# Solutions Guide

for

Case Studies in Finance
Written by

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

Case 1 Insider Trading

2

Case 2 The Tobacco Industry

4 .discrimination. law suits are sure to be a result of the ban. As economically rational as it may be.

2.75 \$1.0% +12.00 \$9.00 \$9.0% -1.50 \$6.75 \$1.8% +12. Additionally.3% +8. underground installs.00 \$14.49 (just multiply Bob's real price by the average number of jobs Chris performs per week).50 \$1.0% +2.5% +12. They must devise a plan themselves that will get the job done.50 \$6. First.50 \$5. add the numbers in the third column to find the average increase in pay 5 .50 \$1.3% The numbers in column four of this table are somewhat subjective.25 \$4. 3.50 \$10.77.50 \$5. specific guidelines which must be followed. there must be a difference in pay between the wired and unwired outlets in order to encourage extra work by the sub-contractors. Table 1 Calculations Worksheet for New Prices (1) (2) (3) = {[(2)-(1)(1-.50 \$5.0% +9.0% +5.50 \$6.Case 3 Connect Cable Contractors Purpose: This case allows students to work on the typical small business situation where no existing model or framework is available.0% +2.25 \$6. Chris would have earned \$569.50 \$14. A/O Only: Wired Unwired Reconnect VCR (w/ reconnect) VCR Hook-Up Only Upgrades Trip Charge Bob’s price \$14. From Table 2. however.12)}*100 Type of job Overhead Install Underground Install A/O(unwired-w/) A/O( wired-w/) VCR (w/ install) Long Drop Replace Drop Relocate.00 Steve’s price \$13. That is. Secondly. there must be a significant price differential between overhead installs.76 \$13.3% +2.9% +12. the student cannot just plug numbers into an existing formula.12)]/ (1)(1-. Burt would have earned \$514.00 \$10.00 \$13. 1.50 \$10.8% +3.50 \$10.50 Percentage increase in pay +7. and replaced drops. there must be an overall increase in real pay of between 7%-8% for both Burt and Chris.25 \$5.3% +9.00 \$10. Under Bob's old system.50 \$9. There are.50 \$4.

4 6.24 \$0.20 \$0.66 -\$0.10 Total dollar increase In pay per type of job \$8.6 4.8 2.09 \$5.02 \$3.21 -\$0.09 \$0.49 \$0. A/O Only: Wired Unwired Reconnect VCR (w/ reconnect) VCR Hook-Up Only Average number of each job per week 11.9 3.53 Total dollar increase In pay per type of job \$11.51 \$0.20 \$0.43. Burt's increase in pay per week under the new system would be \$38.18 \$1.00 6 .8 0.79 \$11.4 7.0 1.02.18 \$0.per week for Chris.7 0.9 0.18 \$0.20 \$0.62 -\$1.47 \$0.6 11.89 \$2.52 \$0.8 0.70 \$0.8 0.6 18. From Table 3.66 -\$0.99 \$0.4 Dollar increase in pay per job \$0.0 2.24 \$0.5 9.70 \$0.20 \$0.14 \$4.88 \$3.68 \$0. Doing this yields an answer of \$41.44 \$0.72 \$12.8 8.04 \$2.4 3.16 \$5.9 11.2 3.6 2.68 \$0.99 \$0. Table 2 Calculations Worksheet for Increases in Weekly Earnings Under the New Pricing System for Chris Type of job Overhead Install Underground Install A/O(unwired-w/) A/O( wired-w/) VCR (w/ install) Long Drop Replace Drop Relocate.8 1.18 \$1.49 \$0.6 11.0 Dollar increase in pay per job \$0. A/O Only: Wired Unwired Reconnect VCR (w/ reconnect) VCR Hook-Up Only Upgrades Trip Charge Average number of each job per week 8.09 \$0.6 17.51 \$0.67 \$0.53 \$0.1 7.53 \$0.00 \$0.08 \$2.38 \$3.51 \$0.68 \$0.24 Table 3 Calculations Worksheet for Increases in Weekly Earnings Under the New Pricing System for Burt Type of job Overhead Install Underground Install A/O(unwired-w/) A/O( wired-w/) VCR (w/ install) Long Drop Replace Drop Relocate.53 \$0.22 \$0.

089 115.254 1.815 106.Case 4 IBP Purpose: The purpose of this case is to provide students with the practice of constructing a Balance Sheet.096 \$3.781 10.747.774 (843.418 51.492 544.093 724.096.400 599.256 1. and equipment Other assets Goodwill Other Total other assets Total Assets \$ 27. and equipment Land and improvements Buildings and stockyards Equipment Accumulated depreciation and amortization Construction in progress Net Property.008.099 839.096 8 .072.999 405.571 1. plant.937) 903. IBP's Balance Sheet Assets Current Assets Cash and cash equivalents Marketable securities Accounts receivable Inventories Deferred income tax benefits Prepaid expenses Total Current Assets Property.711 1.096. plant.837 168.983 1.

278 1.750 405.037 148.008.967 152.388 865.456) (60.812 575.067.Liabilities and Stockholder's Equity Current Liabilities Accounts payable and accrued expenses Notes payable to banks Federal and State income taxes deferred income taxes other Total current liabilities Total Long-term Obligations Deferred credits and other liabilities deferred income taxes other Total deferred credits and other liabilities Commitments and Contingencies Stockholders' Equity Preferred stock Common stock.096 \$ 565.914 \$3.818 5.517 140.400.383) 1.725 (16.522 17. \$.122 1.05 par value per share Additional paid-in capital Retained earnings Other Treasury stock Total Stockholder's Equity Total Liabilities and Stockholder's Equity 0 4.848 9 .811 165.

22 . Liquidity Net Working Capital Current Ratio Quick Ratio (Acid Test) Activity Inventory Turnover Average Age of Inventory Average Collection Period Fixed Asset Turnover Total Asset Turnover Debt Debt Ratio Times Interest Earned Profitability Gross Profit Margin Net Profit Margin Return on Total Assets Return on Equity This year \$9.99 80% 4.321 1.8% 18. 1.26 11.05 78% 7. the number is high enough to relieve concern over Chrysler's ability to meet its debt obligations.22 27% 6. Debt The debt ratio seems to be right in line with industry figures. Liquidity Chrysler has lower than average liquidity ratios.527 1.29 . Still.9% 3.44 1. Their inventory levels appear to be in line with industry standards.026 13.7% 7.Case 5 Chrysler Purpose: The purpose of this case is to familiarize students with the calculations and interpretation of basic financial ratio analysis. 10 .9% Last year \$8.031 11.7% 2. Activity Chrysler's inventory and asset turnover ratios are much higher than the industry average. but the times interest earned ratio is lower than average.56 4.72 1.32 .48 1.68 4.1% 32. This may be due in part to their fast collection period. but their current assets are a bit too low relative to their liabilities.47 22% 3.26 9. which is good.

4. Chrysler was not in any financial trouble nor were they out performing their competitors to the extent that attention should be drawn to them. Kerkorian held a large stake in Chrysler's common stock. the stock price of that company tends to increase. It is possible that Kerkorian intended to sell his holdings of Chrysler and just wanted the stock's price to be higher when he did sell. The answer to this question is much deeper than the knowledge that can be gained by performing a financial analysis. But.Profitability Gross and Net Profit Margins are slightly lower than average. he could fake a buyout and sell his holdings at a higher price. But. Returns are lower as well. based on the analysis. Whenever rumors surface that a company is undergoing a merger or acquisition. Therefore. 3. the differences are small enough not to cause concern. 11 .

general and administrative Interest Other Earnings Before Income Taxes Income Taxes Net Earnings Net Earnings Per Share Basic Diluted \$704.143 \$26.461 \$110.679 \$32.054 (\$64) \$42.13 \$2.938 \$2. MOOG Consolidated Statement of Earnings Net Sales Cost of Sales Gross Profit Research and Development Selling.013 \$14.Case 6 Moog Purpose: The purpose of this case is to have students practice constructing the Consolidated Statement of Earnings.378 \$493.11 12 .075 \$27.235 \$211.

50 = \$117. (12)(\$200. PV = \$98.95.6666% (8%/12).20) = \$26. 8 years of payments. 8 years times 12 payments per year. Let. n = 8. n = 8 years.85 .95.35. those funds are earning interest throughout the year. Solving for payment yields an answer of \$200.000.38 deposits would accrue throughout the year.Case 7 Kate Myers Purpose: The time value of money is a fundamental concept that must be understood by all business students.77. the answer from question 1.50. For example. \$2. i = 4%. 3. while funds deposited only at year's end are not accumulating interest.38) = \$2. This case emphasizes the important variables to consider when saving for a down payment on a house and shows how these variables should dictate the actions of an individual. Solving for payment yields an answer of \$2.119. Let. n = 96.\$2. (8*12). 4-5.119. FV = \$26. Solving for future value via a calculator yields \$134. the answer from question 1.404. 1. FV = \$26. A table will better represent the sensitivity analysis performed in questions 4 and 5. This amount is greater than 12 times the monthly payment because when Kate deposits funds at the end of each month.404.77)(.521. 13 . Let.823. (\$134.823. 2. i = 8%. 20% of this amount is Kate's required down payment. This additional amount represents the interest that the eleven \$200.85 per year.95.521.38 per month. i = . the annual return from the Merrill Lynch account. This is the same procedure as question 2 with the exception that the compounding frequency has changed. the monthly return from the Merrill Lynch account.823.

(1) The more Lakewood home prices appreciate.59 \$237. Home Appreciation 2% 2% 2% 4% 4% 4% 6% 6% 6% Return on Merrill Lynch account 4% 8% 12% 4% 8% 12% 4% 8% 12% End-of-Month Required Deposit \$203. 14 .38 \$167.55 \$200.36 \$195.65 \$233.55 \$143. the more Kate will have to raise to make a down payment in the future.34 This sensitivity analysis clearly demonstrates the relationship among the three variables. (2) The greater the return on her Merrill Lynch account. the lower the monthly deposit required.The calculations are the same as those from question 2.73 \$276.37 \$171.

524.714. n = 13. Let. Let. Let.98 + \$8. i = 3%.000. Stanford To find the future costs of tuition.12 To find the future costs of living expenses.811.500. 15 .20 = \$46. Solve for FV. Solve for FV.811. A simple future value calculation is necessary to determine the amount of tuition and living expenses per year when Brady is ready to attend. Let.712. This case emphasizes the important variables to consider when saving up for a child's education and shows how these variables should dictate the actions of an individual striving to achieve this goal. PV = \$2. the calculation is the same as above by assumption. FV = \$4.18 UNC To find the future costs of tuition. FV = \$37. PV = \$20. n = 13. i = 5%. FV = \$8.Case 8 Quilici Family Purpose: The time value of money is a fundamental concept that must be understood by all business students. PV = \$6.000. 1.712. n = 13.98 To find the future costs of living expenses. i = 5%. Solve for FV.20 Total Expenses = \$37.

