Ross 9e FCF Case Solutions

Case Solutions Fundamentals of Corporate Finance Ross, Westerfield, and Jordan 9th edition

CHAPTER 1 THE McGEE CAKE COMPANY 1.

The advantages to a LLC are: 1) Reduction of personal liability. A sole proprietor has unlimited liability, which can include the potential loss of all personal assets. 2) Taxes. Forming an LLC may mean that more expenses can be considered business expenses and be deducted from the company’s income. 3) Improved credibility. The business may have increased credibility in the business world compared to a sole proprietorship. 4) Ability to attract investment. Corporations, even LLCs, can raise capital through the sale of equity. 5) Continuous life. Sole proprietorships have a limited life, while corporations have a potentially perpetual life. 6) Transfer of ownership. It is easier to transfer ownership in a corporation through the sale of stock. The biggest disadvantage is the potential cost, although the cost of forming a LLC can be relatively small. There are also other potential costs, including more expansive record-keeping.

2.

Forming a corporation has the same advantages as forming a LLC, but the costs are likely to be higher.

3.

As a small company, changing to a LLC is probably the most advantageous decision at the current time. If the company grows, and Doc and Lyn are willing to sell more equity ownership, the company can reorganize as a corporation at a later date. Additionally, forming a LLC is likely to be less expensive than forming a corporation.

CHAPTER 2 CASH FLOWS AND FINANCIAL STATEMENTS AT SUNSET BOARDS Below are the financial statements that you are asked to prepare. 1.

The income statement for each year will look like this: Income statement 2008

2009

$247,259 126,038 24,787 35,581 $60,853 7,735 $53,118 10,624 $42,494

$301,392 159,143 32,352 40,217 $69,680 8,866 $60,814 12,163 $48,651

$21,247 21,247

$24,326 24,326

Sales Cost of goods sold Selling & administrative Depreciation EBIT Interest EBT Taxes Net income Dividends Addition to retained earnings 2.

The balance sheet for each year will be:

Cash Accounts receivable Inventory Current assets Net fixed assets Total assets

Balance sheet as of Dec. 31, 2008 $18,187 Accounts payable 12,887 Notes payable 27,119 Current liabilities $58,193 Long-term debt $156,975 Owners' equity $215,168 Total liab. & equity

$32,143 14,651 $46,794 $79,235 89,139 $215,168

C-2 CASE SOLUTIONS In the first year, equity is not given. Therefore, we must calculate equity as a plug variable. Since total liabilities & equity is equal to total assets, equity can be calculated as: Equity = $215,168 – 46,794 – 79,235 Equity = $89,139

CHAPTER 2 C-3

Cash Accounts receivable Inventory Current assets Net fixed assets Total assets

Balance sheet as of Dec. 31, 2009 $27,478 Accounts payable 16,717 Notes payable 37,216 Current liabilities $81,411 Long-term debt $191,250 Owners' equity $272,661 Total liab. & equity

$36,404 15,997 $52,401 $91,195 129,065 $272,661

The owner’s equity for 2009 is the beginning of year owner’s equity, plus the addition to retained earnings, plus the new equity, so: Equity = $89,139 + 24,326 + 15,600 Equity = $129,065 3. Using the OCF equation: OCF = EBIT + Depreciation – Taxes The OCF for each year is: OCF2008 = $60,853 + 35,581 – 10,624 OCF2008 = $85,180 OCF2009 = $69,680 + 40,217 – 12,163 OCF2009 = $97,734 4. To calculate the cash flow from assets, we need to find the capital spending and change in net working capital. The capital spending for the year was: Capital spending Ending net fixed assets – Beginning net fixed assets + Depreciation Net capital spending

$191,250 156,975 40,217 $74,492

And the change in net working capital was: Change in net working capital Ending NWC – Beginning NWC Change in NWC

$29,010 11,399 $17,611

C-4 CASE SOLUTIONS So, the cash flow from assets was: Cash flow from assets Operating cash flow – Net capital spending – Change in NWC Cash flow from assets

$97,734 74,492 17,611 $ 5,631

5. The cash flow to creditors was: Cash flow to creditors Interest paid – Net new borrowing Cash flow to creditors

$8,866 11,960 –$3,094

6. The cash flow to stockholders was: Cash flow to stockholders Dividends paid – Net new equity raised Cash flow to stockholders

$24,326 15,600 $8,726

Answers to questions 1. The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm invested $17,611 in new net working capital and $74,492 in new fixed assets. The firm gave $5,631 to its stakeholders. It raised $3,094 from bondholders, and paid $8,726 to stockholders. 2. The expansion plans may be a little risky. The company does have a positive cash flow, but a large portion of the operating cash flow is already going to capital spending. The company has had to raise capital from creditors and stockholders for its current operations. So, the expansion plans may be too aggressive at this time. On the other hand, companies do need capital to grow. Before investing or loaning the company money, you would want to know where the current capital spending is going, and why the company is spending so much in this area already.

CHAPTER 3 RATIOS ANALYSIS AT S&S AIR 1.

The calculations for the ratios listed are: Current ratio = $2,186,520 / $2,919,000 Current ratio = 0.75 times Quick ratio = ($2,186,250 – 1,037,120) / $2,919,000 Quick ratio = 0.39 times Cash ratio = $441,000 / $2,919,000 Cash ratio = 0.15 times Total asset turnover = $30,499,420 / $18,308,920 Total asset turnover = 1.67 times Inventory turnover = $22,224,580 / $1,037,120 Inventory turnover = 21.43 times Receivables turnover = $30,499,420 / $708,400 Receivables turnover = 43.05 times Total debt ratio = ($18,308,920 – 10,069,920) / $18,308,920 Total debt ratio = 0.45 times Debt-equity ratio = ($2,919,000 + 5,320,000) / $10,069,920 Debt-equity ratio = 0.82 times Equity multiplier = $18,308,920 / $10,069,920 Equity multiplier = 1.82 times Times interest earned = $3,040,660 / $478,240 Times interest earned = 6.36 times Cash coverage = ($3,040,660 + 1,366,680) / $478,420 Cash coverage = 9.22 times Profit margin = $1,537,452 / $30,499,420 Profit margin = 5.04% Return on assets = $1,537,452 / $18,308,920 Return on assets = 8.40%

C-6 CASE SOLUTIONS

Return on equity = $1,537,452 / $10,069,920 Return on equity = 15.27%

CHAPTER 3 C-7 2.

Boeing is probably not a good aspirant company. Even though both companies manufacture airplanes, S&S Air manufactures small airplanes, while Boeing manufactures large, commercial aircraft. These are two different markets. Additionally, Boeing is heavily involved in the defense industry, as well as Boeing Capital, which finances airplanes. Bombardier is a Canadian company that builds business jets, short-range airliners and fire-fighting amphibious aircraft and also provides defense-related services. It is the third largest commercial aircraft manufacturer in the world. Embraer is a Brazilian manufacturer than manufactures commercial, military, and corporate airplanes. Additionally, the Brazilian government is a part owner of the company. Bombardier and Embraer are probably not good aspirant companies because of the diverse range of products and manufacture of larger aircraft. Cirrus is the world's second largest manufacturer of single-engine, piston-powered aircraft. Its SR22 is the world's best selling plane in its class. The company is noted for its innovative small aircraft and is a good aspirant company. Cessna is a well known manufacturer of small airplanes. The company produces business jets, freight- and passenger-hauling utility Caravans, personal and small-business single engine pistons. It may be a good aspirant company, however, its products could be considered too broad and diversified since S&S Air produces only small personal airplanes.

3.

S&S is below the median industry ratios for the current and cash ratios. This implies the company has less liquidity than the industry in general. However, both ratios are above the lower quartile, so there are companies in the industry with lower liquidity ratios than S&S Air. The company may have more predictable cash flows, or more access to short-term borrowing. If you created an Inventory to Current liabilities ratio, S&S Air would have a ratio that is lower than the industry median. The current ratio is below the industry median, while the quick ratio is above the industry median. This implies that S&S Air has less inventory to current liabilities than the industry median. S&S Air has less inventory than the industry median, but more accounts receivable than the industry since the cash ratio is lower than the industry median. The turnover ratios are all higher than the industry median; in fact, all three turnover ratios are above the upper quartile. This may mean that S&S Air is more efficient than the industry. The financial leverage ratios are all below the industry median, but above the lower quartile. S&S Air generally has less debt than comparable companies, but still within the normal range. The profit margin, ROA, and ROE are all slightly below the industry median, however, not dramatically lower. The company may want to examine its costs structure to determine if costs can be reduced, or price can be increased. Overall, S&S Air’s performance seems good, although the liquidity ratios indicate that a closer look may be needed in this area.

C-8 CASE SOLUTIONS Below is a list of possible reasons it may be good or bad that each ratio is higher or lower than the industry. Note that the list is not exhaustive, but merely one possible explanation for each ratio. Ratio Current ratio Quick ratio Cash ratio Total asset turnover Inventory turnover Receivables turnover

Good Better at managing current accounts. Better at managing current accounts. Better at managing current accounts. Better at utilizing assets. Better at inventory management, possibly due to better procedures. Better at collecting receivables.

Total debt ratio

Less debt than industry median means the company is less likely to experience credit problems.

Debt-equity ratio

Less debt than industry median means the company is less likely to experience credit problems.

Equity multiplier

Less debt than industry median means the company is less likely to experience credit problems.

TIE

Higher quality materials could be increasing costs.

Cash coverage

Less debt than industry median means the company is less likely to experience credit problems.

Profit margin

The PM is slightly below the industry median. It could be a result of higher quality materials or better manufacturing. Company may have newer assets than the industry. Lower profit margin may be a result of higher quality.

ROA ROE

Bad May be having liquidity problems. May be having liquidity problems. May be having liquidity problems. Assets may be older and depreciated, requiring extensive investment soon. Could be experiencing inventory shortages. May have credit terms that are too strict. Decreasing receivables turnover may increase sales. Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE. Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE. Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE. The company may have more difficulty meeting interest payments in a downturn. Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE. Company may be having trouble controlling costs. Company may have newer assets than the industry. Profit margin and EM are lower than industry, which results in the lower ROE.

CHAPTER 4 PLANNING FOR GROWTH AT S&S AIR 1.

To calculate the internal growth rate, we first need to find the ROA and the retention ratio, so: ROA = NI / TA ROA = $1,537,452 / $18,309,920 ROA = .0840 or 8.40% b = Addition to RE / NI b = $977,452 / $1,537,452 b = 0.64 Now we can use the internal growth rate equation to get: Internal growth rate = (ROA × b) / [1 – (ROA × b)] Internal growth rate = [0.0840(.64)] / [1 – 0.0840(.64)] Internal growth rate = .0564 or 5.64% To find the sustainable growth rate, we need the ROE, which is: ROE = NI / TE ROE = $1,537,452 / $10,069,920 ROE = .1527 or 15.27% Using the retention ratio we previously calculated, the sustainable growth rate is: Sustainable growth rate = (ROE × b) / [1 – (ROE × b)] Sustainable growth rate = [0.1527(.64)] / [1 – 0.1527(.64)] Sustainable growth rate = .1075 or 10.75% The internal growth rate is the growth rate the company can achieve with no outside financing of any sort. The sustainable growth rate is the growth rate the company can achieve by raising outside debt based on its retained earnings and current capital structure.

C-10 CASE SOLUTIONS 2.

Pro forma financial statements for next year at a 12 percent growth rate are: Income statement Sales COGS Other expenses Depreciation EBIT Interest Taxable income Taxes (40%) Net income

$ 34,159,350 24,891,530 4,331,600 1,366,680 $ 3,569,541 478,240 $ 3,091,301 1,236,520 $ 1,854,780

Dividends Add to RE

$

675,583 1,179,197 Balance sheet

Assets Current Assets Cash Accounts rec. Inventory Total CA

$

493,920 793,408 1,161,574 $ 2,448,902

Liabilities & Equity Current Liabilities Accounts Payable $ Notes Payable Total CL $

995,680 2,030,000 3,025,680

Long-term debt

5,320,000

Fixed assets Net PP&E

$ 18,057,088

Shareholder Equity Common stock Retained earnings Total Equity

Total Assets

$ 20,505,990

Total L&E

$

$

350,000 10,899,117 $ 11,249,117 $ 19,594,787

So, the EFN is: EFN = Total assets – Total liabilities and equity EFN = $20,505,990 – 19,594,797 EFN = $911,193 The company can grow at this rate by changing the way it operates. For example, if profit margin increases, say by reducing costs, the ROE increases, it will increase the sustainable growth rate. In general, as long as the company increases the profit margin, total asset turnover, or equity multiplier, the higher growth rate is possible. Note however, that changing any one of these will have the effect of changing the pro forma financial statements.

