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33880966 Principles of Corporate Finance

# 33880966 Principles of Corporate Finance

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## Sections

• CHAPTER 3 How to Calculate Present Values
• CHAPTER 4 The Value of Common Stocks
• CHAPTER 5
• CHAPTER 6 Making Investment Decisions with the Net Present Value Rule
• CHAPTER 7 Introduction to Risk, Return, and the Opportunity Cost of Capital
• CHAPTER 8
• CHAPTER 9
• CHAPTER 10 A Project is Not a Black Box
• CHAPTER 11
• CHAPTER 12
• CHAPTER 13 Corporate Financing and the Six Lessons of Market Efficiency
• CHAPTER 14
• CHAPTER 15
• CHAPTER 16
• CHAPTER 17
• CHAPTER 18
• CHAPTER 19 Financing and Valuation
• CHAPTER 20 Understanding Options
• CHAPTER 21 Valuing Options
• CHAPTER 22 Real Options
• CHAPTER 23 Warrants and Convertibles
• CHAPTER 24 Valuing Debt
• CHAPTER 25 The Many Different Kinds of Debt
• CHAPTER 26
• CHAPTER 27
• CHAPTER 28
• CHAPTER 29
• CHAPTER 30
• CHAPTER 31
• CHAPTER 32

# CHAPTER 3

How to Calculate Present Values
1.
a.
PV = \$100 × 0.905 = \$90.50
b.
PV = \$100 × 0.295 = \$29.50
c.
PV = \$100 × 0.035 = \$ 3.50
d.
PV = \$100 × 0.893 = \$89.30
PV = \$100 × 0.797 = \$79.70
PV = \$100 × 0.712 = \$71.20
PV = \$89.30 + \$79.70 + \$71.20 = \$240.20
2.
a.
PV = \$100 × 4.279 = \$427.90
b.
PV = \$100 × 4.580 = \$458.00
c. We can think of cash flows in this problem as being the difference between
two separate streams of cash flows. The first stream is \$100 per year
received in years 1 through 12; the second is \$100 per year paid in years
1 through 2.
The PV of \$100 received in years 1 to 12 is:
PV = \$100 × [Annuity factor, 12 time periods, 9%]
PV = \$100 × [7.161] = \$716.10
The PV of \$100 paid in years 1 to 2 is:
PV = \$100 × [Annuity factor, 2 time periods, 9%]
PV = \$100 × [1.759] = \$175.90
Therefore, the present value of \$100 per year received in each of years 3
through 12 is: (\$716.10 - \$175.90) = \$540.20. (Alternatively, we can think
of this as a 10-year annuity starting in year 3.)
1
2
3. a.
⇒ ·
+
· 0.88
r 1
1
DF
1
1 so that r
1
= 0.136 = 13.6%
b.
0.82
(1.105)
1
) r (1
1
DF
2 2
2
2
· ·
+
·
c. AF
2
= DF
1
+ DF
2
= 0.88 + 0.82 = 1.70
d. PV of an annuity = C × [Annuity factor at r% for t years]
Here:
\$24.49 = \$10 × [AF
3
]
AF
3
= 2.45
e. AF
3
= DF
1
+ DF
2
+ DF
3
= AF
2
+ DF
3
2.45 = 1.70 + DF
3
DF
3
= 0.75
4. The present value of the 10-year stream of cash inflows is (using
Appendix Table 3): (\$170,000 × 5.216) = \$886,720
Thus:
NPV = -\$800,000 + \$886,720 = +\$86,720
At the end of five years, the factory’s value will be the present value of the five
remaining \$170,000 cash flows. Again using Appendix Table 3:
PV = 170,000 × 3.433 = \$583,610
5. a. Let S
t
= salary in year t
∑ ∑

·
· ·
30
1 t
t
1 t 30
1 t
t
t
(1.08)
(1.05) 20,000
(1.08)
S
PV
∑ ∑
− ·
· ·
30
1 t
t
30
1 t
t
(1.029)
19,048
1.05) / (1.08
05) (20,000/1.
\$378,222
(1.029) (0.029)
1
0.029
1
19,048
30
·
]
]
]

×
− × ·
b. PV(salary) x 0.05 = \$18,911.
Future value = \$18,911 x (1.08)
30
= \$190,295
c. Annual payment = initial value ÷ annuity factor
20-year annuity factor at 8 percent = 9.818
3
Annual payment = \$190,295/9.818 = \$19,382
4
6.
Period Discount
Factor
Cash Flow Present Value
0 1.000 -400,000 -400,000
1 0.893 +100,000 + 89,300
2 0.797 +200,000 +159,400
3 0.712 +300,000 +213,600
Total = NPV = \$62,300
7. We can break this down into several different cash flows, such that the sum of
these separate cash flows is the total cash flow. Then, the sum of the present
values of the separate cash flows is the present value of the entire project. All
dollar figures are in millions.
 Cost of the ship is \$8 million
PV = -\$8 million
 Revenue is \$5 million per year, operating expenses are \$4 million. Thus,
operating cash flow is \$1 million per year for 15 years.
PV = \$1 million × [Annuity factor at 8%, t = 15] = \$1 million × 8.559
PV = \$8.559 million
 Major refits cost \$2 million each, and will occur at times t = 5 and t = 10.
PV = -\$2 million × [Discount factor at 8%, t = 5]
PV = -\$2 million × [Discount factor at 8%, t = 10]
PV = -\$2 million × [0.681 + 0.463] = -\$2.288 million
 Sale for scrap brings in revenue of \$1.5 million at t = 15.
PV = \$1.5 million × [Discount factor at 8%, t = 15]
PV = \$1.5 million × [0.315] = \$0.473
Adding these present values gives the present value of the entire project:
PV = -\$8 million + \$8.559 million - \$2.288 million + \$0.473 million
PV = -\$1.256 million
8. a. PV = \$100,000
b. PV = \$180,000/1.12
5
= \$102,137
c. PV = \$11,400/0.12 = \$95,000
d. PV = \$19,000 × [Annuity factor, 12%, t = 10]
PV = \$19,000 × 5.650 = \$107,350
e. PV = \$6,500/(0.12 - 0.05) = \$92,857
Prize (d) is the most valuable because it has the highest present value.
5
9. a. Present value per play is:
PV = 1,250/(1.07)
2
= \$1,091.80
This is a gain of 9.18 percent per trial. If x is the number of trials needed
to become a millionaire, then:
(1,000)(1.0918)
x
= 1,000,000
Simplifying and then using logarithms, we find:
(1.0918)
x
= 1,000
x (ln 1.0918) = ln 1000
x = 78.65
Thus the number of trials required is 79.
b. (1 + r1) must be less than (1 + r2)
2
. Thus:
DF1 = 1/(1 + r1)
must be larger (closer to 1.0) than:
DF2 = 1/(1 + r2)
2
10. Mr. Basset is buying a security worth \$20,000 now. That is its present value.
The unknown is the annual payment. Using the present value of an annuity
formula, we have:
PV = C × [Annuity factor, 8%, t = 12]
20,000 = C × 7.536
C = \$2,654
11. Assume the Turnips will put aside the same amount each year. One approach to
solving this problem is to find the present value of the cost of the boat and equate
that to the present value of the money saved. From this equation, we can solve
for the amount to be put aside each year.
PV(boat) = 20,000/(1.10)
5
= \$12,418
PV(savings) = Annual savings × [Annuity factor, 10%, t = 5]
PV(savings) = Annual savings × 3.791
Because PV(savings) must equal PV(boat):
Annual savings × 3.791 = \$12,418
Annual savings = \$3,276
6
Another approach is to find the value of the savings at the time the boat is
purchased. Because the amount in the savings account at the end of five years
must be the price of the boat, or \$20,000, we can solve for the amount to be put
aside each year. If x is the amount to be put aside each year, then:
x(1.10)
4
+ x(1.10)
3
+ x(1.10)
2
+ x(1.10)
1
+ x = \$20,000
x(1.464 + 1.331 + 1.210 + 1.10 + 1) = \$20,000
x(6.105) = \$20,000
x = \$ 3,276
12. The fact that Kangaroo Autos is offering “free credit” tells us what the cash
payments are; it does not change the fact that money has time value. A 10
percent annual rate of interest is equivalent to a monthly rate of 0.83 percent:
rmonthly = rannual /12 = 0.10/12 = 0.0083 = 0.83%
The present value of the payments to Kangaroo Autos is:
\$1000 + \$300 × [Annuity factor, 0.83%, t = 30]
Because this interest rate is not in our tables, we use the formula in the text to
find the annuity factor:
8 \$8,93
(1.0083) (0.0083)
1
0.0083
1
\$300 \$1,000
30
·
]
]
]

×
− × +
A car from Turtle Motors costs \$9,000 cash. Therefore, Kangaroo Autos offers
the better deal, i.e., the lower present value of cost.
7
13. The NPVs are:
at 5 percent
\$26,871
(1.05)
\$300,000
1.05
\$100,000
\$150,000 NPV
2
· + − − · ⇒
at 10 percent
\$7,025
(1.10)
300,000
1.10
\$100,000
\$150,000 NPV
2
· + − − · ⇒
at 15 percent
\$10,113
(1.15)
300,000
1.15
\$100,000
\$150,000 NPV
2
− · + − − · ⇒
The figure below shows that the project has zero NPV at about 12 percent.
As a check, NPV at 12 percent is:
\$128
(1.12)
300,000
1.12
\$100,000
\$150,000 NPV
2
− · + − − ·
8
-20
-10
0
10
20
30
0.05 0.10 0.15
Rate of Interest
NPV NPV
14. a. Future value = \$100 + (15 × \$10) = \$250
b. FV = \$100 × (1.15)
10
= \$404.60
c. Let x equal the number of years required for the investment to double at
15 percent. Then:
(\$100)(1.15)
x
= \$200
Simplifying and then using logarithms, we find:
x (ln 1.15) = ln 2
x = 4.96
Therefore, it takes five years for money to double at 15% compound
interest. (We can also solve by using Appendix Table 2, and searching for
the factor in the 15 percent column that is closest to 2. This is 2.011, for
five years.)
15. a. This calls for the growing perpetuity formula with a negative growth rate
(g = -0.04):
million \$14.29
0.14
million \$2
0.04) ( 0.10
million \$2
PV · ·
− −
·
b. The pipeline’s value at year 20 (i.e., at t = 20), assuming its cash flows last
forever, is:
g r
g) (1 C
g r
C
PV
20
1 21
20

+
·

·
With C1 = \$2 million, g = -0.04, and r = 0.10:
million \$6.314
0.14
million \$0.884
0.14
0.04) (1 million) (\$2
PV
20
20

· ·
− ×
·
Next, we convert this amount to PV today, and subtract it from the answer
to Part (a):
million \$13.35
(1.10)
million \$6.314
million \$14.29 PV
20
· − ·
9
16. a. This is the usual perpetuity, and hence:
\$1,428.57
0.07
\$100
r
C
PV · · ·
b. This is worth the PV of stream (a) plus the immediate payment of \$100:
PV = \$100 + \$1,428.57 = \$1,528.57
c. The continuously compounded equivalent to a 7 percent annually
compounded rate is approximately 6.77 percent, because:
e
0.0677
= 1.0700
Thus:
\$1,477.10
0.0677
\$100
r
C
PV · · ·
Note that the pattern of payments in part (b) is more valuable than the
pattern of payments in part (c). It is preferable to receive cash flows at the
start of every year than to spread the receipt of cash evenly over the year;
with the former pattern of payment, you receive the cash more quickly.
17. a. PV = \$100,000/0.08 = \$1,250,000
b. PV = \$100,000/(0.08 - 0.04) = \$2,500,000
c.
\$981,800
(1.08) (0.08)
1
0.08
1
\$100,000 PV
20
·
]
]
]

×
− × ·
d. The continuously compounded equivalent to an 8 percent annually
compounded rate is approximately 7.7 percent , because:
e
0.0770
= 1.0800
Thus:
\$1,020,284
(0.077)
1
0.077
1
\$100,000 PV
) (0.077)(20
·
]
]
]

×
− × ·
e
(Alternatively, we could use Appendix Table 5 here.) This result is greater
than the answer in Part (c) because the endowment is now earning
interest during the entire year.
10
18. To find the annual rate (r), we solve the following future value equation:
1,000 (1 + r)
8
= 1,600
Solving algebraically, we find:
(1 + r)
8
= 1.6
(1 + r) = (1.6)
(1/8)
= 1.0605
r = 0.0605 = 6.05%
The continuously compounded equivalent to a 6.05 percent annually
compounded rate is approximately 5.87 percent, because:
e
0.0587
= 1.0605
19. With annual compounding: FV = \$100 × (1.15)
20
= \$1,637
With continuous compounding: FV = \$100 × e
(0.15)(20)
= \$2,009
20. One way to approach this problem is to solve for the present value of:
(1) \$100 per year for 10 years, and
(2) \$100 per year in perpetuity, with the first cash flow at year 11
If this is a fair deal, these present values must be equal, and thus we can solve
for the interest rate, r.
The present value of \$100 per year for 10 years is:
]
]
]

+ ×
− × ·
10
r) (1 (r)
1
r
1
\$100 PV
The present value, as of year 10, of \$100 per year forever, with the first payment
in year 11, is: PV10 = \$100/r
At t = 0, the present value of PV10 is:
]
]
]

×
]
]
]

+
·
r
\$100
r) (1
1
PV
10
Equating these two expressions for present value, we have:
]
]
]

×
]
]
]

+
·
]
]
]

+ ×
− ×
r
\$100
r) (1
1
r) (1 (r)
1
r
1
\$100
10 10
Using trial and error or algebraic solution, we find that r = 7.18%.
11
21. Assume the amount invested is one dollar.
Let A represent the investment at 12 percent, compounded annually.
Let B represent the investment at 11.7 percent, compounded semiannually.
Let C represent the investment at 11.5 percent, compounded continuously.
After one year:
FVA = \$1 × (1 + 0.12)
1
= \$1.120
FVB = \$1 × (1 + 0.0585)
2
= \$1.120
FVC = \$1 × (e
0.115
×
1
) = \$1.122
After five years:
FVA = \$1 × (1 + 0.12)
5
= \$1.762
FVB = \$1 × (1 + 0.0585)
10
= \$1.766
FVC = \$1 × (e
0.115
×
5
) = \$1.777
After twenty years:
FVA = \$1 × (1 + 0.12)
20
= \$9.646
FVB = \$1 × (1 + 0.0585)
40
= \$9.719
FVC = \$1 × (e
0.115
×
20
) = \$9.974
The preferred investment is C.
22. 1 + rnominal = (1 + rreal) × (1 + inflation rate)
Nominal Rate Inflation Rate Real Rate
6.00% 1.00% 4.95%
23.20% 10.00% 12.00%
9.00% 5.83% 3.00%
23. 1 + rnominal = (1 + rreal) × (1 + inflation rate)
Approximate
Real Rate
Actual Real
Rate
Difference
4.00% 3.92% 0.08%
4.00% 3.81% 0.19%
11.00% 10.00% 1.00%
20.00% 13.33% 6.67%
12
24. The total elapsed time is 113 years.
At 5%: FV = \$100 × (1 + 0.05)
113
= \$24,797
At 10%: FV = \$100 × (1 + 0.10)
113
= \$4,757,441
25. Because the cash flows occur every six months, we use a six-month discount rate,
here 8%/2, or 4%. Thus:
PV = \$100,000 + \$100,000 × [Annuity Factor, 4%, t = 9]
PV = \$100,000 + \$100,000 × 7.435 = \$843,500
26. PVQB = \$3 million × [Annuity Factor, 10%, t = 5]
PVQB = \$3 million × 3.791 = \$11.373 million
PVRECEIVER = \$4 million + \$2 million × [Annuity Factor, 10%, t = 5]
PVRECEIVER = \$4 million + \$2 million × 3.791 = \$11.582 million
Thus, the less famous receiver is better paid, despite press reports that the
quarterback received a “\$15 million contract,” while the receiver got a “\$14 million
contract.”
27. a. Each installment is: \$9,420,713/19 = \$495,827
PV = \$495,827 × [Annuity Factor, 8%, t = 19]
PV = \$495,827 × 9.604 = \$4,761,923
b. If ERC is willing to pay \$4.2 million, then:
\$4,200,000 = \$495,827 × [Annuity Factor, x%, t = 19]
This implies that the annuity factor is 8.471, so that, using the annuity
table for 19 times periods, we find that the interest rate is about 10
percent.
28. This is an annuity problem with the present value of the annuity equal to \$2 million
(as of your retirement date), and the interest rate equal to 8 percent, with 15 time
periods. Thus, your annual level of expenditure (C) is determined as follows:
\$2,000,000 = C × [Annuity Factor, 8%, t = 15]
\$2,000,000 = C × 8.559
C = \$233,672
13
With an inflation rate of 4 percent per year, we will still accumulate \$2 million as
of our retirement date. However, because we want to spend a constant amount
per year in real terms (R, constant for all t), the nominal amount (C t ) must
increase each year. For each year t:
R = C t /(1 + inflation rate)
t
Therefore:
PV [all C t ] = PV [all R × (1 + inflation rate)
t
] = \$2,000,000
\$2,000,000
0.08) (1
.04) 0 (1
. . .
.08) 0 (1
0.04) (1
0.08) (1
.04) 0 (1
R
15
15
2
2
1
1
·
]
]
]

+
+
+ +
+
+
+
+
+
×
R × [0.9630 + 0.9273 + . . . + 0.5677] = \$2,000,000
R × 11.2390 = \$2,000,000
R = \$177,952
Thus C1 = (\$177,952 × 1.04) = \$185,070, C2 = \$192,473, etc.
29. First, with nominal cash flows:
a. The nominal cash flows form a growing perpetuity at the rate of inflation,
4%. Thus, the cash flow in 1 year will be \$416,000 and:
PV = \$416,000/(0.10 - 0.04) = \$6,933,333
b. The nominal cash flows form a growing annuity for 20 years, with an
additional payment of \$5 million at year 20:
\$5,418,389
.10) (1
5,000,000
(1.10)
876,449
. . .
.10) (1
432,640
.10) (1
416,000
PV
20 20 2 1
·
]
]
]

+ + + + ·
Second, with real cash flows:
a. Here, the real cash flows are \$400,000 per year in perpetuity, and we can find
the real rate (r) by solving the following equation:
(1 + 0.10) = (1 + r) × (1.04) ⇒ r = 0.0577 = 5.77%
PV = \$400,000/(0.0577) = \$6,932,409
14
b. Now, the real cash flows are \$400,000 per year for 20 years and \$5 million
(nominal) in 20 years. In real terms, the \$5 million dollar payment is:
\$5,000,000/(1.04)
20
= \$2,281,935
Thus, the present value of the project is:
\$5,417,986
.0577) (1
\$2,281,935
.0577) (0.0577)(1
1
(0.0577)
1
\$400,000 PV
20 20
· +
]
]
]

− × ·
[As noted in the statement of the problem, the answers agree, to within rounding
errors.]
30. Let x be the fraction of Ms. Pool’s salary to be set aside each year. At any point in
the future, t, her real income will be:
(\$40,000)(1 + 0.02)
t

The real amount saved each year will be:
(x)(\$40,000)(1 + 0.02)
t

The present value of this amount is:
Ms. Pool wants to have \$500,000, in real terms, 30 years from now. The present
value of this amount (at a real rate of 5 percent) is:
\$500,000/(1 + 0.05)
30
Thus:
\$115,688.72 = (x)(\$790,012.82)
x = 0.146
15
t
t
0.05) (1
0.02) (1 40,000) (x)(\$
+
+

·
·
30
1 t
t
t
30
(1.05)
.02) (1 0) (x)(\$40,00
(1.05)
\$500,000

·
·
30
1 t
t
t
30
(1.05)
.02) (1 (\$40,000)
(x)
(1.05)
\$500,000
31.
\$10,522.42
(1.048)
\$10,000
(1.048)
\$600
PV
5
5
1 t
t
· + ·

·
\$10,527.85
(1.024)
\$10,000
(1.024)
\$300
PV
10
10
1 t
t
· + ·

·
32.
\$11,128.76
(1.035)
\$10,000
(1.035)
\$600
PV
5
5
1 t
t
· + ·

·
\$11,137.65
(1.0175)
\$10,000
(1.0175)
\$300
PV
10
10
1 t
t
· + ·

·
33. Using trial and error:
At r = 12.0%
\$966.20
(1.12)
\$1,000
(1.12)
\$100
PV
2
2
1 t
t
· + · ⇒

·
At r = 13.0%
\$949.96
(1.13)
\$1,000
(1.13)
\$100
PV
2
2
1 t
t
· + · ⇒

·
At r = 12.5%
\$958.02
(1.125)
\$1,000
(1.125)
\$100
PV
2
2
1 t
t
· + · ⇒

·
At r = 12.4%
\$959.65
(1.124)
\$1,000
(1.124)
\$100
PV
2
2
1 t
t
· + · ⇒

·
Therefore, the yield to maturity is approximately 12.4%.
16
Challenge Questions
1. a. Using the Rule of 72, the time for money to double at 12 percent is 72/12,
or 6 years. More precisely, if x is the number of years for money to
double, then:
(1.12)
x
= 2
Using logarithms, we find:
x (ln 1.12) = ln 2
x = 6.12 years
b. With continuous compounding for interest rate r and time period x:
e
r x
= 2
Taking the natural logarithm of each side:
r x = ln(2) = 0.693
Thus, if r is expressed as a percent, then x (the time for money to double)
is: x = 69.3/(interest rate, in percent).
3. Let P be the price per barrel. Then, at any point in time t, the price is:
P (1 + 0.02)
t

The quantity produced is: 100,000 (1 - 0.04)
t

Thus revenue is:
100,000P × [(1 + 0.02) × (1 - 0.04)]
t
= 100,000P × (1 - 0.021)
t

Hence, we can consider the revenue stream to be a perpetuity that grows at a
negative rate of 2.1 percent per year. At a discount rate of 8 percent:
990,099P
0.021) ( 0.08
P 100,000
PV ·
− −
·
With P equal to \$14, the present value is \$13,861,386.
17
4. Let c = the cash flow at time 0
g = the growth rate in cash flows
r = the risk adjusted discount rate
PV = c(1 + g)(1 + r)
-1
+ c(1 + g)
2
(1 + r)
-2
+ . . . + c(1 + g)
n
(1 + r)
-n
The expression on the right-hand side is the sum of a geometric progression (see
Footnote 7) with first term: a = c(1 + g)(1 + r)
-1
and common ratio: x = (1 + g)(1 + r)
-1
Applying the formula for the sum of n terms of a geometric series, the PV is:
]
]
]

+ + −
+ + −
+ + ·
]
]
]

·

1
n n
1
N
r) (1 g) (1 1
r) (1 g) (1 1
r) g)(1 c(1
x 1
x 1
(a) PV
5. The 7 percent U.S. Treasury bond (see text Section 3.5) matures in five years
and provides a nominal cash flow of \$70.00 per year. Therefore, with an inflation
rate of 2 percent:
Year Nominal Cash Flow Real Cash Flow
2002 70.00 70.00/(1.02)
1
= 68.63
2003 70.00 70.00/(1.02)
2
= 67.28
2004 70.00 70.00/(1.02)
3
= 65.96
2005 70.00 70.00/(1.02)
4
= 64.67
2006 1,070.00 1070.00/(1.02)
5
= 969.13
With a nominal rate of 7 percent and an inflation rate of 2 percent, the real rate (r)
is:
r = [(1.07/1.02) – 1] = 0.0490 = 4.90%
The present value of the bond, with nominal cash flows and a nominal rate, is:
\$1,000.00
(1.07)
1070
(1.07)
70
(1.07)
70
(1.07)
70
(1.07)
70
PV
5 3 2 1
4
· + + + + ·
The present value of the bond, with real cash flows and a real rate, is:
\$1,000.00
(1.0490)
969.13
(1.0490)
64.67
(1.0490)
65.96
(1.0490)
67.28
(1.0490)
68.63
PV
5 3 2 1
4
· + + + + ·
18
CHAPTER 4
The Value of Common Stocks
1. Newspaper exercise, answers will vary
2. The value of a share is the discounted value of all expected future dividends.
Even if the investor plans to hold a stock for only 5 years, for example, then,
at the time that the investor plans to sell the stock, it will be worth the
discounted value of all expected dividends from that point on. In fact, that is
the value at which the investor expects to sell the stock. Therefore, the
present value of the stock today is the present value of the expected dividend
payments from years one through five plus the present value of the year five
value of the stock. This latter amount is the present value today of all
expected dividend payments after year five.
3. The market capitalization rate for a stock is the rate of return expected by the
investor. Since all securities in an equivalent risk class must be priced to
offer the same expected return, the market capitalization rate must equal the
opportunity cost of capital of investing in the stock.
4.
Expected Future Values Present Values
Horizon
Period
(H)
Dividend
(DIVt )
Price
(Pt )
Cumulative
Dividends
Future
Price Total
0 100.00 100.00 100.00
1 10.00 105.00 8.70 91.30 100.00
2 10.50 110.25 16.64 83.36 100.00
3 11.03 115.76 23.89 76.11 100.00
4 11.58 121.55 30.51 69.50 100.00
10 15.51 162.89 59.74 40.26 100.00
20 25.27 265.33 83.79 16.21 100.00
50 109.21 1,146.74 98.94 1.06 100.00
100 1,252.39 13,150.13 99.99 0.01 100.00
Assumptions
1. Dividends increase by 5% per year compounded.
2. The capitalization rate is 15%.
19
5. a. Using the growing perpetuity formula, we have:
P0 = Div1/(r – g)
73 = 1.68/(r - 0.085)
r = 0.108 = 10.8%
b. We know that:
Plowback ratio = 1.0 – payout ratio
Plowback ratio = 1.0 - 0.5 = 0.5
And, we also know that:
dividend growth rate = g = plowback ratio × ROE
g = 0.5 × 0.12 = 0.06 = 6.0%
Using this estimate of g, we have:
P0 = Div1/(r – g)
73 = 1.68/(r - 0.06)
r = 0.083 = 8.3%
6. Using the growing perpetuity formula, we have:
P0 = Div1/(r – g) = 2/(0.12 - 0.04) = \$25
7. \$100.00
0.10
\$10
r
DIV
P
1
A
· · ·
\$83.33
.04 0 0.10
5
g r
DIV
P
1
B
·

·

·

,
`

.
|
× + + + + + + ·
6
7
6
6
5
5
4
4
3
3
2
2
1
1
C
1.10
1
0.10
DIV
1.10
DIV
1.10
DIV
1.10
DIV
1.10
DIV
1.10
DIV
1.10
DIV
P
\$104.50
1.10
1
0.10
12.44
1.10
12.44
1.10
10.37
1.10
8.64
1.10
7.20
1.10
6.00
1.10
5.00
P
6 6 5 4 3 2 1
C
·
,
`

.
|
× + + + + + + ·
At a capitalization rate of 10 percent, Stock C is the most valuable.
For a capitalization rate of 7 percent, the calculations are similar. The results
are:
PA = \$142.86
PB = \$166.67
PC = \$156.48
20
Therefore, Stock B is the most valuable.
8. a. We know that g, the growth rate of dividends and earnings, is given by:
g = plowback ratio × ROE
g = 0.40 × 0.20 = 0.08 = 8.0%
We know that:
r = (DIV1/P0) + g
r = dividend yield + growth rate
Therefore:
r = 0.04 + 0.08 = 0.12 = 12.0%
b. Dividend yield = 4%. Therefore:
DIV1/P0 = 0.04
DIV1 = 0.04 × P0
A plowback ratio of 0.4 implies a payout ratio of 0.6, and hence:
DIV1/EPS1 = 0.6
DIV1 = 0.6 × EPS1
Equating these two expressions for DIV1 gives a relationship between
price and earnings per share:
0.04 × P0 = 0.6 × EPS1
P0/EPS1 = 15
Also, we know that:
]
]
]

− × ·
0 0
1
P
PVGO
1 r
P
EPS
With (P0/EPS1) = 15 and r = 0.12, the ratio of the present value of growth
opportunities to price is 44.4 percent. Thus, if there are suddenly no
future investment opportunities, the stock price will decrease by 44.4
percent.
c. In Part (b), all future investment opportunities are assumed to have
a net present value of zero. If all future investment opportunities
have a rate of return equal to the capitalization rate, this is
equivalent to the statement that the net present value of these
investment opportunities is zero. Hence, the impact on share price
is the same as in Part (b).
21
9. Internet exercise; answers will vary depending on time period.
10. Internet exercise; answers will vary depending on time period.
11. Using the concept that the price of a share of common stock is equal to
the present value of the future dividends, we have:
]
]
]

×
+
+
+
+
+
+
+
·
g) (r
DIV
r) (1
1
r) (1
DIV
r) (1
DIV
r) (1
DIV
P
4
3 3
3
2
2 1
]
]
]

×
×
+
+
+
+
+
+
+
·
) 06 . 0 r (
) 06 . 1 3 (
) r 1 (
1
) r 1 (
3
) r 1 (
2
) r 1 (
1
50
3 3 2
Using trial and error, we find that r is approximately 11.1 percent.
12. There are two reasons why the corresponding earnings-price ratios are
not accurate measures of the expected rates of return.
First, the expected rate of return is based on future expected earnings; the price-
earnings ratios reported in the press are based on past actual earnings. In
general, these earnings figures are different.
Second, we know that:
]
]
]

− ·
0 0
1
P
PVGO
1 r
P
EPS
Hence, the earnings-price ratio is equal to the expected rate of return only if
PVGO is zero.
13. a. An Incorrect Application. Hotshot Semiconductor’s earnings and
dividends have grown by 30 percent per year since the firm’s founding ten
years ago. Current stock price is \$100, and next year’s dividend is
projected at \$1.25. Thus:
31.25% .3125 0 .30 0
100
1.25
g
P
DIV
r
0
1
· · + · + ·
This is wrong because the formula assumes perpetual growth; it is not
possible for Hotshot to grow at 30 percent per year forever.
22
A Correct Application. The formula might be correctly applied to the Old
Faithful Railroad, which has been growing at a steady 5 percent rate for
decades. Its EPS1 = \$10, DIV1 = \$5, and P0 = \$100. Thus:
10.0% .10 0 .05 0
100
5
g
P
DIV
r
0
1
· · + · + ·
Even here, you should be careful not to blindly project past growth into the
future. If Old Faithful hauls coal, an energy crisis could turn it into a
growth stock.
b. An Incorrect Application . Hotshot has current earnings of \$5.00 per
share. Thus:
5.0% .05 0
100
5
P
EPS
r
0
1
· · · ·
This is too low to be realistic. The reason P0 is so high relative to earnings
is not that r is low, but rather that Hotshot is endowed with valuable growth
opportunities. Suppose PVGO = \$60:
PVGO
r
EPS
P
1
0
+ ·
60
r
5
100 + ·
Therefore, r = 12.5%
A Correct Application. Unfortunately, Old Faithful has run out of valuable
growth opportunities. Since PVGO = 0:
PVGO
r
EPS
P
1
0
+ ·
0
r
10
100 + ·
Therefore, r = 10.0%
23
14.
g r
NPV
r
EPS
price Share
1

+ ·
Therefore:
0.15) (r
NPV
r
EPS
Ρ
α α
1 α
α

+ ·
α
0.08) (r
NPV
r
EPS
Ρ
β
β
β
β1
β

+ ·
The statement in the question implies the following:

,
`

.
|

+

>

,
`

.
|

+
− 0.15) (r
NPV
r
EPS
0.15) (r
NPV
0.08) (r
NPV
r
EPS
0.08) (r
NPV
α
α
α
α1
α
α
β
β
β
β1
β
β
Rearranging, we have:
1 1
EPS
r
) 08 . 0 r (
NPV
EPS
r
) 15 . 0 r (
NPV
β
β
β
β
α
α
α
α
×

< ×

a. NPV
α
< NPV
β
, everything else equal.
b. (r
α
- 0.15) > (r
β
- 0.08), everything else equal.
c.
0.08) (r
NPV
0.15) (r
NPV
β
β
α
α

<

, everything else equal.
c.
β1
β
α1
α
EPS
r
EPS
r
<
, everything else equal.
15. a. Growth-Tech’s stock price should be:
23.81
.08) 0 (0.12
1.24
(1.12)
1
(1.12)
1.15
(1.12)
0.60
(1.12)
0.50
P
3 3 2
\$ ·

,
`

.
|

× + + + ·
b. The horizon value contributes:
\$22.07
.08) 0 (0.12
1.24
(1.12)
1
) PV(P
3 H
·

× ·
24
c. Without PVGO, P3 would equal earnings for year 4 capitalized at
12 percent:
\$20.75
0.12
2.49
·
Therefore: PVGO = \$31.00 - \$20.75 = \$10.25
d. The PVGO of \$10.25 is lost at year 3. Therefore, the current stock
price of \$23.81 will decline by:
\$7.30
(1.12)
10.25
3
·
The new stock price will be \$23.81 - \$7.30 = \$16.51
16. Internet exercise; answers will vary depending on time period.
17. Internet exercise; answers will vary.
18. Internet exercise; answers will vary.
19. a. Here we can apply the standard growing perpetuity formula with
DIV1 = \$4, g = 0.04 and P0 = \$100:
8.0% .08 0 .04 0
100
4
g
P
DIV
r
0
1
· · + · + ·
The \$4 dividend is 60 percent of earnings. Thus:
EPS1 = 4/0.6 = \$6.67
Also:
PVGO
r
EPS
P
1
0
+ ·
PVGO
0.08
6.67
100 + ·
PVGO = \$16.63
25
b. DIV1 will decrease to: (0.20 × 6.67) = \$1.33
However, by plowing back 80 percent of earnings, CSI will grow by
8 percent per year for five years. Thus:
Year 1 2 3 4 5 6 7, 8 . . .
DIVt 1.33 1.44 1.56 1.68 1.81 5.88 Continued
growth at
EPSt 6.67 7.20 7.78 8.40 9.07 9.80 4 percent
Note that DIV6 increases sharply as the firm switches back to a 60 percent
payout policy. Forecasted stock price in year 5 is:
\$147
.04 0 0.08
5.88
g r
DIV
P
6
5
·

·

·
Therefore, CSI’s stock price will increase to:
\$106.22
1.08
147 1.81
1.08
1.68
1.08
1.56
1.08
1.44
1.08
1.33
P
5 4 3 2
0
·
+
+ + + + ·
20. Formulas for calculating PV(PH) include the following:
a. PV(PH) = (EPSH/r) + PVGO
where EPSH is the firm’s earnings per share at the horizon date.
(This formula would be the easiest to apply if PVGO = 0.)
b. PV(PH) = EPSH × (P/E)C
where (P/E)C is the P/E ratio for comparable firms.
(This formula would be a good choice if comparable firms can be readily
identified.)
c. PV(PH) = BVH × (MV/BV)C
where BVH is the firm’s book value per share at the horizon date, and
(MV/BV)C is the market-book ratio for comparable firms.
(This formula would be a good choice if comparable firms can be readily
identified.)
d. PV(PH) = CH + 1 /(r – g)
where CH + 1 is the firm’s cash flow in the subsequent time period.
(This formula would be a good choice if the assumption of growth at a
constant rate g for the foreseeable future is a reasonable assumption.)
26
21. a.
Year
1 2 3 4 5 6 7 8 9 10
Asset value 10.00 11.50 13.23 15.21 17.49 19.76 22.33 23.67 25.09 26.60
Earnings 1.20 1.38 1.59 1.83 2.10 2.37 2.68 2.84 3.01 3.20
Investment 1.50 1.73 1.98 2.28 2.27 2.57 1.34 1.42 1.51 1.60
Free cash flow -0.30 -0.35 -0.39 -0.45 -0.17 -0.20 1.34 1.42 1.50 1.60
Earnings growth 20.0% 20.0% 20.0% 20.0% 20.0% 13.0% 13.0% 6.0% 6.0% 6.0%
The present value of the near-term flows (i.e., years 1 through 6) is -\$1.38
The present value of the horizon value is:
\$18.91
.06) 0 (0.10
1.34
(1.10)
1
) PV(P
6 H
·

× ·
Therefore, the present value of the free cash flows is:
(\$18.91-\$1.38) = \$17.53
The present value of the near term cash flows increases because the
amount of investment each year decreases. However, the present value
of the horizon value decreases by a greater amount, so that the total
present value decreases.
b. With one million shares currently outstanding, price per share is:
(\$17.53 million/1 million shares) = \$17.53
The amount of financing required is \$1.38 million, so the number of shares
to be issued is: (\$1.38 million/\$17.53) = 79,000 shares (approximately)
c. (i) \$17.53 million/1 million shares = \$17.53 per share
(ii) previously outstanding shares/total shares =
1 million/1.079 million = 0.9268
0.9268 × \$18.91 = \$17.53
22. The value of the company increases from \$100 million to \$200 million.
The value of each share remains the same at \$10.
27
23.
Expected Future Values Present Values
Horizon
Period
(H)
Dividend
(DIVt )
Price
(Pt )
Cumulative
Dividends
Future
Price Total
0 100.00 100.00 100.00
1 15.00 100.00 13.04 86.96 100.00
2 5.00 110.00 16.82 83.18 100.00
3 5.50 121.00 20.44 79.56 100.00
4 6.05 133.10 23.90 76.10 100.00
10 10.72 235.79 41.72 58.28 100.00
20 27.80 611.59 62.63 37.37 100.00
50 485.09 10,671.90 90.15 9.85 100.00
100 56,944.68 1,252,782.94 98.93 1.07 100.00
In order to pay the extra dividend, the company needs to raise an extra \$10 per
share in year 1. The new shareholders who provide this cash will demand a
dividends of \$0.50 per share in year 2, \$0.55 in year 3, and so on. Thus, each
old share will receive dividends of \$15 in year 1, (\$5.50 – \$0.50) = \$5 in year 2,
(\$6.05 – \$0.55) = \$5.50 in year 3, and so on. The present value of a share at
year 1 is computed as follows:
\$100.00
1.15
1
0.10 - 0.15
\$5
1.15
\$15
PV ·
,
`

.
|
× + ·
28
Challenge Questions
1. There is something of an inconsistency in Practice Question 11 since the
dividends are growing at a very high rate initially. This high growth rate
suggests the company is investing heavily in its future. Free cash flow
equals cash generated net of all costs, taxes, and positive NPV
investments. If investment opportunities are abundant, free cash flow can
be negative when investment outlays are large. Hence, where do the
funds to pay the increasing dividends come from?
At some point in time, competition is likely to drive ROE down to the cost of
equity, at which point investment will decrease and free cash flow will turn
positive.
2. From the equation given in the problem, it follows that:
b ROE) / (r
b 1
ROE) (b r
b) (1 ROE
BVPS
P
0

·
× −
− ×
·
Consider three cases:
ROE < r ⇒ (P0/BVPS) < 1
ROE = r ⇒ (P0/BVPS) = 1
ROE > r ⇒ (P0/BVPS) > 1
Thus, as ROE increases, the price-to-book ratio also increases, and when ROE =
r, price-to-book equals one.
3. Assume the portfolio value given, \$100 million, is the value as of the end of the
first year. Then, assuming constant growth, the value of the contract is given by
the first payment (0.5 percent of portfolio value) divided by (r – g). Also:
r = dividend yield + growth rate
Hence:
r - growth rate = dividend yield = 0.05 = 5.0%
Thus, the value of the contract, V, is:
million \$10
0.05
million) (\$100 0.005
V ·
×
·
CHAPTER 5
Why Net Present Value Leads to Better Investment Decisions Than Other Criteria
29
1. a.
\$90.91
.10) 0 (1
1000
1000 NPV
A
− ·
+
+ − ·
\$4,044.73
10) (1.
1000
(1.10)
1000
(1.10)
4000
(1.10)
1000
(1.10)
1000
2000 NPV
5 4 3 2 B
+ · + + + + + − ·
\$39.47
10) (1.
1000
.10) (1
1000
(1.10)
1000
(1.10)
1000
3000 NPV
5 4 2 C
+ · + + + + − ·
b. Payback
A
= 1 year
Payback
B
= 2 years
Payback
C
= 4 years
c. A and B.
2. The discounted payback period is the number of periods a project must last in order to
achieve a zero net present value. It is marginally preferable to the regular payback rule
because it uses discounted cash flows, thereby overcoming the criticism that all cash
flows prior to the cutoff date have equal weight. However, the discounted payback
period still does not account for cash flows occurring after the cut-off date.
3. Book rate of return uses the accounting definition of income and
investment (i.e., book value of assets). Both of these accounting concepts
differ from cash flow measures. In addition, book rate of return does not
recognize the time value of money. Hence, decisions based on book rate
of return can, and often do, lead to choices that are unacceptable when
analyzed on a net present value basis.
4. a. When using the IRR rule, the firm must still compare the IRR with the
opportunity cost of capital. Thus, even with the IRR method, one must think about the
appropriate discount rate.
b. Risky cash flows should be discounted at a higher rate than the rate used to
discount less risky cash flows. Using the payback rule is equivalent to using the
NPV rule with a zero discount rate for cash flows before the payback period and
an infinite discount rate for cash flows thereafter.
30
5. In general, the discounted payback rule is slightly better than the regular payback rule.
But, in this case, it might actually be worse: with the same cut-off period, fewer
long-lived investment projects will make the grade.
6.
r = -17.44% 0.00% 10.00% 15.00% 20.00% 25.00% 45.27%
Year 0 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00
Year 1 3,500.00 4,239.34 3,500.00 3,181.82 3,043.48 2,916.67 2,800.00 2,409.31
Year 2 4,000.00 5,868.41 4,000.00 3,305.79 3,024.57 2,777.78 2,560.00 1,895.43
Year 3 -4,000.00 -7,108.06 -4,000.00 -3,005.26 -2,630.06 -2,314.81 -2,048.00 -1,304.76
PV = -0.31 500.00 482.35 437.99 379.64 312.00 -0.02
The two IRRs for this project are (approximately): –17.44% and 45.27%. The
NPV is positive between these two discount rates.
7. a. The figure on the next page was drawn from the following points:
Discount Rate
0% 10% 20%
NPV
A +20.00 +4.13 -8.33
NPV
B
+40.00 +5.18 -18.98
b. From the graph, we can estimate the IRR of each project from the point where its line crosses the horizontal axis:
IRR
A
= 13.1% and IRR
B
= 11.9%
c. The company should accept Project A if its NPV is positive and higher than that
of Project B; that is, the company should accept Project A if the discount rate is
greater than 10.7 percent and less than 13.1 percent.
d. The cash flows for (B – A) are:
Therefore:
Discount Rate
0% 10% 20%
NPV
B-A +20.00 +1.05 -10.65
IRR
B-A
= 10.7%
The company should accept Project A if the discount rate is greater than 10.7%
and less than 13.1%. As shown in the graph, for these discount rates, the IRR for
the incremental investment is less than the opportunity of cost of capital.
31
140
C
60
C
60
C
0
C
3 2 1 0
+ − −
32
Figure 5.6
-30.00
-20.00
-10.00
0.00
10.00
20.00
30.00
40.00
50.00
0% 10% 20%
Rate of Interest
N
P
V
Project A
Project B
Increment
8. a. Because Project A requires a larger capital outlay, it is possible that
Project A has both a lower IRR and a higher NPV than Project B. (In fact,
NPVA is greater than NPVB for all discount rates less than 10 percent.)
Because the goal is to maximize shareholder wealth, NPV is the correct
criterion.
b. To use the IRR criterion for mutually exclusive projects, calculate the IRR
for the incremental cash flows:
C0 C1 C2 IRR
A - B -200 +110 +121 10%
Because the IRR for the incremental cash flows exceeds the cost of
capital, the additional investment in A is worthwhile.
c.
81.86 \$
(1.09)
300
(1.09)
250
400 NPV
2 A
· + + − ·
\$79.10
(1.09)
179
(1.09)
140
200 NPV
2 B
· + + − ·
9. Use incremental analysis:
C1 C2 C3
Current arrangement -250,000 -250,000 +650,000
Extra shift -550,000 +650,000 0
Incremental flows -300,000 +900,000 -650,000
The IRRs for the incremental flows are approximately 21.13 and 78.87 percent.
If the cost of capital is between these rates, Titanic should work the extra shift.
10. The statement is true because more immediate cash flows will be discounted less
than cash flows that are further into the future. Hence, projects with quick
paybacks and low investments will be preferred on an IRR basis, even though
longer-term projects might have larger NPVs.
11. a.
.82 0
10,000
8,182
10,000) (
1.10
20,000
10,000
PI
E
· ·
− −
+ −
·
.59 0
20,000
11,818
20,000) (
1.10
35,000
20,000
PI
F
· ·
− −
+ −
·
33
b. Both projects have a Profitability Index greater than zero, and so both are
acceptable projects. In order to choose between these projects, we must
use incremental analysis. For the incremental cash flows:
0.36
10,000
3,636
10,000) (
1.10
15,000
10,000
PI
E F
· ·
− −
+ −
·

The increment is thus an acceptable project, and so the larger project
should be accepted, i.e., accept Project F. (Note that, in this case, the
better project has the lower profitability index.)
12. Because there are three sign changes in the sequence of cash flows, we know that
there can be as many as three internal rates of return. Using trial and error,
graphical analysis, or solving analytically (the easiest way to solve for the IRR is
with a spreadsheet program such as Excel), we can show that there is only one
IRR, 5.24 percent.
A project with an IRR equal to 5.24 percent is not attractive when the opportunity
cost of capital is 14 percent. (Alternatively, we can say that, with a discount rate
of 14 percent, the project’s NPV is -\$2,443 so that the project is not attractive.)
13. Using the fact that Profitability Index = (Net Present Value/Investment), we find that:
Project Profitability Index
1 0.22
2 -0.02
3 0.17
4 0.14
5 0.07
6 0.18
7 0.12
Thus, given the budget of \$1 million, the best the company can do is to accept
Projects 1, 3, 4, and 6.
If the company accepted all positive NPV projects, the market value (compared
to the market value under the budget limitation) would increase by the NPV of
Project 5 and the NPV of Project 7: (\$7,000 + \$48,000) = \$55,000. Thus, the
budget limit costs the company \$55,000 in terms of its market value.
34
14. Maximize: NPV = 6,700xW + 9,000xX + 0XY - 1,500xZ
subject to: 10,000xW + 0xX + 10,000xY + 15,000xZ ≤ 20,000
10,000xW + 20,000xX - 5,000xY - 5,000xZ ≤ 20,000
0xW - 5,000xX - 5,000xY - 4,000xZ ≤ 20,000
0 ≤ xW ≤ 1
0 ≤ xX ≤ 1
0 ≤ xZ ≤ 1
35
Challenge Questions
1. The IRR is the discount rate which, when applied to a project’s cash flows, yields
NPV = 0. Thus, it does not represent an opportunity cost. However, if each
project’s cash flows could be invested at that project’s IRR, then the NPV of each
project would be zero because the IRR would then be the opportunity cost of
capital for each project. The discount rate used in an NPV calculation is the
opportunity cost of capital. Therefore, it is true that the NPV rule does assume
that cash flows are reinvested at the opportunity cost of capital.
2. a.
C0 = -3,000 C0 = -3,000
C1 = +3,500 C1 = +3,500
C2 = +4,000 C2 + PV(C3) = +4,000 – 3,571.43 = 428.57
C3 = -4,000 MIRR = 27.84%
b.
2
3 2
1
1.12
C
1.12
xC
xC · +
(1.12
2
)(x C1) + (1.12)(x C2) = C3
(x)[(1.12
2
)(C1) + (1.12)(C2)] = C3
) ( )
2 1
2
3
1.12)(C )(C (1.12
C
x
+
·
45 . 0
) ( )
·
+
·
0 1.12)(4,00 )(3,500 (1.12
4,000
x
2
0
IRR) (1
x)C - (1
IRR) (1
x)C - (1
C
2
2 1
0
·
+
+
+
+
0
IRR) (1
0) 0.45)(4,00 - (1
IRR) (1
0) 0.45)(3,50 - (1
3,000
2
·
+
+
+
+ −
Now, find MIRR using either trial and error or the IRR function (on a
financial calculator or Excel). We find that MIRR = 23.53%.
It is not clear that either of these modified IRRs is at all meaningful.
Rather, these calculations seem to highlight the fact that MIRR really has
no economic meaning.
3. A project with all positive cash flows has no IRR. For example:
36
C0 = 100
C1 = 100
C2 = 100
C3 = 100
Optimized NPV = \$13,450
with xW = 1; xX = 0.75; xY = 1 and xZ = 0
If the financing available at t = 0 is \$21,000:
Optimized NPV = \$13,500
with xW = 1; xX = (23/30); xY = 1 and xZ = (2/30)
Here, the shadow price for the constraint at t = 0 is \$50, the increase in NPV for a
\$1,000 increase in financing available at t = 0.
In this case, the program viewed xZ as a viable choice, even though the NPV of
Project Z is negative. The reason for this result is that project Z provides a
positive cash flow in periods 1 and 2.
If the financing available at t = 1 is \$21,000:
Optimized NPV = \$13,900
with xW = 1; xX = 0.8; xY = 1 and xZ = 0
Hence, the shadow price of an additional \$1,000 in t = 1 financing is \$450.
5. a. The constraint in the second period would become:
-30xA - 5xB - 5xC + 40xD - (10 -10xA - 5xB - 5xC)(1 + r) ≤ 10
b. The constraint in the first period would become:
10xA + 5xB + 5xC + 0xD + COST OF HIRING & TRAINING ≤ 10
37
CHAPTER 6
Making Investment Decisions with the Net Present Value Rule
1. See the table below. We begin with the cash flows given in the text, Table 6.6,
line 8, and utilize the following relationship from Chapter 3:
Real cash flow = nominal cash flow/(1 + inflation rate)
t
Here, the nominal rate is 20 percent, the expected inflation rate is 10 percent,
and the real rate is given by the following:
(1 + rnominal)
= (1 + rreal) × (1 + inflation rate)
1.20
= (1 + rreal) × (1.10)
rreal = 0.0909 = 9.09%
As can be seen in the table, the NPV is unchanged (to within a rounding error).
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Net Cash Flows/Nominal -12,600 -1,484 2,947 6,323 10,534 9,985 5,757 3,269
Net Cash Flows/Real -12,600 -1,349 2,436 4,751 7,195 6,200 3,250 1,678
NPV of Real Cash Flows (at 9.09%) = \$3,804
2. No, this is not the correct procedure. The opportunity cost of the land is its value
in its best use, so Mr. North should consider the \$45,000 value of the land as an
outlay in his NPV analysis of the funeral home.
3. Unfortunately, there is no simple adjustment to the discount rate that will resolve the
issue of taxes. Mathematically:
1.15
0.35) /(1 C
1.10
C
1 1

and
2
2
2
2
1.15
0.35) (1 / C
1.10
C −

38
4. Even when capital budgeting calculations are done in real terms, an inflation
forecast is still required because:
a. Some real flows depend on the inflation rate, e.g., real taxes and real
proceeds from collection of receivables; and,
b. Real discount rates are often estimated by starting with nominal rates and
“taking out” inflation, using the relationship:
(1 + rnominal)
= (1 + rreal) × (1 + inflation rate)
5. Investment in working capital arises as a forecasting issue only because accrual
accounting recognizes sales when made, not when cash is received (and costs
when incurred, not when cash payment is made). If cash flow forecasts
recognize the exact timing of the cash flows, then there is no need to also include
investment in working capital.
6. If the \$50,000 is expensed at the end of year 1, the value of the tax shield is:
\$16,667
1.05
\$50,000 0.35
·
×
If the \$50,000 expenditure is capitalized and then depreciated using a five-year
MACRS depreciation schedule, the value of the tax shield is:
\$15,306
1.05
.0576
1.05
.1152
1.05
.1152
1.05
.192
1.05
.32
1.05
.20
\$50,000] [0.35
6 5 4 3 2
·
,
`

.
|
+ + + + + × ×
If the cost can be expensed, then the tax shield is larger, so that the after-tax
cost is smaller.
7. a.
\$3,810
1.08
26,000
,000 100 NPV
5
1 t
t
A
· + − ·

·
NPVB = -Investment + PV(after-tax cash flow) + PV(depreciation tax shield)

·
+
− ×
+ − ·
5
1 t
t
B
1.08
.35) 0 (1 26,000
100,000 NPV
[ ]
]
]
]

+ + + + + × ×
6 5 4 3 2
1.08
0.0576
1.08
0.1152
1.08
0.1152
1.08
0.192
1.08
0.32
1.08
0.20
100,000 0.35
NPVB = -\$4,127
39
Another, perhaps more intuitive, way to do the Company B analysis is to
first calculate the cash flows at each point in time, and then compute the
present value of these cash flows:
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6
Investment 100,000
Cash In 26,000 26,000 26,000 26,000 26,000
Depreciation 20,000 32,000 19,200 11,520 11,520 5,760
Taxable Income 6,000 -6,000 6,800 14,480 14,480 -5,760
Tax 2,100 -2,100 2,380 5,068 5,068 -2,016
Cash Flow -100,000 23,900 28,100 23,620 20,932 20,932 2,016
NPV (at 8%) = -\$4,127
b. IRRA = 9.43%
IRRB = 6.39%
Effective tax rate =
32.2% 0.322
0.0943
0.0639
1 · · −
8. Assume the following:
a. The firm will manufacture widgets for at least 10 years.
b. There will be no inflation or technological change.
c. The 15 percent cost of capital is appropriate for all cash flows and is a
real, after-tax rate of return.
d. All operating cash flows occur at the end of the year.
Note: Since purchasing the lids can be considered a one-year ‘project,’ the two
projects have a common chain life of 10 years.
Compute NPV for each project as follows:
NPV(purchase) =
\$1,304,880
1.15
.35) 0 (1 200,000) (2
10
1 t
t
− ·
− × ×

·
NPV(make) = ∑
·
− × ×
− − −
10
1 t
t
1.15
.35) 0 (1 200,000) (1.50
30,000 150,000
[ ] + + + + + × × +
5 4 3 2 1
1.15
0.0893
1.15
0.1249
1.15
0.1749
1.15
0.2449
1.15
0.1429
[ 150,000 0.35
\$1,118,328
1.15
30,000
]
1.15
0.0445
1.15
0.0893
1.15
0.0893
10 8 7 6
− · + + +
Thus, the widget manufacturer should make the lids.
40
9. a. Capital Expenditure
1. If the spare warehouse space will be used now or in the future, then
the project should be credited with these benefits.
2. Charge opportunity cost of the land and building.
3. The salvage value at the end of the project should be included.
Research and Development
1. Research and development is a sunk cost.
Working Capital
1. Will additional inventories be required as volume increases?
2. Recovery of inventories at the end of the project should be
included.
3. Is additional working capital required due to changes in receivables,
payables, etc.?
Revenues
1. Revenue forecasts assume prices (and quantities) will be
unaffected by competition, a common and critical mistake.
Operating Costs
1. Are percentage labor costs unaffected by increase in volume in the
early years?
2. Wages generally increase faster than inflation. Does Reliable
expect continuing productivity gains to offset this?
Depreciation
1. Depreciation is not a cash flow, but the ACRS deprecation does
affect tax payments.
2. ACRS depreciation is fixed in nominal terms. The real value of the
depreciation tax shield is reduced by inflation.
Interest
1. It is bad practice to deduct interest charges (or other payments to
security holders). Value the project as if it is all equity-financed.
Taxes
1. See comments on ACRS depreciation and interest.
2. If Reliable has profits on its remaining business, the tax loss should
not be carried forward.
Net Cash Flow
1. See comments on ACRS depreciation and interest.
2. Discount rate should reflect project characteristics; in general, it is
not equivalent to the company’s borrowing rate.
b. 1. Potential use of warehouse.
2 Opportunity cost of building.
3. Other working capital items.
4. More realistic forecasts of revenues and costs.
5. Company’s ability to use tax shields.
6. Opportunity cost of capital.
41
c. The table on the next page shows a sample NPV analysis for the project.
The analysis is based on the following assumptions:
1. Inflation: 10 percent per year.
2. Capital Expenditure: \$8 million for machinery; \$5 million for market
value of factory; \$2.4 million for warehouse extension (we assume
that it is eventually needed or that electric motor project and surplus
capacity cannot be used in the interim). We assume salvage value
of \$3 million in real terms less tax at 35 percent.
3. Working Capital: We assume inventory in year t is 9.1 percent of
expected revenues in year (t + 1). We also assume that
receivables less payables, in year t, is equal to 5 percent of
revenues in year t.
4. Depreciation Tax Shield: Based on 35 percent tax rate and 5-year
ACRS class. This is a simplifying and probably inaccurate
assumption; i.e., not all the investment would fall in the 5-year
class. Also, the factory is currently owned by the company and
may already be partially depreciated. We assume the company
can use tax shields as they arise.
5. Revenues: Sales of 2,000 motors in 2000, 4,000 motors in 2001,
and 10,000 motors thereafter. The unit price is assumed to decline
from \$4,000 (real) to \$2,850 when competition enters in 2002. The
latter is the figure at which new entrants’ investment in the project
would have NPV = 0.
6. Operating Costs: We assume direct labor costs decline
progressively from \$2,500 per unit in 2000, to \$2,250 in 2001 and
to \$2,000 in real terms in 2002 and after.
7. Other Costs: We assume true incremental costs are 10 percent of
revenue.
8. Tax: 35 percent of revenue less costs.
9. Opportunity Cost of Capital: Assumed 20 percent.
42
Practice Question 9
1999 2000 2001 2002 2003 2004
Capital Expenditure (15,400)
Changes in Working Capital
Inventories (801) (961) (1,690) (345) (380) (418)
Receivables – Payables (440) (528) (929) (190) (209)
Depreciation Tax Shield 1,078 1,725 1,035 621 621
Revenues 8,800 19,360 37,934 41,727 45,900
Operating Costs (5,500) (10,890) (26,620) (29,282) (32,210)
Other costs (880) (1,936) (3,793) (4,173) (4,590)
Tax (847) (2,287) (2,632) (2,895) (3,185)
Net Cash Flow (16,201) 1,250 3,754 4,650 5,428 5,909
2005 2006 2007 2008 2009 2010
Capital Expenditure 5,058
Changes in Working Capital
Inventories (459) (505) (556) (612) 6,727
Receivables – Payables (229) (252) (278) (306) (336) 3,696
Depreciation Tax Shield 310
Revenues 50,489 55,538 61,092 67,202 73,922
Operating Costs (35,431) (38,974) (42,872) (47,159) (51,875)
Other costs (5,049) (5,554) (6,109) (6,720) (7,392)
Tax (3,503) (3,854) (4,239) (4,663) (5,129)
Net Cash Flow 6,128 6,399 7,038 7,742 20,975 3,696
NPV (at 20%) = \$5,991
43
10. The table below shows the real cash flows. The NPV is computed using the real
rate, which is computed as follows:
(1 + rnominal)
= (1 + rreal) × (1 + inflation rate)
1.09
= (1 + rreal) × (1.03)
rreal = 0.0583 = 5.83%
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7 t = 8
Investment -35,000.0 15,000.0
Savings 7,410.0 7,410.0 7,410.0 7,410.0 7,410.0 7,410.0 7,410.0 7,410.0
Insurance -1,200.0 -1,200.0 -1,200.0 -1,200.0 -1,200.0 -1,200.0 -1,200.0 -1,200.0
Fuel -526.5 -526.5 -526.5 -526.5 -526.5 -526.5 -526.5 -526.5
Net Cash Flow -35,000.0 5,683.5 5,683.5 5,683.5 5,683.5 5,683.5 5,683.5 5,683.5 20,683.5
NPV (at 5.83%) = \$10,064.9
11.
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7 t = 8
Sales 4,200.0 4,410.0 4,630.5 4,862.0 5,105.1 5,360.4 5,628.4 5,909.8
Manufacturing Costs 3,780.0 3,969.0 4,167.5 4,375.8 4,594.6 4,824.3 5,065.6 5,318.8
Depreciation 120.0 120.0 120.0 120.0 120.0 120.0 120.0 120.0
Rent 100.0 104.0 108.2 112.5 117.0 121.7 126.5 131.6
Earnings Before Taxes 200.0 217.0 234.9 253.7 273.5 294.4 316.3 339.4
Taxes 70.0 76.0 82.2 88.8 95.7 103.0 110.7 118.8
Cash Flow
Operations 180.0 240.1 250.6 261.8 273.5 285.84 298.8 1,247.4
Working Capital 350.0 420.0 441.0 463.1 486.2 510.5 536.0 562.8 0.0
Increase in W.C. 350.0 70.0 21.0 22.1 23.2 24.3 25.5 26.8 -562.8
Rent (after tax) 65.0 67.6 70.3 73.1 76.0 79.1 82.2 85.5
Initial Investment 1,200.0
Sale of Plant 400.0
Tax on Sale 56.0
Net Cash Flow -1,550.0 180.0 240.1 250.6 261.8 273.5 285.8 298.8 1,247.4
NPV(at 12%) = \$85.8
12. Note: There are several different calculations of pre-tax profit and taxes given in
Section 6.2, based on different assumptions; the solution below is based on
Table 6.6 in the text.
See the table on the next page. With full usage of the tax losses, the NPV of the
tax payments is \$4,779. With tax losses carried forward, the NPV of the tax
payments is \$5,741. Thus, with tax losses carried forward, the project’s NPV
decreases by \$962, so that the value to the company of using the deductions
immediately is \$962.