712.54 = \$48. FV = \$8.05)0 = \$37.20 (1.98 (1.98 (1.811.03)2 = \$9.12 + \$8.926.98 (1.98 \$37.712.83 \$4.56 \$37.657.03)1 = \$9.03)3 = \$9.12 \$4.20 Total Expenses = \$4.524.54 Year 3: \$8. Solve for FV.12 (1.49 + \$9.075.80 = \$50.025.24 Total Expenses Year 1: \$4.12 + \$8.628.811.18 \$37.05)0 = \$4.598.20 (1.n = 13.05)1 = \$4.12 (1.63 + \$9. PV = \$6.657.20 (1.20 (1.811.03)0 = \$8.714.714.811.949.949.20 (1.18 \$39.20 Year 2: \$8.075.811.37 16 .811.98 + \$8.12 (1.20 = \$46.54 = \$14.811.12 (1.712.63 \$37.811.32 \$4.56 + \$9.05)1 = \$39.714.628.712.525.05)3 = \$43.32 Year 2: \$4.811.347.03)1 = \$9.628.714.20 = \$13.714.457. i = 3%.20 Year 2: \$8.674.20 (1.811.811.578.578.714.03)2 = \$9.285.32 2.712.05)3 = \$5.811. Stanford tuition Year 1: Year 2: Year 3: Year 4: \$37.075.49 living expenses Year 1: \$8.24 Total Expenses Year 1: Year 2: Year 3: Year 4: UNC tuition Year 1: Year 2: Year 3: Year 4: \$4.80 Year 4: \$8.03)3 = \$9.54 Year 3: \$8.20 (1.811.24 = \$53.98 (1.197.000.712.73 living expenses Year 1: \$8.20 (1.05)2 = \$41.075.05)2 = \$5.80 Year 4: \$8.347.811.20 = \$13.347.525.03)0 = \$8.17 \$41.83 + \$9.598.714.36 \$43.

18 1 156 \$124.57 Adding all four amounts yields: \$432.525.18 .025.457.94 Year 4 \$53.87 17 Year 4 \$53.674.Year 3: \$5.17 1 168 \$112. Using the answers from question 2.347.27 .197.085.12 1 180 \$29.34 Year 2 \$14.12 4.46 Year 3 \$14. the present value (i.8333 192 \$113.42 3.80 = \$14.11 Year 4 \$15.085.36 .36 1 180 \$101.17 . To determine the monthly payment to cover college expenses.628.32 + \$9.285.15 UNC FV i n PMT ??? Year 1 \$13.545.73 1 192 \$92.8333 168 \$133.73 .926.8333 156 \$146.285.42 1 192 \$26.21 adding all four amounts yields: \$124. Stanford FV i n PMT ??? Year 1 \$46.8333 180 \$122.3 7 1 168 \$32.674. This is the same problem as number three with the exception that the interest rate is different.24 = \$15. at the time Brady starts college) of the four year expenses must be calculated.18 + \$9. The only adjustment is in the interest rate used.833333333 Stanford FV i n PMT ??? Year 1 \$46.545.99 Year 2 \$48.33 Year 2 \$48.12 Year 4: \$5.e.32 1 156 \$36. combine both costs and find the present value keeping in mind that the stream of payments to Brady is a monthly annuity.79 Year 3 \$50.524. i = 10/12 = .926.524.65 Year 3 \$50.

There is clearly a positive relationship between the amount the parents must invest and the increases in future tuition and living expenses.085.8333 192 \$32.55 Year 3 \$14.12 .26 UNC FV i n PMT ??? Year 1 \$13.07 Adding all four amounts yields: \$148.545.025.525.25 5.8333 180 \$35.54 Year 2 \$14.Adding all four amounts yields: \$516.09 Year 4 \$15. 18 .3 7 .8333 168 \$38.32 .42 .8333 156 \$42.

Pt-1 = price of asset at time t-1.67% December 2000: (\$52.\$57.06) / \$47.22 .\$49. 19 . such as Excel.07) / \$52. 1. the following formula should be used: kt = where. To calculate the standard deviation.\$52. To calculate the quarterly returns.22 +\$0. use any calculator or spreadsheet.67 +\$0.55% September 2001: (\$49.P t -1 + D t P t -1 kt = return during period t.66% 2.54 = 1. Dt = dividends received throughout the quarter.\$50.36%.Case 9 WalMart Purpose: The purpose of this case is to teach the student to calculate actual returns for an individual stock from past stock price and dividend data.32 . June 2002: (\$55.\$61.08) / \$57.22 = -10.01 .07) / \$50. Pt = price of asset at time t. In an investing context. The standard deviation is a measure of dispersion about a mean.07) / \$49.01% March 2002: (\$61. The student must then calculate the required rate of return on the stock to determine if the stock is over or under-valued.\$47.32 = 16. The risk of the company will also be determined as proxied by the standard deviation.08) / \$61.41 .67 = 10.54 +\$0.09% March 2001: (\$50.69 = -4.16 .25% December 2001: (\$57.41 = 7.69 +\$0.07) / \$48.41 +\$0.69 . it refers to a measure of total risk.54 .16 +\$0.75% June 2001: (\$48.16 = -3.32 +\$0. The standard deviation is 9. P t .\$48.

Marv should buy WalMart's stock because it is expected return an amount in excess of what is required based on its risk level. 20 . Therefore.25% + 8. the economy goes in cycles. A better performance time period would be over the last ten years or more.Rf)] = 5. Furthermore.59%. 5. Returns considered over such a short time period are not as reliable because the sample size is much too small. In a perfectly efficient market.5. the expected return always equals the required rate of return.2 (12. As long as WalMart is expected to return a rate of greater than 13.25% + 1.2% . Assuming Beta = 1.59% 4. Rf = 5.25%) = 5.25%.2.3. Marv should buy the stock. Rm = 12.2%. That way we would be able to observe how WalMart performed during both expansions and contractions in the economy. kj = Rf + [bj x (km . The time period studied here is very short.34% = 13. If WalMart had an expected rate of return of 14%. while WalMart may have performed well or poorly in the short-run is not necessarily indicative of their long-run performance. the required rate of return can be determined by employing CAPM.

8)(.20) + ( 2.62% 2 ( 7.714)( 3.20) + ( 2.714)( 5.60) + (.35) + ( 8.6) = 6.2)(.21% 4 (-4.38) + (.40) + (. Year 1 (.7) = 10.35) + (-2.2857)( 2.45) = 11.1) = 7.40% 2.8)(.2)(. The standard deviation of a portfolio is equal to the square root of: the sum of each term minus the average return quantity squared divided by n-1. 21 .714)( 6.714)(13.2857)( 6.3)(.41% 6 (10.45) = 6.7)(.8) = .04% 7 (. Mathematically.4)(.45) = 3.35) + ( 7.3)(.9)(.20) + ( 0.20) + (15.20) + (14. k p = Σ wj k j j=1 n Year 1 ( 6.35) + (10.62) + (.51) + (.93% 2 (.20) + (-1.8)(.2857)( 4. Mathematically.20) + ( 7.3)(.6)(.46% 6 (. 1.45) = 13.66% 4 (.714)(-0.1)(.35) + (12.45) = 6.9) = 11.38% 7 (15.9)(.2)(.45) = 6.714)( 6.48% 8 (.2)(.714)(11.2857)(-1.45) = .2857)(11. The student must then calculate the required rate of return on the stock to determine if the stock is over or under-valued.21) + (.8) = 4..1)(.41) + (.1)(.60% 8 ( 9.35) + ( 6.9)(.35) + ( 4.2)(.9)(.Case 10 Intel Purpose: The purpose of this case is to teach the student to calculate actual returns for an individual stock from past stock price and dividend data.714)( 6.85% 3 (.1)(.71% 5 ( 8.20) + (19.2)(.2) = 6.2857)(10. The risk of the company will also be determined as proxied by the standard deviation.2857)(18.26% 3.2857)(10.45) = 5.2)(.71) + (.3) = 7.35) + (-4.51% 3 ( 6. With Intel included.83% 5 (. The expected return on a portfolio is equal to the weighted average of the return from each component in the portfolio.

7) + (.62 .2)(. it would be unlikely that each firm's beta would be the same year after year.58% Σ(k -k ) i i=1 n 2 n-1 The terms (xi . Using the same equation.. all unsystematic risk can be removed.374% = σp 4.6.x)2. beta can be assumed to be stable.45)(1. For shorter periods of time.14 6. are generated as follows: (-.4 . investors are not compensated for taking unsystematic or diversifiable risk.51 .58)2 = 133.6.6. beta is the relevant measure because with proper diversification.322% = σp 5. + (11. they do not normally jump around.1) = 1. When betas vary. The beta of a portfolio is equal to the weighted average of the betas for each asset. the standard deviation with Intel included = 3.35)(1..0) = 1.15) + (. 7. whereas beta is a measure of systematic risk.6/8 = 6.714)(1. 22 . Standard deviation is a measure of total risk.58)2 + (5.94 [(133.σk= The average return = 52.15 With Intel bp = (.94)/(8-1)]1/2 = 4. Beta tends not to be constant over time. In portfolio theory.286)(1. For the eight year period under consideration.6) + (. Instead.58)2 + . b p = Σ wi bi i= 1 n Without Intel bp = (. there will normally be a gradual trend. Therefore. however.

so no calculation is needed.0% 9. solve the equation: (7 + 8 + 9 + 10 + x)/5 = 8. To calculate the second year's short-term rate.5%. and tax considerations) types of bonds. liquidity.5%.Case 11 Amber Plank Purpose: Interest rates affect everyone in the economy whether it be on an individual level or through the workplace. solve the equation: (7 + 8 + x)/3 = 8. Here x = 8% To calculate the third year's short-term rate. or reward. for holding a less liquid asset. 2.6%.0% 10. solve the equation: (7 + x)/2 = 7. Here x = 9% 4. The Expectations Hypothesis states that today's long-term rates are an average of future short-term rates. Here x = 9% To calculate the fourth year's short-term rate. This case gives one such example to which all students can relate. if rates in the future are expected to increase. Exactly how much the premium amounts to is unknown.0% 7.5% 8. but with different times to maturity at a specific point in time. Here x = 10% To calculate the fifth year's short-term rate. solve the equation: (7 + 8 + 9 + x)/4 = 8. liquidity.0% (same) 8. Moreover. The Liquidity Preference Hypothesis states that today's long-term rates are an average of future short-term rates PLUS a premium.5% 8.6% Future Short-term Rates 7. the premium 23 .0% 9. 3.0% Today's short-term rate is already given. tax considerations.0%.0% 8. Time To Maturity 1 year 2 years 3 years 4 years 5 years Today's Long-term Rates 7. A Yield Curve shows the yield to maturity for similar (same risk. Therefore. Based on Table 1. then today's yield curve will be upward sloping. Default risk. 1. and time to maturity.

