2

27

8

89

95

Dec 1758

1/16

292

6 1/2

89

95

Jan

836

2 1/4

849

7 7/8

89

95

Apr

89

6

13 10 1/4

89

100

Jan 1068 1 3/16

58 11 3/4

89

100

Apr

324

89

105

Jan

186

89

110

Jan

92

89

110

Apr

125

4 1/4

2 13 1/4

1/2 ----1/4

-----

5 18 3/8

2 -----

-----

Questions

1. How can Chris use put options to hedge himself against the possibility that Microsoft and AT&T will not come to an agreement? Be sure to indicate which specific contract should be used.

2. If Chris buys 5 put contracts (i.e. on 500 underlying shares) with an exercise price of $90 and an expiration in December for $1.50 per option, how will his overall wealth position change if the stock price jumps up to $93 after the announcement? What if the stock price falls to $85? For simplicity, ignore transaction costs and margin requirements.

3. Microsoft's options trade on a January, April, July, October cycle. Why then do we see that options are offered with a maturity month in December as well?

4. Consider the four call options with a strike price of $90. What appears to be the relationship between time to maturity and volume? What appears to be the relationship between the price of the call and the time to maturity? Do these relationships hold for the corresponding put options as well? Explain why or why not.

5. Most trading volume in calls occurs in contracts where the exercise price is above the current stock price. Why does this make sense?

6. In a call option, when the strike price is far below the current stock price, the call option price tends to be extremely high (in of the money) and when the strike price is far above the current stock price, the call option price tends to be extremely low (out of the money). Why does this relationship make perfect sense?

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aw_gitman_pmf_10|Case Studies in Finance|Case 16: eBay

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Case Studies in Finance

Case 16: eBay Stock Market Efficiency

Everyone knows eBay, Inc. as the world's largest on-line auction based trading system created for individuals. eBay provides a trading place for over a quarter of a million items daily on everything imaginable. If you want to buy, sell or trade it, chances are eBay knows someone else just like you. The creation of this new market has been an overwhelming success for this high-flying internet stock until June 10, 1999. On that date, eBay had an unexpected all day outage of their site that resulted in a plummeting stock price and a need for answers. eBay's CEO promptly refunded customers a total of $4 million in user fees and assured traders that the company would take steps to be sure this type of failure would never happen again. Just before 8:00 A.M. Eastern Standard Time, on August 6, 1999, eBay's web site crashed again following scheduled maintenance that was supposed to occur overnight. Surprisingly, the news of the crash did not make its way to Wall Street as the stock rose early after the opening bell (The stock market opens at 9:30 A.M.). There was some unrelated profit-taking which ended around 10:30 A.M. This dropped the price back down to around $92 where it remained relatively stable until the Dow Jones NewsWire publicly reported the crash at 12:01 P.M. Immediately, eBay's stock took a nosedive amid high volume selling. By the close of trading at 4:00 P.M., the stock had lost $9.625 per share which represents 10.36%, or nearly $1 billion, in market capitalization. Most of the stock price drop had occurred within the first 15 minutes after the news release. Questions

1. At 12:01 P.M., when the Dow Jones NewsWire publicly reported the crash of eBay's web site, the stock price dropped precipitously right away then remained relatively stable (exhibited normal levels of volatility) for the rest of the day. Is this consistent with the notion of efficient markets? Explain.

2. Since eBay's Web site crashed an hour and a half before the stock market opened, why didn't eBay's stock open lower as opposed to higher the way it did?

3. Could people who were aware of the site's crash right before 8 A.M. have made money by taking certain actions in the stock market? If so, what could they have done?

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aw_gitman_pmf_10|Case Studies in Finance|Case 16: eBay

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aw_gitman_pmf_10|Case Studies in Finance|Case 17: Aether Systems