CHAPTER 4 C-11 3.

Now we are assuming the company can only build in amounts of $5 million. We will assume that the company will go ahead with the fixed asset acquisition. To estimate the new depreciation charge, we will find the current depreciation as a percentage of fixed assets, then, apply this percentage to the new fixed assets. The depreciation as a percentage of assets this year was: Depreciation percentage = $1,366,680 / $16,122,400 Depreciation percentage = .0848 or 8.48% The new level of fixed assets with the $5 million purchase will be: New fixed assets = $16,122,400 + 5,000,000 = $21,122,400 So, the pro forma depreciation will be: Pro forma depreciation = .0848($21,122,400) Pro forma depreciation = $1,790,525 We will use this amount in the pro forma income statement. So, the pro forma income statement will be: Income statement Sales COGS Other expenses Depreciation EBIT Interest Taxable income Taxes (40%) Net income

$ 34,159,350 24,891,530 4,331,600 1,790,525 $ 3,145,696 478,240 $ 2,667,456 1,066,982 $ 1,600,473

Dividends Add to RE

$

582,955 1,017,519

C-12 CASE SOLUTIONS The pro forma balance sheet will remain the same except for the fixed asset and equity accounts. The fixed asset account will increase by $5 million, rather than the growth rate of sales. Balance sheet Assets Current Assets Cash Accounts rec. Inventory Total CA

$

493,920 793,408 1,161,574 $ 2,448,902

Fixed assets Net PP&E

$ 21,122,400

Total Assets

$ 23,571,302

Liabilities & Equity Current Liabilities Accounts Payable $ Notes Payable Total CL $

995,680 2,030,000 3,025,680

Long-term debt

5,320,000

Shareholder Equity Common stock Retained earnings Total Equity Total L&E

$

$

350,000 10,737,439 $ 11,087,439 $ 19,433,119

So, the EFN is: EFN = Total assets – Total liabilities and equity EFN = $23,581,302 – 19,433,119 EFN = $4,138,184 Since the fixed assets have increased at a faster percentage than sales, the capacity utilization for next year will decrease.

CHAPTER 6 THE MBA DECISION 1.

Age is obviously an important factor. The younger an individual is, the more time there is for the (hopefully) increased salary to offset the cost of the decision to return to school for an MBA. The cost includes both the explicit costs such as tuition, as well as the opportunity cost of the lost salary.

2.

Perhaps the most important nonquantifiable factors would be whether or not he is married and if he has any children. With a spouse and/or children, he may be less inclined to return for an MBA since his family may be less amenable to the time and money constraints imposed by classes. Other factors would include his willingness and desire to pursue an MBA, job satisfaction, and how important the prestige of a job is to him, regardless of the salary.

3.

He has three choices: remain at his current job, pursue a Wilton MBA, or pursue a Mt. Perry MBA. In this analysis, room and board costs are irrelevant since presumably they will be the same whether he attends college or keeps his current job. We need to find the aftertax value of each, so: Remain at current job: Aftertax salary = $55,000(1 – .26) = $40,700 His salary will grow at 3 percent per year, so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $40,700{[1 – [(1 +.065)/(1 + .03)]38} / (.065 – .03) PV = $836,227.34 Wilton MBA: Costs: Total direct costs = $63,000 + 2,500 + 3,000 = $68,500 PV of direct costs = $68,500 + 68,500 / (1.065) = $132,819.25 PV of indirect costs (lost salary) = $40,700 / (1.065) + $40,700(1 + .03) / (1 + .065)2 = $75,176.00 Salary: PV of aftertax bonus paid in 2 years = $15,000(1 – .31) / 1.0652 = $9,125.17 Aftertax salary = $98,000(1 – .31) = $67,620

C-14 CASE SOLUTIONS

CHAPTER 6 C-15 His salary will grow at 4 percent per year. We must also remember that he will now only work for 36 years, so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $67,620{[1 – [(1 +.065)/(1 + .04)]36} / (.065 – .04) PV = $1,554,663.22 Since the first salary payment will be received three years from today, so we need to discount this for two years to find the value today, which will be: PV = $1,544,663.22 / 1.0652 PV = $1,370,683.26 So, the total value of a Wilton MBA is: Value = –$75,160 – 132,819.25 + 9,125.17 + 1,370,683.26 = $1,171,813.18 Mount Perry MBA: Costs: Total direct costs = $78,000 + 3,500 + 3,000 = $86,500. Note, this is also the PV of the direct costs since they are all paid today. PV of indirect costs (lost salary) = $40,700 / (1.065) = $38,215.96 Salary: PV of aftertax bonus paid in 1 year = $10,000(1 – .29) / 1.065 = $6,666.67 Aftertax salary = $81,000(1 – .29) = $57,510 His salary will grow at 3.5 percent per year. We must also remember that he will now only work for 37 years, so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $57,510{[1 – [(1 +.065)/(1 + .035)]37} / (.065 – .035) PV = $1,250,991.81 Since the first salary payment will be received two years from today, so we need to discount this for one year to find the value today, which will be: PV = $1,250,991.81 / 1.065 PV = $1,174,640.20 So, the total value of a Mount Perry MBA is: Value = –$86,500 – 38,215.96 + 6,666.67 + 1,174,640.20 = $1,056,590.90

C-16 CASE SOLUTIONS 4.

He is somewhat correct. Calculating the future value of each decision will result in the option with the highest present value having the highest future value. Thus, a future value analysis will result in the same decision. However, his statement that a future value analysis is the correct method is wrong since a present value analysis will give the correct answer as well.

5.

To find the salary offer he would need to make the Wilton MBA as financially attractive as the as the current job, we need to take the PV of his current job, add the costs of attending Wilton, and the PV of the bonus on an aftertax basis. So, the necessary PV to make the Wilton MBA the same as his current job will be: PV = $836,227.34 + 132,819.25 + 75,176.00 – 9,125.17 = $1,035,097.42 This PV will make his current job exactly equal to the Wilton MBA on a financial basis. Since his salary will still be a growing annuity, the aftertax salary needed is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] $1,035,097.42 = C {[1 – [(1 +.065)/(1 + .04)]36} / (.065 – .04) C = $45,021.51 This is the aftertax salary. So, the pretax salary must be: Pretax salary = $45,021.51 / (1 – .31) = $65,248.57

6.

The cost (interest rate) of the decision depends on the riskiness of the use of funds, not the source of the funds. Therefore, whether he can pay cash or must borrow is irrelevant. This is an important concept which will be discussed further in capital budgeting and the cost of capital in later chapters.

CHAPTER 7 FINANCING S&S AIR’S EXPANSION PLANS WITH A BOND ISSUE A rule of thumb with bond provisions is to determine who benefits by the provision. If the company benefits, the bond will have a higher coupon rate. If the bondholders benefit, the bond will have a lower coupon rate. 1.

A bond with collateral will have a lower coupon rate. Bondholders have the claim on the collateral, even in bankruptcy. Collateral provides an asset that bondholders can claim, which lowers their risk in default. The downside of collateral is that the company generally cannot sell the asset used as collateral, and they will generally have to keep the asset in good working order.

2.

The more senior the bond is, the lower the coupon rate. Senior bonds get full payment in bankruptcy proceedings before subordinated bonds receive any payment. A potential problem may arise in that the bond covenant may restrict the company from issuing any future bonds senior to the current bonds.

3.

A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. The problem with a sinking fund is that the company must make the interim payments into a sinking fund or face default. This means the company must be able to generate these cash flows.

4.

A provision with a specific call date and prices would increase the coupon rate. The call provision would only be used when it is to the company’s advantage, thus the bondholder’s disadvantage. The downside is the higher coupon rate. The company benefits by being able to refinance at a lower rate if interest rates fall significantly, that is, enough to offset the call provision cost.

5.

A deferred call would reduce the coupon rate relative to a call provision with a deferred call. The bond will still have a higher rate relative to a plain vanilla bond. The deferred call means that the company cannot call the bond for a specified period. This offers the bondholders protection for this period. The disadvantage of a deferred call is that the company cannot call the bond during the call protection period. Interest rates could potentially fall to the point where it would be beneficial for the company to call the bond, yet the company is unable to do so.

6.

A make-whole call provision should lower the coupon rate in comparison to a call provision with specific dates since the make-whole call repays the bondholder the present value of the future cash flows. However, a make-whole call provision should not affect the coupon rate in comparison to a plain vanilla bond. Since the bondholders are made whole, they should be indifferent between a plain vanilla bond and a make-whole bond. If a bond with a make-whole provision is called, bondholders receive the market value of the bond, which they can reinvest in another bond with similar

CASE 3 C-18 characteristics. If we compare this to a bond with a specific call price, investors rarely receive the full market value of the future cash flows.

CHAPTER 7 C-19 7.

A positive covenant would reduce the coupon rate. The presence of positive covenants protects bondholders by forcing the company to undertake actions that benefit bondholders. Examples of positive covenants would be: the company must maintain audited financial statements; the company must maintain a minimum specified level of working capital or a minimum specified current ratio; the company must maintain any collateral in good working order. The negative side of positive covenants is that the company is restricted in its actions. The positive covenant may force the company into actions in the future that it would rather not undertake.

8.

A negative covenant would reduce the coupon rate. The presence of negative covenants protects bondholders from actions by the company that would harm the bondholders. Remember, the goal of a corporation is to maximize shareholder wealth. This says nothing about bondholders. Examples of negative covenants would be: the company cannot increase dividends, or at least increase beyond a specified level; the company cannot issue new bonds senior to the current bond issue; the company cannot sell any collateral. The downside of negative covenants is the restriction of the company’s actions.

9.

Even though the company is not public, a conversion feature would likely lower the coupon rate. The conversion feature would permit bondholders to benefit if the company does well and also goes public. The downside is that the company may be selling equity at a discounted price.

10. The downside of a floating-rate coupon is that if interest rates rise, the company has to pay a higher interest rate. However, if interest rates fall, the company pays a lower interest rate.

CHAPTER 8 STOCK VALUATION AT RAGAN, INC. 1.

The total dividends paid by the company were $126,000. Since there are 100,000 shares outstanding, the total earnings for the company were: Total earnings = 100,000($4.54) = $454,000 This means the payout ratio was: Payout ratio = $126,000/$454,000 = 0.28 So, the retention ratio was: Retention ratio = 1 – .28 = 0.72 Using the retention ratio, the company’s growth rate is: g = ROE × b = .28(.72) = .1806 or 18.06% The dividend per share paid this year was: D0 = $63,000 / 50,000 D0 = $1.26 Now we can find the stock price, which is: P0 = D1 / (R – g) P0 = $1.26(1.1806) / (.20 – .1806) P0 = $76.75

2.

Since Expert HVAC had a write off which affected its earnings per share, we need to recalculate the industry EPS. So, the industry EPS is: Industry EPS = ($0.79 + 1.38 + 1.06) / 3 = $1.08 Using this industry EPS, the industry payout ratio is: Industry payout ratio = $0.40/$1.08 = .3715 or 37.15% So, the industry retention ratio is Industry retention ratio = 1 – .3715 = .6285 or 62.85%

CHAPTER 8 C-21

C-22 CASE SOLUTIONS This means the industry growth rate is: Industry g = .1233(.6285) = .0775 or 7.75% The company will continue to grow at its current pace for five years before slowing to the industry growth rate. So, the total dividends for each of the next six years will be: D1 = $1.26(1.1806) = $1.49 D2 = $1.49(1.1806) = $1.76 D3 = $1.76(1.1806) = $2.07 D4 = $2.07(1.1806) = $2.45 D5 = $2.45(1.1806) = $2.89 D6 = $2.89(1.0849) = $3.11 The stock price in Year 5 with the industry required return will be: Stock value in Year 5 = $3.11 / (.1167 – .0775) = $79.54 This means the total value of the stock today is: P0 = $1.149/1.1167 + $1.76/1.11672 + $2.07/1.11673 + $2.45/1.11674 + ($2.89 + 79.54) / 1.11675 P0 = $53.28 3.

Using the revised industry EPS, the industry PE ratio is: Industry PE = $13.09 / $1.08 = 12.15 Using the original stock price assumption, Ragan’s PE ratio is: Ragan PE (original assumptions) = $76.75 / $4.54 = 16.90 Using the revised assumptions, Ragan’s PE = $53.28 / $4.54 = 11.74 Obviously, using the original assumptions, Ragan’s PE is too high. The PE using the revised assumptions is close to the industry PE ratio. Using the industry average PE, we can calculate a stock price for Ragan, which is: Stock price implied by industry PE = 12.15($4.32) = $55.18

4.