44
Tax Cash Flows
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7
Pretax Profit -4,000 -4,514 748 9,807 16,940 11,579 5,539 1,949
Full usage of tax losses
Immediately (Table 6.6) -1,400 -1,580 262 3,432 5,929 4,053 1,939 682
NPV at 20% \$4,779
Tax loss carry-forward 0 0 0 714 5,929 4,053 1,939 682
NPV (at 20%) = \$5,741
13. (Note: Row numbers in the table below refer to the rows in Table 6.8.)
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7 t = 8
1. Capital investment 83.5 -12.0
4. Working capital 2.3 4.4 7.6 6.9 5.3 3.2 2.5 0.0 0.0
Change in W.C. 2.1 3.2 -0.7 -1.6 -2.1 -0.7 -2.5 0.0
9. Depreciation 11.9 11.9 11.9 11.9 11.9 11.9 11.9 11.9
12. Profit after tax -5.8 3.9 25.0 21.8 14.3 4.7 1.5 7.2
Cash Flow -85.8 4.0 12.6 37.6 35.3 28.3 17.3 15.9 7.2
NPV (at 11.0%) = \$15.60
14. In order to solve this problem, we calculate the equivalent annual cost for each of
the two alternatives. (All cash flows are in thousands.)
Alternative 1 – Sell the new machine: If we sell the new machine, we receive the
cash flow from the sale, pay taxes on the gain, and pay the costs associated with
keeping the old machine. The present value of this alternative is:
5 4 3 2
1
1.12
30
1.12
30
1.12
30
1.12
30
1.12
30
20 0)] .35(50 [0 50 PV − − − − − − − − ·
\$93.80
1.12
0) (5 0.35
1.12
5
5 5
− ·

− +
The equivalent annual cost for the five-year period is computed as follows:
PV1 = EAC1 × [annuity factor, 5 time periods, 12%]
-93.80 = EAC1 × [3.605]
EAC1 = -26.02, or an equivalent annual cost of \$26,020
45
Alternative 2 – Sell the old machine: If we sell the old machine, we receive the
cash flow from the sale, pay taxes on the gain, and pay the costs associated with
keeping the new machine. The present value of this alternative is:
5 4 3 2
2
1.12
20
1.12
20
1.12
20
1.12
20
1.12
20
0)] [0.35(25 25 PV − − − − − − − ·
10 9 8 7 6 5
1.12
30
1.12
30
1.12
30
1.12
30
1.12
30
1.12
20
− − − − − −
\$127.51
1.12
0) (5 .35 0

1.12
5
10 10
− ·

− +
The equivalent annual cost for the ten-year period is computed as follows:
PV2 = EAC2 × [annuity factor, 10 time periods, 12%]
-127.51 = EAC2 × [5.650]
EAC2 = -22.57, or an equivalent annual cost of \$22,570
Thus, the least expensive alternative is to sell the old machine because this
alternative has the lowest equivalent annual cost.
One key assumption underlying this result is that, whenever the machines have
to be replaced, the replacement will be a machine that is as efficient to operate
as the new machine being replaced.
15. The current copiers have net cost cash flows as follows:
Year
Before-
Tax
Cash Flow After-Tax Cash Flow
Net Cash
Flow
1 -2,000 (-2,000 × .65) + (.35 × .0893 ×
20,000)
-674.9
2 -2,000
(-2,000 × .65) + (.35 × .0893 ×
20,000)
-674.9
3 -8,000 (-8,000 × .65) + (.35 × .0893 ×
20,000)
-4,574.9
4 -8,000
(-8,000 × .65) + (.35 × .0445 ×
20,000)
-4,888.5
5 -8,000 (-8,000 × .65) -5,200.0
6 -8,000 (-8,000 × .65) -5,200.0
These cash flows have a present value, discounted at 7 percent, of -\$15,857.
Using the annuity factor for 6 time periods at 7 percent (4.767), we find an
46
equivalent annual cost of \$3,326. Therefore, the copiers should be replaced
only when the equivalent annual cost of the replacements is less than \$3,326.
47
When purchased, the new copiers will have net cost cash flows as follows:
Year
Before-
Tax
Cash Flow After-Tax Cash Flow
Net Cash
Flow
0 -25,000 -25,000 -25,000.0
1 -1,000
(-1,000 × .65) + (.35 × .1429 ×
25,000)
600.0
2 -1,000 (-1,000 × .65) + (.35 × .2449 ×
25,000)
1,493.0
3 -1,000
(-1,000 × .65) + (.35 × .1749 ×
25,000)
880.0
4 -1,000 (-1,000 × .65) + (.35 × .1249 ×
25,000)
443.0
5 -1,000
(-1,000 × .65) + (.35 × .0893 ×
25,000)
131.0
6 -1,000 (-1,000 × .65) + (.35 × .0893 ×
25,000)
131.0
7 -1,000
(-1,000 × .65) + (.35 × .0893 ×
25,000)
131.0
8 -1,000 (-1,000 × .65) + (.35 × .0445 ×
25,000)
-261.0
These cash flows have a present value, discounted at 7 percent, of -\$21,969.
The decision to replace must also take into account the resale value of the
machine, as well as the associated tax on the resulting gain (or loss). Consider
three cases:
a. The book (depreciated) value of the existing copiers is now \$6,248. If the
existing copiers are replaced now, then the present value of the cash
flows is:
-21,969 + 8,000 – [0.35 × (8,000 – 6,248)] = -\$14,582
Using the annuity factor for 8 time periods at 7 percent (5.971), we find
that the equivalent annual cost is \$2,442.
b. Two years from now, the book (depreciated) value of the existing copiers
will be \$2,676. If the existing copiers are replaced two years from now,
then the present value of the cash flows is:
(-674.9/1.07
1
) + (-674.9/1.07
2
) + (-21,969/1.07
2
) +
{3,500 – [0.35 × (3,500 – 2,676)]}/1.07
2
= -\$17,604
Using the annuity factor for 10 time periods at 7 percent (7.024), we find
that the equivalent annual cost is \$2,506.
48
c. Six years from now, both the book value and the resale value of the
existing copiers will be zero. If the existing copiers are replaced six years
from now, then the present value of the cash flows is:
-15,857+ (-21,969/1.07
6
) = -\$30,496
Using the annuity factor for 14 time periods at 7 percent (8.745), we find
that the equivalent annual cost is \$3,487.
The copiers should be replaced immediately.
16. a.
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10Year 11
MACRS
Percent
10.00%18.00%14.40%11.52% 9.22% 7.37% 6.55% 6.55% 6.55% 6.55% 3.29%
MACRS
Depr.
40.00 72.00 57.60 46.08 36.88 29.48 26.20 26.20 26.20 26.20 13.16
Tax
Shield
15.60 28.08 22.46 17.97 14.38 11.50 10.22 10.22 10.22 10.22 5.13
Present Value (at 7%) = \$114.57 million
The equivalent annual cost of the depreciation tax shield is computed by
dividing the present value of the tax shield by the annuity factor for 25
years at 7%:
Equivalent annual cost = \$114.57 milliion/11.654 = \$9.83 million
The equivalent annual cost of the capital investment is:
\$34.3 million – \$9.83 million = \$24.47 million
b. The extra cost per gallon (after tax) is:
\$24.47 million/900 million gallons = \$0.0272 per gallon
The pre-tax charge = \$0.0272/0.65 = \$0.0418 per gallon
17. Since the growth in value of both timber and land is less than the cost of capital after
year 8, it must pay to cut by that time. The table below shows that PV is
maximized if you cut in year 8. Therefore, if we cut in year 8, the NPV of the
offer is: \$140,000 – 109,900 = \$30,100
Year 1 Year 2 Year 3 Year 4 Year 5
Future Value: Timber 48.3 58.2 70.2 84.7 97.8
Land 52 .0 54 .1 56 .2 58 .5 60 .8
Total 100.3 112.3 126.4 143.2 158.6
Present Value: 92.0 94.5 97.6 101.4 103.1
Year 6 Year 7 Year 8 Year 9
49
Future Value: Timber 112.9 130.3 150.5 162.7
Land 63 .3 65 .8 68 .4 71 .2
Total 176.2 196.1 218.9 233.9
Present Value: 105.1 107.3 109.9 107.7
50
18. a.
3 2
A
1.06
10,000
1.06
10,000
1.06
10,000
40,000 PV + + + ·
PVA = \$66,730 (Note that this is a cost.)
4 3 2
B
1.06
8,000
1.06
8,000
1.06
8,000
1.06
8,000
50,000 PV + + + + ·
PVB = \$77,721 (Note that this is a cost.)
Equivalent annual cost (EAC) is found by:
PVA =
EACA × [annuity factor, 6%, 3 time periods]
66,730 =
EACA × 2.673
EACA = \$24,964 per year rental
PVB =
EACB × [annuity factor, 6%, 4 time periods]
77,721 =
EACB × 3.465
EACB = \$22,430 per year rental
b. Annual rental is \$24,964 for Machine A and \$22,430 for Machine B.
c. The payments would increase by 8 percent per year. For example, for
Machine A, rent for the first year would be \$24,964; rent for the second
year would be (\$24,964 × 1.08) = \$26,961; etc.
19. Because the cost of a new machine now decreases by 10 percent per year, the rent
on such a machine also decreases by 10 percent per year. Therefore:
3 2
A
1.06
7,290
1.06
8,100
1.06
9,000
40,000 PV + + + ·
PVA = \$61,820 (Note that this is a cost.)
4 3 2
B
1.06
5,249
1.06
5,832
1.06
6,480
1.06
7,200
50,000 PV + + + + ·
PVB = \$71,613 (Note that this is a cost.)
51
Equivalent annual cost (EAC) is found as follows:
PVA =
EACA × [annuity factor, 6%, 3 time periods]
61,820 =
EACA × 2.673
EACA = \$23,128, a reduction of 7.35%
PVB =
EACB × [annuity factor, 6%, 4 time periods]
71,613 =
EACB × 3.465
EACB = \$20,668, a reduction of 7.86%
20. With a 6-year life, the equivalent annual cost (at 8 percent) of a new jet is:
(\$1,100,000/4.623) = \$237,941. If the jet is replaced at the end of year 3 rather
than year 4, the company will incur an incremental cost of \$237,941 in year 4.
The present value of this cost is:
\$237,941/1.08
4
= \$174,894
The present value of the savings is:
The president should allow wider use of the present jet because the present
value of the savings is greater than the present value of the cost.
52
\$206,168
1.08
80,000
3
1 t
t
·

·
Challenge Questions
1. a.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Pre-Tax Flows -14,000.0 -3,064.0 3,209.0 9,755.0 16,463.0 14,038.0 7,696.0 3,444.0
IRR = 33.3%
Post-Tax Flows -12,600.0 -1,630.0 2,381.0 6,205.0 10,685.0 10,136.0 6,110.0 3,444.0
IRR = 26.8%
Effective Tax Rate = 19.5%
b. If the depreciation rate is accelerated, this has no effect on the pretax IRR,
but it increases the after-tax IRR. Therefore, the numerator decreases
and the effective tax rate decreases.
If the inflation rate increases, we would expect pretax cash flows to
increase at the inflation rate, while after tax cash flows increase at a
slower rate. After tax cash flows increase at a slower rate than the
inflation rate because depreciation expense does not increase with
inflation. Therefore, the numerator of TE becomes proportionately larger
than the denominator and the effective tax rate increases.
c.
C C
C
C
C
C
C
C
E
T ) T (1 1
C
) T I(1
I
C
) T I(1
C
) T I(1
C
) T I(1
) T C(1
) T I(1
C
T · − − ·
]
]
]

]
]
]

·

·
Hence, if the up-front investment is deductible for tax purposes, then the
effective tax rate is equal to the statutory tax rate.
2. a. With a real rate of 6 percent and an inflation rate of 5 percent, the nominal
rate, r, is determined as follows:
(1 + r) =
(1 + 0.06) × (1 + 0.05)
r = 0.113 = 11.3%
For a three-year annuity at 11.3 percent, the annuity factor (using the
annuity formula from Chapter 3) is 2.4310; for a two-year annuity, the
annuity factor is 1.7057.
For a three-year annuity with a present value of \$28.37, the nominal
annuity is: (\$28.37/2.4310) = \$11.67
For a two-year annuity with a present value of \$21.00, the nominal annuity
is: (\$21.00/1.7057) = \$12.31
53
These nominal annuities are not realistic estimates of equivalent annual
costs because the appropriate rental cost (i.e., the equivalent annual cost)
must take into account the effects of inflation.
b. With a real rate of 6 percent and an inflation rate of 25 percent, the
nominal rate, r, is determined as follows:
(1 + r) =
(1 + 0.06) × (1 + 0.25)
r = 0.325 = 32.5%
For a three-year annuity at 32.5 percent, the annuity factor (using the
annuity formula from Chapter 3) is 1.7542; for a two-year annuity, the
annuity factor is 1.3243.
For a three-year annuity with a present value of \$28.37, the nominal
annuity is: (\$28.37/1.7542) = \$16.17
For a two-year annuity with a present value of \$21.00, the nominal annuity
is: (\$21.00/1.3243) = \$15.86
With an inflation rate of 5 percent, Machine A has the lower nominal
annual cost (\$11.67 compared to \$12.31). With inflation at 25 percent,
Machine B has the lower nominal annual cost (\$15.86 compared to
\$16.17). Thus it is clear that inflation has a significant impact on the
calculation of equivalent annual cost, and hence, the warning in the text to
do these calculations in real terms. The rankings change because, at the
higher inflation rate, the machine with the longer life (here, Machine A) is
affected more.
3. a. The cash outflow in Period 0 becomes -\$10,426,000 and
NPV = \$5,693,684. The format is advantageous since it recognizes
additional cash flows created by the tax-deductibility of depreciation.
However, it may also be disadvantageous because several assumptions
are made here. We are assuming:
1. The tax rate remains constant.
2. The depreciation method remains constant.
3. The company’s ability to generate taxable income continues so the
tax shield can be used.
b. Since the cash flows are relatively safe, they should probably be discounted
at an after-tax borrowing or lending rate.
c. The discount rate for the other cash flows should not change since it must
represent the opportunity cost of funds in a project of similar risk.
54
CHAPTER 7
Introduction to Risk, Return, and the Opportunity Cost of Capital
2. Recall from Chapter 3 that:
(1 + rnominal) = (1 + rreal) × (1 + inflation rate)
Therefore:
rreal = (1 + rnominal)/(1 + inflation rate) - 1
a. The real return on the S&P 500 in each year was:
1996: 19.2%
1997: 31.2%
1998: 26.6%
1999: 17.8%
2000: -12.1%
b. From the results for Part (a), the average real return was 16.5 percent.
c. The risk premium for each year was:
1996: 17.9%
1997: 28.1%
1998: 23.7%
1999: 16.3%
2000: -15.0%
d. From the results for Part (c), the average risk premium was 14.2 percent.
e. The standard deviation (σ ) of the risk premium is calculated as follows:
2 2 2 2
0.142) (0.237 0.142) (0.281 0.142) (0.179 [
1 5
1
σ − + − + − ×

,
`

.
|

·
] 0.142) 0.150 ( 0.142) (0.163
2 2
− − + − +
3. Internet exercise; answers will vary.
55
0.02886 ] 0.115420 [
4
1
σ
2
· ×
,
`

.
|
·
17.0% 0.170 σ · ·
3. a. A long-term United States government bond is always absolutely safe in
terms of the dollars received. However, the price of the bond fluctuates as
interest rates change and the rate at which coupon payments can be
invested also changes as interest rates change. And, of course, the
payments are all in nominal dollars, so inflation risk must also be
considered.
b. It is true that stocks offer higher long-run rates of return than bonds, but it
is also true that stocks have a higher standard deviation of return. So,
which investment is preferable depends on the amount of risk one is
willing to tolerate. This is a complicated issue and depends on numerous
factors, one of which is the investment time horizon. If the investor has a
short time horizon, then stocks are generally not preferred.
c. Unfortunately, 10 years is not generally considered a sufficient amount of
time for estimating average rates of return. Thus, using a 10-year average
4. If the distribution of returns is symmetric, it makes no difference whether we look
at the total spread of returns or simply the spread of unexpectedly low returns.
Thus, the speaker does not have a valid point as long as the distribution of
returns is symmetric.
5. The risk to Hippique shareholders depends on the market risk, or beta, of the
investment in the black stallion. The information given in the problem suggests
that the horse has very high unique risk, but we have no information regarding
the horse’s market risk. So, the best estimate is that this horse has a market risk
about equal to that of other racehorses, and thus this investment is not a
particularly risky one for Hippique shareholders.
6. In the context of a well-diversified portfolio, the only risk characteristic of a single
security that matters is the security’s contribution to the overall portfolio risk. This
contribution is measured by beta. Lonesome Gulch is the safer investment for a
diversified investor because its beta (+0.10) is lower than the beta of
Amalgamated Copper (+0.66). For a diversified investor, the standard deviations
are irrelevant.
7. a. To the extent that the investor is interested in the variation of possible
future outcomes, risk is indeed variability. If returns are random, then the
greater the period-by-period variability, the greater the variation of
possible future outcomes. Also, the comment seems to imply that any rise
to \$20 or fall to \$10 will inevitably be reversed; this is not true.
56
b. A stock’s variability may be due to many uncertainties, such as
unexpected changes in demand, plant manager mortality or changes in
costs. However, the risks that are not measured by beta are the risks that
can be diversified away by the investor so that they are not relevant for
investment decisions. This is discussed more fully in later chapters of the
text.
c. Given the expected return, the probability of loss increases with the
standard deviation. Therefore, portfolios that minimize the standard
deviation for any level of expected return also minimize the probability of
loss.
d. Beta is the sensitivity of an investment’s returns to market returns. In
order to estimate beta, it is often helpful to analyze past returns. When we
do this, we are indeed assuming betas do not change. If they are liable to
change, we must allow for this in our estimation. But this does not affect
the idea that some risks cannot be diversified away.
8. xI = 0.60 σ I = 0.10
xJ = 0.40 σ J = 0.20
a.
b.
c.
9. a. Refer to Figure 7.10 in the text. With 100 securities, the box is 100 by
100. The variance terms are the diagonal terms, and thus there are 100
variance terms. The rest are the covariance terms. Because the box has
(100 times 100) terms altogether, the number of covariance terms is:
100
2
- 100 = 9,900
Half of these terms (i.e., 4,950) are different.
57
1 ρ
IJ
·
)] σ σ ρ x 2(x σ x σ x [ σ
J I IJ J I
2
J
2
J
2
I
2
I
2
p
+ + ·
0.0196 ] 0)(0.20) 40)(1)(0.1 2(0.60)(0. (0.20) 0.40) ( (0.10) (0.60) [
2 2 2 2
· + + ·
0 ρ
ij
·
0.0148 ] ) 0.10)(0.20 40)(0.50)( 2(0.60)(0. (0.20) 0.40) ( (0.10) (0.60) [
2 2 2 2
· + + ·
0.50 ρ
IJ
·
0.0100 ] 0)(0.20) 40)(0)(0.1 2(0.60)(0. (0.20) 0.40) ( (0.10) (0.60) [
2 2 2 2
· + + ·
)] σ σ ρ x 2(x σ x σ x [ σ
J I IJ J I
2
J
2
J
2
I
2
I
2
p
+ + ·
)] σ σ ρ x 2(x σ x σ x [ σ
J I IJ J I
2
J
2
J
2
I
2
I
2
p
+ + ·
b. Once again, it is easiest to think of this in terms of Figure 7.10. With 50
stocks, all with the same standard deviation (0.30), the same weight in the
portfolio (0.02), and all pairs having the same correlation coefficient (0.4),
the portfolio variance is:
Variance = 50(0.02)
2
(0.30)
2
+ [(50)
2
- 50](0.02)
2
(0.4)(0.30)
2
=0.0371
Standard deviation = 0.193 = 19.3%
c. For a completely diversified portfolio, portfolio variance equals the average
covariance:
Variance = (0.30)(0.30)(0.40) = 0.036
Standard deviation = 0.190 = 19.0%
10. a. Refer to Figure 7.10 in the text. For each different portfolio, the relative
weight of each share is [one divided by the number of shares (n) in the
portfolio], the standard deviation of each share is 0.40, and the correlation
between pairs is 0.30. Thus, for each portfolio, the diagonal terms are the
same, and the off-diagonal terms are the same. There are n diagonal
terms and (n
2
– n) off-diagonal terms. In general, we have:
Variance = n(1/n)
2
(0.4)
2
+ (n
2
- n)(1/n)
2
(0.3)(0.4)(0.4)
For one share: Variance = 1(1)
2
(0.4)
2
+ 0 = 0.160000
For two shares:
Variance = 2(0.5)
2
(0.4)
2
+ 2(0.5)
2
(0.3) (0.4)(0.4) = 0.104000
The results are summarized in the second and third columns of the table
on the next page.
b. (Graphs are on the next page.) The underlying market risk that can not be
diversified away is the second term in the formula for variance above:
Underlying market risk = (n
2
- n)(1/n)
2
(0.3)(0.4)(0.4)
As n increases, [(n
2
- n)(1/n)
2
] = [(n-1)/n] becomes close to 1, so that the
underlying market risk is: [(0.3)(0.4)(0.4)] = 0.048
58
c. This is the same as Part (a), except that all the off-diagonal terms are now
equal to zero. The results are summarized in the fourth and fifth columns
of the table below.
(a) (a) (c) (c)
No. of Standard Standard
Shares Variance Deviation Variance Deviation
1 .160000 .400 .160000 .400
2 .104000 .322 .080000 .283
3 .085333 .292 .053333 .231
4 .076000 .276 .040000 .200
5 .070400 .265 .032000 .179
6 .066667 .258 .026667 .163
7 .064000 .253 .022857 .151
8 .062000 .249 .020000 .141
9 .060444 .246 .017778 .133
10 .059200 .243 .016000 .126
Graphs for Part (a):
Graphs for Part (c):
59
Portfolio Variance Portfolio Variance
0
0.05
0.1
0.15
0.2
0 2 4 6 8 10 12
Number of Securities
V
a
r
i
a
n
c
e
Portfolio Standard Deviation Portfolio Standard Deviation
0
0.1
0.2
0.3
0.4
0.5
0 2 4 6 8 10 12
Number of Securities
S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n
Portfolio Variance Portfolio Variance
0
0.05
0.1
0.15
0.2
0 2 4 6 8 10 12
Number of Securities
V
a
r
i
a
n
c
e
Portfolio Standard Deviation Portfolio Standard Deviation
0
0.1
0.2
0.3
0.4
0.5
0 2 4 6 8 10 12
Number of Securities
S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n
11. Internet exercise; answers will vary depending on time period.
12. xBP = 0.4
xKLM = 0.4
xN = 0.2
13. Internet exercise; answers will vary depending on time period.
14. “Safest” means lowest risk; in a portfolio context, this means lowest variance of
return. Half of the portfolio is invested in Alcan stock, and half of the portfolio
must be invested in one of the other securities listed. Thus, we calculate the
portfolio variance for six different portfolios to see which is the lowest. The safest
attainable portfolio is comprised of Alcan and Nestle.
Stocks Portfolio Variance
Alcan & BP 0.057852
Alcan & Deutsche 0.082431
Alcan & KLM 0.082871
Alcan & LVMH 0.095842
Alcan & Nestle 0.041666
Alcan & Sony 0.096994
15. a. In general, we expect a stock’s price to change by an amount equal to
(beta × change in the market). Beta equal to -0.25 implies that, if the
market rises by an extra 5 percent, the expected change is -1.25 percent.
If the market declines an extra 5 percent, then the expected change is
+1.25 percent.
60
+ + + · σ
2
N
2
N
2
KLM
2
KLM
2
BP
2
BP
σ x σ x σ x
2
p
] ) σ σ ρ x x σ σ ρ x x σ σ ρ x 2[(x
N KLM N KLM, N KLM N BP N BP, N BP KLM BP KLM BP, KLM BP
+ +
+ + + ·
2 2 2 2 2 2
(0.197) (0.2) (0.396) (0.4) (0.248) (0.4)
+ + 48)(0.197) (0.23)(0.2 (0.4)(0.2) ) 248)(0.396 4)(0.2)(0. 2[(0.4)(0.
0.048561 ] 96)(0.197) (0.32)(0.3 (0.4)(0.2) ·
0.220 σ
p
·
b. “Safest” implies lowest risk. Assuming the well-diversified portfolio is
invested in typical securities, the portfolio beta is approximately one. The
largest reduction in beta is achieved by investing the \$20,000 in a stock
with a negative beta. Answer (iii) is correct.
16. a. If the standard deviation of the market portfolio’s return is 20 percent, then
the variance of the market portfolio’s return is 20 squared, or 400.
Further, we know that a stock’s beta is equal to: the covariance of the
stock’s returns with the market divided by the variance of the market
return. Thus:
β Z = 800/400 = 2.0
b. For a fully diversified portfolio, the standard deviation of portfolio return is
equal to the portfolio beta times the market portfolio standard deviation:
Standard deviation = 2 × 20% = 40%
c. By definition, the average beta of all stocks is one.
d. The extra return we would expect is equal to (beta × the extra return on
the market portfolio):
Extra return = 2 × 5% = 10%
17. Diversification by corporations does not benefit shareholders because
shareholders can easily diversify their portfolios by buying stock in many different
companies.
61
Challenge Questions
1. a. In general:
Portfolio variance = σ P
2
= x1
2
σ 1
2
+ x2
2
σ 2
2
+ 2x1x2ρ 12σ 1σ 2
Thus:
σ P
2
= (0.5
2
)(0.627
2
)+(0.5
2
)(0.507
2
)+2(0.5)(0.5)(0.66)(0.627)(0.507)
σ P
2
= 0.26745
Standard deviation = σ P = 0.517 = 51.7%
b. We can think of this in terms of Figure 7.10 in the text, with three
securities. One of these securities, T-bills, has zero risk and, hence, zero
standard deviation. Thus:
σ P
2
= (1/3)
2
(0.627
2
)+(1/3)
2
(0.507
2
)+2(1/3)(1/3)(0.66)(0.627)(0.507)
σ P
2
= 0.11887
Standard deviation = σ P = 0.345 = 34.5%
Another way to think of this portfolio is that it is comprised of one-third
T-Bills and two-thirds a portfolio which is half Dell and half Microsoft.
Because the risk of T-bills is zero, the portfolio standard deviation is two-
thirds of the standard deviation computed in Part (a) above:
Standard deviation = (2/3)(0.517) = 0.345 = 34.5%
c. With 50 percent margin, the investor invests twice as much money in the
portfolio as he had to begin with. Thus, the risk is twice that found in Part
(a) when the investor is investing only his own money:
Standard deviation = 2 × 51.7% = 103.4%
d. With 100 stocks, the portfolio is well diversified, and hence the portfolio
standard deviation depends almost entirely on the average covariance of
the securities in the portfolio (measured by beta) and on the standard
deviation of the market portfolio. Thus, for a portfolio made up of 100
stocks, each with beta = 2.21, the portfolio standard deviation is
approximately: (2.21 × 15%) = 33.15%. For stocks like Microsoft, it is:
(1.81 × 15%) = 27.15%.
62
2. For a two-security portfolio, the formula for portfolio risk is:
Portfolio variance = x1
2
σ 1
2
+ x2
2
σ 2
2
+ 2x1x2ρ
ρ 12σ 1σ 2
If security one is Treasury bills and security two is the market portfolio, then σ 1 is
zero, σ 2 is 20 percent. Therefore:
Portfolio variance = x2
2
σ 2
2
= x2
2
(0.20)
2
Standard deviation = 0.20 x2
Portfolio expected return = x1 (0.06) + x2 (0.06 + 0.85)
Portfolio expected return = 0.06x1 + 0.145x2
Portfolio X1 X2 Exp. Return Std. Deviation
1 1.0 0 0.060 0
2 0.8 0.2 0.077 0.040
3 0.6 0.4 0.094 0.080
4 0.4 0.6 0.111 0.120
5 0.2 0.8 0.128 0.160
6 0 1.0 0.145 0.200
63
Portfolio Return & Risk
Portfolio Return & Risk
0
0.05
0.1
0.15
0.2
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n
0 0.05 0.1 0.15 0.2 0.25
s
s
s
s
s
s
3. a. From the text, we know that the standard deviation of a well-diversified portfolio
of common stocks (using history as our guide) is about 20.2 percent.
Hence, the variance of portfolio returns is 0.202 squared, or 0.040804 for
a well-diversified portfolio.
The variance of our portfolio is given by (see Figure 7.10):
Variance = 2[(0.2)
2
(0.4)
2
] + 6[(0.1)
2
(0.4)
2
]
+ 2[(0.2)(0.2)(0.3)(0.4)(0.4)]
+ 24[(0.1)(0.2)(0.3)(0.4)(0.4)]
+ 30[(0.1)(0.1)(0.3)(0.4)(0.4)] = 0.063680
Thus, the proportion is (0.040804/0.063680) = 0.641
b. In order to find n, the number of shares in a portfolio that has the same
risk as our portfolio, with equal investments in each typical share, we must
solve the following portfolio variance equation for n:
n(1/n)
2
(0.4)
2
+ (n
2
- n)(1/n)
2
(0.3)(0.4)(0.4) = 0.063680
Solving this equation, we find that n = 7.14 shares.
The first measure provides an estimate of the amount of risk that can still be
diversified away. With a fully diversified portfolio, the ratio is approximately one.
Unfortunately, the use of average historical data does not necessarily reflect
current or expected conditions.
The second measure indicates the potential reduction in the number of securities
in a portfolio while retaining the current portfolio’s risk. However, this measure
does not indicate the amount of risk that can yet be diversified away.
4. Internet exercise; answers will vary.
5. Internet exercise; answers will vary.
64
CHAPTER 8
Risk and Return
1. a. False – investors demand higher expected rates of return on stocks with more nondiversifiable risk.
b. False – a security with a beta of zero will offer the risk-free rate of return.
c. False – the beta will be: (1/3)× (0) + (2/3)× (1) = 0.67
d. True.
e. True.
2. In the following solution, security one is Coca-Cola and security two is Reebok. Then:
r
1
= 0.10 σ
1
= 0.315
r
2
= 0.20 σ
2
= 0.585
Further, we know that for a two-security portfolio:
r
p
= x
1
r
1
+ x
2
r
2
σ
p
2
= x
1
2
σ
1
2
+ 2x
1
x
2
σ
1
σ
2
ρ
12
+ x
2
2
σ
2
2
Therefore, we have the following results:
x1 x
2
r
p
σ
p1
when ρ = 0
σ
p1
when ρ = 1
σ
p1
when ρ = -1
1.0 0.0 0.10 0.315 0.315 0.315
0.9 0.1 0.11 0.289 0.342 0.225
0.8 0.2 0.12 0.278 0.369 0.135
0.7 0.3 0.13 0.282 0.396 0.045
0.6 0.4 0.14 0.301 0.423 0.045
0.5 0.5 0.15 0.332 0.450 0.135
0.4 0.6 0.16 0.373 0.477 0.225
0.3 0.7 0.17 0.420 0.504 0.315
0.2 0.8 0.18 0.472 0.531 0.405
0.1 0.9 0.19 0.527 0.558 0.495
0.0 0.0 0.20 0.585 0.585 0.585
65
66
Correlation = 0
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
0.0% 20.0% 40.0% 60.0% 80.0%
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Correlation = 1
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
0.0% 20.0% 40.0% 60.0% 80.0%
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n
Correlation = -1
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
0.0% 20.0% 40.0% 60.0% 80.0%
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n
3. a.
Portfolio r
σ
1 10.0% 5.1%
2 9.0 4.6
3 11.0 6.4
b. See the figure below. The set of portfolios is represented by the curved line. The
five points are the three portfolios from Part (a) plus the two following two
portfolios: one consists of 100% invested in X and the other consists of 100%
invested in Y.
c. See the figure below. The best opportunities lie along the straight line. From the diagram, the optimal portfolio of risky
assets is portfolio 1, and so Mr. Harrywitz should invest 50 percent in X and 50 percent in Y.-+
4. a. Expected return = (0.6 × 15) + (0.4 × 20) = 17%
Variance = (0.6)
2
× (20)
2
+ (0.4)
2
× (22)
2
+ 2(0.6)(0.4)(0.5)(20)(22) = 327
Standard deviation = (327)
(1/2)
= 18.1%
b. Correlation coefficient = 0 ⇒Standard deviation = 14.9%
Correlation coefficient = -0.5 ⇒Standard deviation = 10.8%
c. His portfolio is better. The portfolio has a higher expected return and a lower
standard deviation.
67
0
0.05
0.1
0.15
0 0.02 0.04 0.06 0.08 0.1
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
u
r
n

5. Internet exercise; answers will vary depending on time period.
6. Internet exercise; answers will vary depending on time period.
7. a.
b. Market risk premium = rm - rf = 0.12 - 0.04 = 0.08 = 8.0%
c. Use the security market line:
r = rf + β (rm - rf)
r = 0.04 + [1.5× (0.12 - 0.04)] = 0.16 = 16.0%
d. For any investment, we can find the opportunity cost of capital using the
security market line. With β = 0.8, the opportunity cost of capital is:
r = rf + β (rm - rf)
r = 0.04 + [0.8× (0.12 - 0.04)] = 0.104 = 10.4%
The opportunity cost of capital is 10.4 percent and the investment is
expected to earn 9.8 percent. Therefore, the investment has a negative
NPV.
e. Again, we use the security market line:
r = rf + β (rm - rf)
0.112 = 0.04 + β (0.12 - 0.04) ⇒ β = 0.9
8. Internet exercise; answers will vary depending on time period.
9. Internet exercise; answers will vary.
68
0
5
10
15
20
0 0.5 1 1.5 2
Beta
E
x
p
e
c
t
e
d

R
e
t
u
r
n
10. a. Percival’s current portfolio provides an expected return of 9 percent with
an annual standard deviation of 10 percent. First we find the portfolio
weights for a combination of Treasury bills (security 1: standard deviation
= 0 percent) and the index fund (security 2: standard deviation = 16
percent) such that portfolio standard deviation is 10 percent. In general,
for a two security portfolio:
σ P
2
= x1
2
σ 1
2
+ 2x1x2σ 1σ 2ρ 12 + x2
2
σ 2
2
(0.10)
2
= 0 + 0 + x2
2
(0.16)
2
x2 = 0.625 ⇒ x1 = 0.375
Further:
rp = x1r1 + x2r2
rp = (0.375 × 0.06) + (0.625 × 0.14) = 0.11 = 11.0%
Therefore, he can improve his expected rate of return without changing
the risk of his portfolio.
b. With equal amounts in the corporate bond portfolio (security 1) and the
index fund (security 2), the expected return is:
rp = x1r1 + x2r2
rp = (0.5 × 0.09) + (0.5 × 0.14) = 0.115 = 11.5%
σ P
2
= x1
2
σ 1
2
+ 2x1x2σ 1σ 2ρ 12 + x2
2
σ 2
2
σ P
2
= (0.5)
2
(0.10)
2
+ 2(0.5)(0.5)(0.10)(0.16)(0.10) + (0.5)
2
(0.16)
2
σ P
2
= 0.0097
σ P = 0.985 = 9.85%
Therefore, he can do even better by investing equal amounts in the
corporate bond portfolio and the index fund. His expected return
increases to 11.5% and the standard deviation of his portfolio decreases
to 9.85%.
11. No. Every stock has unique risk in addition to market risk. The unique risk reflects
uncertain events that are unrelated to the return on the market portfolio. The
Capital Asset Pricing Model does not predict these events. If the events are
favorable, the stock will do better than the model predicts. If the events are
unfavorable, the stock will do worse.
12. a. True
b. True
c. True
69
13. a. True. By definition, the factors represent macro-economic risks that
cannot be eliminated by diversification.
b. False. The APT does not specify the factors.
c. True. Investors will not take on nondiversifiable risk unless it entails a
d. True. Different researchers have proposed and empirically investigated
different factors, but there is no widely accepted theory as to what these
factors should be.
e. True. To be useful, we must be able to estimate the relevant parameters.
If this is impossible, for whatever reason, the model itself will be of
theoretical interest only.
14. For Stock P ⇒ r = (1.0)× (6.4%) + (-2.0)× (-0.6%) + (-0.2)× (5.1%) = 6.58%
For Stock P
2
⇒ r = (1.2)× (6.4%) + (0)× (-0.6%) + (0.3)× (5.1%) = 9.21%
For Stock P
3
⇒ r = (0.3)× (6.4%) + (0.5)× (-0.6%) + (1.0)× (5.1%) = 6.72%
15. a. Factor risk exposures:
b1(Market) = (1/3)× (1.0) + (1/3)× (1.2) + (1/3)× (0.3) = 0.83
b2(Interest rate) = (1/3)× (-2.0) +(1/3)× (0) + (1/3)× (0.5) = -0.50
b3(Yield spread) = (1/3)× (-0.2) + (1/3)× (0.3) + (1/3)× (1.0) = 0.37
b. rP = (0.83)× (6.4%) + (-0.50)× (-0.6%) + (0.37)× (5.1%) = 7.5%
16. rCC = 3.5% + (0.82 × 8.8%) + (-0.29 × 3.1%) + (0.24 × 4.4%) = 10.87%
rXON = 3.5% + (0.50 × 8.8%) + (0.04 × 3.1%) + (0.27 × 4.4%) = 9.21%
rP = 3.5% + (0.66 × 8.8%) + (-0.56 × 3.1%) + (-0.07 × 4.4%) = 7.26%
rR = 3.5% + (1.17 × 8.8%) + (0.73 × 3.1%) + (1.14 × 4.4%) = 21.08%
70
Challenge Questions
1. [NOTE: In the first printing of the seventh edition of the text, footnote 4 states
that, for the minimum risk portfolio, the investment in Reebok is 21.4%. This
figure is incorrect. The correct figure is 16.96%, as shown below.]
In general, for a two-security portfolio:
σ p
2
= x1
2
σ 1
2
+ 2x1x2σ 1σ 2ρ 12 + x2
2
σ 2
2
and:
x1 + x2 = 1
Substituting for x2 in terms of x1 and rearranging:
σ p
2
= σ 1
2
x1
2
+ 2σ 1σ 2ρ 12(x1 - x1
2
) + σ 2
2
(1 - x1)
2
Taking the derivative of σ p
2
with respect to x1, setting the derivative equal to
zero and rearranging:
x1(σ 1
2
- 2σ 1σ 2ρ 12 + σ 2
2
) + (σ 1σ 2ρ 12 - σ 2
2
) = 0
Let Coca-Cola be security one (σ 1 = 0.315) and Reebok be security two
(σ 2 = 0.585). Substituting these numbers, along with ρ 12 = 0.2, we have:
x1 = 0.8304
Therefore:
x2 = 0.1696
2. a. The ratio (expected risk premium/standard deviation) for each of the four
portfolios is as follows:
Portfolio A: (34.6 – 10.0)/110.6 = 0.222
Portfolio B: (21.6 – 10.0)/30.8 = 0.377
Portfolio C: (19.0 – 10.0)/23.7 = 0.380
Portfolio D: (13.4 – 10.0)/14.6 = 0.233
Therefore, an investor should hold Portfolio C.
71
b. The beta for Amazon relative to Portfolio C is equal to the ratio of the risk
premium of Amazon to the risk premium of the portfolio times the beta of
the portfolio:
[(34.6% - 10.0%)/(19% - 10%)] × 1.0 = 2.733
Similarly, the betas for the remainder of the holdings are as follows:
β Amazon
= 2.733
β Boeing
= 0.333
β Dell
= 1.800
β EX-M
= 0.200
β GE
= 0.889
β McD
= 0.444
β Pfizer
= 0.533
β Reebok
= 1.111
c. If the interest rate is 5%, then Portfolio C remains the optimal portfolio, as
indicated by the following calculations:
Portfolio A: (34.6 – 5.0)/110.6 = 0.268
Portfolio B: (21.6 – 5.0)/30.8 = 0.539
Portfolio C: (19.0 – 5.0)/23.7 = 0.591
Portfolio D: (13.4 – 5.0)/14.6 = 0.575
The betas for the holdings in Portfolio C become:
β Amazon
= 2.114
β Boeing
= 0.571
β Dell
= 1.514
β EX-M
= 0.486
β GE
= 0.929
β McD
= 0.643
β Pfizer
= 0.700
β Reebok
= 1.071
72
3 Whether the APT can be used to make money is a question related to competition in
the financial markets. Given sufficient competition, no widely-known model will
provide an advantage (i.e., enable someone to make a return above that
expected, given the level of risk undertaken). So, whether an economic model
enables one to make money is not relevant to the validity of that model. To put
this somewhat differently, the validity of an economic model hinges on whether
the model enables us to better identify and understand relationships among key
parameters, not whether the model can be used to make money.
4. Let rx be the risk premium on investment X, let xx be the portfolio weight of X (and
similarly for Investments Y and Z, respectively).
a. rx = (1.75)× (0.04) + (0.25)× (0.08) = 0.09 = 9.0%
ry = (-1.00)× (0.04) + (2.00)× (0.08) = 0.12 = 12.0%
rz = (2.00)× (0.04) + (1.00)× (0.08) = 0.16 = 16.0%
b. This portfolio has the following portfolio weights:
xx = 200/(200 + 50 - 150) = 2.0
xy = 50/(200 + 50 - 150) = 0.5
xz = -150/(200 + 50 - 150) = -1.5
The portfolio’s sensitivities to the factors are:
Factor 1: (2.0)× (1.75) + (0.5)× (-1.00) – (1.5)× (2.00) = 0
Factor 2: (2.0)× (0.25) + (0.5)× (2.00) – (1.5)× (1.00) = 0
Because the sensitivities are both zero, the expected risk premium is zero.
c. This portfolio has the following portfolio weights:
xx = 80/(80 + 60 - 40) = 0.8
xy = 60/(80 + 60 - 40) = 0.6
xz = -40/(80 + 60 - 40) = -0.4
The sensitivities of this portfolio to the factors are:
Factor 1: (0.8)× (1.75) + (0.6)× (-1.00) – (0.4)× (2.00) = 0
Factor 2: (0.8)× (0.25) + (0.6)× (2.00) – (0.4)× (1.00) = 1.0
The expected risk premium for this portfolio is equal to the expected risk
premium for the second factor, or 8 percent.
73
d. This portfolio has the following portfolio weights:
xx = 160/(160 + 20 - 80) = 1.6
xy = 20/(160 + 20 - 80 ) = 0.2
xz = -80/(160 + 20 - 80) = -0.8
The sensitivities of this portfolio to the factors are:
Factor 1: (1.6)× (1.75) + (0.2)× (-1.00) - (0.8)× (2.00) = 1.0
Factor 2: (1.6)× (0.25) + (0.2)× (2.00) – (0.8)× (1.00) = 0
The expected risk premium for this portfolio is equal to the expected risk
premium for the first factor, or 4 percent.
e. The sensitivity requirement can be expressed as:
Factor 1: (xx)(1.75) + (xy)(-1.00) + (xz)(2.00) = 0.5
xx + xy + xz = 1
With two linear equations in three variables, there is an infinite number of
solutions. Two of these are:
1. xx = 0 xy = 0.5 xz = 0.5
2. xx = (6/11) xy = (5/11) xz = 0
The risk premiums for these two funds are:
r1 = 0× [(1.75 × 0.04) + (0.25 × 0.08)]
+ (0.5)× [(-1.00 × 0.04) + (2.00 × 0.08)]
+ (0.5)× [(2.00 × 0.04) + (1.00 × 0.08)] = 0.14 = 14.0%
r2 = (6/11)× [(1.75 × 0.04) + (0.25 × 0.08)]
+(5/11)× [(-1.00 × 0.04) + (2.00 × 0.08)]
+0 × [(2.00 × 0.04) + (1.00 × 0.08)] = 0.104 = 10.4%
These risk premiums differ because, while each fund has a sensitivity of
0.5 to factor 1, they differ in their sensitivities to factor 2.
74
f. Because the sensitivities to the two factors are the same as in Part (b),
one portfolio with zero sensitivity to each factor is given by:
xx = 2.0 xy = 0.5 xz = -1.5
The risk premium for this portfolio is:
(2.0)× (0.08) + (0.5)× (0.14) – (1.5)× (0.16) = -0.01
Because this is an example of a portfolio with zero sensitivity to each
factor and a nonzero risk premium, it is clear that the Arbitrage Pricing
Theory does not hold in this case.
A portfolio with a positive risk premium is:
xx = -2.0 xy = -0.5 xz = 1.5
75
CHAPTER 9
Capital Budgeting and Risk
1. It is true that the cost of capital depends on the risk of the project being evaluated. However, if the risk of the project is similar to the
risk of the other assets of the company, then the appropriate rate of return is the company cost of capital.
2. Internet exercise; answers will vary.
3. Internet exercise; answers will vary.
4. a. Both British Petroleum and British Airways had R
2
values of 0.25, which means that, for both stocks 25% of total risk
comes from movements in the market (i.e., market risk). Therefore, 75% of total risk is unique risk.
b. The variance of British Petroleum is: (25)
2
= 625
Unique variance for British Petroleum is: (0.75 × 625) = 468.75
c. The t-statistic for β BA is: (0.90/0.17) = 5.29
This is significant at the 1% level, so that the confidence level is 99%.
d. rBP = rf + β BP × (rm - rf) = 0.05 + (1.37)× (0.12 – 0.05) = 0.1459 = 14.59%
e. rBP = rf + β BP × (rm - rf) = 0.05 + (1.37)× (0 – 0.05) = -0.0185 = -1.85%
5. Internet exercise; answers will vary.
6. If we don’t know a project’s β , we should use our best estimate. If β ’s are uncertain, the required return depends on the expected β . If
we know nothing about a project’s risk, our best estimate of β is 1.0, but we usually have some information on the project that allows
us to modify this prior belief and make a better estimate.
76
7. a. The total market value of outstanding debt is 300,000 euros. The cost of debt capital is 8 percent. For the common stock,
the outstanding market value is: (50 euros × 10,000) = 500,000 euros. The cost of equity capital is 15 percent. Thus, Lorelei’s weighted-
average cost of capital is:
) (0.15
500,000 300,000
500,000
(0.08)
500,000 300,000
300,000
r
assets
×

,
`

.
|
+
+ ×

,
`

.
|
+
·
rassets = 0.124 = 12.4%
b. Because business risk is unchanged, the company’s weighted-average cost of capital will not change. The financial
structure, however, has changed. Common stock is now worth 250,000 euros. Assuming that the market value of debt and
the cost of debt capital are unchanged, we can use the same equation as in Part (a) to calculate the new equity cost of
capital, requity:
)
equity
r (
250,000 300,000
250,000
(0.08)
250,000 300,000
300,000
0.124 ×

,
`

.
|
+
+ ×

,
`

.
|
+
·
requity = 0.177 = 17.7%
8. a. rBN = rf + β BN × (rm - rf) = 0.035 + (0.64 × 0.08) = 0.0862 = 8.62%
rIND = rf + β IND × (rm - rf) = 0.035 + (0.50 × 0.08) = 0.075 = 7.50%
b. No, we can not be confident that Burlington’s true beta is not the industry average. The difference between β BN and β IND
(0.14) is less than one standard error (0.20), so we cannot reject the hypothesis that β BN = β IND.

c. Burlington’s beta might be different from the industry beta for a variety of reasons. For example, Burlington’s business
might be more cyclical than is the case for the typical firm in the industry. Or Burlington might have more fixed operating
costs, so that operating leverage is higher. Another possibility is that Burlington has more debt than is typical for the
industry so that it has higher financial leverage.
d. Company cost of capital = (D/V)(rdebt) + (E/V)(requity)
Company cost of capital = (0.4 × 0.06) + (0.6 × 0.075) = 0.069 = 6.9%
77
9. a. With risk-free debt: β assets = E/V × β equity
Therefore:
β food = 0.7 × 0.8 = 0.56
β elec = 0.8 × 1.6 = 1.28
β chem= 0.6 × 1.2 = 0.72
b. β assets = (0.5 × 0.56) + (0.3 × 1.28) + (0.2 × 0.72) = 0.81
Still assuming risk-free debt:
β assets = (E/V) × (β equity)
0.81 = (0.6) × (β equity)
β equity = 1.35
c. Use the Security Market Line:
rassets = rf + β assets × (rm - rf)
We have:
rfood = 0.07 + (0.56)× (0.15 - 0.07) = 0.115 = 11.5%
relec = 0.07 + (1.28)× (0.15 - 0.07) = 0.172 = 17.2%
rchem = 0.07 + (0.72)× (0.15 - 0.07) = 0.128 = 12.8%
d. With risky debt:
β food = (0.3 × 0.2) + (0.7 × 0.8) = 0.62 ⇒rfood = 12.0%
β elec = (0.2 × 0.2) + (0.8 × 1.6) = 1.32 ⇒relec = 17.6%
β chem = (0.4 × 0.2) + (0.6 × 1.2) = 0.80 ⇒rchem = 13.4%
10.
Ratio of σ ’s Correlation Beta
Egypt 3.11 0.5 1.56
Poland 1.93 0.5 0.97
Thailand 2.91 0.5 1.46
Venezuela 2.58 0.5 1.29
The betas increase compared to those reported in Table 9.2 because the returns for these markets are now more highly correlated with
the U.S. market. Thus, the contribution to overall market risk becomes greater.
11. Foreign capital investment projects will be evaluated on the basis of the amount of market risk the project brings to the portfolio. Further,
the decrease in diversifiable country bias may result in higher overall correlations.
12. The information could be helpful to a U.S. company considering international capital investment projects. By examining the beta
estimates, such companies can evaluate the contribution to risk of the potential cash flows.
78
A German company would not find this information useful. The relevant risk depends on the beta of the country relative to the
portfolio held by investors. German investors do not invest exclusively, or even primarily, in U.S. company stocks. They invest the
major portion of their portfolios in German company stocks.
13. a. The threat of a coup d’état means that the expected cash flow is less than \$250,000. The threat could also increase the
discount rate, but only if it increases market risk.
b. The expected cash flow is: [(0.25 × 0) + (0.75 × 250,000)] = \$187,500
Assuming that the cash flow is about as risky as the rest of the company’s business:
PV = \$187,500/1.12 = \$167,411
14. a. Expected daily production =
(0.2 × 0) + (0.8) × [(0.4 x 1,000) + (0.6 x 5,000)] = 2,720 barrels
Expected annual cash revenues = 2,720 x 365 x \$15 = \$14,892,000
b. The possibility of a dry hole is a diversifiable risk and should not affect the discount rate. This possibility should affect
forecasted cash flows, however. See Part (a).
15. The opportunity cost of capital is given by:
r = rf + β (rm - rf) = 0.05 + (1.2)× (0.06) = 0.122 = 12.2%
Therefore:
CEQ1 = 150(1.05/1.122) = 140.37
CEQ2 = 150(1.05/1.122)
2
= 131.37
CEQ3 = 150(1.05/1.122)
3
= 122.94
CEQ4 = 150(1.05/1.122)
4
= 115.05
CEQ5 = 150(1.05/1.122)
5
= 107.67
79
a1 = 140.37/150 = 0.9358
a2 = 131.37/150 = 0.8758
a3 = 122.94/150 = 0.8196
a4 = 115.05/150 = 0.7670
a5 = 107.67/150 = 0.7178
From this, we can see that the a t values decline by a constant proportion each year:
a2/a1 = 0.8758/0.9358 = 0.9358
a3/a2 = 0.8196/0.8758 = 0.9358
a4/a3 = 0.7670/0.8196 = 0.9358
a5/a4 = 0.7178/0.7670 = 0.9358
16. a. Using the Security Market Line, we find the cost of capital:
r = 0.07 + 1.5× (0.16 - 0.07) = 0.205 = 20.5%
Therefore:
b.
CEQ1 = 40× (1.07/1.205) = 35.52
CEQ2 = 60× (1.07/1.205)
2
= 47.31
CEQ3 = 50× (1.07)/1.205)
3
= 35.01
c.
a1 = 35.52/40 = 0.8880
a2 = 47.31/60 = 0.7885
a3 = 35.01/50 = 0.7001
d. Using a constant risk-adjusted discount rate is equivalent to assuming that at decreases at a constant compounded rate.
80
103.09
1.205
50
1.205
60
1.205
40
PV
3 2
· + + ·
17. At t = 2, there are two possible values for the project’s NPV:
Therefore, at t = 0:
81
0 ) successful not is test if ( NPV
2
·
\$833,333
0.12
700,000
5,000,000 ) successful is test if ( NPV
2
· + − ·
\$244,898
1.40
833,333) .60 (0 0) (0.40
500,000 NPV
2
0
− ·
× + ×
+ − ·
Challenge Questions
1. It is correct that, for a high beta project, you should discount all cash flows at a high rate. Thus, the higher the risk of the cash
outflows, the less you should worry about them because, the higher the discount rate, the closer the present value of these cash flows is
to zero. This result does make sense. It is better to have a series of payments that are high when the market is booming and low when
it is slumping (i.e., a high beta) than the reverse.
The beta of an investment is independent of the sign of the cash flows. If an investment has a high beta for anyone paying out the cash
flows, it must have a high beta for anyone receiving them. If the sign of the cash flows affected the discount rate, each asset would
have one value for the buyer and one for the seller, which is clearly an impossible situation.
2. a. The real issue is the degree of risk relative to the investor’s portfolio. If German investors hold a stock portfolio comprised
largely of German equities, then they are likely to find that U.S. pharmaceutical stocks are less highly correlated with their
portfolios than they are with U.S. stocks, and will therefore have lower betas. This suggests that German investors might
require a lower return for investing in U.S. pharmaceutical companies than U.S. investors require. That does not
necessarily imply that they should move their R&D and production facilities to the U.S. however. First, there might be
extra costs involved in managing the business in a foreign country. Also, R&D that simply serves a German parent
company may be more highly correlated with the German market.
b. The answer here depends on the reason that German investors keep much of their money at home. If there are high costs for shareholders to
invest overseas, then the German company may well provide its shareholders with a service by providing them with cheap international
diversification.
c. Not necessarily. The German company needs to be remunerated only for the risk it is taking relative to its German
portfolio. If the German company holds a portfolio comprised primarily of U.S. holdings, then 13% is the appropriate rate.
82
3. a. Since the risk of a dry hole is unlikely to be market-related, we can use the same discount rate as for producing wells.
Thus, using the Security Market Line:
rnominal = 0.06 + (0.9)× (.08) = 0.132 = 13.2%
We know that:
(1 + rnominal) = (1 + rreal) × (1 + rinflation)
Therefore:
8.85% 0.0885 1
1.04
1.132
r
real
· · − ·
b.
d. Expected income from Well 1: [(0.2 × 0) + (0.8 × 3 million)] = \$2.4 million
Expected income from Well 2: [(0.2 × 0) + (0.8 × 2 million)] = \$1.6 million
Discounting at 8.85 percent gives.
e. For Well 1, one can certainly find a discount rate (and hence a “fudge factor”) that, when applied to cash flows of \$3
million per year for 10 years, will yield the correct NPV of \$5,504,600. Similarly, for Well 2, one can find the appropriate
discount rate. However, these two “fudge factors” will be different. Specifically, Well 2 will have a smaller “fudge factor”
because its cash flows are more distant. With more distant cash flows, a smaller addition to the discount rate has a larger
impact on present value.
4. Internet exercise; answers will vary.
83
(3.1914)] (3million) million 10
1.2885
3million
million 10 NPV
10
1 t
t
1
× + − · + − ·

·
[
\$425,800 NPV
1
− ·
(3.3888)] (2million) [ 10million
1.2885
2million
million 10 NPV
15
1 t
t
2
× + − · + − ·

·
\$3,222,300 NPV
2
− ·
(6.4602)] n) (2.4millio [ million 10
1.0885
2.4million
million 10 NPV
10
1 t
t
1
× + − · + − ·

·
\$5,504,600 NPV
1
·
(8.1326)] n) (1.6millio [ 10million
1.0885
1.6million
million 10 NPV
15
1 t
t
2
× + − · + − ·

·
\$3,012,100 NPV
2
·
CHAPTER 10
A Project is Not a Black Box
1.
Year 0 Years 1-10
Investment ¥15 B
1. Revenue ¥44.00 B
2. Variable Cost 39.60 B
3. Fixed Cost 2.00 B
4. Depreciation 1.50 B
5. Pre-tax Profit ¥0.90 B
6. Tax @ 50% 0.45 B
7. Net Operating Profit ¥0.45 B
8. Operating Cash Flow ¥1.95 B
2. Following the calculations in Section 10.1 of the text, we find:
NPV
Pessimistic Expected Optimistic
Market Size -1.2 3.4 8.0
Market Share -10.4 3.4 17.3
Unit Price -19.6 3.4 11.1
Unit Variable Cost -11.9 3.4 11.1
Fixed Cost -2.7 3.4 9.6
The principal uncertainties appear to be market share, unit price, and unit
variable cost.
3. a.
Year 0 Years 1-10
Investment ¥30 B
1. Revenue ¥37.5 B
2. Variable Cost 26.0
3. Fixed Cost 3.0
4. Depreciation 3.0
5. Pre-tax Profit (1-2-3-4) ¥5.5
6. Tax 2.75
7. Net Operating Profit (5-6) ¥2.75
8. Operating Cash Flow (4+7) 5.75
84
¥3.02B
1.10
¥1.95B
¥15B - NPV
10
1 t
t
− · + ·

·
Net cash flow - ¥30 B + ¥5.33 B
b. (See chart on next page.)
Inflows Outflows
Unit Sales Revenues Investment V. Costs F. Cost Taxes PV PV NPV
(000’s) Yrs 1-10 Yr 0 Yr 1-10 Yr 1-10 Yr 1-10 Inflows Outflows
0 0.00 30.00 0.00 3.00 -3.00 0.0 -30.0 -30.0
100 37.50 30.00 26.00 3.00 2.75 230.4 -225.1 5.3
200 75.00 60.00 52.00 3.00 7.00 460.8 -441.0 19.8
Note that the break-even point can be found algebraically as follows:
NPV = -Investment + [PV × (t × Depreciation)] +
[Quantity × (Price - V.Cost) - F.Cost]× (1 - t)× (PVA
10/10%
)
Set NPV equal to zero and solve for Q:
Proof:
1. Revenue ¥31.8 B
2. Variable Cost 22.1
3. Fixed Cost 3.0
4. Depreciation 3.0
5. Pre-tax Profit ¥3.7 B
6. Tax 1.85
7. Net Profit ¥1.85
8. Operating Cash Flow ¥4.85
0.2 30 8 29. 30
(1.10)
4.85
NPV
10
1 t
t
− · − · − ·

·
85
V P
F
t) (1 V) (P ) (PVA
t) D (PV I
Q
10/10%

+
− × − ×
× × −
·
260,000 375,000
000 3,000,000,
(0.5) 260,000) (375,000 (6.144567)
659 9,216,850, ,000 30,000,000

+
× − ×

·
84,910.7 26,087.0 58,823.7
115,000
000 3,000,000,
353,313
,342 20,783,149
· + · + ·
) rounding to due difference (
c. The break-even point is the point where the present value of the cash flows, including the opportunity cost of capital, yields
a zero NPV.
d. To find the level of costs at which the project would earn zero profit, write the
equation for net profit, set net profit equal to zero, and solve for variable costs:
Net Profit = (R - VC - FC - D)× (1 - t)
0 = (37.5 - VC – 3.0 – 1.5)× (0.5)
VC = 33.0
This will yield zero profit.
Next, find the level of costs at which the project would have zero NPV. Using the
data in Table 10.1, the equivalent annual cash flow yielding a zero NPV would
be:
¥15 B/PVA
10/10%
= ¥2.4412 B
86
0
50
100
150
200
250
300
350
400
450
500
0 100 200
Units
(000's)
P
V

(
B
i
l
l
i
o
n
s

o
f

Y
e
n
)

Break-Even
Break-Even
NPV = 0
PV Inflows
PV Outflows
If we rewrite the cash flow equation and solve for the variable cost:
NCF = [(R - VC - FC - D)× (1 - t)] + D
2.4412 = [(37.5 - VC – 3.0 – 1.5)× (0.5)] + 1.5
VC = 31.12
This will yield NPV = 0, assuming the tax credits can be used elsewhere in the company.
4. If Rustic replaces now rather than in one year, several things happen:
i. It incurs the equivalent annual cost of the \$10 million capital investment.
ii. It reduces manufacturing costs.
iii. It earns a return for 1 year on the \$1 million salvage value.
For example, for the “Expected” case, analyzing “Sales” we have (all dollar
figures in millions):
i. The economic life of the new machine is expected to be 10 years, so the equivalent annual cost of the new machine is:
10/5.6502 = 1.77
ii. The reduction in manufacturing costs is:
(0.5) × (4) = 2.00
iii. The return earned on the salvage value is:
(0.12) × (1) = 0.12
Thus, the equivalent annual cost savings is:
-1.77 + 2.0 + 0.12 = 0.35
Continuing the analysis for the other cases, we find:
Equivalent Annual Cost Savings (Millions)
Pessimistic Expected Optimistic
Sales -0.05 0.35 1.15
Manufacturing Cost -0.65 0.35 0.85
Economic Life -0.07 0.35 0.56
5. From the solution to Problem 4, we know that, in terms of potential negative outcomes, manufacturing cost is the key variable. Rustic
should go ahead with the study, because the cost of the study is considerably less than the possible annual loss if the pessimistic
manufacturing cost estimate is realized.
6. a. ‘Optimistic’ and ‘pessimistic’ rarely show the full probability distribution of outcomes.
b. Sensitivity analysis changes variables one at a time, while in practice, all variables change, and the changes are often
interrelated. Sensitivity analysis using scenarios can help in this regard.
87
7. a.
sales in change %
income operating in change %
leverage Operating ·
For a 1% increase in sales, from 100,000 units to 101,000 units:
2.50
37.5 / 0.375
3 / 0.075
leverage Operating · ·
b.
profit operating
n deprecatio cost fixed
1 leverage Operating
+
+ ·
2.5
3.0
1.5) (3.0
1 ·
+
+ ·
c.
sales in change %
income operating in change %
leverage Operating ·
For a 1% increase in sales, from 200,000 units to 202,000 units:
.43
/75 75) - (75.75
10.5)/10.5 - (10.65
leverage Operating 1 · ·
8. This is an opened-ended question, and the answer is a matter of opinion. However, a satisfactory answer should make the following points
regarding Monte Carlo simulation:
a. It is more likely to be worthwhile if a large amount of money is at stake.
b. It will be most useful for a complex project with cash flows that depend on several interacting variables; forecasting cash
flows and assessing risks is likely to be particularly difficult for such projects.
c. It is most useful when it can be applied to a series of similar projects, so that the decision-maker can make the personal
investment necessary to understand the technique and gain experience in interpreting the output.
d. It is most likely to be useful to large companies in industries that require major investments. For example, capital intensive
industries, such as oil refining, chemicals, steel, and mining, or the pharmaceutical industry, require large investments in
research and development.
9.
88
Pilot production
and market tests
Observe
demand
High demand
(50%
probability)
Low demand
(50%
probability)
Invest in full-scale production:
NPV = -1000 + (250/0.10)
= +\$1,500
Stop:
NPV = \$0
[ For full-scale production:
NPV = -1000 + (75/0.10)
= -\$250 ]
10. a. Timing option
b. Expansion option
c. Abandonment option
d. Production option
e. Expansion option
11. a. The expected value of the NPV for the plant is:
(0.5 × \$140 million) + (0.5 × \$50 million) - \$100 million = -\$5 million
Since the expected NPV is negative you would not build the plant.
b. The expected NPV is now:
(0.5 × \$140 million) + (0.5 × \$90 million) - \$100 million = +\$15 million
Since the expected NPV is now positive, you would build the plant.
89
c.
12. (See Figure 10.9, which is a revision of Figure 10.8 in the text.)
We analyze the decision tree by working backwards. So, for example, if we purchase the piston plane and demand is high:
• The NPV at t = 1 of the ‘Expanded’ branch is:
• The NPV at t = 1 of the ‘Continue’ branch is:
Thus, if we purchase the piston plane and demand is high, we should expand further at t = 1. This branch has the highest NPV.
Similarly, if we purchase the piston plane and demand is low:
• The NPV of the ‘Continue’ branch is:
90
\$461
1.08
100) .2 (0 800) (0.8
150 ·
× + ×
+ −
\$337
1.08
180) .2 (0 410) (0.8
·
× + ×
\$137
1.08
100) .6 (0 220) (0.4
·
× + ×
Build auto plant
(Cost = \$100
million)
Observe
demand
Line is
successful
(50%
probability)
Line is
unsuccessful
(50% probability)
Continue production:
NPV = \$140 million - \$100 million
= +\$40 million
Continue production:
NPV = \$50 million –
\$100 million
= - \$50 million
Sell plant:
NPV = \$90 million –
\$100 million
= - \$10 million
• We can now use these results to calculate the NPV of the ‘Piston’ branch at t = 0:
• Similarly for the ‘Turbo’ branch, if demand is high, the expected cash flow at t = 1 is:
(0.8 × 960) + (0.2 × 220) = \$812
• If demand is low, the expected cash flow is:
(0.4 × 930) + (0.6 × 140) = \$456
• So, for the ‘Turbo’ branch, the combined NPV is:
\$319
(1.08)
456) .4 (0 812) (0.6
(1.08)
30) .4 (0 150) (0.6
350 NPV
2
·
× + ×
+
× + ×
+ − ·
Therefore, the company should buy the turbo plane.
In order to determine the value of the option to expand, we first compute the NPV without the option to expand:
+
× + ×
+ − ·
(1.08)
50) .4 (0 100) (0.6
250 NPV
\$62.07
(1.08)
100)] (0.6 220) (0.4)[(0.4 180)] .2 (0 410) (0.6)[(0.8
2
·
× + × + × + ×
Therefore, the value of the option to expand is: \$201 - \$62 = \$139
91
\$201
1.08
137) (50 .4) (0 461) (100 (0.6)
180 ·
+ × + + ×
+ −
92
FIGURE 10.9
Turbo
-\$350
Piston
-\$180
Hi demand (.6)
\$150
Lo demand (.4)
\$30
Hi demand (.6)
\$100
Lo demand (.4)
\$50
Continue
Hi demand (.8)
\$960
Lo demand (.2)
\$220
Continue
Expand
-\$150
Continue
Continue
Hi demand (.4)
\$930
Lo demand (.6)
\$140
Hi demand (.8)
\$800
Lo demand (.2)
\$100
Hi demand (.8)
\$410
Lo demand (.2)
\$180
Hi demand (.4)
\$220
Lo demand (.6)
\$100
13. a. Ms. Magna should be prepared to sell either plane at t = 1 if the present value of the expected cash flows is less than the
present value of selling the plane.
b. See Figure 10.10, which is a revision of Figure 10.8 in the text.
c. We analyze the decision tree by working backwards. So, for example, if we purchase the piston plane and demand is high:
 The NPV at t = 1 of the ‘Expand’ branch is:
 The NPV at t = 1 of the ‘Continue’ branch is:
 The NPV at t = 1 of the ‘Quit’ branch is \$150.
Thus, if we purchase the piston plane and demand is high, we should expand further at t = 1 because this branch has the
highest NPV.
Similarly, if we purchase the piston plane and demand is low:
 The NPV of the ‘Continue’ branch is:
 The NPV of the ‘Quit’ branch is \$150
Thus, if we purchase the piston plane and demand is low, we should sell the plane at t = 1 because this alternative has a
higher NPV.
Putting these results together, we calculate the NPV of the ‘Piston’ branch at t = 0:
 Similarly for the ‘Turbo’ branch, if demand is high, the NPV at t = 1 is:
 The NPV at t = 1 of ‘Quit’ is \$500.
 If demand is low, the NPV at t = 1 of ‘Quit’ is \$500.
 The NPV of ‘Continue’ is:
93
\$461
1.08
100) .2 (0 800) (0.8
150 ·
× + ×
+ −
\$337
1.08
180) .2 (0 410) (0.8
·
× + ×
\$137
1.08
100) .6 (0 220) (0.4
·
× + ×
\$206
1.08
150) (50 .4) (0 461) (100 (0.6)
180 ·
+ × + + ×
+ −
\$752
1.08
220) .2 (0 960) (0.8
·
× + ×
\$422
1.08
140) .6 (0 930) (0.4
·
× + ×
In this case, ‘Quit’ is better than ‘Continue.’ Therefore, for the ‘Turbo’ branch at t = 0, the NPV is:
With the abandonment option, the turbo has the greater NPV, \$347 compared to \$206 for the piston.
d. The value of the abandonment option is different for the two different planes. For the piston plane, without the
abandonment option, NPV at t = 0 is:
Thus, for the piston plane, the abandonment option has a value of:
\$206 - \$201 = \$5
For the turbo plane, without the abandonment option, NPV at t = 0 is:
For the turbo plane, the abandonment option has a value of:
\$347 - \$319 = \$28
14. Decision trees can help the financial manager to better understand a capital investment project because they illustrate how future
decisions can mitigate disasters or help to capitalize on successes. However, decision trees are not complete solutions to the valuation
of real options because they cannot show all possibilities and they do not inform the manager how discount rates can change as we go
through the tree.
94
\$347
1.08
500) (30 .4 0 752) (150 0.6
350 ·
+ × + + ×
+ −
\$201
1.08
137) (50 0.4 461) (100 0.6
180 ·
+ × + + ×
+ −
\$319
1.08
422) (30 .4 0 752) (150 0.6
350 ·
+ × + + ×
+ −
95
FIGURE 10.10
Turbo
-\$350
Piston
-\$180
Hi demand (.6)
\$150
Lo demand (.4)
\$30
Hi demand (.6)
\$100
Lo demand (.4)
\$50
Continue
Quit
Hi demand (.8)
\$960
Lo demand (.2)
\$220
Continue
Quit
Expand
-\$150
Continue
Quit
Continue
Quit
Hi demand (.4)
\$930
Lo demand (.6)
\$140
Hi demand (.8)
\$800
Lo demand (.2)
\$100
Hi demand (.8)
\$410
Lo demand (.2)
\$180
Hi demand (.4)
\$220
Lo demand (.6)
\$100
\$500
\$500
\$150
\$150
Challenge Questions
1. a. 1. Assume we open the mine at t = 0. Taking into account the distribution of possible future prices of gold over
the next 3 years, we have:
1.10
460] 450) .5 (0 550) [(0.5 (1,000)
100,000 NPV
− × + × ×
+ − ·
2
2
1.10
460] 400) 500 500 (600 ) [(0.5 (1,000) − + + + × ×
+
\$526
1.10
460] 350) 450 450 450 550 550 550 (650 ) [(0.5 (1,000)
3
3
− ·
− + + + + + + + × ×
+
Notice that the answer is the same if we simply assume that the price of gold remains at \$500. This is because, at t = 0, the
expected price for all future periods is \$500.
Because this NPV is negative, we should not open the mine at t = 0. Further, we know that it does not make sense to plan
to open the mine at any price less than or equal to \$500 per ounce.
2. Assume we wait until t = 1 and then open the mine if the price is \$550. At that point:
Since it is equally likely that the price will rise or fall by \$50 from its level at the start of the year,
then, at t = 1, if the price reaches \$550, the expected price for all future periods is then \$550. The NPV, at t = 0, of this NPV at t = 1 is:
\$123,817/1.10 = \$112,561
If the price rises to \$550 at t = 1, we should open the mine at that time. The expected NPV of this
strategy is:
(0.50 × 112,561) + (0.50 × 0) = 56,280.5
b. 1. Suppose you open at t = 0, when the price is \$500. At t = 2, there is a 0.25 probability that the price will be \$400.
Then, since the price at t = 3 cannot rise above the extraction cost, the mine should be closed. At t = 1, there is a 0.5
probability that the price will be \$450. In that case, you face the following, where each branch has a probability of 0.5:
t = 1 t = 2 t = 3
⇒ 550
⇒ 500
450 ⇒ 450
⇒ 400 ⇒ Close mine
To check whether you should close the mine at t = 1, calculate the PV with the mine open:
\$7,438
1.10
460) (400 1,000
.5) (0
1.10
460) (500 1,000
.5) (0 PV
2
1 t
t
·
− ×
× +
− ×
·

·
96
\$123,817
1.10
460) (550 (1,000)
100,000 NPV
3
1 t
t
·
− ×
+ − ·

·
Thus, if you open the mine when the price is \$500, you should not close if the price is \$450 at t = 1, but you should close if
the price is \$400 at t = 2. There is a 0.25 probability that the price will be \$400 at t = 1, and then you will save an expected loss of \$60,000
at t = 3. Thus, the value of the option to close is:
Now calculate the PV, at t = 1, for the branch with price equal to \$550:
\$246,198
1.10
90,000
PV
2
0 t
t
· ·

·
The expected PV at t = 1, with the option to close, is:
(0.5) × [7,438 + (450 – 460) × (1,000)] + (0.5 × 246,198) = \$121,818
The NPV at t = 0, with the option to close, is:
NPV = 121,818/1.10 – 100,000 = \$10,744
Therefore, opening the mine at t = 0 now has a positive NPV.
We can verify this result by noting that the NPV from part (a) (without the option to abandon) is -\$526, and the value of
the option to abandon is \$11,270 so that the NPV with the option to abandon is:
NPV = -\$526 + \$11,270 = 10,744
2. Now assume that we wait until t = 1 and then open the mine if the price is
\$550 at that time. For this strategy, the mine will be abandoned if price reaches \$450 at t = 3 because the expected profit at t = 4 is: [(450 –
460) × 1,000] = -\$10,000
Thus, with this strategy, the value of the option to close is:
(0.125) × (10,000/1.10
4
) = \$854
Therefore, the NPV for this strategy is: \$56,280.5 [the NPV for this strategy from part (a)] plus the
value of the option to close:
NPV = \$56,280.5 + \$854 = \$57,134.5
The option to close the mine increases the net present value for each strategy, but the optimal choice
remains the same; that is, strategy 2 is still the preferable alternative because its NPV (\$57,134.5) is still greater than the NPV for strategy 1
(\$10,744).
2. See Figure 10.11. The choice is between buying the computer or renting.
The cost is \$2,000 at t = 0. If demand is high at t = 1, we will have, at that time:
(\$900 - \$500) = \$400
If demand is high at t = 1, there is an 80 percent chance that demand will continue high for the remaining time (until t = 10). The
present value (at t = 1) of \$400 per year for 9 years is \$2,304. Because there is an 80 percent chance demand will be high for the
remaining time, there is a 20 percent chance it will be low, in which case we will get (\$700 - \$500) = \$200 per year. This has a
present value of \$1,152. Similar calculations are made for the case of low initial demand.
If we rent:
97
\$11,270
1.10
60) (1,000
(0.25)
3
·
×
×
The cost is 40 percent of revenue per year, so if demand is high at t = 1, then we will get:
[(\$900 - \$500) – (0.4× \$900)] = \$40
If demand continues high, we get \$40 per year for the remaining time. This has a present value of \$230. If demand is low at t = 2, we
will get:
[(\$70 - \$500) – (0.4× \$700)] = -\$80
In this case, it pays to stop renting after low demand in year 2 because we know this low demand will continue. Similar calculations
are made for the case of low initial demand.
From the tree (Figure 10.11):
PVRent = \$100.36 or \$100,360
The computer should be rented, not purchased.
3. In the extreme case, if future cash flows are known with certainty, options have no value because optimal choices can be determined
with certainty. Therefore, the option to choose other alternative courses of action has no value to the decision-maker. On the other
hand, the option to abandon a project has value if there is a chance that demand for a product will not meet expectations, so that cash
flows are below expectations. Or, the option to expand a project has value if there is a chance that demand w ill exceed expectations.
98
1.10
200) .4 (0 400) (0.6
2,000 PV
× + ×
+ − ·
1.10
1,152)] .6 (0 2,304) [(0.4 .4) (0 ] 1,152) .2 (0 2,304) [(0.8 (0.6) × + × + × + ×
+
1.10
80)] ( .4 [0 40) (0.6
PV
Rent
− × + ×
·
1.10
] 80) ( .6) (0 230) [(0.4 .4) (0 ] 80) ( .2) (0 230) [(0.8 (0.6) − × + × + − × + ×
+
99
FIGURE 10.11
-\$2000
Rent
Hi demand (.6)
\$400
Lo demand (.4)
\$200
Hi demand (.6)
\$40
Lo demand (.4)
-\$80
Hi demand (.8)
\$2304*
Lo demand (.2)
\$1152*
Hi demand (.4)
2304*
Lo demand (.6)
1152*
Hi demand (.8)
\$230*
Lo demand (.2)
\$-80
Hi demand (.4)
\$230*
Lo demand (.6)
-\$80
Stop
Stop
*PV at t = 1 of cash flows from years 2-10.
CHAPTER 11
Where Positive Net Present Value Comes From
1. The 757 must be a zero-NPV investment for the marginal user. Unless Boeing can charge different prices to different users (which is
precluded with a secondary market), Delta will earn economic rents if the 757 is particularly well suited to Delta’s routes (and
competition does not force Delta to pass the cost savings through to customers in the form of lower fares). Thus, the decision focuses
on the issue of whether the plane is worth more in Delta’s hands than in the hands of the marginal user.
a. With a good secondary market and information on past changes in aircraft prices, it becomes somewhat more feasible to
ignore cash flows beyond the first few years and to substitute the expected residual value of the plane.
b. Past aircraft prices may be used to estimate systematic risk (see Chapter 9).
c. The existence of a secondary market makes it more important to take note of the abandonment option (see Chapter 10).
2. The key question is: Will Gamma Airlines be able to earn economic rents on the Akron-Yellowknife route? The necessary steps
include:
a. Forecasting costs, including the cost of building and maintaining terminal facilities, all necessary training, advertising,
equipment, etc.
b. Forecasting revenues, which includes a detailed market demand analysis (what types of travelers are expected and what
prices can be charged) as well as an analysis of the competition (if Gamma is successful, how quickly would competition
spring up?).
c. Calculating the net present value.
The leasing market comes into play because it tells Gamma Airlines the opportunity cost of the planes, a critical component of costs.
If the Akron-Yellowknife project is attractive and growth occurs at the Ulan Bator hub, Gamma Airlines should simply lease
3. To a baby with a hammer, everything looks like a nail. The point is that financial managers should not mechanically apply DCF to
every problem. Sometimes, part or all of a valuation problem can be solved by direct observation of market values. Sometimes
careful thought about economic rents clarifies whether NPV is truly positive.
4. The price of \$280 per ounce represents the discounted value of expected future gold prices. Hence, the present value of 1 million
ounces produced 8 years from now should be: (\$280 × 1 million) = \$280 million
5. First, consider the sequence of events:
 At t = 0, the investment of \$25,000,000 is made.
 At t = 1, production begins, so the first year of revenue and expenses is recorded at t = 2.
 At t = 5, the patent expires and competition may enter. Since it takes one year to achieve full production, competition is
not a factor until t = 7. (This assumes the competition does not begin construction until the patent expires.)
 After t = 7, full competition will exist and thus any new entrant into the market for BGs will earn the 9% cost of capital.
Next, calculate the cash flows:
 At t = 0: -\$25,000,000
 At t = 1: \$0
 At t = 2, 3, 4, 5, 6: Sale of 200,000 units at \$100 each, with costs of \$65 each, yearly cash flow = \$7,000,000.
 After t = 5, the NPV of new investment must be zero. Hence, to find the selling price per unit (P) solve the following for
P:
12 2
1.09
65) (P (200,000)
1.09
65) (P (200,000)
25,000,000 0
− ×
+ +
− ×
+ − ·