5% 8.00 = 8.0% (same) 8.50 = 8.75 = 9.0% 8.75% 9. whereas banks tend to invest short-term so as to match short-term deposits.changes over time. There should.25 = 7.0 – 0. For example. Time To Maturity 1 year 2 years 3 years 4 years 5 years Today's Long-term Rates 7. this hypothesis does little in the way of inferring future short-term rates from today's longterm rates.50% 10. insurance companies invest primarily in longterm markets because of the maturity matches with their liabilities or pay-outs. The Market Segmentation Hypothesis states that Supply and Demand in different term to maturity markets are responsible for determining interest rates and these markets are separate from each other. 24 . each student will likely have a different set of future short-term interest rate forecasts. be consistency between their answers to questions 3 and 4.6% Future Short-term Rates 7. Unfortunately. For example.00% 5.0% 7.0 – 0.0 – 0.25% 9.0 – 1. The answers to question 4 should be lower than those for question 3 because the "liquidity premiums" need to be removed from all of the estimates. however.5% 8. For this reason.

It is all a function of the probability of default. The 8. This lowers the probability that these bondholders will receive their promised payments which effectively increases the risk of the bonds. This is important because these bondholders cannot receive coupon payments or the return of principle in the event of maturity or default until all of the other debt holders receive their money first. financial studies have shown that rating companies take time to make changes to corporate bond ratings. As the case states. like the technology sector. 25 . Fruit of the Loom's overall corporate credit rating remained at BB-. can afford to take on more debt than firms in a less stable industry. junior debenture holders. it is unlikely that the stock price will be affected. Firms with more stable earnings. 4.Case 12 Fruit of the Loom Purpose: The purpose of this case is to introduce students to bond rating systems and to show them the effect it has on the corporation. like utility companies. even if the overall company were to be downgraded. the change was already anticipated by the stock market. However. This order represents which investor group has first through last claim when it comes to receiving coupon or dividend payments and even in the event of collecting in liquidation. Capital structure and level of Earnings Per Share (EPS) will definitely affect a corporation's bond ratings. by the time a rating change has been made. Moreover. what the question did not include is the volatility in EPS. Therefore. and finally. and therefore. The order is as follows: senior debenture holders. its effect is already imbedded into the stock's price.875% bonds received a downgrade because it effectively slipped down in the Pecking Order. 3. 1. Pecking Order refers to the chain of priority that stakeholders in a company have on the company's assets. Therefore. and still have the same bond rating. 2. preferred stockholders. since this represents a mere shuffling within the pecking order. common stockholders. Higher risk translates into a lower bond rating.

g = growth rate in dividends. we have to assume that future dividend payments will grow at a constant rate into the future forever. D1 = per share dividend expected at the end of year 1. P0 = D1 = D0 (1+ g) ( k s . kj = required return on asset j. On a calculator. Ks = required return on common stock. To calculate g. This constant rate can be estimated by examining the average growth rate in the past.13%. Solve for i.75(10% . The equation for CAPM is kj = Rf + [bj x (Rm . Rm = market return.Case 13 Nations Bank Purpose: The purpose of this case is to calculate a stock's price using its past dividends as an indicator of future dividend growth rates.Rf)] where.86. bj = beta coefficient for asset j. n = 8. Rf = risk-free rate of return. 26 . Let.6%) kj = 13% 2. i = the average growth rate. P0 = price of the common stock. 1.00.g) where.g) ( k s . The student must determine the stock's required rate of return (CAPM) and future expected dividend growth rate and use the Gordon Growth Model to calculate a current price. In this case i = g = 11. kj = 6% + 1. FV = \$2. The equation for the Gordon Growth Model is. D0 = most recently paid dividend. PV = \$ .

00/. the stock's price can fluctuate wildly. The Gordon Growth Model. i = g = 7. This would be an example of a zero growth stock. the calculated stock price will be extremely sensitive to the required rate of return when the required rate of return is close to g. has major drawbacks in that we are not sure what the true future growth rate in dividends is.12 .00(1 + .13 . the Gordon Growth Model will yield a price of P0 = \$2.1113 3. Plugging this growth rate into the Gordon Growth Model.0709 This value is not much different.1113) = \$118. When this special case occurs. FV = \$2. Solve for i. n = 5.38 27 . P0 = \$2.47 . but consider the result when the growth rate in dividends is near the required rate of return on the common stock as is the case from 1987-1995..13 .. depending on the period we consider.1113 In general.24 .00(1 + . Let. a simplified equation can be used. The stream of payments would be constant (annuity) and they would last forever (perpetuity).0709) = \$43.0709 4. This time.. P0 = \$2. As we have just demonstrated.0709) = \$36. P0 = \$2.62 .12 .Plugging this growth rate into the Gordon Growth Model.42. 5. The required rate of return calculation has an enormous effect on the stock's price using these types of models.00(1 + .00(1 + . If we assume that Nations Bank's required rate of return on its common stock is 12% instead of 13%.09%.00.1113) = \$255.13 = \$15. P0 = D1/Ks = \$2..86 . PV = \$1. 6. or any other dividend based pricing model.

00 and a discount rate of . and \$.29. the less valuable they are in today's dollars. the present value of these three dividends are \$. 28 . Using a dividend amount of \$1.88.7. respectively.000004922. \$. The further out into the future the dividend payments are received.13.

they will learn of the relationship between interest rates and time to maturity (TTM) and the sensitivity of a bond's price to TTM.2Fn ) +AM ( P Vk d / 2I.10 + \$377 = \$999. B0 = value of the bond at time zero.2nF) B0 2 where.000 x . PVIFkd/2.Case 14 AMR . PVIFAkd/2. PMT = \$50. the answer is exactly \$1.2n = present value of the coupon payments. 1. Using a calculator.377 = \$632. the amount is slightly different from \$1. PV = ??? = \$1.000 29 .000.000 Because this method of looking up values in a table suffers from rounding errors. Plugging into the equation. use the equation: I = ( P V k d I/ 2 .642 + \$1.000.American Airlines Purpose: The purpose of this case is to help the student to understand the behavior of bonds. I/2 = semi-annual bond coupon payment. M = par value of bond.10 ≈ \$1. For example.000. FV = \$1. B0 = \$100/2 x 12. i = 5% (10%/2 because we want the interest rate per period).2n = present value of par which will be received by the bondholder when the bond matures. Let. n = 20 (10 years times 2 payments per year). but when a calculator is used. I = annual bond coupon payment. To calculate the price of the bond.

30 . bonds will sell at par. the more sensitive its price will be to changes in interest rates. The answers from questions 2 through 4 are better represented in a table.54 \$1. the sensitivity of a bond's price to changes in interest rates increases.226.93 30 years \$1.000.000 \$849. The calculation procedure is the same as that shown in question 1.000 \$885. It is not actually the time to maturity that is driving the bond's sensitivity.30 \$1. the answers also come out to be \$1.197. 6. The longer a bond's duration. The time to maturity will have nothing to do with the price of the bond in this very specific situation. Whenever the current market interest rate equals the coupon rate. Interest rates 10% 12% \$1.39 Maturity 8% 10 years \$1.23 5.135.When the maturity is increased to 20 and 30 years.000 \$838. 2-4. It is the bond's duration. As the time to maturity increases.90 20 years \$1.

000) after taxes Unamortized discount on old bond [(7/20)(\$40.000 + [(.333 \$256.11)(\$40.000 .860.00 0 \$1.000 bonds) minus taxes (.000 (\$114.\$1.000)(40.500) \$3.35)] Unamortized floatation cost of old bond [(7/20)(\$200.065.003)(\$40.11)(2/12)(\$40.666 \$476.400.000-\$39. The student is given information necessary for the refunding analysis.597.000 2.000.35)(\$733.00 0 \$2. They must decide if and when the old issue should be refunded with a new issue.629 \$400.35)(\$4.000.000. 1. Floatation Costs: \$120.400.000)(.540.110 .Case 15 Mirage Resorts Purpose: When interest rates decrease after the issuance of a corporate bond.667 \$4.538) (\$24.004 + .400.000) minus taxes (.35)] Initial Investment 3.000)] = \$400. the firm may find it advantageous to recall the issue and refund the old bonds with new bonds that have a lower coupon rate.000) \$4. Annual cash flows from the old issue: Interest costs before taxes (.00 31 \$733.000.333) after taxes Call Premium before taxes (\$1.000)(. Initial Investment: Floatation Costs Overlapping interest before taxes (.

000)/(20)] x (.400.628 = \$3.000.361 .35) Total annual after tax cash flow 5.C. Present value of annual cash flow savings: (\$780.C.210.000 (\$10.137 .35) after taxes Tax savings from amortization of F.0 minus taxes (\$4.769) \$2.906 ) x PVIFAk=6%. Mirage Resorts should refund the bond issue because the present value of the savings exceeds the costs involved with issuing the new bonds. Therefore.000)(.231 = \$780. Interest rates.00 0 \$3.35) Tax savings from amortization of discount [(\$935.597.363) (\$3. [(\$400. [(\$200.\$2.980.000 (\$16.35) Total annual after tax cash flow 4.190.400.853 = \$6.000)/(20)] x (.000. Annual cash flow savings: \$2.231 \$1.980.000)/(13)] x (.733 8.906 6.500) \$2.00 0 \$2.361 7.\$3. Annual cash flows from the new issue: Interest costs before taxes (.199.35) after taxes Tax savings from amortization of F.00 0 \$1.000) minus taxes (\$3.906 ) x 8.315. have decreased over this seven year period. in general.n=13 (\$780.137 . it 32 \$3.000)(.913.913.400.400. \$6.085)(\$40.199.