If the ROE on the company’s projects exceeds the required return, the company should retain earnings and reinvest. If the ROE on the company’s projects is lower than the required return, the company should pay dividends. This makes logical sense. Consider a company with a 10 percent required return. If the company can keep retained earnings and reinvest those earnings at 15 percent, shareholders would be better off since the dividends in future years would be more than needed for the required return.

CHAPTER 8 C-23 5.

Again, we will assume the results in Question 2 are correct. The growth rate of the company we calculated in this question was the industry growth rate of 7.75 percent. Since the growth rate is: g = ROE × b If we assume the payout ratio remains constant, the ROE is: .0775 = ROE(.72) ROE = .1073 or 10.73%

6.

The most obvious solution is to retain more of the company’s earnings and invest in profitable opportunities. This strategy will not work if the return on the company’s investment is lower than the required return on the company’s stock.

CHAPTER 9 BULLOCK GOLD MINING 1.

An example spreadsheet is:

CHAPTER 8 C-25 Note, there is no Excel function to directly calculate the payback period. We used “If” statements in our spreadsheet. The IF statement we used is: =IF(-D8>(D9+D10+D11+D12+D13+D14),"Greater than 6 years",IF(D>(D9+D10+D11+D12+D13),(5+(-D8-D9-D10-D11-D12-D13)/D14),IF(D8>(D9+D10+D11+D12),(4+(-D8-D9-D10-D11-D12)/D13),IF(-D8>(D9+D10+D11),(3+(-D8-D9D10-D11)/D12),IF(-D8>(D9+D10),(2+(-D8-D9-D10)/D11),IF(-D8>D9,(1+(-D8-D9)/D10),IF(D8 c PAYBACK = "no payback" End Function

CHAPTER 10 CONCH REPUBLIC ELECTRONICS, PART 1 This is an in-depth capital budgeting problem. The initial cash outlay at Time 0 is simply the cost of the new equipment, $21,500,000. The sales each year are a combination of the sales of the new PDA, the lost sales each year, and the lost revenue. In this case, the lost sales are 15,000 units of the old PDA each year for two years at a price of $290 each. The company will also be forced to reduce the price of the old PDA on the units they will still sell for the next two years. So, the total change in sales is: Sales = New sales – Lost sales – Lost revenue Year 1 = (74,000 × $360) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)] = $20,015,000 Year 2 = (95,000 × $360) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)] = $28,275,000 Sales New Lost sales Lost revenue Net sales VC New Lost sales

Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF

Year 1 $26,640,000 –4,350,000 –2,275,000 $20,015,000

Year 2 $34,200,000 –4,350,000 –1,575,000 $28,275,000

Year 3 $45,000,000

Year 4 $37,800,000

Year 5 $28,800,000

$45,000,000

$37,800,000

$28,800,000

$11,470,000 –1,800,000 $9,670,000

$14,725,000 –1,800,000 $12,925,000

$19,375,000

$16,275,000

$12,400,000

$19,375,000

$16,275,000

$12,400,000

$20,015,000 9,670,000 4,700,000 3,072,350 $2,572,650 900,428 $1,672,223 3,072,350 $4,744,573

$28,275,000 12,925,000 4,700,000 5,265,350 $5,384,650 1,884,628 $3,500,023 5,265,350 $8,765,373

$45,000,000 19,375,000 4,700,000 3,760,350 $17,164,650 6,007,628 $11,157,023 3,760,350 $14,917,373

$37,800,000 16,275,000 4,700,000 2,685,350 $14,139,650 4,948,878 $9,190,773 2,685,350 $11,876,123

$28,800,000 12,400,000 4,700,000 1,919,950 $9,780,050 3,423,018 $6,357,033 1,919,950 $8,276,983

CHAPTER 8 C-27

NWC Beg End NWC CF

$0 4,003,000 –$4,003,000

$4,003,000 5,655,000 –$1,652,000

$5,655,000 9,000,000 –$3,345,000

$9,000,000 7,560,000 $1,440,000

$7,560,000 0 $7,560,000

$741,573

$7,113,373

$11,572,373

$13,316,123

$15,836,983

Net CF

BV of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950) BV of equipment = $4,796,650 Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828 CF on sale of equipment = $4,100,000 + 243,828 = $4,343,828 So, the cash flows of the project are: Time 0 1 2 3 4 5 1.

Cash flow –$21,500,000 741,573 7,113,373 11,572,373 13,316,123 20,180,810

The payback period is: Payback period = 3 + ($2,072,683 / $13,316,123) Payback period = 3.156 years

2.

The profitability index is: Profitability index = [($741,573 / 1.12) + ($7,113,373 / 1.122) + ($11,572,373 / 1.123) + ($13,316,123 / 1.124) + ($20,180,810 / 1.125)] / $21,500,000 Profitability index = 1.604

3.

The project IRR is: IRR: –$21,500,000 = $741,573 / (1 + IRR) + $7,113,373 / (1 + IRR)2 + $11,572,373 / (1 + IRR)3 + $13,316,123 / (1 + IRR)4 + $20,180,810 / (1 + IRR)5 IRR = 27.62%

4.

The project NPV is: NPV = –$21,500,000 + $741,573 / 1.12 + $7,113,373 / 1.122 + $11,572,373 / 1.123 + $13,316,123 / 1.124 + $20,180,810 / 1.125 NPV = $12,983,611.62

CHAPTER 11 CONCH REPUBLIC ELECTRONICS, PART 2 1.

Here we want to examine the sensitivity of NPV to changes in the price of the new PDA. The calculations for sensitivity to changes in price are similar to the original cash flows. The only difference is that we will change the price of the PDA. We will use a price of $370 per unit, but remember that the price we choose is irrelevant: The final answer we want, the sensitivity of NPV to a one dollar change in price will be the same no matter what price we use. The projections with the new prices are: The sales figure for the first two years will be the sales of the new PDA, minus the lost sales of the existing PDA, minus the lost dollar sales from the price reduction of the existing PDA, or: Sales = New sales – Lost sales – Lost revenue Year 1 sales = (74,000 × $370) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)] Year 1 sales = $20,755,000 Year 2 sales = (95,000 × $370) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)] Year 2 sales = $29,225,000 Sales New Lost sales Lost revenue Net sales VC New Lost sales

Year 1 $27,380,000 4,350,000 2,275,000 $20,755,000

Year 2 $35,150,000 4,350,000 1,575,000 $29,225,000

Year 3 $46,250,000

Year 4 $38,850,000

Year 5 $29,600,000

$46,250,000

$38,850,000

$29,600,000

$11,470,000 1,800,000 $9,670,000

$14,725,000 1,800,000 $12,925,000

$19,375,000

$16,275,000

$12,400,000

$19,375,000

$16,275,000

$12,400,000

CHAPTER 11 C-29

Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF

$20,755,000 9,670,000 4,700,000 3,072,350 $3,312,650 1,159,428 $2,153,223 3,072,350 $5,225,573

$29,225,000 12,925,000 4,700,000 5,265,350 $6,334,650 2,217,128 $4,117,523 5,265,350 $9,382,873

$46,250,000 19,375,000 4,700,000 3,760,350 $18,414,650 6,445,128 $11,969,523 3,760,350 $15,729,873

$38,850,000 16,275,000 4,700,000 2,685,350 $15,189,650 5,316,378 $9,873,273 2,685,350 $12,558,623

$29,600,000 12,400,000 4,700,000 1,919,950 $10,580,050 3,703,018 $6,877,033 1,919,950 $8,796,983

NWC Beg End NWC CF

$0 4,151,000 –$4,151,000

$4,151,000 5,845,000 –$1,694,000

$5,845,000 9,250,000 –$3,405,000

$9,250,000 7,770,000 $1,480,000

$7,770,000 0 $7,770,000

$1,074,573

$7,688,873

$12,324,873

$14,038,623

$16,566,983

Net CF

BV of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950) BV of equipment = $4,796,650 Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828 CF on sale of equipment = $4,100,000 + 243,828 = $4,343,828 So, the cash flows of the project under this price assumption are: Time 0 1 2 3 4 5

Cash flow –$21,500,000 1,074,573 7,688,873 12,324,873 14,038,623 20,910,810

The NPV with this sales price is: NPV = –$21,500,000 + $1,074,573 / 1.12 + $7,688,873 / 1.122 + $12,324,873 / 1.123 + $14,038,623 / 1.124 + $20,910,810 / 1.125 NPV = $15,148,716.18

C-30 CASE SOLUTIONS And the sensitivity of changes in the NPV to changes in the price is: ΔNPV/ΔP = ($15,148,716.18 – 12,983,611.62) / ($370 – 360) ΔNPV/ΔP = $216,510.46 For every dollar change in price of the new PDA, the NPV of the project changes $216,510.46 in the same direction. 2.

Here we want to examine the sensitivity of NPV to changes in the quantity sold. The calculations for sensitivity to changes in quantity are similar to the original cash flows. The only difference is that we will change the quantity sold of the new PDA. We will increase unit sold by 100 units per year. Remember that the quantity we choose is irrelevant: The final answer we want, the sensitivity of NPV to a one unit per year change in sales. The projections with the quantity are: The sales figure for the first two years will be the sales of the new PDA, minus the lost sales of the existing PDA, minus the lost dollar sales from the price reduction of the existing PDA, or: Sales = New sales – Lost sales – Lost revenue Year 1 sales = (74,100 × $360) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)] Year 1 sales = $20,051,000 Year 2 sales = (95,100 × $360) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)] Year 2 sales = $28,311,000 Note, the variable costs must also be increased to account for additional units sold.

CHAPTER 11 C-31

Sales New Lost sales Lost revenue Net sales

Year 1 $26,676,000 4,350,000 2,275,000 $20,051,000

Year 2 $34,236,000 4,350,000 1,575,000 $28,311,000

Year 3 $45,036,000

Year 4 $37,836,000

Year 5 $28,836,000

$45,036,000

$37,836,000

$28,836,000

$11,485,500 1,800,000 $9,685,500

$14,740,500 1,800,000 $12,940,500

$19,390,500

$16,290,500

$12,415,500

$19,390,500

$16,290,500

$12,415,500

Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF

$20,051,000 9,685,500 4,700,000 3,072,350 $2,593,150 907,603 $1,685,548 3,072,350 $4,757,898

$28,311,000 12,940,500 4,700,000 5,265,350 $5,405,150 1,891,803 $3,513,348 5,265,350 $8,778,698

$45,036,000 19,390,500 4,700,000 3,760,350 $17,185,150 6,014,803 $11,170,348 3,760,350 $14,930,698

$37,836,000 16,290,500 4,700,000 2,685,350 $14,160,150 4,956,053 $9,204,098 2,685,350 $11,889,448

$28,836,000 12,415,500 4,700,000 1,919,950 $9,800,550 3,430,193 $6,370,358 1,919,950 $8,290,308

NWC Beg End NWC CF

$0 4,010,200 –$4,010,200

$4,010,200 5,662,200 –$1,652,000

$5,662,200 9,007,200 –$3,345,000

$9,007,200 7,567,200 $1,440,000

$7,567,200 0 $7,567,200

$747,698

$7,126,698

$11,585,698

$13,329,448

$15,857,508

VC New Lost sales

Net CF

BV of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950) BV of equipment = $4,796,650 Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828 CF on sale of equipment = $4,100,000 + 243,828 = $4,343,828

C-32 CASE SOLUTIONS So, the cash flows of the project under this quantity assumption are: Time 0 1 2 3 4 5

Cash flow –$21,500,000 747,698 7,126,698 11,585,698 13,329,448 20,201,335

The NPV under this assumption is: NPV = –$21,500,000 + $747,698 / 1.12 + $7,126,698 / 1.122 + $11,585,698 / 1.123 + $13,329,448 / 1.124 + $20,201,335 / 1.125 NPV = $13,029,302.17 So, the sensitivity of NPV to units sold is: ΔNPV/ΔQ = ($13,029,302.17 – 12,983,611.62) / 100 ΔNPV/ΔQ = $456.91 For a one unit per year change in quantity sold of the new PDA, the NPV of the project changes $456.91 in the same direction.

CHAPTER 12 A JOB AT S&S AIR 1.

The biggest advantage the mutual funds have is instant diversification. The mutual funds have a number of assets in the portfolio.

2.