100
Solving, we find P = \$85.02 so that, for years t = 7 through t = 12, the yearly cash flow will be: [(200,000)× (\$85.02 - \$65)] =
\$4,004,000.
Finally, the net present value (in millions):
12 7 6 3 2
1.09
4.004
1.09
4.004
1.09
7
1.09
7
1.09
7
25 NPV + + + + + + + − ·  
NPV = \$10.69 or \$10,690,000
101
6. The selling price after t = 6 now changes because the required investment is:
[\$25,000,000× (1 - 0.03)
5
] = \$21,468,351
After t = 5, the NPV of new investment must be zero, and hence the selling price per unit (P) is found by solving the following
equation for P:
12 2
1.09
65) (P (200,000)
1.09
65) (P (200,000)
21,468,351 0
− ×
+ +
− ×
+ − · 
P = \$82.19
Thus, for years t = 7 through t = 12, the yearly cash flow will be:
[200,000 × (\$82.19 - \$65)] = \$3,438,000.
Finally, the net present value (in millions) is:
12 7 6 3 2
1.09
3.438
1.09
3.438
1.09
7
1.09
7
1.09
7
25 NPV + + + + + + + − ·  
NPV = \$9.18 or \$9,180,000
7. a. (See the table below.) The net present value is positive at \$3.76 million. However, this seems like a very small margin.
Unless there is some factor unaccounted for in the analysis (e.g., strategic position such that the project creates an option for future
expansion), management might not proceed with the Polyzone project.
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6-10
Investment 100
Production 0 0 40 80 80 80 80
Spread 1.20 1.20 1.20 1.20 1.20 1.10 0.95
Net Revenues 0 0 48 96 96 88 76
Prod. Costs 0 0 30 30 30 30 30
Transport 0 0 4 8 8 8 8
Other Costs 0 20 20 20 20 20 20
Cash Flow -100 -20 -6 38 38 30 18
NPV (at 8%) = \$3.76
102
b. (See the table below.) The net present value is \$14.68 million, and so the project is acceptable.
t = 0 t = 1 t = 2 t – 3 t = 4 t = 5-10
Investment 100
Production 0 40 80 80 80 80
Spread 1.20 1.20 1.20 1.20 1.10 0.95
Net Revenues 0 48 96 96 88 76
Prod. Costs 0 30 60 30 30 30
Transport 0 4 8 8 8 8
Other Costs 0 20 20 20 20 20
Cash Flow -100 -6 8 38 30 18
NPV (at 8%) = \$14.68
c. (See the table below.) The net present value is \$18.64 million, and so the project is acceptable. However, the assumption
that the technological advance will elude the competition for ten years seems questionable.
t = 0 t = 1 t = 2 t – 3 t = 4 t = 5-10
Investment 100
Production 0 0 40 80 80 80
Spread 1.20 1.20 1.20 1.20 1.10 0.95
Net Revenues 0 0 48 96 88 76
Prod. Costs 0 0 25 25 25 25
Transport 0 0 4 8 8 8
Other Costs 0 20 20 20 20 20
Cash Flow -100 -20 -1 43 35 23
NPV (at 8%) = \$18.64
8. There are four components that contribute to this project’s NPV:
 The initial investment of \$100,000.
 The depreciation tax shield. Depreciation expense is \$20,000 per year for five years and is valued at the nominal rate of
interest because it applies to nominal cash flows, i.e., earnings.
 The after-tax value of the increase in silver yield. Like gold, silver has low convenience yield and storage cost. (You can
verify this by checking that the difference between the futures price and the spot price is approximately the interest saving
from buying the futures contract.) We conclude, therefore, that the PV of silver delivered (with certainty) in the future is
approximately today’s spot price, and so there is no need to forecast the price of silver and then discount.
 The cost of operating the equipment. This cost is \$80,000 per year for ten years and is not valued at the real company cost
of capital because we do not assume any future increase in cost due to inflation. We are concerned only with the after-tax
cost.
Assume that the nominal interest rate is 11 percent. Then:
20) 5,000 (10 .35) (1
1.11
20,000) ( (0.35)
100,000 NPV
5
1 t
t
× × × − +
×
+ − ·

·
\$226,947
1.08
(80,000) .35) (1
10
1 t
t
·

·
103
9. Assume we can ignore dividends paid on the stock market index. On June 30, 2005, each ticket must sell for \$100 because this date marks
the base period for the return calculation. At this price, investment in a ticket will offer the same return as investment in the index.
On January 1, 2005, you know that each ticket will be worth \$100 in 6 months. Therefore, on January 1, 2005, a ticket will be worth:
100/(1.10)
1/2
= \$95.35
The price will be the same for a ticket based on the Dow Jones Industrial Average.
10. If available for immediate occupancy, the building would be worth \$1 million. But because it will take the company one year to clear it out,
the company will incur \$200,000 in clean-up costs and will lose \$80,000 net rent. Assume both rent and costs are spread evenly
throughout the year. Thus (all dollar amounts are in millions):
PV = 1,000 - PV(200 + 80) = 1,000 - 280(0.962) = 731
Since the selling price at each date is the present value of forecasted rents, the only effect of postponing the sale to year 2 is to
postpone the sales commission. The commission is currently (0.05 × 1000) = 50 and grows in line with property value. To estimate
the growth rate of value, we can use the constant-growth model:
PV = 1000 = 80/(0.08 - g) so that g = 0%
Thus, the commission in year 2 is: (50 × 1.00
2
) and:
PV (commission) = 50 × (1.00
2
/1.08
2
) = 43
The value of the warehouse, net of the sales commission, is:
731 - 43 = 688 or \$688,000
104
Challenge Questions
1. a. The NPV of such plants is likely to be zero, because the industry is competitive and, after two years, no company will enjoy
b. The PV of each of these new plants would be \$100,000 because the NPV is zero and the cost is \$100,000.
c. The PV of revenue from such a plant is:
[100,000 tons × (Price - 0.85)]/0.10 = 100,000
Therefore, the price of polysyllabic acid will be \$0.95 per ton.
d. At t = 2, the PV of the existing plant will be:
[100,000 tons × (0.95 - 0.90)]/0.10 = \$50,000
Therefore, the existing plant would be scrapped at t = 2 as long as scrap value at that time exceeds \$50,000.
e. No. Book value is irrelevant. NPV of the existing plant is negative after year 2.
f. Yes. Sunk costs are irrelevant. NPV of the existing plant is negative after year 2.
g. Phlogiston’s project causes temporary excess capacity. Therefore, the price for the next two years must be such that the
existing plant’s owners will be indifferent between scrapping now and scrapping at the end of year 2. This allows us to
solve for price in years 1 and 2.
Today’s scrap value is \$60,000. Also, today’s scrap value is equal to the present value of future cash flows. Therefore:
60,000
1.10
57,900
1.10
.90) 0 (Price 100,000
1.10
0.90) (Price 100,000
2 2
· +
− ×
+
− ×
Solving, we find that the price is \$0.97 per ton. Knowing this, we can calculate the PV of Phlogiston’s new plant:
\$103,471
1.10 0.10
.85 0 0.95
1.10
.85 0 0.97
1.10
.85 0 0.97
100,000 PV
2 2
·
]
]
]

×

+

+

× ·
2. Aircraft will be deployed in a manner that will minimize costs. This means that each aircraft will be used on the route for which it has
the greatest comparative advantage. Thus, for example, for Part (a) of this problem, it is clear that Route X will be served with five
A’s and five B’s, and that Route Y will be served with five B’s and five C’s. The remaining C-type aircraft will be scrapped.
The maximum price that anyone would pay for an aircraft is the present value of the total additional costs that would be incurred if
that aircraft were withdrawn from service. Using the annuity factor for 5 time periods at 10 percent, we find the PV of the operating
costs (all numbers are in millions):
Type X Y
A 5.7 5.7
105
B 9.5 7.6
C 17.1 13.3
Again, consider Part (a). The cost of using an A-type aircraft on Route X (Cost = Price of A + 5.7) must be equal to the cost of using
a B-type aircraft on Route X (Cost = Price of B + 9.5). Also, the cost of using a B-type aircraft on Route Y (Price of B + 7.6) equals
the cost of using a C-type on Route Y (Price of C + 13.3). Further, because five C-type aircraft are scrapped, the price of a C-type
aircraft must be \$1.0, the scrap value. Therefore, solving first for the price of B and then for the price of A, we find that the price of
an A-type is \$10.5 and the price of a B-type is \$6.7. Using this approach, we have the following solutions:
Usage Aircraft Value (in millions)
X Y Scrap A B C
a. 5A+5B 5B+5C 5C \$10.5 \$6.7 \$1.0
b. 10A 10B 10C 10.5 6.7 1.0
c. 10A 5A+5B 5B+10C 2.9 1.0 1.0
d. 10A 10A 10B+10C 2.9 1.0 1.0
3. a.
106
\$76.62
1.20
58.33
1.20
43.33
plant old year 1 of PV
2
· + · − −
\$48.61
1.20
58.33
plant old year 2 of PV · · − −
b. Given that the industry is competitive, the investment in a new plant to produce bucolic acid must yield a zero NPV. First,
we solve for the revenues (R) at which a new plant has zero NPV.
0 1 2 3
1. Initial investment -100
2. Revenues net of tax 0.6R 0.6R 0.6R
3. Operating costs net of tax -30 -30 -30
4. Depreciation tax shield +40
5. Salvage value net of tax +15
Therefore:
We can now use the new revenue to re-compute the present values from Part (a) above. (Recall that existing plants must
use the original tax depreciation schedule.).
\$72.95
1.20
55.93
1.20
40.93
plant old year 1 of PV
2
· + · − −
\$46.61
1.20
55.93
plant old year 2 of PV · · − −
c. Existing 2-year-old plants have a net-of-tax salvage value of:
50 – [(0.4)× (50.0 - 33.3)] = \$43.33
d. Solve again for revenues at which the new plant has zero NPV:
0 1 2 3
1. Initial investment -100
2. Revenues +R +R +R
3. Operating costs -50 -50 -50
4. Salvage value +25
107
0
1.20
15) 30 (0.6R
1.20
30) (0.6R
1.20
40) 30 (0.6R
100 NPV
3 2
·
+ −
+

+
+ −
+ − ·
21.181 1.264R 100 0 − + − ·
\$95.87 R·
0
1.20
25) 50 (R
1.20
50) (R
1.20
50) (R
100 NPV
3 2
·
+ −
+

+

+ − ·
90.856 2.106R 100 0 − + − ·
\$91 R ·
With revenues of \$91:
\$80
1.20
66
1.20
41
plant old year 1 of PV
2
· + · − −
\$55
1.20
66
plant old year 2 of PV · · − −
108
CHAPTER 12
Making Sure Managers Maximize NPV
1. Post-audits provide information on problems that may need to be
corrected in order for newly completed projects to operate as intended.
Also, the postaudit provides preliminary data on the validity of the
forecasts for the project and the corrections that may be needed in this
process.
The postaudit should be performed by a disinterested party. It should not be done by
someone involved in the operations of the project or someone responsible for its
planning. The postaudit should be performed after resolving any minor “bugs” that occur
during the start-up process. Once this stage has been reached, the postaudit should
investigate all phases of the project, both financial and technical.
The issue of which projects to audit depends on the cost of performing audits and on the
value of the information obtained. Larger projects usually require audits in order to be
certain that everything performs as expected. If there are unexpected problems, it is
generally advisable to find out about them as soon as possible. Postaudits for smaller
projects might make sense when a series of projects of a given type can be investigated.
Standardized postaudit procedures can be developed and statistical analyses performed.
2. Outline of steps in capital budgeting process:
(1) Plant manager gets idea, does some very rough estimates, and
determines whether idea is worth pursuing.
(2) Staff of plant manager develops detailed proposal, including:
• Discussion of reason that the company should invest in this machine
• Economic forecasts
• Demand forecasts
• Cash flow forecasts, both revenue and expenses
• Estimate of cost of capital (unless specified at a higher level)
• Net present value or internal rate of return calculation
(3) Proposal is evaluated by division level staff. If approved, proposal
is evaluated at company level.
(4) Project authorization is requested, which may require a final
check/revision of the numbers in the original proposal.
(5) Purchase and installation proceed. If there are significant cost
overruns, these must be re-approved by the division and company
staff.
(6) When the machine is up and running, say after one year, a
postaudit might be conducted to evaluate the entire process.
109
3. The typical compensation and incentive plans for top management include
salary plus profit sharing and stock options. This is usually done to align
as closely as possible the interests of the manager with the interests of the
shareholders. These managers are usually responsible for corporate
strategy and policies that can directly affect the future of the entire firm.
Plant and divisional managers are usually paid a fixed salary plus a bonus based
on accounting measures of performance. This is done because they are directly
responsible for day-to-day performance and this valuation method provides an
absolute standard of performance, as opposed to a standard that is relative to
shareholder expectations. Further, it allows for the evaluation of junior managers
who are only responsible for a small segment of the total corporate operation.
4. a. When paid a fixed salary without incentives to act in shareholders’ best
interest, managers often act sub-optimally.
1. They may reduce their efforts to find and implement projects that
2. They may extract benefits-in-kind from the corporation in the form
of a more lavish office, tickets to social events, overspending on
expense accounts, etc.
3. They may expand the size of the operation just for the prestige of
running a larger company
4. They may choose second-best investments to reward existing
employees rather than the alternative that requires outside
personnel but has a higher NPV.
5. In order to maintain their comfortable jobs, managers may invest in
safer rather than riskier projects.
b. Tying the manager’s compensation to EVA attempts to ensure that
assets are deployed efficiently and that earned returns exceed the
cost of capital. Hence, actions taken by the manager to shirk the
duty of maximizing shareholder wealth generally result in a return
that does not exceed the minimum required rate of return (cost of
capital). The more the manager works in the interests of the
shareholder, the greater the EVA.
5. a. EVA = Income earned – (Cost of capital x Investment)
= \$8.03m – (0.09 x \$55.4m) = \$8.03m - \$4.99m = \$3.04m
b. EVA = \$8.03m – (0.09 x \$95m) = \$8.03m - \$8.55m = -\$0.52m
The market value of the assets should be used to capture the true
opportunity cost of capital.
110
6. a. If a firm announces the hiring of a new manager who is expected to
increase the firm’s value, this information should be immediately reflected
in the stock price. If the manager then performs as expected, there should
not be much change in the share price since this performance has already
been incorporated in the stock value.
b. This could potentially be a very serious problem since the manager could
lose money for reasons out of her control. One solution might be to index
the price changes and then compare the actual raw material price paid
with the indexed value. Another alternative would be to compare the
performance with the performance of competitive firms.
c. It is not necessarily an advantage to have a compensation scheme
tied to stock returns. For example, in addition to the problem of
expectations discussed in Part (a), there are numerous factors
outside the manager’s control, such as federal monetary policy or
new environmental regulations. However, the stock price does
tend to increase or decrease depending on whether the firm does
or does not exceed the required cost of capital. To this extent, it is
a measure of performance.
7. EVA = Income earned – (Cost of capital x Investment)
= \$1.2m – [0.15 x (\$4m + \$2m + \$8m)] = \$1.2m - \$2.1m = -\$0.9m
8. Agency problems likely to be encountered in capital investment decisions:
 Reduced effort: Shirking the responsibility of finding and implementing value-
 Perks: Exploiting the benefits of the managerial position in order to get benefits
from the corporation for personal use.
 Empire building: Obtaining and running larger operations merely for personal
prestige.
 Entrenching investment: Favoring projects to reward existing managers instead
of pursuing higher value-added projects requiring new expertise.
 Avoiding risk: Choosing safer projects over more risky, higher value-added
projects.
9. Security analysts generate business for their own firms based upon the
accuracy of their recommendations. Thus, in looking-out for their own
shareholders’ or customers’ interests, they are also working in the best
interests of the shareholders of the firms they analyze. This is particularly
true for firms with large numbers of shareholders. A motivated monitoring
agent reduces the free-rider problem by assuming the delegated
monitoring duties. Also, because they are industry experts and are paid
by potential investors, the analysts examine the performance of the firm’s
111
capital investment program. Firms are eager to have more investors since
it makes raising capital easier for future projects.
10. Delegated monitoring refers to a group of individuals, usually the Board of
Directors and independent outside auditors, who are elected and/or paid
to meet with top management in order to determine whether the firm is
being operated in a fashion consistent with the best interests of the
shareholders.
11. a. False. The biases rarely wash out. For example, steady state income
may not be much affected by investments in R & D but book asset value is
understated. Thus, book profitability is too high, even in the steady state.
b. True. All biases in book profitability can be traced to accounting rules
governing which assets are put on the balance sheet and the choice of
book depreciation schedules.
12. The year-by-year book and economic profitability and rates of return are
calculated in the table below. (We assume straight-line depreciation, \$10 per
year for years one through ten).
Because a plant lasts for 10 years, ‘steady state’ for a mature company implies
that we are operating ten plants, and every year we close one and begin
construction on another. The total book income is \$76, which is the same as the
sum of the Book Income figures from the table (i.e., the sum of -\$30, -\$22, \$16,
etc.). Similarly, the total book investment is \$550. Thus, the steady state book
rate of return for a mature company producing Polyzone is: (76/550) = 13.8%.
Note that this is considerably different from the economic rate of return, which is
8 percent.
t=0 t=1 t=2 t=3 t=4 t=5 t=6 t=7 t=8 t=9 t=10
Investment 100
Depreciation 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0
Book Value
End of Year 90.0 80.0 70.0 60.0 50.0 30.0 20.0 10.0 0.0
Net Revenue 0 0.0 76.0 76.0 76.0 76.0 76.0 76.0 76.0
Production Costs 0 0.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0
Transport & Other 0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0
Book Income 0 -30.0 -22.0 16.0 16.0 16.0 16.0 16.0 16.0 16.0
Book Rate of Return -30.0% -24.4% 20.0% 22.9% 26.7% 40.0% 53.3% 80.0% 160.0%
Cash Flow -100 -20.0 -12.0 26.0 26.0 26.0 26.0 26.0 26.0 26.0
PV at Start of Year 99.3 127.2 149.4 135.4 120.2 86.1 67.0 46.4 24.1
PV at End of Year 127.2 149.4 135.4 120.2 103.8 67.0 46.4 24.1 0.0
Change in PV 27.9 22.2 -14.0 -15.2 -16.4 -19.1 -20.6 -22.3 -24.1
Economic Depreciation -27.9 -22.2 14.0 15.2 16.4 19.1 20.6 22.3 24.1
Economic Income 7.9 10.2 12.0 10.8 9.6 6.9 5.4 3.7 1.9
112
Economic Rate
of Return
8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
13. a. See table below. Straight-line depreciation would be \$166.67 per year.
Hence, economic depreciation in this case is accelerated, relative to
straight-line depreciation.
b. The true rate of return is found by dividing economic income by the
start-of-period present value. As stated in the text, this will always
be 10 percent. The book ROI is calculated in Panel B (using
straight-line depreciation).
A. Forecasted Economic Income and Rate of Return
Year
1 2 3 4 5 6
Cash Flow 298.0 298.0 298.0 138.0 138.0 138.0
PV at start of year 998.9 800.8 582.9 343.2 239.5 125.5
PV at end of year 800.8 582.9 343.2 239.5 125.5 0.0
Change in PV -198.1 -217.9 -239.7 -103.7 -114.0 -125.5
Economic depreciation 198.1 217.9 239.7 103.7 114.0 125.5
Economic return 99.9 80.1 58.3 34.3 24.0 12.5
Rate of return 0.1000 0.1000 0.1000 0.0999 0.1002 0.0996
B. Forecasted Book Income and ROI
Year
1 2 3 4 5 6
Cash Flow 298.00 298.00 298.00 138.00 138.00 138.00
BV at start of year 1000.00 833.33 666.66 500.00 333.33 166.66
BV at end of year 833.33 666.66 500.00 333.33 166.66 0.00
Change in BV -166.67 -166.67 -166.66 -166.67 -166.67 -166.66
Book depreciation 166.67 166.67 166.66 166.67 166.67 166.66
Book income 131.33 131.33 131.34 -28.67 -28.67 -28.66
Book ROI 0.1313 0.1576 0.1970 -0.0573 -0.0860 -0.1720
14. Internet exercise; answers will vary.
113
Challenge Questions.
1. The optimal level of agency costs is the point at which the marginal return
derived from monitoring top management and ensuring they are working
in the best interests of the shareholders equals the marginal cost of any
shirking and other acts that do not maximize value.
2. No, there would be no need for EVA. The problem in managing
performance is the difficulty in obtaining economic values for some
activities (e.g., the ability to expand production in the future). As a result,
we are left with accounting figures derived from arbitrary rules governing
the assets or expenditures that should be put on the balance sheet, and
how these assets are treated for deprecation purposes.
3. For a 10 percent expansion in book investment, ROI for Nodhead is given
in the table below. When the steady-state growth rate is exactly equal to
the economic rate of return (i.e., 10 percent), the economic rate of return
and book ROI are the same.
Book Income for
Assets Put in Place
During Year 1 2 3 4 5 6
1 -67 33 83 131 131 131
2 -74 36 91 144 144
3 -81 40 100 159
4 -89 44 110
5 -98 48
6 -108
Total Book Income: -67 -41 38 173 321 484
Book Value for
Assets Put in Place
During Year 1 2 3 4 5 6
1 1000 833 667 500 333 167
2 1100 916 734 550 366
3 1210 1008 807 605
4 1331 1109 888
5 1464 1220
6 1610
Total Book Income: 1000 1933 2793 3573 4263 4856
Book ROI: -0.067 -0.021 0.014 0.048 0.075 0.100*
*This is the steady state rate of return.
114
4.
Year 1 Year 2 Year 3
Cash Flow 5.20 4.80 4.40
PV at start of year 12 8 4
PV at end of year 8 4 0
Change in PV -4 -4 -4
Economic depreciation 4 4 4
Economic income 1.20 0.80 0.40
Economic rate of return 0.10 0.10 0.10
Book depreciation 4 4 4
Book income 1.20 0.80 0.40
Book rate of return 0.10 0.10 0.10
115
5. First calculate present value and economic income of one parlor (figures in
thousands):
Year 1 Year 2 Year 3 Year 4 Year 5
Cash flow 0 40 80 120 170
PV start of year 200 240 248 218 142
Change in PV +40 +8 -30 -76 -142
Economic income +40 +48 +50 +44 +28
Economic return 0.20 0.20 0.20 0.20 0.20
Given that the cost of capital is 20 percent, these parlors are break-even
investments; i.e., the rate of return equals the cost of capital (or investing
\$200,000 buys an asset worth \$200,000). In that case, the rate of
expansion is immaterial. The value of Kipper’s stock should not be
affected by the announcement that it intends to make more zero-NPV
investments. If Kipper’s sole asset in 2001 was one parlor, the market
value of the common stock should be \$200,000.
Now consider what happens to Kipper’s book income and return. For the
first expansion plan:
Year 1 Year 2 Year 3 Year 4 Year 5
Number of parlors 1 2 3 4 5
Cash flow 0 40 120 240 410
BV start of year 200 360 480 560 600
Book depreciation 40 80 120 160 200
Book income -40 -40 0 80 210
Book ROI -0.20 -0.11 0 0.14 0.35
The steady-state book return of 35 percent is reached in year 5.
116
For the second expansion plan:
Year 1 Year 2 Year 3 Year 4 Year 5
Number of parlors 1 3 6 10 15
Cash flow 0 40 160 400 810
BV start of year 200 560 1040 1600 2200
Book depreciation 40 120 240 400 600
Book income -40 -80 -80 0 210
Book ROI -0.20 -0.14 -0.08 0 0.10
By year 5, Kipper’s book profitability has crept up to only 10 percent.
Perhaps this explains the market letter’s change of heart. Of course,
Kipper’s rate of expansion under the second plan must slow down
eventually. The point is that, because economic depreciation is
decelerated, more rapid growth in zero-NPV investments hurts book
profitability. It would also reduce earnings per share. Of course, the rate
at which you add zero-NPV investments does not affect economic return
or economic earnings per share. Thus, the market letter has responded to
book prospects, not to true value.
6. a. See table on next page. Note that economic depreciation is simply
the change in market value, while book depreciation (per year) is:
[19.69 – (0.2 × 19.69)]/15 = 1.05
Thus, economic depreciation is accelerated in this case, relative to
book depreciation.
b. See table on next page. Note that the book rate of return exceeds the
true rate in only the first year.
c. Because the economic return from investing in one airplane
is 10 percent each year, the economic return from investing
in a fixed number per year is also 10 percent each year. In
order to calculate the book return, assume that we invest in
one new airplane each year (the number of airplanes does
not matter, just so long as it is the same each year). Then,
book income will be (3.67 – 1.05) = 2.62 from the airplane in
its first year, (3.00 – 1.95) = 1.95 from the airplane in its
second year, etc., for a total book income of 15.21. Book
value is calculated similarly: 19.69 for the airplane just
purchased, 18.64 for the airplane that is one year old, etc.,
for a total book value of 185.10. Thus, the steady-state book
rate of return is 8.22 percent, which understates the true
(economic) rate of return (10 percent).
117
Year
1 2 3 4 5 6 7 8
Market value 19.69 17.99 16.79 15.78 14.89 14.09 13.36 12.68
Economic depreciation 1.70 1.20 1.01 0.89 0.80 0.73 0.68
Cash flow 3.67 3.00 2.69 2.47 2.29 2.14 2.02
Economic income 1.97 1.80 1.68 1.58 1.49 1.41 1.34
Economic return 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
Book value 19.69 18.64 17.59 16.54 15.49 14.44 13.39 12.34
Book depreciation 1.05 1.05 1.05 1.05 1.05 1.05 1.05
Book income 2.62 1.95 1.64 1.42 1.24 1.09 0.97
Book return 13.3% 10.5% 9.3% 8.6% 8.0% 7.5% 7.2%
Year
9 10 11 12 13 14 15 16
Market value 12.05 11.46 10.91 10.39 9.91 9.44 9.01 8.59
Economic depreciation 0.63 0.59 0.55 0.52 0.48 0.47 0.43 0.42
Cash flow 1.90 1.80 1.70 1.61 1.52 1.46 1.37 1.32
Economic income 1.27 1.21 1.15 1.09 1.04 0.99 0.94 0.90
Economic return 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
Book value 11.29 10.24 9.19 8.14 7.09 6.04 4.99 3.94
Book depreciation 1.05 1.05 1.05 1.05 1.05 1.05 1.05 1.05
Book income 0.85 0.75 0.65 0.56 0.47 0.41 0.32 0.27
Book return 6.9% 6.6% 6.3% 6.1% 5.8% 5.8% 5.3% 5.4%
118
CHAPTER 13
Corporate Financing and the Six Lessons of Market Efficiency
1. a. An individual can do crazy things, but still not affect the efficiency of
markets. The price of the asset in an efficient market is a consensus price
as well as a marginal price. A nutty person can give assets away for free
or offer to pay twice the market value. However, when the person’s
supply of assets or money runs out, the price will adjust back to its prior
level (assuming there is no new, relevant information released by his
action). If you are lucky enough to know such a person, you will receive a
positive gain at the nutty investor’s expense. You had better not count on
this happening very often, though. Fortunately, an efficient market
protects crazy investors in cases less extreme than the above. Even if they
trade in the market in an “irrational” manner, they can be assured of
getting a fair price since the price reflects all information.
b. Yes, and how many people have dropped a bundle? Or more to the point,
how many people have made a bundle only to lose it later? People can be
lucky and some people can be very lucky; efficient markets do not
preclude this possibility.
c. Investor psychology is a slippery concept, more often than not used to explain price movements that the
individual invoking it cannot personally explain. Even if it exists, is there any way to make money from it? If
investor psychology drives up the price one day, will it do so the next day also? Or will the price drop to a
‘true’ level? Almost no one can tell you beforehand what ‘investor psychology’ will do. Theories based on it
have no content.
d. What good is a stable value when you can’t buy or sell at that value because new conditions or information have
developed which make the stable price obsolete? It is the market price, the price at which you can buy or sell
today, which determines value.
2. a. There is risk in almost everything you do in daily life. You could lose your job or your spouse, or suffer
damage to your house from a storm. That doesn’t necessarily mean you should quit your job, get a divorce, or sell your house.
If we accept that our world is risky, then we must accept that asset values fluctuate as new information emerges. Moreover, if
capital markets are functioning properly, then stock price changes will follow a random walk. The random walk of values is the
result of rational investors coping with an uncertain world.
b. To make the example clearer, assume that everyone believes in the same chart. What happens when the chart
shows a downward movement? Are investors going to be willing to hold the stock when it has an expected
loss? Of course not. They start selling, and the price will decline until the stock is expected to give a positive
return. The trend will ‘self-destruct.’
c. Random-walk theory as applied to efficient markets means that fluctuations from the expected outcome are
random. Suppose there is an 80 percent chance of rain tomorrow (because it rained today). Then the local
umbrella store’s stock price will respond today to the prospect of high sales tomorrow. The store’s sales will
not follow a random walk, but its stock price will, because each day the stock price reflects all that investors
know about future weather and future sales.
119
3. One of the ways to think about market inefficiency is that it implies there is easy money to be made. The following appear
to suggest market inefficiency:
(b) strong form
(d) weak form
(e) semi-strong form
4. a. Companies tend to split after their stock has performed well, but that does not mean that the stock of each
individual company in the figure performed well in each month before the split. Some may have performed well in month 12
and others in month 11, and so on. There is a smooth progression in the averages, but you could not have taken advantage of
this unless you knew ahead of time which stocks would split and when they would split.
b. The price fell to levels prevailing before the announcement of the split.
5. Dividends . A company that pays high dividends is putting its money where its mouth is, i.e., showing that it has (and expects to
continue to have) cash to distribute.
Capital Structure. If the manager suffers a penalty when the firm goes bankrupt, high leverage may be a signal of
management confidence.
Manager’s Shareownership. An entrepreneur who puts her own money into the business is telling you something about
6. The estimates are first substituted in the market model. Then the result from this expected return equation is subtracted from the
actual return for the month to obtain the abnormal return.
Abnormal return (Intel) = Actual return - [0.07 + (1.61 × Market return)]
Abnormal return (Conagra) = Actual return - [0.17 + (0.47 × Market return)]
7. One possible procedure is to first form groups of stocks with similar P/E ratios, adjusting for market risk (using either historical
estimates of alpha or estimates based on the Capital Asset Pricing Model). Then determine whether the alpha of each
group is significantly different from zero. Here are some things to look out for:
a. Don’t select samples of stock at the end of the period. You will have omitted the companies that went bankrupt.
b. Include dividends in the actual rate of return. Low P/E stocks have high yields.
c. Check that earnings are known on the date that you calculate P/E. Stocks whose earnings subsequently turned
out high relative to price naturally perform better.
d. Adjust for risk. Low P/E stocks tend to be more risky.
e. You may need to disentangle the P/E effect from other effects, e.g., size or dividend yield.
8. This is not necessarily true. The company should consider its particular circumstances. There may be tax advantages to issuing
debt or some other security, for example. The transaction costs of issuing some securities may be more than the costs of
issuing others. (These and related issues are examined in subsequent chapters.)
9. The efficient market hypothesis does not imply that portfolio selection should be done with a pin. The manager still has three
important jobs to do. First, she must make sure that the portfolio is well diversified. It should be noted that a large number
of stocks is not enough to ensure diversification. Second, she must make sure that the risk of the diversified portfolio is
appropriate for the manager’s clients. Third, she might want to tailor the portfolio to take advantage of special tax laws for
pension funds. These laws may make it possible to increase the expected return of the portfolio without increasing risk.
120
10. They are both under the illusion that markets are predictable and they are wasting their time trying to guess the market’s
direction. Remember the first lesson of market efficiency: Markets have no memory. The decision as to when to issue
stock should be made without reference to ‘market cycles.’
11. The efficient-market hypothesis says that there is no easy way to make money. Thus, when such an opportunity seems to present
itself, we should be very skeptical. For example:
 In the case of short- versus long-term rates, and borrowing short-term versus long-term, there are different risks
involved. For example, suppose that we need the money long-term but we borrow short-term. When the short-
term note is due, we must somehow refinance. However; this may not be possible, or may only possible at a
very high interest rate.
 In the case of Japanese versus United States interest rates, there is the risk that the Japanese yen - U.S. dollar
exchange rate will change during the period of time for which we have invested.
12. Some key points are as follows:
a. Unidentified Risk Factor: From an economic standpoint, given the information available and the number of
participants, it is hard to believe that any securities market in the U.S is not very efficient. Thus, the most likely
explanation for the small-firm effect is that the model used to estimate expected returns is incorrect, and that
there is some as-yet-unidentified risk factor.
b. Coincidence: In statistical inference, we never prove an affirmative fact. The best we can do is to accept or
reject a specified hypothesis with a given degree of confidence. Thus, no matter what the outcome of a
statistical test, there is always a possibility, however slight, that the small-firm effect is simply the result of
statistical chance or, in other words, a coincidence.
c. Market Inefficiency: One key to market efficiency is the high level of competition among participants in the
market. For small stocks, the level of competition is relatively low because major market participants (e.g.,
mutual funds and pension funds) are biased toward holding the securities of larger, well-known companies.
Thus, it is likely that the market for small stocks is fundamentally different from the market for larger stocks
and hence, it is quite plausible that the small-firm effect is simply a reflection of market inefficiency.
13. Not true. If everyone believes that patterns exist, all will look for these patterns and all will trade based on such patterns. But
such trading itself will destroy the patterns. Remember that we cannot all get rich simultaneously.
121
14. There are several ways to approach this problem, but all (when done correctly!) should give approximately the same answer.
We have chosen to use the regression analysis function of an electronic spreadsheet program to calculate the alpha and beta
for each security. The regressions are in the following form:
Security return = alpha + (beta × market return) + error term
The results are:
Alpha Beta
Executive Cheese -0.89 0.50
(As a point of interest, the R
2
for the Executive Cheese regression is 0.082, which is relatively low for a regression of this
type. For Paddington Beer, it is 0.74, a relatively high value.)
The abnormal return for Executive Cheese in September 2000 was:
5.6 – [-0.89 + 0.50 × (-5.7)] = 9.34%
For Paddington Beer in January 2000 the abnormal return was:
-11.1 – [-0.51 + 2.01 × (-9.5)] = 8.51%
Thus, the average abnormal return of the two stocks during the month of the dividend announcement was 8.93 percent.
15. The market is most likely efficient. The government of Kuwait is not likely to have non-public information about the BP shares.
Goldman Sachs is providing an intermediary service for which they should be remunerated. Stocks are bought at (higher)
ask prices and sold at (lower) bid prices. The spread between the two (\$0.11) is revenue for the broker. In the U.S., at that
time, a bid-ask spread of 1/8 (\$0.125) was not uncommon. The ‘profit’ of \$15 million reflects the size of the order more
than any mispricing.
122
Challenge Questions
1. Used car dealers do not have all relevant information about a car that they plan to purchase. The current owner, who wants
to sell the car, is better informed about its condition. In order for the used car dealer to make up for the ‘lemons’ he
The bond dealer does not usually have to worry about buying a bond for too high a price from a seller with inside
information. (If strong-form efficiency holds, the dealer doesn’t have to worry at all.) Whether the dealer knows
everything about the particular bond makes no difference. The market has the information and that information is reflected
in the price. Therefore, the cost of ‘lemons’ is a relatively small part of the dealer’s spread.
2. No, this does not follow. The decline in prices merely reflects the consensus market opinion about the seriousness of the
country’s difficulties. The stability after the announcement reflects the market’s opinion of the nature of the assistance and
its likelihood of success.
3. Internet exercise; answers will vary.
123
CHAPTER 14
An Overview of Corporate Financing
1. Internet exercise; answers will vary.
2. In general, using market values of equity results in lower debt-to-total
capital ratios. This occurs because the book value of equity reflects
historical values at the time of the original stock issues. Market values
reflect not only the firm’s current operations but also the market’s
expectations of future operations.
3. Besides the function of providing funds to industry, capital markets also
provide managers with information. Without this information, it would be
very difficult to determine the firm’s opportunity cost of capital or to assess
the firm’s financial performance.
Capital markets provide liquidity for investors. Because individual
stockholders can always recover retained earnings by selling shares, they
are willing to invest in companies that retain earnings rather than paying
out earnings as dividends. Well-functioning capital markets allow the firm
to serve all its stockholders simply by maximizing value.
4. a. It appears that par value is approximately \$0.05 per share, which is
computed as follows:
\$213 million/4,260 million shares
b. The shares were sold at an average price of:
[\$213 million + \$5,416 million]/4,260 million shares = \$1.32
c. The company has repurchased:
4,260 million - 3,847 million = 413 million shares.
d. Average repurchase price:
\$6,851 million/413 million shares = \$16.59 per share.
e. The value of the net common equity is:
\$213 million + \$5,416 million + \$10,109 million - \$6,851 million = \$8,887
million
124
125
5. a. The day after the founding of Inbox:
Common shares (\$0.10 par value) \$ 50,000
Retained earnings 0
Treasury shares at cost 0
Net common equity \$2,000,000
b. After 2 years of operation:
Common shares (\$0.10 par value) \$ 50,000
Retained earnings 120,000
Treasury shares at cost 0
Net common equity \$2,120,000
c. After 3 years of operation:
Common shares (\$0.10 par value) \$ 50,000
Retained earnings 370,000
Treasury shares at cost 0
Net common equity \$7,370,000
6. a.
Common shares (\$0.25 par value) \$ 120.5
Retained earnings 4,757.0
Treasury shares (2,920.0)
Net common equity \$3,097.0
b.
Common shares (\$0.25 par value) \$ 120.5
Retained earnings 4,757.0
Treasury shares (3,620.0)
Net common equity \$2,397.0
7. One would expect that the voting shares have a higher price because they
have an added benefit/responsibility that has value.
126
8. a.
Gross profits \$ 760,000
Interest 100,000
EBT \$ 660,000
Tax (at 35%) 231,000
Funds available to common shareholders \$ 429,000
b.
Gross profits \$ 760,000
Interest 100,000
EBT \$ 660,000
Tax (at 35%) 231,000
Net income \$ 429,000
Preferred dividend 80,000
Funds available to common shareholders \$ 349,000
9. Internet exercise; answers will vary.
10. a. Less valuable
b. More valuable
c. More valuable
d. Less valuable
127
Challenge Questions
1. a. For majority voting, you must own or otherwise control the votes of
a simple majority of the shares outstanding, i.e., one-half plus one.
Here, with 200,000 shares outstanding, you must control the votes
of 100,001 shares.
b. With cumulative voting, the directors are elected in order of the total
and five directors to be elected, there will be a total of 1,000,000
votes cast. To ensure you can elect at least one director, you must
ensure that someone else can elect at most four directors. That is,
you must have enough votes so that, even if the others split their
your candidate gets would be higher by one.
Let x be the number of votes controlled by you, so that others
control (1,000,000 - x) votes. To elect one director:
Solving, we find x = 166,667.8 votes, or 33,333.4 shares. Because
there are no fractional shares, we need 33,334 shares.
2. A corporation could issue a bond whose interest payments are linked to
economic variables, such as the level of unemployment or housing prices.
Such a security might not be issued due to problems in measurement of
the relevant economic variables, or the cash flows might have a low
correlation with the firm’s ability to pay.
Other possibilities include:
• Securities that act as a hedge for the issuer, such as bonds
indexed to copper prices for a copper producer, or to real estate prices
for a real estate firm.
• Securities that may help to avoid undesirable outcomes, such as a
bond that converts automatically to equity as the firm approaches
bankruptcy.
1
5
x 000 , 000 , 1
x +

·
128
CHAPTER 15
How Corporations Issue Securities
1. a. Zero-stage financing represents the savings and personal loans the
company’s principals raise to start a firm. First-stage and second-stage
financing comes from funds provided by others (often venture capitalists)
to supplement the founders’ investment.
b. An after-the-money valuation represents the estimated value of the firm
after the first-stage financing has been received.
c. Mezzanine financing comes from other investors, after the financing
provided by venture capitalists.
d. A road show is a presentation about the firm given to potential investors in
order to gauge their reactions to a stock issue and to estimate the demand
for the new shares.
e. A best efforts offer is an underwriter’s promise to sell as much as possible
of a security issue.
f. A qualified institutional buyer is a large financial institution which, under
SEC Rule 144A, is allowed to trade unregistered securities with other
g. Blue-sky laws are state laws governing the sale of securities within the
state.
2. a. Management’s willingness to invest in Marvin’s equity was a credible signal because the management team
stood to lose everything if the new venture failed, and thus they signaled their seriousness. By accepting only part of the venture
capital that would be needed, management was increasing its own risk and reducing that of First Meriam. This decision would
be costly and foolish if Marvin’s management team lacked confidence that the project would get past the first stage.
b. Marvin’s management agreed not to accept lavish salaries. The cost of
management perks comes out of the shareholders’ pockets. In Marvin’s
case, the managers are the shareholders.
129
3. Alternative procedures for initial public offerings of common stock include:
a. Firm commitment underwriting in which the investment bankers buy the
entire issue before reselling it to the public. The issuing company receives
the money immediately, but at a price below the offering price.
b. Best efforts offers in which the investment banker tries to sell as much of
the issue as possible. The share price is higher but the entire issue may not
be sold.
c. In some countries, the issue may be auctioned off. In these cases, the firm
may place a reserve (i.e., lowest acceptable) price, but both price and the
number of shares sold are not known in advance.
d. In a fixed price offer, the price of the shares is fixed and the number of
shares sold is in question. If the price is too high, not enough shares will
be sold; if the price is too low, the issue is oversubscribed and investors
receive only a portion of their desired shares.
4. If he is bidding on under-priced stocks, he will receive only a portion of the shares
he applies for. If he bids on under-subscribed stocks, he will receive his full
allotment of shares, which no one else is willing to buy. Hence, on average, the
stocks may be under-priced but once the weighting of all stocks is considered, it
may not be profitable.
5. Some possible reasons for cost differences:
a. Large issues have lower proportionate costs.
b. Debt issues have lower costs than equity issues.
c. Initial public offerings involve more risk for underwriters than issues of
seasoned stock. Underwriters demand higher spreads in compensation.
6. There are several possible reasons why the issue costs for debt are lower than
those of equity, among them:
 The cost of complying with government regulations may be lower for
debt.
 The risk of the security is less for debt and hence the price is less volatile.
This increases the probability that the issue will be mis-priced and
therefore increases the underwriter’s.
7. This is a one-time cost, not an annual cost, so it is not correct that
flotation costs increase the cost of external equity capital by ten
percentage points. However, flotation costs do increase the cost of
external equity capital.
130
8. a. Inelastic demand implies that a large price reduction is needed in order to sell additional shares. This would be
the case only if investors believe that a stock has no close substitutes (i.e., they value the stock for its unique properties).
b. Price pressure may be inconsistent with market efficiency. It implies that
the stock price falls when new stock is issued and subsequently recovers.
c. If a company’s stock is undervalued, managers will be reluctant to sell new stock, even if it means foregoing a
good investment opportunity. The converse is true if the stock is overvalued. Investors know this and,
therefore, mark down the price when companies issue stock. (Of course, managers of a company with
undervalued stock become even more reluctant to issue stock because their actions can be misinterpreted.)
If (b) is the reason for the price fall, there should be a subsequent
price recovery. If (a) is the reason, we would not expect a price
recovery, but the fall should be greater for large issues. If (c) is the
reason, the price fall will depend only on issue size (assuming the
information is correlated with issue size).
9. A private placement is preferable to a public issue for firms that face high public
issue costs, and for firms that may later require a re-negotiation of the terms of the
debt contract.
10. a. Example: Before issue, there are 100 shares outstanding at \$10 per share.
The company sells 20 shares for cash at \$5 per share. Company value
increases by: (20 x \$5) = \$100. Thus, after issue, each share is worth:
\$9.17
120
\$1,100
20) (100
\$100 \$10) (100
· ·
+
+ ×
Note that new shareholders gain: (20 × \$4.17) = \$83, while old
shareholders lose: (100 × \$0.83) = \$83.
b. Example : Before issue, there are 100 shares outstanding at \$10 per share.
The company makes a rights issue of 20 shares at \$5 per share. Each right
is worth:
The new share price is \$9.17. If a shareholder sells his right, he
receives \$0.83 cash and the value of each share declines by
\$10 - \$9.17 = \$0.83. The shareholder’s total wealth is unaffected.
11. [Note: The parts of this problem were labeled incorrectly in the first printing
of the seventh edition.]
a. 5 × (10,000,000/4) = \$12.5 million
b.
\$0.20
1 4
5 6
1 N
price) issue ( price) on (rights
right of Value ·
+

·
+

·
\$0.83
6
5 10
1 N
price) (issue price) on (rights
right of Value ·

·
+

·

131
c.
\$5.80
2,500,000) 0 (10,000,00
0 \$12,500,00 \$6) 0 (10,000,00
price Stock ·
+
+ ×
·

A stockholder who previously owned four shares had stocks with a
value of: (4 × \$6) = \$24. This stockholder has now paid \$5 for a
fifth share so that the total value is: (\$24 + \$5) = \$29. This
stockholder now owns five shares with a value of: (5 × \$5.80) =
\$29, so that she is no better or worse off than she was before.
d. The share price would have to fall to the issue price per share, or
\$5 per share. Firm value would then be: (10 million × \$5) = \$50
million
12. (\$12,500,000/\$4) = 3,125,000 shares
(\$10,000,000/3,125,000) = 3.20 rights per share
\$0.48
1 3.2
4 6
1 N
price) issue ( price) on (rights
right of Value ·
+

·
+

·
\$5.52
,125,000) 0 (10,000,00
0 \$12,500,00 \$6) 0 (10,000,00
price Stock ·
+
+ ×
·
3

A stockholder who previously owned 3.2 shares had stocks with a value
of:
(3.2 × \$6) = \$19.20. This stockholder has now paid \$4 for an additional
share, so that the total value is: (\$19.20 + \$4) = \$23.20. This stockholder
now owns 4.2 shares with a value of: (4.2 × \$5.52) = \$23.18 (difference
due to rounding).
132
Challenge Questions
1. a. Venture capital companies prefer to advance money in stages
because this approach provides an incentive for management to
reach the next stage, and it allows First Meriam to check at each
stage whether the project continues to have a positive NPV.
Marvin is happy because it signals their confidence. With hindsight,
First Meriam loses because it has to pay more for the shares at
each stage.
b. The problem with this arrangement would be that, while Marvin
would have an incentive to ensure that the option was exercised, it
would not have the incentive to maximize the price at which it sells
the new shares.
c. The right of first refusal could make sense if First Meriam was
making a large up-front investment that it needed to be able to
recapture in its subsequent investments. In practice, Marvin is
2. In a uniform-price auction, all successful bidders pay the same price. In a
discriminatory auction, each successful bidder pays a price equal to his
own bid. A uniform-price auction provides for the pooling of information
from bidders and reduces the winner’s curse.
3. Pisa Construction’s return on investment is 8%, whereas investors require
a 10% rate of return. Pisa proposes a scenario in which 2,000 shares of
common stock are issued at \$40 per share, and the proceeds (\$80,000)
are then invested at 8%. Assuming that the 8% return is received in the
form of a perpetuity, then the NPV for this scenario is computed as
follows:
-\$80,000 + (0.08 × \$80,000)/0.10 = -\$16,000
Share price would decline as a result of this project, not because the
company sells shares for less than book value, but rather due to the fact
that the NPV is negative.
133
Note that, if investors know price will decline as a consequence of Pisa’s
undertaking a negative NPV investment, Pisa will not be able to sell
shares at \$40 per share. Rather, after the announcement of the project,
the share price will decline to:
(\$400,000 - \$16,000)/10,000 = \$38.40
Therefore, Pisa will have to issue (\$80,000/\$38.40) = 2,083 new shares.
One can show that, if the proceeds of the stock issue are invested at 10%,
then share price remains unchanged.
4. This question is a matter of opinion. Students might discuss whether
there are likely to be shortages of venture capital; for example, in some
countries there might not be an active market for small firm IPOs. Another
issue to be discussed is whether there are side benefits to the rest of the
economy from an active venture capital industry.
134
CHAPTER 16
The Dividend Controversy
1. Newspaper exercise; answers will vary depending on the stocks chosen.
2. The available evidence is consistent with the observation that
managers believe shareholders prefer a steady progression of
dividends. For managers of risky companies whose earnings have
high variability, it is easy to show, using the Lintner model, that a
lower target payout (e.g., zero) and a lower adjustment rate (e.g.,
zero) reduce the variance of dividend changes.
3. a. Distributes a relatively low proportion of current earnings to offset fluctuations in operational cash flow; lower
P/E ratio.
b. Distributes a relatively high proportion of current earnings since the
decline is unexpected; higher P/E ratio.
c. Distributes a relatively low proportion of current earnings in order to offset anticipated declines in earnings;
lower P/E ratio.
d. Distributes a relatively low proportion of current earnings in order to fund expected growth; higher P/E ratio.
4. a. A t = 0 each share is worth \$20. This value is based on the
expected stream of dividends: \$1 at t = 1, and increasing by 5% in
each subsequent year. Thus, we can find the appropriate discount
rate for this company as follows:
g r
DIV
P
1
0

·
g r
1
20

·
⇒ r = 0.10 = 10.0%
Beginning at t = 2, each share in the company will enjoy a perpetual
stream of growing dividends: \$1.05 at t = 2, and increasing by 5%
in each subsequent year. Thus, the total value of the shares at t =
1 (after the t = 1 dividend is paid and after N new shares have been
issued) is given by:
million \$21
.05 0 0.10
million 1.05
V
1
·

·
If P1 is the price per share at t = 1, then:
135
V1 = P1 × (1,000,000 + N) = \$21,000,000
and:
P1 × N = \$1,000,000
From the first equation:
(1,000,000 × P1) + (N × P1) = 21,000,000
Substituting from the second equation:
(1,000,000 × P1) + 1,000,000 = 21,000,000
so that P1 = \$20.00
b. With P1 equal to \$20, and \$1,000,000 to raise, the firm will sell
50,000 new shares.
c. The expected dividends paid at t = 2 are \$1,050,000, increasing by
5% in each subsequent year. With 1,050,000 shares outstanding,
dividends per share are: \$1 at t = 2, increasing by 5% in each
subsequent year. Thus, total dividends paid to old shareholders
are: \$1,000,000 at t = 2, increasing by 5% in each subsequent year.
d. For the current shareholders:
5. From Question 4, the fair issue price is \$20 per share. If these shares are
instead issued at \$10 per share, then the new shareholders are getting a
bargain, i.e., the new shareholders win and the old shareholders lose.
As pointed out in the text, any increase in cash dividend must be offset by
a stock issue if the firm’s investment and borrowing policies are to be held
constant. If this stock issue cannot be made at a fair price, then
shareholders are clearly not indifferent to dividend policy.
6. The risk stems from the decision to not invest, and it is not a result of the
form of financing. If an investor consumes the dividend instead of re-
investing the dividend in the company’s stock, she is also ‘selling’ a part of
her stake in the company. In this scenario, she will suffer an equal
opportunity loss if the stock price subsequently rises sharply.
7. No, this does not make sense. Restricting dividends does not restrict the
investor’s ‘wages.’ For the policy to be effective, it would also have to
restrict capital gains.
0 \$20,000,00
(1.10) .05) 0 (0.10
\$1,000,000
1.10
\$2,000,000
0) (t PV ·
× −
+ · ·
136
8. If the company does not pay a dividend:
Cash 0 0 Debt
Existing fixed assets 4,500 5,500 + NPV Equity
New project 1,000 + NPV
\$5,500 + NPV \$5,500 + NPV
If the company pays a \$1,000 dividend:
Cash 0 0 Debt
Existing fixed assets 4,500 1,000 Value of new stock
New project 1,000 + NPV 4,500 + NPV Value of original stock
\$5,500 + NPV \$5,500 + NPV
Because the new stockholders receive stock worth \$1,000, the value of
the original stock declines by \$1,000, which exactly offsets the dividends.
9. One problem with this analysis is that it assumes the company’s net profit
remains constant even though the asset base of the company shrinks by
20%. That is, in order to raise the cash necessary to repurchase the
shares, the company must sell assets. If the assets sold are
representative of the company as a whole, we would expect net profit to
decrease by 20% so that earnings per share and the P/E ratio remain the
same. After the repurchase, the company will look like this next year:
Net profit: \$8 million
Number of shares: 0.8 million
Earnings per share: \$10
Price-earnings ratio: 20
Share price: \$200
10. a. If we ignore taxes and there is no information conveyed by the
repurchase when the repurchase program is announced, then
share price will remain at \$80.
b. The regular dividend has been \$4 per share, and so the company
has \$400,000 cash on hand. Since the share price is \$80, the
company will repurchase 5,000 shares.
137
c. Total asset value (before each dividend payment or stock
repurchase) remains at \$8,000,000. These assets earn \$400,000
per year, under either policy.
Old Policy: The annual dividend is \$4, which never changes, so the
stock price (immediately prior to the dividend payment) will be \$80
in all years.
New Policy: Every year, \$400,000 is available for share
repurchase. As noted above, 5,000 shares will be repurchased at t
= 0. At t = 1, immediately prior to the repurchase, there will be
95,000 shares outstanding. These shares will be worth
\$8,000,000, or \$84.21 per share. With \$400,000 available to
repurchase shares, the total number of shares repurchased will be
4,750. Using this reasoning, we can generate the following table:
Time Shares
Outstanding
Share
Price
Shares
Repurchased
t = 0 100,000 \$80.00 5,000
t = 1 95,000 \$84.21 4,750
t = 2 90,250 \$88.64 4,513
t = 3 85,737 \$93.31 4,287
Note that the stock price is increasing by 5.26% each year. This is
consistent with the rate of return to the shareholders under the old
policy, whereby every year assets worth \$7,600,000 (the asset
value immediately after the dividend) earn \$400,000, or a return of
5.26%.
11. If markets are efficient, then a share repurchase is a zero-NPV
investment. Suppose that the trade-off is between an investment in real
assets or a share repurchase. Obviously, the shareholders would prefer a
share repurchase to a negative-NPV project. The quoted statement
seems to imply that firms have only negative-NPV projects available.
Another possible interpretation is that managers have inside information
indicating that the firm’s stock price is too low. In this case, share
repurchase is detrimental to those stockholders who sell and beneficial to
those who do not. It is difficult to see how this could be beneficial to the
firm, however.
12. Because companies are reluctant to reduce their dividends, they will
normally increase dividends only when management is fairly certain that
the increases can be sustained. Thus, an increase in dividends signals
138
management’s confidence about the company’s future earnings potential,
and it is this signal that causes the stock price to rise.
13. a. This statement implicitly equates the cost of equity capital with the
stock’s dividend yield. If this were true, companies that pay no
dividend would have a zero cost of equity capital, which is clearly
not correct.
b. One way to think of retained earnings is that, from an economic
standpoint, the company earns money on behalf of the
shareholders, who then immediately re-invest the earnings in the
company. Thus, retained earnings do not represent free capital.
Retained earnings carry the full cost of equity capital (although
issue costs associated with raising new equity capital are avoided).
c. If the tax on capital gains is less than that on dividends, the
conclusion of this statement is correct; i.e., a stock repurchase is
always preferred over dividends. This conclusion, however, is
strictly because of taxes. Earnings per share is irrelevant.
14. a. If we assume that the constraint on dividends is binding, that is, if
we assume that dividends would have risen in the absence of the
constraint, then the restriction on dividends would increase capital
change. Dividends would be lower than otherwise, but capital
gains would increase to offset the reduction in dividends. Thus,
stock prices would increase.
b. The total return to equity capital is unchanged, and the firm’s
overall cost of capital is also unchanged. Thus, there will be no
effect on capital investment.
15. a. Because this is a regular dividend, the announcement is not news
to the stock market. Hence, the stock price will adjust only when
the stock begins to trade without the dividend and, thus, the stock
price will fall on the ex-dividend date.
b. With no taxes, the stock price will fall by the amount of the dividend,
here \$1.
c. With taxes on dividends but no taxes on capital gains, investors will
require the same after-tax return from two comparable companies,
one of which pays a dividend, the other, a capital gain of the same
magnitude. The stock price will thus fall by the amount of the after-
tax dividend, here \$1 × (1 - 0.30) = \$0.70.
139
d. If dealers are taxed equally on capital gains and dividends, then
they should not demand any extra return for holding stocks that pay
dividends. Thus, if shareholders are able to freely trade securities
around the time of the dividend payment, there should be no tax
effects associated with dividends.
16. a. If you own 100 shares at \$100 per share, then your wealth is
\$10,000. After the dividend payment, each share will be worth \$99
and your total wealth will be the same: 100 shares at \$99 per share
plus \$100 in dividends, or \$10,000.
b. With no taxes, it does not matter how the company transfers wealth
to the shareholders; that is, you are indifferent between a dividend
and a share repurchase program. In either case, your total wealth
will remain at \$10,000.
17. After-tax Return on Share A: At t = 1, a shareholder in company A will
receive a dividend of \$10, which is subject to taxes of 30%. Therefore, the
after-tax gain is \$7. Since the initial investment is \$100, the after-tax rate
of return is 7%.
After-tax Return on Share B: If an investor sells share B after 2 years, the
price will be: (100 × 1.10
2
) = \$121. The capital gain of \$21 is taxed at the
30% rate, and so the after-tax gain is \$14.70. On an initial investment of
\$100, over a 2-year time period, this is an after-tax annual rate of return of
7.10%.
If an investor sells share B after 10 years, the price will be:
(100 × 1.10
10
) = \$259.37. The capital gain of \$159.37 is taxed at the 30%
rate, and so the after-tax gain is \$111.56. On an initial investment of
\$100, over a 10-year time period, this is an after-tax annual rate of return
of 7.78%.
18. a. (i) The tax-free investor should buy on the with-dividend date
because the dividend is worth \$1 and the price decrease is only
\$0.90.
(ii) The dividend is worth only \$0.60 to the taxable investor who is
subject to a 40% marginal tax rate. Therefore, this investor
should buy on the ex-dividend date. [Actually, the taxable
investor’s problem is a little more complicated. By buying at the
ex-dividend price, this investor increases the capital gain that is
eventually reported upon the sale of the asset. At most,
however, this will cost:
(0.16 × 0.90) = \$0.14
This is not enough to offset the tax on the dividend.]
140
b. The marginal investor, by definition, must be indifferent between
buying with-dividend or ex-dividend. If we let T represent the
marginal tax rate on dividends, then the marginal tax rate on capital
gains is (0.4T). In order for the net extra return from buying with-
dividend (instead of ex-dividend) to be zero:
- Extra investment + After-tax dividend + Reduction in capital gains
tax = 0
Therefore, per dollar of dividend:
-0.85 + [(1 - T) × (1.00)] + [(0.4T) × (0.85)] = 0
T = 0.227 = 22.7%
c. We would expect the high-payout stocks to show the largest
decline per dollar of dividends paid because these stocks should be
held by investors in low, or perhaps even zero, marginal tax
brackets.
d. Some investors (e.g., pension funds and security dealers) are
indifferent between \$1 of dividends and \$1 of capital gains. These
investors should be prepared to buy any amount of stock with-
dividend as long as the fall-off in price is fractionally less than the
dividend. Elton and Gruber’s result suggests that there must be
some impediment to such tax arbitrage (e.g., transactions costs or
IRS restrictions). But, in that case, it is difficult to interpret their
result as indicative of marginal tax rates.
e. Since the passage of the Tax Reform Act, the tax advantage to
capital gains has been reduced. If investors are now indifferent
between dividends and capital gains, we would expect that the
payment of a \$1 dividend would result in a \$1 decrease in price.
19. Under the tax system in the United States, the only investors who are
indifferent to the dividend payout ratio are those who pay the same tax
rate on dividends as on capital gains. This is true regardless of the
corporate tax rate.
Under Australia’s imputation tax system, shareholders pay income tax on
dividends received, but they can deduct from their tax bill their share of the
corporate tax on pre-tax earnings paid by the company. The only
investors who would be indifferent with regard to the payout ratio are
those whose marginal tax rate is 100%, because they do not receive
anything after tax, regardless of whether the income is a capital gain or a
dividend. Therefore, all Australian investors prefer dividends because the
141
corporation, in effect, pays part of the personal tax on dividends but pays
no part of the personal tax on capital gains.
20. Even if the middle-of-the-road party is correct about the supply of
dividends, we still do not know why investors wanted the dividends they
got. So, it is difficult to be sure about the effect of the tax change. If there
is some non-tax advantage to dividends that offsets the apparent tax
disadvantage, then we would expect investors to demand more dividends
after the Tax Reform Act. If the apparent tax disadvantage were irrelevant
because there were too many loopholes in the tax system, then the Tax
Reform Act would not affect the demand for dividends. In any case, the
supply of dividends to the new equilibrium, dividend policy would again
become irrelevant.
142
Challenge Questions
1. We make use of Lintner’s model, suitably rearranged:
DIVt = Adjustment Rate x Target Ratio x EPS t + (1 – Adjustment Rate) x
DIVt - 1
Thus, if we regress dividends at time t against earnings per share (also at
time t) and dividends (at time t – 1), the adjustment rate and the target rate
can be found as follows:
Adjustment Rate = 1 – (coefficient of DIVt - 1)
Target Ratio = (coefficient of EPS t )/Adjustment Rate
These two regressions were performed using Excel®(forcing the constant
to be zero). The results are:
Merck International Paper
Target Ratio 1.574 2.309
For Merck, if EPS in 2001 is \$5, then the predicted dividend in 2001 is:
DIV2001 = (0.043)× (1.574)× (5.00) + (1 - 0.043)× (1.21) = \$1.50
For International Paper, if EPS in 2001 is \$3, then the predicted dividend
in 2001 is:
DIV2001 = (0.009)× (2.309)× (3.00) + (1 - 0.009)× (1.00) = \$1
2. Nice try! 
3. Generally, a share repurchase is viewed as a signal that::
a. Management desires to avoid excess cash, and/or;
b. Management desires to Increase the debt:equity ratio, and/or;
c. The stock is a good value even at 20% above the current market
share price.
Under any or all of these conditions, the share price would likely increase.
Conversely, if the repurchase made the firm substantially more risky, or if
managers were having their own shares repurchased, or if the action was
interpreted as an inability to find positive NPV projects for the future, then
the share price might either remain unchanged or decrease.
4. It is true that researchers have been consistent in finding a positive
association between price-earnings multiples and payout ratios. But
143
simple tests like this one do not isolate the effects of dividend policy, so
the evidence is not convincing.
Suppose that King Coal Company, which customarily distributes half its
earnings, suffers a strike that cuts earnings in half. The setback is
regarded as temporary, however, so management maintains the normal
dividend. The payout ratio for that year turns out to be 100 percent, not 50
percent.
The temporary earnings drop also affects King Coal’s price-earnings ratio.
The stock price may drop because of this year’s disappointing earnings,
but it does not drop to one-half its pre-strike value. Investors recognize
the strike as temporary, and the ratio of price to this year’s earnings
increases. Thus, King Coal’s labor troubles create both a high payout
ratio and a high price-earnings ratio. In other words, they create a
spurious association between dividend policy and market value. The
same thing happens whenever a firm encounters temporary good fortune,
or whenever reported earnings underestimate or overestimate the true
long-run earnings on which both dividends and stock prices are based.
A second source of error is omission of other factors affecting both the
firm’s dividend policy and its market valuation. For example, we know that
firms seek to maintain stable dividend rates. Companies whose prospects
are uncertain therefore tend to be conservative in their dividend policies.
Investors are also likely to be concerned about such uncertainty, so that
the stocks of such companies are likely to sell at low multiples. Again, the
result is an association between the price of the stock and the payout
ratio, but it stems from the common association with risk and not from a
market preference for dividends.
Another reason that earnings multiples may be different for high-payout
and low-payout stocks is that the two groups may have different growth
prospects. Suppose, as has sometimes been suggested, that
management is careless in the use of retained earnings but exercises
appropriately stringent criteria when spending external funds. Under such
circumstances, investors would be correct to value stocks of high-payout
firms more highly. But the reason would be that the companies have
different investment policies. It would not reflect a preference for high
dividends as such, and no company could achieve a lasting improvement
in its market value simply by increasing its payout ratio.
144
CHAPTER 17
Does Debt Policy Matter?
1. a. The two firms have equal value; let V represent the total value of the firm. Rosencrantz could buy one percent
of Company B’s equity and borrow an amount equal to:
0.01 × (D
A
- D
B
) = 0.002V
This investment requires a net cash outlay of (0.007V) and provides a net
cash return of:
(0.01 × Profits) – (0.003 × r
f
× V)
where rf is the risk-free rate of interest on debt. Thus, the two investments are identical.
b. Guildenstern could buy two percent of Company A’s equity and lend an amount equal to:
0.02 × (DA - DB) = 0.004V
This investment requires a net cash outlay of (0.018V) and provides a net cash return of:
(0.02 × Profits) – (0.002 × rf × V)
Thus the two investments are identical.
c. The expected dollar return to Rosencrantz’ original investment in A is:
(0.01 × C) – (0.003 × rf × VA)
where C is the expected profit (cash flow) generated by the firm’s assets. Since the firms are the same except
for capital structure, C must also be the expected cash flow for Firm B. The dollar return to Rosencrantz’ alternative strategy is:
(0.01 × C) – (0.003 × rf × VB)
Also, the cost of the original strategy is (0.007VA) while the cost of the alternative strategy is (0.007VB).
If VA is less than VB, then the original strategy of investing in Company A would provide a larger dollar return
at the same time that it would cost less than the alternative. Thus, no rational investor would invest in Company B if the value of
Company A were less than that of Company B.
145
2. When a firm issues debt, it shifts its cash flow into two streams. MM’s Proposition I states that this does not affect firm
value if the investor can reconstitute a firm’s cash flow stream by creating personal leverage or by undoing the effect of the
firm’s leverage by investing in both debt and equity.
It is similar with Carruther’s cows. If the cream and skim milk go into the same pail, the cows have no special value. (If
an investor holds both the debt and equity, the firm does not add value by splitting the cash flows into the two streams.) In
the same vein, the cows have no special value if a dairy can costlessly split up whole milk into cream and skim milk. (Firm
borrowing does not add value if investors can borrow on their own account.) Carruther’s cows will have extra value if
consumers want cream and skim milk and if the dairy cannot split up whole milk, or if it is costly to do so.
3. The company cost of capital is:
rA = (0.8 × 0.12) + (0.2× 0.06) = 0.108 = 10.8%
Under Proposition I, this is unaffected by capital structure changes. With the bonds remaining at the 6 percent default-risk
free rate, we have:
Debt-Equity
Ratio
rE rA
0.00 0.108 0.108
0.10 0.113 0.108
0.50 0.132 0.108
1.00 0.156 0.108
2.00 0.204 0.108
3.00 0.252 0.108
See figure on next page.
4. This is not a valid objection. MM’s Proposition II explicitly allows for the rates of return for both debt and equity to
increase as the proportion of debt in the capital structure increases. The rate for debt increases because the debt-holders are
taking on more of the risk of the firm; the rate for common stock increases because of increasing financial leverage. See
Figure 17.2 and the accompanying discussion.
146
Rates of Return
Debt / Equity
1 2 3
.060
.108
.150
.200
.250
r
D
r
A
r
E
147
5. a. Under Proposition I, the firm’s cost of capital (rA) is not affected by the choice of capital structure. The reason
the quoted statement seems to be true is that it does not account for the changing proportions of the firm financed by debt and
equity. As the debt-equity ratio increases, it is true that both the cost of equity and the cost of debt increase, but a smaller
proportion of the firm is financed by equity. The overall effect is to leave the firm’s cost of capital unchanged.
b. Moderate borrowing does not significantly affect the probability of financial distress, but it does increase the
variability (and market risk) borne by stockholders. This additional risk must be offset by a higher average
6. a. If the opportunity were the firm’s only asset, this would be a good deal. Stockholders would put up no money
and, therefore, would have nothing to lose. However, rational lenders will not advance 100 percent of the asset’s value for an 8
percent promised return unless other assets are put up as collateral.
Sometimes firms find it convenient to borrow all the cash required for a particular investment. Such
investments do not support all of the additional debt; lenders are protected by the firm’s other assets too.
In any case, if firm value is independent of leverage, then any asset’s contribution to firm value must be
independent of how it is financed. Note also that the statement ignores the effect on the stockholders of an increase in financial
leverage.
b. This is not an important reason for conservative debt levels. So long as MM’s Proposition I holds, the
company’s overall cost of capital is unchanged despite increasing interest rates paid as the firm borrows more.
(However, the increasing interest rates may signal an increasing probability of financial distress—and that can
be important.
7. Examples of such securities are given in the text and include unbundled stock units, preferred equity redemption
cumulative stock and floating-rate notes. Note that, in order to succeed, such securities must both meet regulatory
requirements and appeal to an unsatisfied clientele.
148
8. Why does share price drop during a recession? Because forecasted cash flows to stockholders decline. (Stockholders may also
perceive higher risks and demand a higher expected rate of return.) The stock price will decline to the point where the
expected return to the stock, given the amount of debt, is a ‘fair’ return.
Suppose that a recession hits and stock price declines. Would the cost of capital for new investment be less if the firm had
used more debt in the past? No, the firm’s past financing decisions are bygones. Moreover, MM’s Proposition I holds in
recessions as well as booms. The firm’s overall cost of capital is independent of its debt ratio.
Incidentally, the more debt a firm has, the greater the percentage decline in the value of its shares as a result of a recession
or any other unfortunate event.
9. a. As the debt/equity ratio increases, both the cost of debt capital and the cost of equity capital increase. The cost
of debt capital increases because increasing the debt/equity ratio increases the risk of default so that bondholders require a higher
rate of return to compensate for the increase in risk. The cost of equity capital increases because increasing the debt/equity ratio
increases the financial risk borne by the stockholders; a higher rate of return is required to compensate for this increase in risk.
b. For higher levels of the debt/equity ratio, we have the cost of debt capital increasing and approaching (but never
being equal to, or greater than) the cost of capital for the firm. Similarly, the cost of equity capital will also
continue to rise; in particular, it can not decrease beyond a certain point.
10. a. As leverage is increased, the cost of equity capital rises. This is the same as saying that, as leverage is
increased, the ratio of the income after interest (which is the cash flow stockholders are entitled to) to the value of equity
increases. Thus, as leverage increases, the ratio of the market value of the equity to income after interest decreases.
b. (i) Assume MM are correct. The market value of the firm is determined by the
income of the firm, not how it is divided among the firm’s security holders. Also, the firm’s income
before interest is independent of the firm’s financing. Thus, both the value of the firm and the value
of the firm’s income before interest remain constant as leverage is increased. Hence, the ratio is a
constant.
(ii) Assume the traditionalists are correct. The firm’s income before interest is independent of leverage.
As leverage increases, the firm’s cost of capital first decreases and then increases; as a result, the
market value of the firm first increases and then decreases. Thus, the ratio of the market value of the
firm to firm income before interest first increases and then decreases, as leverage increases.
11. We begin with rE and the capital asset pricing model:
rE = rf + β E (rm - rf)
rE = 0.10 + 1.5 (0.18 - 0.10) = 0.22 = 22.0%
Similarly for debt:
rD = rf + β D (rm - rf)
0.12 = 0.10 + β D (0.18 – 0.10)
β D = 0.25
Also, we know that:
17.0% 0.17 0.22) (0.5 0.12) (0.5
E
r
E D
E
D
r
E D
D
A
r · · × + × · ×
+
+ ×
+
·

,
`

.
|

,
`

.
|
To solve for β A, use the following:
149
0.875 1.5) (0.5 0.25) (0.5 β
E D
E
β
E D
D
β
E D A
· × + × ·

,
`

.
|
×
+
+

,
`

.
|
×
+
·
12. We know from Proposition I that the value of the firm will not change. Also, because the expected operating income is
unaffected by changes in leverage, the firm’s overall cost of capital will not change. In other words, rA remains equal to
17% and β A remains equal to 0.875. However, risk and, hence, the expected return for equity and for debt, will change.
We know that rD is 11%, so that, for debt:
rD = rf + β D (rm - rf)
0.11 = 0.10 + β D (0.18 - 0.10)
β D = 0.125
For equity:

,
`

.
|

,
`

.
|
×
+
+ ×
+
·
E
r
E D
E
D
r
E D
D
A
r
0.17 = (0.3 × 0.11) + (0.7 × rE)
rE = 0.196 = 19.6%
Also:
rE = rf + β E (rm - rf)
0.196 = 0.10 + β E (0.18 - 0.10)
β E = 1.20
13. Before the refinancing, Schuldenfrei is all equity financed. The equity beta is 0.8 and the expected return on equity is 8%.
Thus, the firm’s asset beta is 0.8 and the firm’s cost of capital is 8%. We know that these overall firm values will not
change after the refinancing and that the debt is risk-free.
a.