9. A small change in interest rates causes a large change in the annual cash flow from a new issue.831.335. the after-tax cost of debt (which is used to calculate the present value of the annual cash flows) is extremely critical. 33 . will affect the refunding decision. Interest rates are somewhat unpredictable. especially the further out in time you try to predict them. Try assuming the after-tax cost of debt is only 5% and you will see that the present value of the savings has increased to \$7. The greater the floatation costs. There are several factors that affect the refunding decision. both fixed and variable. the less likely the firm will be to refund the old issue. Also. The movement in the interest rates is likely the most important. Finally. the floatation costs. Mirage is wise to invest in new hotels/projects independent of current interest rates because a firm cannot just stop investing because they feel interest rates are too high.makes sense that new bond issues can have lower coupon rates. everything else constant.

not right away. If no investors were aware of the crash until it was publicly announced at 12:01 P. However. the eBay backup system is supposed to work within two or three hours. 3.. 2. "If the Dow Jones NewsWire reported the crash 15 minutes earlier or 15 minutes later. No single study or a single case will ever resolve this issue. or (2) investors did not anticipate that the reaction would be enough to make selling or short selling stocks worth while. then there is no way they could have reacted to the news. If the second explanation was the case. ask yourself this question. The fact that millions of people use the site each day coupled with the fact that it was down for four hours before the stock price reacted makes this explanation extremely difficult to believe. but instead it was the fact that the announcement was made over the Dow Jones NewsWire. when an outage does occur. Maybe investors felt the site would be up and running again very soon. the profit derived from such actions would not exceed transaction costs.M. this case provides an account of events that will invoke plenty of discussion amongst students concerning the degree of market efficiency. would the announcement effect have been any different?" No one can say with 100% certainty. but we have to believe that it wasn't the 12:01 P. The fact that the first public announcement of a relevant piece of information caused an immediate and non-over reacting effect in a stock's price is consistent with an efficient market. Assumed knowledge of inefficiencies are the building blocks on which some investors base their entire trading strategies. 34 . why would investors not fully anticipate the adverse affect this would have on eBay's stock price? One possible explanation is that web sites do go down from time to time.M. and who anticipated that this news would result in a severe drop in eBay's stock price could have avoided losing money by selling their shares in eBay or could have made money in the stock market by short selling shares of eBay's common stock. If you are a person who still holds on to the notion that the Semi-Strong form of the Efficient Market Hypothesis (EMH) holds all the time. 1. that made the stock price drop so immediately. Either (1) no investors were aware of the crash until the public announcement at 12:01 P.M. Any person who was aware of the eBay web site crash before 12:01 P.Case 16 eBay Purpose: The degree of efficiency in the stock market is an area of debate that has gone on for as long as the stock market has been open. In addition to being normal. This explanation is weak as well.M. That is.

\$2.71 \$2.13)12 = \$0.13)15 = \$7. Shares should be purchased up until the point where the present value of the dividends is exactly equal to the trading price of the stock.53 /(1.13)15 = \$0.09)5 = \$3.50(1.97 \$2.64 \$3.04)/(.50(1. then adding them together yields a (t = 0) stock price of \$11.50 \$2.09)3 = \$3.13-. this represents a buy signal. This represents the present value equivalent at time t = 15 of all the dividends starting at time t = 16 and going through to infinity.17 4. Discounting all 6 amounts.53 \$2.09)2 = \$2. 3.66 \$3.13)10 = \$0.Case 17 Aether Systems Purpose: The purpose of this case is to have students work through the Variable Growth Model. Since the intrinsic value of \$11. they will have to use the Gordon Growth Model. 35 .17.13)11 = \$0.73 \$2.09)1 = \$2.50(1.50. simply multiply by (1 + i)n t = 10 t = 11 t = 12 t = 13 t = 14 t = 15 \$2.04) = \$44.73 /(1. \$3.45/(1.13)13 = \$0.24 \$2.17 is greater than the market price of \$10.09)0 = \$2.50(1. An additional wrinkle is thrown in here. 1.50 /(1.85(1.97 /(1.62 \$44.13)14 = \$0.69 \$3. The stream of dividends will not start right way.11 \$11.74 \$2.09)4 = \$3.45. Along the way.50(1.24 /(1.50(1.85 /(1. Starting with the dividend of \$2.85 2.

WalMart or MicroSoft before everyone else in the market identifies it as a star. 4. it can achieve all the benefits of going public. There have been a number of firms that have gone public based on the promise of future success. 36 . and to many. The Internet is the primary launching pad for such companies. The answer to this question extends the answer from the first. While there certainly are drawbacks to merging with this type of firm.com Purpose: This solution reflects the environment that existed when the case was originally written. stock market. As such. As such. 2. The answer to this question is elusive to say the least. 3. More importantly. while mitigating many of the disadvantages. It is not the current earnings that are attracting investors. they have convinced investors that they have an immediate need for cash in order to be successful. but deliver nothing in return. alarming trend in the U. While the World Wide Web has been around for years. Every investor would like to own the next McDonalds. It is the potential to generate earnings in the future. Many have argued that we are resting on the largest bubble ever. The price of any asset is the present value of all future benefits the asset generates. it wasn’t until recently that its potential uses have been recognized. This case addresses a growing. investors are willing to buy up the newcomers hoping that somewhere in the basket of firms will be the golden egg. Others say the Internet has brought about profit potential never seen before by any market. the primary benefit is avoiding the extremely lengthy and expensive IPO process.Case 18 NetJ. If a private firm can circumvent the process. 1. Companies being created in this industry have convinced investors that they can be successful in a short period of time. proponents argue the current price levels are justified by the continued economic expansion and prosperous times that lie ahead.S. Many corporations today are considered “ghost firms” who command a high stock price.

Investors understand the concept of the risk-return tradeoff. If we assume that Matt wishes to invest in highly speculative stocks. 4. It is not only the asset class that matters. riskier is definitely not necessarily better. While the SEC still has regulatory control over the OTCBB market (For example. Others will argue on the side of ethics and say that if one market was found to be inferior to another. Therefore. Datek might as well be the firm to offer the brokerage service. it could halt trading.Case 19 OTCBB Purpose: This solution reflects the environment that existed when the case was originally written. there are still plenty of high risk/expected return opportunities available in other markets. OTCBB stocks certainly do not enjoy the same level of market efficiency that the NASDAQ and organized exchanges do. Many would argue that if investors wish to trade in the OTCBB market for any reason.). 3. then a brokerage firm should not offer the sale of those stocks. It is also the market in which each asset trades that matters. 1. If they don’t someone else will. This is not to say that Matt should not invest in OTCBB stocks. only that he must seriously consider the extensive limitation of such a market compared to other markets in which he could invest. the Securities and Exchange Commission (SEC) was created to ensure full disclosure of relevant company information to the public. etc. Investors have enjoyed such a tremendous run-up in stock prices in recent years that many think they can do no wrong. Instead they should remember that high-risk companies have the potential for extremely low and even negative returns as well. The purpose of this case is to introduce students to some of the risk factors to consider when investing in one type of market versus another. it oversees illegal insider trading. In 1933. but have not experienced its downward bite for several years now. 37 . For this reason. This question dates back to the Great Depression. many investors view high-risk companies as high-return companies. 2.

Yet. it will not go away by ignoring it. The board should maximize the value of both stocks since their position is designated as such. While it may be a stretch. none of the merger/divestiture reasons should apply here. Instead. There will also likely have to be established some legal boundaries on the allocation of the conglomerate’s corporate resources between the parent and the tracking division. 2. The fundamentals of financial valuation would state that since the management of the two has remained completely the same. Many would argue that we are currently experiencing an irrational stock market bubble. it will probably get worse because the tracking stock trend is on the rise. 4. 38 . If this is correct. The reason why there are so many more tracking stocks in the technology sector is likely due to the fact that this is where most firms believe the “bubbles” exist. It also addresses several managerial compensation and conflict of interest concerns that arise. This is a question that requires a very involved answer. or divisions. So if investors are willing to pay higher prices for operations in this industry. This case introduces students to an increasingly popular way firms are accessing the hot IPO market. Firms. the rational parent price plus the irrational tracking division price sum to an amount greater than the price of the two when trading under one ticker symbol. the concept of “agency cost” would not exist if management acted in accordance with what they were hired to do…maximize the firm’s value as opposed to their own. These are just a few of the issues to consider. more complete answer. As such. it is human nature to let the good times roll when things are going well. the short answer today might include making sure management has the same percentage or absolute ownership in both stocks. Perhaps we need look no further than the psychology of market participants. Of course. firms should feel free to accept them.Case 20 Pittston Purpose: This solution reflects the environment that existed when the case was originally written. 5. in this sector do not have to show any success today to have an astronomically high stock price. 1. it could be argued that the introduction of new stockholders might increase monitoring and therefore reduce the potential for agency costs. Like any problem. firms are exploiting it wisely by representing their “bubble” divisions separately from the rest of their firm. 3. which is rationally priced. While future research in the area of financial management will certainly provide a better. It should not take a market slowdown to attract the attention of the potentially severe drawbacks associated with tracking stocks.

“If you want to know what to do. Let’s illustrate through an example. In most classes. do the exact opposite of what the small investor does. it does not drive it. Logically. so the realized capital gain is \$280 (\$300 \$20). They hold the stock for 40 years and eventually have to sell it for liquidity purposes. that amount should be pro rated and allocated to each investor who owned shares in the mutual fund during the 40 years. this does not work from a practical perspective. they are spread out over the current mutual fund shareholders. money chases performance. and you will be left with a huge tax bill.” Stated another way. the stock is trading for \$300. At that time. does their estate now owe the taxes? Now consider you are that old investor. The problem is that mutual funds report performance based on pre-tax total returns. it is usually time for a correction. they are not affected when their clients are stuck with a huge tax bill. This is when the uninformed investor gets in. They simply blame it on small investor sentiment and move on. How will the mutual fund locate the investor who bought 38 years ago and sold all her shares 35 years ago? Where will they mail the notice? Has the person passed away in the last 35 years? If so. 2 & 3. students are explained the concept of index investing. Instead. While I understand Vanguard’s desire to maintain the fund’s objective. This affects you because in bad times.Case 21 Vanguard Purpose: This case discusses the too often swept under the rug problems associated with index mutual fund investing. The tax basis is only \$20. Will you have the money to pay a tax bill on an investment you owned 35 years ago? Will you ever remember even owning the mutual fund? Since there is no reasonable way to locate many of the historical investors and because it would seem unreasonable to ask them to pay ancient tax bills even if you could find them. 1. This is a tough problem to correct. the fund will be forced to sell off shares. Small investors are known for jumping on the bandwagon – usually long after it is a good idea to do so. this is not how taxes are determined. By the time the market makes a large enough run up to catch sufficient media attention. However. The problem with being a disciplined mutual fund investor is that the people whose funds have been pooled with yours are typically very poor market timing decision makers. For this reason. The implicit argument being made is that the fund is 39 . There is an old adage on Wall Street that says. 4. they will pull all their money out. Assume a mutual fund buys General Motors (GM) for \$20 per share. but are never told of the tax related dangers. it is unacceptable to manage their portfolio with a complete disregard for the tax ramifications it will have on their clients. You are now 95 years old living on a fixed and extremely tight budget.