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Case Studies in Finance

Case 17: Aether Systems Common Stock Valuation: The Variable Growth Model

It seems the whole world is going wireless. On the shuttle bus from SFO airport to my hotel downtown, I couldn't help but overhear an attorney discuss his legal strategy. First he called his office on his cell phone to see if a settlement offer had been reached. Then he pulled out his Palm Pilot to log the next sequence of motions to be filed. Not wanting to seem nosey, I busied myself by tracking the latest stock performance within my portfolio via PocketBroker, a hand-held wireless investment service through Charles Schwab. With my RIM (Research in Motion) 950, I can access my account, download the latest quotes and even execute trades all while being driven on Highway 101. With my TradeStation 2000 technical analysis based automated software package, I was able to identify several sell signals and lock in a hefty profit all before arriving at my hotel. The shuttle driver used his antenna to obtain my credit card approval and I was off to my meeting. If you think only business people use wireless technology to this extent, think again. On board the USS McFaul, one of the Navy's newest vessels, crew members are now able to move freely throughout the ship while sending vital information back and forth over their wireless Palm handheld devices. Note only does the mobility directly translate into greater efficiency, but the need to keep extensive paper records and hold clipboards is a way of the past. The Wake Forest University School of Medicine uses wireless handheld devices not only to track patient records, but update them as well. Updated records are automatically sent back to the central computer via the system's intranet. Aether Systems, Inc., is the firm responsible for many of these advancements. Their commitment to increasing mobility, productivity, and efficiency has allowed them to grow at an exponential rate. Your task is to determine, using the discounted cash flow method, whether or not Aether is fairly, over-, or under-valued. To complicate matters, since the firm only came into existence in 1998 and because they are growth oriented, they have yet to pay a dividend and do not plan to do so in the short to intermediate run. Instead, Aether will only begin to pay a dividend 10 years from now. The expected annualized dividend at the end of year 10 will be $2.50 per share. This dividend is expected to grow at a rate of 9% over the next 5 years and will then taper off to a steady 4%, a rate at which it is assumed to grow forever. Answer the following questions using a discount rate of 13%. Questions

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aw_gitman_pmf_10|Case Studies in Finance|Case 17: Aether Systems

1. Calculate the dividends over the first growth stage. 2. Using the Gordon Growth Model, calculate the value of all remaining dividends at time 15.

3. Calculate the present value (at time 0) of ALL future dividends. 4. Assuming Aether was currently trading at $10 per share, what would be your longterm recommendation for this stock: buy, sell, or hold?

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aw_gitman_pmf_10|Case Studies in Finance|Case 18: NetJ.com

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Case Studies in Finance

Case 18: NetJ.com The Behavioral Component of Pricing Common Stocks

A few years ago when the stock market was reaching new highs every day, investors were pouring more and more money into the capital markets. This free flow of funds encouraged small firms to go public before they were ready. More directly, many of these firms had limited track records, and in several cases, no track record at all. Still, with such a hot IPO market, these premature public offerings had been extremely successful; the majority of these firms had no problem fully subscribing their shares. The market capitalization of NetJ.com was over $22.9 million. Yet in their SEC statement it read, "The company is not currently engaged in any substantial business activity and has no plans to engage in any such activity in the foreseeable future." How is it that a firm with no business operations had come to command such a market capitalization? NetJ.com began under the name NetBanx.com. The mission of this firm was to perform bad debt collections for doctors. Finding this to be a not so profitable venture, the firm shifted gears. Recognizing that the IPO process is a lengthy and expensive one, they saw value in the fact that they were already a publicly held corporation. As such, they could identify private companies who wished to go public, but didn't want to put the necessary time and effort into the process. The game plan was to merge with the other firm and have that be their line of business. This practice of making it up as you go along seemed not only to be a necessary course of action, but an attractive one as well. The trick appears to be keeping yourself "new." NetJ.com is certainly keeping itself open to possibilities. As stated in their SEC statement, "The company does not intend to restrict its search (for a partner) to any particular business or industry…high tech, natural resources, manufacturing, R&D, communications, transportations, insurance, brokerage, finance, and all medical related industries." That pretty much covers it. With "extremely limited assets" and "no source of revenue," one wonders how long NetJ.com can continue to command a stock price above zero before investors stop believing in possibilities and start demanding performance. Questions

1. How is it that a company with little to no track record can successfully go public? 2. How can a firm with no revenue have a positive stock price?

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aw_gitman_pmf_10|Case Studies in Finance|Case 18: NetJ.com

3. Why would a privately held firm generating significant profits consider merging with a publicly held firm who seems to be without direction and who is operating at a loss?

4. How long can a corporation with no revenue and no immediate plans to generate revenue expect to have their stock price supported by the market?