,
`

.
|
×
+
+

,
`

.
|
×
+
·
E D A
β
E D
E
β
E D
D
β
0.8 = (0.5 × 0) + (0.5 × β E)
β E = 1.60
b. Before the refinancing, the stock’s required return is 8% and the risk-free rate is 5%; thus, the risk premium for
the stock is 3%.
c. After the refinancing:

,
`

.
|

,
`

.
|
×
+
+ ×
+
·
E
r
E D
E
D
r
E D
D
A
r
0.08 = (0.5 × 0.05) + (0.5 × rE)
rE = 0.11 = 11.0%
After the refinancing, the risk premium for the stock is 6%.
150
d. The required return for the debt is 5%, the risk-free rate.
e. The required return for the company remains at 8%.
f. Let E be the operating profit of the company and N the number of shares outstanding before the refinancing.
Also, we know that E is (0.08V). Thus, the earnings per share before the refinancing is:
EPSB = 0.08V/N
After the refinancing the operating profit is still E and the number of shares is (0.5 × N). Interest on the debt is
5% of the value of the debt, which is (0.5 × V). Thus, the earnings per share after the refinancing is:
EPSA = [0.08V – (0.05 × 0.5 × V)]/(0.5 × N) = 0.11V/N
It follows that earnings per share has increased by 37.5%.
g. Before the refinancing, the P/E ratio is 12.5. The price of the common stock is the same before and after the
refinancing, but the earnings per share has increased from (0.08V/N) to (0.11V/N). (See Part (f) above.) Thus,
the new P/E ratio is 9.09.
151
14. We make use of the basic relationship:

,
`

.
|

,
`

.
|
×
+
+ ×
+
·
E
r
E D
E
D
r
E D
D
A
r
If the company is all-equity-financed and the cost of equity capital (rE) is 18%, then the company cost of capital (rA) is
18%, which will not change as the capital structure changes. In addition, we know that the risk-free rate (rf) is 10% and
that Gamma’s debt is risk-free. Thus:
D/E rA rD rE
0 0.18 0.10 0.18
1 0.18 0.10 0.26
2 0.18 0.10 0.34
3 0.18 0.10 0.42
D/V rA rD rE
0 0.18 0.10 0.180
0.25 0.18 0.10 0.207
0.50 0.18 0.10 0.260
0.75 0.18 0.10 0.420
15. a. Because the firms are identical except for capital structure, and there are no taxes or other market imperfections,
the total values of these companies must be the same. Thus, L’s stock is worth:
(\$500 - \$400) = \$100.
b. If you own \$20 of U’s common stock, you own 4% of the outstanding shares and, thus, are entitled to (0.04 ×
\$150) = \$6 if there is a boom and (0.04 × \$50) = \$2 if there is a slump.
The equivalent investment is to purchase 4% of L’s outstanding stock, which will cost (0.04 × \$100) = \$4, and to invest \$16 at
the risk-free rate. The total amount invested is the same (\$20). In a boom, you are entitled to: [(0.10 × \$16) + (0.04) × (\$150 -
\$40)] = \$6, and in a slump you are entitled to: [(0.10 × \$16) + (0.04) × (\$50 - \$40)] = \$2.
c. If you own \$20 of L’s common stock, you own 20% of the outstanding shares and, thus, are entitled to [0.20 ×
(\$150 - \$40)] = \$22 if there is a boom, and [0.20 × (\$50 - \$40) = \$2 if there is a slump.
The equivalent investment is to purchase 20% of U’s outstanding stock, which costs: (0.20 × \$500) = \$100 and to borrow \$80 at
the risk-free rate. The total invested is the same (\$20). In a boom you are entitled to:
Return
D/V
.25 .50 .75
.10
.20
.30
.40
rD
rA
rE
Return
D/E
1 2 3
.10
.20
.30
.40
rD
r
A
rE
152
[(-0.10) × (\$80) + (0.20 × \$150)] = \$22 and in a slump you are entitled to: [(-0.10) × (\$80) + (0.20 × \$50)] = \$2.
d. Proposition II can be stated as follows:
) r (r
E
D
r r
D A A E
− + ·
For U, the expected return on assets is:
20.0% .20 0
\$500
\$100
\$500
\$150) .5 (0 \$50) (0.5
· · ·
× + ×
Thus, for both companies, rA is 20%. For L, the expected return on equity is:
60.0% .60 0
\$100
\$60
\$100
\$40)] (\$150 .5 [0 \$40)] (\$50 [0.5
· · ·
− × + − ×
This is the same result we derive from the Proposition II formula:
rE = 0.20 + [4 × (0.20 - 0.10) = 0.60 = 60%
153
Challenge Questions
1. Assume the election is near so that we can safely ignore the time value of money.
Because one, and only one, of three events will occur, the guaranteed payoff from holding all three tickets is \$10. Thus,
the three tickets, taken together, could never sell for less than \$10. This is true whether they are bundled into one
composite security or unbundled into three separate securities.
However, unbundled they may sell for more than \$10. This will occur if the separate tickets fill a need for some currently
unsatisfied clientele. If this is indeed the case, Proposition I fails. The sum of the parts is worth more than the whole.
2. Some shoppers may want only the chicken drumstick. They could buy a whole chicken, cut it up, and sell off the other
parts in the supermarket parking lot. This is costly. It is far more efficient for the store to cut up the chicken and sell the
pieces separately. But this also has some cost, hence the observation that supermarkets charge more for chickens after they
have been cut.
The same considerations affect financial products, but:
a. The proportionate costs to companies of repackaging the cash flow stream are generally small.
b. Investors can also repackage cash flows cheaply for themselves. In fact, specialist financial institutions can
often do so more cheaply than the companies can do it themselves.
154
CHAPTER 18
How Much Should a Firm Borrow?
1. For \$1 of debt income:
Corporate tax = \$0
Personal tax = 0.44× \$1 = \$0.440
Total = \$0.440
For \$1 of equity income, with all capital gains realized immediately:
Corporate tax = 0.35× \$1 = \$0.350
Personal tax = 0.44× 0.5× [\$1 – (0.35× \$1)] + 0.20× 0.5× [\$1 – (0.35× \$1)] =
\$0.208
Total = \$0.558
For \$1 of equity income, with all capital gains deferred forever:
Corporate tax = 0.35× \$1 = \$0.350
Personal tax = 0.44× 0.5× [\$1 – (0.35× \$1)] = \$0.143
Total = \$0.493
2. Consider a firm that is levered, has perpetual expected cash flow X, and has an interest rate for debt of rD. The personal and
corporate tax rates are Tp and Tc, respectively. The cash flow to stockholders each year is:
(X - rDD)(1 - Tc)(1 - Tp)
Therefore, the value of the stockholders’ position is:
where r is the opportunity cost of capital for an all-equity-financed firm. If the stockholders borrow D at the same rate rD,
and invest in the unlevered firm, their cash flow each year is:
) T (1 ) (r
) T (1 ) T (1 D) ( ) (r
) T (1 (r)
) T (1 ) T (1 (X)
V
p D
p c D
p
p c
L

− −

− −
·
)] T (1 D) (
) T (1 (r)
) T (1 ) T (1 (X)
V
c
p
p c
L
− −

− −
· [
)] T (1 D) ( ) r ( )] T (1 ) T (1 [(X)
p D p c
− − − − [
155
The value of the stockholders’ position is then:
The difference in stockholder wealth, for investment in the same assets, is:
VL – VU = DTc
This is the change in stockholder wealth predicted by MM. If individuals could not deduct interest for personal tax
purposes, then:
Then:
So the value of the shareholders’ position in the levered firm is relatively greater when no personal interest deduction is
allowed.
3. The book value of Pfizer’s assets is \$21,529 million. With a 40 percent book debt ratio:
Long-term debt + Other long-term liabilities = 0.40 × \$21,529 = \$8,612
This is [\$8,612 – (\$2,123 + \$4,330)] = \$2,159 more than shown in Table 18.3(a). The corporate tax rate is 35 percent, so
firm value increases by:
0.35 × \$2,159 = \$756 million
The market value of the firm is now: (\$296,247 + \$756) = \$297,003 million.
The market value balance sheet is:
Net working capital \$5,206 \$4,282 Long-term debt
Market value of long-term assets 291,797 4,330 Other long-term liabilities
288,391 Equity
Total Assets \$297,003 \$297,003 Firm market value
) T (1 ) (r
) T (1 D) ( ) (r
) T (1 (r)
) T (1 ) T (1 (X)
V
p D
p D
p
p c
U

− −
·
D
) T (1 (r)
) T (1 ) T (1 (X)
V
p
p c
U

− −
·
) T (1 ) (r
D) )( (r
) T (1 (r)
) T (1 ) T (1 (X)
V
p D
D
p
p c
U

− −
·
) T (1 ) (r
)] T (1 ) T (1 D) )( r ( [ D) ( ) (r
V V
p D
p c D D
U L

− − −
· −

,
`

.
|

+ · −
) T (1
T
D ) T D ( V V
p
p
c U L
156
4. Answers here will vary depending on the company chosen.
5. The value of interest tax shields is determined by:
 The on-going degree of profitability.
 The ability to carry-forward and carry-back excess credits
 The ability to maintain debt levels on an on-going basis.
 The rates of personal and corporate taxes.
 The amount of non-interest tax shields
6. When a firm defaults, the cause (absent fraud) is usually an operating problem. Although both shareholders and debtholders are
worse off, their respective expected rates of return are determined in a manner that compensates for this risk. The
combined positions of stockholders and bondholders in limited liability and unlimited liability firms are the same. The
ability to assign the assets to the creditors, and not have to repay, has value to the shareholders since it is a more efficient
transfer of wealth.
7. Assume the following facts for Circular File:
Book Values
Net working capital \$20 \$50 Bonds outstanding
Fixed assets 80 50 Common stock
Total assets \$100 \$100 Total liabilities
Market Values
Net working capital \$20 \$25 Bonds outstanding
Fixed assets 10 5 Common stock
Total assets \$30 \$30 Total liabilities
a. Playing for Time
Suppose Circular File foregoes replacement of \$10 of capital equipment, so that the new balance sheet may appear as follows:
Market Values
Net working capital \$30 \$29 Bonds outstanding
Fixed assets 8 9 Common stock
Total assets \$38 \$38 Total liabilities
Here the shareholder is better off but has obviously diminished the firm’s competitive ability.
b. Cash In and Run
Suppose the firm pays a \$5 dividend:
Market Values
Net working capital \$15 \$23 Bonds outstanding
Fixed assets 10 2 Common stock
Total assets \$25 \$25 Total liabilities
Here the value of common stock should have fallen to zero, but the bondholders bear part of the burden.
c. Bait and Switch
Market Values
Net working capital \$30 \$20 New Bonds outstanding
157
20 Old Bonds outstanding
Fixed assets 20 10 Common stock
Total assets \$50 \$50 Total liabilities
8. Static trade-off theory reduces the debt-equity decision to a trade-off between interest tax shields and the costs of financial
distress. In the real world, matters are not so simple because there are costs to adjusting the firm’s capital structure, and
individual managers have different attitudes toward debt. High-tech growth firms with risky assets tend to be equity
financed while low risk mature businesses tend to have more debt. Similarly, firms often issue equity to pay off excess
debt. However, many profitable firms have very little debt and changes in tax rates have little effect on debt-equity ratios.
9. Answers here will vary according to the companies chosen; however, the important considerations are given in the text, Section
18.3.
10. a. SOS stockholders could lose if they invest in the positive NPV project and then SOS becomes bankrupt. Under
these conditions, the benefits of the project accrue to the bondholders.
b. If the new project is sufficiently risky, then, even though it has a negative NPV, it might increase stockholder
wealth by more than the money invested. This is a result of the fact that, for a very risky investment, undertaken by a firm with a
significant risk of default, stockholders benefit if a more favorable outcome is actually realized, while the cost of unfavorable
outcomes is borne by bondholders.
c. Again, think of the extreme case: Suppose SOS pays out all of its assets as one lump-sum dividend.
Stockholders get all of the assets, and the bondholders are left with nothing.
These conflicts of interest are severe only when the company is in financial distress. Adherence to a moderate target debt ratio
limits the conflicts.
158
11. a. The bondholders benefit. The fine print limits actions that transfer wealth from the bondholders to the
stockholders.
b. The stockholders benefit. In the absence of fine print, bondholders charge a higher rate of interest to ensure that
they receive a fair deal. The firm would probably issue the bond with standard restrictions. It is likely that the
restrictions would be less costly than the higher interest rate.
12. Certainly part of this drop must be attributed to bankruptcy costs, which come out of the shareholders’ pockets. It is likely,
however, that the actual bankruptcy filing conveyed some negative information to the market about Caldor’s future
prospects and that part of the drop must, therefore, be attributed to this negative information.
13. Other things equal, the announcement of a new stock issue to fund an investment project with an NPV of \$40 million
should increase equity value by \$40 million (less issue costs). But, based on past evidence, management expects equity
value to fall by \$30 million. There may be several reasons for the discrepancy:
(i) Investors may have already discounted the proposed investment. (However, this alone would not explain a fall
in equity value.)
(ii) Investors may not be aware of the project at all, but they may believe instead that cash is required because of,
say, low levels of operating cash flow.
(iii) Investors may believe that the firm’s decision to issue equity rather than debt signals management’s belief that
the stock is overvalued.
If the stock is indeed overvalued, the stock issue merely brings forward a stock price decline that will occur eventually
anyway. Therefore, the fall in value is not an issue cost in the same sense as the underwriter’s spread. If the stock is not
overvalued, management needs to consider whether it could release some information to convince investors that its stock is
correctly valued, or whether it could finance the project by an issue of debt.
159
14. a. Masulis’ results are consistent with the view that debt is always preferable because of its tax advantage, but are
not consistent with the ‘tradeoff’ theory, which holds that management strikes a balance between the tax advantage of debt and
the costs of possible financial distress. In the tradeoff theory, exchange offers would be undertaken to move the firm’s debt level
toward the optimum. That ought to be good news, if anything, regardless of whether leverage is increased or decreased.
b. The results are consistent with the evidence regarding the announcement effects on security issues and
repurchases.
c. One explanation is that the exchange offers signal management’s assessment of the firm’s prospects.
Management would only be willing to take on more debt if they were quite confident about future cash flow, for
example, and would want to decrease debt if they were concerned about the firm’s ability to meet debt
payments in the future.
15. Let us assume that, as companies are started, grow, and mature, they stick to the same line of business and are consistently
profitable. Then, if the tradeoff theory is correct, because the types of assets the company has do not change over time, the
firm’s debt ratio will likewise not be expected to change over time. If the pecking-order theory is correct, the company’s
debt ratio will tend to decrease over time because the company will fund projects from retained earnings, i.e., internally
generated cash.
16. In general, the pecking order theory explains intra-industry debt levels since less profitable firms end up borrowing more
because they have lower internal cash flow. However, the argument seems to fail on an inter-industry basis. High-tech,
high growth firms have low debt levels even though they need cash, and stable, mature industries (e.g., utilities) often do
not pay down debt but pay the cash out as dividends.
17. Bondholders require a higher interest rate than they would otherwise in order to compensate for the fact that interest
attracts more tax than equity returns.
160
18. a.
Expected Payoff to Bank Expected Payoff to Ms. Ketchup
Project 1 +10.0 +5
Project 2 (0.4× 10) + (0.6× 0) = +4.0 (0.4× 14)+(0.6× 0)=+5.6
Ms. Ketchup would undertake Project 2.
b. Break even will occur when Ms. Ketchup’s expected payoff from Project 2 is equal to her expected payoff from
Project 1. If X is Ms. Ketchup’s payment on the loan, then her payoff from Project 2 is:
0.4 (24 – X)
Setting this expression equal to 5 (Ms. Ketchup’s payoff from Project 1), and solving, we find that: X = 11.5
Therefore, Ms. Ketchup will borrow less than the present value of this payment.
19. Internet exercise; answers will vary.
Challenge Questions
1. a. Internet exercise; answers will vary.
161
CHAPTER 19
Financing and Valuation
1. If the bank debt is treated as permanent financing, the capital structure
proportions are:
Bank debt (rD = 10 percent) \$280 9.4%
Long-term debt (rD = 9 percent) 1800 60.4
Equity (rE = 18 percent, 90 x 10 million shares) 900 30.2
\$2980 100.0%
WACC* = [0.10× (1 - 0.35)× 0.094] + [0.09× (1 - 0.35)× 0.604] +
[0.18× 0.302]
= 0.096 = 9.6%
2. Forecast after-tax incremental cash flows as explained in Section 6.1.
Interest is not included; the forecasts assume an all-equity financed firm.
3. Calculate APV by subtracting \$4 million from base-case NPV.
4. We make three adjustments to the balance sheet:
• Ignore deferred taxes; this is an accounting entry and represents
neither a liability nor a source of funds
• ‘Net out’ accounts payable against current assets
• Use the market value of equity (7.46 million x \$46)
Now the right-hand side of the balance sheet (in thousands) looks like:
Short-term debt \$75,600
Long-term debt 208,600
Share holder equity 343,160
Total \$627,360
The after-tax weighted-average cost of capital formula, with one element for each
source of funding, is:
WACC = [r
D-ST
× (1 – T
c
)× (D-ST/V)]+[r
D-LT
× (1 – T
c
)× (D-LT/V)]+[r
E
× (E/V)]
WACC = [0.06× (1 - 0.35)× (75,600/627,360)] + [0.08× (1 -
0.35)× (208,600/627,360)]
162
+ [0.15× (343,160/627,360)]
= 0.004700 + 0.017290 + 0.082049 = 0.1040 = 10.40%
5. Assume that short-term debt is temporary. From Practice Question 4:
Long-term debt \$208,600
Share holder equity 343,160
Total \$551,760
Therefore:
(D/V) = (\$208,600/\$551,760) = 0.378
(E/V) = (\$343,160/\$551,760) = 0.622
Step 1:
r = rD (D/V) + rE (E/V) = (0.08 × 0.378) + (0.15 × 0.622) = 0.1235
Step 2:
rE = r + (r – rD) (D/E) = 0.1235 + (0.1235 - .08) × (0.4) = 0.1409
Step 3:
WACC = [rD × (1 – TC) × (D/V)] + [rE × (E/V)]
= (0.08 × 0.65 × 0.286) + (0.1409 × 0.714) = 0.1155 =
11.55%
6.
Pre-tax operating income \$100.5
Short-term interest 4.5
Long-term interest 16.7
Earnings before tax \$79.3
Tax 27.8
Net income \$51.5
Value of equity = \$51.5/0.15 = \$343.3
Value of firm = \$343.3 + \$75.6 + \$208.6 = \$627.5
7. The problem here is that issue costs are a one-time expenditure, while
adjusting the WACC implies a correction every year. The only way to
account for issue costs in project evaluation is to use the APV
formulation and adjust directly by subtracting the issue costs from the
base case NPV.
163
8. a. Base case NPV = -1,000 + (600/1.12) + (700/1.12
2
) = \$93.75 or
\$93,750
Year
Debt
Outstanding at
Start Of Year Interest
Interest
Tax Shield
PV
(Tax Shield)
1 300 24 7.20 6.67
2 150 12 3.60 3.09
APV = 93.75 + 6.67 + 3.09 = 103.5 or \$103,500
9. [\$100,000 × (1 - 0.35)] + [\$100,000 × (1 - 0.35) × (Annuity Factor5/9 (1 –
0.35)%)]
= \$65,000 + \$274,925 = \$339,925
10. a. Base-case NPV = -\$1,000,000 + (\$85,000/0.10) = -\$150,000
PV(tax shields) = 0.35 × \$400,000 = \$140,000
APV = -\$150,000 + \$140,000 = -\$10,000
b. PV(tax shields, approximate) = (0.35 × 0.07 ×
\$400,000)/0.10 = \$98,000
APV = -\$150,000 + \$98,000 = -\$52,000
PV(tax shields, exact) = \$98,000 × (1.10/1.07) = \$100,748
APV = -\$150,000 + \$100,748 = -\$49,252
The present value of the tax shield is higher when the debt is fixed and
therefore the tax shield is certain. When borrowing a constant proportion
of the market value of the project, the interest tax shields are as uncertain
as the value of the project, and therefore must be discounted at the
project’s opportunity cost of capital.
11. The immediate source of funds (i.e., both the proportion borrowed
and the expected return on the stocks sold) is irrelevant. The
project would not be any more valuable if the university sold stocks
offering a lower return. If borrowing is a zero-NPV activity for a tax-
exempt university, then base-case NPV equals APV, and the
adjusted cost of capital r* equals the opportunity cost of capital with
all-equity financing. Here, base-case NPV is negative; the
university should not invest.
12. r* is the after-tax adjusted weighted average cost of capital. An adjusted
discount rate does not equal the WACC when it takes into account major
changes in expected capital structure or costs.
164
13. Note the following:
• The costs of debt and equity are not 8.5% and 19%, respectively. These
figures assume the issue costs are paid every year, not just at issue.
• The fact that Bunsen can finance the entire cost of the project with debt is
irrelevant. The cost of capital does not depend on the immediate
source of funds; what matters is the project’s contribution to the firm’s
overall borrowing power.
• The project is expected to support debt in perpetuity. The fact that the first
debt issue is for only 20 years is irrelevant.
Assume the project has the same business risk as the firm’s other assets.
Because it is a perpetuity, we can use the firm’s weighted-average cost of
capital. If we ignore issue costs:
WACC = [rD × (1 - TC) × (D/V)] + [rE × (E/V)]
WACC = [0.07 × (1 - .35) × (0.4)] + [0.14 × 0.6] = 0.1022 =
10.22%
Using this discount rate:
\$272,016
0.1022
\$130,000
\$1,000,000 NPV · + − ·
The issue costs are:
Stock issue:
(0.050 × \$1,000,000) = \$50,000
Bond issue:
(0.015 × \$1,000,000) = \$15,000
Debt is clearly less expensive. Project NPV net of issue costs is reduced
to:
(\$272,016 - \$15,000) = \$257,016. However, if debt is used, the firm’s debt
ratio will be above the target ratio, and more equity will have to be raised
later. If debt financing can be obtained using retaining earnings, then
there are no other issue costs to consider. If stock will be issued to regain
the target debt ratio, an additional issue cost is incurred.
A careful estimate of the issue costs attributable to this project would
require a comparison of Bunsen’s financial plan ‘with’ as compared to
‘without’ this project.
14. From the text, Section 19.6, footnote 29, solving for β A, we find
that:

,
`

.
|

+

,
`

.
|

− ·
) D T ( V
E
) (β
) D T ( V
D
) )(β T (1 β
C
E
C
D C A

165

,
`

.
|

+

,
`

.
|

− ·
D/V) T ( 1
E/V
) (β
D/V) T ( 1
D/V
) )(β T (1 β
C
E
C
D C A

0.6738
) 0.55 (0.35 1
0.45
(1.09)
) 0.55 (0.35 1
0.55
) 0.35)(0.15 (1 β
A
·

,
`

.
|
× −
+

,
`

.
|
× −
− ·
Using the Security Market Line, we calculate the opportunity cost of capital
for Sphagnum’s assets:
rA = rf + β A (rm – rf) = 0.09 + (0.6738 × 0.085) = 0.147 = 14.7%
Following MM’s original analysis and considering only corporate taxes, we
have:
r* = r (1 – TC L)
r* = 0.147 × [1 – (0.35 × 0.55)] = 0.1187 or approximately 12%
This matches the consultant’s estimate for the weighted-average cost of
capital.
15. Disagree. The Banker’s Tryst calculations are based on the
assumption that the cost of debt will remain constant, and that the
cost of equity capital will not change even though the firm’s
financial structure has changed. The former assumption is
appropriate while the latter is not.
16. Tax or financing side effects in international projects:
 Project financing issues, such as early cash flows going to debt service
resulting in a non-constant debt ratio.
 Subsidized financing rates.
 Guaranteed contracts for output.
 Government restrictions on the flow of funds.
17. a.
Year
Principal at
Start of Year
Principal
Repayment Interest
Interest
Less Tax
Net Cash
Flow
On Loan
1 5000.0 397.5 250.0 162.5 560.0
2 4602.5 417.4 230.1 149.6 567.0
3 4185.1 438.2 209.3 136.0 574.2
4 3746.9 460.2 187.3 121.7 581.9
5 3286.7 483.2 164.3 106.8 590.0
6 2803.5 507.3 140.2 91.1 598.4
166
7 2296.2 532.7 114.8 74.6 607.3
8 1763.5 559.3 88.2 57.3 616.6
9 1204.2 587.3 60.2 39.1 626.4
10 616.9 616.9 30.8 20.0 636.9
Therefore:
\$4,530,000
(.08) .35) (1 1
636.9
(.08) .35) (1 1
560.0
loan of PV
10 1
·
− +
+ +
− +
· 
Value of subsidy = \$5,000,000 - \$4,530,000 = \$470,000
b. Yes. The value of the subsidy measures the additional value
to the firm from a government loan at 5 percent, compared to
an unsubsidized loan at 10 percent. Therefore, the company
should calculate APV, including
PV (tax shields) on the unsubsidized loan, and then add in the
value of subsidy.
167
18. a. Assume that the expected future Treasury-bill rate is equal to the
20-year Treasury bond rate (5.8%) less the average historical
premium of Treasury bonds over Treasury bills (1.8%), so that the
risk-free rate (rf) is 4%. Also assume that the market risk premium
(rm – rf) is 8%. Then, using the CAPM, we find rE as follows:
rE = rf + β A × [rm - rf] = 4% + (0.66 × 8%) = 9.28%
Market value of equity (E) is equal to: 256.2 × \$59 = \$15,115.8 so
that:
V = \$6,268 + \$15,115.8 = \$21,383.8
D/V = \$6,268/\$21,383.8 = 0.293
E/V = \$15,115.8/\$21,383.8 = 0.707
WACC = (0.707 × 9.28%) + (0.293 × 0.65 × 7.4%) = 7.97%
b. Step 1. Calculate the opportunity cost of capital.
Opportunity cost of capital = r = rD × (D/V) + rE × (E/V)
= 7.4% × 0.293 + 9.28% × 0.707 =
8.73%
Step 2. Estimate the cost of debt and calculate the new cost of
equity.
Assume that the interest rate on the debt falls to 7.2% so that:
rE = r + (r - rD) × (D/E) = 8.73% + (8.73% - 7.2%) × (0.25/0.75) =
9.25%
Step 3. Recalculate WACC.
WACC = (0.75 × 9.25%) + (0.25 × 0.65 × 7.2%) = 8.11%
19. The company weighted-average cost of capital is appropriate for
evaluating capital budgeting projects that are exact replicas of the firm
as it currently exists. If the project in question is more like the industry
as a whole than it is like the company, then the industry weighted-
average cost of capital would be a better choice.
168
Challenge Questions
1. a. For a one-period project to have zero APV:
Rearranging gives:
For a one-period project, the left-hand side of this equation is the
project IRR. Also, (D/ -C0) is the project’s debt capacity. Therefore,
the minimum acceptable return is:
b. For a company that follows Financing Rule 2, all of the
variables in the Miles-Ezzell formula are constant. For
example, we know that debt is assumed to be a constant
proportion of market value, so that the adjusted cost of
capital (r
*
) is also constant over time. In other words, when
we are at period 1, the Miles-Ezzell formula gives the same
value for r
*
as at period 0. We know from part (a) that the
formula is correct for a one-period cash flow. So the value,
in period 1, of the period 2 cash flow is:
PV1 = C2/(1 + r
*
)
The value today is:
PV0 = PV1/(1 + r
*
) = C2/(1 + r
*
)
2
By analogy, we would discount the period 3 cash flow, at r
*
, in
period 2 to give:
PV2 = C3/(1 + r
*
)
Therefore, the value today is:
PV0 = C3/(1 + r
*
)
3
0
r 1
D) r * (T
r 1
C
C APV
D
D 1
0
·
+
× ×
+
+
+ ·

,
`

.
|
+
+

,
`

.
|

× − · −

D 0
D
0
1
r 1
r 1

C
D
) r * T ( r 1
C
C

,
`

.
|
+
+
× × − ·
D
D
r 1
r 1
) L r * T ( r * r
169
2.
D/V E/V D/E r rd rE WACC ME
0.20 0.80 0.250 12.00% 8.00% 13.00% 11.44% 11.42%
0.40 0.60 0.667 12.00% 8.00% 14.67% 10.88% 10.84%
0.60 0.40 1.500 12.00% 10.00% 15.00% 9.90% 9.86%
T* = TC = 0.35
Different values result because the Miles-Ezzell formula assumes debt is
rebalanced at the end of every period (Financing Rule 2).
3. The expected cash flow from the firm is: (Vu r + Tc rD D) where r is the
return on assets and rD is the rate on debt (the interest tax shield has the
same level of risk). The cash flow to the stockholders and bondholders is:
Er* + DrD
Because the firm generates a perpetual cash flow stream:
Er* + DrD = Vur + Tc rD D
Divide by E and subtract DrD:
Substitute L = D/E
We know that: Vu = E + (1 - Tc)D:
a. Whenever r > rD, r* increases with leverage.
b. The formulas for levering and relevering the cost of equity implicitly
assume on-going corporate profitability so that the interest tax
shields can be exploited.
4. This is not necessarily true. Note that, when the debt is
rebalanced, next year’s interest tax shields are fixed and, thus,
discounted at a lower rate. The following year’s interest is not
known with certainty for one year and, hence, is discounted for one
year at the higher risky rate and for one year at the lower rate. This
is much more realistic since it recognizes the uncertainty of future
events.

,
`

.
|
− −
,
`

.
|
·
D c
u
r
E
D
) T (1 r
E
V
* r
L] r ) T (1 [ r) (
E
D ) T (1 E
* r
D c
c
− −
,
`

.
| − +
·
] L ) T (1 ) r (r [ r * r
c D
− − + ·
L) )(r T (1 r
E
V
* r
D c
u
− −
,
`

.
|
·
170
CHAPTER 20
Understanding Options
1. Statement (a) incorporates a put option.
Statement (b) uses ‘option’ in the sense of choice.
Statement (c) uses ‘option’ in the sense of choice.
Statement (d) incorporates a call option.
2. a. The put places a floor on value of investment, i.e., less risky than buying
stock. The risk reduction comes at the cost of the option premium.
b. Benefit from upside, but also lose on the downside.
c. A naked option position is riskier than the underlying asset. Investor gains
from increase in stock price, but loses entire investment if stock price is
less than exercise price at expiration.
d. Investor exchanges uncertain upside changes in stock price for the known
up-front income from the option premium.
e. Safe investment if the debt is risk free.
f. From put-call parity, this is equivalent (for European options) to ‘buy
bond.’ Therefore, this is a safe investment.
g. Another naked, high-risk position with known up-front income but
exposure to down movements in stock price.
3. While it is true that both the buyer of a call and the seller of a put hope
the price will rise, the two positions are not identical. The buyer of a
call will find her profit changing from zero and increasing as the stock
price rises (see text Figure 20.2), while the seller of a put will find his
loss decreasing and then remaining at zero as the stock price rises
(see text Figure 20.3).
171
4. You would buy the American call for \$75, exercise the call immediately in order to
purchase a share of Pintail stock for \$50, and then sell the share of Pintail stock
for \$200. The net gain is: [\$200 – (\$75 + \$50)] = \$75.
If the call is a European call, you should buy the call, deposit in the bank an
amount equal to the present value of the exercise price, and sell the stock short.
This produces a current cash flow equal to: [\$200 – \$75 – (\$50/1 + r))]. At the
maturity of the call, the action depends on whether the stock price is greater than
or less than the exercise price. If the stock price is greater than \$50, then you
would exercise the call (using the cash from the bank deposit) and buy back the
stock. If the stock price is less than \$50, then you would let the call expire and
buy back the stock. The cash flow at maturity is the greater of zero (if the stock
price is greater than \$50) or [\$50 – stock price] (if the stock price is less than
\$50). Therefore, the cash flows are positive now and zero or positive one year
from now.
5. Let P3 = the value of the three month put, C3 = the value of the three
month call, S = the market value of a share of stock, and EX = the
exercise price of the options. Then, from put-call parity:
C3 + [EX/(1 + r)
0.25
] = P3 + S
Since both options have an exercise price of \$60 and both are worth \$10,
then:
EX/(1 + r)
0.25
= S
From put-call parity for the six-month options, we have:
C6 + [EX/(1 + r)
0.50
] = P6 + S
Since S = EX/(1 + r)
0.25
, and EX/(1 + r)
0.50
is less than EX/(1 + r)
0.25
, then
the value of the six-month call is greater than the value of the six-month
put.
6. [Note: In the first printing of the seventh edition, the call option price is
shown incorrectly as \$2.30. The price should be \$12.30.]
From put-call parity:
C + [EX/(1 + r)
0.50
] = P + S
P = -S + C + [EX/(1 + r)
0.50
] = -27.27 + 12.30 + [22.50/(1.039
0.50
)] =
\$7.10
7. Internet exercise; answers will vary.
172
8. a. Rank and File has an option to put the stock to the underwriter.
b. 1. EX = exercise price of the rights
2. t = time from rights agreement to final exercise date for right
3. σ
2
= variance of stock returns
4. r
f
= interest rate
[Note: The answer to (b) ignores dilution. Chapter 23 discusses how
dilution affects the valuation of warrants and convertibles. Dilution has a
similar effect on the valuation of standby underwriting. This is because, if
the option is exercised, the underwriter pays the issue price, but also
obtains an equity stake in this new money. After reading Chapter 23,
students might return to the issue of the effect of dilution on the value of
standby agreements.]
9. The \$100 million threshold can be viewed as an exercise price. Since she gains 20%
of all profits in excess of this level, it is comparable to a call option. Whether this
provides an adequate incentive depends on how achievable the \$100 million
threshold is and how Ms. Cable evaluates her prospects of generating income
greater than this amount.
10. a. The payoffs at expiration for the two options are shown in the following
position diagram:
50 100 150
50
100
150
-50
-100
Option value
Share price
173
Taking into account the \$100 that must be repaid at expiration, the net
payoffs are:
b. Here we can use the put-call parity relationship:
Value of call + Present value of exercise price = Value of put + Share
price
The value of Mr. Colleoni’s position is:
Value of put (EX = 150) - Value of put (EX = 50) - PV (150 - 50)
Using the put-call parity relationship, we find that this is equal to:
Value of call (EX = 150) - Value of call (EX = 50)
Thus, one combination that gives Mr. Colleoni the same payoffs is:
 Buy a call with an exercise price of \$150
 Sell a call with an exercise price of \$50
Similarly, another combination with the same set of payoffs is:
 Buy a put with an exercise price of \$150
 Buy a share of stock
 Borrow the present value of \$150
 Sell a call with an exercise price of \$50
50 100 150
50
100
150
-50
-100
Option value
Share price
174
11. Statement (b) is correct. The appropriate diagrams are in Figure 20.5 in the
text. The second row of diagrams in Figure 20.5 shows the payoffs for
the strategy:
The third row of Figure 20.5 shows the payoffs for the strategy:
Buy a call and lend an amount equal to the exercise price.
12. Answers here will vary depending on the options chosen, but the formulas will work
very well; discrepancies should be on the order of 5 percent or so, at most.
13. We make use of the put-call parity relationship:
Value of call + Present value of exercise price = Value of put +
Share price
a. Rearranging the put-call parity relationship to show a short sale of a share
of stock, we have:
(- Share price) = Value of put - Value of call - PV(EX)
This implies that, in order to replicate a short sale of a share of stock, you
would purchase a put, sell a call, and borrow the present value of the
exercise price.
b. Again we rearrange the put-call parity relationship:
PV(EX) = Value of put - Value of call + Share price
This implies that, in order to replicate the payoffs of a bond, you
14. a. Use the put-call parity relationship for European options:
Value of call + Present value of exercise price = Value of put +
Share price
Solve for the value of the put:
Value of put = Value of call + PV(EX) - Share price
Thus, to replicate the payoffs for the put, you would buy a 26-week call
with an exercise price of \$100, invest the present value of the exercise
price in a 26-week risk-free security, and sell the stock short.
b. Using the put-call parity relationship, the European put will sell for:
8 + (100/1.05) - 90 = \$13.24
15. a. From the put-call parity relationship:
175
Value of call + Present value of exercise price = Value of put +
Share price
Equity + PV(Debt, at risk-free rate) = Default option + Assets
\$250 + \$350 = \$70 + \$530
b. Value of default put = \$350 - \$280 = \$70
Butterfly
The buyer of the straddle profits if the stock price moves substantially in
either direction; hence, the straddle is a bet on high variability. The buyer
of the butterfly profits if the stock price doesn’t move very much, and
hence, this is a bet on low variability.
17. a. The bond value increases to the present value of the guaranteed payoff,
valued at the risk-free rate:
Bond value = (\$50 + \$5)/1.08 = \$50.93
100
100
Payoff
Share price
Payoff to put
Payoff to call
Calcall
100 120
Payoff
EX = 100
EX = 120
Share price
Payoff to sell call,
EX = 110,sell two
176
b. The payoffs to stockholders are unaffected. If the firm defaults, its
bondholders are paid off, but shareholders get nothing, just as before. If
the firm does not default, payments to shareholders do not change.
177
c. The firm effectively acquires a new asset, the government guarantee worth
\$25.93 (the difference between the previous and new bond values). The
firm’s balance sheet could be expressed this way:
Asset value \$30.00 \$50.93 Bonds
Government’s guarantee 25.93 5.00 Stock
\$55.93 \$55.93 Firm value
d. By issuing 10-percent bonds with \$50 face value, Rectangular
raises \$50.93 cash (the present value, at 8 percent, of \$55), which
is used to repurchase stock. After the transaction, the market value
balance sheet is the same as Circular’s. Shareholders have
pocketed the \$25.93 value of the government guarantee.
18. Answers here will vary according to the stock and the specific options
selected, but all should exhibit properties very close to those predicted by
the theory described in the chapter.
19. Imagine two stocks, each with a market price of \$100. For each stock, you
have an at-the-money call option with an exercise price of \$100. Stock
A’s price now falls to \$50 and Stock B’s rises to \$150. The value of your
portfolio of call options is now:
Value
Call on A 0
Call on B 50
Total \$50
Now compare this with the value of an at-the-money call to buy a portfolio
with equal holdings of A and B. Since the average change in the prices of
the two stocks is zero, the call expires worthless.
This is an example of a general rule: An option on a portfolio is less
valuable than a portfolio of options on the individual stocks because, in the
latter case, you can choose which options to exercise.
20. Consider each company in turn, making use of the put-call parity relationship:
Value of call + Present value of exercise price = Value of put + Share price
Drongo Corp. Here, the left-hand side [52 + (50/1.05) = 99.62] is less than
the right-hand side [20 + 80 = 100]. Therefore, there is a slight mispricing.
To take advantage of this situation, one should buy the call, invest \$47.62
at the risk-free rate, sell the put, and sell the stock short.
178
Ragwort, Inc. Here, the left-hand side [15 + (100/1.05) = 110.24) is
greater than the right-hand side [10 + 80 = 90]. Therefore, there is a
significant mispricing. To take advantage of this situation, one should sell
the call, borrow \$95.24 at the risk-free rate, buy the put, and buy the stock.
Wombat Corp. For the three-month option, the left-hand side
[18 + (40/1.025) = 57.02] and the right-hand side [7 + 50 = 57] are
essentially equal, so there is no mispricing.
For the first six-month option, the left-hand side [17 + (40/1.05) = 55.10] is
slightly greater than the right-hand side [5 + 50 = 55], so there is a slight
mispricing.
For the second six-month option, the left-hand side [10 + (50/1.05) =
57.62] is slightly less than the right-hand side [8 + 50 = 58], and so there is
a slight mispricing.
21. The value of the options increases if the variance of the cash flows increases.
Therefore, you will prefer the riskier proposal.
22. One strategy might be to buy straddle, that is, buy a call and a put with
exercise price equal to the asset’s current price. If the asset price does
not change, both options become worthless. However, if the price falls,
the put will be valuable and, if price rises, the call will be valuable. The
larger the price movement in either direction, the greater the profit.
If investor’s have underestimated volatility, the option prices will be too
low. Thus, an alternative strategy is to buy a call (or a put) and hedge
against changes in the asset price by simultaneously selling (or, in the
case of the put, buying) delta shares of stock.
179
Challenge Questions
1. Letter the diagrams in Figure 20.13 (a) through (d), beginning in the
upper-left corner and proceeding clockwise. Then we have the following
diagram interpretations:
a. Purchase a call with a given exercise price and sell a call with a
higher exercise price; borrow the difference necessary. (This is
b. Sell a put and sell a call with the same exercise price. (This is
c. Buy one call with a given exercise price, sell two calls with a higher
exercise price, and buy one call with a still higher exercise price.
(This is known as a ‘Butterfly Spread.’)
d. Borrow money and use this money to buy a put and buy the stock.
2. a. If the land is worth more than \$110 million, Bond will exercise its
call option. If the land is worth less than \$110 million, the buyer will
exercise its put option.
b. Bond has: (1) sold a share; (2) sold a put; and (3) purchased a call.
Therefore:
Payoff
Price of land
(3)
(2)
(1)
180
This is equivalent to:
c. The interest rate can be deduced using the put-call parity
relationship. We know that the call is worth \$20, the exercise price
is \$110, and the combination [sell share and sell put option] is
worth \$110. Therefore:
Value of call + Present value of exercise price = Value of put +
Share price
Value of call + PV(EX) = Value of put + Share price
20 + [110/(1 + r)] = 110
r = 0.222 = 22.2%
d. From the answer to Part (a), we know that Bond will end up owning
the land after the expiration of the options. Thus, in an economic
sense, the land has not really been sold, and it seems misleading
to declare a profit on a sale that did not really take place. In effect,
Bond has borrowed money, not sold an asset.
3. One way to profit from Hogswill options is to purchase the call options with
exercise prices of \$90 and \$110, respectively, and sell two call options
with an exercise price of \$100. The immediate benefit is a cash inflow of:
[(2 × 11) - (5 + 15)] = \$2
Immediately prior to maturity, the value of this position and the net profit
(at various possible stock prices) is:
Stock Price Position Value Net Profit
85 0 0 + 2 = 2
90 0 0 + 2 = 2
95 5 5 + 2 = 7
100 10 10 + 2 = 12
105 5 5 + 2 = 7
110 0 0 + 2 = 2
115 0 0 + 2 = 2
Payoff
Price of land
181
Thus, no matter what the final stock price, we can make a profit trading in
these Hogswill options.
It is possible, but very unlikely, that you can identify such opportunities
from data published in the newspaper. Someone else has most likely
already noticed (even before the paper was printed, much less distributed
to you) and traded on the information; such trading tends to eliminate
these profit opportunities.
4. a.
b. This incentive scheme is a combination of the following options:
 Buy 4,000,000 call options with an exercise price of
\$119.875.
 Sell 4,000,000 call options with an exercise price of \$120.
Option Value
Stock Price
120
500,000
182
CHAPTER 21
Valuing Options
1. a.
844 . 0 / 1 ; 185 . 1
5 . 0 24 . 0
· · · · u d e u
\$45
\$53.33
\$37.98
\$63.19
\$45.01
\$45.01
\$32.06
887 . 0 / 1 ; 127 . 1
25 . 0 24 . 0
· · · · u d e u
\$45
\$50.72
\$57.16
\$64.41
\$35.41
\$50.70
\$39.92
\$44.98
\$39.91
\$72.60
\$57.14
\$57.14
\$44.97
\$44.97
\$35.40
\$31.41
\$35.40
\$27.86
183
b.
809 . 0 / 1 , 236 . 1
5 . 0 3 . 0
· · · · u d e u
\$45
\$55.62
\$36.41
\$68.75
\$45.00
\$45.00
\$29.46
\$45
\$52.29
\$60.76
\$70.60
\$33.36
\$52.32
\$38.75
\$45.02
\$38.77
\$82.04
\$60.79
\$60.79
\$45.05
\$45.05
\$33.38
\$28.72
\$33.38
\$24.73
861 . 0 / 1 ; 162 . 1
25 . 0 3 . 0
· · · · u d e u
184
a. Let p equal the probability of a rise in the stock price. Then, if investors
are risk-neutral:
(p × 0.15) + (1 - p)× (-0.13) = 0.10
p = 0.821
The possible stock prices next period are:
\$60 × 1.15 = \$69.00
\$60 × 0.87 = \$52.20
Let X equal the break-even exercise price. Then the following must
be true:
X – 60 = (p)(\$0) + [(1 – p)(X – 52.20)]/1.10
That is, the value of the put if exercised immediately equals the
value of the put if it is held to next period. Solving for X, we find
that the break-even exercise price is \$61.52.
b. If the interest rate is increased, the value of the put option
decreases.
If there is an
increase in:
The change in the put
option price is:
Stock price (P) Negative
Exercise price (EX) Positive
Interest rate (rf) Negative
Time to expiration (t) Positive
Volatility of stock price (σ )
Positive
Consider the following base case assumptions:
P = 100, EX = 100, rf = 5%, t = 1, σ = 50%
Then, using the Black-Scholes model, the value of the put is \$16.98
The base case value along with values computed for various changes in
the assumed values of the variables are shown in the table below:
Black-Scholes
put value:
Base case 16.98
P = 120 11.04
EX = 120 29.03
rf = 10% 14.63
t = 2 21.94
σ = 100%
35.04
185
a. The future stock prices of Matterhorn Mining are:
With dividend
Ex-dividend
Let p equal the probability of a rise in the stock price. Then, if
investors are risk-neutral:
(p × 0.25) + (1 - p)× (-0.20) = 0.10
p = 0.67
Now, calculate the expected value of the call in month 6.
If stock price decreases to SFr80 in month 6, then the call is
worthless. If stock price increases to SFr125, then, if it is exercised
at that time, it has a value of (125 – 80) = SFr45. If the call is not
exercised, then its value is:
Therefore, it is preferable to exercise the call.
The value of the call in month 0 is:
b. The future stock prices of Matterhorn Mining are:
With dividend
Ex-dividend
100
80 125
60 105
75 48 131.25 84
?
0
0 0
32.42
51.25 4
SFr27.41
1.10
0) (0.33 5) (0.67

4
·
× + ×
100
80 125
51.2 80 125
64 100
SFr32.42
1.10
4) (0.33 51.25) (0.67
·
× + ×
186
187
Let p equal the probability of a rise in the price of the stock. Then,
if investors are risk-neutral:
(p × 0.25) + (1 - p)× (-0.20) = 0.10
p = 0.67
Now, calculate the expected value of the call in month 6.
If stock price decreases to SFr80 in month 6, then the call is
worthless. If stock price increases to SFr125, then, if it is exercised
at that time, it has a value of (125 – 80) = SFr45. If the call is not
exercised, then its value is:
Therefore, it is preferable to exercise the call.
The value of the call in month 0 is:
a. The possible prices of Buffelhead stock and the associated call option
values (shown in parentheses) are:
Let p equal the probability of a rise in the stock price. Then, if
investors are risk-neutral:
p (1.00) + (1 - p)(-0.50) = 0.10
p = 0.4
220
(?)
110
(?)
440
(?)
55
(0)
220
(55)
880
(715)
?
0
0 0
27.41
45 0
SFr27.41
1.10
) (0.33 5) (0.67
·
× + × 0 4
SFr27.41
1.10
0) (0.33 5) (0.67

4
·
× + ×
188
If the stock price in month 6 is \$110, then the option will not be
exercised so that it will be worth:
[(0.4 × 55) + (0.6 × 0)]/1.10 = \$20
Similarly, if the stock price is \$440 in month 6, then, if it is
exercised, it will be worth (\$440 - \$165) = \$275. If the option is not
exercised, it will be worth:
[(0.4 × 715) + (0.6 × 55)]/1.10 = \$290
Therefore, the call option will not be exercised, so that its value
today is:
[(0.4 × 290) + (0.6 × 20)]/1.10 = \$116.36
b. (i) If the price rises to \$440:
(ii) If the price falls to \$110:
c. The option delta is 1.0 when the call is certain to be exercised and
is zero when it is certain not to be exercised. If the call is certain to
be exercised, it is equivalent to buying the stock with a partly
deferred payment. So a one-dollar change in the stock price must
be matched by a one-dollar change in the option price. At the other
extreme, when the call is certain not to be exercised, it is valueless,
regardless of the change in the stock price.
d. If the stock price is \$110 at 6 months, the option delta is 0.33.
Therefore, in order to replicate the stock, we buy three calls and
lend, as follows:
Initial Stock Stock
Outlay Price = 55 Price = 220
Buy 3 calls -60 0 165
Lend PV(55) -50 +55 +55
-110 +55 +220
This strategy Is equivalent to:
1.0
220 880
55 715
Delta ·

·
.33 0
55 220
0 55
Delta ·

·
189
a. Yes, it is rational to consider the early exercise of an American put option.
b. The possible prices of Buffelhead stock and the associated
American put option values (shown in parentheses) are:
Let p equal the probability of a rise in the stock price. Then, if
investors are risk-neutral:
p (1.00) + (1 - p)(-0.50) = 0.10
p = 0.4
If the stock price in month 6 is \$110, and if the American put option
is not exercised, it will be worth:
[(0.4 × 0) + (0.6 × 165)]/1.10 = \$90
On the other hand, if it is exercised after 6 months, it is worth \$110.
Thus, the investor should exercise the put early.
Similarly, if the stock price in month 6 is \$440, and if the American
put option is not exercised, it will be worth:
[(0.4 × 0) + (0.6 × 0)]/1.10 = \$0
On the other hand, if it is exercised after 6 months, it will cost the
investor \$220. The investor should not exercise early.
Finally, the value today of the American put option is:
[(0.4 × 0) + (0.6 × 110)]/1.10 = \$60
c. Unlike the American put in part (b), the European put can not be
exercised prior to expiration. We noted in part (b) that, If the stock
price in month 6 is \$110, the American put would be exercised
because its value if exercised (i.e., \$110) is greater than its value if
not exercised (i.e., \$90). For the European put, however, the value
at that point is \$90 because the European put can not be exercised
early. Therefore, the value of the European put is:
[(0.4 × 0) + (0.6 × 90)]/1.10 = \$49.09
220
(?)
110
(?)
440
(?)
55
(165)
220
(0)
880
(0)
190
The following tree shows stock prices, with option values in parentheses:
With dividend
Ex-dividend
We calculate the option value as follows:
1. The option values in month 6, if the option is not exercised,
are computed as follows:
If the stock price in month 6 is \$110, then it would not pay to
exercise the option. If the stock price in month 6 is \$440, then the
call is worth:
(440 - 165) = 275. Therefore, the option would be exercised at that
time.
2. Working back to month 0, we find the option value as
follows:
b. If the option were European, it would not be possible to exercise
early. Therefore, if the price rises to \$440 at month 6, the value of
the option is \$265, not \$275 as is the case for the American option.
Therefore, in this case, the value of the European option is less
than the value of the American option. The value of the European
option is computed as follows:
220 (100.99)
110
85 (1.82)
42.5
(0)
170
(5)
440
415 (275)
207.5
(42.5)
830
(665)
1.82
1.10
0) (0.6 5) (0.4
·
× + ×
265
1.10
42.5) (0.6 665) (0.4
·
× + ×
100.99
1.10
1.82) (0.6 275) (0.4
value Option ·
× + ×
·
97.36
1.10
1.82) (0.6 265) (0.4
value Option ·
× + ×
·
191
The following tree (see Practice Question 5) shows stock prices, with the values
for the one-year option values in parentheses:
The put option is worth \$55 in month 6 if the stock price falls and \$0 if the
stock price rises. Thus, with a 6-month stock price of \$110, it pays to
exercise the put (value = \$55). With a price in month 6 of \$440, the
investor would not exercise the put since it would cost \$275 to exercise.
The value of the option in month 6, if it is not exercised, is determined as
follows:
Therefore, the month 0 value of the option is:
9. a. The following tree shows stock prices (with put option values in parentheses):
Let p equal the probability that the stock price will rise. Then, for a
risk-neutral investor:
(p × 0.111) + (1 - p)× (-0.10) = 0.05
p = 0.71
220
110
(55)
440
(290)
55
(0)
220
(55)
880
(715)
\$135.45
1.10
55) (0.6 290) (0.4
value Option ·
× + ×
·
100 (2.35)
90.0 (7.15)
81.0
(21)
100
(2)
111.1 (.55)
123.4
(0)
290
1.10
55) (0.6 715) (0.4
·
× + ×
192
If the stock price in month 6 is C\$111.1, then the value of the
European put is:
If the stock price in month 6 is C\$90.0, then the value of the put is:
Since this is a European put, it can not be exercised at month 6.
The value of the put at month 0 is:
b. Since the American put can be exercised at month 6, then, if the
stock price is C\$90.0, the put is worth (102 – 90) = \$12 if exercised,
compared to \$7.15 if not exercised. Thus, the value of the
American put in month 0 is:
10. a. P = 200 EX = 180 σ = 0.223 t = 1.0 rf = 0.21
1.2158 ) 1.0 (0.223 1.4388 t σ d d
1.4388 /2 ) 1.0 (0.223 ) 1.0 (0.223 80/1.21)]/ log[200/(1
/2 t σ t X)]/ σ log[P/PV(E d
1 2
1
· × − · − ·
· × + × ·
+ ·
N(d1) = N(1.4388) = 0.9249
N(d2) = N(1.2158) = 0.8880
Call value = [N(d1) × P] – [N(d2) × PV(EX)]
= [0.9249 × 200] – [0.8880 × (180/1.21)] = \$52.88
b.
0.8001 1/1.2498 1/u d change downside 1
1.2498 e e u change upside 1
1.0 0.223 h σ
· · · · +
· · · · +
Let p equal the probability that the stock price will rise. Then, for a
risk-neutral investor:
(p × 0.25) + (1 - p)× (-0.20) = 0.21
p = 0.91
.55 C\$0
1.05
2) (0.29 0) (0.71
·
× + ×
7.15 C\$
1.05
21) (0.29 2) (0.71
·
× + ×
2.35 C\$
1.05
7.15) (0.29 .55) 0 (0.71
·
× + ×
3.69 C\$
1.05
12) (0.29 .55) 0 (0.71
·
× + ×
193
In one year, the stock price will be either \$250 or \$160, and the
option values will be \$70 or \$0, respectively. Therefore, the value
of the option is:
c.
0.8541 1/1.1708 1/u d change downside 1
1.1708 e e u change upside 1
0.5 0.223 h σ
· · · · +
· · · · +
Let p equal the probability that the stock price will rise. Then, for a
risk-neutral investor:
(p × 0.171) + (1 - p)× (-0.146) = 0.10
p = 0.776
The following tree gives stock prices, with option values in parentheses:
Option values are calculated as follows:
1.
2.
3.
200
(52.63)
170.8
(14.11)
145.9
(0)
200.0
(20)
234.2
(70.53)
274.2
(94.2)
\$14.11
1.10
0) (0.224 20) (0.776
·
× + ×
\$70.53
1.10
94.2) (0.776 20) (0.224
·
× + ×
\$52.63
1.10
70.53) (0.776 14.11) (0.224
·
× + ×
.64 \$52
1.21
0) (0.09 0) 7 (0.91
·
× + ×
194
d. (i)
To replicate a call, buy 0.89 shares and borrow:
[(0.89 × 200) - 52.63] = \$125.37
(ii)
To replicate a call, buy one share and borrow:
[(1.0 × 200) - 70.53] = \$129.47
(iii)
To replicate a call, buy 0.37 shares and borrow:
[(0.37 × 200) - 14.11] = \$59.89
11. To hold time to expiration constant, we will look at a simple one-period
binomial problem with different starting stock prices. Here are the
possible stock prices:
Now consider the effect on option delta:
Current Stock Price
Option Deltas 100 110
In-the-money (EX = 60) 140/150 = 0.93 160/165 = 0.97
At-the-money (EX = 100) 100/150 = 0.67 120/165 = 0.73
Out-of-the-money (EX = 140) 60/150 = 0.40 80/165 = 0.48
Note that, for a given difference in stock price, out-of-the-money options
result in a larger change in the option delta. If you want to minimize the
number of times you rebalance an option hedge, use in-the-money
options.
delta Option

·
.89 0
170.8 234.2
14.11 70.53
delta Option ·

·
1.00
200 274.2
20 94.2
delta Option ·

·
.37 0
145.9 200
0 20
delta Option ·

·
100
50 200
110
55 220
195
12. a. The call option. (You would delay the exercise of the put until after the
dividend has been paid and the stock price has dropped.)
b. The put option. (You never exercise a call if the stock price is below
exercise price.)
c. The put when the interest rate is high. (You can invest the exercise
price.)
13. a. When you exercise a call, you purchase the stock for the exercise price.
Naturally, you want to maximize what you receive for this price, and
so you would exercise on the with-dividend date in order to capture
the dividend.
b. When you exercise a put, your gain is the difference between the
price of the stock and the amount you receive upon exercise, i.e.,
the exercise price. Therefore, in order to maximize your profit, you
want to minimize the price of the stock and so you would exercise
on the ex-dividend date.
14. [Note: the answer to this question is based on the assumption that the stock
price is known.]
We can value the call by using the put-call parity relationship:
Value of put = value of call – share price + present value of
exercise price
Then we must purchase two items of information [value of European put
and PV(Exercise price)] and, hence, will spend \$20.
If we use the Black-Scholes model, we must also purchase two items
[standard deviation times square root of time to maturity and PV(exercise
price)] and, hence, will spend \$20.
15. Internet exercise; answers will vary.
196
Challenge Questions
1. For the one-period binomial model, assume that the exercise price of the
options (EX) is between u and d. Then, the spread of possible option
prices is:
For the call: [(u – EX) – 0]
For the put: [(d – EX) – 0]
The option deltas are:
Option delta(call) = [(u – EX) – 0]/(u – d) = (u – EX)/(u – d)
Option delta(put) = [(d – EX) – 0]/(u – d) = (d – EX)/(u – d)
Therefore:
[Option delta(call) – 1] = [(u – EX)/(u – d)] – 1
= [(u – EX)]/(u – d)] – [(u – d)/(u – d)]
= [(u – EX) – (u – d)]/(u – d)
= [d – EX]/(u – d) = Option delta(put)
2. If the exercise price of a call is zero, then the option is equivalent to the stock,
so that, in order to replicate the stock, you would buy one call option.
Therefore, if the exercise price is zero, the option delta is one. If the
exercise price of a call is indefinitely large, then the option value remains
low even if there is a large percentage change in the price of the stock.
Therefore, the dollar change in the value of the option will be much
smaller than the dollar change in the price of the stock, so that the option
delta is close to zero. Between these two extreme cases, the option delta
varies between zero and one.
4. Both of these announcements may convey information about company
prospects, and thereby affect the price of the stock. But, when the
dividend is paid, stock price decreases by an amount approximately equal
to the amount of the dividend. This price decrease reduces the value of
the option. On the other hand, a stock repurchase at the market price
does not affect the price of the stock. Therefore, you should hope that the
board will decide to announce a stock repurchase program.
197
5. a. Assume the following:
1. The annual market standard deviation is 21 percent.
2. The risk-free interest rate is 3 percent.
3. Dividends equal 2 percent of the index value, and grow by 9
percent per year to give a total return of 11 percent.
4. The yield on a 4-year bond is 5.5 percent.
Then:
Therefore, the value of the call option = 172.78
b. Salomon Brothers has sold a four-year call option on the market.
To hedge this position, Salomon needs to replicate the purchase of
an equivalent option. It could do this by a series of levered
investments in a diversified stock portfolio. (A more practical
alternative would be to use index futures, rather than the underlying
stocks; these are discussed in Chapter 27.)
6. a. As the life of the call option increases, the present value of the exercise
price becomes infinitesimal. Thus the only difference between the
call option and the stock is that the option holder misses out on any
dividends. If dividends are negligible, the value of the option
approaches its upper bound, i.e., the stock price.
b. While it is true that the value of an option approaches the upper
bound as maturity increases and dividend payments on the stock
decrease, a stock that never pays dividends is valueless.
.42 0 4 .21 0 time σ · ·
price) (Exercise PV
) (dividends PV value Asset −
1.047
888.49
929.85
1.03 / 1000
1.11
25.90
1.11
23.76
1.11
21.80

1.11
20.00
1000
4
4 3 2
· ·
− − − −
·
\$980.00 172.78
1.055
1,000
SPINS of Value
4
· + ·
198
CHAPTER 22
Real Options
1. a. A five-year American call option on oil. The initial exercise price is
\$32 a barrel, but the exercise price rises by 5 percent per year.
b. An American put option to abandon the restaurant at an exercise
price of \$5 million. The restaurant’s current value is (\$700,000/r).
The annual standard deviation of the changes in the value of the
restaurant as a going concern is 15 percent.
c. A put option, as in (b), except that the exercise price should be
interpreted as \$5 million in real estate value plus the present value
of the future fixed costs avoided by closing down the restaurant.
Thus, the exercise price is:
\$5,000,000 + (\$300,000/0.10) = \$8,000,000. Note: The underlying
asset is now PV(revenue – variable cost), with annual standard
deviation of 10.5 percent.
d. A complex option that allows the company to abandon temporarily
(an American put) and (if the put is exercised) to subsequently
restart (an American call).
e. An in-the-money American option to choose between two assets;
that is, the developer can defer exercise and then determine
whether it is more profitable to build a hotel or an apartment
building. By waiting, however, the developer loses the cash flows
from immediate development.
f. A call option that allows Air France to fix the delivery date and
price.
2. A commitment to invest in the Mark II would have a negative NPV. The
option to invest has a positive NPV. The value of the option more than
offsets the negative NPV of the Mark I.
3. a. P = 467 EX = 800 σ = 0.35 t = 3.0 rf = 0.10
.7194 ) 3.0 (0.35 .1132 t σ d d
.1132 /2 ) 3.0 (0.35 ) 3.0 )]/(0.35 00/1.10 log[467/(8
/2 t σ t X)]/ σ log[P/PV(E d
1 2
3
1
0 0
0
− · × − − · − ·
− · × + × ·
+ ·
N(d1) = N(-0.1132) = 0.4549
199
N(d2) = N(-0.7194) = 0.2359
Call value = [N(d1) × P] – [N(d2) × PV(EX)]
= [0.4549 × 467] – [0.2359 × (800/1.10
3
)] = \$70.65
b. P = 500 EX = 900 σ = 0.35 t = 3.0 rf = 0.10
0.8010 ) 3.0 (0.35 0.1948 t σ d d
0.1948 /2 ) 3.0 (0.35 ) 3.0 )]/(0.35 00/1.10 log[500/(9
/2 t σ t X)]/ σ log[P/PV(E d
1 2
3
1
− · × − − · − ·
− · × + × ·
+ ·
N(d1) = N(-0.1948) = 0.4228
N(d2) = N(-0.8010) = 0.2116
Call value = [N(d1) × P] – [N(d2) × PV(EX)]
= [0.4228 × 500] – [0.2116 × (900/1.10
3
)] = \$68.32
c. P = 467 EX = 900 σ = 0.20 t = 3.0 rf = 0.10
1.2417 ) 3.0 (0.20 0.8953 t σ d d
0.8953 /2 ) 3.0 (0.20 ) 3.0 )]/(0.20 00/1.10 log[467/(9
/2 t σ t X)]/ σ log[P/PV(E d
1 2
3
1
− · × − − · − ·
− · × + × ·
+ ·
N(d1) = N(-0.8953) = 0.1853
N(d2) = N(-1.2417) = 0.1072
Call value = [N(d1) × P] – [N(d2) × PV(EX)]
= [0.1853 × 467] – [0.1072 × (900/1.10
3
)] = \$14.05
4. P = 1.7 EX = 2 σ = 0.15 t = 1.0 rf = 0.12
.4029 ) 1.0 (0.15 0.2529 t σ d d
0.2529 /2 ) 1.0 (0.15 ) 1.0 )]/(0.15 /1.12 log[1.7/(2
/2 t σ t X)]/ σ log[P/PV(E d
1 2
1
1
0 − · × − − · − ·
− · × + × ·
+ ·
N(d1) = N(-0.2529) = 0.4002
N(d2) = N(-0.4029) = 0.3435
Call value = [N(d1) × P] – [N(d2) × PV(EX)]
= [0.4002 × 1.7] – [0.3435 × (2/1.12
1
)] = \$0.0669 million or
\$66,900
200
5. The asset value from Practice Question 4 is now reduced by the present
value of the rents:
PV(rents) = 0.15/1.12 = 0.134
Therefore, the asset value is now (1.7 – 0.134) = 1.566
P = 1.566 EX = 2 σ = 0.15 t = 1.0 rf = 0.12
.9503 ) 1.0 (0.15 0.8003 t σ d d
0.8003 /2 ) 1.0 (0.15 ) 1.0 )]/(0.15 (2/1.12 log[1.566/
/2 t σ t X)]/ σ log[P/PV(E d
1 2
1
1
0 − · × − − · − ·
− · × + × ·
+ ·
N(d1) = N(-0.8003) = 0.2118
N(d2) = N(-0.9503) = 0.1710
Call value = [N(d1) × P] – [N(d2) × PV(EX)]
= [0.2118 × 1.566] – [0.1710 × (2/1.12
1
)] = \$0.0263 million or
\$26,300
6. a. In general, an increase in variability increases the value of an option.
Hence, if the prices of both oil and gas were very variable, the option
to burn either oil or gas would be more valuable.
b. If the prices of coal and gas were highly correlated, then there would
be minimal advantage to shifting from one to the other, and hence,
the option would be less valuable.
7. If the cash flows are delayed one year, the value of the option is:
8. For the case where the investment can be postponed for two years, the
end-of-period values and intermediate cash flows are:
million \$21.8
1.05
0) (0.657 70) (0.343
2
·
× + ×
200
16
160
16
160
25
250
25
250
25
250
16
160
201
a. At the end of the first year, the decision about whether or not to
invest should be postponed if demand at that time is low.
b. Because the option to delay has value, overall project Net Present
Value will be higher.
c. If you could undertake the project only in years 0 and 2, overall
project Net Present Value would change because choices would be
constrained. If, for example, demand is high at t = 1, but the project
cannot be undertaken until t = 2, the intermediate cash flow of \$25
will be lost.
9. a. The values in the binomial tree below are the ex-dividend values,
with the option values shown in parentheses.
b. The option values in the binomial tree above are computed using
the risk neutral method. Let p equal the probability of a rise in
asset value. Then, if investors are risk-neutral:
p (0.10) + (1 - p)(-0.0909) = 0.02
p = 0.581
2700
(327)
2920
(491)
3162
(712)
3428 (978)
2136
(0)
2825 (375)
2405
(115)
2605
(208)
2318 (0)
2309 (0)
2805 (355)
2300 (0)
1892 (0)
2595
(202)
2815 (365)
202
If, for example, asset value at month 6 is \$3,162 (this is the value
after the \$50 cash flow is paid to the current owners), then the
option value will be:
[(0.419 × 375) + (0.581 × 978)]/1.02 = \$711
If the option is exercised at month 6 when asset value is \$3,212
then the option value is: (\$3,212 - \$2,500) = \$712. Therefore, the
option value is \$712.
At each asset value in month 3 and in month 6, the option value if
the option if not exercised is greater than or equal to the option
value if the option is exercised. (The one minor exception here is
the calculation above where we show that the value is \$712 if the
option is exercised and \$711 if it is not exercised. Due to rounding,
this difference does not affect any of our results and conclusions.)
Therefore, under the condition specified in part (b), you should not
exercise the option now because its value if not exercised (\$327) is
greater than its value if exercised (\$200).
c. If you exercise the option early, it is worth the with-dividend value
less \$2,500. For example, if you exercise in month 3 when the
with-dividend value is \$2,970, the option would be worth: (\$2,970 -
\$2,500) = \$470. Since the option is worth \$490 if not exercised,
you are better off keeping the option open. At each point before
month 9, the option is worth more unexercised than exercised. (As
noted above in part (b) there is one minor exception to this
conclusion.) Therefore, you should wait rather than exercise today.
The value of the option today is \$327, as shown in the binomial tree
above.
10. a. Technology B is equivalent to Technology A less a certain payment
of \$0.5 million. Since PV(A) = \$11.5 million then, ignoring
abandonment value:
PV(B) = PV(A) – PV(certain \$0.5 million)
= \$11.5 million – (\$0.5 million/1.07) = \$11.03 million
b. Assume that, if you abandon Technology B, you receive the \$10
million salvage value but no operating cash flows. Then, if demand
is sluggish, you should exercise the put option and receive \$10
million. If demand is buoyant, you should continue with the project
and receive \$18 million. So, in year 1, the put would be worth: (\$10
million - \$8 million) = \$2 million if demand is sluggish and \$0 if
demand is buoyant
203
We can value the put using the risk-neutral method. If demand is
buoyant, then the gain in value is: (\$18 million/\$10 million) –1 =
63.2%
If demand is sluggish, the loss is: (\$8 million/\$11.03 million) =
-27.5%
Let p equal the probability of a rise in asset value. Then, if
investors are risk-neutral:
p (0.632) + (1 - p)(-0.275) = 0.07
p = 0.38
Therefore, the value of the option to abandon is:
[(0.62 × 0) + (0.38 × 2)]/1.07 = \$0.71 million
11. a.
b. The only case in which one would want to abandon at the end of
the year is if project value is \$5.54 (i.e., if value declines in each of
the four quarters). In this case, the value of the abandonment
option would be:
(7 – 5.54) = 1.46
Let p equal the probability of a rise in asset value. Then, using the
quarterly risk-free rate, we find that, if investors are risk-neutral:
p (0.25) + (1 - p)(-0.167) = 0.017
p = 0.441
\$11.50
\$14.38
\$17.97
\$22.46
\$7.98
\$14.97
\$9.58
\$11.97
\$9.97
\$28.08
\$18.71
\$18.71
\$12.47
\$12.47
7
\$8.31
\$6.65
\$8.31
\$5.54
204
The risk-neutral probability of a fall in value in each of the four
quarters is:
(1 – 0.441)
4
= 0.0976
The expected risk-neutral value of the abandonment option is:
0.0976 × 1.06 = 0.1035
The present value of the abandonment option is:
(0.0976 × 1.06)/1.07 = 0.0967 or \$96,700
12. Decision trees are potentially more complex that the simple binomial trees.
For example, decision trees might recognize three or more outcomes at
each stage. Furthermore, decision trees are used to help decision-makers
to understand the alternative courses of action available, while the
binomial trees in Chapter 22 are used for valuation purposes.
13. The valuation approach proposed by Josh Kidding will not give the right
answer because it ignores the fact that the discount rate within the tree
changes as time passes and the value of the project changes.
14. We can no longer rely on arbitrage arguments for assets that are not traded in
financial markets, but we can use the risk-neutral method, which is an
application of the certainty-equivalent concept. (See the end of Section
22.6.)
205
Challenge Questions
1. a. You don’t take delivery of the new plant until month 36. Think of
the situation one month before completion. You have a call option
to get the plant by paying the final month’s construction costs to the
contractors. One month before that, you have an option on the
option to buy the plant. The exercise price of this second call
option is the construction cost in the next to last month. And so on.
b. Alternatively, you can think of the firm as agreeing to construction
and putting the present value of the construction cost in an escrow
account. Each month, the firm has the option to abandon the
project and receive the unspent balance in the escrow account.
Thus, in month 1, you have a put option on the project with an
exercise price equal to the amount in the escrow account. If you do
not exercise the put in month 1, you get another option to abandon
it in month 2. The exercise price of this option is the amount in the
escrow account in month 2. And so on.
2. The present value of the investment is:
PV = 250/0.15 = \$1,667
The net present value is:
NPV = -1,000 + 1,667 = \$667
Considered by itself, the project has a positive Net Present Value.
Now consider the option to wait one year. This is a call option with an
exercise price of \$1,000. The possible cash flows and end-of-period
values for the first year are:
1,667
Cash flow
= 50
333 3,000
Cash flow
= 450
206
If fuel savings are \$450 per year, then the project has a cash flow of \$450
the first year and an end-of-year value equal to: (\$450/0.15) = \$3,000.
The total return is: [(450 + 3,000)/1,667] – 1.0 = 1.07 = 107%. On the
other hand, if fuel savings are \$50 per year, then the project has a cash
flow of \$50 the first year and an end-of-year value equal to: (\$50/0.15) =
\$333. The total return is:
[(50 + 333)/1,677] – 1.0 = -0.77 = -77%. In a risk-neutral world, the
expected return would be equal to the risk-free interest rate. Let p be the
probability that fuel prices are high, under the assumption of risk-
neutrality:
(p × 1.07) + [(1 - p) × (-0.77)] = 0.10
p = 0.473 = 47.3%
To value the call option, consider its possible values. If fuel prices rise to
\$450, the option will be worth: (\$3,000 - \$1,000) = \$2,000. If fuel prices
fall to \$50, the option is worthless. Thus, today the option to invest in
energy-saving equipment is worth:
\$860
1.10
0] .473) 0 [(1 2,000) (0.473
·
× − + ×
If the energy-efficient investment is undertaken today, its value is \$667.
However, the value of the option to wait is \$860. Hence, it makes sense
for consumers to wait.
3. a. An increase in PVGO increases the stock’s risk. Since PVGO is a
portfolio of expansion options, it has higher risk than the risk of the
assets currently in place.
b. The cost of capital derived from the CAPM is not the correct hurdle
rate for investments to expand the firm’s plant and equipment, or to
introduce new products. The expected return will reflect the
expected return on the real options as well as the assets in place.
Consequently, the rate will be too high.
207
CHAPTER 23
Warrants and Convertibles
1. a. Exercise later. By exercising now, you gain a dividend of \$3. However,
you forgo the interest you could have earned on the exercise price:
(0.10 × \$40) = \$4. Also, by exercising now, you give up the option to
own the bond and not own the stock.
b. If the dividend is \$5, you pick up \$1 of extra income by exercising, but
you still give up the option. If the stock has low variability, it is unlikely
that the share price will change very much. In that case, the income gain
may outweigh the loss from shortening the option life. If the stock has
high variability, it may be better to keep the option alive because of the
higher option value.
2. a. The Moose Stores warrant issue is large relative to the value of the
firm, so the dilution adjustment is correspondingly important. Total
equity value after the warrant issue (V) is (\$40 million + \$5 million)
= \$45 million. Thus, (V/N) = (\$45 million/1 million shares) = 45.
P = (V/N) = 45 EX = 30 σ = 0.20 t = 5.0 rf =
0.08
1.5435 ) 5.0 (0.20 1.9907 t σ d d
1.9907 /2 ) 5.0 (0.20 ) 5.0 )]/(0.20 /1.08 log[45/(30
/2 t σ t X)]/ σ log[P/PV(E d
1 2
5
1
· × − · − ·
· × + × ·
+ ·
N(d1) = N(1.9907) = 0.9767
N(d2) = N(1.5435) = 0.9386
Call value = [N(d1) × P] – [N(d2) × PV(EX)]
= [0.9767 × 45] – [0.9386 × (30/1.08
5
)] = \$24.79
b. The market value of each share of common stock is:
(\$45 - \$12.395) = \$32.605
\$12.395
2
\$24.79
value) (Call
q 1
1
value Warrant · · ×