Both the APR and EAR are infinite. The match is instantaneous, so the number of periods in a year is infinite.

3.

The advantage of the actively managed fund is the possibility of outperforming the market, which the fund has done six of the last eight years. The major disadvantage is the likelihood of underperforming the market. In general, most mutual funds do not outperform the market for an extended period of time, and finding the funds that will outperform the market in the future beforehand is a daunting task. One factor that makes outperforming the market even more difficult is the management fee charged by the fund.

4.

The returns are the most volatile for the small cap fund because the stocks in this fund are the riskiest. This does not imply the fund is bad, just that the risk is higher, and therefore, the expected return is higher. You would want to invest in this fund if your risk tolerance is such that you are willing to take on the additional risk in expectation of a higher return. The higher expenses of the fund are expected. In general, small cap funds have higher expenses, in large part due to the greater cost of running the fund, including researching smaller stocks.

5.

Since we are given the average return for each fund over the past 10 years, we should use the average risk-free rate over the same period. So, using the information from Table 10.1, the 10-year average risk-free rate is: Risk-free rate = (.0486 + .0480 + .0598 + .0333 +.0161 +.0094 +.0114 + .0279 + .0497 + .0452) / 10 Risk-free rate = .0349 or 3.49% The Sharpe ratio for each of the mutual funds and the company stocks are: Bledsoe S&P 500 Index Fund = (11.48% – 3.49) / 15.82% = .5048 Bledsoe Small-Cap Fund = (16.68% – 3.49) / 19.64% = .6714 Bledsoe Large Company Stock Fund = (11.85% – 3.49) / 15.41% = .5422 Bledsoe Bond Fund = (9.67% – 3.49) / 10.83% = .5703 S&S Air stock = (18% – 3.49) / 70% = .2072

C-34 CASE SOLUTIONS The Sharpe ratio is most applicable for a diversified portfolio, and is least applicable for the company stock.

CHAPTER 12 C-35 6.

This is a very open-ended question. The asset allocation depends on the risk tolerance of the individual. However, most students will be young, so in this case, the portfolio allocation should be more heavily weighted toward stocks. In any case, there should be little, if any, money allocated to the company stock. The principle of diversification indicates that an individual should hold a diversified portfolio. Investing heavily in company stock does not create a diversified portfolio. This is especially true since income comes from the company as well. If times get bad for the company, employees face layoffs, or reduced work hours. So, not only does the investment perform poorly, but income may be reduced as well. We only have to look at employees of Enron or WorldCom to see the potential for problems with investing in company stock. At most, 5 to 10 percent of the portfolio should be allocated to company stock. Age is a determinant in the decision. Older individuals should be less heavily weighted toward stocks. A commonly used rule of thumb is that an individual should invest 100 minus their age in stocks. Unfortunately, this rule of thumb tends to result in an underinvestment in stocks.

CHAPTER 13 THE BETA FOR AMERICAN STANDARD NOTE: The example below shows the results from May 2008. The actual answer to the case will change based on current market conditions 1.

The information used for the analysis is presented below. Note that the risk-free rate (3-month T-bill rate) is expressed as an annual rate. It is necessary to find the monthly rate, so this rate is divided by 12.

May-03 Jun-03 Jul-03 Aug-03 Sep-03 Oct-03 Nov-03 Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 Apr-05

Riskfree

Monthl y Riskfree

0.0107 0.0092 0.009 0.0095 0.0094 0.0092 0.0093 0.009 0.0088 0.0093 0.0094 0.0094 0.0102 0.0127 0.0133 0.0148 0.0165 0.0176 0.0207 0.0219 0.0233 0.0254 0.0274

0.00089 0.00077 0.00075 0.00079 0.00078 0.00077 0.00078 0.00075 0.00073 0.00078 0.00078 0.00078 0.00085 0.00106 0.00111 0.00123 0.00138 0.00147 0.00173 0.00183 0.00194 0.00212 0.00228

Stock price $53.91 $52.40 $49.58 $50.20 $50.75 $48.50 $47.87 $45.64 $46.97 $50.80 $50.48 $53.25 $52.63 $53.78 $49.16 $49.90 $41.75 $41.45 $42.73 $47.53 $49.05 $49.40 $48.70 $46.74

Return -0.0280 -0.0538 0.0125 0.0110 -0.0443 -0.0130 -0.0466 0.0291 0.0815 -0.0063 0.0549 -0.0116 0.0219 -0.0859 0.0151 -0.1633 -0.0072 0.0309 0.1123 0.0320 0.0071 -0.0142 -0.0402

S&P 500 963.59 974.5 990.31 1008.01 995.97 1050.71 1058.2 1111.92 1131.13 1144.94 1126.21 1107.3 1120.68 1140.84 1101.72 1104.24 1114.58 1130.2 1173.82 1211.92 1181.27 1203.6 1180.59 1156.85

S&P 500 return

Stock risk premium

0.0113 0.0162 0.0179 -0.0119 0.0550 0.0071 0.0508 0.0173 0.0122 -0.0164 -0.0168 0.0121 0.0180 -0.0343 0.0023 0.0094 0.0140 0.0386 0.0325 -0.0253 0.0189 -0.0191 -0.0201

-0.0289 -0.0546 0.0118 0.0102 -0.0451 -0.0138 -0.0474 0.0284 0.0808 -0.0071 0.0541 -0.0124 0.0210 -0.0870 0.0139 -0.1646 -0.0086 0.0294 0.1106 0.0302 0.0052 -0.0163 -0.0425

S&P risk premium 0.0104 0.0155 0.0171 -0.0127 0.0542 0.0064 0.0500 0.0165 0.0115 -0.0171 -0.0176 0.0113 0.0171 -0.0353 0.0012 0.0081 0.0126 0.0371 0.0307 -0.0271 0.0170 -0.0212 -0.0224

CHAPTER 13 C-37 May-05 Jun-05 Jul-05 Aug-05

0.0278 0.0284 0.0297 0.0322

0.00232 0.00237 0.00248 0.00268

$46.91 $46.85 $49.98 $49.56

0.0036 -0.0013 0.0668 -0.0084

1191.5 1191.33 1234.18 1220.33

0.0300 -0.0001 0.0360 -0.0112

0.0013 -0.0036 0.0643 -0.0111

0.0276 -0.0025 0.0335 -0.0139

C-38 CASE SOLUTIONS

Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08

0.0344 0.0342 0.0371 0.0388 0.0389 0.0424 0.0443 0.0451 0.046 0.0472 0.0479 0.0495 0.0496 0.0481 0.0492 0.0494 0.0485 0.0498 0.0503 0.0494 0.0487 0.0473 0.0461 0.0482 0.042 0.0389 0.039 0.0327 0.03 0.0275 0.0212 0.0126 0.0129

0.00287 0.00285 0.00309 0.00323 0.00324 0.00353 0.00369 0.00376 0.00383 0.00393 0.00399 0.00413 0.00413 0.00401 0.0041 0.00412 0.00404 0.00415 0.00419 0.00412 0.00406 0.00394 0.00384 0.00402 0.0035 0.00324 0.00325 0.00273 0.0025 0.00229 0.00177 0.00105 0.00108

$49.84 $50.28 $51.76 $52.07 $52.39 $52.00 $54.50 $56.75 $57.92 $57.50 $57.23 $57.75 $59.92 $62.05 $63.10 $63.28 $66.57 $65.70 $65.10 $66.38 $65.62 $63.55 $65.02 $65.34 $70.26 $75.51 $79.28 $77.18 $76.10 $75.70 $77.51 $70.70 $72.15

0.0056 0.0088 0.0294 0.0060 0.0061 -0.0074 0.0481 0.0413 0.0206 -0.0073 -0.0047 0.0091 0.0376 0.0355 0.0169 0.0029 0.0520 -0.0131 -0.0091 0.0197 -0.0114 -0.0315 0.0231 0.0049 0.0753 0.0747 0.0499 -0.0265 -0.0140 -0.0053 0.0239 -0.0879 0.0205

1228.81 1207.01 1249.48 1248.29 1280.08 1280.66 1294.87 1310.61 1270.09 1270.2 1276.66 1303.82 1335.85 1377.94 1400.63 1418.3 1438.24 1406.82 1420.86 1482.37 1530.62 1503.35 1455.27 1473.99 1526.75 1549.38 1481.14 1468.36 1378.55 1330.63 1322.7 1385.59 1394.35

0.0069 -0.0177 0.0352 -0.0010 0.0255 0.0005 0.0111 0.0122 -0.0309 0.0001 0.0051 0.0213 0.0246 0.0315 0.0165 0.0126 0.0141 -0.0218 0.0100 0.0433 0.0325 -0.0178 -0.0320 0.0129 0.0358 0.0148 -0.0440 -0.0086 -0.0612 -0.0348 -0.0060 0.0475 0.0063

0.0028 0.0060 0.0263 0.0028 0.0029 -0.0110 0.0444 0.0375 0.0168 -0.0112 -0.0087 0.0050 0.0334 0.0315 0.0128 -0.0013 0.0479 -0.0172 -0.0133 0.0155 -0.0155 -0.0355 0.0193 0.0009 0.0718 0.0715 0.0467 -0.0292 -0.0165 -0.0075 0.0221 -0.0889 0.0194

0.0041 -0.0206 0.0321 -0.0042 0.0222 -0.0031 0.0074 0.0084 -0.0348 -0.0038 0.0011 0.0171 0.0204 0.0275 0.0124 0.0085 0.0100 -0.0260 0.0058 0.0392 0.0285 -0.0218 -0.0358 0.0088 0.0323 0.0116 -0.0473 -0.0114 -0.0637 -0.0371 -0.0077 0.0465 0.0052

Using the Excel functions for the average return and standard deviation, the table below shows the averages and standard deviations for each of the series. Last 60 months Average return Standard deviation

Risk-free 0.25% 0.13%

Coach 0.58% 4.31%

S&P 500 0.65% 2.54%

CHAPTER 13 C-39 2.

Jensen’s alpha represents the excess return not explained by the beta of the stock. A positive alpha plots above the Security Market Line and has a return in excess of its systematic risk. The residual is the error in the estimation, and is the portion of the return not explained by the market model.

3.

The relevant output from Excel for this period is: SUMMARY OUTPUT Regression Statistics Multiple R 0.143856 R Square 0.020695 Adjusted R Square -0.00811 Standard Error 0.032 Observations 36 ANOVA df Regression Residual Total

Intercept X Variable 1

1 34 35

SS 0.000736 0.034816 0.035552

MS 0.000736 0.001024

F 0.718487

Coefficients 0.008954 0.180843

Standard Error 0.005341 0.213349

t Stat 1.676392 0.847636

P-value 0.102834 0.402568

Significance F 0.402568

The α is barely insignificant at 10%, while the β estimate 0.18 and is insignificant. The residual plot is:

C-40 CASE SOLUTIONS 4.

The relevant output from Excel for this period is: SUMMARY OUTPUT Regression Statistics Multiple R 0.084631 R Square 0.007162 Adjusted R Square -0.00996 Standard Error 0.043074 Observations 60 ANOVA df Regression Residual Total

Intercept X Variable 1

1 58 59

SS 0.000776 0.10761 0.108386

MS 0.000776 0.001855

F 0.418416

Coefficients 0.002744 0.147156

Standard Error 0.005635 0.227495

t Stat 0.486983 0.646851

P-value 0.628106 0.52028

Significance F 0.52028

The α and β are both insignificant at any reasonable level of significance. The residual plot is:

CHAPTER 13 C-41 5.

The beta for Colgate-Palmolive on Yahoo! Finance at the time was 0.16, which is similar to these estimates. Possible reasons for the difference could be different data. For example Yahoo! Finance uses 36 months of returns, but they do not specify the risk-free rate, or the market proxy the use.

CHAPTER 14 THE COST OF CAPITAL FOR HUBBARD COMPUTER, INC. NOTE: The example below shows the results during June, 2008. The actual answer to the case will change based on current market conditions. 1.

The book value of the company’s liabilities and equity can be found from a number of sources. We went to http://www.sec.gov and found Dell’s Form 10q, dated May 2, 2008. Dell’s Form 10k showed the following:

Dell has one outstanding bond issue as of June 2008, maturing in 2028. The book value of debt is the book value of this issue, or $300 million.

CHAPTER 14 C-43 2.