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aw_gitman_pmf_10|Case Studies in Finance|Case 19: OTCBB

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Case Studies in Finance

Case 19: OTCBB The Trading of Stocks in the OTCBB Market

Having just made senior partner in his Hawaii based architectural firm, Matt Gilbertson sought to invest a substantial portion of his new, much higher salary in speculative grade stock. Normally in the habit of deleting mass e-mail, Matt's attention was drawn to the subject line: "Bulletin Board Trading Now Available," that was sent by Datek Online. Datek is an online trading company where investors pay $9.99 per transaction and can trade up to 5,000 shares of a single stock. This emerging trend of do-it-yourself investing (at a much lower commission cost) was attractive to Matt. However, since Matt did not know what a Bulletin Board Stock was, he carefully read the e-mail to learn more about them. Bulletin Board stocks are recommended for investors at the high end of the risk-return spectrum. There are several sources of risk associated with these securities. OTCBB stocks are not required to meet minimum listing and reporting requirements as are stocks listed on organized exchanges, such as the New York Stock Exchange (NYSE) or the American Stock Exchange (ASE or AMEX). This means that investors will find it more difficult to find publicly available information and news that affects the value of the firm. Moreover, since national exchanges have stringent listing requirements, OTCBB stocks tend to be less stable companies with short track records, possibly facing regulatory actions or maybe even bankruptcy. Another concern with OTCBB stocks is that because of low volume or liquidity, they have dramatically higher bid-ask spreads and are subject to partial order executions and in some cases unfilled orders. Finally, automation, which so many investors have become accustomed to in recent years, is not available in the OTCBB. For all these reasons, OTCBB stock investing opportunities are being presented by Datek with a warning label that investors should do their homework, not only about the firm itself, but on this risky marketplace as well. Questions

1. With the added risk associated with OTCBB stocks, why are investors so attracted to them?

2. If we assume the added risk of the OTCBB stocks is not sufficiently compensated for by higher rates of return, should Datek continue to offer these stocks for sale to their customers?

3. Should stocks be allowed to be available for sale if they do not have to disclose information and have no reporting requirements? http://wps.aw.com/aw_gitman_pmf_10/0,6047,347202-,00.html (1 of 2) [11/27/2002 12:21:07 AM]

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4. Should an investor in Matt's position decide to invest in OTCBB stocks?

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aw_gitman_pmf_10|Case Studies in Finance|Case 20: Pittston

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Case Studies in Finance

Case 20: Pittston Tracking Stocks

With the Initial Public Offering (IPO) market doing so well a few years ago, tracking stocks were popping up everywhere. A tracking stock is a separately traded common stock that only reflects the well being of a particular division. The parent company still completely owns and operates the division. But, the parent has its own stock price that trades independent of the tracking stock's division. Tapping into the then hot IPO market, tracking stocks, particularly those in the technology sector, were able to generate significant proceeds when offered as a separate trading opportunity. With the overall market performing so well for so long, there seemed to be no drawback to this relatively new way to raise extra capital. The question many investors started to ask was, "What will happen if tracking stocks start to act more as an anchor rather than a sail?" Pittston Co., announced it would revert back to its non-tracking stock structure because its coal division was dragging down its other, more healthy divisions. This brings up many interesting conflict of interest concerns for investors. While the two stocks are managed by the same Board of Directors, the stockholders are not necessarily the same. In fact, they will likely be quite different. For which set of shareholders should the board seek to maximize value? Both the tracking stock and the parent stock are tapping into the same pool of resources. If the tracking division begins to flag or seems to be an unsuccessful venture, the natural managerial decision might be to divest or at least cut back on investment. However, this would cause the tracking stockholders to complain because their stock would go down in value. The question then becomes, is the job of management to maximize the value of the two stocks concurrently? Executive compensation becomes an issue as well. Consider what might happen if the board owned a different amount or percentage of shares in the parent company when compared to the tracking stock. Might there be an incentive to place the interests of one set of stockholders above those of the other? The stock market cannot remain bullish forever. And when it corrects, there is likely to be a tremendous backlash surrounding tracking stocks. Are tracking stocks the wave of the future or are they a law suit waiting to happen? Questions

1. Why would the price of a firm before tracking stocks are introduced be different from the combined price of the parent and the tracking stock once the new structure is in place? http://wps.aw.com/aw_gitman_pmf_10/0,6047,347203-,00.html (1 of 2) [11/27/2002 12:21:10 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 20: Pittston

2. Why are there so many tracking stocks in the technology sector as opposed to other sectors?

3. Why is it necessary for the market to become bearish before the potential problems associated with tracking stocks get noticed?

4. For which set of shareholders should the board seek to maximize value? 5. How could executive compensation be structured to discourage favoritism of either the parent stock or the tracking stock?