,
`

.
|
+
·
208
3. a. An approximate solution can be derived here by assuming that the
warrant holder pre-commits to exercising at a specified future date.
For example, suppose the warrants are not exercised before year
five. Warrant holders would then lose the first four dividends. We
recalculate the warrant value as follows:
P = (V/N) – PV(dividends) = 45 – 11.27 = 33.73
EX = 30 σ = 0.20 t = 5.0 rf = 0.08
.8989 ) 5.0 (0.20 1.3461 t σ d d
1.3461 /2 ) 5.0 (0.20 ) 5.0 )]/(0.20 (30/1.08 log[33.73/
/2 t σ t X)]/ σ log[P/PV(E d
1 2
5
1
0 · × − · − ·
· × + × ·
+ ·
N(d1) = N(1.3461) = 0.9109
N(d2) = N(0.8989) = 0.8156
Call value = [N(d1) × P] – [N(d2) × PV(EX)]
= [0.9109 × 33.73] – [0.8156 × (30/1.08
5
)] = \$14.07
b. The market value of each share of common stock is:
(\$45 - \$7.035) = \$37.965
4. The cost of extending the warrant life is the same as issuing a new warrant with
maturity equal to the time of extension. In essence, the new warrants are given to
the old warrant holders at no charge.
5. a. With a \$1,000 face value for the bonds, a bondholder can convert
one bond into: (1,000/25) = 40 shares. The conversion value is:
(40 × \$30) = \$1,200
b. A convertible sells at the conversion value only if the convertible is
certain to be exercised. You can think of owning the convertible as
equivalent to owning forty shares plus an option to put the shares
back to the company in exchange for the value of the bond. The
price of the convertible bond exceeds the conversion value by the
value of this put. Also, if the interest on the convertible exceeds the
dividends on forty shares of common stock, the convertible’s value
c. Yes. When Surplus calls, the price of the convertibles will fall to the
conversion value. That is, bondholders will be forced to convert in
order to escape the call. By not calling, Surplus is handing
\$7.035
2
\$14.07
value) (Call
q 1
1
value Warrant · · ×

,
`

.
|
+
·
209
bondholders a ‘free gift’ worth 25 percent of the bond’s face value
(i.e., 130 - 105), at the expense of the shareholders.
6. a. If the fair rate of return on a 10-year zero-coupon non-convertible
bond is 8%, then the price would be:
\$1,000/1.08
10
= \$463.19
The conversion value is: (10 × \$50) = \$500. By converting, you
would gain: (\$500 - \$463.19) = \$36.81. That is, you could convert,
sell the ten shares for \$500, and then buy a comparable straight
bond for \$463.19. Otherwise, if you do not convert, and the bond is
no longer convertible in the future, you will own a non-convertible
Piglet bond worth \$463.19
b. Investors are paying (\$550.00 - \$463.19) = \$86.81 for the option to
c. In one year, bond value = (\$1,000/1.08
9
) = \$500.25 (i.e., the value
of a comparable non-convertible bond). Then the value of the
convertible bond is: (\$500.25 + \$86.81) = \$587.06
7. a. Assume a face value of \$1,000. The conversion price is:
(\$1,000/27) = \$37.04
b. The conversion value is: (27 × \$47) = \$1,269.
c. Yes, you should convert because the value of the shares (\$1,269)
is greater than the maturity value of the bond.
8. a. Stock
b. Straight bond
c. Straight bond
d. Stock
9. a. The yield to maturity on the bond is computed as follows:
1,000 = 532.15 × (1 + r)
15

1,000/532.15 = 1.8792 = (1 + r)
15

1.8792
(1/15)
= 1.0430 = (1 + r)
r = 0.0430 = 4.30%
b. The value of the non-convertible bond would be:
1,000/(1.10)
15
= \$239.39
210
The conversion option was worth:
\$532.15 - \$239.39 = \$292.76
c. Conversion value of the bonds at time of issue was:
8.76 × \$50.50 = \$442.38
d. The initial conversion price was:
\$532.15/8.76 = \$60.75
e. Call price in 2005 is:
603.71 × (1.0430
6
) = \$777.20
Therefore, the conversion price is:
\$777.20/8.76 = \$88.72
The increase in the conversion price reflects the accreted value of
the bond since it has a zero coupon.
f. If investors act rationally, they should put the bond back to Marriott
as soon as the market price falls to the put exercise price.
g. Marriott can call the bonds at \$810.36. Marriott should call the
bonds if the price is greater than \$810.36.
10. Disagree. The expected return affects the price of the stock, but it does
not affect the relative values of the stock and the option. Remember that
the investor can construct a package of debt and warrants that gives
exactly the same return as the stock. The value of this package does not
depend on the stock return.
11. A convertible feature in a bond is analogous to a call option. When the
riskiness of the stock increases, the value of the conversion feature also
increases.
12. These companies have a need for cash but the current share price often
does not allow for large issuances of equity. Issuing a convertible
effectively lets the firm ‘sell’ shares at a higher price.
13. The option holder misses out on the bond’s interest payments. The
present value of these missed payments is subtracted from the present
value of the bond (which is \$1,000, or par, because the coupon rate is
equal to the interest rate). In other words, the option buyer saves interest
211
by not having to buy the bond immediately but loses out by not receiving
the next two years’ interest payments on the bond. Thus:
P = 797.19 EX = 1,200 σ = 0.20 t = 3.0 rf = 0.12
.3724 ) 3.0 (0.20 .0260 t σ d d
.0260 /2 ) 3.0 (0.20 ) 3.0 )]/(0.20 2 /(1200/1.1 log[797.19
/2 t σ t X)]/ σ log[P/PV(E d
1 2
3
1
0 0
0
− · × − − · − ·
− · × + × ·
+ ·
N(d1) = N(-0.0260) = 0.4896
N(d2) = N(-0.3724) = 0.3548
Call value = [N(d1) × P] – [N(d2) × PV(EX)]
= [0.4896 × 797.19] – [0.3548 × (1200/1.12
3
)] = \$87.26
797.19
1.12
120
1.12
120
1,000 value Asset
2
· − − ·
212
Challenge Questions
1. a. The warrant is like a 5-year call option with an exercise price of \$30
on a stock with a value of \$19. Given an estimate of the
appropriate standard deviation and risk-free rate of return, the
warrant can be valued using the Black-Scholes formula. However,
you would need to adjust for dividends.
b. To take dilution into account, we note that the warrant value is
equal to the value of [1/(1 + q)] call options written on a stock with
price (V/N).
The standard deviation for the Black-Scholes formula is the
standard deviation of (V/N) rather than the standard deviation of the
firm’s common stock.
2. a. The value of the alternative share = (V/N) where V is the total value
of equity (common stock plus warrants) and N is the number of
shares outstanding. For Electric Bassoon:
When valuing the warrant, we use the standard deviation of this
alternative ‘share.’ This can be obtained from the following
relationship (see chapter footnote 6):
The proportion of the firm financed by equity (calculated before the
issue of the warrant) times the standard deviation of stock returns
(calculated before the issue of the warrant)
is equal to
the proportion of the firm financed by equity (calculated after the
issue of the warrant) times the standard deviation of the alternative
share.
b. The value of the warrant is equal to the value of [1/(1 + q)] call
options on the alternative share, where q is the number of warrants
issued per share outstanding. For Electric Bassoon:
q = 1,000/2,000 = 0.5
Therefore:
1/(1 + q) = 1/1.5 = 0.67
The value of the warrant is [0.67 × 6] = \$4. At the current price of
\$5 the warrants are overvalued.
\$12.50
2,000
5,000 20,000
N
V
·
+
·
213
3. a. In the case of the safe project, the payoff always exceeds \$7
million, so that the lender will always receive the promised
payment. Ms. Blavatsky has a 40% chance of receiving (\$12.5
million - \$7 million) = \$5.5 million and a 60% chance of receiving
(\$8 million - \$7 million) = \$1 million. Thus, for the lender, the
expected payoff is:
(0.4 × 7) + (0.4 × 7) = \$7 million
For Ms. Blavatsky, the expected payoff is:
(0.4 × 5.5) + (0.6 × 1) = \$2.8 million
b. In the case of the risky project, there is a 40% chance of a \$20
million payoff, in which case the lender will receive \$7 million and
Ms. Blavatsky \$13 million. There is also a 60% chance of a \$5
million payoff, in which case the lender will receive \$5 million and
Ms. Blavatsky nothing.
For the lender, the expected payoff is:
(0.4 × 7) + (0.6 × 5) = \$5.8 million
For Ms. Blavatsky, the expected payoff is:
(0.4 × 13) + (0.6 × 0) = \$5.2 million
Thus, the lender will want Ms. Blavatsky to choose the safe project
while Ms. Blavatsky will prefer the risky project.
Suppose now that the debt is convertible into 50% of the value of
the firm. For the safe project, there is a 40% chance the lender will
be faced with a choice of \$7 million or 50% of the \$12.5 million,
which is \$6.25 million; the lender will choose the former. There is
also a 60% chance the lender will face a choice of \$7 million or
50% of \$8 million, which is \$4 million; the lender will choose \$7
million. Thus, the expected payoff to the lender from the safe
project is:
(0.4 × 7) + (0.6 × 7) = \$7 million
For the risky project, there is a 40% chance the lender will be faced
with a choice of \$7 million or 50% of \$20 million, which is \$10
million; the lender will choose the latter. There is also a 60%
chance the lender will face a choice of \$5 million or 50% of \$5
million, which is \$2.5 million; the lender will choose \$5 million.
Thus, the expected payoff to the lender from the risky project is:
214
(0.4 × 10) + (0.6 × 5) = \$7 million
Therefore, the lender receives the same expected payoff (i.e., \$7
million) from each of the two projects.
4. The existing shareholders will be harmed by the issue of convertible bonds.
The conversion provision will be worth more than the convertible holders
pay for it. The new convertible holders will gain less than new
shareholders would gain, however. This can be seen by considering the
convertible as the stock plus a put option. In general, if the stock is truly
underpriced, the existing shareholders are better off issuing the safest
possible asset; this prevents the new holders of the asset from sharing the
rewards of an increase in stock value when an increase in new information
becomes known.
The one exception to this result may occur when common stock is
undervalued because investors overestimate the firm’s risk. Remember
that options written on risky assets are more valuable than options written
on safe ones. Thus, in this case, investors may overvalue the conversion
option, which may make the convertible issue more attractive than a stock
issue.
215
CHAPTER 24
Valuing Debt
1. Some reasons Fisher’s theory might not be true are:
a. Taxes are levied on nominal interest. Therefore, if expected
inflation is high, part of the tax is actually on the real principal.
b. Inflation may be associated with the level of real economic activity,
which, in turn, may affect real interest rates.
c. It ignores uncertainty about inflation.
2. If expected real interest rates are negative, then individuals will be
tempted to save by buying and storing real goods. This forces the prices
of goods up and the prices of securities down until real rates are no longer
negative.
However, goods are costly to store and expensive to resell if you do not
want them. Some goods are impossible to store, e.g., haircuts and
appendectomies. Prices of these goods may be expected to rise faster
than the interest rate. Note also that it is difficult for a country on its own
to maintain a very low real rate without imposing exchange controls on its
citizens.
3. The key here is to find a combination of these two bonds (i.e., a portfolio
of bonds) that has a cash flow only at t = 6. Then, knowing the price of the
portfolio and the cash flow at t = 6, we can calculate the 6-year spot rate.
We begin by specifying the cash flows of each bond and using these and
their yields to calculate their current prices:
Investment Yield C1 . . . C5 C6 Price
6% bond 12% 60 . . . 60 1,060 \$753.32
10% bond 8% 100 . . . 100 1,100 \$1,092.46
From the cash flows in years one through five, it is clear that the required
portfolio consists of one 6% bond minus 60% of one 10% bond, i.e., we
should buy the equivalent of one 6% bond and sell the equivalent of 60%
of one 10% bond. This portfolio costs:
\$753.32 – (0.6 × \$1,092.46) = \$97.84
The cash flow for this portfolio is equal to zero for years one through five
and, for year 6, is equal to:
\$1,060 – (0.6 × 1,100) = \$400
Thus:
216
\$97.84 × (1 + r6)
6
= 400
r6 = 0.265 = 26.5%
4. Downward sloping. This is because high coupon bonds provide a greater
proportion of their cash flows in the early years. In essence, a high
coupon bond is a ‘shorter’ bond than a low coupon bond of the same
maturity.
5. Using the general relationship between spot and forward rates, we have:
(1 + r2)
2
= (1 + r1) × (1 + f2) = (1.060) × (1.064) ⇒
r2 = 0.062 = 6.2%
(1 + r3)
3
= (1 + r2)
2
× (1 + f3) = (1.062)
2
× (1.071) ⇒
r3 = 0.065 = 6.5%
(1 + r4)
4
= (1 + r3)
3
× (1 + f4) = (1.065)
3
× (1.073) ⇒
r4 = 0.067 = 6.7%
(1 + r5)
5
= (1 + r4)
4
× (1 + f5) = (1.067)
4
× (1.082) ⇒
r5 = 0.070 = 7.0%
If the expectations hypothesis holds, we can infer—from the fact that the
forward rates are increasing—that spot interest rates are expected to
increase in the future.
6. In order to lock in the currently existing forward rate for year five (f5), the
firm should:
 Borrow the present value of \$100 million. Because this money will
be received in four years, this borrowing is at the four-year spot
rate:
r4 = 6.7%
 Invest this amount for five years, at the five-year spot rate: r5 =
7.0%
Thus, the cash flows are:
Today: Borrow (100/1.067)
4
= \$77.151 million
Invest \$77.151 million for 5 years at 7.0%
Net cash flow: Zero
In four years: Repay loan: (\$77.151 × 1.067
4
) = \$100 million
dollars
Net cash flow: -\$100 million
In five years: Receive amount of investment:
(\$77.151 × 1.070
5
) = \$108.2 million
Net cash flow: +\$108.2 million
217
Note that the cash flows from this strategy are exactly what one would
expect from signing a contract today to invest \$100 million in four years,
for a time period of one year, at today’s forward rate for year 5 (8.2%).
With \$108.2 million available, the firm can cover the payment of \$107
million at t = 5.
218
7. We make use of the usual definition of the internal rate of return to
calculate the yield to maturity for each bond.
5% Coupon Bond:
r = 0.06930 = 6.930%
7% Coupon Bond:
r = 0.06925 = 6.925%
12% Coupon Bond:
r = 0.06910 = 6.910%
Assuming that the default risk is the same for each bond, one might be
tempted to conclude that the bond with the highest yield is the best
investment. However, we know that the yield curve is rising (the spot
rates are those found in Question 5) and that, because the bonds have
different coupon rates, their durations are different.
5% Coupon Bond:
7% Coupon Bond:
0
r) (1
1050
r) (1
50
r) (1
50
r) (1
50
r) (1
50
920.70 NPV
5 4 3 2
·
+
+
+
+
+
+
+
+
+
+ − ·
0
r) (1
1070
r) (1
70
r) (1
70
r) (1
70
r) (1
70
1003.10 NPV
5 4 3 2
·
+
+
+
+
+
+
+
+
+
+ − ·
0
r) (1
1120
r) (1
120
r) (1
120
r) (1
120
r) (1
120
1209.20 NPV
5 4 3 2
·
+
+
+
+
+
+
+
+
+
+ − ·
920.70
1.070
(1050) 5
1.067
(50) 4
1.065
(50) 3
1.062
(50) 2
1.060
(50) 1
DUR
5 4 3 2
+ + + +
·
years 4.52 920.70 / 4157.5 DUR · ·
1003.10
1.070
(1070) 5
1.067
(70) 4
1.065
(70) 3
1.062
(70) 2
1.060
(70) 1
DUR
5 4 3 2
+ + + +
·
years 4.38 1003.10 / 4394.5 DUR · ·
219
12% Coupon Bond:
Thus, the bond with the longest duration is also the bond with the highest
yield to maturity. This is precisely what is expected, given that the yield
curve is rising. We conclude that the bonds are equally attractive.
8. a. & b.
Year Discount Factor Forward Rate
1 1/1.05 = 0.952
2 1/(1.054)
2
= 0.900 (1.054
2
/1.05) – 1 = 0.058 = 5.8%
3 1/(1.057)
3
= 0.847 (1.057
3
/1.054
2
) – 1 = 0.063 = 6.3%
4 1/(1.059)
4
= 0.795 (1.059
4
/1.057
3
) – 1 = 0.065 = 6.5%
5 1/(1.060)
5
= 0.747 (1.060
5
/1.059
4
) – 1 = 0.064 = 6.4%
c. 1. 5%, two-year note:
\$992.79
(1.054)
1050
1.05
50
PV
2
· + ·
2. 5%, five-year note:
\$959.34
(1.060)
1050
(1.059)
50
(1.057)
50
(1.054)
50
1.05
50
PV
5 4 3 2
· + + + + ·
3. 10%, five-year note:
\$1,171.43
(1.060)
1100
(1.059)
100
(1.057)
100
(1.054)
100
1.05
100
PV
5 4 3 2
· + + + + ·
d. First, we calculate the yield for each of the two bonds. For the 5%
bond, this means solving for r in the following equation:
5 4 3 2
r) (1
1050
r) (1
50
r) (1
50
r) (1
50
r 1
50
959.34
+
+
+
+
+
+
+
+
+
·
r = 0.05964 = 5.964%
1209.20
1.070
(1120) 5
1.067
(120) 4
1.065
(120) 3
1.062
(120) 2
1.060
(120) 1
DUR
5 4 3 2
+ + + +
·
years 4.12 1209.20 / 4987.1 DUR · ·
220
For the 10% bond:
5 4 3 2
r) (1
1100
r) (1
100
r) (1
100
r) (1
100
r 1
100
1171.43
+
+
+
+
+
+
+
+
+
·
r = 0.05937 = 5.937%
The yield depends upon both the coupon payment and the spot
rate at the time of the coupon payment. The 10% bond has a
slightly greater proportion of its total payments coming earlier, when
interest rates are low, than does the 5% bond. Thus, the yield of
the 10% bond is slightly lower.
e. The yield to maturity on a five-year zero coupon bond is the five-
year spot rate, here 6.00%.
f. First, we find the price of the five-year annuity, assuming that the
annual payment is \$1:
Now we find the yield to maturity for this annuity:
r = 0.0575 = 5.75%
g. The yield on the five-year Treasury note lies between the yield on a
five-year zero-coupon bond and the yield on a 5-year annuity
because the cash flows of the Treasury bond lie between the cash
flows of these other two financial instruments. That is, the annuity
has fixed, equal payments, the zero-coupon bond has one payment
at the end, and the bond’s payments are a combination of these.
9. A 6-year spot rate of 4.8 percent implies a negative forward rate:
(1.048
6
/1.06
5
) - 1 = -0.01 = -1.0%
To make money, you could borrow \$1,000 for 6 years at 4.8 percent and
lend \$990 for 5 years at 6 percent. The future value of the amount
borrowed is:
FV6 = \$1,000 × (1.048)
6
= \$1,324.85
The future value of the amount loaned is:
\$4.2417
(1.060)
1
.059) (1
1
.057) (1
1
.054) (1
1
1.05
1
PV
5 4 3 2
· + + + + ·
5 4 3 2
r) (1
1
r) (1
1
r) (1
1
r) (1
1
r 1
1
4.2417
+
+
+
+
+
+
+
+
+
·
221
FV5 = \$990 × (1.06)
5
= \$1,324.84
This ensures enough money to repay the loan by holding cash over from
year 5 to year 6, and provides an immediate \$10 inflow.
The minimum sensible rate satisfies the condition that the forward rate is
0%:
(1 + r6)
6
/(1.06)
5
= 1.00
This implies that r6 = 4.976 percent.
10. a. Under the expectations theory, the expected spot rate equals the
forward rate, which is equal to:
(1.06
5
/1.059
4
) - 1 = 0.064 = 6.4 percent
b. If the liquidity-preference theory is correct, the expected spot rate is
less than 6.4 percent.
c. If the term structure contains an inflation uncertainty premium, the
expected spot is less than 6.4 percent.
11. In general, yield changes have the greatest impact on long-maturity, low-
coupon bonds.
12. It may be upward sloping because short-term rates are expected to rise or
because long-term bonds are more risky. A sensible starting position is
to assume that all debt is fairly priced.
13. [Note: The duration stated in Section 24.3 is 4.574 years. The table below
provides a result that differs from this figure due to rounding.]
Year Ct
PV
@4.90%
Proportion
of Value
Proportion
of Value x
Time
1 46.25 44.09 0.045 0.045
2 46.25 42.03 0.043 0.086
3 46.25 40.07 0.041 0.123
4 46.25 38.20 0.039 0.156
5 1046.25 823.68 0.834 4.170
Totals 988.07 4.580
14. The duration of a perpetual bond is: [(1 + yield)/yield]
The duration of a perpetual bond with a yield of 5% is:
222
D5 = 1.05/0.05 = 21 years
The duration of a perpetual bond yielding 10% is:
D10 = 1.10/0.10 = 11 years
Because the duration of a zero-coupon bond is equal to its maturity, the
15-year zero-coupon bond has a duration of 15 years.
Thus, comparing the 5% bond and the zero-coupon bond, the 5% bond
has the longer duration. Comparing the 10% bond and the zero, the zero
has a longer duration.
15. The formula for the duration of a level annuity is:
years 2.83 9.28 12.11
1 (1.09)
5
0.09
1.09
1 y) (1
T
y
y 1
5 T
· − ·

− ·
− +

+
Also, we know that:
2.60%
1.09
2.83
yield 1
duration
(percent) Volatility · ·
+
·
This tells us that a 1% variation in the interest rate will cause the contract’s
value to change by 2.60%. On average, then, a 0.5% increase in yield will
cause the contract’s value to fall by 1.30%. The present value of the
annuity is \$583,448 so the value of the contract decreases by: (0.0130 ×
\$583,448) = \$7,585
16. If interest rates rise and the medium-term bond price decreases to \$90.75
instead of \$95, then it will be underpriced relative to the short-term and
long-term bonds. Investors would buy the medium-term bond at the low
price in order to gain from the difference between its value and its price.
This will increase the price and decrease the yield. If the bond price
increased to \$115.50 instead of \$111.50, investors would sell the medium-
term bond because it is overpriced relative to the short-term and long-term
bonds.
17. The value of a corporate bond can be thought of as the value of a risk-free
bond minus the value of a put option on the firm’s assets. The value of
the safe bond depends on risk-free spot rates. The value of the put
decreases as the value of the assets increases relative to the exercise
price. The value of the put also decreases with increases in the interest
rate, and increases with increases in the volatility of the stock. Other
factors that determine the yield on corporate bonds are: differences in
features (e.g., call or put provisions), differences in tax treatment and
differences among countries.
223
18. If the floating rate debt is risk free, then the price should vary only if the
interest rate on the bond is not reset continuously. However, the value of
risky debt will also vary as the value of the default option varies.
19. The value of Company A’s zero-coupon bond depends only on the ten-year
spot rate. In order to value Company B’s ten-year coupon bond, each
coupon interest payment must be discounted at the appropriate spot rate.
This is not complicated if the term structure is flat so that all spot rates are
the same. However, it can cause difficulties when long-term rates are
very different from short-term rates.
20. If Company X has successfully matched the terms of its assets and liabilities,
the payment of \$150 may be reasonably assured while the \$50 is
considerably smaller and not due until the distant future. Company Y has
a relatively large amount due in an intermediate time frame. Thus, the risk
exposure of Company Y to future events may be greater than that for
Company X.
224
Challenge Questions
1. The statement that the nominal interest rate equals the real rate plus the
expected inflation rate is a tautology. Fisher’s hypothesis is that changes
in the inflation rate do not change the expected real rate; in other words,
the two variables fluctuate independently.
2. Arbitrage opportunities can be identified by finding situations where the
implied forward rates or spot rates are different.
We begin with the shortest-term bond, Bond G, which has a two-year
maturity. Since G is a zero-coupon bond, we determine the two-year spot
rate directly by finding the yield for Bond G. The yield is 9.5 percent, so
the implied two-year spot rate (r2) is 9.5 percent. Using the same
approach for Bond A, we find that the three-year spot rate (r3) is 10.0
percent.
Next we use Bonds B and D to find the four-year spot rate. The following
position in these bonds provides a cash payoff only in year four:
a long position in two of Bond B and a short position in Bond D.
Cash flows for this position are:
[(-2 × \$842.30) + (\$980.57)] = -\$704.03 today;
[(2 × \$50) – (\$100)] = \$0 in years 1, 2 and 3; and,
[(2 × \$1050) – (\$1100)] = \$1000 in year 4.
We determine the four-year spot rate from this position as follows:
4
)
4
r (1
1000
704.03
+
·
r4 = 0.0917 = 9.17%
Next, we use r2, r3 and r4 with the one of the four-year coupon bonds to
determine r1. For Bond C:
978.74
r 1
120
(1.0917)
1120
(1.100)
120
(1.095)
120
r 1
120
1,065.28
1
4 3 2
1
+
+
· + + +
+
·
r1 = 0.3867 = 38.67%
Now, in order to determine whether arbitrage opportunities exist, we use
these spot rates to value the remaining two four-year bonds. This
produces the following results: for Bond B, the present value is \$854.55,
and for Bond D, the present value is \$1,005.07. Since neither of these
values equals the current market price of the respective bonds, arbitrage
opportunities exist. Similarly, the spot rates derived above produce the
225
following values for the three-year bonds: \$1,074.22 for Bond E and
\$912.77 for Bond F.
3. We begin with the definition of duration as applied to a bond with yield r
and an annual payment of C in perpetuity
We first simplify by dividing each term by C:
The denominator is the present value of a perpetuity of \$1 per year, which
is equal to (1/r). To simplify the numerator, we first denote the numerator
S and then divide S by (1 + r):
Note that this new quantity [S/(1 + r)] is equal to the square of
denominator in the duration formula above, that is:
Therefore:
Thus, for a perpetual bond paying C dollars per year:
4. We begin with the definition of duration as applied to a common stock with
yield r and dividends that grow at a constant rate g in perpetuity:
 
 
+
+
+ +
+
+
+
+
+
+
+
+ +
+
+
+
+
+
·
t 3 2
t 3 2
r) (1
C
r) (1
C
r) (1
C
r 1
C
r) (1
tC
r) (1
3C
r) (1
2C
r 1
1C
DUR
 
 
+
+
+ +
+
+
+
+
+
+
+
+ +
+
+
+
+
+
·
t 3 2
t 3 2
r) (1
1
r) (1
1
r) (1
1
r 1
1
r) (1
t
r) (1
3
r) (1
2
r) (1
1
DUR
  +
+
+ +
+
+
+
+
+
·
+
+ 1 t 4 3 2
r) (1
t
r) (1
3
r) (1
2
r) (1
1
r) (1
S
2
t 3 2
r) (1
1
r) (1
1
r) (1
1
r 1
1
r) (1
S

,
`

.
|
+
+
+ +
+
+
+
+
+
·
+
 
2
2
r
r 1
S
r
1
r) (1
S +
· ⇒
,
`

.
|
·
+
r
r 1
r) / (1
1
r
r 1
DUR
2
+
· ×
+
·
226
We first simplify by dividing each term by [C(1 + g)]:
The denominator is the present value of a growing perpetuity of \$1 per
year, which is equal to [1/(r - g)]. To simplify the numerator, we first
denote the numerator S and then divide S by (1 + r):
Note that this new quantity [S/(1 + r)] is equal to the square of
denominator in the duration formula above, that is:
Therefore:
Thus, for a perpetual bond paying C dollars per year:
5. a. We make use of the one-year Treasury bill information in order to
determine the one-year spot rate as follows:
1
r 1
100
93.46
+
·
r1 = 0.0700 = 7.00%
The following position provides a cash payoff only in year two:
a long position in twenty-five two-year bonds and a short position in
one one-year Treasury bill. Cash flows for this position are:
 
 
+
+
+
+ +
+
+
+
+
+
+
+
+
+
+
+
+ +
+
+
+
+
+
+
+
+
·
t
t
3
3
2
2
t
t
3
3
2
2
r) (1
g) C(1
r) (1
g) C(1
r) (1
g) C(1
r 1
g) C(1
r) (1
g) tC(1
r) (1
g) 3C(1
r) (1
g) 2C(1
r 1
g) 1C(1
DUR
 
 
+
+
+
+ +
+
+
+
+
+
+
+
+
+
+
+ +
+
+
+
+
+
+
+
·

t
1 t
3
2
2
t
1 t
3
2
2
r) (1
g) (1
r) (1
g) (1
r) (1
g 1
r 1
1
r) (1
g) t(1
r) (1
g) 3(1
r) (1
g) 2(1
r 1
1
DUR
  +
+
+
+ +
+
+
+
+
+
+
+
·
+
+

1 t
2 t
4
2
3 2
r) (1
g) t(1
r) (1
g) 3(1
r) (1
g) 2(1
r) (1
1

r) (1
S
2
t
1 t
3
2
2
r) (1
g) (1
r) (1
g) (1
r) (1
g 1
r 1
1
r) (1
S

,
`

.
|
+
+
+
+ +
+
+
+
+
+
+
+
·
+

 
2
2
g) (r
r 1
S
g r
1
r) (1
S

+
· ⇒

,
`

.
|

·
+
g r
r 1
g)] (r / [1
1
g) (r
r 1
DUR
2

+
·

×

+
·
227
[(-25 × \$94.92) + (1 × \$93.46)] = -\$2,279.54 today;
[(25 × \$4) – (1 × \$100)] = \$0 in year 1; and,
(25 × \$104) = \$2,600 in year 2.
We determine the two-year spot rate from this position as follows:
2
)
2
r (1
2600
2279.54
+
·
r2 = 0.0680 = 6.80%
The forward rate f2 is computed as follows:
f2 = [(1 + 0.0680)
2
/1.0700] = 0.0660 = 6.60%
The following position provides a cash payoff only in year three:
a long position in the three-year bond and a short position equal to
(8/104) times a package consisting of a one-year Treasury bill and
a two-year bond. Cash flows for this position are:
[(-1 × \$103.64) + (8/104) × (\$93.46 + \$94.92)] = -\$89.15
today;
[(1 × \$8) – (8/104) × (\$100 + \$4)] = \$0 in year 1;
[(1 × \$8) – (8/104) × \$104] = \$0 in year 2; and,
(1 × \$108) = \$108 in year 3.
We determine the three-year spot rate from this position as follows:
3
)
3
r (1
108
89.15
+
·
r3 = 0.0660 = 6.60%
The forward rate f3 is computed as follows:
f3 = [(1 + 0.0660)
3
/(1.0680)
2
] = 0.0620 = 6.20%
b. We make use of the spot and forward rates to calculate the price of
the 4 percent coupon bond:
The actual price of the bond (\$950) is significantly greater than the
price deduced using the spot and forward rates embedded in the
prices of the other bonds (\$931.01). Hence, a profit opportunity
exists. In order to take advantage of this opportunity, one should
sell the 4 percent coupon bond short and purchase the 8 percent
coupon bond.
\$931.01
(1.062) (1.066) (1.07)
1040
(1.066) (1.07)
40
(1.07)
40
P · + + ·
228
6. a. Let BS, BM and BL be the prices of the short-, medium- and long-
term bonds, respectively. Then, buying two medium-term bonds
and short-selling one short-term bond gives the same payoffs as
buying the long-term bond. Therefore, BL = 2BM – BS = (2 × 83) –
98 = \$68
b. Whether rates rise or fall, the short-term bond will be worth 100.
The price of the medium-term bond will decrease to \$76.5 if rates
rise and will increase to \$93 if rates fall. The price of the long-term
bond will decrease to \$53 if rates rise and will increase to \$86 if
rates fall.
c. The risk-neutral expectation is 2% per quarter, or, more precisely:
2/98 = 2.04% per quarter
d. Let p equal the probability of a rate decrease. Then, if investors are
risk-neutral:
83 + (10 × p) + (1 – p) × -6.5 = 83 × 1.02
Solving, we find that: p = 0.4945 and (1 – p) = 0.5055
e. The expected return for the Treasury bill is 2%. The expected
return for the medium term bond is:
0.4945 × (10/83) + 0.5055 × (-6.5/83) = 0.02 = 2%
The expected return for the long-term bond is:
0.4945 × (18/68) + 0.5055 × (-15/68) = 0.02 = 2%
7. Newspaper exercise. The price of the bonds should be higher if the
8. a. It is difficult to charge for information because; you cannot stop one
services thus find it much easier to charge the companies, rather
than the investors.
b. Start with a scenario in which no bonds are rated. Companies with
the highest quality bonds want to demonstrate that fact. Once the
highest quality bonds have been rated, companies with the highest
quality bonds of those remaining have an incentive to demonstrate
that their bonds are the best of the remainder. And so on, until only
the lowest quality bonds are left. In essence, companies are willing
229
to pay to have their bonds rated in order to alleviate investors’ fears
that the bonds might be of even lower quality.
c. It follows from the answer to (b) that only companies with extremely
poor quality bonds will not pay to have them rated.
9. We can consider the value of equity to be the value of a call on the firm’s
assets, with an exercise price equal to the payment due to the
bondholders. For Backwoods, the exercise price is \$1,090. Also:
P = 1200 σ = 0.45 t = 1.0 rf = 0.09
.1802 ) 1.0 (0.45 .6302 t σ d d
.6302 /2 ) 1.0 (0.45 ) 1.0 )]/(0.45 1090/1.09 log[1200/(
/2 t σ t X)]/ σ log[P/PV(E d
1 2
1
1
0 0
0
· × − · − ·
· × + × ·
+ ·
N(d1) = N(0.6302) = 0.7357
N(d2) = N(0.1802) = 0.5714
Call value = [N(d1) × P] – [N(d2) × PV(EX)]
= [0.7357 × 1200] – [0.5714 × 1000)] = \$311.44
Thus, the value of equity is \$311. With an asset market value of \$1,200,
the market value of debt is: (\$1,200 - \$311) = \$889.
10. Backwoods will default if the market value of the assets one year from
now is less than \$1,090. From Challenge Question 9, we know that the
current value of the debt is \$889. Assuming that the debt earns the same
return as the assets, then in one year the expected payoff is: (\$889 × e
rt
)
= (\$889 × e
0.10
) = \$982.50
Let x = the probability of default. Then:
\$982.50 = \$1090 (1 – x) + \$0 (x)
0.9014 = (1 – x)
x = 0.0986 = 9.86% probability of default
230
CHAPTER 25
The Many Different Kinds of Debt
1. If the bond is issued at face value and investors demand a yield of
9.5%, then, immediately after the issue, the price will be \$1,000.
As time passes, the price will gradually rise to reflect accrued
interest. For example, just before the first (semi-annual) coupon
payment, the price will be \$1,047.50, and then, upon payment of
the coupon (\$47.50), the price will drop to \$1,000. This pattern will
be repeated throughout the life of the bond as long as investors
continue to demand a return of 9.5%.
2. Answers here will vary, depending on the company chosen. Some key areas that
should be examined are: coupon rate, maturity, security, sinking fund provision,
and call provision.
3. Floating-rate bonds provide bondholders with protection against
inflation and rising interest rates, but this protection is not complete.
In practice, the extent of the protection depends on the frequency of
the rate adjustments and the benchmark rate. (Not only can the
yield curve shift, but yield spreads can shift as well.)
Similarly, puttable bonds provide the bondholders with protection against an increase
in default risk, but this protection is not absolute. If the company’s problems
suddenly become public knowledge, the value of the company may fall so quickly
that bondholders might still suffer losses even if they put their bonds immediately.
4. First mortgage bondholders will receive the \$200 million proceeds
from the sale of the fixed assets. The remaining \$50 million of
mortgage bonds then rank alongside the unsecured senior
debentures. The remaining \$100 million in assets will be divided
between the mortgage bondholders and the senior debenture
holders. Thus, the mortgage bondholders are paid in full, the
231
senior debenture holders receive \$50 million and the subordinated
232
5. If the assets are sold and distributed according to strict precedence,
the following distribution will result. In Subsidiary A, the \$320
million of debentures will be paid off and (\$500 million - \$320
million) = \$180 million will be remitted to the parent. In Subsidiary
B, the \$180 million of senior debentures will be paid off and
(\$220 million - \$180 million) = \$40 million of the \$60 million
subordinated debentures will be paid. In the holding company, the
real estate will be sold and (\$180 million + \$80 million) = \$260
million will be paid in partial satisfaction of the \$400 million senior
collateral trust bonds.
6. a. Typically, a variable-rate mortgage has a lower interest rate than a
comparable fixed-rate mortgage. Thus, you can buy a bigger
house for the same mortgage payment if you use a variable-rate
mortgage. The second consideration is risk. With a variable-rate
mortgage, the borrower assumes the interest rate risk (although in
practice this is mitigated somewhat by the use of caps), whereas,
with a fixed-rate mortgage, the lending institution assumes the risk.
b. If borrowers have an option to prepay on a fixed-rate mortgage, they are likely to do so when interest rates are low. Of
course, this is not the time that lenders want to be repaid because they do not want to reinvest at the lower rates. On the other
hand, the option to prepay has little value if rates are floating, so floating rate mortgages reduce the reinvestment risk for holders
of mortgage pass-through certificates.
7. A sharp increase in interest rates reduces the price of an
outstanding bond relative to the price of a newly issued bond. For
a given call price, this implies that the value to the firm of the call
provision is greater for the newly issued bond. Other things equal,
the yield of the more recently issued bonds should be greater,
reflecting the higher probability of call. Notice, however, that the
outstanding bond will probably have a lower call price and perhaps
a shorter period of call protection; these may be offsetting factors.
8. If the company acts rationally, it will call a bond as soon as the
bond price reaches the call price. For a zero-coupon bond, this will
never happen because the price will always be below the face
value. For the coupon bond, there is some probability that the bond
will be called. To put this somewhat differently, the company’s
option to call is meaningless for the zero-coupon bond, but has
some value for the coupon bond. Therefore, the price of the
coupon bond (all else equal) will be less than the price of the zero,
and, hence, the yield on the coupon bond will be higher.
233
9. a. Using Figure 25.2 in the text, we can see that, if interest rates rise, the
change in the price of the noncallable bond will be greater than the change
in price of the callable bond.
b. On that date, it will be in one party’s interest to exercise its option, and the
bonds will be repaid.
10. See figure below.
11. Most bonds contain covenants that restrict the firm’s ability to issue
new debt of equal or greater seniority unless the firm’s tangible
assets exceed some multiple of the existing debt. This restriction is
intended to preclude the firm from increasing the default risk borne
by existing bondholders.
A similar restriction is the negative pledge clause, which prevents the firm
from issuing more secured debt. Even if this did not increase the ratio of
debt to tangible assets, it would decrease the value of unsecured debt
because unsecured debt is junior to secured debt in the event of default.
12. The issue of additional junior debt does not harm the senior bondholders. As far
as senior bondholders are concerned, the junior debt is similar to equity. The
senior bondholders would prefer that the junior debt not have a shorter maturity,
but it is still in their interest to have a claim on the money put up by the junior
bondholders for the duration of the junior debt.
Value of
straight bond
Value of puttable bond
0
100
100
Putttable bond
Straight bond
234
13. Alpha Corp.’s net tangible asset limit is 200 percent of senior debt. Therefore,
with net tangible assets of \$250 million, Alpha’s total debt cannot exceed
\$125 million. Alpha can issue an additional \$25 million in senior debt.
14. a. There are two primary reasons for limitations on the sale of company
assets. First, coupon and sinking fund payments provide a regular check
on the company’s solvency. If the firm does not have the cash, the
bondholders would like the shareholders to put up new money or default.
But this check has little value if the firm can sell assets to pay the coupon
or sinking fund contribution. Second, the sale of assets in order to reinvest
in more risky ventures harms the bondholders.
b. The payment of dividends to shareholders reduces assets that can be used
to pay off debt. In the extreme case, a dividend that is equal to the value
of the assets leaves bondholders with nothing.
c. If the existing debt is junior, then the original debtholders lose by having
the new debt rank ahead of theirs. If the existing debt is senior, then debt
the issuance of additional senior debt means that the same amount of
equity supports a greater amount of debt; i.e., the firm’s leverage has
increased, and the firm faces a greater probability of default. This harms
the original debtholders.
15. Answers will vary depending on instrument chosen.
16. For purposes of illustration, assume the Christiania Bank issue is a
one-year reverse floater. Suppose also that the current interest
rate on fixed-rate one-year loans is 7.8 percent. Then, for three
different possible future interest rates, the payoffs on the reverse
floater, a fixed-rate loan, and a normal floating-rate loan are as
follows:
Possible Future
Interest Rates
Payoffs at End of Year
Reverse Floater Fixed-Rate Normal Floater
9.8% 1,030 1,078 1,098
7.8% 1,050 1,078 1,078
5.8% 1,070 1,078 1,058
Now consider the payoffs if you borrowed \$1,000 at a floating rate and
loaned \$1,974 at a fixed rate of 7.8%:
Possible Future
Interest Rates
Payoffs at End of Year
Floating Rate
Borrowing
Fixed-Rate
Lending
Total
9.8% -1,098 2,128 1,030
7.8% -1,078 2,128 1,050
5.8% -1,058 2,128 1,070
235
Thus, buying a reverse floater is equivalent to issuing floating-rate debt
and buying fixed-rate debt. This is equivalent to borrowing at short-term
rates in order to lend long-term, which is a risky strategy. The reverse
floater is a very volatile bet on future interest rates.
17. Project finance makes sense if the project is physically isolated from the
parent, offers the lender tangible security and involves risks that are better
shared between the parent and others. The best example is in the
financing of major foreign projects, where political risk can often be
minimized by involving international lenders.
18. A prepackaged bankruptcy avoids the expenses of a bankruptcy court,
and can usually be negotiated more quickly. A prepackaged bankruptcy
also avoids the problems that can arise, as in Eastern’s case, from
continuing to operate assets at a loss. Unlike informal workouts,
prepackaged bankruptcies reduce the likelihood of subsequent litigation
and get the tax advantages of Chapter 11. The problems of conflicts of
interest are the same, and each party can threaten to hold out for a court
solution unless the respective parties each believe that the prepackaged
bankruptcy provides at least as good a deal.
236
Challenge Questions
1. The existing bonds provide \$30,000 per year for 10 years and a payment
of \$1,000,000 in the tenth year. Assuming that all bondholders are
exempt from income taxes, the market value of the bonds is:
\$569,880
1.10
1,000,000
1.10
30,000
1.10
30,000
1.10
30,000
PV
10 10 2
· + + + + · 
Thus, the debt could be repurchased with a payment of \$569,880 today.
From the standpoint of the company, the cash outflows associated with
the bonds are \$1,000,000 in the tenth year, and \$30,000 per year, less
annual tax savings of (0.35 × \$30,000) = \$10,500. Therefore, the net
cash outflow is (\$30,000 - \$10,500) = \$19,500 per year. To calculate the
amount of new 10 percent debt supported by these cash flows, discount
the after-tax cash flows at the after-tax interest rate (6.5 percent):
\$672,908
1.065
1,000,000
1.065
19,500
1.065
19,500
1.065
19,500
PV
10 10 2
· + + + + · 
In other words, the value of these bonds to the firm is \$672,908 and the
market value of the bonds is \$569,880. The firm could repurchase the
bonds for \$569,880 and then issue \$672,908 of new 10 percent debt that
would require cash outflows with a present value equal to that of the
original debt. The firm could also, of course, immediately pocket the
difference (\$103,028).
Now suppose that bondholders are subject to personal income taxes.
High-income investors (i.e., those in high income tax brackets) will favor
low-coupon bonds and will bid up the prices of those bonds. If the low
coupon bonds are worth more to the high-income investor than they are to
Dorlcote, then Dorlcote should not repurchase the bonds. (Note that, if
Dorlcote issued the 3 percent bonds at face value and then repurchases
the bonds for \$569,880, then the company will be liable for taxes on the
gain.)
2. The advantages of setting up a separately financed company for Hubco stem
primarily from the attempt to align the interests of various parties with the
successful operation of the plant. For example, the construction firm was
also a shareholder in order to ensure that the plant would run according to
specifications. By making it a separate entity, Hubco could also enter into
contraction agreements without the need to gain approval from a parent
company. Similarly, if Hubco failed, then no assets beyond the projects’
could be attached. Independence also allowed Hubco to design contracts
with suppliers, customers, and funding sources to meet specific needs
and/or concerns.
237
CHAPTER 26
Leasing
1. “100 percent financing” is not an advantage unique to the lessee because precisely
the same cash flows can be arranged by borrowing as an alternate source of
financing for the acquisition of an asset.
2. a. For comparison purposes, the solution to Quiz Question 5 is shown below:
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6
Initial Cost -3000.00
Depreciation 600.00 960.00 576.00 345.60 345.60 172.80
Depreciation tax shield 210.00 336.00 201.60 120.96 120.96 60.48
After-tax admin. costs -260.00 -260.00 -260.00 -260.00 -260.00 -260.00
Total -3260.00 -50.00 76.00 -58.40 -139.40 -139.40 60.48
PV(at 9%) = -\$3,439.80
Break-even rent 1082.30 1082.30 1082.30 1082.30 1082.30 1082.30
Tax -378.81 -378.81 -378.81 -378.81 -378.81 -378.81
Break-even rent after tax 703.49 703.49 703.49 703.49 703.49 703.49
PV(at 9%) = -\$3,439.82
Cash Flow -2556.51 653.50 779.50 645.10 564.46 564.46 60.48
In the above table, we solve for the break-even lease payments by
first solving for the after-tax payment that provides a present value,
discounted at 9%, equal to the present value of the costs, keeping
in mind that the annuity begins immediately. Then solve for the
break-even rent as follows:
Break-even rent = \$703.49/(1 – 0.35) = \$1,082.30
If the expected rate of inflation is 5 percent per year, then administrative
costs increase by 5 percent per year. We further assume that the lease
payments grow at the rate of inflation (i.e., the payments are indexed to
inflation). However, the depreciation tax shield amounts do not change
because depreciation is based on the initial cost of the desk. The
appropriate nominal discount rate is now:
(1.05 × 1.09) – 1 = 0.1445 = 14.45%
These changes yield the following, indicating that the initial lease payment
has increased from \$1,082 to about \$1,113:
238
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6
Initial Cost -3000.00
Depreciation 600.00 960.00 576.00 345.60 345.60 172.80
Depreciation. tax shield 210.00 336.00 201.60 120.96 120.96 60.48
After-tax admin. costs -260.00 -273.00 -286.65 -300.98 -316.03 -331.83
Total -3260.00 -63.00 49.35 -99.38 -195.07 -210.87 60.48
PV(at 14.45%) = -\$3,537.83
Break-even rent 1113.13 1168.79 1227.23 1288.59 1353.02 1420.67
Tax -389.60 -409.08 -429.53 -451.01 -473.56 -497.23
Break-even rent after tax 723.53 759.71 797.70 837.58 879.46 923.43
PV(at 14.45%) = -\$3,537.83
Cash Flow -2536.47 696.71 847.05 738.20 684.39 712.56 60.48
Here, we solve for the break-even lease payments by first solving
for the after-tax payment that provides a present value, discounted
at 9%, equal to the present value of the costs, keeping in mind that
the annuity begins immediately. We use the 9% discount rate in
order to find the real value of the payments (i.e., \$723.53). Then
each of the subsequent payments reflects the 5% inflation rate.
Solve for the break-even rent as follows:
Break-even rent = \$723.53/(1 – 0.35) = \$1,113.13
b. With a reduction in real lease rates of 10 percent each year, the nominal
lease amount will decrease by 5.5 percent each year. That is, the nominal
lease rate is multiplied by a factor of (1.05 × 0.9) = 0.945 each year.
Thus, we have:
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6
Initial Cost -3000.00
Depreciation 600.00 960.00 576.00 345.60 345.60 172.80
Depreciation. tax shield 210.00 336.00 201.60 120.96 120.96 60.48
After-tax admin. costs -260.00 -273.00 -286.65 -300.98 -316.03 -331.83
Total -3260.00 -63.00 49.35 -99.38 -195.07 -210.87 60.48
PV(at 14.45%) = -3537.83
Break-even rent 1388.85 1312.46 1240.28 1172.06 1107.60 1046.68
Tax -486.10 -459.36 -434.10 -410.22 -387.66 -366.34
Break-even rent after tax 902.75 853.10 806.18 761.84 719.94 680.34
PV(at 14.45%) = -3537.84
Cash Flow -2357.25 790.10 855.53 662.46 524.87 469.47 60.48
Here, when we solve for the first after-tax payment, use a discount rate of:
[(0.9/1.09) – 1 = 0.2111 = 21.11%
239
3. If the cost of new limos decreases by 5 percent per year, then the lease payments
also decrease by 5 percent per year. In terms of Table 26.1, the only change is in
the break-even rent.
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6
Total -82.80 -2.55 0.60 -2.76 -4.78 -4.78 -6.29
Break-even rent 29.97 28.47 27.05 25.70 24.41 23.19 22.03
Tax -10.49 -9.97 -9.47 -8.99 -8.54 -8.12 -7.71
Cash flow -63.32 15.96 18.18 13.94 11.09 10.29 8.03
NPV (at 7%) = 0.00
4. The leasing of trucks, airplanes, or computers is big business
because each such asset requires a significant outlay of cash and
each is used by many companies that are marginally profitable.
Also, in each case standardization of the asset leased leads
naturally to standardization of the contracts; this, in turn, provides
5. Yes, but because operating leases are generally much shorter term than financial
leases, the value of this advantage is not nearly as great as it is for operating
leases.
6. a.
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7
Cost of new bus 100.00
Lost depreciation tax shield -4.00 -6.40 -3.84 -2.30 -2.30 -1.15 0.00
Lease payment -16.90 -16.90 -16.90 -16.90 -16.90 -16.90 -16.90 -16.90
Tax shield of lease
payment 3.38 3.38 3.38 3.38 3.38 3.38 3.38 3.38
Cash flow of lease 86.48 -17.52 -19.92 -17.36 -15.82 -15.82 -14.67 -13.52
NPV (at 6.5%) = -\$4,510
b. Assume the straight-line depreciation is figured on the same basis
as the ACRS depreciation, namely 5 years, beginning halfway
through the first year.
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7
Cost of new bus 100.00
Lost depreciation tax shield -3.50 -7.00 -7.00 -7.00 -7.00 -3.50 0.00
Lease payment -16.90 -16.90 -16.90 -16.90 -16.90 -16.90 -16.90 -16.90
Tax shield of lease
payment 5.92 5.92 5.92 5.92 5.92 5.92 5.92 5.92
Cash flow of lease 89.02 -14.49 -17.99 -17.99 -17.99 -17.99 -14.49 -10.99
NPV (at 6.5%) = \$566
240
7. The net present value of the lessor’s cash flows consists of the cost of the
bus (\$100), the present value of the depreciation tax shield (\$29.469) and
the present value of the after-tax lease payments:
To find the minimum rental, set NPV = 0 and solve for P:
4.21494P = 70.53
P = 16.73 or \$16,730
Greymare should take the lease as long as the NPV of the lease is greater
than or equal to zero. The net present value of the cash flows is the cost
of the bus saved (\$100) less the present value of the lease payments:
(Note that, because Greymare pays no taxes, the appropriate discount
rate is 10 percent.)
Setting this expression equal to zero and solving for P, we find:
P = 17.04 or \$17,040
This is the maximum amount that Greymare could pay. Thus, the lease
payment will be between \$16,730 and \$17,040.
8. The original cash flows are as given in the text. In general, the net
present value of the lessor’s cash flows consists of the cost of the bus, the
present value of the depreciation tax shield, and the present value of the
after-tax lease payments. To find the minimum rental P, we set the net
present value to zero and solve for P. We can then use this value for P to
calculate the value of the lease to the lessee.
a. A lessor tax rate of 50%. Cash flows for the lessor are:

,
`

.
|
+ + + + + × × + −
6 5 4 3 2
1.05
0.0576
1.05
0.1152
1.05
0.1152
1.05
0.1920
1.05
0.3200
1.05
0.2000
100) .50 (0 100
0 P(3.3932) 43.730 100
1.05
1
1.05
1
1.05
1
1 P .50) 0 (1
7 2
· + + − ·
,
`

.
|
+ + + + × × − + 
P = 16.58 or \$16,580
For Greymare, the net present value of the cash flows is the cost of
the bus saved (100) less the present value of the lease payments:

,
`

.
|
+ + + + × × − + + −
7 2
1.065
1
1.065
1
1.065
1
1 P .35) (1 29.469 100  0

,
`

.
|
+ + + + × −
7 2
1.10
1
1.10
1
1.10
1
1 P 100 
241
\$2,700 or 2.70 5.8684) (16.58 100
1.10
1
1.10
1
1.10
1
1 P 100
7 2
· × − ·
,
`

.
|
+ + + + × − 
b. Immediate 100% depreciation. Cash flows for the lessor are:
0 4.2149) (P 35 100
1.065
1
1.065
1
1.065
1
1 P .35) 0 (1 100) (0.35 100
7 2
· × + + −
·
,
`

.
|
+ + + + × × − + × + − 
P = 15.42 or \$15,240
For Greymare, the net present value of the cash flows is:
\$9,510 or .51 5.8684) (15.42 100
1.10
1
1.10
1
1.10
1
1 P 100
7 2
9 · × − ·
,
`

.
|
+ + + + × − 
c. 3-year lease with 4 annual rentals. Cash flows for the lessor are:

,
`

.
|
+ + + + + × × + −
6 5 4 3 2
1.065
0.0576
1.065
0.1152
1.065
0.1152
1.065
0.1920
1.065
0.3200
1.065
0.2000
100) .35 (0 100
0 P(2.3715) 29.469 100
1.065
1
1.065
1
1.065
1
1 P .35) 0 (1
3 2
· + + − ·
,
`

.
|
+ + + × × − +
P = 29.74 or \$29,740
For Greymare, the net present value of the cash flows is
\$3,700 - or 3.70 3.4869) (29.74 100
1.10
1
1.10
1
1.10
1
1 P 100
3 2
− · × − ·
,
`

.
|
+ + + × −
d. An interest rate of 20%. Cash flows for the lessor are:

,
`

.
|
+ + + + + × × + −
6 5 4 3 2
1.13
0.0576
1.13
0.1152
1.13
0.1152
1.13
0.1920
1.13
0.3200
1.13
0.2000
100) .35 (0 100
0 P(3.5247) 25.253 100
1.13
1
1.13
1
1.13
1
1 P .35) 0 (1
7 2
· + + − ·
,
`

.
|
+ + + + × × − + 
P = 21.21 or \$21,210
For Greymare, the net present value of the cash flows is:
242
\$2,340 or 2.34 4.6046) (21.21 100
1.10
1
1.20
1
1.20
1
1 P 100
7 2
· × − ·
,
`

.
|
+ + + + × − 
9. If Greymare pays no taxes, its lease cash flows consist of an inflow of
\$100 at t = 0 and yearly outflows of \$16.9 at t = 0 through t = 7. If the
interest rate is zero, the NPV of the lease is the sum of these cash flows,
or -\$35.2 (-\$35,200).
243
10. Under the conditions outlined in the text, the value to the lessor is \$700
and the value to the lessee is \$820. The key to structuring the lease is to
realize that the lessee and the lessor are discounting at different interest
rates: 10% for the lessee and 6.5% for the lessor. Thus, if we decrease
the early lease payments and increase the later lease payments in such a
way as to leave the lessor’s NPV unchanged, the lessee, by virtue of the
higher discount rate, will be better off. One such set of lease payments is
shown in the following table:
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7
Cost of new bus -100.00
Depreciation tax shield 7.00 11.20 6.72 4.03 4.03 2.02 0.00
Lease payment 13.00 14.00 17.00 17.00 17.00 20.00 20.00 20.00
Tax on lease payment -4.55 -4.90 -5.95 -5.95 -5.95 -7.00 -7.00 -7.00
Cash flow of lease -91.55 16.10 22.25 17.77 15.08 17.03 15.02 13.00
Lessor NPV (at 6.5%) = 0.707 (\$707)
Lessee NPV (at 10%) = 1.868 (\$1,868)
The value to the lessor is \$707 and the value to the lessee (still assuming
it pays no tax) is \$1,868.
11. a. Because Nodhead pays no taxes:
b. The cash flows to Compulease are as follows (assume 5-year
ACRS beginning at t = 0):
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6
Cost of computer -250.0
Depreciation 50.0 80.0 48.0 28.8 28.8 14.4
Depreciation tax shield 17.5 28.0 16.8 10.1 10.1 5.0
Lease payment 62.0 62.0 62.0 62.0 62.0 62.0
Tax on lease payment -21.7 -21.7 -21.7 -21.7 -21.7 -21.7
Net Cash Flow -209.7 57.8 68.3 57.1 50.4 50.4 5.0
The after-tax interest rate is: [(1 - 0.35) × 0.08] = 0.052 = 5.2%.
The NPV of the cash flows for Compulease is: 40.0 or \$40,000.
c. The overall gain from leasing is: (\$40,000 - \$59,600) = -\$19,600.

·
− − · − + ·
5
0 t
t
\$59,500 or 59.5
1.08
62
250 NPV
244
12. a. The Safety Razor Company should take the lease as long as the
NPV of the financing is greater than or equal to zero. If P is the
annual lease payment, then the net present value of the lease to
the company is:
Setting NPV equal to zero and solving for P, we find the company’s
maximum lease payment is 17.04 or \$17,040.
The NPV to the lessor has three components:
• Cost of machinery = -100
• PV of after-tax lease payments, discounted at the after-tax
interest rate of: [(1 - 0.35) × 0.10] = .065 = 6.5%:
• PV of the depreciation tax shield, discounted at the after-tax
rate of 6.50% (we assume depreciation expense begins at t =
1):
28.095
1.065
.0445
1.065
.0893
1.065
.0893
1.065
.0893
1.065
.1249
1.065
.1749
1.065
.2449
1.065
.1429
100) .35 (0
8 7 6 5 4 3 2
·
,
`

.
|
+ + + + + + + ×
To find the minimum rental the lessor would accept, we sum these
three components, set this total NPV equal to zero, then solve for
P:
-100 + (P × 4.2149) + 28.095 = 0
Thus, P is equal to 17.06 or \$17,060, which is the minimum lease
payment the lessor will accept.
b. If the lessor is obliged to use straight-line depreciation, this has no
effect on the company’s maximum lease payment. The lessor’s PV
of the depreciation tax shield becomes:
Thus, the lessor’s minimum acceptable lease payment becomes
\$17,410.

,
`

.
|
+ + + × − ·
7
1.10
1
1.10
1
1 P 100 NPV 
4.2149 P
1.065
1
1.065
1
1 .35) 0 (1 P
7
× ·
,
`

.
|
+ + + × − × 
26.638
1.065
1
1.065
1
8) (100/ .35) (0 PV
8
·
,
`

.
|
+ + × × · 
245
13. In general, if INV is the value of the leased asset, P the lease payment, Tc
the corporate tax rate, Dt the depreciation at time t, n the appropriate time
horizon and r* the after-tax discount rate [i.e., r* = rd × (1 - Tc)], then:
The overall gain from leasing is the sum of these values. The overall gain
is zero if the firms have the same discount rate, the same depreciation
schedule for tax purposes, and the same corporate tax rates.
In order to illustrate how the gains to the lessee and lessor are affected by
changes in these parameters, we can use the Greymare bus example
from the text.
a. Consider the rate of interest. If, for example, the appropriate rate of
interest is 20%, instead of 10%, for both the lessor and the lessee,
then the cash flows given in the text remain the same but the NPV
changes for both parties. The NPV of the lease to the lessor is still
precisely the negative of the NPV to the lessee and the overall gain
is still zero.
If the discount rate is different for the lessor and the lessee, then
the overall gain is not be zero. For example, if the lessor’s discount
rate is less than the lessee’s discount rate, then the overall gain
from leasing is positive.
b. Consider the choice of depreciation schedule. If, for example, the
lessor uses 5-year ACRS but the lessee uses straight-line
depreciation, then the lessee’s cash flows and NPV do not change.
The cash flows and NPV for the lessee change, and the overall
gain is now positive.
c. Consider the difference between the tax rates of the lessor and the
lessee. If the lessor’s tax rate remains at 35% and the lessee’s tax
rate is zero, then the NPV to the lessor does not change. For the
lessee, however, both the cash flows and the after-tax discount rate
change; the effect is to increase the overall gain, which is now
positive.