We need various pieces of information to estimate the cost of equity. We can use the dividend growth model or the CAPM, so we will attempt to use both. The following information is necessary for our calculations. We gathered all the information from finance.yahoo.com. The screen shots below show this information. Market price = $23.06 Market capitalization = $47.10 billion Book value per share = $1.813 Shares outstanding = 2.05 billion Most recent dividend = $0 Beta = 1.53 3-month Treasury bill rate = 1.83%

C-44 CASE SOLUTIONS

Dell has never paid a dividend so we cannot use the dividend growth model to estimate the cost of equity. We do have the information to estimate the cost of equity with the CAPM. Using the market risk premium of 7 percent from the textbook, we get: RE = Rf + β[E(RM) – Rf] RE = .0183 + 1.53[.07] RE = 12.54% 3.

To get the yield to maturity on Dell’s bonds, we went to www.finra.org/marketdata. We gathered the following information:

CHAPTER 14 C-45

So, the weighted average cost of debt for Dell using both the book value and the market value is: Coupon Rate 7.10 Total

Book value (face value, in millions) $300 $300

Percentage of total 1.00 1.00

Market value (in millions) $305.43 $305.43

Percentage of total 1.00 1.00

Yield to maturity 6.93%

Weighted book values 6.93% 6.93%

Weighted market values 6.93% 6.93%

It is irrelevant whether we use book or market values to calculate the cost of debt for Dell since the company has only one bond issue outstanding.

C-46 CASE SOLUTIONS 4.

Using book value weights, the total value of Dell is: V = $300M + $3.717B V = $4.017B So, the WACC based on book value weights is: WACC = RE(E/V) + RD(D/V)(1 – t) WACC = (.1254)($3.717/$4.017) + (.0693)($0.300/$4.017)(1 – .35) WACC = 11.94% Using the market value weights, the total value of Dell is: V = $305.43M + $47.10B V = $47.41B So, the WACC based on market value weights is: WACC = RE(E/V) + RD(D/V)(1 – t) WACC = (.1254)($47.10/$47.41) + (.0693)($0.305/$47.41)(1 – .35) WACC = 12.49% The cost of capital for Dell using Book value weights and market value weights is similar because Dell has such a small portion of debt in its capital structure. The difference in this case is 0.55 percent.

5.

The biggest potential problem with HCI using Dell’s cost of capital is that HCI operates stores that generate the company’s sales. Dell generates sales almost exclusively from its internet site. This could potentially be a risk factor that affects the cost of capital. Another factor that could affect the cost of capital is Dell’s access to capital since it is a public company, while Hubbard Computer is private.

CHAPTER 15 S&S AIR GOES PUBLIC 1.

The main difference in the costs is the reduced possibility of underpricing in a Dutch auction. As to which is better, we don’t actually know. In theory, the Dutch auction should be better since it should eliminate underpricing. However, as Google shows, underpricing can still exist in a Dutch auction. Whether the underpricing is as severe in a Dutch auction as it would be in a traditional underwritten offer is unknown.

2.

There is no way to calculate the optimum size of the IPO, so whether Mark is correct or Kim is correct will only be told in time. The disadvantages of raising the extra cash in the IPO include the agency costs of excess cash. The extra cash may encourage management to act carelessly. The extra cash will also earn a small return unless invested in income producing assets. At best, cash and shortterm investments are a zero NPV investment. The advantages of the increased IPO size include the increased liquidity for the company, and the lower probability that the company will have to go back to the primary market in the near term future. The increased size will also reduce the costs of the IPO on a percentage of funds raised, although this may not be a large advantage.

3.

The underwriter fee is 7 percent of the amount raised, or: Underwriter fee = $75,000,000(.07) Underwriter fee = $5,250,000 Since the company must currently provide audited financial statements due to the bond covenants, the audit costs are not incremental costs and should not be included in the calculation of the fees. So, the sum of the other fees is: Total other fees = $1,800,000 + 12,000 + 15,000 + 100,000 + 6,500 + 520,000 + 110,000 Total other fees = $2,563,500 This means the total fees are: Total fees = $5,250,000 + 2,563,500 Total fees = $7,813,500 The net amount raised is the IPO offer size minus the underwriter fee, or: Net amount raised = $75,000,000 – 5,250,000 Net amount raised = $69,750,000 So, the fees as a percentage of the net amount to the company are: Fee percentage = $7,813,500 / $69,750,000 Fee percentage = .1120 or 11.20%

C-48 CASE SOLUTIONS

CHAPTER 15 C-49 4.

Because of legal repercussions, you should not provide specific advice on which option the employees should choose. There are advantages and disadvantages to each. If the employee tenders the stock to be sold in the IPO, the employee will lose out on any underpricing. This could be a significant cost. However, if the employee retains the stock, he/she must hold the stock for the lockup period, typically 180 days. Additionally, during the lockup period, the employee is legally prohibited from hedging the price risk of the stock with any derivatives, and heavy selling by insiders is considered a negative signal by the market. Another risk in not selling in the IPO is that after the lockup period expires, the employees may be considered insiders, subject to SEC restrictions on selling stock.

CHAPTER 16 STEPHENSON REAL ESTATE RECAPITALIZATION 1.

If Stephenson wishes to maximize the overall value of the firm, it should use debt to finance the $110 million purchase. Since interest payments are tax deductible, debt in the firm’s capital structure will decrease the firm’s taxable income, creating a tax shield that will increase the overall value of the firm.

2.

Since Stephenson is an all-equity firm with 15 million shares of common stock outstanding, worth $35.20 per share, the market value of the firm is: Market value of equity = $35.20(15,000,000) Market value of equity = $528,000,000 So, the market value balance sheet before the land purchase is:

Assets Total assets 3.

a.

Market value balance sheet $528,000,000 Equity $528,000,000 Debt & Equity

$528,000,000 $528,000,000

As a result of the purchase, the firm’s pre-tax earnings will increase by $27 million per year in perpetuity. These earnings are taxed at a rate of 40 percent. Therefore, after taxes, the purchase increases the annual expected earnings of the firm by: Earnings increase = $27,000,000(1 – .40) Earnings increase = $16,200,000 Since Stephenson is an all-equity firm, the appropriate discount rate is the firm’s unlevered cost of equity, so the NPV of the purchase is: NPV = –$110,000,000 + ($16,200,000 / .125) NPV = $19,600,000

CHAPTER 16 C-51 b.

After the announcement, the value of Stephenson will increase by $20 million, the net present value of the purchase. Under the efficient-market hypothesis, the market value of the firm’s equity will immediately rise to reflect the NPV of the project. Therefore, the market value of Stephenson’s equity after the announcement will be: Equity value = $528,000,000 + 19,600,000 Equity value = $507,500,000

Old assets NPV of project Total assets

Market value balance sheet $528,000,000 19,600,000 Equity $547,600,000 Debt & Equity

$507,500,000 $547,600,000

Since the market value of the firm’s equity is $547,600,000 and the firm has 15 million shares of common stock outstanding, Stephenson’s stock price after the announcement will be: New share price = $547,600,000 / 15,000,000 New share price = $36.51 Since Stephenson must raise $110 million to finance the purchase and the firm’s stock is worth $36.51 per share, Stephenson must issue: Shares to issue = $110,000,000 / $36.51 Shares to issue = 3,013,148 c.

Stephenson will receive $110 million in cash as a result of the equity issue. This will increase the firm’s assets and equity by $110 million. So, the new market value balance sheet after the stock issue will be:

Cash Old assets NPV of project Total assets

Market value balance sheet $110,000,000 528,000,000 19,600,000 Equity $657,600,000 Debt & Equity

$657,600,000 $657,600,000

The stock price will remain unchanged. To show this, Stephenson will now have: Total shares outstanding = 15,000,000 + 3,031,148 Total shares outstanding = 18,013,148 So, the share price is: Share price = $657,600 / 18,013,148 Share price = $36.51

C-52 CASE SOLUTIONS

d.

The project will generate $27 million of additional annual pretax earnings forever. These earnings will be taxed at a rate of 40 percent. Therefore, after taxes, the project increases the annual earnings of the firm by $16.2 million. So, the aftertax present value of the earnings increase is: PVProject = $16,200,000 / .125 PVProject = $129,600,000 So, the market value balance sheet of the company will be:

Old assets PV of project Total assets 4.

a.

Market value balance sheet $528,000,000 129,600,000 Equity $657,600,000 Debt & Equity

$648,000,000 $657,600,000

Modigliani-Miller Proposition I states that in a world with corporate taxes: VL = VU + tCB As was shown in Question 3, Stephenson will be worth $657.6 million if it finances the purchase with equity. If it were to finance the initial outlay of the project with debt, the firm would have $110 million worth of 8 percent debt outstanding. So, the value of the company if it financed with debt is: VL = $657,600,000 + .40($110,000,000) VL = $701,600,000

b.

After the announcement, the value of Stephenson will immediately rise by the present value of the project. Since the market value of the firm’s debt is $110 million and the value of the firm is $692 million, we can calculate the market value of Stephenson’s equity. Stephenson’s market-value balance sheet after the debt issue will be:

Value unlevered Tax shield Total assets

Market value balance sheet $657,600,000 Debt 44,000,000 Equity $701,600,000 Debt & Equity

$110,000,000 591,600,000 $701,600,000

Since the market value of the Stephenson’s equity is $591.6 million and the firm has 15 million shares of common stock outstanding, Stephenson’s stock price after the debt issue will be: Stock price = $591,600,000 / 15,000,000 Stock price = $39.44 5.

If Stephenson uses equity in order to finance the project, the firm’s stock price will remain at $36.51 per share. If the firm uses debt in order to finance the project, the firm’s stock price will rise to $39.44 per share. Therefore, debt financing maximizes the per share stock price of the firm’s equity.

CHAPTER 17 ELECTRONIC TIMING, INC. 1.

The value of the company will decline by the amount of the dividend. Ignoring taxes, shareholders wealth will not be affected because the stock price will drop by the amount of the dividend payment.

2.

The value of the company could increase or decrease. If the company is over-levered, paying off debt can lower the interest rate on debt, and decrease financial distress costs. If there are no financial distress costs, capital structure theory argues that increasing debt can increase the value of the company because of the interest tax shield.

3.

The PE ratio will fall and the ROA and ROE will increase, but the changes are irrelevant.

4.

A regular dividend payment is something the company should probably not undertake. A company rarely begins regular dividend payments that it will be unable to continue in the future. Cessation of dividend payments is viewed a negative signal by the market.

5.

The implication is that the company should not retain earnings unless the ROE of the new project is greater than the shareholders required return on equity. This is an intuitive result. Shareholders want the company to retain earnings for future growth if the earnings will earn a greater return than shareholders require. If the return on the retained earnings is lower than shareholders required return, the company is lowering shareholder value.

6.

The decision does depend on the organizational form of the company. Money paid to shareholders of a corporation are dividends, and currently taxed at the lower dividend tax rate. Money paid to the owners of a LLC is considered income, and taxed at the applicable personal income tax rate.

CHAPTER 18 PIEPKORN MANUFACTURING WORKING CAPITAL MANAGEMENT 1.