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aw_gitman_pmf_10|Case Studies in Finance|Case 21: Vanguard

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Case Studies in Finance

Case 21: Vanguard Mutual Funds and Taxes

Most everyone is aware that mutual funds are an ideal investment vehicle for the small investor. Mutual funds allow for the benefits of a diversified portfolio yet require only a small amount of funds to be invested. Moreover, for those who wish to avoid market timing strategies and the time consuming process of analyzing individual stocks, index investing in broad market indexes is a favorable alternative. What most people do not know, however, is that even a buy and hold objective pursued through an index mutual fund is not without serious potential tax consequences. Billy and Sherri Simpson invest regularly in Vanguard's Extended Market Fund, a mid-cap, buy and hold index mutual fund roughly tracking the Wilshire 4500. To date, Billy and Sherri have never withdrawn money from the fund. Instead, they periodically make deposits whenever they have enough to do so. Even though the Simpsons have never sold their mutual fund shares, they noticed on their FORM 1099-DIV, that they were listed as earning $1,266.90 in capital gains (Box 2a). Thinking there had been a mistake, Billy called Vanguard's 1-800 number and asked for clarification. The Vanguard representative explained that when common stock is owned directly, there are two ways to realize returns: (1) payment of dividends by the company, and (2) capital gains (or losses) when the individual sells their shares. However, with mutual funds, there are three ways to realize a return. The first two are the same as if the stock was owned directly. The third is a capital gain that occurs when the fund itself sells shares in the portfolio. It was this third reason that had caused the Simpsons to realize the capital gain even though they themselves had never redeemed any mutual fund shares. The next year when the Simpsons received their FORM 1099-Div, they noticed that the capital gains number in Box 2a had jumped up to $4,208.71 even though they did not contribute any more money that year. Knowing that the index fund had a buy and hold strategy, the Simpsons were very surprised that so much turnover could have been caused within a single year's time. After again calling Vanguard, they learned that due to the stock market's run up in that year, the mid-cap stocks that the fund held were now large cap stocks. To keep to the objective of holding mid-cap stocks, Vanguard said they sold off the firms that had become large cap stocks and used the proceeds to buy smaller firms. This turnover generated realized capital gains that had to be spread out over the mutual fund investment base on a pro rata basis. The next year, the stock market bottomed out. Vanguard's Extended Market fund lost over http://wps.aw.com/aw_gitman_pmf_10/0,6047,347204-,00.html (1 of 2) [11/27/2002 12:21:13 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 21: Vanguard

40% of its value. Sherri joked that the good news was that at least they didn't have to pay high capital gains this year. However, at the end of January when they received their FORM 1099-DIV, they saw the highest number yet in Box 2a. The Total Capital Gain Distributions were reported to $7,444.72, even though the Simpsons had never withdrawn money from the account. Not surprisingly, Sherri called Vanguard for an answer. The Vanguard representative explained that investors panicked when the stock market dropped. They sold off so many shares that the cash the fund keeps on hand to handle "normal" transactions had run out. In order to meet investor demand to withdraw funds, Vanguard had to sell off shares to raise the necessary funds. Many of the shares sold were originally purchased many decades ago. As such, they had a very low cost basis for tax accounting purposes. Extremely upset by the turn about of events that had transpired, Billy and Sherri Simpson seriously contemplated the way they would invest in the future. Questions

1. Do you think Vanguard's objective to maintain a mid-cap index is more important than the tax burden it causes their clients?

2. Explain how investor behavior can be extremely detrimental to a mutual fund owner who will truly follow a buy and hold strategy through good times and bad.

3. Will there be certain economic conditions/times when this investor behavior will be worse than others?

4. Why should current mutual fund shareholders pay for the taxes caused by stocks that were purchased many decades before they became an investor? That is, why not recalculate the cost basis of a stock to more fairly assign tax liabilities to investors?

5. How might you change the way you would invest if you were the Simpsons?

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aw_gitman_pmf_10|Case Studies in Finance|Case 22: Florida Power & Light