5. in a way. The idea is that it will all balance out in the long run. you. they can sell off the shares and use the proceeds accordingly. will likely cash out before those issues are ever sold. their portfolio value is large enough to create a well-diversified portfolio on their own.using new money over time to purchase new shares. Presumably. Unfortunately. for you in the short run. This sticks you with an unfairly high portion of the historical tax bill. the new investor. In short. events like drops in the stock market cause investors to panic and pull out funds. Another option is to maintain their Vanguard account and devote new money strictly to purchasing individual shares. they should seriously consider investing their money directly into stocks. The Simpsons have a long term buy and hold strategy. you are in turn sticking the tax burden to the next generation of investors. 40 . As such. So. Moreover. no system is perfect. Since the mutual fund and the investors within the fund are messing up the profitability of their strategy.

0 Net profit before taxes \$253.00 0 \$5. firms will be faced with the decision to either replace or fix up a piece of machinery.6 Operating net cash flows \$396.000 \$80.4 Year 1 41 . Net after-tax cash flows: All cash flows are in units of \$1.00 0 \$85.000 \$105. a building.Case 22 Florida Power & Light Purpose: At some point in time. 1.000.000 \$114. Alternative 1 Net increase in profits \$650 Taxable increase in Depreciation profits \$16.000 2.000 \$105.000 \$20. This case makes the student consider the cost and intangible advantages and disadvantages associated with the two alternatives.000) \$15.000 \$5. or any other physical asset.000 ) \$4.000 (\$6. Alternative 1 Initial investment Cost of asset Installation costs Total cost of installation Change in net working capital Total Initial Investment Alternative 2 Initial investment Cost of asset Installation costs Total cost of installation Proceeds from sale of old asset Tax on sale of asset Total after-tax proceeds Change in net working capital Total Initial Investment \$100.000 (\$10.0 \$634.

3 \$135.2 \$1.8 -\$1.0 3.7 \$84.6 \$15.4 \$135.2 \$47. The stream of cash flows for each project is: Alternative 1 42 .6 Year 1 2 3 4 5 6 Net increase in profits \$350 \$350 \$350 \$350 \$350 \$0 Depreciation \$20 \$32 \$19 \$12 \$12 \$5 Taxable increase in profits \$330 \$318 \$331 \$338 \$338 -\$5 Net profit before taxes \$132.000 ) \$6.6 \$265.8 \$2.8 \$214.000 \$21.8 \$81.000 (\$4.6 \$214.000 (\$2.4 -\$4.2 3 4 5 6 Alternative 2 \$425 \$317 \$220 \$129 \$0 \$25.4 \$119.000 4.000 ) \$3.000 \$23.0 \$222.0 \$127.2 \$9.8 \$217.000 \$15.4 \$301.2 -\$2.6 \$9.2 \$196.0 \$159.0 Operating net cash flows \$218.6 \$4. Alternative 1 Proceeds from sale of asset Taxes on sale After-tax proceeds Change in net working capital Additional year 5 cash flow Alternative 2 Proceeds from sale of asset Taxes on sale After-tax proceeds Change in net working capital Additional year 5 cash flow \$10.8 \$120. The present value of each cash flow is found by discounting each future cash flow at 10%.2 \$135.2 \$132.000 \$5.8 \$210.000 \$20.0 \$399.

280 \$135.600 \$214.000 \$1. The NPV's of the two alternatives are only separated by \$54.000) \$218.000) \$396.800 + \$21. While this sounds like a large difference. when we consider the magnitude of the cash flows. If any of these very large amounts are wrong. Many computer experts would argue that a new computer which is built for expanded memory is better than an old computer that has been expanded. we are assuming that five years from now we will be able to sell the renewed or new reactimeter for \$5. Alternative 2 Year 0 1 2 3 4 5 6 Net cash flow (\$114.22.000 \$2. respectively.393.86.000 The net present value of this stream at 10% is \$726.840 \$81.000 and \$10.240 \$196. the less accurate we will be. A bigger issue to consider is the fact that our analysis is based on numerous assumptions.053. 5.400 \$265. For example. 43 .446.800 \$214. our decision may change.64. it really is not. 6. The further out into the future we try to predict.600 The net present value of this stream at 10% is \$780. Paul is more likely to allow the qualitative issues to weigh on his decision. Paul should chose to renew the existing reactimeter instead of replacing it with a new one.800 \$217.Year 0 1 2 3 4 5 6 Net cash flow (\$105. With such a small amount separating the two choices. Since the NPV of alternative 1 is higher than the NPV of alternative 2. how certain are we? Another example is our estimates concerning the increase in profitability for both alternatives.000 \$222. Since these two amounts are so far off into the future.000.240 + \$23.

the time value of money. The calculated solution is 4. When the criteria conflict. Conflicts between the PP and either NPV or IRR can occur at any time.9/2. It does not consider the timing of the cash flows. the firm will increase its value by accepting the project.1 )7 1. 5. The NPV method assumes these intermediate cash flows can be reinvested at the discount rate. PP = 4 years + 0. the overall value of Southwest will decrease by \$2. the project should be accepted.1 ) (1. 44 .1 ) (1. the internal rate of return. based on PP. and any cash flows beyond the payback period. the modified internal rate of return. 2. Finally.77%. Managers often prefer to think in terms of percentages instead of absolute dollars. This measure differs from the NPV methods in two major ways. + + + 1 2 5 6 (1.followed by the IRR.5 \$6. Therefore. while NPV is a dollar amount. based on NPV. the IRR criterion indicates that the project should not be accepted. This is because PP suffers from three mathematical flaws. The student must chose to either accept or reject the project based on the above criteria which will conflict.43 years 4.1 PP = 4. However. and the net present value of a proposed project. They therefore must also decide which criteria has priority over the others.560 NPV is the present value of all future net cash flows associated with a project minus the initial investment.637 million.1 ) (1. Second. In this case. First. \$4. The Payback Period is the number of years it takes to recoup the project's initial investment. 3. IRR assumes that when the cash flows are received year after year.1 ) (1.1 \$1. IRR is a percentage. it should not be accepted. because the calculated IRR is below the hurdle rate. the NPV is negative which means that if the firm accepts the project.. then PP.3 \$0. the NPV of the project is negative..637. they can be reinvested at the IRR.8 + NPV = -\$2. The IRR is the discount rate that makes the present value of the future net cash flows equal to the initial investment. Since the project's payback period is less than the 5 year maximum.Case 23 Southwest Airlines Purpose: This basic case requires that the student calculate the payback period. If the NPV is greater than 0.3 \$2. the NPV should be most trusted . NPV = -\$20.5 + + .

i=10%) \$2. MIRR is found by taking the future value of each intermediate cash flow to a terminal point (the last year of the project).3 \$5. the MIRR will always fall between the discount rate and the IRR. MIRR assumes the intermediate cash flows are returning a higher amount (discount rate) than the IRR.9 \$2. 7.5 Future Value of Net Cash flow \$7. PV = -\$20.Both IRR and NPV take into consideration these concepts. n = 7.97 (n=6.54 (n=2. MIRR maintains that the IRR is too high and assumes that the intermediate cash flows are returning a level only equal to the discount rate. Why? When the IRR is below the discount rate. Year 0 1 2 3 4 5 6 7 Net Cash flow -\$20.8. i = 7. i=10%) \$1. The difference is that like the NPV.19 (n=3. Conversely. With normal cash flows.15 (n=5. Let. i=10%) \$5. FV = \$35.98%.3 \$0. i=10%) \$10. i=10%) Sum = \$35.39. MIRR assumes that the project's intermediate cash flows are re-invested at the discount rate.8 \$4. IRR is actually over estimating the true yield. It compounds based on the discount rate as shown below. This is the project's MIRR.61 (n=4.1 \$1. IRR may lead to the wrong accept/reject decision if the projects under consideration are mutually exclusive and if any of the future net cash flows are negative or if the magnitude of the cash flows from one project are greatly different from the magnitude of the cash flows from other projects. However. 45 . i=10%) \$7.050 (n=0.2 \$3. 6.43 (n=1.59 Plugging into a calculator. MIRR is similar to IRR in that it expresses a project's attractiveness in terms of a percentage. Solve for i. i=10%) \$. This assumption is methodologically preferred.5 \$6. when the IRR exceeds the discount rate.

t= ( +1k ) 1 Where CFt is the net cash flow during the given year and k is the appropriate discount rate. 2. SCE NPV = \$3.I.000 = 1. 1.Case 24 Acclaim Entertainment Purpose: This case considers a firm's decision to accept or reject multiple proposed projects. When the NPV is greater than 0. Therefore. Mathematically.000/\$41. Both independent and mutually exclusive projects will be considered. Ct F N =PΣ V t .613 Nintendo NPV = \$13.60 years Nintendo PP = \$40. it is necessary to understand the concept of annualized net present value.000/\$10. SCE PP = 1 + \$6. Nintendo would be the preferred carrier of Mortal Combat since it has the shortest PP – less than 1 year.91 years Sega PP = \$40.000 = . NPV is defined as the present value of all future net cash flows minus the initial investment.223 46 n . investing in the project will add value to the firm..000 = . Using a discount rate of 10%. the projects will have unequal lives. Further.98 years Assuming a required payback period of 1 year.000/\$44. Payback Period is defined as the time required to recover a project’s initial investment.

all three have acceptable IRRs. the traditional NPV measure will possibly lead to the wrong accept/reject decision. or via a calculator.e. Internal Rate of Return (IRR) is the discount rate that forces the NPV to equal zero. by using an approximation formula. Since the life of Mortal Combat is projected to be different under each of the three hardware systems. ANPV is calculated by dividing the NPV by the present value interest factor of an annuity at a given discount rate and for a given number of years (i.613/3. the Annualized Net Present Value (ANPV) measure should be used. 5. 4. Based on NPV. all three carriers would be used since they all have a positive NPV. the project should be accepted. In this case Acclaim could sell through none.154 Based on NPV. The calculator provides the most accurate answer. IRR can be solved through trial and error. If the IRR exceeds the company's hurdle rate.170 = \$1. 3.82% Sega IRR = 39.140 47 . Nintendo and Sega would be chosen because both have payback periods under the required 1 year maximum while SCE does not. Instead. all three marketers have an IRR in excess of Acclaim's hurdle rate of 10%. only zero or one project can be chosen. or all three companies.04% Nintendo IRR = 38. the life of the project). Based on the payback period criterion. SCE IRR = 17. two. the following solutions were obtained from a financial calculator.Sega NPV = \$15. Similarly. Mathematically. With mutually exclusive projects. Therefore. any number of projects can be selected.n=4 = \$3.n ) ANPV = SCE ANPV = NPV/PVIFAk=10%. Mortal Combat should be sold through the Sega system because the NPV under Sega is the greatest amount. The higher IRR. The highest is Sega. one. the better. With independent projects. NPV ( PVIFA k.80% Based on IRR.