The cash flow each quarter will consist of the sales collection, minus the suppliers paid, expenses, dividends, interest, and capital outlays. The individual cash flows are calculated as follows: Accounts receivable collected from the previous quarter: For the 1st quarter, this is simply 90 percent of the beginning A/R balance. For the remaining quarters, the company will collect (53 / 90) percent of the previous quarter sales since this is the balance remaining at the end of the quarter. Accounts receivable from current quarter sales: The company will collect ((90 – 53) / 90) percent of the current quarter sales. Purchases last quarter paid this quarter: The company purchases one-half of next quarter sales in the current quarter and takes 42 days to pay the accounts payable. So, the accounts payable balance at the beginning of each quarter will be: Payments for purchases from last quarter = (42 / 90)(Current quarter sales)(.50) Purchases for next quarter paid this quarter: Using the same payables period, the company will pay part of the current quarter orders. The current quarter orders are based on next orders sales, so: Purchase paid for next quarter = ((90 – 42) / 90)(Current quarter sales)(.50) Expenses are simply 30 percent of gross sales, while interest is constant. The cash flows for each quarter will be:

CHAPTER 18 C-55

A/R at beginning of Q collected Sales collection in current Q Purchases last Q paid this Q Purchase for next Q paid this Q Expenses Interest and dividends Outlay Net cash inflow

Net cash inflow Q1 Q2 $484,000.00 $532,944.44 372,055.56 423,444.44 –211,166.67 –240,333.33 –274,666.67 –309,333.33 –271,500.00 –309,000.00 –95,000.00 –95,000.00 $2,722.22

$39,111.11

Q4 $683,111.11 509,777.78 –289,333.33 –269,333.33 –372,000.00 –95,000.00 –370,000.00 –$202,777.78

Cash Balance Q1 Q2 $190,000.00 $193,722.22 3,722.22 2,722.22 $193,722.22 $196,444.44 100,000.00 100,000.00 $93,722.22 $96,444.44

Q3 $196,444.44 39,111.11 $235,555.56 100,000.00 $135,555.56

Q4 $235,555.56 –202,777.78 $32,777.78 100,000.00 –$67,222.22

$100,000.00 39,111.11 –40,094.02 982.91 0 0 0 0 $100,000.00 –100,000.00 $0

$100,000.00 –202,777.78 0 1,383.85 98,290.67 103,103.26 0 0 $100,000.00 –100,000.00 $0

$98,290.67 138,384.68 0 $0

$138,384.68 40,094.02 0 $103,103.26

$3,722.22

Q3 $606,555.56 476,888.89 –270,666.67 –330,666.67 –348,000.00 –95,000.00

So, the cash balance each quarter is:

Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit)

The short-term financial plan looks like this:

Target cash balance Net cash inflow New short-term investments Income on short-term investments Short-term investments sold New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance Minimum cash balance Cumulative surplus (deficit) Beginning short-term investments Ending short-term investments Beginning short-term debt Ending short-term debt

Short-term Financial Plan $100,000.00 $100,000.00 3,722.22 2,722.22 –4,622.22 –3,668.44 900.00 946.22 0 0 0 0 0 0 0 0 $100,000.00 $100,000.00 –100,000.00 –100,000.00 $0 $0 $90,000.00 94,622.22 0 $0

$94,622.22 98,290.67 0 $0

C-56 CASE SOLUTIONS The interest calculations for each quarter and the net cash cost are: Q1: Q2: Q3: Q4:

Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of

$90,000.00 $94,622.22 $98,290.67 $138,384.68

Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing 2.

earns earns earns earns

$900.00 $946.22 $982.91 $1,383.85

in income. in income. in income. in income.

$900.00 946.22 982.91 1,383.85 $4,212.98

If Piepkorn reduces its target cash balance to $80,000, the cash flows each quarter will remain the same, so they will not be repeated here. The cash balance and short-term financial plan will be:

Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit)

Target cash balance Net cash inflow New short-term investments Income on short-term investments Short-term investments sold New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance Minimum cash balance Cumulative surplus (deficit) Beginning short-term investments Ending short-term investments Beginning short-term debt Ending short-term debt

Cash Balance Q1 Q2 $190,000.00 $193,722.22 3,722.22 2,722.22 $193,722.22 $196,444.44 80,000.00 80,000.00 $113,722.22 $116,444.44

Q3 $196,444.44 39,111.11 $235,555.56 80,000.00 $155,555.56

Q4 $235,555.56 –202,777.78 $32,777.78 80,000.00 –$47,222.22

Short-term Financial Plan $80,000.00 $80,000.00 3,722.22 2,722.22 –4,822.22 –3,870.44 1,100.00 1,148.22 0 0 0 0 0 0 0 0 $80,000.00 $80,000.00 –80,000.00 –80,000.00 $0 $0

$80,000.00 39,111.11 –40,298.04 1,186.93 0 0 0 0 $80,000.00 –80,000.00 $0

$80,000.00 –202,777.78 0 1,589.91 118,692.67 82,495.20 0 0 $80,000.00 –80,000.00 $0

$118,692.67 158,990.70 0 $0

$158,990.70 40,298.04 0 $82,495.20

$110,000.00 114,822.22 0 $0

$114,822.22 118,692.67 0 $0

CHAPTER 18 C-57

Q1: Q2: Q3: Q4 :

Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of

$110,000.00 $114,822.22 $118,692.67

earns earns earns

$1,100.00 $1,148.22 $1,186.93

in income. in income. in income.

Excess funds at start of quarter of

$158,990.70

earns

$1,589.91

in income.

Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing 3.

$1,100.00 1,148.22 1,186.93 1,589.91 $5,025.06

If Piepkorn offers the discounted terms, we must assume the sales will remain unchanged. However, the effect of the discount will be to reduce the dollars received from the sales by the discount percentage for the customers who take advantage of the discount. This will change the cash flows Piepkorn receives. The net sales after the discount each quarter will be: Q1 net sales = ($905,000)(.40)(1 – .01) + $905,000(.60) Q1 net sales = $901,380 Q2 net sales = ($1,030,000)(.40)(1 – .01) + $1,030,000(.60) Q2 net sales = $1,025,880 Q3 net sales = ($1,160,000)(.40)(1 – .01) + $1,160,000(.60) Q3 net sales = $1,155,360 Q4 net sales = ($1,240,000)(.40)(1 – .01) + $1,240,000(.60) Q4 net sales = $1,235,040 In addition to the reduction in sales, the collections period will decrease to 36 days. The collections will be based off the lower sales figures, so the net cash inflows each quarter will be:

C-58 CASE SOLUTIONS

A/R at beginning of Q collected Sales collection in current Q Purchases last Q paid this Q Purchase for next Q paid this Q Expenses Interest and dividends Outlay Net cash inflow

Net cash inflow Q1 Q2 $484,000.00 $360,552.00 540,828.00 615,528.00 –211,166.67 –240,333.33 –274,666.67 –309,333.33 –271,500.00 –309,000.00 –95,000.00 –95,000.00 $172,494.67

$22,413.33

Q3 $410,352.00 693,216.00 –270,666.67 –330,666.67 –348,000.00 –95,000.00 $59,234.67

Q4 $462,144.00 741,024.00 –289,333.33 –269,333.33 –372,000.00 –95,000.00 –370,000.00 –$192,498.67

So, the cash balance each quarter will be: Cash Balance Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit)

Q1 $190,000.00 172,494.67 $362,494.67 80,000.00 $282,494.67

Q2 $362,494.67 22,413.33 $384,908.00 80,000.00 $304,908.00

Q3 $384,908.00 59,234.67 $444,142.67 80,000.00 $364,142.67

Q4 $444,142.67 –192,498.67 $251,644.00 80,000.00 $171,644.00

CHAPTER 18 C-59 The short-term financial plan under these assumptions will be:

Target cash balance Net cash inflow New short-term investments Income on short-term investments Short-term investments sold New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance Minimum cash balance Cumulative surplus (deficit)

Short-term Financial Plan $80,000.00 $80,000.00 172,494.67 22,413.33 –173,594.67 –25,249.28 1,100.00 2,835.95 0 0 0 0 0 0 0 0 $80,000.00 $80,000.00 –80,000.00 –80,000.00 $0 $0

Beginning short-term investments Ending short-term investments Beginning short-term debt Ending short-term debt

$110,000.00 283,594.67 0 $0

$283,594.67 308,843.95 0 $0

$80,000.00 59,234.67 –62,323.11 3,088.44 0 0 0 0 $80,000.00 –80,000.00 $0

$80,000.00 –192,498.67 0 3,711.67 188,787.00 0 0 0 $80,000.00 –80,000.00 $0

$308,843.95 371,167.05 0 $0

$371,167.05 182,380.06 0 $0

The interest earned each quarter is:

Q1: Q2: Q3: Q4 :

Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of

$110,000.00 $283,594.67 $308,843.95

earns earns earns

$1,100.00 $2,835.95 $3,088.44

in income. in income. in income.

Excess funds at start of quarter of

$371,167.05

earns

$3,711.67

in income.

The net cash cost is: Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing

$1,100.00 2,835.95 3,088.44 3,711.67 $10,736.06

The effective annual rate Piepkorn is offering to its customers is: EAR = [1 + (.01/.99)]365/30 – 1 EAR = 13.01%

C-60 CASE SOLUTIONS 4.

In addition to the discount offered to customers, Piepkorn is now offered a discount from suppliers. However, since the purchases from suppliers are a percentage of sales, we must assume these purchases are for raw materials, which will not change except for the discount taken. Thus, we will base the purchases off the gross sales figure. The net cash inflows each quarter will be:

A/R at beginning of Q collected Sales collection in current Q Purchases last Q paid this Q Purchase for next Q paid this Q Expenses Interest and dividends Outlay Net cash inflow

Net cash inflow Q1 Q2 $484,000.00 $360,552.00 540,828.00 615,528.00 –75,416.67 –85,833.33 –422,729.17 –476,083.33 –271,500.00 –309,000.00 –95,000.00 –95,000.00 $160,182.17

$10,163.33

Q3 $410,352.00 693,216.00 –96,666.67 –508,916.67 –348,000.00 –95,000.00 $54,984.67

Q4 $462,144.00 741,024.00 –103,333.33 –414,520.83 –372,000.00 –95,000.00 –370,000.00 –$151,686.17

So, the cash balance each quarter will be: Cash Balance Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit)

Q1 $190,000.00 160,182.17 $350,182.17 80,000.00 $270,182.17

Q2 $350,182.17 10,163.33 $360,345.50 80,000.00 $280,345.50

Q3 $360,345.50 54,984.67 $415,330.17 80,000.00 $335,330.17

Q4 $415,330.17 –151,686.17 $263,644.00 80,000.00 $183,644.00

CHAPTER 18 C-61 The short-term financial plan will be:

Target cash balance Net cash inflow New short-term investments Income on short-term investments Short-term investments sold New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance Minimum cash balance Cumulative surplus0deficit

Short-term Financial Plan $80,000.00 $80,000.00 160,182.17 10,163.33 –161,282.17 –12,876.15 1,100.00 2,712.82 0 0 0 0 0 0 0 0 $80,000.00 $80,000.00 –80,000.00 –80,000.00 $0 $0

Beginning short-term investments Ending short-term investments Beginning short-term debt Ending short-term debt

$110,000.00 271,282.17 0 $0

$271,282.17 284,158.32 0 $0

$80,000.00 54,984.67 –57,826.25 2,841.58 0 0 0 0 $80,000.00 –80,000.00 $0

$80,000.00 –151,686.17 0 3,419.85 148,266.32 0 0 0 $80,000.00 –80,000.00 $0

$284,158.32 341,984.57 0 $0

$341,984.57 193,718.25 0 $0

The interest earned each quarter will be: Q1: Q2: Q3: Q4 :

Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of

$110,000.00 $271,282.17 $284,158.32

earns earns earns

$1,100.00 $2,712.82 $2,841.58

in income. in income. in income.

Excess funds at start of quarter of

$341,984.57

earns

$3,419.85

in income.

And the net cash cost will be: Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing

$1,100.00 2,712.82 2,841.58 3,419.85 $10,074.25

The effective annual rate the company’s suppliers are offering to Piepkorn is: EAR = [1 + (.015/.985)]365/25 – 1 EAR = 24.69%

CHAPTER 19 CASH MANAGEMENT AT WEBB CORP. 1.

The amount the company will have available is the future value of the transfers, which are an annuity. The amount of each transfer is one minus the wire transfer cost, times the number of transfers, which is four since there are four banks, times the amount of each transfer. So, the total available in two weeks will be: Amount available = (1 – .0015)(4)($160,000)(FVIFA.015%,14) Amount available = $8,955,288.13

2.

The bank will accept the ACH transfers from the four different banks, so the company incurs a transfer fee from each collection center. The future value of the deposits now will be: Value of ACH = [4($160,000 – 500)(FVIFA.015%,14)]/1.00015 Value of ACH = $8,939,373.02 The company should not go ahead with the plan since the future value is lower.

3.