Home > Case Studies in Finance > Case 22: Florida Power & Light >

Case Studies in Finance

Case 22: Florida Power & Light Capital Budgeting: Renewal versus Replacement

Florida Power & Light (FP&L) is the primary subsidiary of Florida Power & Light Group, representing 97% of their operating revenues. FP&L is a utility company that supplies electric service throughout most of Florida's eastern seaboard. Their service area contains 27,605 square miles which translates into approximately 3.4 million customers. Of these 3.4 million customers, as a percentage of operating income, roughly 55% comes from residential customers, 35% from commercial, 4% from industrial, and the remaining 6% from other sources. Paul Seiler, a senior contracts agent in the nuclear division at FP&L's Turkey Point Plant in Florida City, Florida, is debating on whether to renew or replace the commercial nuclear reactor's reactimeter. A reactimeter is a vital component of the nuclear power generating process. The core of a nuclear reactor must be maintained at a certain temperature and must possess a particular chemical composition. Any deviation from this sensitive optimal mix will result in the sub-optimization of the plant and a corresponding waste of energy. The reactimeter is a computer with accompanying software that is used to monitor the requisite characteristics of the Reactor Coolant System (RCS) and make minor adjustments as needed. Alternative 1: In order to determine whether the reactimeter should be renewed or replaced, Paul had to gather some financial information. If the current computer system is upgraded and new software is purchased, the cost will be $80,000. An additional $5,000 will be required to have the system installed and calibrated for accuracy. The renewed computer system will have a useful life of just five years and will be depreciated in compliance with the MACRS five year recovery system. Depreciation rates for years one through five are .20, .32, .19, .12, and .12, respectively. Only the purchase cost of $80,000 will be depreciable, not the installation cost. At the end of the five year period, the renewed machine can be sold for $5,000 before taxes. The renewed machine would also result in an increase in net working capital of $20,000. Net profits resulting from an increase in operational efficiency for each year will be as follows: Table 1 Year Net increase in profits http://wps.aw.com/aw_gitman_pmf_10/0,6047,347205-,00.html (1 of 3) [11/27/2002 12:21:17 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 22: Florida Power & Light

1

$650,000

2

$425,000

3

$317,000

4

$220,000

5

$129,000

Alternative 2: The new system will also have a five year life and will be depreciated in compliance with the MACRS five year recovery system. The fully depreciable cost of the new system will be $100,000. Installation costs will be an additional $5,000. At the end of the five year period, the renewed machine can be sold for $10,000 before taxes. Implementing the new machine would result in an increase in net working capital of $15,000. If FP&L decides to replace the old system with a new reactimeter, the resulting net profits will be: Table 2 Year Net increase in profits 1

$350,000

2

$350,000

3

$350,000

4

$350,000

5

$350,000

If a new system is purchased, the old system can be salvaged for $10,000. Finally, FP&L has a 40% corporate tax rate. Questions

1. What is the initial investment associated with both alternatives? 2. Calculate the net after-tax operating cash inflows associated with both alternatives. 3. Calculate the year 5 cash flow associated with the sale of the computer for both alternatives. That is, remember to consider that both computer systems can be sold at the end of the fifth year.

4. Using a discount rate of 10%, calculate the present value of both alternatives. Which alternative should Paul choose?

5. What are some of the qualitative factors to consider when making a decision between the two alternatives? http://wps.aw.com/aw_gitman_pmf_10/0,6047,347205-,00.html (2 of 3) [11/27/2002 12:21:17 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 22: Florida Power & Light

6. Based on your answers from questions 4 and 5, has your decision changed concerning which alternative is preferred?

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aw_gitman_pmf_10|Case Studies in Finance|Case 35: REITs

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Case Studies in Finance

Case 35: REITs Real Estate Investment Trusts

REITs have been in existence since 1960. However, it wasn't until around 1992 that they became popular. A REIT is a securitized form of owning real estate. Before REITs, the only way to experience the risk and return associated with commercial real estate was to own it directly through property pools, commingled real estate funds (CREFs), syndications, or separate accounts. Today, you can buy a REIT, which represents ownership in a company that holds real estate as their primary assets. REITs are real estate stocks and are traded on the NASDAQ, AMEX, and NYSE. As such, they are exposed to market noise like any other stocks, but are also similar to their underlying assets, real estate. This makes the capital gains component of their returns very attractive as a hedge against inflation, a characteristic much desired by investors. Moreover, since a minimum of 90% of a REIT's taxable income must be paid out in the form of a dividend, investors liken the income stream to utility stocks that also pay a high percentage in dividends. Finally, REITs have a low correlation with other stocks, bonds, etc. and therefore have been found to warrant inclusion in mixed-asset portfolios. But, even with their steady returns and low volatility, REITs have received little attention from the investment community. One of the reasons why REITs are given little attention is because there are only 188 in existence today. While this is three times greater than the number just ten years ago, the total market capitalization of all REITs is still less than that of Microsoft. As such, analysts have not considered them worth the time to monitor and evaluate. That being said, REITs are being used by several real estate portfolio managers as a way to rebalance their portfolios over time. Why? Unsecuritized real estate, such as a $50 million dollar office building in downtown Chicago, is an illiquid and lumpy asset. That is, if you want to sell $1 million dollars of it, it would not be possible. You would have to be able to sell off  just one or two floors of the building. Since this is not possible, institutional investors might instead sell off $1 million worth of an office REIT. Whether or not REITs gain widespread acceptance and continue to perform well remains to be seen. Still, at present, REITs do offer an attractive risk-return tradeoff. Questions

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aw_gitman_pmf_10|Case Studies in Finance|Case 35: REITs

1. Why would you suspect real estate is a good hedge against inflation? 2. Which types of investors are more likely to own REITs? 3. REITs have had a lower correlation recently than in the past. Explain why and justify whether or not you think this trend will continue.