093 Based on ANPV.154/2. the decision has changed. It is now clear that Nintendo is the hardware company through which Acclaim should distribute Mortal Combat.n=3 = \$15.617 Sega ANPV = NPV/PVIFAk=10%.Nintendo ANPV = NPV/PVIFAk=10%.736 = \$7. Acclaim would have lost money by choosing the wrong interactive hardware company (Sega).487 = \$6. 48 . Without considering this more appropriate measure.223/1.n=2 = \$13.

500.000...000 \$1.10 )7 NPV = -\$2. To calculate the NPV of the Gourmet Hazel Nut.000 \$840.000 C. Using the RADR of 12%.. 1. Year 0 1 2 3 4 Net cash flow Gourmet Hazel Nut -\$4..000 49 .10 ) (1.000 \$206. traditional net present value techniques cannot be used.80 . \$1. the Gourmet Hazel Nut is no longer a positive NPV project and should therefore be rejected.000 \$206.00 0 + With the more appropriate RADR. Therefore..000 \$950.70 . the NPV of the Gourmet Hazel Nut.000 \$800.60 .+ = \$47.000 \$450.000. + = −\$167.000 \$750.000 + . The projects in question are not of similar risk.000.534 1 (1.000 + . + = \$31.000 + .000.000.10 )1 (1.10 )7 NPV = -\$4. 2.Case 25 Philip Morris Purpose: This case considers a firm's decision to accept or reject multiple proposed projects..000 \$425.12 ) (1. both projects should be accepted. 1.000 \$1.00 0 + Since the projects are independent and both have a positive NPV.000 \$519.200.000.098 1 (1.00 0 + The NPV of the Post Blueberry Morning is \$803. 3. Instead.000.E.50 Certain cash flow -\$4.00 . the use of Risk Adjusted Discount Rates (RADRs) and Certainty Equivalents are necessary.12 )7 NPV = -\$4. \$1.349 (1.

. the manager might be indifferent between receiving a somewhat uncertain \$100 two years into the future or a certain \$80 two years into the future.80 . 4.000 \$400. RADRs do not.000 \$498. For example.850 +.+ = -\$1.000 \$612.900 \$199. but can be less accurate.85 . Certainty equivalents adjust cash flows for risk and time separately.30 .70 .05 )7 NPV = -\$4. 50 . They lump the adjustment in together..500. 1.320.400 \$337.95 .200 The NPV of the certain net cash flows is calculated by discounting these cash flows at the risk-free rate of 5%. \$800.000 \$235.000 \$150.00 0 + Year 0 1 2 3 4 5 6 7 Net cash flow Post Blueberry Morning -\$2.200 + .500.000 \$519.90 .000 \$803..000 \$500.750 \$320.00 .000 C.000 \$521.40 .000 \$762. RADRs are easier to interpret conceptually.000.000 ..500.5 6 7 \$880.350 NPV = -\$2.05 ) (1. 5.80 1 1 (1.850 \$468.750 On a certainty equivalents basis.+ \$337.000 \$41.000 \$41.000 \$373.75 .000 \$206.500 \$428.000 + \$762.20 \$352.E. Certainty equivalents can be defined as the percentage of the cash flow in each period that the manager would be willing to accept if the amount was 100% certain.65 Certain cash flow -\$2. only Post Blueberry Morning has a positive NPV.350 = \$390.

Two methods can be used to find kd. kp = cost of preferred stock.00/\$95. N = number of periods in which a coupon payment was received. 1." the interest 51 . kp = \$11. FV = Future Value (the amount the firm returns to the bondholder when the bond matures).00 Np = \$95. (1) The first is the calculator method: Let. Dp = annual preferred stock dividend. PV = \$970 (\$1005 . solve for "i.5%. After plugging these four variables into a financial calculator. The Cost of Long-Term Debt: kd = cost of long-term debt.\$35) FV = \$1. Since preferred stock dividends are paid from after-tax earnings.000 * 9%)/2)] N = 40 (20 * 2) where. The WACC is an essential number to determine because it is the appropriate discount rate used in net present value (NPV) calculations for all similar-risk. equal-life projects. Dp = \$100 * 11% = \$11. 2. this is the after-tax cost of preferred stock. Therefore. Np = net proceeds from the preferred stock issue.50.Case 26 Computerized Business Systems Purpose: The purpose of this case is to find the weighted average cost of capital (WACC) for a firm.000 PMT = \$45 [(\$1. PV = Present Value (the amount the firm receives upon issuing the debt). here.50 = 11. PMT = Payment (this is the amount the bondholder receives at the end of every six month period until the bond matures). The Cost of Preferred Stock: k p= Dp Np where.

40 is the present value interest factor of an annuity for 40 6-month periods at an interest for which we are trying to solve.. with the second method. k re = where. This is the interest rate on a semi-annual basis. we must multiply Kd by (1-t).rate. the full \$68. 3.25 k re = + . the constant growth (Gordon Growth) model should be used. however. Under either method. When new common stock is issued.40) = 5. simply multiply by two to yield a before tax cost of debt of 9. D1 + g = D0 (1 + g) + g P0 P0 kre = cost of retained earnings.40) Here. so no adjustment is needed.334 * (1 .000 20 years into the future to its present value equivalent. with one minor alteration. After 52 . 4. PVIFk%.63% Funds from retained earnings have already been exposed to corporate taxes.40) + FV(PVIFk%.10) 68. P0 = current price of the stock. D0 = most recent dividend paid. where t = the corporate tax rate. To annualized it. This portion of the equation will convert the bond's par value from \$1. the answer should be the same. is used here. g = growth rate in dividends. Cost of Retained Earnings: Since the dividends in this case are expected to grow at a constant rate into the future. PVIFAk%. ki = 9.40 is the present value interest factor.10 = 13.667%.25 is not received. Most financial tables do not list non-integer interest rates. Coupon payments are deducted from corporate earnings before taxes are paid.334%. D1 = next year's dividend. Therefore. Doing so will yield an answer of 4. One problem does arise. 2.6%.25(1. Cost of Common Stock: The same formula as was used in question 3. (2) The second method is to employ a formula such as the following and use financial tables to generate the answer: PV = PMT(PVIFAk%. to find the after-tax cost of long-term debt.

000 / \$92.10823)(13. Plugging into the equation: 2.000.07575 . simply divide each proportion by the sum of all the four sources.000.000 / \$90.400.000 / \$90.400. The same procedure is used again except now the weights will be slightly altered.000 = \$10.94%)+(.38888)(5.000 = Weight .25(1.11111)(13. the company only receives \$62.000.000 = \$40.000.6%) + (. 5. To calculate the weights of each type of fund.000 = \$42.000.45455)(13.05555)(11.000 / \$90. Asset Class Long-term Debt Preferred Stock Common Stock Retained Earnings Book Value \$35.71% 6.6%)+(.000 = \$10.10) 62.000 / \$92.10823 A Applying the formula. Asset Class Long-term Debt Preferred Stock Common Stock Retained Earnings Market Value \$33.400.000.000 = \$5. ka = after-tax cost of each type of fund.5%) + (.44444)(13.45455 .10 = 13.75.000.000 = Weight .63%) 53 .000. WACC = (.07575)(11.000 / \$92.000.11111 So. wa = weight of each type of fund.36147 .63%) = 10.000.44444 . WACC = (.000.000 / \$90.94%) + (. no tax adjustment is needed.400.94% Again.5%)+(.36147)(5.000 = \$7.floatation costs.38888 .400.75 kn= + .05555 . The WACC can be defined by the following equation: =C k a = W A C ∑ wa k a = wi k i + w p k p + wn k n + wr k r a= 1 where.000 / \$92.

05)(11.I . Book values are usually preferred by the accounting department. The financial manager wants only to stay relatively close to the target weights over time. This choice is primarily a function of floatation costs. 8.1071 )1 (1.71% 10. 7.. Therefore. 9.000 \$80 .1071 )10 (1.000 \$10.63%) WACC = 10. It will cause us to accept or reject the project depending on which rate we use.1071 )11 NPV = \$188.5%) + (. + + (1.000 + .101. the discount rate makes a big difference.35)(5. Yes.WACC = 10.460. This is why we need to be as accurate as possible when calculating the WACC. using book values.000 + C Ft ..94%) + (. the company should buy the CBS system.48.84%.6%) + (.I . Finally.84% 10.\$480. NPV∑ = Using market weights: NPV = . Using target ratios. market weights are typically preferred because financial managers are concerned more with market values. target weights are more of an idealistic goal.52% NPV -\$2. In the industry. but it is not attempted or expected to be the exact percentage of weight for each type of funds. t t= 1( 1+ k ) n \$80.40)(13.40 54 .52%.20)(13.48 \$4. using target ratios. The firm's target ratio will not be exactly maintained because when a firm goes to the financial markets to raise funds. they usually do so by issuing only one type of security. WACC 10. WACC = (.18 \$188.

41 (2) Estimated Required Return 10.30 \$4.38 \$0.60 \$0. 1.48 \$3.49 \$0.11 \$1.03 1.45 \$0.21 \$0.52 \$0. To do so.2% 13.67 0.08 (3) = (2)/(1) Coefficient of Variation 0.55 \$0.26 \$0.62 \$0. This case is important not only because it gives students a chance to approach this very elusive optimization problem.3% 10.6% 11.43 \$0.4% 16. they must determine their optimal capital structure.69 \$4.06 \$4.60 \$0. Debt Ratio 0% 10% 20% 30% 40% 50% 60% (1) Expected EPS \$0. but also because ALL firms must decide on the level of debt they will carry.84 \$1.33 \$0.38 \$0.51 \$4.99 3.41 (2) Standard Deviation of EPS \$0.43 \$0.6% (3) = (1)/(2) Estimated Stock Price \$3.49 \$0.Case 27 McLeodUSA Purpose: The goal of any firm is to maximize shareholder wealth.52 \$0. The Gordon Growth model for pricing stocks is as follows: P0 = DPS ks +g 55 .63 2.4% 12.55 0. The formula is stated as follows: P0 = EPS ks Debt Ratio 0% 10% 20% 30% 40% 50% 60% (1) Expected EPS \$0.55 \$0.82 1.7% 20.62 2.60 0.