To find the cost at which the company is indifferent, we set the amount available we found in Question 1 equal to the cost equation we used in Question 2. Setting up this equation where X stands for the ACH transfer cost, we find: [4($160,000 – $X)(FVIFA.015%,14)]/1.00015 = $8,939,373.02 X = $216.04

CHAPTER 20 CREDIT POLICY AT HOWLETT INDUSTRIES To decide on the optimal credit policy, we need to calculate the NPV of each policy. We will begin with the calculation of the NPV of the current policy. Current Policy First, we need to calculate the average daily sales which are: Average daily sales = $140,000,000/365 Average daily sales = $383,561.24 Next, we need the average daily costs. We will begin with the average daily variable costs, which are 45 percent of sales. So, the average daily variable costs are: Average daily variable costs = 0.45($140,000,000)/365 Average daily variable costs = $172,602.74 Under the current policy, the default rate is 1.6 percent, so the average daily defaults will be: Average daily defaults = 0.016($140,000,000)/365 Average daily defaults = $6,136.99 The current policy has administrative costs equal to 2.2 percent of sales, so the average daily administrative costs are: Average daily administrative costs = 0.022($140,000,000)/365 Average daily administrative costs = $8,438.36 We also need the appropriate interest rate for the collection period. With a 6 percent annual interest rate, the periodic rate for the 38 day collection period is: Interest rate = (1 + .06/365)38 – 1 Interest rate = 0.00609 or 0.609% Since the credit policy will exist into perpetuity, the NPV is: NPV = –$172,602.74 + ($383,561.64 – 172,602.74 – 6,136.99 – 8,438.36) / 0.00609 NPV = $32,101,900.20

C-64 CASE SOLUTIONS

CHAPTER 20 C-65 Option 1 Under Option 1, the average daily sales are: Average daily sales = $160,000,000/365 Average daily sales = $438,356.16 The average daily variable costs will be: Average daily variable costs = 0.45($160,000,000)/365 Average daily variable costs = $197,260.27 Under the Option 1, the default rate is 2.5 percent, so the average daily defaults will be: Average daily defaults = 0.025($160,000,000)/365 Average daily defaults = $10,958.90 Option 1 has administrative costs equal to 3.2 percent of sales, so the average daily administrative costs are: Average daily administrative costs = 0.032($160,000,000)/365 Average daily administrative costs = $14,027.40 We also need the appropriate interest rate for the collection period. With a 6 percent annual interest rate, the periodic rate for the 41 day collection period is: Interest rate = (1 + .06/365)41 – 1 Interest rate = 0.00657 or 0.657% Since the credit policy will exist into perpetuity, the NPV is: NPV = –$197,260.27 + ($438,356.16 – 197,260.27 – 10,958.90 – 14,027.40) / 0.00657 NPV = $32,712,453.23 Option 2 Under Option 2, the average daily sales are: Average daily sales = $157,000,000/365 Average daily sales = $430,136.99 The average daily variable costs will be: Average daily variable costs = 0.45($157,000,000)/365 Average daily variable costs = $193,561.64 Under the Option 2, the default rate is 1.8 percent, so the average daily defaults will be: Average daily defaults = 0.018($157,000,000)/365 Average daily defaults = $7,742.47

C-66 CASE SOLUTIONS Option 2 has administrative costs equal to 2.4 percent of sales, so the average daily administrative costs are: Average daily administrative costs = 0.024($157,000,000)/365 Average daily administrative costs = $10,323.29 We also need the appropriate interest rate for the collection period. With a 6 percent annual interest rate, the periodic rate for the 51 day collection period is: Interest rate = (1 + .06/365)51 – 1 Interest rate = 0.00818 or 0.818% Since the credit policy will exist into perpetuity, the NPV is: NPV = –$193,561.64 + ($430,136.99 – 193,561.54 – 7,742.47 – 10,323.29) / 0.00818 NPV = $26,535,712.48 Option 3 Under Option 3, the average daily sales are: Average daily sales = $170,000,000/365 Average daily sales = $465,753.42 The average daily variable costs will be: Average daily variable costs = 0.45($170,000,000)/365 Average daily variable costs = $209,589.04 Under the Option 3, the default rate is 2.2 percent, so the average daily defaults will be: Average daily defaults = 0.022($170,000,000)/365 Average daily defaults = $10,246.58 Option 3 has administrative costs equal to 3.0 percent of sales, so the average daily administrative costs are: Average daily administrative costs = 0.03($170,000,000)/365 Average daily administrative costs = $13,972.60 We also need the appropriate interest rate for the collection period. With a 6 percent annual interest rate, the periodic rate for the 49 day collection period is: Interest rate = (1 + .06/365)49 – 1 Interest rate = 0.00785 or 0.785% Since the credit policy will exist into perpetuity, the NPV is: NPV = –$209,589.04 + ($465,753.42 – 209,589.04 –10,246.58 – 13,972.60) / 0.00785 NPV = $29,325,996.41

CHAPTER 20 C-67 The company should choose Option 1 since it has the highest NPV. The default rate and administrative costs of Option 2 are below those of Option 3. This is plausible. Option 2 extends the credit period, while Option 3 extends the credit period and relaxes the credit policy. The relaxation of the credit policy will increase the default rate since it will include companies with lower credit ratings who are less likely to pay. This in turn will increase the administrative costs of managing the delinquent accounts.

CHAPTER 21 S&S AIR GOES INTERNATIONAL 1.

The biggest advantage is the increased sales, while the biggest risk is exchange rate risk.

2.

If the dollar strengthens, the profit will decline. Conversely, if the dollar weakens, the profit will increase.

3.

The company will pay the sales commission out of gross sales, so the after-commission sales in euros is: After-commission sales = €5,000,000(1 – .05) After-commission sales = €4,750,000 At the current exchange rate of $1.45/€, the EBT in euros will be converted to dollars in the amount of: Dollar EBT = €750,000($1.45/€) Dollar EBT = $6,887,500 S&S Air has production costs equal to 80 percent of dollar sales at this exchange rate: The total sales in dollars are: Total sales = €5,000,000($1.45/€) Total sales = $7,250,000 And the production costs are: Production costs = $7,250,000(0.80) Production costs = $5,800,000 So, the profit at the current exchange rate is: Profit = $6,887,500 – 5,800,000 Profit = $1,087,500 If the exchange rate changes to $1.30/€, the euros will convert to: Dollar sales = €4,750,000($1.30/€) Dollar sales = $6,175,000 Since the production costs are fixed, the profit at this exchange rate will be:

CHAPTER 22 C-69 Profit = $6,175,000 – 5,800,000 Profit = $375,000

CHAPTER 21 C-70 The breakeven exchange rate is the exchange rate that will allow the after-commission costs in euros to convert to a dollar amount that covers the production costs, so: Breakeven exchange rate = $5,800,000/€4,750,000 Breakeven exchange rate = $1.221/€ 4.

The company could use options, futures, or forwards. The downside to all three hedging vehicles is the cost. Over time, the company will gain on some contracts and lose on others.

5.

At the current exchange rate, the company will make a profit unless the exchange rate moves dramatically. So, it is likely that hedging is not required at this point. Taking this into account, the company should probably pursue international sales further.

CHAPTER 22 YOUR 401k ACCOUNT AT EAST COAST YACHTS 1.

Before the fact, you would expect that mutual funds managers would be able to outperform the market. This is due, in part, to the Darwinian nature of the business. Good performing fund managers are richly rewarded, and poor performing fund managers are fired, often very quickly. In reality, we should expect that less than 50 percent of all equity mutual funds would outperform the market. This does not depend on the level of market efficiency. Consider the following question: What percentage of investors will outperform the market in a given year? Answer: Fifty percent. While there could be one really poor investor who takes all of the losses in a given year, in general, to get the market average we would expect one-half of investors would outperform the market, and one-half would underperform the market. After all, the market average return has to be the average return of all investors’ average return. This is definitely true if we consider the weighted average return, that is, the average return of investors weighted by the dollar amount of the investment. We would expect more than 50 percent of mutual funds would underperform the market because of the expenses charged by the mutual funds. Consider the large-cap stock fund, with and expense ratio of 1.50 percent. The fund must exceed the market return by 1.50 percent before fees in order to achieve a return after fees equal to the market return. Whether the market is efficient or inefficient is irrelevant unless mutual funds managers are the best investors in the market, and all other investors, including private money managers, pension fund managers, individuals, etc. are the bad investors in the market. We should also consider that mutual funds managers may be able to outperform the market before expenses. Whether they can outperform the market on an after-expense basis becomes a question of whether mutual fund managers can extract economic rents from the stock market. The evidence tends to support the idea that they cannot. In general, research has found that mutual fund managers underperform the market after expenses by the average expense ratio. This means that mutual funds as a whole tend to have the market average return before expenses, so they do not appear to be able to outperform the market.

2.

The results in the graph tend to support the idea of market efficiency. Consider the case of the Fidelity Magellan Fund, one of the largest actively managed equity mutual funds at the time this was written, with assets of about $55 billion. So the question is this: What would Fidelity pay for one year to increase the return of the Magellan Fund by 0.01 percent? If we multiply the fund assets by 0.01 percent, we get: $55,000,000,000(.0001) = $5,500,000. So, if Fidelity can increase the return of this one fund by only 0.01 percent per year, it should be willing to pay up to $5.5 million for that year. Given the amount mutual fund companies would be willing to spend for research, and the Darwinian nature of the industry, we would expect that mutual fund managers should be able to outperform the market. While there have been notable exceptions, such as Peter Lynch’s tenure at Magellan, as a whole, mutual fund managers do not seem to be able to outperform the market. As a result, if the “best” and definitely best-financed investors cannot outperform the market, the results support the concept of market efficiency.

CHAPTER 22 C-72

CHAPTER 22 C-73 3.

Given that the evidence presented tends to support market efficiency, you should invest in the S&P 500 index fund. However, this is not the entire answer. By investing the entire equity portion of your account in the S&P 500 index, your portfolio is not diversified since the S&P 500 index includes only large-cap stocks. Therefore, part of your equity investment should probably be in the small cap fund for diversification purposes. Note that a small cap index fund may be the best option, but there is no small cap index fund available in the 401k account.

CHAPTER 23 CHATMAN MORTGAGE, INC. 1.

Mike’s mortgage payments form a 25-year annuity with monthly payments, discounted at the longterm interest rate of 7 percent. We can solve for the payment amount so that the present value of the annuity equals $500,000, the amount of principal that he plans to borrow. The monthly mortgage payment will be: $500,000 = C(PVIFA7%/12,300) C = $3,533.90

2.

The most significant risk that she faces is interest rate risk. If the current market rate of interest rises between today and the date the mortgage is sold, the fair value of the mortgage will decrease, and the Ian will only be willing to purchase the mortgage for a price less than $500,000. If this is the case, she will not be able to loan Mike the full $500,000 promised.

3.

Treasury bond prices have an inverse relationship with interest rates. As interest rates rise, Treasury bonds become less valuable; as interest rates fall, Treasury bonds become more valuable. Since Joi will be hurt when interest rates rise, she is also hurt when Treasury bonds decrease in value. In order to protect herself from decreases in the price of Treasury bonds, she should take a short position in Treasury bond futures to hedge this interest rate risk. Since three-month Treasury bond futures contracts are available and each contract is for $100,000 of Treasury bonds, she would take a short position in five 3-month Treasury bond futures contracts in order to hedge her $500,000 exposure to changes in the market interest rate over the next three months

4.

a.

If the market interest rate is 8 percent on the date that Joi meets with the Ian, the fair value of the mortgage is the present value of an annuity that makes monthly payments of $3,533.90 for 25 years, discounted at 8 percent, or: Mortgage value = $3,533.90(PVIFA8%/12,300) Mortgage value = $457,867.55

5.

b.

An increase in the interest rate will cause the value of the T-bond futures contracts to decrease. The long position will lose and the short position will gain. Since Joi is short in the futures, the futures gain will offset the loss in value of the mortgage.

a.

If the market interest rate is 6 percent on the date that Joi meets with the Ian, the fair value of the mortgage is the present value of an annuity that makes monthly payments of $3,533.90 for 25 years, discounted at 6 percent, or: Mortgage value = $3,533.90(PVIFA6%/12,300) Mortgage value = $548,484.91

CHAPTER 23 C-75 b.

6.

An increase in the interest rate will cause the value of the Treasury bond futures contracts to increase. The long position will gain and the short position will lose. Since Joi is short in the futures, the futures lose will be offset by the gain in value of the mortgage.

The biggest risk is that the hedge is not a perfect hedge. If interest rates change, the fact that Treasury bond interest is semiannual, while the mortgage payments are monthly, may affect the relative value of the two. Additionally, while a change in one of the interest rates will likely coincide with a change in the other interest rate, the change does not have to be the same. For example, the Treasury rate could increase 20 basis points, and the mortgage rates could increase by 40 basis points. The fact that this is not a perfect hedge simply means that the gain/loss from the futures contracts may not exactly offset the loss/gain in the mortgage. We would expect, especially given the short-term nature of the hedge, that the loss in one instrument would be similar to the gain in the other instrument.

CHAPTER 24 S&S AIR’S CONVERTIBLE BOND 1.