4. Does the fact that the total market capitalization of all REITs sums to less than that of Microsoft present a problem for real estate portfolio investors who are trying to use REITs to rebalance their large portfolios? Explain why or why not.

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aw_gitman_pmf_10|Case Studies in Finance|Case 36: HOLDRs

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Case Studies in Finance

Case 36: HOLDRs New Security Offerings: HOLDRs versus UITs

A new type of security, known as a HOLDR, is now available to investors. The first HOLDR was introduced by Merrill Lynch in September of 1999. Since then three more have been offered, and given their early success, this trend is likely to continue. A HOLDR is similar to a Unit Investment Trust (UIT) in that both are unmanaged baskets of securities that can be redeemed for their underlying assets. The primary differences involve pricing and trading. UITs are like mutual funds in that their price is calculated once a day, at the end of each trading session. HOLDRs, on the other hand, trade like stocks in that their price changes continuously during trading hours. This is an added attraction in today's environment of so many day traders. The second major difference is that it is not difficult to find the price of a HOLDR. HOLDRs have a ticker symbol which means it is very easy to track their prices - say from various Internet sites. UITs do not have ticker symbols. Investors are often forced to call brokers or the trust sponsor to get pricing information. In response to the new, much more convenient HOLDR security, a UIT industry representative states, "It's being discussed among the major broker/dealers and sponsors, and we want to implement them (ticker symbols) as soon as possible." Other differences between the two types of secureties include changes in the composition of portfolios (HOLDRs are completely fixed, whereas UITs can add securities - particularly ones that track indexes), sales charges (HOLDRs are very similar to common stocks, whereas UITs are quite complex and vary from UIT to UIT), and time to maturity (HOLDRs, like common stocks, have no expiration, but UITs have a finite life). While it is difficult to draw definite conclusions as to which type of investment vehicle is better for investors, HOLDRs do seem to have caught the attention of UIT sponsors. What we do know is that Merrill Lynch plans to offer more of these stock bundles in the future. Whether HOLDRs will cut into the volume of UIT trading, simply attract more capital into the markets as a whole, or at least provide a financial incentive for the UIT industry to improve upon the transparency and availability of price data for their products remains to be seen. Questions

1. What causes firms, like Merrill Lynch, to offer new variations of existing securities?

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aw_gitman_pmf_10|Case Studies in Finance|Case 36: HOLDRs

2. When compared to UITs, why would HOLDRs attract more day traders? 3. Do you think it is a coincidence that the UIT industry is starting to offer better price availability now that HOLDRs have emerged? Explain.

4. The HOLDRs introduced thus far by Merrill Lynch have been industry specific (Internet - HHH, Biotech - BBH, Telecom - TTH, and Pharmaceutical - PPH). Considering diversification, is it enough to hold just one type of HOLDR? Explain.

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aw_gitman_pmf_10|Case Studies in Finance|Case 37: Reynolds

Home > Case Studies in Finance > Case 37: Reynolds >

Case Studies in Finance

Case 37: Reynolds Mergers and Takeovers

Strap your seatbelts on, keep your hands inside the vehicle and hold on for dear life. The merger mania roller coaster that has been so prevalent in today's market is going for another ride. Just hours after a three-way $17.6 billion mega-merger was announced between Canada's Alcan, Pechiney of France, and Switzerland's Algroup, U.S. based Alcoa, the world leader in the aluminum industry, announced plans to buy Reynolds Metal for $5.6 billion. If the merger between Alcoa and Reynolds, the third largest aluminum firm, were to happen it would make the resulting Alcoa by far the market dominator. There are two things standing in the way of the Alcoa-Reynolds merger. Since the union of the two giants would result in a market leader akin to Microsoft in the computer industry, and because competition would be drastically reduced, there are several regulatory anti-trust concerns. The second potential hold up involves the degree of willingness on the part of Reynolds' management to be purchased by Alcoa. Since mergers also mean layoffs, managers are always cautious about merger deals. But mergers also mean large stock price increases for the firms who are the target of merger and takeover attempts. Therefore, most stockholders prefer their company to be the topic of bidding speculation. In fact, Highfields Capital Management LP, Reynolds' single largest stockholder, has taken the initiative to foster further merger consideration. They are pressuring Reynolds' management to arrange an auction to the highest bidder. Highfields Capital's managing director, Richard Grubman, wrote a letter to Reynolds' CEO, Jeremiah Sheehan stating, "Your shareholders deserve nothing less and will hold you accountable if you fail to take this action now." Fearing derivative shareholder action and accepting what seems to be the inevitable, Reynolds appears to be open to listen to deals from anyone and everyone. So where do the smaller firms in the aluminum industry fit into all this? Industry analysts report that these firms are scrambling in an attempt to be a part of deals while the market is in a state of frenzy. The fear of being left out could be a rational one as many feel bidding wars result in over paying for firms. Just when things could not be more unpredictable, an outside player has announced intentions to challenge the bid of Alcoa for Reynolds Metal. Michigan Avenue Partners (MAP), a firm who got their start in commercial real estate, has come out of the woodwork to announce interest in Reynolds. MAP is not exactly a stranger to the aluminum industry, however. A few years ago they bought Reynolds' McCook division and are now the second http://wps.aw.com/aw_gitman_pmf_10/0,6047,347220-,00.html (1 of 2) [11/27/2002 12:21:25 AM]