·
+
+ − ×
− ·
n
0 t
t
c t c
r*) (1
T D )] T (1 [P
INV lessee to Value
) (

·
+
+ − ×
+ − ·
n
0 t
t
c t c
r*) (1
T D )] T (1 [P
INV lessor to Value
) (
246
d. Consider the length of the lease. If the length of the lease changes,
the NPV to each of the parties changes, but they are still equal in
absolute value. The overall gain to the lease is still zero.
14. The problems resulting from the use of IRR for analyzing financial leases
are the same problems discussed in Chapter 5. However, four of these
problems are particularly troublesome here:
a. Multiple roots occur rarely in capital budgeting because the
expected cash flows generally change signs only once. For
financial leases, however, this is often not the case. A lessee has
an immediate cash inflow, a series of outflows for a number of
years, and then an inflow in the last year. With two changes of
sign, there may be, and in practice frequently are, two different
values for the IRR.
b. Another problem arises from the fact that risk is not constant. For
the lessee, the lease payments are fairly riskless and the interest
rate should reflect this. However, the salvage value of the asset is
probably much riskier. This requires two different discount rates.
Each cash flow is not implicitly discounted to reflect its risk when
the IRR is used.
c. If the lessor and lessee do not pay taxes or if both pay at the same
rate, then the IRR should be calculated for the lease cash flows and
then compared to the after-tax rate of interest. However, if the
company is temporarily in a non-taxpaying position, the cost of
capital changes over time. There is no simple standard of
comparison.
d. The IRR method cannot be used to choose between alternative
lease bids with different lives or payment patterns.
15. a. Proponents of this view note that a firm paying no taxes already
has an advantage over tax-paying companies in the development
of new projects, even without leasing. In addition, leasing for a
company in this position allows for a shifting of tax shields from
lessee to lessor. The government loses and the lessee and/or
lessor gain. Many believe that the combination of these two
advantages is more than is necessary to encourage non-taxpaying
companies to invest.
b. The argument for this view is as follows: If the government feels
more investment is needed, then allowing non-taxpaying
companies to take advantage of depreciation tax shields, through
leasing, is likely to provide an incentive. Why make investment
incentives like accelerated depreciation credit available only to
currently profitable companies? If such companies end up with an
247
excessive tax break, then the solution should be to restrict tax loss
carry-forwards rather than to change the tax rules for leasing.
248
Challenge Questions
1. Consider first the choice between buying and a five-year financial lease.
Ignoring salvage value, the incremental cash flows from leasing are shown
in the following table:
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5
Buy: 0.80 probability that contract will be renewed for 5 years
Initial cost of plane 500.00
Depreciation tax shield -35.00 -35.00 -35.00 -35.00 -35.00
Lease payment -75.00 -75.00 -75.00 -75.00 -75.00
Lease payment tax shield 26.25 26.25 26.25 26.25 26.25
Total cash flow 451.25 -83.75 -83.75 -83.75 -83.75 -35.00
Buy: 0.20 probability that contract will not be renewed
Initial cost of plane 500.00
Depreciation tax shield -35.00
Lease payment -75.00
Lease payment tax shield 26.25
Total cash flow 451.25 -35.00
Expected cash flow 451.25 -74.00 -67.00 -67.00 -67.00 -28.00
PV(at 5.85%) 451.25 -69.91 -59.80 -56.49 -53.37 -21.07
Total PV(at 5.85%) = \$190.61
We have discounted these cash flows at the firm’s after-tax borrowing
rate:
0.65 × 0.09 = 0.0585 = 5.85%
The table above shows an apparent net advantage to leasing of \$190.61.
However, if Magna buys the plane, it receives the salvage value. There is
an 80% probability that the plane will be kept for five years and then sold
for \$300 (less taxes) and there is a 20% probability that the plane will be
sold for \$400 in one year. Discounting the expected cash flows at the
company cost of capital (these are risky flows) gives:
\$151.20
(1.14)
400
.20 0
(1.14)
0.35) - (1 300
.80 0
1 5
·

,
`

.
|
× +

,
`

.
| ×
×
The net gain to a financial lease is: (\$190.61 - \$151.20) = \$39.41
(Note that the above calculations assume that, if the contract is not
renewed, Magna can, with certainty, charge the same rent on the plane
that it is paying, and thereby zero-out all subsequent lease payments.
This is an optimistic assumption.)
249
The after-tax cost of the operating lease for the first year is:
0.65 × \$118 = \$76.70
Assume that a five-year old plane is as productive as a new plane, and
that plane prices increase at the inflation rate (i.e., 4% per year). Then the
expected payment on an operating lease will also increase by 4% per
year. Since there is an 80% probability that the plane will be leased for
five years, and a 20% probability that it will be leased for only one year,
the expected cash flows for the operating lease are as shown in the table
below:
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5
Lease: 0.80 probability that contract will be renewed for 5 years
After-tax lease payment -76.70 -79.77 -82.96 -86.28 -89.73 0.00
Lease: 0.20 probability that contract will not be renewed
After-tax lease payment -76.70
Expected cash flow -76.70 -63.81 -66.37 -69.02 -71.78 0.00
PV(at 14%) -76.70 -55.97 -51.07 -46.59 -42.50 0.00
Total PV(at 14%) = \$-272.83
These cash flows are risky and depend on the demand for light aircraft.
Therefore, we discount these cash flows at the company cost of capital
(i.e., 14%). The present value of these payments is greater than the
present value of the safe lease payments from the financial lease (-
\$184.36), so it appears that the financial lease is the lower cost
alternative. Notice, however, our assumption about future operating lease
costs. If old planes are less productive than new ones, the lessor would
not be able to increase lease charges by 4% per year.
2. The net payments for the cancelable lease are:
0.65 × (-\$125) = -\$81.25
Ignoring the cancellation option, the first payment is -\$81.25, and the
expected value for the subsequent payments is:
0.80 × (-\$81.25) = -\$65
The present value of these payments, discounted at the after-tax
borrowing rate (5.85%) is -\$307.26, compared to -\$184.36 for the financial
lease. Therefore, Magna would be paying \$122.90 for the cancellation
option. Suppose that, for example, Magna were able to cancel its lease
after one year and take out a four-year financial lease with rental
payments of \$57 per year. The present value of the cash flows would
then be the same as for the financial lease. Therefore, it would require a
250
24% reduction in the lease payments, from \$75 to \$57, to make the
cancellation option worthwhile
251
3.
t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 t = 7
Cost of new bus 100.00
Lost depreciation tax shield 0.00 0.00 -6.72 -4.03 -4.03 -2.02 0.00
Lease payment -16.90 -16.90 -16.90 -16.90 -16.90 -16.90 -16.90 -16.90
Tax shield of lease payment 0.00 0.00 0.00 5.92 5.92 5.92 5.92 5.92
Cash Flow of Lease 83.10 -16.90 -16.90 -17.70 -15.02 -15.02 -13.00 -10.98
NPV = 0.503 (\$503)
252
CHAPTER 27
Managing Risk
1. Insurance companies have the experience to assess routine risks
and to advise companies on how to reduce the frequency of losses.
Insurance company experience and the very competitive nature of
the insurance industry result in correct pricing of routine risks.
However, BP Amoco has concluded that insurance industry pricing
of coverage for large potential losses is not efficient because of the
industry’s lack of experience with such losses. Consequently, BP
has chosen to self insure against these large potential losses.
Effectively, this means that BP uses the stock market, rather than
insurance companies, as its vehicle for insuring against large
losses. In other words, large losses result in reductions in the value
of BP’s stock. The stock market can be an efficient risk-absorber
for these large but diversifiable risks.
2. As we have noted in the answer to Practice Question 1, insurance company
expertise can be beneficial to large businesses because the insurance company’s
experience allows the insurance company to correctly price insurance coverage
for routine risks and to provide advice on how to minimize the risk of loss. In
addition, the insurance company is able to pool risks and thereby minimize the
cost of insurance.
Rarely does it pay for a company to insure against all risks, however. Typically,
large companies self-insure against small potential losses. In addition, at least one
very large company, BP Amoco, has also chosen to self-insure against very large
losses, as described in the answer to Practice Question 1.
3. Moral hazard: Having an insurance policy can make the
policyholder less careful with regard to the insured risk and can
therefore increase the odds of loss.
Adverse selection: When an insurance company offers insurance
coverage at a set price, without discriminating between high-risk and low-
risk customers, it will attract more high-risk customers.
253
Moral hazard and adverse selection both increase the insurance
company’s losses. Consequently, the insurance company must increase
254
4. If payments are reduced when claims against one issuer exceed a
specified amount, the issuer is co-insured above some level, and
some degree of on-going viability is ensured in the event of a
catastrophe. The disadvantage is that, knowing this, the insurance
company may over-commit in this area in order to gain additional
premiums. If the payments are reduced based on claims against
the entire industry, an on-going and viable insurance market may
be assured but some firms may under-commit and yet still enjoy the
benefits of lower payments. Basis risk will be highest in the first
case due to the larger firm specific risk.
5. This is not a fair comment. By selling wheat futures, the farmer has
indeed eliminated risk. She knows exactly what the price will be.
‘Eliminating risk’ means that there is no possibility of a loss, but it
also means that there is no possibility of a gain.
6. a. Futures contracts are available only in standardized units, for
standardized contract dates, and for a limited number of assets.
Forward contracts are not standardized with respect to unit, date or
asset.
b. Futures contracts are traded on organized exchanges. You
can buy a six-month futures contract today and sell it
tomorrow. Your contract is with the futures exchange
clearing house, not with a particular investor. A forward
contract is not traded on an exchange, and a forward
contract is a contract with a particular investor.
c. Futures contracts are marked-to-market. In effect, you close
your position each day, settle any profits or losses, and open
up a new position. Forward contracts are not marked-to-
market.
7. The list of commodity futures contracts is long, and includes.
 Gold
Sellers include gold-mining companies.
 Suga
r
Sellers include sugar-cane farmers.
 Alum
inum
Sellers include bauxite miners.
255
8. (i) A currency swap is a promise to make a series of payments in one
currency in exchange for receiving a series of payments in another
currency.
(ii) An interest rate swap is a promise to make a series of fixed-
rate payments in exchange for receiving a series of floating-
rate payments (or vice versa). Also, the exchange of
floating-rate payments is linked to different reference rates
(e.g., LIBOR and the commercial paper rate).
(iii) A default swap is a promise to pay a series of fixed rate
payments in exchange for receiving a single large payment
in the event that a particular issuer defaults on a loan.
Swaps may be used because a company believes it has an advantage
borrowing in a particular market or because a company wishes to change
the structure of its existing liabilities.
9.
ds) PV(dividen price spot
) r (1
price Futures
t
f
− ·
+
14,052.99
(1.19)
15,330
) r (1
price Futures
1/2 t
f
· ·
+
Spot price – PV(dividends) = 13,743 – [(13,743 × 0.04 × 0.5)/1.19
(1/2)
] =
13,491.04
The futures are not fairly priced.
10. If we purchase a 9-month Treasury bill futures contract today, we
are agreeing to spend a certain amount of money nine months from
now for a 3-month Treasury bill. So, the valuation of this futures
contract involves three steps:
 First, find the expected yield of a 3-month Treasury bill 9 months from now
(yf).
 Second, find the corresponding price of the 3-month Treasury bill 9
months from now (Pf). (Note: Pf is the answer to this Practice
Question, so step 3 is not a required step for this solution.)
 Third, find the corresponding spot price today.
(Note that the yields given in the problem statement are annualized.)
The yield of a 3-month Treasury bill nine months from today is found as
follows (where r denotes a spot rate and the subscripts refer to the time to
maturity, in months):
256
(1 + r9)
3/4
× (1 + yf)
1/4
= (1 + r12)
1
(1 + 0.07)
3/4
× (1 + yf)
1/4
= (1 + 0.08)
1
Solving, we find that: yf = 0.1106 = 11.06% (annualized rate).
It follows that the price (per dollar) of a 3-month Treasury bill nine months
from now will be:
The corresponding spot price today is:
11. To check whether futures are correctly priced, we use the basic
relationship:
This gives the following:
Actual Futures
Price
Value of
Future
a. Magnoosium \$2728.50 \$2728.50
b. Quiche 0.514 0.589
d. Pulgas 6,900.00 7,126.18
e. Establishment
Industries stock 97.54 97.58
f. Wine 14,200.00 13,107.50*
* Assumes surplus storage cannot be rented out. Otherwise, futures are
overpriced as long as the opportunity cost of storage is less than:
(\$14,200 - \$13,107.50) = \$1,092.50
Note that for the currency futures in part (d), the futures and spot currency
quotes are indirect quotes (i.e., pulgas per dollar) rather than direct quotes
(i.e., dollars per pulga). If I buy pulgas today, I pay (\$1/9300) per pulga in
the spot market and earn interest of [(1.95
0.5
) –1] = 0.3964 = 39.64% for
six months. If I buy pulgas in the futures market, I pay (\$1/6900) per pulga
and I earn 7% interest on my dollars. Thus, the futures price of one pulga
should be:
1.3964/(9300 × 1.07) = 0.00014033 = 1/7126.18
Therefore, a futures buyer should demand 7126.18 pulgas for \$1.
\$0.9741
0.1106) (1
1
P
1/4 f
·
+
·
\$0.9259
0.07) (1
0.9741
P
3/4
·
+
·
yield) ence PV(conveni costs) PV(storage price spot
) r (1
Future of Value
t
f
− + ·
+
257
Where the futures are overpriced [i.e., (f) above], it pays to borrow, buy
the goods on the spot market, and sell the future. Where they are
underpriced [i.e., (b) and (d)], it pays to buy the future, sell the commodity
on the spot market, and invest the receipts in a six-month account.
12. We make use of the basic relationship between the value of futures and
the spot price:
This gives the following values:
Contract Length (Months)
1 3 9 15 21
(1 + rf)
t
1.00437 1.01663 1.05799 1.10288 1.15058
rf 5.37% 6.82% 7.81% 8.15% 8.34%
13. a. The NPV of a swap at initiation is zero, assuming the swap is fairly
priced.
b. If the long-term rate rises, the value of a five-year note with a
coupon rate of 4.5% would decline to 957.30:
957.30
.055) (1
1045
.055) (1
45
.055) (1
45
.055) (1
45
.055) (1
45
5 4 3 2 t
· + + + +
With hindsight, it is clear that A would have been better off keeping
the fixed-rate debt. A loses as a result of the increase in rates and
the dealer gains.
c. A now has a liability equal to (1,000 – 957.30) = 42.70 and
the dealer has a corresponding asset.
14. Once it is clear that a swap is profitable, then it must be determined
how this profit is to be divided between the principals. For
purposes of illustration, let us first assume that A will break even
and then calculate the profit to B. (Having shown that there is a
profit, we could then rearrange the calculations to find the swap
which gives all the gains to A, or to find a swap for which the gains
are shared.)
To begin, we assume that A demands a 10% dollar cost of borrowing:
Step 1: B borrows \$1,000 at its 8 percent borrowing rate.
Step 2: B changes \$1,000 into 2,000 Swiss Francs (SF).
price spot
) r (1
price Futures
t
f
·
+
258
Step 3: A promises to pay B \$80 per year in years 1 through 4, and
\$1,080 in year 5. (This covers B’s cost of servicing its
dollar debt.)
Step 4: A discounts these promised dollar payments at its 10
percent dollar cost of borrowing:
This is the amount that A needs to borrow.
Step 5: A borrows 1848.36 SF at its 7 percent borrowing rate.
Step 6: A changes 1848.36 SF into \$924.18.
Step 7: B promises to pay A 129.39 SF per year in years 1 through
4, and 1977.75 SF in year 5. This covers A’s cost of
servicing its SF debt.
The net effect of B’s dollar loan, A’s Swiss franc loan, and the currency
swap is:
1. A borrows \$924.18 at 10 percent, i.e., A receives \$924.18
and is obligated to pay \$80 per year in years 1 through 4,
and \$1,080 in year 5. A’s SF obligations are paid by B.
2. B borrows 2000 SF and is obligated to pay 129.39 SF per
year in years 1 through 4, and 1,977.75 SF in year 5. B’s
dollar obligations are paid by A. The cost, or yield, of this
loan to B may be calculated from the following:
Thus, as a result of the swap, A can borrow dollars on a break-even
basis, and B can borrow Swiss francs more cheaply (5.1 percent
versus 6 percent). As noted above, we could rearrange this so that
the profit is shared, which is the usual case.
15. Suppose you own an asset A and wish to hedge against changes in
the value of this asset by selling another asset B. In order to
minimize your risk, you should sell delta units of B; delta measures
the sensitivity of A’s value to changes in the value of B.
In practice, delta can be measured by using regression analysis, where
the value of A is the dependent variable and the value of B is the
independent variable. Delta is the regression coefficient of B. Sometimes
considerable judgement must be used. For example, it may be that hedge
you wish to establish has no historical data that can be used in a
regression analysis.
SF 36 . 848 . 1 18 . 924 \$
1 . 1
1080
1 . 1
80
5
4
1 t
t
· · +

·
5.1% 0.051 x 2000
x) (1
1977.75
x) (1
129.39
5
4
1 t
t
· · ⇒ ·
+
+
+

·
259
16.
Gold Price
Per Ounce
(a)
Unhedged
Revenue
(b)
Futures-Hedged
Revenue
(c)
Options-Hedged
Revenue
\$280 \$280,000 \$301,000 \$298,000
\$300 \$300,000 \$301,000 \$298,000
\$320 \$320,000 \$301,000 \$318,000
260
17. Standard & Poor’s index futures are contracts to buy or sell a mythical
share, which is worth \$500 times the value of the index. For example, if
the index is currently at 400, each ‘share’ is worth: (\$500 × 400) =
\$200,000. Legs’ portfolio is equivalent to five such ‘shares.’
If Legs sells five index futures contracts, then, in six months, he will
5 × \$500 × price of futures
If the relationship between the futures price and the spot price is used, this
is equivalent to receiving:
5 × 500 × (spot price of index) × (1 + rf)
1/2
= \$1,000,000 × (1 + rf )
1/2
This is exactly what he would receive in six months if he sold his portfolio
now and put the money in a six-month deposit. Of course, when he sells
the futures, Legs also agrees to hand over the value of a portfolio of five
index ‘shares.’ So, at the end of six months, he can sell his portfolio and
use the proceeds to settle his futures obligation. Thus, by hedging his
portfolio, Legs can ‘cash in’ without selling his portfolio today.
18. Legs can equally well hedge his portfolio by selling seven-month
index futures now and liquidating his futures position six months
from today. If rp is the return on the portfolio and rf is the risk-free
rate, then his cash flows are:
Sell portfolio: +1,000,000 × (1 + rp)
Sell 7-month future: +1,000,000 × (1 + rf)
½
(using the relationship between the spot
and futures prices)
Buy 7-month future: -1,000,000 × (1 + rp)
(because the spot price of the future will
increase as the index increases)
Thus, the net cash flow six months from today will be [1,000,000 × (1 +
rf)
1/2
], exactly what Legs would receive if he sold the \$1,000,000 portfolio
now and put the money in a six-month deposit.
19. We find the appropriate delta by using regression analysis, with the
change in the value of Swiss Roll as the dependent variable and
261
the change in the value of Frankfurter Sausage as the independent
variable. The result is that the regression coefficient, which is the
delta, is 0.5. In other words, the short position in Frankfurter
Sausage should be half as large as that in Swiss Roll, or \$50
million.
20. a. 0.75 × 100,000 = \$75,000
b. δ = 0.75
c. You could sell (1.2 × 100,000) = \$120,000 of gold (or gold
futures) to hedge your position. However, since the R
2
is
less (0.5 versus 0.6 for Stock B), you would be less well
hedged.
21. a. For the lease:
Year Ct
PV(Ct)
at 12%
Proportion
of Total
Value
Proportion of
Total Value
Times Year
1 2 1.786 0.180 0.180
2 2 1.594 0.160 0.320
3 2 1.424 0.143 0.429
4 2 1.271 0.128 0.512
5 2 1.135 0.114 0.570
6 2 1.013 0.102 0.612
7 2 0.905 0.091 0.637
8 2 0.808 0.081 0.648
V = 9.935 Duration = 3.908
For the 6-year debt (value \$8.03 million):
Year Ct
PV(Ct)
at 12%
Proportion
of Total
Value
Proportion of
Total Value
Times Year
1 120 107.1 0.107 0.107
2 120 95.7 0.096 0.191
3 120 85.4 0.085 0.256
4 120 76.3 0.076 0.305
5 120 68.1 0.068 0.340
6 1120 567.4 0.567 3.402
V = 1000.0 Duration = 4.601
The duration of the one-year debt (value \$1.91 million) is one year.
Therefore, the average duration of the debt portfolio is:
years 3.91 4.6
8.03 1.91
8.03
1
8.03 1.91
1.91
·

,
`

.
|
×
+
+

,
`

.
|
×
+
262
This is equal to the duration of the lease.
263
b. See the table below. Potterton is no longer fully hedged.
The value of the liabilities (\$14.02 million) is now less than
the value of the asset (\$14.04 million). A one percent
change in interest rates affects the value of the asset more
than the value of the liabilities. To maintain the hedge, the
financial manager would adjust the debt package to have the
same duration as the lease. Note, however, that the
mismatch is negligible and should not give the manager
sleepless nights.
Lease 6-Year Debt 1-Year Debt Debt Package
Yield Value Change Price Value Price Value Value Change
2.5% 14.340 +2.144% 152.33 12.232
a
109.27 2.087
b
14.319 +2.118%
3.0% 14.039 148.75 11.945 108.74 2.077 14.022
3.5% 13.748 -2.073% 145.29 11.667 108.21 2.067 13.734 -2.054%
(a) \$8.03 million face value
(b) \$1.91 million face value
22. a. PV = [-20/(1.10)
3
] – [20/(1.10)
4
] = -\$28.69
b. Duration of the liability:
Year Ct
PV(Ct)
at 12%
Proportion
of Total
Value
Proportion of
Total Value
Times Year
3 20 15.03 0.524 1.572
4 20 13.66 0.476 1.904
V = 28.69 Duration = 3.476
Duration of the note:
Year Ct
PV(Ct)
at 12%
Proportion
of Total
Value
Proportion of
Total Value
Times Year
1 12 10.91 0.103 0.103
2 12 9.92 0.093 0.187
3 12 9.02 0.085 0.254
4 112 76.50 0.719 2.877
V = 106.35 Duration = 3.421
c. Let x = the proportion invested in the note so that (1 – x) is the
proportion invested in the bank deposit. Then:
3.421x + 0 (1 –x) = 3.476
x = 3.476/3.421 = 1.016
1 – x = -0.016
264
Therefore, invest (1.016 × \$28.69 million) = \$29.149 million in the
note and borrow (\$29.149 million - \$28.69 million) = \$0.459 million.
d. No, not perfectly. However, the imbalance would generally be
relatively small.
e. In order to perfectly hedge this liability, we must invest so that the
cash flows from the investment exactly match the cash flows of the
liability. One way to do this is with zero-coupon notes, as follows:
• Invest \$15.03 million in a 3-year zero-coupon note paying 10%
• Invest \$13.66 million in a 4-year zero-coupon note paying 10%
When the 3-year zero-coupon note matures, it will pay \$20 million,
and when the 4-year zero-coupon note matures, it will pay \$20
million.
23. Assume the current price of oil is \$14 per barrel, the futures price is
\$16, and the option exercise price is \$16.
Oil Price
Per Barrel
Futures-Hedged
Expense
Options-Hedged
Expense
\$14 \$16 \$14
\$16 \$16 \$16
\$18 \$16 \$16
The advantages of using futures are that risk is eliminated and that the
hedge, once in place, can be safely ignored. The disadvantage,
compared to hedging with options, is that options allow for the possibility
of a gain. Hedging with options has a cost (i.e., the cost of the option).
24. Insurance eliminates downside risk by providing a put option.
Hedging removes all uncertainty. Option hedging therefore
requires a dynamic strategy. An example is the delta hedge set up
by the miller, as described in the chapter.
25. Think of Legs Diamond’s problem (see Practice Question 17). If
futures are underpriced, he will still be hedged by selling futures
and borrowing, but he will make a known loss (the amount of the
underpricing). If he hedges by selling seven-month futures (see
Practice Question 18), he not only needs to know that they are
fairly priced now but also that they will be fairly priced when he
buys them back in six months. If there is uncertainty about the
fairness of the repurchase price, he will not be fully hedged.
265
Speculators like mispriced futures. For example, if six-month futures are
overpriced, speculators can make arbitrage profits by selling futures,
borrowing and buying the spot asset. This arbitrage is known as ‘cash-
and-carry.’
266
Challenge Questions
1. a. Phillips is not necessarily stupid. The company simply wants to eliminate
interest rate risk.
b. The initial terms of the swap (ignoring transactions costs and dealer
profit) will be such that the net present value of the transaction is
zero. Phillips will borrow \$20 million for five years at a fixed rate of
9% and simultaneously lend \$20 million at a floating rate two
percentage points above the three-month Treasury bill rate which is
currently a rate of 7%.
c. Under the terms of the swap agreement, Phillips is obligated to pay
\$0.45 million per quarter (\$20 million at 2.25% per quarter) and, in
turn, receives \$0.40 million per quarter (\$20 million at 2% per
quarter). That is, Phillips has a net swap payment of \$0.05 million
per quarter.
d. Long-term rates have decreased, so the present value of Phillips’
long-term borrowing has increased. Thus, in order to cancel the
swap, Phillips will have to pay the dealer. The amount paid is the
difference between the present values of the two positions:
 The present value of the borrowed money is the present value of
\$0.45 million per quarter for 16 quarters, plus \$20 million at
quarter 16, evaluated at 2% per quarter (8% annual rate, or two
percentage points over the long-term Treasury rate). This
present value is \$20.68 million.
 The present value of the lent money is the present value of \$0.40
million per quarter for 16 quarters, plus \$20 million at quarter 16,
evaluated at 2% per quarter. This present value is \$20 million,
as we would expect. Because the rate floats, the present value
does not change.
Thus, the amount that must be paid to cancel the swap is \$0.68
million.
2. a. Cash flows (in thousands) for the two alternatives are as follows:
Hoopoe’s International Issue
Year Cash Flow
0 C\$99,800
100,000 – (100,000 × 0.002)
1 -10,625
-(100,000 × 0.10625)
2 -10,625
267
3 -10,625
4 -10,625
5 -110,625 (-10,625 - 100,000)
The ‘all-in cost’ (yield to maturity) implicit in these cash flows is
10.68%.
Hoopoe’s Swiss Franc (SF) Issue:
Year Cash Flow
0 SF 199,600
200,000 – (200,000 × 0.002)
1 -10,750
-(200,000 × 0.05375)
2 -10,750
3 -10,750
4 -10,750
5 -210,750 (-10,750 - 200,000)
For the swap to be successful the counterparty must pay Hoopoe’s
Swiss franc costs (10,750 in years 1 through 4 and 210,750 in year
5). Further, the counterparty requires an all-in cost in Swiss francs
of 6.45%. Using 6.45% as the discount rate, we can calculate the
net proceeds required from the counterparty’s dollar issue:
With these net proceeds, we can calculate the required dollar face
value (x) of the counterparty’s debt issue:
x (1 – 0.002) = 95,527 ⇒ x = \$95,718
We can now calculate the cash flows related to the counterparty’s
issue of dollar debt.
Year Cash Flow
0 \$95,527
95,718 – (95,718 × 0.002)
1 -10,170
(95,718 × 0.10625)
2 -10,170
3 -10,170
4 -10,170
5 -105,888 (-10,170 - 95,178)
Thus, Hoopoe can issue Swiss franc debt and raise 199,600 SF,
which is equivalent to \$99,800, and have its SF obligation paid by
the counterparty; in turn, it is obligated to pay its counterparty’s
dollar obligations. The all-in cost (x) implied by these cash flows is
calculated as follows:
\$95,527 or SF 191,053
(1.0645)
210,750
(1.0645)
10,750
5
4
1 t
t
· +

·
9.51% 0.0951 x 99,800
x) (1
105,888
x) (1
10,170
5
4
1 t
t
· · ⇒ ·
+
+
+

·
268
(Note that, by construction, the counterparty’s all-in cost is 6.45
percent for its SF borrowing.)
The swap is better than the international bond issue, since the
effective interest rate is less: 9.51% versus 10.66%
b. Hoopoe must clearly worry that the counterparty may default on the
swap agreement. The cost of a replacement swap with a new
counterparty could be considerably higher than the first one, for
example, if the dollar has fallen sharply relative to the franc. Often,
however, the counterparty is a major international bank; in that
case, the default risk is probably small.
3. a. For each, we make use of the general relationship:
− ·
+
price Spot
) r (1
price Futures
t
f
PV(convenience yield)
or
Futures price = (1 + rf)
t
× [Spot price – PV(convenience
yield)]
Thus, the six-month futures prices are:
Magnoosium:
1.03 × [2800 – (0.04 × 2800)/1.03] =
\$2,722 per ton
Oat Bran:
1.03 × [0.44 – (0.005 × 0.44)/1.03] =
\$0.451 per bushel
Biotech:
1.03 × [140.2 – 0] =
\$144.4
Allen Wrench:
1.03 × [58.00 – (1.2/1.03)] =
\$58.54
5-Year T-Note:
1.03 × [108.93 – (4/1.03)] =
\$108.20
Ruple: * 3.017 ruples/\$
*Note that, for the currency futures (i.e., the Westonian ruple), the spot
currency quote is an indirect quote (i.e., ruples per dollar) rather than a
direct quote (i.e., dollars per ruple). If I buy ruples today in the spot
market, I pay (\$1/3.1) per ruple in the spot market and earn interest of
[(1.12
0.5
) –1] = 0.0583 = 5.83% for six months. If I buy ruples in the futures
market, I pay (\$1/X) per ruple (where X is the indirect futures quote) and I
earn 6% interest on my dollars. Thus, the futures price of one ruple
should be:
1.0583/(3.1 × 1.03) = 0.33144 = 3.017
Therefore, a futures buyer should demand 3.017 ruples for \$1.
b. The magnoosium producer would sell 1,000 tons of six-
month magnoosium futures.
269
c. Because magnoosium prices have fallen, the magnoosium
producer will receive payment from the exchange. It is not
necessary for the producer to undertake additional futures
market trades to restore its hedge position.
d. No, the futures price depends on the spot price, the risk-free
rate of interest, and the convenience yield.
e. The futures price will fall to \$48.24 (same calculation as
above, with a spot price of \$48).
f. First, we recalculate the current spot price of the 5-year
Treasury note. The spot price given (\$108.93) is based on
semi-annual interest payments of \$40 each (annual coupon
rate is 8%) and a flat term structure of 6% per year.
Assuming that 6% is the compounded rate, the six-month
rate is:
(1 + 0.06)
1/2
- 1 = 0.02956 = 2.956%
Incorporating similar assumptions with the new term structure
specified in the problem, the new spot price of the 5-year Treasury
note will be \$113.46. Thus, the futures price of the 5-year T-note
will be:
1.02 × [113.46 - (4/1.02)] = \$111.73
The dealer who shorted 100 notes at the (previous) futures price
has lost money.
g. The importer could buy a three-month option to exchange
dollars for ruples, or the importer could buy a futures
contract, agreeing to exchange dollars for ruples in three
months’ time.
270
CHAPTER 28
Managing International Risks
1. Answers here will vary, depending on when the problem is
assigned.
2. a. The dollar is selling at a forward premium on the baht.
b.
c. Using the expectations theory of exchange rates, the forecast is:
\$1 = 44.555 baht
d. 100,000 baht = \$(100,000/44.555) = \$2,244.42
3. We can utilize the interest rate parity theory:
If the three-month rand interest rate were substantially higher than 5.07%, then
you could make an immediate arbitrage profit by buying rands, investing in a
three-month rand deposit, and selling the proceeds forward.
4. Answers will vary depending on when the problem is assigned. However, we can say
that if a bank has quoted a rate substantially different from the market rate, an
arbitrage opportunity exists.
5. Our four basic relationships imply that the difference in interest rates
equals the expected change in the spot rate:
1.89% .0189 0 1
44.345
44.555
4 · ·
,
`

.
|
− ×
5.07% 0.0507 r
8.3693
8.4963
1.035
r 1
rand
rand
· · ⇒ ·
+
\$ / rand
\$ / rand
\$
rand
s
f
r 1
r 1
·
+
+
271
We would expect these to be related because each has a clear relationship with the
difference between forward and spot rates.
6. If international capital markets are competitive, the real cost of funds in
Japan must be the same as the real cost of funds elsewhere. That is,
the low Japanese yen interest rate is likely to reflect the relatively low
expected rate of inflation in Japan and the expected appreciation of the
Japanese yen. Note that the parity relationships imply that the
difference in interest rates is equal to the expected change in the spot
exchange rate. If the funds are to be used outside Japan, then Ms.
Stone should consider whether to hedge against changes in the
exchange rate, and how much this hedging will cost.
7. a. Exchange exposure. Compare the effect of local financing with the export
of capital from the U.S.
b. Capital market imperfections. Some countries use exchange controls to
force the domestic real interest rate down; others offer subsidized loans to
foreign investors.
c. Taxation. If the subsidiary is in a country with high taxes, the parent may
prefer to provide funds in the form of a loan rather than equity.
d. Government attitudes to remittance. Interest payments, royalties, etc.,
may be less subject to control than dividend payments
e. Expropriation risk. Although the host government might be ready to
expropriate a venture that was wholly financed by the parent company, the
government may be reluctant to expropriate a project financed directly by
a group of leading international banks.
f. Availability of funds, issue costs, etc. It is not possible to raise large sums
outside the principal financial centers. In other cases, the choice may be
affected by issue costs and regulatory requirements. For example,
Eurodollar issues avoid SEC registration requirements.
8. Suppose, for example, that the real value of the deutschemark (DM)
declines relative to the dollar. Competition may not allow Lufthansa to
raise trans-Atlantic fares in dollar terms. Thus, if dollar revenues are
fixed, Lufthansa will earn fewer DM. This will be offset by the fact that
Lufthansa’s costs may be partly set in dollars, such as the cost of fuel
and new aircraft. However, wages are fixed in DM. So the net effect
will be a fall in DM profits from its trans-Atlantic business.
However, this is not the whole story. For example, revenues may not be wholly
in dollars. Also, if trans-Atlantic fares are unchanged in dollars, there may be
L/\$
L/\$
L/\$
L/\$
\$
L
s
) (s E
s
f
r 1
r 1
· ·
+
+
272
extra traffic from German passengers who now find that the DM cost of travel has
fallen.
In addition, Lufthansa may be exposed to changes in the nominal exchange rate.
For example, it may have bills for fuel that are awaiting payment. In this case, it
would lose from a rise in the dollar.
Note that Lufthansa is partly exposed to a commodity price risk (the price of fuel
may rise in dollars) and partly to an exchange rate risk (the rise in fuel prices may
not be offset by a fall in the value of the dollar). In some cases, the company can,
to a great extent, fix the dollar cash flows, such as by buying oil futures.
However, it still needs at least a rough-and-ready estimate of the hedge ratios, i.e.,
the percentage change in company value for each 1% change in the exchange rate.
(Hedge ratios are discussed in Chapter 27.) Lufthansa can then hedge in either
the exchange markets (forwards, futures, or options) or the loan markets.
9. Suppose a firm has a known foreign currency income (e.g., a foreign currency receivable). Even if the law of one price
holds, the firm is at risk if the overseas inflation rate is unexpectedly high and the value of the currency declines
correspondingly. The firm can hedge this risk by selling the foreign currency forward or borrowing foreign currency and
selling it spot. Note, however, that this is a relative inflation risk, rather than a currency risk; e.g., if you were less certain
about your domestic inflation rate, you might prefer to keep the funds in the foreign currency.
If the firm owns a foreign real asset (like Outland Steel’s inventory), your worry
is that changes in the exchange rate may not affect relative price changes. In
other words, you are exposed to changes in the real exchange rate. You cannot so
easily hedge against these changes unless, say, you can sell commodity futures to
fix income in the foreign currency and then sell the currency forward.
10. The dealer estimates the following relationship in order to calculate the
hedge ratio (delta):
Expected change in company value = a + (δ × Change in value of yen)
For the Ford dealer:
Expected change in company value = a + (5 × Change in value of yen)
Thus, to fully hedge exchange rate risk, the dealer should sell yen forward
in an amount equal to one-fifth of the current company value.
273
11. The future cash flows from the two strategies are as follows:
Sell Euro Forward
Euro Appreciates to
\$0.92/euro
Euro Depreciates to
\$0.89/euro
spot rate to settle contract)
1,000,000 (0.9070)
- 1,000,000 (0.92)
= -\$13,000
1,000,000 (0.9070)
- 1,000,000 (0.89)
= \$17,000
(inflow of 1,000,000 euros
to settle contract)
1,000,000 (0.9070)
= \$907,000
1,000,000 (0.9070)
= \$907,000
Put Option
Euro Appreciates to
\$0.92/euro
Euro Depreciates to
\$0.89/euro
euros at future spot rate and
exercise put)
\$0 1,000,000 (0.9070)
- 1,000,000 (0.89)
= \$17,000
higher of the spot or put
exercise price)
1,000,000 (0.92)
= \$920,000
1,000,000 (0.9070)
= \$907,000
Note that, if the firm is uncertain about receiving the order, it cannot completely
remove the uncertainty about the exchange rate. However, the put option does
place a downside limit on the cash flow although the company must pay the
option premium to obtain this protection.
12. a. Pesos invested = 1,000 × 500 pesos = 500,000 pesos
Dollars invested = 500,000/9.1390 = 54,710.58
b.
Dollars received = (550 × 1000)/9.5 = 57,894.74
c. There has been a return on the investment of 10% but a loss on the
exchange rate.
13. The nominal exchange rate is given in the table in the statement of the
problem. The real exchange rate is equal to the nominal exchange
10.0% 0.10
1000 500
(1000) 500) (550
×
× −
·
5.82% 0.0582
54,710.58
54,710.58 57,894.74

·
274
rate multiplied by the inflation differential. (See footnote 15, p. 795 of
the text.)
14. George lives in the U.S. and receives \$100,000 per year. Since 1983, inflation in
the U.S. has reduced his real earnings. From 1983 to 2000, inflation in the U.S.
was 63%. So, his real income (measured in 1983 US dollars) has decreased from
\$100,000 in 1983 to: (\$100,000/1.63) = \$61,349 in 2000, a decrease of 38.7%.
Bruce, who lives in Australia, received US \$100,000 in 1983, which was worth
A\$110,800. In 2000, he also received US\$100,000, which was worth A\$179,900
(in 2000 Australian dollars). Because of Australian inflation (202% since 1983),
his real income in 2000 (measured in 1983 Australian dollars) was:
A\$179,900/2.02 = A\$89,059
Therefore, Bruce’s real income, measured in Australian dollars, has decreased by
19.6%.
15. a. If the law of one price holds, then the bottle of Scotch will cost the same anywhere, which implies that:
US\$22.84 = S\$69

US\$1 = S\$3.02
US\$22.84 = 3240 roubles

US\$1 = 141.9 roubles
1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1
9
8
3
1
9
8
5
1
9
8
7
1
9
8
9
1
9
9
1
1
9
9
3
1
9
9
5
1
9
9
7
1
9
9
9
Year
A
\$
/
U
S
\$
Nominal
Real
275
b. Using the actual exchange rates, the Scotch costs:
\$22.84 in the U.S.
\$42.33 in Singapore
\$12.96 in Moscow
We would prefer to buy our Scotch in Moscow.
16. To determine whether arbitrage opportunities exist, we use the interest
rate theory. For example, we check to see whether the following
relationship between the U.S. and Costaguana holds:
For the different currencies, we have:
Difference in Interest
Rates
Difference between
Spot and Forward
Rates
Costaguana 1.194175 1.194200
Westonia 1.019417 1.019231
Gloccamorra 1.048544 1.064327
Anglosaxophonia 1.010680 0.991304
For Anglosaxophonia and Gloccamorra, there are arbitrage opportunities because
interest rate parity does not hold. For example, one could borrow \$1,019 at 3%
today, convert \$1,000 to 2,300 wasps, and invest at 4.1%. This yields 2,394
wasps in one year. With a forward contract to sell these for dollars, one receives
(2,394/2.28) = \$1,050 dollars in one year. This is just sufficient to repay the
\$1,019 loan. The \$19 difference between the amount borrowed (\$1,019) and the
amount converted to wasps (\$1,000) is risk-free profit today.
17. A major point in finance is that risk is undesirable particularly when it
can be reduced or eliminated. This is the purpose of hedging. At the
time the hedge was initiated, the hedger’s opinion was that sterling
was priced correctly (otherwise the hedge would not have been
placed) and that any deviations from the expected value were
unacceptable.
\$ / pulgas
\$ / pulgas
\$
pulgas
s
f
r 1
r 1
·
+
+
276
18. Future spot prices are rarely equal to forward prices and ex post
rationalization regarding which strategy would have been more
successful is irrelevant since the decision must be made before the
future spot price is known. Recall that forward contract gains or losses
are exactly offset by losses or gains in the underlying transaction and
the forward contract is costless at inception. However, if the
transaction exposure is uncertain because the volume and/or foreign
currency prices of the items bought or sold are unknown, a forward
contract will not match the transaction exposure. In these cases, a
currency option is more appropriate, but the option does have a cost.
Nonetheless, currency options allow the manager to lock in a rate that
will be no greater than the exercise price and allows the firm to benefit
from favorable currency movements.
19.
\$10.12
(1.10)
24.563
(1.10)
24.797
(1.10)
25.033
(1.10)
18.953
(1.10)
19.134
1.10
12.877
78 NPV
6 5 4 3 2
G
· + + + + + + − ·
\$10.26
(1.10)
24.712
(1.10)
24.477
(1.10)
24.244
(1.10)
20.582
(1.10)
20.386
1.10
13.462
80 NPV
6 5 4 3 2 S
· + + + + + + − ·
Sample calculations:
Since both projects have a positive NPV, both should be accepted. If the firm
must choose, then the Swiss plant is the better choice. Note that the NPV
calculation is in dollars and implicitly assumes currency hedging.
12.877
1.06
1.05
10) (1.3 ·
,
`

.
|
× ×
13.462
1.04
1.05
1.5
20
·
,
`

.
|
×
,
`

.
|
277
Challenge Questions
1. a. Revenues are dollars, expenses are Swiss francs: SwissAir stock price will decline.
b. Both revenues and expenses are in a wide range of currencies, none of
which is tied directly to the Swiss franc: Nestle stock price will be
unaffected.
c. All monetary positions are hedged, expenses are Swiss francs: Union Bank stock price will be unaffected or
may increase, depending on the nature of the hedge.
2. Alpha has revenues in euros and expenses in dollars. If the value
of the euro falls, its profit will decrease. In the short run, Alpha
could hedge this exchange risk by entering into a forward contract
to sell euros for dollars.
Omega has revenues in dollars and expenses in euros. If the value of the euro
falls, its profit will increase. In the short run, Omega could hedge this exchange
risk by entering into a forward contract to sell dollars for euros.
278
CHAPTER 29
Financial Analysis and Planning
1. Internet exercise; answers will vary.
2. Internet exercise; answers will vary.
3. Internet exercise; answers will vary.
4. a. The following are examples of items that may not be shown on the company’s books: intangible assets, off-
balance sheet debt, pension assets and liabilities (if the pension plan has a surplus), derivatives positions.
b. The value of intangible assets generally does not show up on the
company’s balance sheet. This affects accounting rates of return because
book assets are too low. It can also make debt ratios seem high, again
because assets are undervalued. Research and development expenditures
are generally recorded as expenses rather than assets, thereby understating
income and understating assets. Patents and trademarks, which can be
extremely valuable assets, are not recorded as assets unless they are
acquired from another company.
c. Inventory profits can increase. Depreciation is understated, as are asset values. Equity income is depressed
because the inflation premium in interest payments is not offset by a reduction in the real value of debt.
5. Individual exercise; answers will vary.
6. The answer, as in all questions pertaining to financial ratios, is, “It
depends on what you want to use the measure for.” For most
purposes, a financial manager is concerned with the market value
of the assets supporting the debt, but, since intangible assets may
be worthless in the event of financial distress, the use of book
values may be an acceptable proxy. You may need to look at the
market value of debt, e.g., when calculating the weighted average
cost of capital. However, if you are concerned with, say, probability
of default, you are interested in what a firm has promised to pay,
not necessarily in what investors think that promise is worth.
279
Looking at the face value of debt may be misleading when comparing firms with
debt having different maturities. After all, a certain payment of \$1,000 ten years
from now is worth less than a certain payment of \$1,000 next year. Therefore, if
the information is available, it may be helpful to discount face value at the risk-
free rate, i.e., calculate the present value of the exercise price on the option to
default. (Merton refers to this measure as the quasi-debt ratio.)
You should not exclude items just because they are off-balance-sheet, but you
need to recognize that there may be other offsetting off-balance-sheet items, e.g.,
the pension fund.
How you treat preferred stock depends upon what you are trying to measure.
Preferred stock is largely a fixed charge that accentuates the risk of the common
stock. On the other hand, as far as lenders are concerned, preferred stock is a
junior claim on firm assets.
Deferred tax reserves arise because companies typically use accelerated
depreciation for tax calculations while they use straight-line depreciation for
financial reporting. In the event that the company’s investment slows down or
ceases, this tax would become payable, but, for most companies, deferred tax
reserves are a permanent feature.
Minority interests arise because the company consolidates all the assets of its
subsidiaries even though some subsidiaries may be less than 100% owned.
Minority interests reflect the portion of the equity of these subsidiaries that is not
owned by the company’s shareholders. For most purposes, it makes sense to
exclude deferred tax and minority interests from measures of leverage.
7. a. Liquidity ratios:
1. Net working capital to total assets =
2.
3.
4.
5.
) (decrease 0.251
300 1450
300) (460 300) (900
·
+
+ − +
) (decrease 1.58
300 460
300 900
ratio Current ·
+
+
·
(decrease) 1.12
300 460
440 300 110
ratio Quick ·
+
+ +
·
(increase) 0.539
300 460
300 110
ratio Cash ·
+
+
·
(increase) days 156.7
365 1980
440 300 110
measure Interval ·
÷
+ +
·
280
b. Leverage ratios:
1. The Debt Ratio and the Debt-Equity Ratio would be unchanged at
0.45 and 0.83, respectively. These calculations involve only long-
term debt, leases and equity, none of which is affected by a short-
term loan that increases cash. However, the Debt Ratio (including
short-term debt) changes from 0.50 to 0.61, as shown below:
2. Times interest earned would decrease because approximately the
same amount would be added to the numerator (interest earned on
the marketable securities) and the denominator (interest expense
associated with the short-term loan).
8. The effect on the current ratio of the following transactions:
a. Inventory is sold ⇒no effect
b. The firm takes out a bank loan to pay its suppliers ⇒no effect
c. A customer pays its overdue bills ⇒no effect
d. The firm uses cash to purchase additional inventories ⇒no effect
9. After the merger, sales will be \$100, assets will be \$70, and profit
will be \$14. The financial ratios for the firms are:
Federal Stores Sara Togas Merged Firm
Sales-to-Assets 2.00 1.00 1.43
Profit Margin 0.10 0.20 0.14
ROA 0.20 0.20 0.20
Note that the calculation of profit is straightforward in one sense, but in
another it is somewhat complicated. Before the merger, Federal’s cost of
goods includes the \$20 it purchases from Sara, and Sara’s cost of goods
sold is: (\$20 - \$4) = \$16. After the merger, therefore, the cost of goods sold
will be: (\$90 - \$20 + \$16) = \$86. With sales of \$100, profit will be \$14.
10. The dividend per share is \$2 and the dividend yield is 4%, so the stock
price per share is \$50. A market-to-book ratio of 1.5 indicates that the
book value per share is 2/3 of the market price, or \$33.33. The number of
outstanding shares is 10 million, so that the book value of equity is \$333.3
million.
0.50
540 450 100
450 100
·
+ +
+
0.61
300 540 450 100
300 450 100
·
+ + +
+ +
281
11. [Note: In the first printing of the seventh edition, Times Interest Earned is
incorrectly stated in this practice question; Times Interest Earned should
be 11.2 rather than 8.]
Total liabilities + Equity = 115 ⇒ Total assets = 115
Total current liabilities = 30 + 25 = 55
Current ratio = 1.4 ⇒ Total current assets = 1.4 × 55 = 77
Cash ratio = 0.2 ⇒ Cash = 0.2 × 55 = 11
Quick ratio = 1.0 ⇒ Cash + Accounts receivable = current liabilities = 55 ⇒
Accounts receivable = 44
Total current assets = 77 = Cash + Accounts receivable + Inventory ⇒
Inventory = 22
Total assets = Total current assets + Fixed assets = 115 ⇒ Fixed assets =
38
Long-term debt + Equity = 115 – 55 = 60
Financial leverage = 0.4 = Long-term debt/(Long-term debt + Equity) ⇒
Long-term debt = 24
Equity = 60 – 24 = 36
Average inventory = (22 + 26)/2 = 24
Inventory turnover = 5.0 = (Cost of goods sold/Average inventory) ⇒
Cost of goods sold = 120
Average receivables = (34 + 44)/2 = 39
Receivables’ collection period = 71.2 = Average receivables/(Sales/365) ⇒
Sales = 200
EBIT = 200 – 120 – 10 – 20 = 50
Times-interest-earned = 11.2 = (EBIT + Depreciation)/Interest ⇒ Interest =
6.27
Earnings before tax = 50 – 6.27 = 43.73
Average total assets = (105 + 115)/2 = 110
Return on total assets = 0.18 = (EBIT – Tax)/Average total assets ⇒ Tax =
30.2
Average equity = (30 + 36)/2 = 33
Return on equity = 0.41 = Earnings available for common stock/average
equity ⇒
Earnings available for common stockholders = 13.53
The result is:
Fixed assets \$38 Sales 200.0
Cash 11 Cost of goods sold 120.0
Accounts receivable 44 Selling, general, and
Total current assets 77 Depreciation 20.0
TOTAL \$115 EBIT 50.0
Equity \$36 Interest 6.27
282
Long-term debt 24 Earnings before tax 43.73
Notes payable 30 Tax 30.20
Accounts payable 25 Available for common 13.53
Total current liabilities 55
TOTAL \$115
12. Two obvious choices are:
a. Total industry income over total industry market value:
Company A B C D E Total
Net income 10 0.5 6.67 -1.0 6.67 22.84
Market value 300 30 120 50.0 120 620
Price/earnings = 620/22.84 = 27.1
b. Average of the individual companies’ P/Es:
Company A B C D E
EPS 3.33 .125 3.35 -.20 .67
Share price 100 5 50 8 10
P/E 30 40 15 -40 15
Average P/E = 12.0
Clearly, the method of calculation has a substantial impact on the result.
The first method is generally preferable. Here, the second method gives
too much weight to Company D, which is a small company and has a
negative P/E that is large in absolute value.
13. Any of the following can temporarily depress or inflate accounting
earnings:
a. Capitalizing or expensing investment in intangibles, e.g., Research
and Development.
b. Straight-line versus accelerated depreciation.
c. LIFO versus FIFO for pricing inventory.
d. Standards for capitalizing leases.
e. Profits on work-in-process.
g. Profits and losses on foreign exchange.
h. Compensation in options rather than cash.
14. Rapid inflation distorts virtually every item on a firm’s balance sheet and
income statement. For example, inflation affects the value of inventory
(and, hence, cost of goods sold), the value of plant and equipment, the
value of debt (both long-term and short-term); and so on. Given these
distortions, the relevance of the numbers recorded is greatly diminished.
283
The presence of debt introduces more distortions. As mentioned above,
the value of debt is affected, but so is the rate demanded by bondholders,
who include the effects of inflation in their lending decisions.
284
15. In 1986, the book value of each airplane was \$0.2 million, while the
market value was \$20 million. In other words, the depreciation charges
used were too high, relative to economic depreciation. Thus, the book
value of assets has understated actual asset value, and reported earnings
have understated actual earnings. This has the following effects on the
firm’s financial ratios:
 Leverage ratios: Because assets were understated, equity has
been understated, and leverage ratios have been overstated (i.e., a
more realistic depreciation schedule would result in a lower debt ratio).
 Liquidity ratios: Some would be unaffected (e.g., the cash ratio)
while others were overstated. For example, a more realistic
depreciation schedule would result in a lower ratio of net working
capital to total assets.
 Profitability ratios: Some would be unaffected (e.g., sales to net
working capital), some would decrease (e.g., sales to average total
needed to determine the impact on return on total assets, for example.
Both the numerator and denominator would increase with a more
realistic depreciation schedule.
 Market value ratios: Some would be unaffected, as long as we
make the assumption (common in finance) that capital markets can
see through the obscurity imposed on the firm’s financial condition by
accounting conventions (e.g., dividend yield). Others would decrease
by using a more realistic depreciation schedule (e.g., the P/E ratio).
short answer is yes. However, one could also argue that the market
certainly has already taken the value of these brand names into
consideration, and any financial analysis that does not do so is poor
indeed. Then too, if one expects to use these numbers for meaningful
comparisons, one must assume that the managers of RHM have correctly
estimated their brand names’ value.
17. All of the financial ratios are likely to be helpful, although to varying
degrees. Presumably those ratios that relate directly to the variability of
earnings and the behavior of the stock price have the strongest
associations with market risk; likely candidates include the debt-equity
ratio and the P/E ratio. Other accounting measures of risk might be
devised by taking five-year averages of these ratios.
18. Answers will vary depending on companies and industries chosen.
285
19. Pro forma financial statements (balance sheets, income statements, and
sources and uses of cash), a description of planned capital expenditures,
and a summary of planned financing.
20. Most financial models are designed to forecast accounting statements.
They do not focus on the factors that directly determine firm value, such
as incremental cash flow or risk.
21. Any discussion of this topic should include the following points:
a. Most models are accounting-based and do not recognize firm value
maximization as the objective of the firm. In other words, key
concepts like incremental cash flow, net present value and market
risk are ignored.
b. Often the “rules” embodied in the model are arbitrarily chosen, and
the decisions they imply are not considered explicitly once the
model has been constructed.
c. Models are expensive to build and maintain.
d. Models are often so complicated that it is difficult to use or to
efficiently make changes to them.
22. Ideally, the financial plan should provide unbiased forecasts. Many times,
however, the financial plan represents the goals of the firm, which exceed
the true expectations.
23. Bottom-up models may be excessively detailed and can prevent
managers from seeing the forest for the trees. However, if the firm has
diverse operations or large, discrete investments, it may be essential to
forecast separately for individual divisions or projects. Thus, we would
expect conglomerates or companies with individually large projects (e.g.,
Boeing) to use a bottom-up approach.
It is easier to express and implement corporate strategy with a top-down
model. We expect to find such models used for homogeneous
businesses, especially where growth is rapid, markets are changing, and
intangible assets are important. Of course, the danger is that such models
lose contact with plant-by-plant, product-by-product developments that are
the activities that actually generate profits and growth.
It is generally easier to evaluate performance if the detail of a bottom-up
model is available.
286
24. The ability to meet or beat the targets embodied in a financial plan is
obviously a reassuring signal of management talent and motivation.
Moreover, the financial plan focuses attention on the specific targets that
top management deems most important. There are, however, several
dangers.
a. Financial plans are usually accounting-based, and thus, are subject
to the biases inherent in book profitability measures.
b. Managers may sacrifice the firm’s best long-term interests in order
to meet the plan’s short- or medium-run targets.
c. Manager A may make all the right decisions, but fail to meet the
plan because of events beyond his control. Manager B may make
the wrong decisions, but be rescued by good luck. In other words,
it may be difficult to separate performance and ability from results.
25. Obviously, problems multiply as the plan attempts to track more and more
detail. But keeping it up-to-date is not just a matter of mechanical
updating. Remember that a plan is the end result of a discussion and
bargaining process involving virtually all top and middle management, at
least to some degree. A completed plan sets performance targets and
governs operating and investment strategies. Completed plans are,
therefore, not scrapped in mid-stream unless a major new problem or
opportunity emerges. Similarly, it is a very time-consuming (and, hence,
expensive) task to update financial plans.
26. A financial model describes a series of relationships among financial
variables. Given these required relationships, it might not be possible to
find a solution unless one variable is unconstrained. This allows all stated
relationships to be met by setting the unconstrained variable, called the
“balancing item,” at the level required so that the Balance Sheet and the
Sources and Uses Statement are reconciled.
If dividends were made the balancing item, then an equation relating
borrowing to some other variable would be required.
27. From Table 29.6, we see that, in 2000, total uses of funds equals 312.
Since total sources of funds equals 153.4, the firm requires 158.6 of
external capital (assuming dividends of 59.0). If no dividends are paid, the
firm’s external financing required is: (\$158.6 - \$59.0) = \$99.6
287
28. In the following table, long-term debt is the balancing item:
Pro Forma Income Statement 1999 2000 2000
(+50%) (+10%)
Revenues 2200.0 3300.0 2420.0
Costs (90% of revenues) 1980.0 2970.0 2178.0
Depreciation (10% of fixed assets at
start of year) 53 .3 55 .0 55 .0
EBIT 166.7 275.0 187.0
Interest (10% of long-term debt at
start of year) 42.5 45.0 45.0
Tax (40% of pretax profit) 49 .7 92 .0 56 .8
Net Income 74.5 138.0 85.2
Operating cash flow 127.8 193.0 140.2
Pro Forma Sources & Uses of Funds 1999 2000
(+50%)
2000
(+10%)
Sources
Net Income 74.5 138.0 85.2
Depreciation 53.3 55.0 55.0
Operating cash flow 127.8 193.0 140.2
Issues of long-term debt 25.0 439.8 64.9
Issues of equity 0.0 0.0 0.0
Total sources 152.8 632.8 205.1
Uses
Investment in net working capital 38.5 220.0 44.0
Increase in fixed assets 71.0 330.0 110.0
Dividends 43.8 82.8 51.1
Total uses 152.8 632.8 205.1
External capital required 25.0 439.8 64.9
Pro Forma Balance Sheet 1999 2000
(+50%)
2000
(+10%)
Net working capital (20% of revenues) 440.0 660.0 484.0
Net fixed assets (25% of revenues) 550 .0 825 .0 605 .0
Total net assets 990.0 1485.0 1089.0
Long-term debt 450.0 889.8 514.9
Equity 540.0 595.2 574.1
Total long-term liabilities and equity 990.0 1485.0 1089.0
The borrowing requirement is much greater if revenues increase by 50% (\$439.8)
than it is if revenues increase by 10% (\$64.9).
288
29. a.
Pro Forma Income Statement 1999 2000 2001
Revenues 2200.0 2860.0 3718.0
Costs (90% of revenues) 1980.0 2574.0 3346.2
Depreciation (10% of fixed assets at
start of year) 53 .3 55 .0 71 .5
EBIT 166.7 231.0 300.3
Interest (10% of long-term debt at
start of year) 42.5 45.0 70.2
Tax (40% of pretax profit) 49 .7 74 .4 92 .0
Net Income 74.5 111.6 138.1
Operating cash flow 127.8 166.6 209.6
Pro Forma Sources & Uses of Funds 1999 2000 2001
Sources
Net Income 74.5 111.6 138.1
Depreciation 53.3 55.0 71.5
Operating cash flow 127.8 166.6 209.6
Issues of long-term debt 25.0 252.4 330.9
Issues of equity 0.0 0.0 0.00
Total sources 152.8 419.0 540.5
Uses
Investment in net working capital 38.5 132.0 171.6
Increase in fixed assets 71.0 220.0 286.0
Dividends 43.8 67.0 82.9
Total uses 152.8 419.0 540.5
External capital required 25.0 252.4 330.9
Pro Forma Balance Sheet 1999 2000 2001
Net working capital (20% of revenues) 440.0 572.0 743.6
Net fixed assets (25% of revenues) 550 .0 715 .0 929 .5
Total net assets 990.0 1287.0 1673.1
Long-term debt 450.0 702.4 1033.3
Equity 540.0 584.6 639.8
Total long-term liabilities and equity 990.0 1287.0 1673.1
b. For the year 2000, the firm’s debt ratio is: (\$702.4/\$1287.0) = 0.546 and
the interest coverage ratio is: (\$231 + \$55)/\$45 = 6.356
For the year 2001, the firm’s debt ratio is: (\$1033.3/\$1673.1) = 0.618 and
the interest coverage ratio is: (\$300.3 + \$71.5)/\$70.2 = 5.296
c. It would be difficult to financing continuing growth at this rate by
borrowing alone. The debt ratio is already very high. If the firm
continued to expand at a 30% rate, then by 2009 the debt ratio would
reach 84%.
289
30. a. & b. [Note: the following solution is based on the assumption that working
capital remains a constant proportion of fixed assets. This assumption is not
stated in the first printing of the seventh edition.]
Pro Forma Income Statement 2001 2002
Revenue 1785.0 2100.0
Fixed costs 53.0 53.0
Variable costs (80% of revenue) 1428.0 1680.0
Depreciation 80 .0 100 .0
EBIT 224.0 267.0
Interest ( at 11.8%) 24.0 28.3
Taxes (at 40%) 80 .0 95 .5
Net Income 120.0 143.2
Operating cash flow 200.0 243.2
Pro Forma Sources & Uses of Funds 2001 2002
Sources
Net Income 120.0 143.2
Depreciation 80.0 100.0
Operating cash flow 200.0 243.2
Issues of long-term debt 36.0 30.0
Issues of equity 104.0 72.3
Total sources 340.0 345.5
Uses
Investment in net working capital 60.0 50.0
Increase in fixed assets 200.0 200.0
Dividends 80.0 95.5
Total uses 340.0 345.5
External capital required 140.0 102.3
Pro Forma Balance Sheet 2001 2002
Net working capital 400.0 450.0
Net fixed assets 800 .0 900 .0
Total net assets 1200.0 1350.0
Long-term debt 240.0 270.0
Equity 960.0 1080.0
Total long-term liabilities and equity 1200.0 1350.0
290
31. [Note: The references to the year 2007 that appear in the first printing of the
seventh edition are incorrect; the relevant year is 2003. Also in the first printing,
Table 29.14 incorrectly states that Dividends are \$80 and Retained earnings are
\$40. These figures should be Dividends: \$120 and Retained earnings: \$0.]
a.
Pro Forma Income Statement 2002 2003
Revenue 1800.0 2250.0
Fixed costs 56.0 56.0
Variable costs (80% of revenue) 1440.0 1800.0
Depreciation 80 .0 80 .0
EBIT 224.0 314.0
Interest ( 8% of beginning-of-year debt) 24.0 24.0
Taxes (at 40%) 80 .0 116 .0
Net Income 120.0 174.0
Operating cash flow 200.0 254.0
Pro Forma Sources & Uses of Funds 2002 2003
Sources
Net Income 120.0 174.0
Depreciation 80.0 80.0
Operating cash flow 200.0 254.0
Issues of long-term debt 0.0 75.0
Issues of equity 0.0 167.0
Total sources 200.0 496.0
Uses
Investment in net working capital 0.0 100.0
Increase in fixed assets 80.0 280.0
Dividends 120.0 116.0
Total uses 200.0 496.0
External capital required 0.0 242.0
Pro Forma Balance Sheet 2002 2003
Net working capital 400.0 500.0
Net fixed assets 800 .0 1000 .0
Total net assets 1200.0 1500.0
Long-term debt 300.0 375.0
Equity 900.0 1125.0
Total long-term liabilities and equity 1200.0 1500.0
291
b.
Pro Forma Income Statement 2002 2003
Revenue 1800.0 2250.0
Fixed costs 56.0 56.0
Variable costs (80% of revenue) 1440.0 1800.0
Depreciation 80 .0 80 .0
EBIT 224.0 314.0
Interest ( 8% of beginning-of-year debt) 24.0 24.0
Taxes (at 40%) 80 .0 116 .0
Net Income 120.0 174.0
Operating cash flow 200.0 254.0
Pro Forma Sources & Uses of Funds 2002 2003
Sources
Net Income 120.0 174.0
Depreciation 80.0 80.0
Operating cash flow 200.0 254.0
Issues of long-term debt 0.0 242.0
Issues of equity 0.0 0.0
Total sources 200.0 496.0
Uses
Investment in net working capital 0.0 100.0
Increase in fixed assets 80.0 280.0
Dividends 120.0 116.0
Total uses 200.0 496.0
External capital required 0.0 242.0
Pro Forma Balance Sheet 2002 2003
Net working capital 400.0 500.0
Net fixed assets 800 .0 1000 .0
Total net assets 1200.0 1500.0
Long-term debt 300.0 542.0
Equity 900.0 958.0
Total long-term liabilities and equity 1200.0 1500.0
The debt ratios are:
For 2002: \$300/\$1200 = 0.250
For 2003: \$542/\$1500 = 0.361
292
32. a. With a growth rate of 15%, total assets will increase to \$3,450,
implying required funding of \$450. With a growth rate of 15% and
using a tax rate of (200/700) = 28.6%, Eagle’s Income Statement
for 2003 will be:
Sales \$1,092.5
Costs 287 .5
EBIT 805.0
Taxes 230 .0
Net Income \$575.0
Dividends will be: (0.6 × \$575) = \$345
Retained earnings will be: (0.4 × \$575) = \$230
Thus, the needed external funds will be: (\$450 - \$230) = \$220
b. Debt must be the balancing item, and will increase by \$220 to a
total value of \$1,220.
c. With no new shares of stock, and debt increased by \$100, the only
other source of the additional \$120 is retained earnings, which must
increase to \$350. Dividends will, thus, be reduced to \$225.
33. a. Internal growth rate = retained earnings/net assets
Internal growth rate = \$230/\$3000 = 0.077 = 7.7%
b.
Equity
NI
NI
RE
equity on Return ratio Plowback rate growth e Sustainabl × · × ·
11.5% 0.115
2000
575
0.4 rate growth e Sustainabl · · × ·
34. a.
assets Net
Equity
ROE ratio Plowback
assets net
earnings retained
rate growth Internal × × · ·
8.0% 0.08 1.0 0.20 0.40
1,000,000
0.40 1,000,000 0.20
rate growth Internal · · × × ·
× ×
·
b. The need for external financing is equal to the increase in assets
less the retained earnings:
(0.30 × 1,000,000) – (0.20 × 1,000,000 × 0.40 = \$220,000
c. With no dividends, the plowback ratio becomes 1.0 and:
293
20.0% 0.20
1,000,000
1.0 1,000,000 0.20
rate growth Internal · ·
× ×
·
d. Retained earnings will now be \$200,000 and the need for external
funds is reduced to \$100,000. Clearly, the more generous the
dividend policy (i.e., the higher the payout ratio), the greater the
need for external financing.
294
Challenge Questions
1. Because both current assets and current liabilities are, by definition, short-
term accounts, ‘netting’ them out against each other and then calculating
the ratio in terms of total capitalization is preferable when evaluating the
safety of long-term debt. Having done this, the bank loan would not be
included in debt.
Whether or not the other accounts (i.e., deferred taxes, R&R reserve, and
the unfunded pension liability) are included in the calculation would
depend on the time horizon of interest. All of these accounts represent
long-term obligations of the firm. If the goal is to evaluate the safety of
Geomorph’s debt, the key question is: What is the maturity of this debt
relative to the obligations represented by these accounts? If the debt has
a shorter maturity, then they should not be included because the debt is,
in effect, a senior obligation. If the debt has a longer maturity, then they
should be included. [It may be of interest to note here that some
companies (e.g., Disney) have recently issued debt with a maturity of 100
years.)
2. Internet exercise; answers will vary.
295
CHAPTER 30
Short-term Financial Planning
1. Unless otherwise stated in the problem, assume all expenses are for cash.
February March April
Sources of cash
Collections on cash sales \$100 \$110 \$90
Collections on A/R 90 100 110
Total sources of cash 190 210 200
Uses of cash
Payments on A/P 30 40 30
Cash purchases of materials 70 80 60
Other expenses 30 30 30
Capital expenditures 100 0 0
Taxes, interest, dividends 10 10 10
Total uses of cash 240 160 130
Net cash inflow -50 50 70
Cash at start of period 100 50 100
+ Net cash inflow -50 50 70
= Cash at end of period 50 100 170
+ Minimum operating cash balance 100 100 100
= Cumulative short-term
financing required \$50 \$0 \$0
2. 30-Day Delay: This quarter it will pay 1/3 of last quarter’s purchases and 2/3 of
this quarter’s.
60-Day Delay: This quarter it will pay 2/3 of last quarter’s purchases and 1/3 of
this quarter’s.
296
3. a. Rise in interest rates: Interest payments on bank loan and interest on
marketable securities
b. Interest on late payments: Stretching payables; net new borrowing.
c. Underpayment of taxes: Cash required for operations.
(Bear in mind, however, that if any of these events were unforeseen, they would
not appear in the financial plan, which is constructed well in advance of the
beginning of the first quarter.)
4. Sources and Uses of Cash:
Sources
Sold marketable securities 2
Increased bank loans 1
Increased accounts payable 5
Cash from operations:
Net income 6
Depreciation 2
Total sources 16
Uses
Increased inventories 6
Increased accounts receivable 3
Invested in fixed assets 6
Dividend 1
Total uses 16
Increase in cash balance 0
Sources and Uses of Funds:
Sources
Cash from operations
Net income 6
Depreciation 2
Total sources 8
Uses
Invested in fixed assets 6
Dividend 1
Total uses 7
Increase in net working capital 1
297
5. The new plan is shown below:
First
Quarter
Second
Quarter
Third
Quarter
Fourth
Quarter
New borrowing:
1. Bank loan 41.50 8.50 0.00 0.00
2. Stretching payables 0.00 7.64 0.00 0.00
3. Total 41.50 16.14 0.00 0.00
Repayments:
4. Bank loan 0.00 0.00 16.59 33.41
5. Stretching payables 0.00 0.00 7.64 0.00
6. Total 0.00 0.00 24.23 33.41
7. Net new borrowing 41.50 16.14 -24.23 -33.41
8. Plus securities sold 5.00 0.00 0.00 0.00
9. Less securities bought 0.00 0.00 0.00 0.65
10. Total cash raised 46.50 16.14 -24.23 -34.06
Interest payments:
11. Bank loan 0.00 1.04 1.25 0.84
12. Stretching payables 0.00 0.00 0.43 0.00
13. Interest on
securities sold 0.00 0.10 0.10 0.10
14. Net interest paid 0.00 1.14 1.78 0.94
15. Cash required for
operations 46.50 15.00 -26.00 -35.00
16. Total cash required 46.50 16.14 -24.23 -34.06
298
6.
First
Quarter
Second
Quarter
Third
Quarter
Fourth
Quarter
Sources of cash:
Collections on A/R 85.0 80.3 108.5 128.0
Other 0.0 0.0 12.5 0.0
Total sources 85.0 80.3 121.0 128.0
Uses of cash:
Payments on A/P 65.0 60.0 55.0 50.0
Labor, administrative, other 30.0 30.0 30.0 30.0
Capital expenditures 2.5 1.3 5.5 8.0
Lease 1.5 1.5 1.5 1.5
Taxes, interest, dividends 4.0 4.0 4.5 5.0
Total uses 103.0 96.8 96.5 94.5
Sources - uses -18.0 -16.5 24.5 33.5
Calculation of short-term financing requirement
1. Cash at start of period 5.0 -13.0 -29.5 -5.0
2. Change in cash balance -18.0 -16.5 24.5 33.5
3. Cash at end of period -13.0 -29.5 -5.0 28.5
4. Min. operating cash bal. 5.0 5.0 5.0 5.0
5. Cumulative short-term
financing required.
18.0 34.5 10.0 -23.5
299
First
Quarter
Second
Quarter
Third
Quarter
Fourth
Quarter
New borrowing:
1. Bank loan 13.00 16.93 0.00 0.00
2. Stretching payables 0.00 0.00 0.00 0.00
3. Total 13.00 16.93 0.00 0.00
Repayments:
4. Bank loan 0.00 0.00 22.81 7.12
5. Stretching payables 0.00 0.00 0.00 0.00
6. Total 0.00 0.00 22.81 7.12
7. Net new borrowing 13.00 16.93 -22.81 -7.12
8. Plus securities sold 5.00 0.00 0.00 0.00
9. Less securities bought 0.00 0.00 0.00 26.10
10. Total cash raised 18.00 16.93 -22.81 -33.22
Interest payments:
11. Bank loan 0.00 0.33 0.75 0.18
12. Stretching payables 0.00 0.00 0.85 0.00
14. Interest on
securities sold 0.00 0.10 0.10 0.10
14. Net interest paid 0.00 0.43 1.69 0.28
16. Cash required for
operations 18.00 16.50 -24.50 -33.50
16. Total cash required 18.00 16.93 -22.81 -33.22
300
7. Newspaper exercise; answers will vary depending on time period.
8. The following assets are most likely to be good collateral:
a ⇒ a tanker load of fuel in transit from the Middle East
c ⇒ an account receivable for office supplies sold to the City of New
York
g ⇒ 100 ounces of gold
h ⇒ a portfolio of Treasury bills
The following assets are likely to be bad collateral:
b ⇒ 1,000 cases of Beaujolais Nouveau, because it might depreciate
quickly and be difficult to value.
d ⇒ an inventory of 15,000 used books, because these are difficult to
value.
e ⇒ a boxcar full of bananas, because it will depreciate quickly.
f ⇒ electric typewriters, because they are obsolete.
i ⇒ a half-completed luxury yacht, because it has little value unless
completed.
9. a ⇒ a tanker load of fuel in transit from the Middle East – The lender
would require a bill of lading.
b ⇒ 1,000 cases of Beaujolais Nouveau – Might be good collateral for a
short-term loan.
c ⇒ an account receivable for office supplies sold to the City of New
York – The lender might require the borrower to obtain credit
insurance.
d ⇒ an inventory of 15,000 used books – The lender would have to be
able to validate the condition and the value of the books.
e ⇒ a boxcar full of bananas – Might be collateral for a very short-term
loan.
f ⇒ electric typewriters – A floor-planning arrangement might be
arranged.
g ⇒ 100 ounces of gold – The bank would require that the gold be held
by another financial institution, and would lend only a fraction of the
current market value. The shorter the term of the loan, the higher
the fraction would be.
h ⇒ a portfolio of Treasury bills – The lender would want to hold the
Treasury bills.
i ⇒ a half-completed luxury yacht – The lender might require the builder
to find a committed buyer for the yacht.
10. It pays to eliminate the middleman (i.e., the bank) when the borrower is a
larger, well-known firm, so that the lender does not require collateral and
301
does not incur costs of credit appraisal. Note that the cost of commercial
paper includes the dealer’s commission plus the cost of a stand-by line of
credit. Note also that companies may wish to maintain a relationship with
the bank in order to be able to obtain other services from the bank, and to
ensure a source of funds if commercial paper is no longer a feasible
alternative source of financing.
11. There are several factors to be considered. First, the scenario described
in the question is what finance companies do, and so you would have to
compete with finance companies. Second, banks have come under
increasing pressure in recent years from the commercial paper market,
and have shown a willingness to lower their rates in order to remain
competitive. Therefore, the competition would be intense, which is
another way of saying that the profit margins will be very thin and,
perhaps, negative for a new firm.
12. Internet exercise; answers will vary.
13. Internet exercise; answers will vary.
14. Internet exercise; answers will vary.
302
Challenge Questions
1. One of the disadvantages of this sort of short-term borrowing is the
uncertainty it creates about future interest payments. Most firms prefer a
known stream of payments. However, the real interest rate may actually
be more certain with successive short-term loans. Also, long-term lending
may carry a higher expected real interest rate if lenders are concerned
Another problem is the cost, in time and money, of having to renegotiate
the loan every period. This is necessary only once with the longer-term
loan. There is one advantage to frequent renegotiations, however. Just
as with privately placed debt, it is possible to have non-standard terms in
the loan contract. Lenders are more likely to accept such terms if they are
not locked into them for a long time.
2. Axle Chemical’s expected requirement for short-term financing is:
(0.5 × \$1,000,000) + (0.2 × \$0) + (0.3 × \$2,000,000) = \$1,100,000
If Axle Chemical takes out a 90-day unsecured loan for \$2 million, then the
interest paid at the end of the 90 days is:
\$2,000,000 × [(1.01
3
) – 1] = \$60,602
Under this arrangement, the expected cash surplus is:
\$2,000,000 - \$1,100,000 = \$900,000
This surplus will earn interest for an average period of 1.5 months at a 9%
annual rate, for total interest of:
\$900,000 × [(1.0075
1.5
) – 1] = \$10,144
Therefore, the expected net cost of borrowing is:
\$60,602 - \$10,144 = \$50,458
If Axle Chemical uses the credit line, then the future value of the \$20,000
commitment fee is:
\$20,000 × 1.01
3
= \$20,606
Assuming that the cash requirement accumulates steadily during the
quarter, the average maturity of the loan is 1.5 months and the expected
interest cost is:
\$1,100,000 × [(1.01
1.5
) – 1] = \$16,541
The total cost of the credit line is therefore: \$20,606 + \$16,541 = \$37,147.
The credit line has the lower expected cost.
303
3. The main points to be considered are:
• The commercial paper is cheaper than the bank loan (9%
compared to 10%). Large firms with good credit ratings can usually
reduce the cost of credit by not borrowing from a bank.
• On the other hand, the firm will need to roll over the commercial
paper ten times. That is acceptable as long as the firm’s credit
rating remains good, but commercial paper can be very expensive
for companies with poor credit ratings, and may even dry up
entirely. Also, liquidity in the commercial paper market varies over
time. For example, during the Russian crisis in 1998, commercial
paper became very expensive. The advantage of the bank loan is
that the company is sure of the availability of the money for five
years and is also certain regarding the margin above the prime
rate. It is also important to note that the commercial paper will
need to be backed by a line of credit, which will increase its cost.
• The floating rate loan from the bank appears to be cheaper than the
11% fixed rate loan from the insurance company, but it is important
to remember that the difference between fixed and floating rates
may indicate an expectation of a rate rise.
• The choice between the fixed-rate and the floating-rate loans may
also depend on whether one or the other better hedges the firm’s
exposure to interest rates. For example, if the firm’s income is
positively related to interest rate levels, it might make sense to
borrow at a floating rate; that is, when the firm’s income is low, its
cost of debt service is also low.
304
CHAPTER 31
Cash Management
1. a. Payment float = 5 × \$100,000 = \$500,000
Availability float = 3 × \$150,000 = \$450,000
Net float = \$500,000 – \$450,000 = \$50,000
b. Reducing the availability float to one day means a gain of:
2 × \$150,000 = \$300,000
At an annual rate of 6%, the annual savings will be:
0.06 × \$300,000 = \$18,000
The present value of these savings is the initial gain of \$300,000. (Or, if you prefer, it is the present value of a
perpetuity of \$18,000 per year at an interest rate of 6% per year, which is \$300,000.)
2. a. Ledger balance = starting balance – payments + deposits
Ledger balance = \$250,000 – \$20,000 – \$60,000 + \$45,000 = \$215,000
b. The payment float is the outstanding total of (uncashed) checks written by the firm, which equals \$60,000.
c. The net float is: \$60,000 - \$45,000 = \$15,000
3. a. Knob collects \$180 million per year, or (assuming 360 days per year) \$0.5 million per day. If the float is reduced by three
days, then Knob gains by increasing average balances by \$1.5 million.
b. The line of credit can be reduced by \$1.5 million, for savings per year of:
1,500,000 × 0.12 = \$180,000
c. The cost of the old system is \$40,000 plus the opportunity cost of the extra float required (\$180,000), or \$220,000 per year. The
cost of the new system is \$100,000. Therefore, Knob will save \$120,000 per year by switching to the new system.
4. Because the bank can forecast early in the day how much money will be paid out, the company does not need to keep extra cash
in the account to cover contingencies. Also, since zero-balance accounts are not held in a major banking center, the
company gains several days of additional float.
5. The cost of a wire transfer is \$10, and the cash is available the same day. The cost of a check is \$0.80 plus the loss of interest for
three days, or:
0.80 + [0.12 × (3/365) × (amount transferred)]
Setting this equal to \$10 and solving, we find the minimum amount transferred is \$9,328.
6. a. The lock-box will collect an average of (\$300,000/30) = \$10,000 per day. The money will be available three days earlier
so this will increase the cash available to JAC by \$30,000. Thus, JAC will be better off accepting the
compensating balance offer. The cost is \$20,000, but the benefit is \$30,000.
305
b. Let x equal the average check size for break-even. Then, the number of checks written per month is (300,000/x) and the monthly
cost of the lock-box is:
(300,000/x) (0.10)
The alternative is the compensating balance of \$20,000. The monthly cost is the lost interest, which is equal to:
(20,000) (0.06/12)
These costs are equal if x = \$300. Thus, if the average check size is greater than \$300, paying per check is less costly; if the
average check size is less than \$300, the compensating balance arrangement is less costly.
c. In part (a), we compare available dollar balances: the amount made available to JAC compared to the amount required for the
compensating balance. In part (b), one cost is compared to another. The interest foregone by holding the compensating balance
is compared to the cost of processing checks, and so here we need to know the interest rate.
7. a. In the 28-month period encompassing September 1976 through December 1978, there are 852 days (365 + 365 + 30 + 31
+30 + 31). Thus, per day, Merrill Lynch disbursed:
\$1,250,000,000/852 = \$1,467,000
306
b. Remote disbursement delayed the payment of:
1.5 × \$1,467,000 = \$2,200,500
That is, remote disbursement shifted the stream of payments back by 1½ days. At an annual interest rate of 8%, the present
value of the gain to Merrill Lynch was:
PV = [2,200,500 × (1.08
(28/12)
– 1)]/[1.08
(28/12)
] = \$361,708
c. If the benefits are permanent, the net benefit is the immediate cash flow of \$2,200,500
d. The gain per day to Merrill Lynch was:
1,467,000 × [1.08
(1.5/365)
- 1] = \$464
Merrill Lynch writes (365,000/852] = 428.4 checks per day Therefore, Merrill Lynch would have been justified in incurring
extra costs of no more than (464/428.4) = \$1.083 per check.
8. Firms may choose to pay by check because of the float available. Wire transfers do not generate float. Also, the payee may not
be a part of the Automated Clearinghouse system.
9. a. An increase in interest rates should decrease cash balances, because an
increased interest rate implies a higher opportunity cost of holding
cash.
e. A decrease in volatility of daily cash flow should decrease cash balances.
f. An increase in transaction costs should increase cash balances and decrease the number of transactions.
10. The problem here is a straightforward application of the Baumol model. The optimal amount to transfer is:
Q = [(2 × 100,000 × 10)/(0.01)]
1/2
= \$14,142
This implies that the average number of transfers per month is:
100,000/14,142 = 7.07
This represents approximately one transfer every four days.
307
11. With an increase in inflation, the rate of interest also increases, which increases the opportunity cost of holding cash. This by
itself will decrease cash balances. However, sales (measured in nominal dollars) also increase. This will increase cash
balances. Overall, the firm’s cash balances relative to sales might be expected to remain essentially unchanged.
12. a. The average cash balance is Q/2 where Q is given by the square root of:
(2 × annual cash disbursements × cost per sale of T-bills)/(annual interest rate)
Thus, if interest rates double, then Q and, hence, the average cash balance, will be reduced to (1/√2) = 0.707 times the previous
cash balance. In other words, the average cash balance decreases by approximately 30 percent.
b. If the interest rate is doubled, but all other factors remain the same, the gain from operating the lock-box also
doubles. In this case, the gain increases from \$72 to \$144.
13. Price of three-month Treasury bill = \$100 – (3/12 × 10) = \$97.50
Yield = (100/97.50)
4
– 1 = 0.1066 = 10.66%
Price of six-month Treasury bill = \$100 – (6/12 × 10) = \$95.00
Yield = (100/95.00)
2
– 1 = 0.1080 = 10.80%
Therefore, the six-month Treasury bill offers the higher yield.
14. The annually compounded yield of 5.19% is equivalent to a five-month yield of:
1.0519
(5/12)
– 1 = 0.021306 = 2.1306%
The price (P) must satisfy the following:
(100/P) – 1 = 0.021306
Therefore: P = \$97.9138
The return for the month is:
(\$97.9138/\$97.50) – 1 = 0.004244
The annually compounded yield is:
1.004244
12
– 1 = 0.0521 = 5.21% (or approximately 5.19%)
15. [Note: In the first printing of the seventh edition, the second sentence of this Practice Question is incorrect; it should read:
“Suppose another month has passed, so the bill has only four months left to run.”]
Price of the four-month bill is: \$100 – (4/12) × \$5 = \$98.33
Return over four months is: (\$100/\$98.33) – 1 = 0.01698 = 1.698%
Yield (on a simple interest basis) is: 0.01698 × 3 = 0.05094 = 5.094%
Realized return over two months is: (\$98.33/\$97.50) – 1 = 0.0085 = 0.85%
16. Answers here will vary depending on when the problem is assigned.
308
17. Let X = the investor’s marginal tax rate. Then, the investor’s after-tax return is the same for taxable and tax-exempt securities,
so that:
0.0589 (1 – X) = 0.0399
Solving, we find that X = 0.3226 = 32.26%, so that the investor’s marginal tax rate is 32.26%.
Numerous other factors might affect an investor’s choice between the two types of securities, including the securities’
respective maturities, default risk, coupon rates, and options (such as call options, put options, convertibility).
18. If the IRS did not prohibit such activity, then corporate borrowers would borrow at an effective after-tax rate equal to [(1 – tax
rate) × (rate on corporate debt)], in order to invest in tax-exempt securities if this after-tax borrowing rate is less than the
yield on tax-exempts. This would provide an opportunity for risk-free profits.
19. For the individual paying 39.1 percent tax on income, the expected after-tax yields are:
a. On municipal note: 6.5%
b. On Treasury bill: 0.10 × (1 – 0.391) = 0.0609 = 6.09%
c. On floating-rate preferred: 0.075 × (1 – 0.391) = 0.0457 = 4.57%
For a corporation paying 35 percent tax on income, the expected after-tax yields are:
a. On municipal note: 6.5%
b. On Treasury bill: 0.10 × (1 – 0.35) = 0.065 = 6.50%
c. On floating-rate preferred (a corporate investor excludes from taxable income 70% of dividends paid by another
corporation):
Tax = 0.075 × (1 - 0.70) × 0.35 = 0.007875
After-tax return = 0.075 – 0.007875 = 0.067125 = 6.7125%
Two important factors to consider, other than the after tax yields, are the credit risk of the issuer and the effect of interest
rate changes on long-term securities.
20. The limits on the dividend rate increase the price variability of the floating-rate preferreds. When market rates move past the
limits, so that further adjustments in rates are not possible, market prices of the securities must adjust so that the dividend
rates can adjust to market rates. Companies include the limits in order to reduce variability in corporate cash flows.
Challenge Questions
1. Corporations exclude from taxable income 70% of dividends paid by another corporation. Therefore, for a corporation
paying a 35% income tax rate, the effective tax rate for a corporate investor in preferred stock is 10.5%, as shown in
Section 31.5 of the text. Therefore, if risk were not an issue, the yield on preferreds should be equal to [(1 – 0.35)/0.895] =
0.726 = 72.6% of the yield on Treasury bills. Of course this is a lower limit because preferreds are both riskier and less
liquid than Treasury bills.
309
CHAPTER 32
Credit Management
1. a. There is a 2% discount if the bill is paid within 30 days of the invoice
date; otherwise, the full amount is due within 60 days.
b. The full amount is due within 10 days of invoice.
c. There is a 2% discount if payment is made within 5 days of the end of the
month; otherwise, the full amount is due within 30 days of the invoice
date.
2. a. Paying in 60 days (as opposed to 30) is like paying interest of \$2 on a \$98
loan for 30 days. Therefore, the equivalent annual rate of interest, with
compounding, is:
27.86% .2786 0 1
98
100
30) / (365
· · −
,
`