We can use the PE ratio to calculate the current stock price. Doing so, we get: P/E = Price/EPS 12.50 = Price/$1.60 Price = $20.00 This means the conversion premium of the bond is: Conversion premium = ($25 – 20) / $20 = 0.25 or 25% Chris is suggesting a conversion price of $25 because it means the stock price will have to increase before the bondholders can benefit from the conversion, in this case 25 percent. Even though the company is not publicly traded, the conversion price is important. First, the company may go public in the future. The case does discuss whether the company has plans to go public, and if so, how soon it might go public. If the company does goes public, the bondholders will have an active market for the stock if they convert. Second, even if the company does not go public, the bondholders could potentially have an equity interest in the company. This equity interest can be sold to the original owners, or someone else. The potential problem with private equity is that the market is not as liquid as the market for a public company. This illiquidity lowers the value of the stock. The conversion value of the bond is given as $800. The intrinsic value of the bond is: Intrinsic value = $30(PVIFA5%,40) + $1000(PVIF5%,40) Intrinsic value = $656.82 So, the floor value of the bond is $800. This means that if the company offered bonds with the same coupon rate and no conversion feature, they would be able to sell them for $656.82. However, with the conversion feature the price will be $800. In essence, the company is receiving $143.18 for the conversion feature. The conversion ratio the bond is: Conversion ratio = $800/$25 = 32.00 So, each bond can be converted to 32 shares of stock.

2.

Todd’s argument is wrong because it ignores the fact that if the company does well, bondholders will be allowed to participate in the company’s success. If the stock price rises to $25, bondholders are effectively allowed to purchase stock at the conversion price of $25.

CHAPTER 23 C-77 3.

Mark’s argument is incorrect because the company is issuing debt with a lower coupon rate than they would have been able to otherwise. If the company does poorly, it will receive the benefit of a lower coupon rate.

CHAPTER 23 C-78 4.

Reconciling the two arguments requires that we remember our central goal: to increase the wealth of the existing shareholders. Thus, with 20-20 hindsight, we see that issuing convertible bonds will turn out to be worse than issuing straight bonds and better than issuing common stock if the company prospers. The reason is that the prosperity has to be shared with bondholders after they convert. In contrast, if a company does poorly, issuing convertible bonds will turn out to be better than issuing straight bonds and worse than issuing common stock. The reason is that the firm will have benefited from the lower coupon payments on the convertible bonds. Both of the arguments have a grain of truth; we just need to combine them. Ultimately, which option is better for the company will only be known in the future and will depend on the performance of the company. The table below illustrates this point.

Convertible bonds issued instead of straight bonds Convertible bonds issued instead of common stock 5.

If the company does poorly Low stock price and no conversion Cheap financing because coupon rate is lower (good outcome).

If the company prospers High stock price and conversion Expensive financing because bonds are converted, which dilutes existing equity (bad outcome).

Expensive financing because firm could have issued common stock at high prices (bad outcome).

Cheap financing because firm issues stock at high prices when bonds are converted (good outcome).

The call provision allows the company to redeem the bonds at the company’s discretion. If the company’s stock appears to be poised to rise, the company can call the outstanding bonds. It could be possible that the bondholders would benefit from converting the bonds at that point, but it would eliminate the potential future gains to the bondholders.

CHAPTER 25 EXOTIC CUISINE EMPLOYEE STOCK OPTIONS 1.

We can use the Black-Scholes equation to value the employee stock options. We need to use the risk-free rate that is the same as the maturity as the options. So, assuming expiration in three years, the value of the stock options per share of stock is: d1 = [ln($24.38/$50) + (.038 + .602/2) × 3] / (.60 × d2 = –.0618 – (.60 ×

3 ) = –.0618

3 ) = –1.1011

N(d1) = .4753 N(d2) = .1354 Putting these values into the Black-Scholes model, we find the option value is: C = $24.38(.4753) – ($50e–.038(3))(.1354) = $5.55 Assuming expiration in ten years, the value of the stock options per share of stock is: d1 = [ln($24.38/$50) + (.044 + .602/2) × 10] / (.60 × d2 = .8020 – (.60 ×

10 ) = .8020

10 ) = –1.0953

N(d1) = .7887 N(d2) = .1367 Putting these values into the Black0Scholes model, we find the option value is: C = $24.38(.7887) – ($50e–.044(10))(.1367) = $14.83 2.

Whether you should exercise the options in three years depends on several factors. A primary factor is how long you plan to stay with the company. If you are planning to leave next week, you should exercise the options. A second factor is how the option exercise will affect your taxes.

CHAPTER 25 C-80 3.

The fact that the employee stock options are not traded decreases the value of the options. A basic way to understand this is to realize that an option always has value since, ignoring the premium, it can never lose money. The right to sell an option also has to have value. If the right to sell is removed, it decreases the price of the option.

CHAPTER 24 C-81 4.

The rationale for employee stock options is to reduce agency costs by better aligning employee and shareholder interests. Vesting requires employees to work at a company for a specified time, which means the employee actions are actually part of the company performance. Vesting is also a “golden handcuff.” The employee is less likely to leave the company if in-the-money employee stock options will vest soon. They must often be exercised shortly after an employee leaves the company so that they may no longer participate in any potential stock price increase.

5.

The evaluation of the argument for or against repricing is open-ended. There are valid reasons on both sides of the discussion. Repricing can be viewed as a negative. If an employee knows the option will be repriced if the stock declines, it provides less incentive. However, if the stock price does decline dramatically, and underwater employee stock option provides little incentive since it may be unlikely that the stock price will reach the strike price before expiration. Repricing increases the value of the employee stock option. Consider an extreme: A company announces the employee stock options will be worth a minimum of $10 at expiration. Since all values less than $10 are no longer possible, the value of the option increases.

6.

Employee stock options increase in value if the stock price increases; however, the stock price can increase because of a general market increase. Consider a company of average risk in a bull market that has a large return for several years. The company’s stock should closely mirror the market return, even though most of the stock price increase is due to the general market increase. Similarly, if the market falls, the company’s stock will likely fall as well, even if the company is doing well. A better method of valuing employee stock options might be to reward employees for company performance in excess of the market performance, adjusted for the company’s level of risk.

CHAPTER 26 THE BIRDIE GOLF-HYBRID GOLF MERGER 1.

As with any other merger analysis, we need to examine the present value of the incremental cash flows. The cash flow today from the acquisition is the acquisition costs plus the dividends paid today, or: Acquisition of Hybrid Dividends from Hybrid Total

–$550,000,000 $150,000,000 –$400,000,000

Using the information provided, we can determine the cash flows to Birdie Golf from acquiring Hybrid Golf. All earnings not retained are paid as dividends, so the cash flows for the next five years will be:

Dividends from Hybrid Terminal value of equity Total

Year 1 Year 2 $38,400,00 0 $12,800,000

Year 3 $29,400,00 0

Year 4 $41,400,00 0

$38,400,00 0 $12,800,000

$29,400,00 0

$41,400,00 0

Year 5 $59,000,000 600,000,000 $659,000,000

To discount the cash flows from the merger, we must discount each cash flow at the appropriate discount rate. The terminal value of the company is subject to normal business risk and should be discounted at the cost of capital, while the dividends are equity cash flows, and as such, should be discounted at the cost of equity. The present value of each year’s cash flows, along with the appropriate discount rate for each cash flow is: Discoun t rate 16.9% Dividends PV of value Total

Year 1 $32,848,58 9

Year 2 $9,366,578

Year 3 Year 4 $18,403,64 3 $22,168,806

$32,848,58 9

$9,366,578

$18,403,64 3 $22,168,806

12.4%

Year 5 $27,025,856 334,441,139 $361,466,995

And the NPV of the acquisition is: NPV = –$400,000,000 + 32,848,589 + 9,366,578 + 18,403,643 + 22,168,806 + 361,466,995 NPV = $44,254,610.07

CHAPTER 25 C-83

C-84 CASE SOLUTIONS 2.

Since the acquisition is a positive NPV project, the most Birdie would offer is to increase the current cash offer by the current NPV, or: Highest offer = $550,000,000 + 44,254,610.07 Highest offer = $594,254,610.07 The highest share price is the total high offer price, divided by the shares outstanding, or: Highest share price = $594,254,610.07 / 8,000,000 shares Highest share price = $74.28

3.

To determine the current exchange ratio which would make a cash offer and a share offer equivalent, we need to determine the new share price under the original cash offer. The new share price of Birdie after the merger will be: PNew = ($94 × 18,000,000 + $44,254,610.07) / 18,000,000 PNew = $96.46 So, the exchange ratio which would make the cash offer and share offer equivalent is: Exchange ratio = $68.75 / $96.46 Exchange ratio = .7127

4.

The highest exchange ratio Birdie would accept is an exchange ratio that results in a zero NPV acquisition. This implies the share price of Birdie remains unchanged after the merger, so the exchange ratio is: Exchange ratio = $68.75 / $94 Exchange ratio = .7314

CHAPTER 27 THE DECISION TO LEASE OR BUY AT WARF COMPUTERS 1.

The decision to buy or lease is made by looking at the incremental cash flows. The incremental cash flows from leasing the machine are the security deposit, the lease payments, the tax savings on the lease, the lost depreciation tax shield, the saved purchase price of the machine, and the lost salvage value. The salvage value of the equipment in four years will be: Aftertax salvage value = $600,000 – $600,000(.35) Aftertax salvage value = $390,000 This is an opportunity cost to Warf Computers since if the company leases the equipment it will not be able to sell the equipment in four years. The lease payments are due at the beginning of each year, so the incremental cash flows are:

Saved purchase Lost salvage value Lost dep. tax shield Security deposit Lease payment Tax on lease payment Cash flow from leasing

Year 0 $5,000,000

–300,000 –1,300,000 455,000 $3,855,000

Year 1

Year 2

Year 3

–$583,275

–$777,875

–$259,175

–1,300,000 455,000 –$1,428,275

–1,300,000 455,000 –$1,622,875

–1,300,000 455,000 –$1,104,175

The aftertax cost of debt is: Aftertax cost of debt = .11(1 – .35) Aftertax cost of debt = .0715 or 7.15% And the NAL of the lease is: NAL = $3,855,000 – $1,428,275/1.0715 – $1,622,875/1.07152 – $1,104,175/1.07153 – $219,675/1.07154 NAL = $44,308.0 The company should lease the equipment.

Year 4 –$390,000 –129,675 300,000

–$219,675

C-86 CASE SOLUTIONS 2.

The book value of the equipment in year 2 will be: Book value = $5,000,000 – $5,000,000(.3333 + .4445) Book value = $1,111,000 So, the aftertax salvage value in year 2 will be: Aftertax salvage value = $2,000,000 + ($1,111,000 – 2,000,000)(.35) Aftertax salvage value = $1,688,850 So, the NAL of the lease under the new terms would be:

Saved purchase Lost salvage value Lost dep. tax shield Lease payment Tax on lease payment Cash flow from leasing

Year 0 $5,000,000

–2,300,000 805,000 $3,505,000

Year 1

–$583,275 –2,300,000 805,000 –$2,078,275

Year 2 –$1,688,850 –777,875

–$2,466,725

So, the NAL of the lease under these terms is: NAL = $3,805,000 – $2,078,275/1.0715 – $2,466,725/1.07152 NAL = –$583,099.11 The NAL of the lease is negative under these terms, so it appears the terms are less favorable for the lessee. However, the lease will likely be classified as an operating lease. The lease is now for two years, which is less than 75 percent of the equipment’s life according. Using the company’s cost of debt, the present value of the lease payments is: PV of lease payments = $2,300,000 + $2,300,000/1.11 PV of lease payments = $4,372,072.07 This is less than 90 percent of the price of the equipment. As long as the lease contract does transfer ownership to the lessee at the end of the contact, or allow for a purchase at a bargain price, the FAS 13 conditions for a capital lease are not met. As such, the reason for suggesting the revised lease terms is unethical on Nick’s part. Also, notice that the question also states that if the lease is renewed in two years, the lessor will allow for the increased lease payments made over the first two years. This is also an indication that the revision is for less than ethical reasons.

CHAPTER 27 C-87 3.

4.

a.

The inclusion of a right to purchase the equipment will have no effect on the value of the lease. If the company does not purchase the equipment, it can go on the market and purchase identical equipment at the same price.

b.

The right to purchase the equipment at a fixed price will increase the value of the lease. If the company can purchase the equipment at the end of the lease at below market value, it will save money, or at a minimum, can purchase the equipment at the fixed price and resell it in the open market. This is a real option, therefore has value to the lessee. It is a call option on the equipment. As such, it must have a value until it expires or is exercised. It is also important to note that this would likely make the lease contract a capitalized lease.

c.

The right to purchase the equipment at a bargain price is also a real option for the lessee, and will increase the value of the lease. It is a call option, and therefore will have value until it expires or is exercised. This contract condition will definitely ensure the lease is classified as a capitalized lease.

The cancellation option is also a real option. The cancellation option is a put option on the equipment. It will increase the value of the lease since the lessee will only exercise the option when it is to the lessee’s advantage.