aw_gitman_pmf_10|Case Studies in Finance|Case 37: Reynolds

largest producer of aluminum plating (behind Alcoa). They also own Metro Metals which is a steel processing firm. Still, analysts did not even see MAP on the bidding radar screen. The next few months will prove telling for this capricious environment. Said John Martin, aluminum industry analyst at the CRU consultancy in London, "Nothing would surprise me." Questions

1. Why is it that firms like Alcoa desire to merger or buy other large firms in the same industry like Reynolds?

2. Why might regulators have a problem with firms like Alcoa buying firms like Reynolds? 3. What are the general reasons why firms merge? 4. What can firms do to prevent a takeover attempt from an unwanted suitor? 5. How are funds raised to complete a merger between two such large firms? 6. In the case it stated that several of the smaller firms in the industry wanted to be considered as bidding candidates because bidders tend to pay over fair market value for the smaller firm's shares. Why does this happen?

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aw_gitman_pmf_10|Case Studies in Finance|Case 38: Adaptec

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Case Studies in Finance

Case 38: Adaptec Corporate Spin-offs

Brian Reeves opened his mailbox to find a letter from Adaptec, Inc., a global leader in data storage access solutions, which had cost him a lot of heartache in the recent 6 months. After being enticed to purchase shares in high-tech companies after they enjoyed a significant runup in value, Brian jumped on the band wagon only to see the value of the stock get cut in half. The letter read, "Adaptec, Inc.,... announced that the Form 10 Registration Statement for the spin-off of Roxio, Inc., a wholly owned subsidiary of Adaptec, has been declared effective by the Securities and Exchange Commission. Included in the Form 10 is an Information Statement, which will be mailed to Adaptec stockholders later this week…" Skipping over a few sentences, Brian continued. "On April 12, 2001, the Adaptec board declared a dividend to Adaptec stockholders of record on April 30, 2001, of shares of Roxio common stock. The dividend will be paid after the close of business on May 11, 2001, in the amount of 0.1646 shares of Roxio common stock for each share of Adaptec common stock. Adaptec stockholders will not be required to pay any cash or other consideration for the shares of Roxio common stock distribution to them or to surrender or exchange their shares of Adaptec common stock to receive the dividend of Roxio common stock." After reading through all the documents, Brian learned that there are two ways to trade the Adaptec shares between the date of record, April 30, and the distribution date of May 11. He could either trade the "regular way," which meant when he sold a share of Adaptec, he would also be selling the right to the shares of Roxio (Ticker symbol = ADPT), or he could sell "when issued," which meant that he is only parting with shares of Adaptec (Ticker symbol = ADPTV). That is, he would retain the rights of owning shares in Roxio when they became available for sale. Questions

1. Brian wondered why he did not have to do anything in order to be awarded shares of this new company, Roxio. Explain why it makes sense that he did not have to do anything.

2. Assume Brian owned 100 shares of Adaptec. Based on the ratio of exchange of 1 share of Adaptec = 0.1646 shares of Roxio, how many shares of Roxio will Brian receive assuming he retains his Adaptec shares?

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aw_gitman_pmf_10|Case Studies in Finance|Case 38: Adaptec

3. To follow up from question 2, what will happen to the rights to FRACTIONAL shares? That is, after calculating the number of shares Brian is to receive, what happens to the extra fraction of a share given that with common stock, fractional shares ownership is disallowed?