In order for the two equations to be equal to each other. and g = 0. Concerning the g = 0 assumption. 56 . that this expected stock price estimation is not without its flaws. from question 3. It is almost never the case that a firm will pay out all of its earnings in dividends. Based on the zero-growth valuation model. Therefore. Although the goals of profit maximization and stock price maximization are highly positively correlated in the long-run. Since the goal of every corporation is to maximize stockholder wealth. "g" refers to the growth rate in dividends. this model is an over-simplification of reality. A note of caution should be taken here. achieving the highest stock price should be the focus of McLeod. McLeod's optimal level of debt is 30% because this is the amount of debt that results in the greatest expected stock price. Clearly the two models do not agree as to the optimum amount of debt that McLeod should employ. There many ways managers can maximize short-term profits at the expense of long-run performance (and therefore stock price). the following two conditions must hold: EPS = DPS. 5. 4. they certainly do not have to be in the short-run. It is extremely unlikely that a company would never increase the dividend payment. Certainly it is not possible in the long-run (which is the way these models value a stock by finding the present value of all future dividends) to have a 100% payout ratio. however. since we have just learned.

Case 28 Lancaster Colony Purpose: The purpose of this case is to discuss the different dividend payment policy alternatives and how they might affect stockholders. The Fixed-Dollar or "Regular" dividend payment policy maintains that the firm would pay the exact same dollar amount every dividend payment period and would only increase the dividend payment when it was very certain that the new. We can also safely assume that both the firm's investment opportunity set and how well they performed have also been taken into consideration given that their dividends do not always increase at the same rate or by the same dollar amount. there are several drawbacks associated with the Constant Payout Ratio policy and it is therefore not often used by firms. given the stable and steady increase in dividend payments. 2. However. it is very likely that Lancaster follows this policy coupled with the very conscience decision to ensure that the annual amount of dividends continues to increase each year. However. If Lancaster cut its dividend for the first time in 39 years. not just at year's end). 3. In the case of Lancaster Colony. it would certainly send a negative signal to the market causing the stock price to drop. 1. The Low-Regular-and-Extra Dividend policy holds that the firm will pay the same dollar dividend over the first three quarters (dividends in the US are typically paid every quarter. Table 1 shows that although the number has been consistent and stable over the last 5 years. but likely higher than that paid for each of the first three quarters. it is certainly unlikely to be the policy chosen by Lancaster. The amount of the year end dividend is a function of how well the company has done during the year and also a function of their investment opportunity set in the near future. 4. it certainly is not the same. Although the data given in the case does not breakdown dividend payments by quarter. Since we are not given an investment opportunity set in the case. Moreover. the dividend payment amount is clearly different each year so this policy is not being followed. then pay a fourth quarter dividend that is at least the same as. it is not possible to say with 100% certainty that Lancaster is not following this policy. Then any money left over should be paid out to stockholders in the form of a dividend so that no free cash flow (FCF) is left. A Constant Payout Ratio means the company will keep the ratio "DPS divided by EPS" at the exact same level each year. higher dividend could be sustained in the long-run as subsequent dividend cuts send a severely negative signal to the market. 5-6. The Residual Theory of Dividends states that all available cash flow should be invested in projects with a positive net present value. Lancaster could mitigate this reaction by coupling their dividend cut announcement with an explanation that the reason for the cut is to allow the company to earn an even greater rate of return 57 .

Even still. This will cause extra volatility in Lancaster's stock as investors buy and sell their shares to transfer ownership. the investor base or investor composition might change from income seeking conservatives to more aggressive growth-oriented investors. 58 .by investing in internal projects that are highly profitable.

88 = \$2.322. 1. Again this assumes the cash will be used on a continuous and smooth basis. Stated another way.898.92) + (.898.23) = \$1. 3. \$2.23. In practice. The total cost associated with managing the funds is given by the following formula: TC = (conversion costs)(# of conversions) + (opportunity costs)(average cash balance) TC = (\$25)(52. Anheuser will round off and liquidate funds once a week. It cannot meet its 59 .88 You can be sure this is the minimum amount because the two components of the cost are equal.Case 29 Anheuser-Busch Purpose: The Baumol Model is used to determine the optimal amount of cash a business should keep on hand to minimize the tradeoff between non-interest bearing cash and the opportunity costs associated with not having ample cash on hand. In practice. Safety stock is very important because when a firm runs out of money. 4.645. 2. salary expenses typically cause cash outflows to be extremely lumpy.92 times per year.45 ECQ is used to minimize the costs associated with the tradeoff between keeping cash on hand (that does not earn interest) and making sure the firm does not have a liquidity problem. It cannot pay its employees.000.000) . the TC equation will determine the minimum total costs by considering the tradeoff between keeping unproductive cash balances on hand and transaction costs associated with liquidating money market accounts.45/2 = \$18.323.45 = 52.00 + \$1.796. ECQ = (2)(conver sion costs)(dem and for cash) opportunit y costs(deci mal form) ECQ = (2)(25)(\$2 .796. it cannot purchase inventory to produce its goods. 5.07)(\$18. \$37.000.796.000/\$37.07 = \$37.

60 .debt payment obligations. The chosen level of safety stock for each firm is a function of the penalties associated with not being able to meet their financial obligations. For all these reasons. the more safety stock the firm should keep on hand. safety stock is added to the ECQ as a fudge factor or as a security against unexpected cash needs. The more severe the penalty.

685 Bar Code System \$3.000)/(365) x 52 = \$3.12. To calculate the annual cost savings. to determine their annual cost to cover their CCC.\$368. OC = AAI + ACP = 42 + 27 = 69 days OC = 69 = APP + CCC = 29 + CCC CCC = 40 Days Financing needs = (total annual outlays)/(365) x CCC = (\$28.493 3. CCC = Cash Conversion Cycle. AAI = Average Age of Inventory. we need to use the answers from questions 1 and 2.466 61 . Students will learn how to reduce the cash conversion cycle to save a firm money. OC = AAI + ACP = APP + CCC 1.000. simply multiply the answer from 1 and 2 by . Old System \$3.219 = \$110. Therefore.Case 30 Pepsi Purpose: The cash conversion cycle measures the amount of time that a firm's cash is tied up and is therefore wasting company resources.041 x .000.493 x . Pepsi is charged 12% for short-term funds.000)/(365) x 40 = \$3. OC = Operating Cycle.685 .219 Annual Savings = \$478. Let.989.068.068.041 2. ACP = Average Collection Period. APP = Average Payment Period.12 = \$368. OC = AAI + ACP = 42 + 39 = 81 days OC = 81 = APP + CCC = 29 + CCC CCC = 52 Days Financing needs = (total annual outlays)/(365) x CCC = (\$28.12 = \$478.989.

the better because short-term funds cannot be used for otherwise productive resources. 6.466 (\$110. These savings. however. by considering different terms of sales procedures for both accounts receivable and accounts payable. it should be used because an additional profit of \$60. The lower the cash conversion cycle. Service firms.4. will far exceed any additional cost of financing. but has yet to receive payment for the goods.466 . There are three ways to speed up the cash conversion cycle. Great strides can be made. A firm can increase its average payment period or decrease either its average collection period or its average age of inventory. the production process is naturally as stream-lined as possible. That is. 62 .000 to implement.000) will result. Cash conversion cycles are very different from industry to industry. tend to have very short and even negative cash conversion cycles.\$50. we still have ignored the reduction in labor costs. Manufacturing firms tend to have longer cash conversion cycles because their average age of inventory tends to be much greater. on the other hand. Therefore. 7. The cash conversion cycle is the amount of time the firm's cash is tied up. Even if the bar code system did work out to be more expensive. In most cases. while extremely difficult to estimate. the firm has paid for the goods. 5. The bar code system will cost \$50.

819) / (360/14) = \$11.700) / (360/23) = \$17.64 6.959.17 .94 . Cost of cash discount (.94 .04) 5. buyers will buy through them. Inn-Room should consider the fact that all of these forecasts about what conditions will be like under the newly proposed accounts receivable policy are just estimates. Cost of marginal investment in accounts receivable Average investment under proposed plan: (\$157 x 1.106.\$11.04 = \$4. InnRoom should take the calculations further and perform a sensitivity analysis to determine how much results might change if their estimates are off. Average investment under proposed plan: (\$157 x 1.700) x (\$234 .971.70 x \$234 x 1. they will be losing money by having their funds tied up at disadvantageous rates of return.Case 31 Inn-Room Safe Purpose: Firms have numerous options to consider when establishing their policy on accounts receivable.106.051. It is important to recognize that 63 .17 4. 1.008 x \$234 x 1.700] – 1.959.40 \$1.51 3.005 x \$234 x 1.00 + \$713.\$5.054.07 x 1. Should discounts be given to buyers who pay within 10 or 15 days? When should accounts be due even when no discount is offered? These questions are important to a business because if their terms of sale are favorable.01.02 x .128.182. Additional profit contribution from increased sales ([1. Net profit from implementation of proposed plan \$9.054. Cost of marginal bad debts Bad debt expense under new plan: (.819) = \$2. If the terms of sale are too favorable.12 x (\$17.700) = \$3.163.819) = (\$5. This delicate tradeoff directly affects a firm's profit from operations.01) = \$713.\$157) = \$9.23 (.51 + \$1.051.163 2.

64 .small changes in assumption inputs can result in large changes in the bottom line.