.
|
b. No discount.
c. For a purchase made at the end of the month, these terms allow the buyer
to take the discount for payments made within five days, or to pay the full
amount within thirty days. For these purchases, the interest rate is
computed as follows:
34.31% .3431 0 1
98
100
25) / (365
· · −
,
`

.
|
For a purchase made at the beginning of the month, these terms allow the
buyer to take the discount for payments made within thirty-five days, or to
pay the full amount within thirty days of the purchase. Clearly, under
these circumstances, the buyer will take the discount and pay within thirty-
five days. The interest rate is negative.
3. When the company sells its goods cash on delivery, for each \$100 of sales, costs are
\$95 and profit is \$5. Assume now that customers take the cash discount offered
under the new terms. Sales will increase to \$104, but after rebating the cash
discount, the firm receives: (0.98 × \$104) = \$101.92
Since customers pay with a ten-day delay, the present value of these sales is:
\$101.757
1.06
\$101.92
(10/365)
·
310
Since costs remain unchanged at \$95, profit becomes:
\$101.757 - \$95 = \$6.757
If customers pay on day 30 and sales increase to \$104, then the present
value of these sales is:
\$103.503
1.06
\$104
(30/365)
·
Profit becomes: (\$103.503 - \$ 95) = \$8.503
In either case, granting credit increases profits.
4. The more stringent policy should be adopted because profit will
increase. For every \$100 of current sales:
Current Policy More Stringent Policy
Sales \$100.0 \$95.0
Less: Cost of Goods** 80.0 76.0
Profit \$14.0 \$15.2
* 6% of sales under current policy; 4% under proposed policy
** 80% of sales
5. Consider the NPV (per \$100 of sales) for selling to each of the four groups:
Classification NPV per \$100 Sales
1
2
3
4
If customers can be classified without cost, then Velcro should sell only to
Groups 1, 2 and 3. The exception would be if non-defaulting Group 4
accounts subsequently became regular and reliable customers (i.e.,
members of Group 1, 2 or 3). In that case, extending credit to new Group
4 customers might be profitable, depending on the probability of repeat
\$13.29
1.15
0) (1 100
85
365 / 45
·
− ×
+ −
\$11.44
1.15
.02) 0 (1 100
85
365 / 42
·
− ×
+ −
3.63 \$
1.15
.10) 0 (1 100
85
365 / 40
·
− ×
+ −
7.41 \$
1.15
0.20) (1 100
85
365 / 80
− ·
− ×
+ −
311
6. By making a credit check, Velcro Saddles avoids a \$7.41 loss per \$100 sale
25 percent of the time. Thus, the expected benefit (loss avoided) from a credit
check is:
0.25 × 7.41 = \$1.85 per \$100 of sales, or 1.85%
A credit check is not justified if the value of the sale is less than x, where:
0.0185 x = 95
x = \$5,135
7. Original terms:
\$17.70
1.12
100
80 sales \$100 per NPV
365 / 75
· + − ·
Changed terms: Assume the average purchase is at mid-month and that the
months have 30 days.
\$17.27
1.12
100) (0.40
1.12
98) (0.60
80 sales \$100 per NPV
365 / 80 365 / 30
·
×
+
×
+ − ·
8. For every \$100 of prior sales, the firm now has sales of \$102. Thus, the cost of goods
sold increases by 2%, as do sales, both cash discount and net:
9. Some of the most important ratios to consider are:
(1) Measures of leverage: debt ratio, times-interest-earned
(2) Measures of liquidity: cash ratio, quick ratio
(3) Measures of profitability: return on assets
(4) Measures of efficiency: especially important is the average
collection period.
(5) Market-value ratios: such as the market-to-book ratio
Identifying the least informative ratios depends on the circumstances.
However, some points to note in this regard are:
(1) Efficiency ratios are often difficult to interpret.
(2) Liquidity ratios may be misleading in some circumstances, for
example, if a company has an unused line of credit.
(3) A high price-earning ratio might be the result of temporarily low
earnings.
\$17.62 17.27 1.02 sales initial of \$100 per NPV · × ·
312
10. Some common problems are:
a. Dishonest responses (usually not a significant problem).
b. The company never learns what would have happened to rejected
applicants, nor can it revise the coefficients to allow for changing
customer behavior.
c. The credit scoring system can only be used to separate (fairly obvious)
sheep from goats.
d. Mechanical application may lead to social and legal problems (e.g.,
red-lining)
e. The coefficient estimation data are, of necessity, from a sample of actual
loans; in other words, the estimation process ignores data from loan
applications that have been rejected. This can lead to biases in the credit
scoring system.
f. If a company overestimates the accuracy of the credit scoring system, it
will reject too many applicants. It might do better to ignore credit scores
altogether and offer credit to everyone.
11. In real life:
a. Repeat orders are not certain, even if the customer pays for the first one.
b. Customers might make partial or delayed payments.
c. There are more than two periods.
d. Order size is not constant.
e. The probabilities of payment are unknown.
The complexity of these factors means that experience and judgement are
necessary in the management of credit; scientific models, while helpful,
cannot do the entire job.
12. a. Other things equal, it makes more sense to grant credit when the profit
margin is high. The expected profit from offering credit (where p is
the probability of payment) is:
[p × PV(REV – COST)] – [( 1 – p) × PV(COST)]
Rearranging, expected profit is:
PV(REV – COST) – [( 1 – p) × PV(REV)]
If the difference between revenue and cost is small, then extending
credit is more likely to result in a loss. Suppose that, for example,
the profit margin is 10% so that PV(REV) = \$100 and PV(COST) =
\$90, and the probability of payment is p = 90% (so that the
probability of default is 10%). Then the firm breaks even: [\$100 -
\$90 – (0.10 × \$100)] = \$0
If the profit margin is only 5% and the probability of default remains
at 10%, the result is a loss: [\$100 - \$95 – (0.10 × \$100)] = -\$5
313
b. Other things equal, it is more costly to grant credit when
interest rates are high. Since the effect of granting credit is
to postpone receipt of revenues, the present value of
revenues is reduced by high interest rates. Suppose that,
for example, the only effect of granting credit is to postpone
payment by 30 days. If the interest rate is 10%, this reduces
PV(REV) by:
1.10
(30/365)
– 1 = 0.0079 = 0.79%
If the rate is 5%, then PV(REV) is reduced by:
1.05
(30/365)
– 1 = 0.0040 = 0.40%
c. If the probability of repeat orders is high, you should be more
willing to grant credit because, if the customer pays
promptly, you may then have a regular customer who is less
likely to default in the future. (Page 917 of the text provides
a numerical example.)
13. Internet exercise; answers will vary.
14. Internet exercise; answers will vary.
314
Challenge Questions
1. If the alternative is to literally pay cash on delivery, it is clearly not
 Deliveries of materials take place on a recurring basis, and it is simpler for
customers to pay on statement rather than invoice.
 Large items of equipment may take considerable time to install and check
out, and customers will want to delay payment until they are sure
everything is working.
A more reasonable question is why firms do not charge interest, e.g., from
date of invoice. The answer is partly the cost of calculation and
enforcement. Also, credit is often used as a tool for price discrimination;
powerful customers obtain an effective price cut by delaying payment.
2. Captive finance companies may offer organizational and marketing
benefits, in addition to financial gains. Because the assets of
captive finance companies are homogenous and relatively low risk,
these finance companies can offer large amounts of high-quality,
easily analyzed commercial paper, thus utilizing a relatively cheap
source of funds. It would be more difficult for the market to monitor
debt quality if the parent borrowed directly against both the
receivables and fixed assets.
3. [Note: in the following solution, we have assumed an interest rate of
10%.]
At a purchase price of \$10, the sales of 30,000 umbrellas will generate
\$300,000 in sales and \$47,000 in profit. It follows that the cost of goods
sold is:
(\$300,000 - \$47,000)/30,000 = \$8.43 per umbrella
Assume that, if Plumpton pays, it does so on the due date. Then, at a 10
percent interest rate, the net present value of profit per umbrella is:
NPV per umbrella = PV(Sales price) - Cost of goods
NPV per umbrella = [10/(1.10)
(60 /365)
] - 8.43 = \$1.41
(If Plumpton pays 30 days slow, i.e., in 90 days, then the NPV falls to
\$1.34)
Thus, the sales have a positive NPV if the probability of collection exceeds
86 percent. However, if Reliant thinks this sale may lead to more
profitable sales in Nevada, then it may go ahead even if the probability of
collection is less than 86 percent.
315
Relevant credit information includes a fair Dun and Bradstreet rating, but
some indication of current trouble (i.e., other suppliers report Plumpton
paying 30 days slow) and indications of future trouble (a pending re-
negotiation of a term loan). Financial ratios can be calculated and
compared with those for the industry.
Debt ratio = 0.15
Net working capital / total assets = 0.39
Current ratio = 2.2
Quick ratio = 0.40
Sales / total assets = 3.0
Net profit margin = 0.020 = 2.0%
Inventory turnover = 2.9
Return on total assets = 0.059 = 5.9%
Return on equity = 0.054 = 5.4%
Some things the credit manager should consider are:
i. What does the stock market seem to be saying about
Plumpton?
ii. How critical is the term loan renewal? Can we get more
decision until after renewal?
iii. Is there any way to make the debt more secure, e.g., use a
promissory note, time draft, or conditional sale?
iv. Should Reliant seek to reduce risk, e.g., by a lower initial
order or credit insurance? How painful would default be to
Reliant?
v. What alternatives are available? Are there better ways to
enter the Nevada market? What is the competition?
4. a. For every \$100 in current sales, Galenic has \$5.0 profit, ignoring
bad debts. This implies the cost of goods sold is \$95.0. If the bad
debt ratio is 1%, then per \$100 sales the bad debts will be \$1 and
actual profit will be \$4.0, a net profit margin of 4%.
b. Sales will fall to 91.6% of their previous level (9,160/10,000),
or to \$91.6 per \$100 of original sales. With a cost of goods
sold ratio of 95%, CGS will be \$87.0. Bad debts will be:
(0.007 × 91.6) = \$0.64
Therefore, the profit under the new scoring system, per \$100 of
original sales, will be \$4.0. Profit will be unaffected.
c. There are many reasons why the predicted and actual
default rates may differ. For example, the credit scoring
system is based on historical data and does not allow for
changing customer behavior. Also, the estimation process
316
ignores data from loan applications that have been rejected,
which may lead to biases in the credit scoring system. If a
company overestimates the accuracy of the credit scoring
system, it will reject too many applications.
d. If one of the variables is whether the customer has an
account with Galenic, the credit scoring system is likely to be
biased because it will ignore the potential profit from new
customers who might generate repeat orders.
317
CASES
318
Case 1
Valuation of an Acquisition Using Real Options
Intel is considering the purchase of Hannover-Ceramics, Inc., a firm that has just
patented a replacement for the silicon wafer, the arsenicon-dithurate wafer. As a result,
Intel estimates that it will be able to manufacture a new generation of processor, with
speeds upwards of 250 gigabytes. However, the current production method calls for the
use of amenocebic acid, a naturally occurring substance with a cost of \$200 per ounce.
Each wafer requires, on average, 4 ounces of the acid to produce. Due to this limitation,
the economic feasibility of this investment remains unclear.
Intel engineers have invested \$400 million and over 4000 work-hours over the
past two years to develop a less expensive substitute for amenocebic acid. They have a
potential substitute known as Carlinium, named in honor of the inventor. This substance,
while far less expensive to produce (\$50/ounce), requires 3 ounces to produce one wafer.
More importantly, there is evidence that Carlinium is a very carcinogenic substance and
may be banned by the EPA. There is currently a study underway to investigate whether
Carlinium is, in fact, dangerous. Preliminary evidence suggests there is a 1 in 3 chance
that Carlinium is poisonous, though the final results of the tests will not be known for 12
months. If Carlinium is proven to cause cancer, Intel will be forced to use the more
expensive amenocebic acid for production and to price the chips accordingly. As a result
of the higher price of the chips, demand is expected to be far less.
Intel will need to build a production facility regardless of the process they use
(amenocebic or Carlinium). The cost of this plant will be \$450 million and will require
one year to come online. Intel already owns the land where the new facility can reside.
Assume that the land has no opportunity cost. You will depreciate this investment using
straight-line depreciation over 10 years. After 10 years of production, you anticipate that
the next generation of processor material will have made arsenicon-dithurate obsolete and
the production facility valueless.
Intel, however, is not in a position that they can wait until the safety of Carlinium
is known to decide whether to purchase Hannover-Ceramics. Motorola, a prime
competitor of Intel, has been rumored to be nearing completion of their own substitute for
amenocebic acid and may try to acquire Hannover-Ceramics before the end of the year.
There are three public firms in the same industry as Hannover-Ceramics, and all
four firms are exclusively equity financed. The following table reports the current stock
prices, 52-week highs and lows, and standard deviation of returns over the past 10
months:

319
Firm
Current
Price
52-week
High
52-week Low
Standard
Deviation
β
equity
Hannover-
Ceramics Inc.
Private Firm
Computer
Internal Inc.
\$75.25 \$125.00 \$75.25 30% 1.65
New Age
Materials Corp.
\$23.45 \$26.13 \$22.63 22% 1.7
Dyne-Ceramic \$54.88 \$110.08 \$17.25 44% 2.1
Current market returns are averaging 10% and the risk-free interest rate is 4%.
The incremental number of units sold per year and price per unit are detailed in
Table 2 under two different scenarios (using Carlinium or Amenocebic acid). In addition
to the price of Carlinium or amenocebic acid, each chip requires an average labor cost of
\$15 and \$25 in other expenses to produce. Assume that there is no require working
capital for this project and that the corporate tax rate is 35%.
Table 2 Carlinium Acid Amenocebic Acid
Year
Millions of
chips
Price/Chip (\$)
Thousands of
chips
Price/Chip (\$)
1 2.5 500 200 1,400
2 3 500 150 1,200
3 3 450 75 1,100
4 4.5 425 75 1,050
5 4 350 65 1,050
6 4.5 300 65 1,050
7 4.5 250 50 950
8 4.5 250 50 950
9 3.5 250 35 875
10 2 250 30 875
Question #1: What is the NPV of this project?
Question #2: What is the value of the option? (Net of the NPV).
Question #3: Should Intel attempt to purchase Hannover-Ceramics and, if so, what is the
maximum price that can be paid?
Your analysis should be summarized in the form of a 1-2 page executive summary, with
attached appendixes. DO NOT be cavalier or “cute” in your write-up; write as
professional of a document as you are able.
You should briefly state any assumptions that you make in your analysis.
320
Case 2
ACFI 701 Case #2
This case requires you to accomplish several tasks related to compensation, governance,
and acquisitions. All cases MUST be typed (25% reduction for hand-written material),
single-spaced, free of grammatical and typographical errors, and submitted to me no later
than Wednesday, May 5
th
, at the end of class. Major grammatical and all typographical
errors will be penalized 5% each, up to 50% of the grade, so plan to proofread your case
very carefully before submitting it to me. You should probably also have someone else
I will be leaving town right after class on Wednesday and not returning until after the
weekend and will likely not have access to email while I am away. Thus, late cases, by
which I mean ANY case submitted to me in any form after the end of class on
Wednesday, will be considered late and will automatically be marked down by 15%. I
will plan to submit the case to me early so that any last minute disasters (faulty disks,
failures of the printer, consumption by a household pet, etc…) can be avoided.
The case is somewhat lengthy and will require a fair amount of time to complete. I am
quite confident that if you wait until one or two days before the case is due to begin
working on it, you will struggle to complete it before the deadline. I will not be available
during the early part of the week that the case is due to help students start the project. In
addition, in order to me fair to everyone, I will not be able to provide too many insights
into exactly how to solve this case. I can answer questions to clarify what you are being
asked to accomplish, but it is up to you to decide what is the correct method to answer the
questions.
You should respond to each of the questions/tasks below on a separate sheet of paper.
All responses should be typed, including tables. If you are unfamiliar with creating tables
in Word, the help feature is quite good and I can clear up any questions you have AFTER
you have tried the help feature.
Some ideas:
You may want to get some ideas of how to answer many of the questions by looking at
what exactly real firms in the industry do. A good place to get information about
companies is from their annual reports and proxy statements. The proxy, in particular,
gives information about compensation policy and board structures. You can find proxies
for the vast majority of traded companies online at EDGAR, which can be accessed
(there is an underscore between “s” and “secfile”). Although you may certainly use other
companies for ideas, do not simply copy the text, as this is both plagiarism and will
321
Question #1) This case is based on a real firm, although I have changed the names and
some of the facts.
You are the chairperson of the compensation committee for a biotechnology corporation.
Two highly qualified individuals are being considered for the CEO post left vacant by the
retirement of the company’s former CEO. Given the information below about each
candidate, design what you consider to be the optimal compensation policy for each
candidate. You policy should include many if not all of the four elements of
compensation we described in class. You should carefully, and yet concisely, justify
each of your recommendations (salary, bonus, option/stock grants (including vesting
periods and exercise price)). Use, at most, one typed page to describe and justify the
policy for each candidate (so 2 pages maximum for this question).
“expertise in rapid, high-capacity antibody development, enabling high throughput screening
of potential diagnostic markers and cost-efficient development of high affinity antibodies for
use in commercialized products”.
Your company is average-sized for the industry, though certainly not the largest.
Although your firm has several patented products that is sells, many of the patents are
aging and the products are being overtaken with newer, more effective methods of
diagnosing health problems. Your firm needs to get back into the game with some
valuable products, which will require diligent work on the part of the CEO and the firm’s
scientists. Also note, the biotechnology sector is very competitive with many patentable
ideas failing at the trial stage. Success in the area is generally considered a combination
of very hard work, very innovative techniques, and not a small amount of luck.
Competitors in this industry (over 60 of them) include OSI Pharmaceuticals,
Immunomedics, Immucell, Human Genome Sciences, and Gene Logic.
Candidate #1:
Dr. Jane Stewart-Regan is a 35-year old entrepreneur, and former university professor,
who has successfully brought 2 companies from the start-up stage through an IPO in the
past seven years. A “wiz-kid” out of Stanford, she is currently the CEO of the second of
these firms. Her Ph.D. is in bimolecular mechanics, and she has an executive MBA from
Harvard. She has a reputation as an aggressive spender, who likes to gamble on “home-
run” type projects (which is how each of her two IPO firms became very successful).
Candidate #2:
Nathan Reilly is a 58-year old vice president of a large car manufacturer. He has an
MBA from Berkeley, and has worked in many positions for many different firms over the
years. He has as a reputation as a hard-worker who likes cost-cutting measures, is quite
frugal with firm resources, and believes his primary mission is to preserve the wealth of
the shareholders who have invested in the firm.
322
Question #2) Randomly pick a publicly traded firm in the U.S that has been around since
at least 1998. Using the information contained in this firm’s proxy statements from 1998
and 2003, document and evaluate what changes, if any, have taken place with the internal
governance structure of the firm. Your should make clear the firm that you are
analyzing. Did the firm conform to the provisions of Sarbanes-Oxley in 1998? What
about in 2003? What are the major weaknesses of the governance structure? If you
could make one improvement in the board, what would it be and why? Limit your
response to this question to 2 pages.
Question #3) In some countries, the initial bidder in a takeover contest is allowed to
revise their bid, but subsequent bidders are not permitted to revise their bids. What do
you imagine is the reason for this rule? If this rule were introduced in the U.S., what
impact would you predict that it would have on overall takeover premiums? Would
target shareholders, bidder shareholders, everyone, or no one gain from its introduction
into the U.S.? Justify your response. Limit your response to a single page.
Solution Case 2
ACFI 701 Case #2
This case requires you to accomplish several tasks related to compensation, governance,
and acquisitions. All cases MUST be typed (25% reduction for hand-written material),
single-spaced, free of grammatical and typographical errors, and submitted to me no later
than Wednesday, May 5
th
, at the end of class. Major grammatical and all typographical
errors will be penalized 5% each, up to 50% of the grade, so plan to proofread your case
very carefully before submitting it to me. You should probably also have someone else
I will be leaving town right after class on Wednesday and not returning until after the
weekend and will likely not have access to email while I am away. Thus, late cases, by
which I mean ANY case submitted to me in any form after the end of class on
Wednesday, will be considered late and will automatically be marked down by 15%. I
will plan to submit the case to me early so that any last minute disasters (faulty disks,
failures of the printer, consumption by a household pet, etc…) can be avoided.
The case is somewhat lengthy and will require a fair amount of time to complete. I am
quite confident that if you wait until one or two days before the case is due to begin
working on it, you will struggle to complete it before the deadline. I will not be available
during the early part of the week that the case is due to help students start the project. In
addition, in order to me fair to everyone, I will not be able to provide too many insights
into exactly how to solve this case. I can answer questions to clarify what you are being
323
asked to accomplish, but it is up to you to decide what is the correct method to answer the
questions.
You should respond to each of the questions/tasks below on a separate sheet of paper.
All responses should be typed, including tables. If you are unfamiliar with creating tables
in Word, the help feature is quite good and I can clear up any questions you have AFTER
you have tried the help feature.
Some ideas:
You may want to get some ideas of how to answer many of the questions by looking at
what exactly real firms in the industry do. A good place to get information about
companies is from their annual reports and proxy statements. The proxy, in particular,
gives information about compensation policy and board structures. You can find proxies
for the vast majority of traded companies online at EDGAR, which can be accessed
(there is an underscore between “s” and “secfile”). Although you may certainly use other
companies for ideas, do not simply copy the text, as this is both plagiarism and will
324
Question #1) This case is based on a real firm, although I have changed the names and
some of the facts.
You are the chairperson of the compensation committee for a biotechnology corporation.
Two highly qualified individuals are being considered for the CEO post left vacant by the
retirement of the company’s former CEO. Given the information below about each
candidate, design what you consider to be the optimal compensation policy for each
candidate. You policy should include many if not all of the four elements of
compensation we described in class. You should carefully, and yet concisely, justify
each of your recommendations (salary, bonus, option/stock grants (including vesting
periods and exercise price)). Use, at most, one typed page to describe and justify the
policy for each candidate (so 2 pages maximum for this question).
“expertise in rapid, high-capacity antibody development, enabling high throughput screening
of potential diagnostic markers and cost-efficient development of high affinity antibodies for
use in commercialized products”.
Your company is average-sized for the industry, though certainly not the largest.
Although your firm has several patented products that is sells, many of the patents are
aging and the products are being overtaken with newer, more effective methods of
diagnosing health problems. Your firm needs to get back into the game with some
valuable products, which will require diligent work on the part of the CEO and the firm’s
scientists. Also note, the biotechnology sector is very competitive with many patentable
ideas failing at the trial stage. Success in the area is generally considered a combination
of very hard work, very innovative techniques, and not a small amount of luck.
Competitors in this industry (over 60 of them) include OSI Pharmaceuticals,
Immunomedics, Immucell, Human Genome Sciences, and Gene Logic.
Candidate #1:
Dr. Jane Stewart-Regan is a 35-year old entrepreneur, and former university professor,
who has successfully brought 2 companies from the start-up stage through an IPO in the
past seven years. A “wiz-kid” out of Stanford, she is currently the CEO of the second of
these firms. Her Ph.D. is in bimolecular mechanics, and she has an executive MBA from
Harvard. She has a reputation as an aggressive spender, who likes to gamble on “home-
run” type projects (which is how each of her two IPO firms became very successful).
Candidate #2:
Nathan Reilly is a 58-year old vice president of a large car manufacturer. He has an
MBA from Berkeley, and has worked in many positions for many different firms over the
years. He has as a reputation as a hard-worker who likes cost-cutting measures, is quite
frugal with firm resources, and believes his primary mission is to preserve the wealth of
the shareholders who have invested in the firm.
325
Question #2) Randomly pick a publicly traded firm in the U.S that has been around since
at least 1998. Using the information contained in this firm’s proxy statements from 1998
and 2003, document and evaluate what changes, if any, have taken place with the internal
governance structure of the firm. Your should make clear the firm that you are
analyzing. Did the firm conform to the provisions of Sarbanes-Oxley in 1998? What
about in 2003? What are the major weaknesses of the governance structure? If you
could make one improvement in the board, what would it be and why? Limit your
response to this question to 2 pages.
Question #3) In some countries, the initial bidder in a takeover contest is allowed to
revise their bid, but subsequent bidders are not permitted to revise their bids. What do
you imagine is the reason for this rule? If this rule were introduced in the U.S., what
impact would you predict that it would have on overall takeover premiums? Would
target shareholders, bidder shareholders, everyone, or no one gain from its introduction
into the U.S.? Justify your response. Limit your response to a single page.
326
Case 3
ACFI 701 Case #3
This case requires you to accomplish several tasks related to compensation, governance,
and acquisitions. All cases MUST be typed (25% reduction for hand-written material),
single-spaced, free of grammatical and typographical errors, and submitted to me no later
than Wednesday, May 5
th
, at the end of class. Major grammatical and all typographical
errors will be penalized 5% each, up to 50% of the grade, so plan to proofread your case
very carefully before submitting it to me. You should probably also have someone else
I will be leaving town right after class on Wednesday and not returning until after the
weekend and will likely not have access to email while I am away. Thus, late cases, by
which I mean ANY case submitted to me in any form after the end of class on
Wednesday, will be considered late and will automatically be marked down by 15%. I
will plan to submit the case to me early so that any last minute disasters (faulty disks,
failures of the printer, consumption by a household pet, etc…) can be avoided.
The case is somewhat lengthy and will require a fair amount of time to complete. I am
quite confident that if you wait until one or two days before the case is due to begin
working on it, you will struggle to complete it before the deadline. I will not be available
during the early part of the week that the case is due to help students start the project. In
addition, in order to me fair to everyone, I will not be able to provide too many insights
into exactly how to solve this case. I can answer questions to clarify what you are being
asked to accomplish, but it is up to you to decide what is the correct method to answer the
questions.
You should respond to each of the questions/tasks below on a separate sheet of paper.
All responses should be typed, including tables. If you are unfamiliar with creating tables
in Word, the help feature is quite good and I can clear up any questions you have AFTER
you have tried the help feature.
Some ideas:
You may want to get some ideas of how to answer many of the questions by looking at
what exactly real firms in the industry do. A good place to get information about
companies is from their annual reports and proxy statements. The proxy, in particular,
gives information about compensation policy and board structures. You can find proxies
for the vast majority of traded companies online at EDGAR, which can be accessed
(there is an underscore between “s” and “secfile”). Although you may certainly use other
companies for ideas, do not simply copy the text, as this is both plagiarism and will
327
Question #1) This case is based on a real firm, although I have changed the names and
some of the facts.
You are the chairperson of the compensation committee for a biotechnology corporation.
Two highly qualified individuals are being considered for the CEO post left vacant by the
retirement of the company’s former CEO. Given the information below about each
candidate, design what you consider to be the optimal compensation policy for each
candidate. You policy should include many if not all of the four elements of
compensation we described in class. You should carefully, and yet concisely, justify
each of your recommendations (salary, bonus, option/stock grants (including vesting
periods and exercise price)). Use, at most, one typed page to describe and justify the
policy for each candidate (so 2 pages maximum for this question).
“expertise in rapid, high-capacity antibody development, enabling high throughput screening
of potential diagnostic markers and cost-efficient development of high affinity antibodies for
use in commercialized products”.
Your company is average-sized for the industry, though certainly not the largest.
Although your firm has several patented products that is sells, many of the patents are
aging and the products are being overtaken with newer, more effective methods of
diagnosing health problems. Your firm needs to get back into the game with some
valuable products, which will require diligent work on the part of the CEO and the firm’s
scientists. Also note, the biotechnology sector is very competitive with many patentable
ideas failing at the trial stage. Success in the area is generally considered a combination
of very hard work, very innovative techniques, and not a small amount of luck.
Competitors in this industry (over 60 of them) include OSI Pharmaceuticals,
Immunomedics, Immucell, Human Genome Sciences, and Gene Logic.
Candidate #1:
Dr. Jane Stewart-Regan is a 35-year old entrepreneur, and former university professor,
who has successfully brought 2 companies from the start-up stage through an IPO in the
past seven years. A “wiz-kid” out of Stanford, she is currently the CEO of the second of
these firms. Her Ph.D. is in bimolecular mechanics, and she has an executive MBA from
Harvard. She has a reputation as an aggressive spender, who likes to gamble on “home-
run” type projects (which is how each of her two IPO firms became very successful).
Candidate #2:
Nathan Reilly is a 58-year old vice president of a large car manufacturer. He has an
MBA from Berkeley, and has worked in many positions for many different firms over the
years. He has as a reputation as a hard-worker who likes cost-cutting measures, is quite
frugal with firm resources, and believes his primary mission is to preserve the wealth of
the shareholders who have invested in the firm.
328
Question #2) Randomly pick a publicly traded firm in the U.S that has been around since
at least 1998. Using the information contained in this firm’s proxy statements from 1998
and 2003, document and evaluate what changes, if any, have taken place with the internal
governance structure of the firm. Your should make clear the firm that you are
analyzing. Did the firm conform to the provisions of Sarbanes-Oxley in 1998? What
about in 2003? What are the major weaknesses of the governance structure? If you
could make one improvement in the board, what would it be and why? Limit your
response to this question to 2 pages.
Question #3) In some countries, the initial bidder in a takeover contest is allowed to
revise their bid, but subsequent bidders are not permitted to revise their bids. What do
you imagine is the reason for this rule? If this rule were introduced in the U.S., what
impact would you predict that it would have on overall takeover premiums? Would
target shareholders, bidder shareholders, everyone, or no one gain from its introduction
into the U.S.? Justify your response. Limit your response to a single page.
329
Questions for Final.
Please note, there are three questions and they are, by design, quite challenging. If you
very carefully and thoroughly to exactly what is being asked. You should provide any
citations necessary, although the vast majority of the work should be your own and in
your own words. Note that over-reliance on the words or thoughts of others will be
penalized.
Question #1: There is substantial evidence that the majority of the merger and
acquisition activity over the past two decades has been concentrated within a particular
type of industry, namely industries that recently deregulated. Based upon the material
1) Explain why this is the case, providing careful justification for your opinion.
2) Predict what effect, if any, deregulation will have on the governance of
deregulated entities.
Please note, I am NOT asking you to research this question. Rather, you should respond
strictly using material that we have covered in our class. Outside research that appears
response to each question cannot exceed 500 words and yet must be complete, so work
very carefully.
Question #2: Consider the following two statements: “Dividend policy is irrelevant” and
“Stock price is the present value of expected future dividends” (See Chapter 4 of the
The current price of the shares of “Charlie, the Good Manager’s Company” is
\$50. Next year’s earnings and dividends per share are \$4 and \$2, respectively. Investors
expect perpetual growth at 8% per year. The expected rate of return demanded by
investors is r=12%.
We can use the perpetual-growth model to calculate stock price
P
0
= DIV/(r-g) = \$2/(.12-.08) = \$50.
Suppose that Charlie, the Good Manager’s Company” announces that it will
switch to a 100 percent payout policy, issuing shares as necessary to finance growth. Use
the perpetual-growth model to show that current stock price is unchanged. Please
carefully document any assumptions that you make in order to respond to this question.
Question #3: Hook Glass Company is considering the installation of a new furnace. The
company’s analysts feel that the company’s adjusted weighted average cost of capital is
the appropriate discount rate for this project, which is derived as follows:
16.98% = 0.25(.12)(1-.34) + 0.75(.20)
where W
d
= 25%, W
e
= 75%, r
e
= 20%, r
d
= 12%, and τ
c
= 34%.
The analysis indicates that the investment expenditures net of the incremental cost
savings (which are positive incremental cash flows) have a net present value of \$500,000
when the cash flows are discounted at 17%. The analysts argue that the project will
support \$1 million of borrowing by the company, which will provide interest expense tax
330
shields that have a present value of \$250,000. Therefore, the total value of the project, or
APV, is estimated to be \$750,000.
1) Critically evaluate this valuation of the new furnace, assuming that the risk of
this project is similar to the risk of the firm’s existing assets.
2) Assume that the company has the opportunity to borrow the \$1,000,000 at a
subsidized rate of 3% (compared to its current 12%). What is the value of this
subsidized loan to the company?
Please limit your response to 250 words plus whatever calculations are necessary for
each of these two questions.
331
a) By the end of two years, the Phlogiston process will be the norm resulting in no
industry member having any kind of a competitive advantage. As such, the prices in the
industry should stabilize around their long-term equilibrium values, which implies that
project investments will have NPVs = 0.
b) As above, the price should reflect the long-term equilibrium value, which will be lower
than the current price of \$1 (because of cheaper production costs). We know the cost of
the plant is \$100,000 and that capacity is 100,000 units. Since the plant has an indefinite
life, the cash flow stream in infinite, or value = cash flow/r. Cash flow will be the
unknown price (P) minus the cost (\$0.85) times the 100,000 units. Thus, we know the
following:
10 . 0
) 85 . 0 \$ ( * 100000
100000 \$

·
P
, which solves to P = \$0.95.
be passed onto customers. Since the cost is declining by \$0.05, then the price should
decline by \$0.05 from \$1.00 to \$0.95.
c) To answer this question, we need to know what is the value of the old plant in two
years. Given that the new market price of acid is \$0.95 and the cost of manufacture is the
old cost of \$0.90, then at 100,000 units per year, the value of the cash flows is \$50,000.
If someone is willing to pay us more than \$50,000 for the asset (and the problem states
that the expected salvage value will be \$57,900), then the firm should scrap the old plant
in two years.
d) No. As in part c, firms will lose value is they forgo an opportunity to sell their assets
at \$57,900 if those assets are only creating value of \$50,000.
e) Sunk cost is irrelevant. After year two, as in parts c & d, the firm should scrap the
asset.
f) We know the NPV after year two is zero because the market is in long-term
competitive equilibrium. Thus, Phlogiston’s excess cash flows will occur in years one
and two. First, we need to determine what will happen to the price of the acid given the
over-capacity and that Phlogiston wants to charge the expected industry price over the
next two years to maximize its profit. Recall that the current salvage price is \$60,000,
which means that in order for any producers of polysyllabic acid, the price that makes
them indifferent to remaining in the market must be such that the value of their next two
years worth of cash flows equals \$60,000. Thus,
2 2
10 . 1
900 , 57 \$
10 . 1
) 90 . 0 \$ ( * 000 , 100
10 . 1
) 90 . 0 \$ ( * 000 , 100
000 , 60 \$ +

+

·
P P
,
which implies P = \$0.97.
332
Although all firms in the industry would like to charge more than \$0.97, none will be able
to without losing market share. So Phlogiston will charge this same amount and will
therefore earn
) 1 . 1 ( * 10 . 0
) 85 . 0 \$ 95 . 0 (\$ 000 , 100
1 . 1
) 85 . 0 \$ 97 . 0 (\$ 000 , 100
1 . 1
) 85 . 0 \$ 97 . 0 (\$ 000 , 100
2 2

+

+

· PV
which equals \$103,471, which implies an NPV = -\$100,000 + \$103,471 = \$3,471.
Note that you would get the same answer recognizing that the new technology will allow
Phlogiston to each \$0.02 extra per ton over the next two years. With 100,000 tons and r
= 10%, this implies a value of \$3,471.
333
ECSY-COLA IN INGLISTAN
Principles of Corporate Finance
7
th
Edition
Richard A. Brealey and Stewart C. Myers
Libby Flannery prepared the attached spreadsheet to analyze the NPV of Ecsy-
Cola’s proposed investment in Inglistan. With the inputs suggested in the mini-case, NPV
is very slightly negative on a \$20 million outlay.
Libby was conscious of the spreadsheet’s simplifying assumptions. First, there
was no provision for working capital. Second, the project cash flows were projected as a
perpetuity. The project, if successful, would generate cash returns for a long time, but not
forever. On the other hand, the 25 per cent nominal discount rate handed down from
Ecsy-Cola’s headquarters seemed unreasonably high – was there a fudge factor built in?
1
At least the discount rate should be converted to real terms, since the revenue and cost
projections did not incorporate inflation. At a 22 per cent discount rate (assuming an
inflation rate of roughly 3 per cent
2
), NPV increased to about \$3 million. [Calculate this
NPV by changing the discount-rate input on the spreadsheet. All NPVs reported below
are calculated at a 22 per cent rate.]
This calculation looked better, but should Libby recommend investing now or
later? A year’s wait would give a better assessment of potential sales. Libby performed a
sensitivity analysis, assuming for simplicity that the optimistic and pessimistic
probabilities were each 25 per cent:
1
See Ch. 9, pp. 235-237.
2
All cash flows were expressed in U. S. dollars, so Libby used the approximate dollar inflation rate in
2004. The inflation rate in local currency (the Inglestanian groupee) was higher than 3 per cent, but this
difference would be offset, on average, by a decline in the groupee-dollar exchange rate. See Ch. 28,
Section 28.2.
334
Steady-State Sales Probabilty NPV at year 1
Optimistic 80 million .25 + \$20.5
Most Likely 50 .50 + \$ 3.1
Pessimistic 20 .25 - \$ 14.2
Of course, if potential sales were only 20 million liters per year, Ecsy-Cola would not
invest, so the NPV in this case would be zero, not - \$11 million. Thus the payoff to
waiting would be:
Expected NPV, invest in year 1 =
.25 × 20.5 + .50 × 3.1 + .25 × 0 = + \$6.7 million
This suggested a “wait and see” strategy.
The problem with that strategy was potential competition. If steady-state sales
turned out higher than now expected – 80 million liters per year, for example – then
Sparky-Cola, or some other competitor, would surely enter. The high cash flows for the
optimistic case were not sustainable in the long run, so the optimistic-case NPV, while no
doubt positive, was less than \$20.5 million.
Libby realized that investing right away, and establishing the Ecsy-Cola brand in
Inglistan before her competitors could act, gave her best chance of generating a
significant positive NPV. In the optimistic scenario, competition would come sooner or
later, but Ecsy-Cola would have a head start and probably the largest market share. If
Ecsy-Cola was just breaking even (earning its cost of capital), competitors would have no
incentive to enter.
the possibility of a costly mistake. Therefore she refocused her analysis on establishing
the minimum potential size of the market. If NPV at that minimum was at least zero, or
perhaps an acceptably small negative number, she resolved to invest right away.
ECSY-COLA IN INGLISTAN
Mini-case Solution for R. A. Brealey and S. C. Myers, Principles of Corporate Finance, 7th ed., Irwin McGraw-Hill,
335
2003.
August 19, 2002
Capital outlay (millions) \$20
Discount rate 0.25
Tax rate 0.3
Fixed costs per year (millions) \$3
Variable costs per liter \$0.12
Revenues per liter \$0.35
millions) 50
Year 0 1 2 3 4 5
6, 7,
etc.
Investment 20.00
Tax depreciation 5.00 5.00 5.00 5.00
Depreciation tax shield 1.50 1.50 1.50 1.50
Liters sold 0.00 12.50 25.00 50.00 50.00 50.00 50.00
Revenues 0.00 4.38 8.75 17.50 17.50 17.50 17.50
- Variable costs 0.00 1.50 3.00 6.00 6.00 6.00 6.00
- Fixed costs 0.00 3.00 3.00 3.00 3.00 3.00 3.00
Operating cash flow 0.00 -0.13 2.75 8.50 8.50 8.50 8.50
- Tax 0.00 -0.04 0.83 2.55 2.55 2.55 2.55
Operating cash flow (after tax) 0.00 -0.09 1.93 5.95 5.95 5.95 5.95
+ Depreciation tax shield 1.50 1.50 1.50 1.50
Net cash flow -20.00 1.41 3.43 7.45 7.45 5.95 5.95
NPV = -0.1
Discrete
Compounding
Continuous
Compounding
336
S \$ 55.00
X \$ 55.00
t 0.5
rf 0.04
stdev 0.4069
PV(X) 53.93193716 53.91092703
d1 0.212018241 0.213372478
d2 -0.075703509 -0.074349272
N(d1) 0.583953598 0.584481777
N(d2) 0.469827492 0.470366236
C \$ 6.779 \$ 6.789
Black Scholes Values
P \$ 300.00
X 305
rf 0.04
t 4
sigma 0.5
d1 0.640353551 0.739029
d2 -0.359646449 0.359556
Black Sholes Value \$ 127.97
337

2

3.

a. b. c.

DF1 =

1 = 0.88 ⇒ so that r1 = 0.136 = 13.6% 1+ r1

DF2 =

1 1 = = 0.82 2 (1 + r2 ) (1.105) 2

AF2 = DF1 + DF2 = 0.88 + 0.82 = 1.70 Here: \$24.49 = \$10 × [AF3] AF3 = 2.45

d. PV of an annuity = C × [Annuity factor at r% for t years]

e. AF3 = DF1 + DF2 + DF3 = AF2 + DF3 2.45 = 1.70 + DF3 DF3 = 0.75 4. Thus: The present value of the 10-year stream of cash inflows is (using Appendix Table 3): (\$170,000 × 5.216) = \$886,720 NPV = -\$800,000 + \$886,720 = +\$86,720 At the end of five years, the factory’s value will be the present value of the five remaining \$170,000 cash flows. Again using Appendix Table 3: PV = 170,000 × 3.433 = \$583,610 5. a. Let St = salary in year t
PV = ∑
t =1 30

St (1.08)

t

=∑
t −1

30

20,000 (1.05) (1.08) t

t −1

=∑
t =1

30

30 (20,000/1. 05) 19,048 =∑ t t (1.08 / 1.05) t −1 (1.029)

= 19,048

 1 1 × − (0.029) × (1.029) 0.029

30

  = \$378,222 

b.

PV(salary) x 0.05 = \$18,911. Future value = \$18,911 x (1.08)30 = \$190,295 Annual payment = initial value ÷ annuity factor 20-year annuity factor at 8 percent = 9.818

c.

3

Annual payment = \$190,295/9.818 = \$19,382

4

6. Period 0 1 2 3 7. Discount Factor 1.000 0.893 0.797 0.712 Cash Flow Present Value

-400,000 -400,000 +100,000 + 89,300 +200,000 +159,400 +300,000 +213,600 Total = NPV = \$62,300

We can break this down into several different cash flows, such that the sum of these separate cash flows is the total cash flow. Then, the sum of the present values of the separate cash flows is the present value of the entire project. All dollar figures are in millions.  Cost of the ship is \$8 million PV = -\$8 million Revenue is \$5 million per year, operating expenses are \$4 million. Thus, operating cash flow is \$1 million per year for 15 years. PV = \$1 million × [Annuity factor at 8%, t = 15] = \$1 million × 8.559 PV = \$8.559 million Major refits cost \$2 million each, and will occur at times t = 5 and t = 10. PV = -\$2 million × [Discount factor at 8%, t = 5] PV = -\$2 million × [Discount factor at 8%, t = 10] PV = -\$2 million × [0.681 + 0.463] = -\$2.288 million Sale for scrap brings in revenue of \$1.5 million at t = 15. PV = \$1.5 million × [Discount factor at 8%, t = 15] PV = \$1.5 million × [0.315] = \$0.473

Adding these present values gives the present value of the entire project: PV = -\$8 million + \$8.559 million - \$2.288 million + \$0.473 million PV = -\$1.256 million 8. a. b. c. d. PV = \$100,000 PV = \$180,000/1.125 = \$102,137 PV = \$11,400/0.12 = \$95,000 PV = \$19,000 × [Annuity factor, 12%, t = 10] PV = \$19,000 × 5.650 = \$107,350 e. PV = \$6,500/(0.12 - 0.05) = \$92,857 Prize (d) is the most valuable because it has the highest present value. 5

9.

a.

Present value per play is: PV = 1,250/(1.07)2 = \$1,091.80 This is a gain of 9.18 percent per trial. If x is the number of trials needed to become a millionaire, then: (1,000)(1.0918)x = 1,000,000 Simplifying and then using logarithms, we find: (1.0918)x = 1,000 x (ln 1.0918) = ln 1000 x = 78.65 Thus the number of trials required is 79.

b.

(1 + r1) must be less than (1 + r2)2. Thus: DF1 = 1/(1 + r1) must be larger (closer to 1.0) than: DF2 = 1/(1 + r2)2

10.

Mr. Basset is buying a security worth \$20,000 now. That is its present value. The unknown is the annual payment. Using the present value of an annuity formula, we have: PV = C × [Annuity factor, 8%, t = 12] 20,000 = C × 7.536 C = \$2,654

11.

Assume the Turnips will put aside the same amount each year. One approach to solving this problem is to find the present value of the cost of the boat and equate that to the present value of the money saved. From this equation, we can solve for the amount to be put aside each year. PV(boat) = 20,000/(1.10)5 = \$12,418 PV(savings) = Annual savings × [Annuity factor, 10%, t = 5] PV(savings) = Annual savings × 3.791 Because PV(savings) must equal PV(boat): Annual savings × 3.791 = \$12,418 Annual savings = \$3,276

6

t = 30] Because this interest rate is not in our tables.000 x(6. 7 . we use the formula in the text to find the annuity factor:  1 1 \$1. or \$20.000 cash.0083 = 0.83 percent: rmonthly = rannual /12 = 0.10)3 + x(1. Kangaroo Autos offers the better deal. i.000.276 12.10)2 + x(1.e. then: x(1.0083) × (1.Another approach is to find the value of the savings at the time the boat is purchased.000 + \$300 ×  − (0.10 + 1) = \$20.10)4 + x(1.105) = \$20. A 10 percent annual rate of interest is equivalent to a monthly rate of 0. 0.0083) 0..464 + 1.210 + 1.83% The present value of the payments to Kangaroo Autos is: \$1000 + \$300 × [Annuity factor.10)1 + x = \$20.000 x = \$ 3.10/12 = 0. we can solve for the amount to be put aside each year. the lower present value of cost. Therefore. it does not change the fact that money has time value.93 8  30 A car from Turtle Motors costs \$9.0083   = \$8.000 x(1.331 + 1. If x is the amount to be put aside each year. The fact that Kangaroo Autos is offering “free credit” tells us what the cash payments are. Because the amount in the savings account at the end of five years must be the price of the boat.83%.

15) 2 The figure below shows that the project has zero NPV at about 12 percent.000 − at 15 percent ⇒ NPV = −\$150.12) 2 30 20 10 NPV 0 NPV -10 -20 0.000 300.000 − \$100.10 Rate of Interest 0.025 1.13.000 − at 10 percent ⇒ NPV = −\$150.05 0.15 8 .000 300.113 1. NPV at 12 percent is: NPV = −\$150. As a check.15 (1. The NPVs are: at 5 percent ⇒ NPV = −\$150.12 (1.10 (1.05 (1.871 1.000 + = −\$128 1.000 + = \$26.10)2 \$100.000 + = −\$10.000 + = \$7.05) 2 \$100.000 300.000 − \$100.000 \$300.

14 Next. This is 2. for five years.884 million = \$6. it takes five years for money to double at 15% compound interest. b. and searching for the factor in the 15 percent column that is closest to 2.04) 0.04) 0.15)10 = \$404. Then: (\$100)(1. The pipeline’s value at year 20 (i.14.96 Therefore.e. and subtract it from the answer to Part (a): PV = \$14. a.04. Future value = \$100 + (15 × \$10) = \$250 FV = \$100 × (1.29 million b.14 20 = \$0.04): PV = \$2 million \$2 m illion = 0. at t = 20).29 million − \$6.10 − ( −0. we find: x (ln 1.35 million (1. (We can also solve by using Appendix Table 2. a. c.14 = \$14.011. is: PV 20 = C21 C (1 + g) 20 = 1 r −g r −g With C1 = \$2 million..15) = ln 2 x = 4.10: PV 20 = (\$2 million) × (1 − 0. g = -0. This calls for the growing perpetuity formula with a negative growth rate (g = -0.60 Let x equal the number of years required for the investment to double at 15 percent.314 million 0.10) 20 9 .15)x = \$200 Simplifying and then using logarithms. and r = 0.314 million = \$13. we convert this amount to PV today. assuming its cash flows last forever.) 15.

077  (Alternatively.0677 Note that the pattern of payments in part (b) is more valuable than the pattern of payments in part (c). and hence: PV = C \$100 = = \$1.500. 10 .57 r 0. c.428.477. a.077)(20 )  (0.0.000/0.04) = \$2.10 r 0.0800 Thus:  1  1 PV = \$100.57 = \$1.) This result is greater than the answer in Part (c) because the endowment is now earning interest during the entire year.428.250. 17.000/(0.0677 = 1. with the former pattern of payment. because: e0.528.000 PV = \$100. b.08) 0.16.020.284 (0.08 = \$1.0700 Thus: PV = C \$100 = = \$1. a.077) × e 0.77 percent. because: e0.0770 = 1. This is the usual perpetuity.57 The continuously compounded equivalent to a 7 percent annually compounded rate is approximately 6.08) × (1. This is worth the PV of stream (a) plus the immediate payment of \$100: PV = \$100 + \$1. PV = \$100. c.000 ×  − (0.08 .07 b. It is preferable to receive cash flows at the start of every year than to spread the receipt of cash evenly over the year.000 ×  − = \$1.7 percent . we could use Appendix Table 5 here. d.800  The continuously compounded equivalent to an 8 percent annually compounded rate is approximately 7.08 20   = \$981.000  1 1 PV = \$100. you receive the cash more quickly.

because: e0. 11 . we find that r = 7.15)(20) = \$2.0605 = 6. and (2) \$100 per year in perpetuity. One way to approach this problem is to solve for the present value of: (1) \$100 per year for 10 years.05 percent annually compounded rate is approximately 5.000 (1 + r)8 = 1.15)20 = \$1.18. with the first cash flow at year 11 If this is a fair deal. To find the annual rate (r).87 percent. The present value of \$100 per year for 10 years is: 1  1 PV = \$100 × −  r (r) × (1 + r)10   The present value.600 Solving algebraically. with the first payment in year 11.05% The continuously compounded equivalent to a 6. With annual compounding: FV = \$100 × (1.637 With continuous compounding: FV = \$100 × e(0. we have: 1   1 1 \$100 × −  = r (r) × (1 + r) 10   (1 + r)10   \$100  ×    r  Using trial and error or algebraic solution.0605 19. we solve the following future value equation: 1.0587 = 1. we find: (1 + r)8 = 1. the present value of PV10 is:  1 PV = 10  (1 + r)  \$100  ×    r  Equating these two expressions for present value. as of year 10. r. these present values must be equal.18%.0605 r = 0. is: PV10 = \$100/r At t = 0.6)(1/8) = 1.6 (1 + r) = (1. and thus we can solve for the interest rate.009 20. of \$100 per year forever.

777 = \$9.08% 0.0585)40 = \$9. compounded continuously.120 = \$1.95% 12.7 percent.974 The preferred investment is C. compounded semiannually.81% 10. 1 + rnominal = (1 + rreal) × (1 + inflation rate) Approximate Real Rate 4.00% 10. Assume the amount invested is one dollar.00% 23. 22. compounded annually.67% 12 .0585)2 = \$1.00% 20.19% 1. Let C represent the investment at 11.719 ) = \$9. After one year: FVA = \$1 × (1 + 0.115 × 20 × × = \$1.20% 9.122 = \$1. Let B represent the investment at 11.00% 23.646 FVB = \$1 × (1 + 0.00% 6.00% 4.115 5) After twenty years: FVA = \$1 × (1 + 0.33% Difference 0.12)5 FVC = \$1 × (e0.115 1) After five years: FVA = \$1 × (1 + 0.762 FVB = \$1 × (1 + 0.00% 11.766 = \$1.12)20 FVC = \$1 × (e0. Let A represent the investment at 12 percent.00% 3.00% Inflation Rate 1.83% Real Rate 4.21.00% 5.120 FVB = \$1 × (1 + 0.12)1 FVC = \$1 × (e0.00% Actual Real Rate 3.00% 13. 1 + rnominal = (1 + rreal) × (1 + inflation rate) Nominal Rate 6.0585)10 = \$1.92% 3.5 percent.

797 FV = \$100 × (1 + 0.000 × [Annuity Factor. 4%.000.761. t = 15] \$2.000 + \$100. t = 19] PV = \$495.24.05)113 = \$24.000. then: \$4.827 × [Annuity Factor. 8%.604 = \$4. and the interest rate equal to 8 percent. 10%.827 × [Annuity Factor. Each installment is: \$9. 8%. or 4%.420. Because the cash flows occur every six months. At 5%: At 10%: FV = \$100 × (1 + 0.000 = \$495. Thus: PV = \$100.791 = \$11. we find that the interest rate is about 10 percent. we use a six-month discount rate. 10%.000 × 7. If ERC is willing to pay \$4.827 × 9. the less famous receiver is better paid. t = 9] PV = \$100.582 million Thus.559 C = \$233.10)113 = \$4.471. with 15 time periods.923 b. t = 5] PVQB = \$3 million × 3.827 PV = \$495.373 million PVRECEIVER = \$4 million + \$2 million × [Annuity Factor.757. x%.200.” while the receiver got a “\$14 million contract. here 8%/2. so that.000 = C × [Annuity Factor. The total elapsed time is 113 years.000 + \$100. Thus.791 = \$11.000 = C × 8.713/19 = \$495. t = 5] PVRECEIVER = \$4 million + \$2 million × 3. using the annuity table for 19 times periods. despite press reports that the quarterback received a “\$15 million contract.672 13 .” 27.2 million. 28. PVQB = \$3 million × [Annuity Factor.500 26. a.441 25. This is an annuity problem with the present value of the annuity equal to \$2 million (as of your retirement date).435 = \$843. your annual level of expenditure (C) is determined as follows: \$2. t = 19] This implies that the annuity factor is 8.

C2 = \$192.0577 = 5. the cash flow in 1 year will be \$416.000.933. etc.With an inflation rate of 4 percent per year.952 Thus C1 = (\$177. and we can find the real rate (r) by solving the following equation: (1 + 0. with nominal cash flows: a. However.04) 1 (1 + 0. the real cash flows are \$400.10) 20   (1. Here.04) 15  R × + +. + 0. The nominal cash flows form a growing perpetuity at the rate of inflation.5677] = \$2.10) = (1 + r) × (1. Thus.070.000 and: PV = \$416.000. .000. we will still accumulate \$2 million as of our retirement date.000 1 (1 +0 . . First. .000  PV =  + +.2390 = \$2.418.10 .0. + +  = \$5.952 × 1.000 R × 11.04) 2 (1 + 0 . with an additional payment of \$5 million at year 20:  416. with real cash flows: a.77% PV = \$400.04) = \$185.000 432.000 R = \$177. . because we want to spend a constant amount per year in real terms (R.000/(0.10) (1. constant for all t).409 14 .000  (1 +0 .04) = \$6. the nominal amount (C t ) must increase each year.10) Second. 29.449 5.932.04) ⇒ r = 0.0577) = \$6.389 1 2 20 (1.000.08) 15   (1+0.000.333 b.9273 + . The nominal cash flows form a growing annuity for 20 years. +  = \$2.000 per year in perpetuity. . .10) (1.000/(0. For each year t: R = C t /(1 + inflation rate)t Therefore: PV [all C t ] = PV [all R × (1 + inflation rate)t] = \$2.640 876.08) R × [0.9630 + 0.08) 2 (1+0. 4%.473.

281.05) t \$115. Pool wants to have \$500. in real terms.012.000)(1 + 0.000 per year for 20 years and \$5 million (nominal) in 20 years.000. t.935 Thus.05) t t Ms.000.000 (1.000 ×  − + = \$5. Pool’s salary to be set aside each year.02) t (1. Now.000) (1 + 0.000 (1.000) (1.02) (1 + 0.b. 30 years from now.000/(1 + 0. to within rounding errors.72 = (x)(\$790. the real cash flows are \$400.82) x = 0. The present value of this amount (at a real rate of 5 percent) is: \$500.0577) (0.986 20  20  (0.05) 30 =∑ t =1 30 (x)(\$40. the answers agree.05) 30 \$500.000)(1 + 0.0577)  (1. the present value of the project is:   \$2.417. In real terms.146 15 .0577) [As noted in the statement of the problem.05)30 Thus: \$500. her real income will be: (\$40. the \$5 million dollar payment is: \$5.02) t The present value of this amount is: (x)(\$ 40.000/(1.04)20 = \$2.935 1 1 PV = \$400.688.05) t 30 =(x) ∑ t =1 (\$40. Let x be the fraction of Ms.02) t The real amount saved each year will be: (x)(\$40. At any point in the future.281.0577)(1 .02) t (1.00 0) (1.] 30.

000 + = \$11. PV = ∑ t =1 10 5 \$600 \$10.0175) (1. the yield to maturity is approximately 12.42 t (1.128.65 t (1.024) 10 PV = ∑ t =1 32. PV = ∑ t =1 10 5 \$600 \$10.048) (1.522.124) 2 At r = 13.0% ⇒ PV = ∑ t =1 2 At r = 12.0% ⇒ PV = ∑ t =1 2 \$100 \$1.527.4%.0175) 10 PV = ∑ t =1 33.000 + = \$959.13) 2 \$100 \$1.02 t (1.5% ⇒ PV = ∑ t =1 2 At r = 12.13) t (1.000 + = \$10. 16 .12) t (1.000 + = \$966.000 + = \$958.125) (1.20 (1.31.000 + = \$10.4% ⇒ PV = ∑ t =1 2 Therefore.048) 5 \$300 \$10.035) (1.76 t (1.000 + = \$11.125) 2 \$100 \$1.12) 2 \$100 \$1.96 (1.024) (1.035) 5 \$300 \$10.000 + = \$949.85 t (1.65 t (1. Using trial and error: At r = 12.124) (1.137.

2. With continuous compounding for interest rate r and time period x: erx = 2 Taking the natural logarithm of each side: r x = ln(2) = 0. 17 .021) t Hence.04) t Thus revenue is: 100. at any point in time t. we can consider the revenue stream to be a perpetuity that grows at a negative rate of 2.04)] t = 100.000 (1 .12) = ln 2 x = 6.3/(interest rate.1 percent per year. 3.099P 0. Then. a.Challenge Questions 1. if x is the number of years for money to double.02) t The quantity produced is: 100. the price is: P (1 + 0. At a discount rate of 8 percent: PV = 100.12 years b. or 6 years. then x (the time for money to double) is: x = 69. if r is expressed as a percent.02) × (1 .0.0.08 − ( −0. we find: x (ln 1.0.693 Thus.000P × (1 .861. in percent).021) With P equal to \$14. the present value is \$13. then: (1.000 P = 990. Using the Rule of 72. Spreadsheet exercise Let P be the price per barrel.12)x = 2 Using logarithms. More precisely.000P × [(1 + 0. the time for money to double at 12 percent is 72/12.386.

with an inflation rate of 2 percent: Year 2002 2003 2004 2005 2006 Nominal Cash Flow 70.000. with nominal cash flows and a nominal rate.070.07/1.07) 5 The present value of the bond.02) – 1] = 0.96 70.07) 4 + 1070 = \$1.13 With a nominal rate of 7 percent and an inflation rate of 2 percent.28 (1. Spreadsheet exercise. 18 . is: PV = 70 70 + 1 (1.0490) 5 = \$1.00 6.02)1 = 68.4.00 (1. is: PV = 68.00 70.96 (1. the real rate (r) is: r = [(1.67 (1.90% The present value of the bond.S.02)5 = 969.0490) 3 + 64.0490 = 4.0490) 2 + 65.07) (1.00 per year.0490) 4 + 969.00 70. The 7 percent U.13 (1.67 1070.00/(1.00/(1. Let c = the cash flow at time 0 g = the growth rate in cash flows r = the risk adjusted discount rate PV = c(1 + g)(1 + r) -1 + c(1 + g)2(1 + r) -2 + .28 70.00/(1.63 70. Therefore.07) 2 + 70 70 + 3 (1.00 1. + c(1 + g)n(1 + r) -n The expression on the right-hand side is the sum of a geometric progression (see Footnote 7) with first term: a = c(1 + g)(1 + r) -1 and common ratio: x = (1 + g)(1 + r) -1 Applying the formula for the sum of n terms of a geometric series. with real cash flows and a real rate. .00/(1.000. Treasury bond (see text Section 3.07) (1.00 Real Cash Flow 70.00 70.02)2 = 67. .02)3 = 65.02)4 = 64.63 (1. the PV is: n −n 1 − xN   −1 1 − (1 + g) (1 + r) PV = (a)   = c(1 + g)(1 + r)  −1  1 − x   1 − (1 + g) (1 + r)  5.00/(1.5) matures in five years and provides a nominal cash flow of \$70.0490) 1 + 67.