4. Continuing with the fractional share discussion, what are the tax ramifications of these fractional shares?

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aw_gitman_pmf_10|Case Studies in Finance|Case 39: Roxio

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Case Studies in Finance

Case 39: Roxio Corporate Spin-offs

Roxio, a wholly-owned subsidiary of Adaptec, recently finalized its decision to become a completely separately traded corporation. In their own words, Roxio describes themselves as "... a leading provider of digital media software solutions that enable individuals to create, manage and move music, photos, video and data onto recordable compact discs, or CDs. Our principal products are our East CD Creator and Toast families of CD recording software and our GoBack system recovery software. Our software was bundled with approximately 70% of the CD recorders shipped in 2000. We sell our products to a wide range of customers, including leading personal computer, or PC, and CD recordable drive manufacturers and integrators such as Dell, Hewlett-Packard, Philips and Yamaha. Sales to PC and CD recordable drive manufacturers and integrators generate 64% of our net revenues for the nine months ended December 31, 2000. We also sell our products to retailers through our distributors, such as Computer 2000, Ingram Micro, Softbank and Tech Data, and directly to end users. Sales to retailers through our distributors and directly to our end users generated 36% of our net revenues for the nine months ended December 31, 2000." Concerning the independence of Roxio from Adaptec, "... we will enter into a Master Separation and Distribution Agreement and several ancillary agreements for the purpose of accomplishing the contribution of substantially all of the business and assets of Adaptec's software products group to us and the distribution of our common stock to Adaptec's stockholders (at a ratio of 1 Adaptec share = 0.1646 shares of Roxio)." Questions

1. Although the benefits can vary from firm to firm, what do you imagine are the common benefits to a firm when they spin-off from a larger corporation?

2. What are the key risk factors associated with any spin-off? 3. Will Adaptec, Inc. keep any of the shares in Roxio? If so, why? 4. Do you imagine Roxio will pay a dividend in the near future?

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aw_gitman_pmf_10|Case Studies in Finance|Case 39: Roxio

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aw_gitman_pmf_10|Case Studies in Finance|Case 40: Tyco

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Case Studies in Finance

Case 40: Tyco Special Topics: Multi-National Financial Management

$17 billion worth of toys are sold each year with 2/3 of the sales occurring during the last quarter. Every year as Christmas nears, parents are bombarded with pressures to fulfill their children's every toy related desire. From increased advertisements on Saturday mornings (cartoon day) to sitting on Santa's lap at the mall, toy companies see the last three months of the year as their make or break time. Tyco Toys, Inc. is the third largest toy company in the United States. They produce and sell radio control toys, dolls, electric racing sets, view-master 3-D viewers, playschool toys, and much, much more. Their most recent success is a product called Doctor Dreadful. Tyco had noticed a recent trend in toys that are designed to push the outer limits on grossing kids out. From candy that turns your tongue different colors to edible candy snot that is dispensed from a toy nose, kids were ready to push the (disgusting) envelope. Doctor Dreadful is a small-scale scientist's laboratory that kids use to create candy warts, brains, and other vile corporal creations. The product is mainly geared towards boys, but none the less, it sold over $50 million in its first quarter. Tyco is not only a domestic seller, but it has several foreign operations as well. Many of its products are sold in the United Kingdom, Canada, Mexico, Australia, Thailand, the People's Republic of China, Belgium, France, Spain, Austria, Switzerland, and Germany. Since Tyco has been able to penetrate the western European market it has been contemplating an entrance into the Netherlands. With the success of Doctor Dreadful, Tyco feels this is the ideal time. Cees Van Der Lelij, Senior Vice President of Tyco International in Europe, is responsible for determining the feasibility of establishing a factory in the Netherlands. Cees noticed that the current exchange rate between the United States and the Netherlands is $1 = 1.6 Guilders. Based on this rate, it will cost approximately $13,000,000 (20.8 million guilders) to build the factory. In order to raise funds for the foreign direct investment, Tyco felt that raising funds domestically would be much less risky than listing securities in a foreign stock market. Tyco decided the funds should be raised with 50% debt and 50% equity. Additionally, working capital would also have to be dedicated to the project in the amount of $1.5 million. To fulfill the need for the net working capital, Tyco could either raise the entire amount in dollars in London's Eurodollar market at a 6% annual rate or the entire amount could be borrowed in the Netherlands at 9% locally. Tyco's domestic cost of equity is 11.4% and its after-tax cost of http://wps.aw.com/aw_gitman_pmf_10/0,6047,347223-,00.html (1 of 2) [11/27/2002 12:21:34 AM]