Case 32 Home Depot
Purpose: Taking or not taking the cash discount offered on a firm's accounts payable is just as important as accepting or not accepting capital budgeting investment projects. This case directs students to walk through the analysis and learn how to make these very important decisions. 1. The cost of giving up the discount is equal to:
C D 360 x = (100% - C ) D N

2% 360 x = 24.49% (100% - 2% ) (45 - 15)

2. Since all of the above figures are far below the cost of giving up the discount, Home Depot should take the discount. However, only one of the three figures is relevant to making this decision. Students might think that the WACC is the right answer because the money used to pay the account earlier would have otherwise gone to investing in a positive net present value project (we could assume). The problem here is that we have ignored risk. The WACC is the required rate of return on an average risk project. If a project has more or less risk than average, a risk-adjusted discount rate (RADR) should be used. With Accounts Payable, the risk is certainly not the same as a regular project. The firm's decision is made today at no risk at all. If the early payment is not made, the future payment is known with 100% certainty (i.e. no risk). The fact that Home Depot can borrow from the bank at 9.7% is only partially relevant. We know from capital budgeting that the specific source of funds used to finance a project is not what should used to discount the associated cash flows to arrive at a NPV. Instead, a weighted average of all sources is what matters. That is the reason we calculate WACC first. Then we account for risk afterwards. In this case, we account for risk by noting from the case that Home Depot's risk-free required rate of return is 7%. This is the correct benchmark for comparison. 3. The approximate cost of giving up the discount is equal to:
360 = 2% x (360/[45-15]) = 24% N

CD x

4. The tables below summarize the results using the same formulas from questions 1 & 3. 65

ACTUAL Costs 30 days 45 days 60 days 1% 24.24 % 12.12 % 8.08% 2% 48.98 % 24.49 % 16.33 % 3% 74.23% 37.11% 24.74%

ESTIMATED Costs 30 days 45 days 60 days 1% 24.00 % 12.00 % 8.00% 2% 48.00 % 24.00 % 16.00 % 3% 72.00% 36.00% 24.00%

Approximation Method Error 30 days 45 days 60 days 1% 0.24% 0.12% 0.08% 2% 0.98% 0.49% 0.33% 3% 2.23% 1.11% 0.74%

As can be seen from the table, the larger the cash discount, the greater the error when using the approximation formula. Also, the fewer the number of days between the cash discount period and the total credit period, the less accurate the approximation formula.

66

Case 33 Hasbro
Purpose: Leasing has become an extremely viable alternative to the traditional purchasing of machinery, buildings, and even land. All manufacturing firms have the opportunity to lease or buy some of their assets. This case will provide the information necessary for the student to determine which option is preferred for a given situation. The calculations for this type of decision are quite lengthy. 1. Each lease payment is deductible for tax purposes. Therefore, the after-tax cost can be calculated as \$7,000 x (1-.4) = \$4,200. During the last year, however, the company will purchase the machinery at a price of \$6,000. The five year after-tax cash flows are shown in the table below. Year 1 2 3 4 5 After-tax Cash flow \$4,200 \$4,200 \$4,200 \$4,200 \$10,200

2. To find the amount of interest paid per year, a table is beneficial. Year Payment Beginning Payment Balance Principle Interest 1 \$7,514 \$30,000 \$5,114 \$2,400 2 \$7,514 \$24,886 \$5,523 \$1,991 3 \$7,514 \$19,363 \$5,965 \$1,549 4 \$7,514 \$13,398 \$6,442 \$1,072 5 \$7,514 \$6,956 \$6,958 \$556 Ending Balance \$24,886 \$19,363 \$13,398 \$6,956 \$0

3. Depreciation expenses are equal to the MACRS rates times the purchase price of the machinery. Year Depreciation Expense 1 \$30,000 x .20 = \$6,000 2 \$30,000 x .32 = \$9,600

67

072 5 \$1.062 5. To find the present value.000 \$5.000 x .600 4.400 2 \$1. for example) are depreciable unless they are leased. The present value of the five net after-tax cash outflows associated with purchasing the machinery is equal to \$22. Year Total after-tax net cash flow 1 \$4. we would want the one with the lower present cost. and interest expense each year multiplied by the tax rate (.600 \$1.600 \$30.12 = \$3.3 4 5 \$30.245 5 \$6.036 \$3.300 \$2. Disadvantages associated with leasing include an unpublished interest rate that the lessee is being charged. The present value of the five net after-tax cash outflows associated with leasing the machinery is equal to \$22.000 \$3.269 \$2.452 6.000 \$9. In the event your firm goes bankrupt.000 \$2.40).549 4 \$1. Year Maintenance Depreciation Interest expense expense expense 1 \$1.885.700 \$30.000 \$3. they get their asset returned to them).991 3 \$1.478 3 \$5.740 \$5.600 \$1.398. If putting a down payment on an asset is a problem. Therefore. use a discount rate of 5% [(8%)(1 . 7. not all assets (land. such as computer technology.514 plus the maintenance costs minus each year's tax shield as shown in question 4. Finally.19 = \$5. leasing is advantageous because it allows the lessee to finance 100% of the asset. depreciation expense. Total after-tax net cash flows are equal to the payments of \$7.600 \$556 Total Tax Shield \$3. You must calculate it to be sure it is not too high. you still have to lease it for the remainder of the contract.4)].774 2 \$3.12 = \$3.000 x .000 \$6. The salvage 68 . Leasing can also be an advantage if the asset you need is in an area that is associated with quick obsolescence. once you have entered into a lease. Of course..000 x . Since these figures reflect the present costs associated with both alternatives. the lessor only has a legal right to recover three years of lease payments (and of course.700 \$1. Hasbro should purchase the machinery instead of leasing it. The total tax shield is equal to the sum of the maintenance expense. if the asset becomes obsolescent.214 4 \$6.

Finally. If the doll does well. The factor that will determine Hasbro's decision concerning whether or not to buy the machinery at the end of the lease will most likely be the success of Maxie's sales. if you are locked into a lease and you desire to make asset improvements. The longer the lease. 8. Hasbro will be more likely to either roll the lease over or purchase the machinery for future production needs. everything else constant.value at the end of the lease belongs to the lessor. the lower will be the savage value. it is common that restrictions will be imposed by the lease. 69 .

and volatility of the underlying common stock. 2. options will be trading with maturities in January. the option still has some value. they will always be offered in the current and following month and also on the next two natural months in the trading cycle. but lose on the stock. Chris' holding of common stock went up in value by \$2. exercise price. and July. he should buy the nearest maturing put option (i. the greater the time to maturity of an option. February. Volatility also has a positive relationship with option prices.50 x 500). 4. April.000. 3. January.750. 6. Technically. Since December options contracts had not expired by December 15. options are available with maturities in December. December).250 and his new wealth position is \$45. 5. but this value will decrease dramatically as it just went out of the money with only a few days to expiration. 1. the greater the value of the option. His new wealth position is down to \$44. he made \$1. On the up side. Volume tends to be higher when the strike price is above the current stock price because stock prices tend to increase over time. Also. His underlying shares lost \$2. Chris will not exercise the put option. Chris will make money on the put options. April. and July.250. Chris lost \$250 from the announcement. Overall. Doing so will allow him to hedge at the lowest possible cost. the greater the trading volume in that option tends to be.Case 34 Microsoft Purpose: This basic options case helps students read and understand how options behave with respect to such factors as time. a) To develop the hedge will cost: \$750 (\$1.e.000 [(\$93-\$89) x 500}. The student will also learn the basics of how a put option can be used to hedge risk. it is considered to be zero. With the same options cost of \$750.500 [(\$90-\$85) x 500]. No matter which trading cycle options are on. The nearer the option is to its expiration. Since the stock price (\$93) exceeds the exercise price (\$90). His put options will be worth roughly \$2. stock price. Each options contract is written on 100 shares of common stock. b) If the stock price decreases to \$85. An investor should buy put options when they need protection against downward movements in a stock's price because long put positions make money when stock prices decrease. The further out of the money an option is the cheaper the price should be. Since Chris feels the downward movement will take place tomorrow. The above relationships hold for both puts and calls. From a practical standpoint. 5 put contracts should be purchased. On January 1. Therefore. This 70 .

71 . can be exercised immediately for a positive payoff. Conversely. in-the-money American options. by definition.follows since the further out of the money an option is the lower the probability it will ever be exercised. the further in the money an option is the more expensive the price should be because it will most likely be exercised. In fact.

In 1998-1999. also own REITs. While it is impossible to measure directly or with a high degree of accuracy. Since the average 72 . When the economy is bad. like pension funds. the total market value of all commercial real estate in the United States is around \$5 trillion. on the other hand. Tax-exempt institutional investors. businesses trim down or even go out of business. When the economy is good. which frees up office space. The reality was that REITs had a low correlation with technology stocks and a much higher correlation with the other stocks in the market which showed the same general return pattern throughout that REITs did.Case 35 REITs Purpose: This case introduces a type of security that is too often ignored in finance. REITs have been shown to generate sufficient returns on a risk-adjusted basis to warrant inclusion in mixed-asset portfolios. all they care about is total return. REITs have historically returned 7. only \$250 billion of this real estate is controlled by REITs. It is important to make students aware of REITs because they have repeatedly been shown to warrant inclusion in mixed-asset portfolios. the S&P 500 would be compared to the NAREIT (National Association of Real Estate Investment Trusts) index.0%-8. Conversely. REITs. 1. therefore. 3. For example. 2. to calculate the correlation between large cap stocks and REITs. Since they do not pay taxes. This higher demand allows the building owners to keep rents at a very high level as firms are competing for space. These lower rents mean lower revenues for REIT shareholders. not whether the total return came from dividends or capital gains. rents are determined based on supply and demand in the local economy. leaving the other half available for ownership. Due to tax consequences. Currently. The widely available space gives renters (lessees) the upper hand. so too did the S&P 500. The correlation between asset classes is typically measured by examining indexes (benchmarks). Landowners compete for tenants by lowering rents. it is likely that REITs will be observed to have a higher correlation in the future. Do to these extreme events. they drug the S&P 500 index along with them. 4. continued their steady returns. Half of this is owned directly by corporations.0% in dividends and a more modest 3%-5% in capital gains. after the technology stocks crashed. is that REITs had a low correlation with the stocks in the S&P 500. The appearance. The REITs that own these building are therefore receiving higher revenues and are thus more profitable. the individuals who own REITs are same investor class as those who own utility stocks – retirees. technology stocks soared in value which caused their weight to be very high in the S&P 500 index. For commercial properties. So as the technology stocks went through the roof. businesses flourish and office space is demanded.

Retail. Given that there are numerous property types (Apartments. 73 . Several researchers have found them to be so different that they should be considered a separate asset class. REITs are not exactly unsecuritized real estate. Warehouse.8 billion. only a small percentage (approximately 10%) of commercial real estate is securitized. Thus.). Moreover. the total market capitalization of all REITs sums to \$141. while it is far beyond the scope of this simple case. Industrial. using them as substitutes can be misleading.REIT has roughly a 40% debt ratio. the ability of a portfolio manager to find enough REITs to make a significant rebalance in a portfolio is dubious. Thus. Office. etc.