4.00 100.33 1.74 13. the present value of the stock today is the present value of the expected dividend payments from years one through five plus the present value of the year five value of the stock.00 100. 19 .252. that is the value at which the investor expects to sell the stock. then.55 162.00 100. The market capitalization rate for a stock is the rate of return expected by the investor.51 59. Even if the investor plans to hold a stock for only 5 years. Newspaper exercise. Therefore.CHAPTER 4 The Value of Common Stocks Answers to Practice Questions 1. for example.00 100.50 40.30 83.27 109. it will be worth the discounted value of all expected dividends from that point on.150.13 100.21 1.21 1.89 30.00 100. 3.03 11. The value of a share is the discounted value of all expected future dividends.51 25.00 10.39 8.64 23. answers will vary 2.146.79 98. This latter amount is the present value today of all expected dividend payments after year five. 2. Since all securities in an equivalent risk class must be priced to offer the same expected return. the market capitalization rate must equal the opportunity cost of capital of investing in the stock.06 0. at the time that the investor plans to sell the stock.94 99.00 10.00 105.70 16. Horizon Period (H) 0 1 2 3 4 10 20 50 100 Expected Future Values Present Values Dividend Price Cumulative Future (DIVt ) (Pt ) Dividends Price 100.00 110.00 100. Dividends increase by 5% per year compounded.00 100.25 115.11 69.58 15.36 76.89 265. The capitalization rate is 15%.26 16.00 100.00 91.01 Total 100. In fact.76 121.50 11.99 Assumptions 1.74 83.

0. we have: P0 = Div1/(r – g) 73 = 1.10 1.10 1.00 r 0.68/(r .06) r = 0.108 = 10.0 .50 1 2 3 4 5 6 1. Using the growing perpetuity formula.44 1  + + + + + + ×  = \$104. Using the growing perpetuity formula.10 D 1 IV 5 = = \$83.10 1.04) = \$25 7. we have: P0 = Div1/(r – g) = 2/(0.04 PC = DIV1 DIV 2 DIV3 DIV 4 DIV5 DIV 6  DIV7 1  + + + + + + × 1 2 3 4 5 6 6  1.10 1.10 −0 .10 1.48 20 .64 10.10 1.5 = 0.10 1. The results are: PA = \$142.67 PC = \$156.10 1.083 = 8.44  12.5.37 12. the calculations are similar.10 1. We know that: Plowback ratio = 1. Stock C is the most valuable.10 At a capitalization rate of 10 percent.0.12 = 0.10 1. PA = PB = DIV1 \$10 = = \$100.085) r = 0.06 = 6.10 1.20 8.12 .8% b.33 r −g 0.10 1. we have: P0 = Div1/(r – g) 73 = 1.0 – payout ratio Plowback ratio = 1. we also know that: dividend growth rate = g = plowback ratio × ROE g = 0.0.86 PB = \$166.10  PC = 5.5 × 0.0% Using this estimate of g. a.3% 6. For a capitalization rate of 7 percent.0.00 6.00 7.10  0.10 6   0.5 And.68/(r .

all future investment opportunities are assumed to have a net present value of zero. Hence.0% b. the impact on share price is the same as in Part (b).0% We know that: r = (DIV1/P0) + g r = dividend yield + growth rate Therefore: r = 0. If all future investment opportunities have a rate of return equal to the capitalization rate. Dividend yield = 4%. if there are suddenly no future investment opportunities.12. Thus. the stock price will decrease by 44. we know that:  EPS 1 PVGO  = r × 1 −  P0 P0   With (P0/EPS1) = 15 and r = 0. We know that g. 8.08 = 0.4 percent.4 implies a payout ratio of 0.04 + 0.04 × P0 A plowback ratio of 0.6 DIV1 = 0. a. 21 . the ratio of the present value of growth opportunities to price is 44.6 × EPS1 P0/EPS1 = 15 Also. Therefore: DIV1/P0 = 0.6.6 × EPS1 Equating these two expressions for DIV1 gives a relationship between price and earnings per share: 0.Therefore.12 = 12. this is equivalent to the statement that the net present value of these investment opportunities is zero.04 DIV1 = 0. Stock B is the most valuable.04 × P0 = 0.08 = 8. is given by: g = plowback ratio × ROE g = 0.4 percent. c.40 × 0.20 = 0. and hence: DIV1/EPS1 = 0. the growth rate of dividends and earnings. In Part (b).

There are two reasons why the corresponding earnings-price ratios are not accurate measures of the expected rates of return. 10. Current stock price is \$100.30 =0 .9. 11. Hotshot Semiconductor’s earnings and dividends have grown by 30 percent per year since the firm’s founding ten years ago. Internet exercise. the earnings-price ratio is equal to the expected rate of return only if PVGO is zero. Internet exercise.0 )  6 (1 + r ) Using trial and error.25% P0 100 This is wrong because the formula assumes perpetual growth. Thus: r= DIV 1 1. An Incorrect Application. we find that r is approximately 11. 22 . Second.1 percent. it is not possible for Hotshot to grow at 30 percent per year forever. 12. we know that:  EPS 1 PVGO  = r 1 −  P0 P0   Hence. the expected rate of return is based on future expected earnings. answers will vary depending on time period. In general. and next year’s dividend is projected at \$1. Using the concept that the price of a share of common stock is equal to the present value of the future dividends. we have:  D 1 IV D 2 IV D 3 IV 1 D 4  IV P= + + + ×  2 3 3 (1 + r) (1 + r) (1 + r) (r −g)  (1 + r)  1 2 3 1 (3 × .25 +g= + 0 . answers will vary depending on time period.3125 = 31. First. these earnings figures are different. 13. a.0 )  1 6 5 = 0 + + + ×  2 3 3 (1 + r ) (1 + r ) (1 + r ) ( r − 0 . the priceearnings ratios reported in the press are based on past actual earnings.25.

Since PVGO = 0: P0 = EPS 1 +PVGO r 10 100 = +0 r Therefore. Thus: r= DIV 1 5 +g= + 0 .05 =0 . The reason P0 is so high relative to earnings is not that r is low. Its EPS1 = \$10. b. An Incorrect Application.0% P0 100 Even here.10 = 10. Suppose PVGO = \$60: P0 = EPS 1 +PVGO r 5 100 = + 60 r Therefore. r = 10. you should be careful not to blindly project past growth into the future. and P0 = \$100. If Old Faithful hauls coal. Unfortunately. r = 12. an energy crisis could turn it into a growth stock. which has been growing at a steady 5 percent rate for decades. Thus: r= EPS 1 5 = =0 . but rather that Hotshot is endowed with valuable growth opportunities.05 =5.00 per share. The formula might be correctly applied to the Old Faithful Railroad.0% P0 100 This is too low to be realistic.A Correct Application. Hotshot has current earnings of \$5.0% 23 .5% A Correct Application. Old Faithful has run out of valuable growth opportunities. DIV1 = \$5.

Share price = EPS 1 NPV + r r −g Therefore: Ρα = Ρβ = EPS rα EPS rβ α1 + + NPV α (rα −0. NV β P NV α P < (r α −0 5 . NPVα < NPVβ .08) β    > NPV α  (r −0.15) α      Rearranging. .12 − 0 . everything else equal. we have: NV β P r NV α P r × α < × β ( rα −0.08) 24 .12) 2 + 1.0 ) E S β 8 P 1 1 a.15) N PV β β1 (rβ −0. rβ rα < .81   b. EPS α1 EPS β1 15.0.07 (0. everything else equal. b.0 ) c. The horizon value contributes: PV(P H ) = 1 (1.08) The statement in the question implies the following: NPV β (rβ −0.08)  EPS β1 NPV β  +  r (rβ −0. a.12) 3  1 +  (1.12)  3 1.15 ) E S α P ( rβ −0.15) > (rβ . c.15) α   EPS α1 NPV α  +  r (rα −0.24 × = \$22.08)  = \$23.12) (1.08).12) 3 1.12 −0 .1 ) (rβ −0 8 .0. Growth-Tech’s stock price should be: 0.14.60 P= + (1. everything else equal.24 × (0.50 0.15 (1. (rα . everything else equal.

30 = \$16.12 Therefore: PVGO = \$31. answers will vary.12) 3 The new stock price will be \$23. 17.\$7. P3 would equal earnings for year 4 capitalized at 12 percent: 2.08 =8. Here we can apply the standard growing perpetuity formula with DIV1 = \$4.67 Also: P0 = EPS 1 +PVGO r 6. The PVGO of \$10.81 .75 = \$10. Internet exercise.25 is lost at year 3.\$20.0% P0 100 The \$4 dividend is 60 percent of earnings.6 = \$6. 19. g = 0. Without PVGO. Internet exercise.25 = \$7. Thus: EPS1 = 4/0.00 .04 and P0 = \$100: r = DIV 1 4 +g = + 0 .63 25 .04 =0 . a.49 = \$20.75 0. Internet exercise.08 100 = PVGO = \$16. 18. answers will vary depending on time period.67 + PVGO 0. the current stock price of \$23. answers will vary.25 d.30 (1.c.51 16.81 will decline by: 10. Therefore.

08 1. CSI’s stock price will increase to: P0 = 1.) b. . PV(PH) = (EPSH/r) + PVGO where EPSH is the firm’s earnings per share at the horizon date. (This formula would be a good choice if comparable firms can be readily identified.) c. CSI will grow by 8 percent per year for five years.67 2 1.68 1.20 × 6. (This formula would be a good choice if the assumption of growth at a constant rate g for the foreseeable future is a reasonable assumption.44 1. 8 .67) = \$1.81 9.68 8. (This formula would be the easiest to apply if PVGO = 0. PV(PH) = BVH × (MV/BV)C where BVH is the firm’s book value per share at the horizon date. . PV(PH) = CH + 1 /(r – g) where CH + 1 is the firm’s cash flow in the subsequent time period.78 4 1.33 However.b. PV(PH) = EPSH × (P/E)C where (P/E)C is the P/E ratio for comparable firms.08 1. Formulas for calculating PV(PH) include the following: a.) 26 .07 6 5. DIV1 will decrease to: (0. Forecasted stock price in year 5 is: P5 = DIV 6 5.56 1.56 7.08 5 20.44 7.80 7.04 Therefore.81 + 147 + + + + = \$106.08 4 1.) d. Thus: Year DIVt EPSt 1 1.33 6.22 2 3 1.40 5 1.08 1.88 9.08 − 0 . and (MV/BV)C is the market-book ratio for comparable firms.20 3 1. (This formula would be a good choice if comparable firms can be readily identified.88 = = \$147 r − g 0.33 1. Continued growth at 4 percent Note that DIV6 increases sharply as the firm switches back to a 60 percent payout policy. by plowing back 80 percent of earnings.

However. b.84 3.42 1.83 2.91 (0.91-\$1.9268 × \$18.59 1.39 -0.10 − 0 .50 1.30 -0.51 1.50 1.67 25. With one million shares currently outstanding.53 million/1 million shares) = \$17. the present value of the horizon value decreases by a greater amount.68 2.34 × = \$18.53 The present value of the near term cash flows increases because the amount of investment each year decreases.00 11. The value of each share remains the same at \$10.0% 20.45 -0.73 1.0% 13.42 1.53 per share (ii) previously outstanding shares/total shares = 1 million/1.21 17.91 = \$17. so the number of shares to be issued is: (\$1.37 2.0% 20.49 19. price per share is: (\$17.28 2.35 -0. 27 .0% 13.34 1.38 1.50 13.76 22.9268 0.38 million. The value of the company increases from \$100 million to \$200 million.0% 20.06) Therefore.34 1.0% 6. Year 1 2 3 4 5 6 7 8 9 10 Asset value 10.27 2.98 2.079 million = 0.0% 6.33 23.0% The present value of the near-term flows (i.e..53 million/1 million shares = \$17. the present value of the free cash flows is: (\$18.0% 6.38 million/\$17.10) 6 1.60 Earnings 1.57 1.0% 20.20 1.20 1.000 shares (approximately) c.53 The amount of financing required is \$1. a.01 3. years 1 through 6) is -\$1.10 2.38 The present value of the horizon value is: PV(P H ) = 1 (1.17 -0.60 Free cash flow -0.38) = \$17.53) = 79.23 15.60 Earnings growth 20.21.53 22.09 26.20 Investment 1. (i) \$17. so that the total present value decreases.

and so on.10 235.15  0.782.00 100.00 121.85 1.00 5.0. The new shareholders who provide this cash will demand a dividends of \$0. \$0.90 41.00 110.23.00 1.00 100. Horizon Period (H) 0 1 2 3 4 10 20 50 100 Expected Future Values Dividend Price (DIVt ) (Pt ) 100. Thus.59 10.50 – \$0.28 37.00 100.09 56. The present value of a share at year 1 is computed as follows: PV = \$15  \$5 1  + ×  = \$100.50) = \$5 in year 2.00 100. (\$6.00 86.80 485.944.82 20.63 90.79 611.00 100.00 15.93 In order to pay the extra dividend.00 5.55) = \$5. and so on.96 83.56 76.00 100. the company needs to raise an extra \$10 per share in year 1.10 1.10 58.72 27.50 6.05 – \$0.00 100.00 133.252. each old share will receive dividends of \$15 in year 1.15  28 .18 79.05 10.94 Present Values Cumulative Future Dividends Price 100.00 100.04 16.15 98.50 per share in year 2.44 23. (\$5.37 9.68 13.72 62.50 in year 3.15 .90 1.671.07 Total 100.00 100.55 in year 3.

assuming constant growth. Hence. and when ROE = r. free cash flow can be negative when investment outlays are large. the price-to-book ratio also increases. Free cash flow equals cash generated net of all costs. Also: r = dividend yield + growth rate Hence: r . competition is likely to drive ROE down to the cost of equity. Assume the portfolio value given. 2.0% Thus. is: V= 0. 3. From the equation given in the problem.005 × (\$100 million) = \$10 million 0. the value of the contract.5 percent of portfolio value) divided by (r – g). V. at which point investment will decrease and free cash flow will turn positive. is the value as of the end of the first year. taxes.05 CHAPTER 5 Why Net Present Value Leads to Better Investment Decisions Than Other Criteria 29 . the value of the contract is given by the first payment (0. it follows that: P0 ROE × (1 −b) 1−b = = BVPS r − (b ×ROE) (r / RO E) −b Consider three cases: ROE < r ⇒ (P0/BVPS) < 1 ROE = r ⇒ (P0/BVPS) = 1 ROE > r ⇒ (P0/BVPS) > 1 Thus. If investment opportunities are abundant.05 = 5. and positive NPV investments. \$100 million. where do the funds to pay the increasing dividends come from? At some point in time.growth rate = dividend yield = 0. price-to-book equals one.Challenge Questions 1. as ROE increases. There is something of an inconsistency in Practice Question 11 since the dividends are growing at a very high rate initially. This high growth rate suggests the company is investing heavily in its future. Then.

Thus. thereby overcoming the criticism that all cash flows prior to the cutoff date have equal weight.044.10) + 4000 (1. However. b.10) 4 + 1000 = +\$39.10) 4 + 1000 = +\$4. Risky cash flows should be discounted at a higher rate than the rate used to discount less risky cash flows. a. 10) 5 NPV C =− 3000 + 2 + 1000 (1. 3. the firm must still compare the IRR with the 4. book value of assets).73 (1. even with the IRR method.10) 1000 1000 + (1. It is marginally preferable to the regular payback rule because it uses discounted cash flows.47 (1. The discounted payback period is the number of periods a project must last in order to achieve a zero net present value. 2. and often do.10) (1. a. In addition.10) 3 + 1000 (1. Book rate of return uses the accounting definition of income and investment (i. Both of these accounting concepts differ from cash flow measures. c.. Using the payback rule is equivalent to using the NPV rule with a zero discount rate for cash flows before the payback period and an infinite discount rate for cash flows thereafter.e. 30 . decisions based on book rate of return can. the discounted payback period still does not account for cash flows occurring after the cut-off date.Answers to Practice Questions 1.10) 2 NPV B =− 2000 + 1000 1000 + (1. When using the IRR rule. book rate of return does not recognize the time value of money. lead to choices that are unacceptable when analyzed on a net present value basis. one must think about the appropriate discount rate.91 (1 +0 . opportunity cost of capital. N PV A = −1000 + 1000 =− \$90. Hence. PaybackA = 1 year PaybackB = 2 years PaybackC = 4 years A and B. 10) 5 b.10) (1.

00 -3.00 Discount Rate 10% +4.31 1.00 -3.31 500.1%.34 3.82 3.777.005.00% 10.314. As shown in the graph.868.13 +5.000.00 -3.00 2. the company should accept Project A if the discount rate is greater than 10.000.000.00 482. in this case.500. for these discount rates. r= -17.916.44% and 45.00 5. But. the discounted payback rule is slightly better than the regular payback rule.00 Year 3 -4.00 Year 1 3.181.00 4. From the graph.00 3.48 2.65 C1 − 60 C2 − 60 C3 + 140 d.00 -3.00 Year 2 4.00 PV = -0.043.41 4.99 379. 7. fewer long-lived investment projects will make the grade.000.76 -0.800.000.00% 25.02 6.895.06 -2.000.43 -1.00 45. The cash flows for (B – A) are: C0 0 Therefore: 0% +20. 31 . The company should accept Project A if its NPV is positive and higher than that of Project B.00 3.5.1% and IRRB = 11.9% c.560. NPVB-A IRRB-A = 10.78 2.81 -2.024.79 3. that is. the IRR for the incremental investment is less than the opportunity of cost of capital.500.048.7 percent and less than 13.239. we can estimate the IRR of each project from the point where its line crosses the horizontal axis: IRRA = 13.7% and less than 13.000.00 -3. it might actually be worse: with the same cut-off period.00 +40.44% 0.630.27% -3. The figure on the next page was drawn from the following points: 0% +20.00% 15.64 312.33 -18.57 2.00% 20.1 percent.305.00 -7.7% The company should accept Project A if the discount rate is greater than 10.00 -3.304.26 -2.18 20% -8. In general. a.000.06 -4.35 437.67 2.00 -3.000.27%.00% Year 0 -3.000.000.98 NPVA NPVB b.108.409.000.05 20% -10.00 Discount Rate 10% +1. The two IRRs for this project are (approximately): –17. The NPV is positive between these two discount rates.

00 NPV 10.Figure 5.00 0.00 -30.00 -10.00 30.00 20.00 0% 10% Rate of Interest 20% Project A Project B Increment 32 .6 50.00 -20.00 40.

182 =0 . To use the IRR criterion for mutually exclusive projects.000 C3 +650.000 1. c.86 NPV B = − 200 + 2 =\$79.000) = 11. a.000 The IRRs for the incremental flows are approximately 21.09) 2 b.59 20.000) − 20.09) 140 179 + (1. a.87 percent.000 33 .000 +650. Because Project A requires a larger capital outlay.000 + = 8.09) (1. the additional investment in A is worthwhile. 20. NPVA is greater than NPVB for all discount rates less than 10 percent. (In fact. even though longer-term projects might have larger NPVs.09) (1.000 0 -650.000 -550.10 9. NPV is the correct criterion. If the cost of capital is between these rates.000 + 11.13 and 78.10 − ( −20. Hence. 10.000 +900. Titanic should work the extra shift.000 C2 -250. =\$ 81. calculate the IRR for the incremental cash flows: C0 C1 C2 IRR A-B -200 +110 +121 10% Because the IRR for the incremental cash flows exceeds the cost of capital. it is possible that Project A has both a lower IRR and a higher NPV than Project B. NPV A = − 400 + 250 300 + (1.000 PI F = 35. projects with quick paybacks and low investments will be preferred on an IRR basis. The statement is true because more immediate cash flows will be discounted less than cash flows that are further into the future. PI = E −10.82 10.000 1.) Because the goal is to maximize shareholder wealth.818 =0 .10 − ( −10.8. Use incremental analysis: Current arrangement Extra shift Incremental flows C1 -250.000 -300.

34 . If the company accepted all positive NPV projects.000 PI F −E = = =0. Using the fact that Profitability Index = (Net Present Value/Investment).. the best the company can do is to accept Projects 1. 3. A project with an IRR equal to 5.07 6 0. the better project has the lower profitability index.000 + 15.02 3 0. (Note that.000.10 − ( −10. or solving analytically (the easiest way to solve for the IRR is with a spreadsheet program such as Excel). (Alternatively. and so the larger project should be accepted. For the incremental cash flows: −10.000 in terms of its market value.e. Because there are three sign changes in the sequence of cash flows.000) 3. graphical analysis.18 7 0. the project’s NPV is -\$2. we must use incremental analysis. in this case.14 5 0.443 so that the project is not attractive. i. given the budget of \$1 million. the budget limit costs the company \$55. we find that: Project Profitability Index 1 0.) 12. 4.636 10.24 percent. with a discount rate of 14 percent. and 6.36 The increment is thus an acceptable project. accept Project F.22 2 -0. In order to choose between these projects. the market value (compared to the market value under the budget limitation) would increase by the NPV of Project 5 and the NPV of Project 7: (\$7. Using trial and error. Thus.17 4 0. we can say that.000 + \$48. we can show that there is only one IRR. and so both are acceptable projects.b. Both projects have a Profitability Index greater than zero. we know that there can be as many as three internal rates of return.12 Thus.24 percent is not attractive when the opportunity cost of capital is 14 percent.) 13. 5.000) = \$55.000 1.

000xZ ≤ 20.5.000xZ ≤ 20.000xY .000 0 ≤ xW ≤ 1 0 ≤ xX ≤ 1 0 ≤ xZ ≤ 1 35 .1.4.000xX .500xZ 10.000xY .5.000xY + 15.14.000xX + 0XY .5.000xW + 0xX + 10.5. Maximize: subject to: NPV = 6.000xX .700xW + 9.000xZ ≤ 20.000 10.000 0xW .000xW + 20.

57 MIRR = 27. C0 = -3.12)(C 2 ) 2 x = 4.000 + Now.12)(x C2) = C3 (x)[(1. Therefore.500 C2 + PV(C3) = +4. For example: 36 . a.12)(4. A project with all positive cash flows has no IRR.12 )(3.50 0) (1 . However. it is true that the NPV rule does assume that cash flows are reinvested at the opportunity cost of capital. xC1 + xC 2 C3 = 1. We find that MIRR = 23.00 0) 2 C0 + (1 .500 ) + ( 1.Challenge Questions 1.000 = 0.53%.12 1.84% 2. if each project’s cash flows could be invested at that project’s IRR.000 – 3. C0 = -3.45)(3.0.000 C1 = +3.00 0) + =0 (1 + IRR) (1 + IRR) 2 − 3. 3.45)(4.x)C1 (1 . when applied to a project’s cash flows. find MIRR using either trial and error or the IRR function (on a financial calculator or Excel). The IRR is the discount rate which.12)(C2)] = C3 x = C3 (1.571. Thus.500 C2 = +4.000 C3 = -4. it does not represent an opportunity cost.0.000 b.43 = 428. The discount rate used in an NPV calculation is the opportunity cost of capital.122)(x C1) + (1.000 C1 = +3.45 (1. It is not clear that either of these modified IRRs is at all meaningful.x)C 2 + =0 (1 + IRR) (1 + IRR) 2 (1 . these calculations seem to highlight the fact that MIRR really has no economic meaning.12 )(C1) + (1. Rather.12 2 (1. then the NPV of each project would be zero because the IRR would then be the opportunity cost of capital for each project.122)(C1) + (1. yields NPV = 0.

The reason for this result is that project Z provides a positive cash flow in periods 1 and 2. even though the NPV of Project Z is negative.5xB . b.000: Optimized NPV = \$13. xY = 1 and xZ = (2/30) Here.000: Optimized NPV = \$13. xX = (23/30). The constraint in the second period would become: -30xA .75. the shadow price for the constraint at t = 0 is \$50. If the financing available at t = 1 is \$21.5xC + 40xD . xY = 1 and xZ = 0 If the financing available at t = 0 is \$21. the shadow price of an additional \$1.5xC)(1 + r) ≤ 10 The constraint in the first period would become: 10xA + 5xB + 5xC + 0xD + COST OF HIRING & TRAINING ≤ 10 37 . xX = 0.000 increase in financing available at t = 0.900 with xW = 1. Using Excel Spreadsheet Add-in Linear Programming Module: Optimized NPV = \$13. 5.450 with xW = 1.000 in t = 1 financing is \$450.500 with xW = 1.C0 = 100 C1 = 100 C2 = 100 C3 = 100 4. a.5xB . the program viewed xZ as a viable choice. the increase in NPV for a \$1.(10 -10xA . xY = 1 and xZ = 0 Hence. In this case. xX = 0.8.

349 2.35) ≠ 2 2 1. there is no simple adjustment to the discount rate that will resolve the issue of taxes.323 10.757 3. The opportunity cost of the land is its value in its best use. so Mr. Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Net Cash Flows/Nominal -12.250 1. line 8.195 6. See the table below. Table 6.10) rreal = 0. and utilize the following relationship from Chapter 3: Real cash flow = nominal cash flow/(1 + inflation rate)t Here.35) ≠ 1 1.09% As can be seen in the table.751 7.10 1. Unfortunately.804 2. Mathematically: C1 C /(1 − 0. North should consider the \$45. We begin with the cash flows given in the text.484 2.15 and C2 C / (1 − 0. 3. the NPV is unchanged (to within a rounding error).200 3. No.985 5.600 -1.15 2 38 . this is not the correct procedure.600 -1.269 Net Cash Flows/Real -12. the expected inflation rate is 10 percent.09%) = \$3.CHAPTER 6 Making Investment Decisions with the Net Present Value Rule Answers to Practice Questions 1.534 9.20 = (1 + rreal) × (1. the nominal rate is 20 percent.436 4.000 value of the land as an outlay in his NPV analysis of the funeral home.678 NPV of Real Cash Flows (at 9.947 6.10 1.0909 = 9. and the real rate is given by the following: (1 + rnominal) = (1 + rreal) × (1 + inflation rate) 1.6.

127 39 .1152 0. not when cash is received (and costs when incurred.05 1. the value of the tax shield is: 0.35 ×100. and.306 2 3 1.000 = \$16. b.20  1.1152 .1152 0.35) + 1.1152 .08 t [0. so that the after-tax cost is smaller. the value of the tax shield is: .05 4 1.05 If the \$50. Some real flows depend on the inflation rate. then the tax shield is larger. a.0576   .. e. real taxes and real proceeds from collection of receivables.4.810 1. Real discount rates are often estimated by starting with nominal rates and “taking out” inflation.000 is expensed at the end of year 1. Even when capital budgeting calculations are done in real terms.35 ×\$50. then there is no need to also include investment in working capital.20 [0.g.0576  + + + + 2 3 4 5 1.32 0. 5 7.08 1. using the relationship: (1 + rnominal) = (1 + rreal) × (1 + inflation rate) 5.000 = \$3.000 + ∑ t =1 5 26.000 + ∑ t =1 26.08 t NPVB = -Investment + PV(after-tax cash flow) + PV(depreciation tax shield) NPV B = −100. an inflation forecast is still required because: a.667 1.05 1.05 If the cost can be expensed.000 expenditure is capitalized and then depreciated using a five-year MACRS depreciation schedule.05 6   1. NPV A = − 100 . not when cash payment is made).000] ×  + + + + +  = \$15.000 ×(1 −0 .08 1.000 ] × 0.08 1.192 . 6.192 0.05 5 1.08 + 0.08 6   NPVB = -\$4.08 1.35 ×\$50. Investment in working capital arises as a forecasting issue only because accrual accounting recognizes sales when made. If cash flow forecasts recognize the exact timing of the cash flows. If the \$50.32 .

0893 0.620 20.000 + + ]+ = −\$1.000 6.35) 1. b. All operating cash flows occur at the end of the year.000) × (1 −0 .380 5.000 26.900 t=2 t=3 t=4 t=5 t=6 Investment Cash In Depreciation Taxable Income Tax Cash Flow -100.016 2.100 23. way to do the Company B analysis is to first calculate the cash flows at each point in time.’ the two projects have a common chain life of 10 years. d. Note: Since purchasing the lids can be considered a one-year ‘project.15 1.200 11.15 1.000 6.15 t 0.0445 30. and then compute the present value of these cash flows: t=0 100.15 1.0893 + + + + + 1 2 3 4 1.1249 0.35 ×150.15 1.0893 0.800 14.15 10 Thus.50 × 200.000 − ∑ + [ 0.760 -5.000 32. IRRA = 9.328 6 7 8 1.068 28.100 2.000 20.880 1.016 b.520 11.0639 = 0.000) × (1 −0 . perhaps more intuitive. The firm will manufacture widgets for at least 10 years.000 −30. c. 40 .000 19. Assume the following: a.000 ] × [ (1. There will be no inflation or technological change.000 t=1 26.760 -2.100 23.35) = − \$1.932 20.Another.43% IRRB = 6.068 5.127 26. the widget manufacturer should make the lids.000 26. after-tax rate of return.480 -2.15 1.39% Effective tax rate = 1 − 0.0943 8.520 -6.15 1.2449 0.304.000 NPV (at 8%) = -\$4.15 t 10 t = 1 NPV(make) = −150.118.15 1.15 5 0. Compute NPV for each project as follows: NPV(purchase) = − ∑ 10 t = 1 (2 × 200.1429 0.932 5.000 2.2% 0.000 26. The 15 percent cost of capital is appropriate for all cash flows and is a real.1749 0.322 = 32.480 14.

a. 5. 3. Is additional working capital required due to changes in receivables. payables. Taxes 1. 3. Working Capital 1. See comments on ACRS depreciation and interest. If the spare warehouse space will be used now or in the future. 3. Other working capital items. it is not equivalent to the company’s borrowing rate. Charge opportunity cost of the land and building. Depreciation is not a cash flow. 6. ACRS depreciation is fixed in nominal terms. Interest 1. 2 Opportunity cost of building. then the project should be credited with these benefits. 41 . Research and development is a sunk cost. 2. Value the project as if it is all equity-financed. Potential use of warehouse. Research and Development 1. Is “overhead” truly incremental? Depreciation 1. in general. 1. Wages generally increase faster than inflation. More realistic forecasts of revenues and costs. Opportunity cost of capital. Company’s ability to use tax shields. but the ACRS deprecation does affect tax payments. the tax loss should not be carried forward. It is bad practice to deduct interest charges (or other payments to security holders). 4. Will additional inventories be required as volume increases? 2. Are percentage labor costs unaffected by increase in volume in the early years? 2. If Reliable has profits on its remaining business. See comments on ACRS depreciation and interest. 2. Discount rate should reflect project characteristics.? Revenues 1. The real value of the depreciation tax shield is reduced by inflation. Net Cash Flow 1. Capital Expenditure 1. b.9. 2. Revenue forecasts assume prices (and quantities) will be unaffected by competition. Does Reliable expect continuing productivity gains to offset this? Overhead 1. 2. Operating Costs 1. The salvage value at the end of the project should be included. Recovery of inventories at the end of the project should be included. a common and critical mistake. etc.

is equal to 5 percent of revenues in year t. 4. 7. Working Capital: We assume inventory in year t is 9. This is a simplifying and probably inaccurate assumption. Revenues: Sales of 2. The table on the next page shows a sample NPV analysis for the project. i. Operating Costs: We assume direct labor costs decline progressively from \$2. Tax: 35 percent of revenue less costs. 9.e. We also assume that receivables less payables. Other Costs: We assume true incremental costs are 10 percent of revenue. in year t.000 motors in 2001. Depreciation Tax Shield: Based on 35 percent tax rate and 5-year ACRS class.500 per unit in 2000.000 motors thereafter. 42 . 3. not all the investment would fall in the 5-year class. \$2. We assume salvage value of \$3 million in real terms less tax at 35 percent.250 in 2001 and to \$2. The unit price is assumed to decline from \$4. 2.1 percent of expected revenues in year (t + 1). and 10.4 million for warehouse extension (we assume that it is eventually needed or that electric motor project and surplus capacity cannot be used in the interim). Opportunity Cost of Capital: Assumed 20 percent. 6. Capital Expenditure: \$8 million for machinery.850 when competition enters in 2002.000 in real terms in 2002 and after.c. The latter is the figure at which new entrants’ investment in the project would have NPV = 0.. 8. 5.000 (real) to \$2. the factory is currently owned by the company and may already be partially depreciated.000 motors in 2000. The analysis is based on the following assumptions: 1. We assume the company can use tax shields as they arise. Inflation: 10 percent per year. \$5 million for market value of factory. Also. to \$2. 4.

Practice Question 9 1999 Capital Expenditure Changes in Working Capital Inventories Receivables – Payables Depreciation Tax Shield Revenues Operating Costs Other costs Tax Net Cash Flow (16.049) (3.690) (528) 1.038 67.202 (47.754 (345) (929) 1.128 2006 2007 2008 2009 5.991 (459) (229) 310 50.287) 3.201) (801) (961) (440) 1.725 19.934 (380) (190) 621 41.632) 4.159) (6.109) (4.058 2010 (505) (252) (556) (278) (612) (306) 6.431) (5.720) (4.895) 5.428 2005 Capital Expenditure Changes in Working Capital Inventories Receivables – Payables Depreciation Tax Shield Revenues Operating Costs Other costs Tax Net Cash Flow NPV (at 20%) = \$5.909 (15.872) (6.078 8.489 (35.936) (2.742 73.538 (38.239) 7.035 37.129) 20.900 (32.650 (4.554) (3.696 55.875) (7.620) (29.282) (3.360 (10.210) (4.854) 6.890) (1.250 (1.173) (2.922 (51.663) 7.727 (418) (209) 621 45.500) (880) (847) 1.793) (2.727 (336) 3.974) (5.503) 6.185) 5.800 (5.590) (3.975 3.400) 2000 2001 2002 2003 2004 (26.092 (42.696 43 .392) (5.399 61.

0 -1.0 15.200.0 -1.0 7.000.200.2.200.105.0 -1.683. See the table on the next page.8 273.0 -1.10.0 104.5 5. the NPV of the tax payments is \$5.779.5 -526.0 7.8 95.2 23.3 76.0 7.6 in the text.8 120.0 120.630.0 234.5 294.8 486. based on different assumptions.5 12.83%) = \$10.5 5.200.0 3.0 4.0 4.0 \$85.4 562.5 Net Cash Flow -35.5 285. With tax losses carried forward.318.909.5 5.2 0.969.4 5.550.5 4.1 70.0 120.410.7 103.0 350.0 120.8 85.0 1.0 -1.6 463.200.4 5.862.410.064.C.09 = (1 + rreal) × (1.200. With full usage of the tax losses.83% t=0 t=1 t=2 t=3 t=4 t=5 t=6 t=7 t=8 Investment -35.0 285. 44 .5 -526. with tax losses carried forward.594.1 298.7 126.0 217.683.410.0 5. The NPV is computed using the real rate.200.3 261.8 82.0 4.683.8 1. Thus.683.4 t=1 t=2 t=3 t=4 t=5 t=6 t=7 t=8 4.5 20. t=0 Sales Manufacturing Costs Depreciation Rent Earnings Before Taxes Taxes Cash Flow Operations Working Capital Increase in W.7 273.5 79.5 NPV (at 5.5 5.8 3.0 -1.8 180.200.741.375.0 Insurance -1.0 120.5 4. the project’s NPV decreases by \$962.824.0 120.3 5.410.3 339.2 112.247.683.6 200. Note: There are several different calculations of pre-tax profit and taxes given in Section 6. which is computed as follows: (1 + rnominal) = (1 + rreal) × (1 + inflation rate) 1.5 -526.0 240.410.0 110.200.6 4.5 -526.1 273.4 70.0 121.0 Savings 7.410.8 1.8 298.0 420.5 131.360.0 67.0 70.0 108.065.780.0583 = 5. The table below shows the real cash flows. so that the value to the company of using the deductions immediately is \$962.410.683.683.0 120.0 -562.1 5.0 65. Rent (after tax) Initial Investment Sale of Plant Tax on Sale Net Cash Flow NPV(at 12%) = 350.2 73.0 76.1 22.0 120.1 441.0 7.5 5.410.0 7.410.2 88.200.0 240. the solution below is based on Table 6.0 100.84 536.7 118.0 5.628.0 56.9 11.5 -526.0 Fuel -526.683.1 250.8 4.6 261.0 7.5 -526.8 180.9 253.0 -1.247.6 250.5 5.0 21.5 510.0 -1.5 117.0 7.0 400.4 316.000.6 5.5 -526.8 26.5 24.000.03) rreal = 0.0 82.0 25.167. the NPV of the tax payments is \$4.

12 1. 9.7 11.Pretax Profit Full usage of tax losses Immediately (Table 6.8 4.939 1.605] EAC1 = -26.2 -2.) Alternative 1 – Sell the new machine: If we sell the new machine.0 0.9 25.9 4.0%) = \$15.12 1.1 11. 12%] -93. In order to solve this problem.12 1.432 714 5.9 14. pay taxes on the gain.8 NPV (at 11.9 12.949 682 682 13.807 16.939 t=7 1. Working capital Change in W.80 = EAC1 × [3.400 \$4. Depreciation 12.8 35.741 t=1 -4.000 -1. The present value of this alternative is: PV1 = 50 −[0 .80 5 1.9 3. and pay the costs associated with keeping the old machine.0 11.7 17.053 t=6 5.6 3.053 4.2 7.9 -0.539 1.9 21.0 0.6) NPV at 20% Tax loss carry-forward NPV (at 20%) = t=0 -4. we calculate the equivalent annual cost for each of the two alternatives.2 14.12 1.7 11. or an equivalent annual cost of \$26.020 45 .02.6 11.) 1. 5 time periods.0 -2.3 -1. Capital investment 4.6 t=4 5.0 37.3 28.60 t=0 83.514 -1.5 2.12 5 The equivalent annual cost for the five-year period is computed as follows: PV1 = EAC1 × [annuity factor.940 262 0 3.9 t=8 -12.579 4.8.C.12 1.3 t=7 0.929 t=5 11. (All cash flows are in thousands.5 15.3 t=5 3. Profit after tax Cash Flow -85.9 -5.9 7.9 1.35 (5 − 0) − = −\$93.3 t=6 2.6 t=3 6.1 11.5 -0.5 11.4 2.929 5.779 0 \$5. (Note: Row numbers in the table below refer to the rows in Table 6.12 5 + 5 0.0 t=2 7.2 11.3 t=1 4.35(50 − 0)] − 20 − 30 30 30 30 30 − − − − 2 3 4 1. we receive the cash flow from the sale.580 0 Tax Cash Flows t=2 t=3 t=4 748 9.

000 (-2. whenever the machines have to be replaced.35 × .51 10 1.12 1. Using the annuity factor for 6 time periods at 7 percent (4.12 1.000) -2. the least expensive alternative is to sell the old machine because this alternative has the lowest equivalent annual cost.35 × . the replacement will be a machine that is as efficient to operate as the new machine being replaced.000) -8.65) + (. 12%] -127.12 1.65) + (. One key assumption underlying this result is that.57.35(25 − 0)] − − 20 20 20 20 20 − − − − 2 3 4 1.000 (-8.000 (-8.570 Thus. 15.0893 × 20.650] EAC2 = -22.200.35 × . we receive the cash flow from the sale.000 (-2.000 × .5 -5.000 (-8.12 10 + 5 0 .35 (5 − 0) − = −\$127.574.0 -5.767). 10 time periods.51 = EAC2 × [5.000 × . of -\$15. or an equivalent annual cost of \$22. The current copiers have net cost cash flows as follows: BeforeTax Cash Flow After-Tax Cash Flow -2. and pay the costs associated with keeping the new machine.12 1.0893 × 20.12 1.12 1.0445 × 20.000 × .9 -4.000) -8.000 (-8.000 × .65) + (.65) + (. discounted at 7 percent.000 × .65) Net Cash Flow -674.65) -8.12 1.Alternative 2 – Sell the old machine: If we sell the old machine.0 Year 1 2 3 4 5 6 These cash flows have a present value.0893 × 20.9 -674.12 5 20 30 30 30 30 30 − − − − − 5 6 7 8 9 1. pay taxes on the gain.35 × .857.12 1.888.200.9 -4. The present value of this alternative is: PV 2 = 25 − [0.12 1. we find an 46 .12 1.000) -8.000 × .12 10 The equivalent annual cost for the ten-year period is computed as follows: PV2 = EAC2 × [annuity factor.

326.equivalent annual cost of \$3. 47 . the copiers should be replaced only when the equivalent annual cost of the replacements is less than \$3. Therefore.326.

2449 × 25. The book (depreciated) value of the existing copiers is now \$6. If the existing copiers are replaced now.1749 × 25.582 Using the annuity factor for 8 time periods at 7 percent (5. discounted at 7 percent.65) + (.000.506.000 × .35 × . we find that the equivalent annual cost is \$2.65) + (. we find that the equivalent annual cost is \$2.000 (-1.676)]}/1.0 880.1249 × 25.000) -1.072) + {3.000 (-1.000 × .9/1.0 443.000 × .0893 × 25. Two years from now.000 × .072 = -\$17.35 × .072) + (-21.0 1.500 – 2.000) -1.35 × .9/1.000) -1.969.000) -1.35 × .493. 48 .When purchased.0 -261.35 × . then the present value of the cash flows is: (-674.000 -25.65) + (.442.000) -1. then the present value of the cash flows is: -21.65) + (. of -\$21.35 × .35 × (3.000) -1.969/1.000 × . Consider three cases: a.0 Year 0 1 2 3 4 5 6 7 8 These cash flows have a present value. b.0 600.0 131.0 131.000 (-1.65) + (.65) + (.000 (-1.0445 × 25.000 -1.000 (-1.604 Using the annuity factor for 10 time periods at 7 percent (7.000 (-1.000) -1.248)] = -\$14.0893 × 25.024).000 (-1.676.000 × . If the existing copiers are replaced two years from now.000 – [0.65) + (.071) + (-674.000 – 6.35 × .000 × .000 × .000 (-1. the book (depreciated) value of the existing copiers will be \$2.0893 × 25.35 × . the new copiers will have net cost cash flows as follows: BeforeTax Cash Flow After-Tax Cash Flow -25.500 – [0.35 × (8. as well as the associated tax on the resulting gain (or loss).0 131.000) Net Cash Flow -25.1429 × 25.248.971). The decision to replace must also take into account the resale value of the machine.65) + (.969 + 8.

57 milliion/11. then the present value of the cash flows is: -15. 16.55% 3.00 57.22 5.2 54.3 million – \$9.55% 6.40% 11. we find that the equivalent annual cost is \$3. Six years from now. if we cut in year 8.22 10.47 million/900 million gallons = \$0.0272 per gallon The pre-tax charge = \$0.1 112. The extra cost per gallon (after tax) is: \$24.487.29% Percent MACRS 40.08 22.3 94.076) = -\$30.2 56.55% 6.65 = \$0.0272/0.1 49 .4 Year 9 Year 5 97. a. Therefore.60 28.4 97.3 52.496 Using the annuity factor for 14 time periods at 7 percent (8.8 60. Tax 15.52% 9. The table below shows that PV is maximized if you cut in year 8.88 29.7 58.969/1.20 26.2 101. it must pay to cut by that time.3 92.50 10.00% 18.55% 6.20 26.6 Year 8 Year 4 84.13 Shield Present Value (at 7%) = \$114. both the book value and the resale value of the existing copiers will be zero.97 14.654 = \$9.08 36.5 143.0418 per gallon 17.8 158.16 Depr.745).48 26.60 46.2 126.900 = \$30.22 10.83 million = \$24.22 10.00% 14.00 72. The copiers should be replaced immediately.20 13.c.20 26.000 – 109. the NPV of the offer is: \$140. If the existing copiers are replaced six years from now.57 million The equivalent annual cost of the depreciation tax shield is computed by dividing the present value of the tax shield by the annuity factor for 25 years at 7%: Equivalent annual cost = \$114.6 103.100 Future Value: Present Value: Timber Land Total Year 1 48.37% 6.857+ (-21.83 million The equivalent annual cost of the capital investment is: \$34.47 million b.22% 7. Since the growth in value of both timber and land is less than the cost of capital after year 8.5 Year 7 Year 3 70.0 100.38 11.46 17. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 MACRS 10.0 Year 6 Year 2 58.

9 109.7 71.1 130.9 63.7 50 .4 218.9 107.Future Value: Present Value: Timber Land Total 112.3 65.2 233.9 162.2 105.3 150.3 176.1 107.8 196.5 68.

08) = \$26. Annual rental is \$24.06 1.000 10.000 + 9.964 × 1.673 EACA = \$24.249 + + + 1. Borstal should buy Machine B. 3 time periods] 66. a.06 2 1.000 + + + 1.290 + + 1.613 (Note that this is a cost.200 6. rent for the second year would be (\$24.06 1.820 (Note that this is a cost. 4 time periods] 77.06 3 PVA = \$61. for Machine A.000 + 8.430 per year rental b.465 EACB = \$22.721 = EACB × 3. rent for the first year would be \$24.730 = EACA × 2.) PVB = 50.000 8.) 51 .000 + 10.964 per year rental PVB = EACB × [annuity factor. etc.721 (Note that this is a cost. 19.18.06 2 1. Because the cost of a new machine now decreases by 10 percent per year.832 5. 6%.000 8.06 3 1.06 1.000 10. 6%.964 for Machine A and \$22. c.964.) Equivalent annual cost (EAC) is found by: PVA = EACA × [annuity factor. Therefore: PVA = 40. PVA = 40. For example.100 7.06 4 PVB = \$77.) PVB = 50.06 3 1.000 8. The payments would increase by 8 percent per year.730 (Note that this is a cost.06 2 1.000 + + 1.06 2 1.480 5.961. the rent on such a machine also decreases by 10 percent per year.430 for Machine B.06 4 PVB = \$71.000 + 7.000 8.06 1.06 3 PVA = \$66.

35% PVB = EACB × [annuity factor.000 = \$206.100.673 EACA = \$23.Equivalent annual cost (EAC) is found as follows: PVA = EACA × [annuity factor.623) = \$237.941/1.86% 20. 6%. 6%. a reduction of 7.820 = EACA × 2.941 in year 4. 52 .613 = EACB × 3. the equivalent annual cost (at 8 percent) of a new jet is: (\$1.168 1. a reduction of 7. the company will incur an incremental cost of \$237.941. With a 6-year life.08 t The president should allow wider use of the present jet because the present value of the savings is greater than the present value of the cost.128. The present value of this cost is: \$237.084 = \$174.668.465 EACB = \$20. 3 time periods] 61. 4 time periods] 71.000/4. If the jet is replaced at the end of year 3 rather than year 4.894 The present value of the savings is: ∑ t =1 3 80.

0 IRR = 26. if the up-front investment is deductible for tax purposes. the numerator decreases and the effective tax rate decreases.136.5% Year 2 3.381. the nominal annuity is: (\$21.0 b. Therefore. while after tax cash flows increase at a slower rate. the annuity factor (using the annuity formula from Chapter 3) is 2.7057) = \$12.37.000.Challenge Questions 1. After tax cash flows increase at a slower rate than the inflation rate because depreciation expense does not increase with inflation.630.06) × (1 + 0. is determined as follows: (1 + r) = (1 + 0.600.0 6.0 2. a. If the inflation rate increases.064. we would expect pretax cash flows to increase at the inflation rate. but it increases the after-tax IRR. r.05) r = 0.0 -1.0 IRR = 33.038.3% Post-Tax Flows -12. the nominal annuity is: (\$28.4310) = \$11.0 Year 7 3. For a three-year annuity with a present value of \$28.0 Year 3 Year 4 Year 5 Year 6 9. for a two-year annuity. the annuity factor is 1.0 6.3% For a three-year annuity at 11. Therefore. c.755.8% Effective Tax Rate = 19.444.0 3.3 percent.110.67 For a two-year annuity with a present value of \$21.113 = 11. the numerator of TE becomes proportionately larger than the denominator and the effective tax rate increases.00.00/1.37/2. then the effective tax rate is equal to the statutory tax rate.463. Year 0 Year 1 Pre-Tax Flows -14.4310. If the depreciation rate is accelerated.0 14.0 16.0 -3. this has no effect on the pretax IRR.0 10. a.685.0 7.7057.205. With a real rate of 6 percent and an inflation rate of 5 percent. 2.696. C C(1 −TC ) −  C C  I(1 −TC )  I(1 −TC ) I(1 −TC ) TE = = −   = 1 − (1 − TC ) = TC C I  C  I(1 −TC ) I(1 −TC ) Hence.0 10.209. the nominal rate.31 53 .444.

2.25) r = 0. Since the cash flows are relatively safe. With inflation at 25 percent. The depreciation method remains constant. a. and hence. they should probably be discounted at an after-tax borrowing or lending rate. b.3243. However.67 compared to \$12.00/1. the warning in the text to do these calculations in real terms. The tax rate remains constant.37/1.37.325 = 32.. the annuity factor is 1.684. the annuity factor (using the annuity formula from Chapter 3) is 1. it may also be disadvantageous because several assumptions are made here.06) × (1 + 0.426. 3. Machine A) is affected more. Machine A has the lower nominal annual cost (\$11. The cash outflow in Period 0 becomes -\$10.86 With an inflation rate of 5 percent. Thus it is clear that inflation has a significant impact on the calculation of equivalent annual cost. 3. the equivalent annual cost) must take into account the effects of inflation. c. the nominal annuity is: (\$28. The format is advantageous since it recognizes additional cash flows created by the tax-deductibility of depreciation.5% For a three-year annuity at 32. the machine with the longer life (here. the nominal rate.7542.These nominal annuities are not realistic estimates of equivalent annual costs because the appropriate rental cost (i.000 and NPV = \$5. We are assuming: 1.00.17). the nominal annuity is: (\$21. For a three-year annuity with a present value of \$28. at the higher inflation rate. The rankings change because. The company’s ability to generate taxable income continues so the tax shield can be used. With a real rate of 6 percent and an inflation rate of 25 percent.e. is determined as follows: (1 + r) = (1 + 0. The discount rate for the other cash flows should not change since it must represent the opportunity cost of funds in a project of similar risk.693. r. b. Machine B has the lower nominal annual cost (\$15.3243) = \$15.17 For a two-year annuity with a present value of \$21.31).86 compared to \$16. for a two-year annuity.7542) = \$16. 54 .5 percent.

the average risk premium was 14. 55 .2% 31. The risk premium for each year was: 1996: 1997: 1998: 1999: 2000: 17. Return.1 2 2 2 +(0 3 .1 a.142) ]  1 σ 2 =   ×[ 0.6% 17.8% -12.1 9   +(0 8 −0 4 ) .142) +( − 0.1 2 2  1  σ 2 = 5 −1× (0 7  [ . Recall from Chapter 3 that: (1 + rnominal) = (1 + rreal) × (1 + inflation rate) Therefore: rreal = (1 + rnominal)/(1 + inflation rate) .2% 26.2 1 .170 = 17.1% From the results for Part (a). 19. e. c.163 −0. the average real return was 16.0% d. The standard deviation (σ ) of the risk premium is calculated as follows: −0 4 ) . From the results for Part (c).5 percent.7% 16.0% 3.02886 4 σ = 0.2 percent.150 −0.1% 23.115420 ] = 0. answers will vary.2 7 −0 4 ) .1 2 2 2 + (0. Internet exercise. and the Opportunity Cost of Capital Answers to Practice Questions 2.CHAPTER 7 Introduction to Risk.3% -15. The real return on the S&P 500 in each year was: 1996: 1997: 1998: 1999: 2000: b.9% 28.

If returns are random. this is not true. Thus. Also. To the extent that the investor is interested in the variation of possible future outcomes. Lonesome Gulch is the safer investment for a diversified investor because its beta (+0. but we have no information regarding the horse’s market risk. The risk to Hippique shareholders depends on the market risk. then the greater the period-by-period variability. For a diversified investor. using a 10-year average is likely to be misleading. 6. 5. 7. the payments are all in nominal dollars. of the investment in the black stallion. the speaker does not have a valid point as long as the distribution of returns is symmetric.10) is lower than the beta of Amalgamated Copper (+0. A long-term United States government bond is always absolutely safe in terms of the dollars received.66). then stocks are generally not preferred. 4. one of which is the investment time horizon. Unfortunately.3. So. So. the comment seems to imply that any rise to \$20 or fall to \$10 will inevitably be reversed. In the context of a well-diversified portfolio. This is a complicated issue and depends on numerous factors. of course. it makes no difference whether we look at the total spread of returns or simply the spread of unexpectedly low returns. the standard deviations are irrelevant. b. but it is also true that stocks have a higher standard deviation of return. However. so inflation risk must also be considered. a. the greater the variation of possible future outcomes. This contribution is measured by beta. a. The information given in the problem suggests that the horse has very high unique risk. which investment is preferable depends on the amount of risk one is willing to tolerate. or beta. and thus this investment is not a particularly risky one for Hippique shareholders. the price of the bond fluctuates as interest rates change and the rate at which coupon payments can be invested also changes as interest rates change. It is true that stocks offer higher long-run rates of return than bonds. c. Thus. If the distribution of returns is symmetric. 56 . 10 years is not generally considered a sufficient amount of time for estimating average rates of return. the only risk characteristic of a single security that matters is the security’s contribution to the overall portfolio risk. the best estimate is that this horse has a market risk about equal to that of other racehorses. risk is indeed variability. If the investor has a short time horizon. And.

10 σ J = 0.40 a.40) (0. 40)(0)(0. Refer to Figure 7.60) (0.60)(0.60)(0. the box is 100 by 100. ρij =0 σp 2 = [ xI 2 2 σI 2 2 + σJ xJ 2 2 2 + 2 ( x I x JρI σ Iσ J ) ] J =[ (0. ρIJ =1 σ p =[ xI σI +x J σ J +2(x I x JρIJ σ Iσ J )] =[ (0.60) 2 2 2 2 2 2 (0. However.40) 2 (0.20) 2 +2(0. a.0196 b. Therefore. the risks that are not measured by beta are the risks that can be diversified away by the investor so that they are not relevant for investment decisions.10) +( 0. it is often helpful to analyze past returns.60 xJ = 0. 40)(1)(0. d.20 c.50)( 0. The variance terms are the diagonal terms. we must allow for this in our estimation. portfolios that minimize the standard deviation for any level of expected return also minimize the probability of loss. If they are liable to change.20) ] = 0.e. Given the expected return. ρIJ =0 0 .10)(0.60)(0. The rest are the covariance terms. With 100 securities. In order to estimate beta. When we do this.5 σp 2 = [ xI 2 2 σI 2 2 + σJ xJ 2 2 2 + 2 ( x I x JρI σ Iσ J ) ] J =[ (0. xI = 0.1 0)(0. and thus there are 100 variance terms. But this does not affect the idea that some risks cannot be diversified away. we are indeed assuming betas do not change. Because the box has (100 times 100) terms altogether..1 0)(0. This is discussed more fully in later chapters of the text.0148 c. 8.10) 2 +( 0. plant manager mortality or changes in costs. Beta is the sensitivity of an investment’s returns to market returns.100 = 9.900 Half of these terms (i.b. the number of covariance terms is: 1002 .20 ) ] = 0.20) 2 +2(0.20) ] = 0.40) (0. the probability of loss increases with the standard deviation.60) (0.950) are different. such as unexpected changes in demand.10 in the text.20) 2 +2(0. A stock’s variability may be due to many uncertainties. σ I = 0. 40)(0.10) +( 0.0100 9. 57 . 4.

036 Standard deviation = 0.104000 The results are summarized in the second and third columns of the table on the next page.4).160000 b. the diagonal terms are the same.4)] = 0.4)(0.30)2 + [(50)2 .02).3) (0. With 50 stocks.4) As n increases.n)(1/n)2(0.30).190 = 19.048 58 .30. and the off-diagonal terms are the same.4) = 0.02)2(0. Variance = 1(1)2(0. Once again.4)(0.50](0.3)(0. for each portfolio. Refer to Figure 7.4) For one share: For two shares: Variance = 2(0.3)(0.4)2 + 2(0. (Graphs are on the next page. all with the same standard deviation (0.10 in the text. so that the underlying market risk is: [(0.30)(0.0371 Standard deviation = 0.193 = 19.4)2 + 0 = 0.5)2(0. we have: Variance = n(1/n)2(0.0% 10.4)2 + (n2 .5)2(0. it is easiest to think of this in terms of Figure 7.10.4)(0.30)2 =0. There are n diagonal terms and (n2 – n) off-diagonal terms. Thus. the same weight in the portfolio (0.n)(1/n)2] = [(n-1)/n] becomes close to 1. and all pairs having the same correlation coefficient (0.n)(1/n)2(0.02)2(0. For each different portfolio.30)(0. For a completely diversified portfolio.40) = 0. portfolio variance equals the average covariance: Variance = (0. the portfolio variance is: Variance = 50(0. the standard deviation of each share is 0.) The underlying market risk that can not be diversified away is the second term in the formula for variance above: Underlying market risk = (n2 .4)(0. and the correlation between pairs is 0.3% c. [(n2 .40. In general.4)(0.b. the relative weight of each share is [one divided by the number of shares (n) in the portfolio]. a.3)(0.

032000 .062000 .3 0.253 .4 0.085333 .126 Graphs for Part (a): Portfolio Variance 0.400 .022857 .292 .2 0.200 .064000 .c.1 0. The results are summarized in the fourth and fifth columns of the table below.231 .059200 (a) Standard Deviation . of Shares 1 2 3 4 5 6 7 8 9 10 Variance .1 0 0 Portfolio Standard Deviation 2 4 6 8 10 12 Number of Securities 59 .2 0.05 0 0 2 4 6 8 10 12 Number of Securities 0.05 0 0 2 4 6 8 10 12 Number of Securities 0.258 .3 0.104000 .2 Standard Deviation 0.249 .243 (c) Variance .053333 .141 .265 .5 0. except that all the off-diagonal terms are now equal to zero. (a) No.080000 .133 .017778 .15 Variance 0.15 Variance 0.070400 .1 0 0 Portfolio Standard Deviation 2 4 6 8 10 12 Number of Securities Graphs for Part (c): Portfolio Variance 0.160000 .246 . This is the same as Part (a).076000 .160000 .1 0.283 .016000 (c) Standard Deviation .060444 .040000 .400 .276 .026667 .5 0.151 .2 Standard Deviation 0.179 .322 .066667 .163 .020000 .4 0.

2) (0.096994 In general.32)(0. Thus. this means lowest variance of return. Nσ BP σ N +x KLM x NρKLM. answers will vary depending on time period.041666 0.4 xKLM = 0. The safest attainable portfolio is comprised of Alcan and Nestle. Internet exercise.4 xN = 0.4) B P 2 2 2 2 2 2 2 2 x KLM ρBP.220 13. Internet exercise. Stocks Alcan & BP Alcan & Deutsche Alcan & KLM Alcan & LVMH Alcan & Nestle Alcan & Sony 15. then the expected change is +1.048561 (0.25 percent. 60 .2)(0. we calculate the portfolio variance for six different portfolios to see which is the lowest.2) ] = 0.095842 0. Nσ KLM σ N )] (0.197) 2 + 48)(0.248) 2 +(0. KLM σ BP σ KLM +x BP x NρBP.082871 0.396 ) + (0.2) 2 (0.25 implies that.2 (0. and half of the portfolio must be invested in one of the other securities listed.4) 2 (0. in a portfolio context.11.197) σ p = 0. Portfolio Variance 0.396) 2 +(0. if the market rises by an extra 5 percent.23)(0. 248)(0. 4)(0. Half of the portfolio is invested in Alcan stock.2 σp = xBP σ BP + x KLM σ KLM + xN σ N + 2 [(x = (0.25 percent. we expect a stock’s price to change by an amount equal to (beta × change in the market).4)(0. Beta equal to -0.4)(0. xBP = 0.082431 0.3 96)(0. 12.4)(0. answers will vary depending on time period.197) + 2[(0. If the market declines an extra 5 percent.057852 0. the expected change is -1. 14. “Safest” means lowest risk. a.

b. The largest reduction in beta is achieved by investing the \$20. then the variance of the market portfolio’s return is 20 squared. Further. Thus: β Z 16. the standard deviation of portfolio return is equal to the portfolio beta times the market portfolio standard deviation: Standard deviation = 2 × 20% = 40% c. For a fully diversified portfolio. By definition. the portfolio beta is approximately one. 61 . d. “Safest” implies lowest risk. If the standard deviation of the market portfolio’s return is 20 percent. the average beta of all stocks is one.000 in a stock with a negative beta. Assuming the well-diversified portfolio is invested in typical securities. a. Answer (iii) is correct. = 800/400 = 2. Diversification by corporations does not benefit shareholders because shareholders can easily diversify their portfolios by buying stock in many different companies.0 b. or 400. The extra return we would expect is equal to (beta × the extra return on the market portfolio): Extra return = 2 × 5% = 10% 17. we know that a stock’s beta is equal to: the covariance of the stock’s returns with the market divided by the variance of the market return.

the risk is twice that found in Part (a) when the investor is investing only his own money: Standard deviation = 2 × 51.4% d.5072)+2(0.66)(0.21 × 15%) = 33. zero standard deviation.5)(0.627)(0.5% Another way to think of this portfolio is that it is comprised of one-third T-Bills and two-thirds a portfolio which is half Dell and half Microsoft. 62 .26745 P Standard deviation = σ = 0. a. T-bills.11887 P Standard deviation = σ = 0. it is: (1. Thus. For stocks like Microsoft.517) = 0. the portfolio standard deviation is twothirds of the standard deviation computed in Part (a) above: Standard deviation = (2/3)(0.5)(0.517 = 51. and hence the portfolio standard deviation depends almost entirely on the average covariance of the securities in the portfolio (measured by beta) and on the standard deviation of the market portfolio.6272)+(1/3)2(0.345 = 34. With 100 stocks. In general: Portfolio variance = σ Thus: σ σ b.Challenge Questions 1. for a portfolio made up of 100 stocks.507) = 0. Thus.5072)+2(1/3)(1/3)(0.10 in the text.627)(0.66)(0.15%.5% c. One of these securities.345 = 34. the investor invests twice as much money in the portfolio as he had to begin with. With 50 percent margin.7% We can think of this in terms of Figure 7.81 × 15%) = 27. with three securities. hence. the portfolio is well diversified. the portfolio standard deviation is approximately: (2. P P 2 2 P 2 = x12σ 1 2 + x22σ 2 2 + 2x1x2ρ 12 σ 1σ 2 = (0.52)(0.21.7% = 103. Thus: σ σ P P 2 2 = (1/3)2(0.507) = 0.52)(0. each with beta = 2.6272)+(0.15%. Because the risk of T-bills is zero. has zero risk and.

05 Standard Deviation 0.8 0.2 0.111 0.2.145 Std. Deviation 0 0.85) Portfolio expected return = 0.8 1.25 63 .200 Portfolio Return & Risk 0.15 s s s s s 0.128 0.094 0.1 0.145x2 Portfolio 1 2 3 4 5 6 X1 1.4 0.120 0.06) + x2 (0.20)2 Standard deviation = 0.040 0.2 0.160 0.15 0. Return 0.6 0. Therefore: Portfolio variance = x22σ 22 = x22(0.06 + 0.0 Exp.20 x2 Portfolio expected return = x1 (0.06x1 + 0.2 Expected R eturn s 0.1 0.2 0 X2 0 0. then σ 1 is zero.05 0 0 0.6 0.0 0.4 0. σ 2 is 20 percent.080 0.060 0. For a two-security portfolio.077 0. the formula for portfolio risk is: Portfolio variance = x12σ 1 2 + x22σ 2 2 + 2x1x2ρ ρ 12 σ 1σ 2 If security one is Treasury bills and security two is the market portfolio.

3)(0. a. we must solve the following portfolio variance equation for n: n(1/n)2(0. The second measure indicates the potential reduction in the number of securities in a portfolio while retaining the current portfolio’s risk.n)(1/n)2(0.1)(0.202 squared.4)(0. the use of average historical data does not necessarily reflect current or expected conditions.4)2 + (n2 .14 shares.2)(0. we know that the standard deviation of a well-diversified portfolio of common stocks (using history as our guide) is about 20.1)2(0. Unfortunately.3.4)(0.3)(0.3)(0.4)] + 24[(0. or 0. The variance of our portfolio is given by (see Figure 7. Internet exercise. The first measure provides an estimate of the amount of risk that can still be diversified away. the number of shares in a portfolio that has the same risk as our portfolio.4)2] + 6[(0. 5.4)2] + 2[(0.4)] + 30[(0. the variance of portfolio returns is 0. this measure does not indicate the amount of risk that can yet be diversified away.3)(0.4) = 0.641 b. In order to find n. the ratio is approximately one.040804 for a well-diversified portfolio.2)(0.4)(0.063680 Solving this equation.4)(0.063680) = 0.1)(0.2 percent. answers will vary. However. the proportion is (0. Hence.2)(0. From the text. With a fully diversified portfolio.2)2(0. 4.063680 Thus.4)] = 0. Internet exercise.10): Variance = 2[(0. answers will vary. 64 . with equal investments in each typical share.040804/0.1)(0. we find that n = 7.

0 0.13 0.7 0.16 0.585 σ p1 when ρ = -1 0.135 0.CHAPTER 8 Risk and Return Answers to Practice Questions 1.10 σ 1 = 0.7 0.2 0.10 0.6 0.14 0.225 0.1 0. e.18 0.315 0.045 0. False – the beta will be: (1/3)× (0) + (2/3)× (1) = 0.315 0.531 0.5 0.9 0. d.225 0.9 0. we know that for a two-security portfolio: = x12σ 2 1 + 2x1x2σ 1σ 2ρ 12 + x22σ 2 2 Therefore.315 0.369 0.12 0.11 0. security one is Coca-Cola and security two is Reebok.405 0.396 0. c.20 rp = x1r1 + x2r2 σ p 2 σ 2 = 0.17 0. False – investors demand higher expected rates of return on stocks with more nondiversifiable risk.585 65 . True.4 0.5 0.477 0.045 0.423 0.15 0.527 0.4 0. a.450 0.20 σ p1 when ρ = 0 0.332 0. In the following solution. b.495 0.420 0.3 0.0 rp 0.373 0.135 0.342 0. 2. False – a security with a beta of zero will offer the risk-free rate of return.0 0.67 True.8 0.3 0.301 0.585 Further.315 0.289 0.8 0.315 r2 = 0. we have the following results: x1 1.278 0.19 0.504 0.282 0.558 0.585 σ p1 when ρ = 1 0.472 0.6 0. Then: r1 = 0.0 x2 0.2 0.1 0.

0% 0.0% 10.0% 80.0% 60.0% 0.0% 5.0% 10.0% Expected Return 20.0% 5.0% 20.0% 40.0% 80.0% 0.Correlation = 0 25.0% Standard Deviation Correlation = -1 25.0% 80.0% 0.0% 20.0% 60.0% 0.0% 40.0% 0.0% 15.0% 60.0% 40.0% 10.0% 5.0% Expected Return 20.0% Expected Return 20.0% 20.0% 15.0% Standard Deviation 66 .0% Standard Deviation Correlation = 1 25.0% 15.

6)2 × (20)2 + (0.1   0. The portfolio has a higher expected return and a lower standard deviation. His portfolio is better. and so Mr.3.15  0.0 11.0 σ 5. From the diagram.05   Expected Return 0 0 0.4)(0. a. 0. 67 .1% b. the optimal portfolio of risky assets is portfolio 1.9% Correlation coefficient = -0. The five points are the three portfolios from Part (a) plus the two following two portfolios: one consists of 100% invested in X and the other consists of 100% invested in Y. a. Expected return = (0. r 10.5 ⇒ Standard deviation = 10.-+ c. Harrywitz should invest 50 percent in X and 50 percent in Y.02 0. The set of portfolios is represented by the curved line.04 0.6 × 15) + (0.08 0.6 6. See the figure below. Portfolio 1 2 3 b.4)2 × (22)2 + 2(0.8% c.5)(20)(22) = 327 Standard deviation = (327)(1/2) = 18. The best opportunities lie along the straight line. Correlation coefficient = 0 ⇒ Standard deviation = 14.0% 9.1% 4.4 × 20) = 17% Variance = (0.06 0.6)(0.4 See the figure below.1 Standard Deviation 4.

a. answers will vary.5 2 b. Internet exercise. Internet exercise.4% The opportunity cost of capital is 10.04)] = 0. answers will vary depending on time period.104 = 10. Market risk premium = rm .8 percent.0.04)] = 0.0.112 = 0.rf) 0. Internet exercise. 7.0. we can find the opportunity cost of capital using the security market line. For any investment.rf) r = 0. With β = 0. Therefore.04 + [0. the investment has a negative NPV.08 = 8.12 .0% Use the security market line: r = rf + β (rm . we use the security market line: r = rf + β (rm . answers will vary depending on time period.9 8.12 .5.12 . 6.4 percent and the investment is expected to earn 9. Internet exercise. Again. e.5 1 Beta 1.16 = 16.04) ⇒ β = 0. 20 Expected Return 15 10 5 0 0 0.04 + [1.0% d.12 .04 + β (0. 9.8.8× (0.rf = 0.5× (0.0. c.04 = 0. answers will vary depending on time period. the opportunity cost of capital is: r = rf + β (rm .rf) r = 0. 68 .

the expected return is: rp = x1r1 + x2r2 rp = (0. Every stock has unique risk in addition to market risk.115 = 11. b.5 × 0.10)2 + 2(0.10. c. No.5)2(0.11 = 11.5 × 0. The Capital Asset Pricing Model does not predict these events. the stock will do worse. If the events are favorable.16)(0. His expected return increases to 11.85% Therefore. b. If the events are unfavorable.0097 = 0.375 Further: rp = x1r1 + x2r2 rp = (0. he can improve his expected rate of return without changing the risk of his portfolio.16)2 x2 = 0.06) + (0. The unique risk reflects uncertain events that are unrelated to the return on the market portfolio. the stock will do better than the model predicts.14) = 0.10) + (0.5)2(0.10)2 = 0 + 0 + x22(0.625 × 0. he can do even better by investing equal amounts in the corporate bond portfolio and the index fund. In general.375 × 0.5% and the standard deviation of his portfolio decreases to 9. 12.10)(0. First we find the portfolio weights for a combination of Treasury bills (security 1: standard deviation = 0 percent) and the index fund (security 2: standard deviation = 16 percent) such that portfolio standard deviation is 10 percent. 11. a. With equal amounts in the corporate bond portfolio (security 1) and the index fund (security 2).85%.5% σ σ σ σ P P P P 2 2 2 = x12σ 1 2 + 2x1x2σ 1σ 2ρ 12 + x22σ 2 2 = (0. for a two security portfolio: σ P 2 = x12σ 1 2 + 2x1x2σ 1σ 2ρ 12 + x22σ 2 2 (0.985 = 9.5)(0.625 ⇒ x1 = 0.14) = 0.0% Therefore.16)2 = 0. a.09) + (0. Percival’s current portfolio provides an expected return of 9 percent with an annual standard deviation of 10 percent. True True True 69 .5)(0.

13.

a. b. c. d. e.

True. By definition, the factors represent macro-economic risks that cannot be eliminated by diversification. False. The APT does not specify the factors. True. Investors will not take on nondiversifiable risk unless it entails a positive risk premium. True. Different researchers have proposed and empirically investigated different factors, but there is no widely accepted theory as to what these factors should be. True. To be useful, we must be able to estimate the relevant parameters. If this is impossible, for whatever reason, the model itself will be of theoretical interest only. ⇒ r = (1.0)× (6.4%) + (-2.0)× (-0.6%) + (-0.2)× (5.1%) = 6.58% ⇒ r = (1.2)× (6.4%) + (0)× (-0.6%) + (0.3)× (5.1%) = 9.21% ⇒ r = (0.3)× (6.4%) + (0.5)× (-0.6%) + (1.0)× (5.1%) = 6.72%

14.

For Stock P For Stock P2 For Stock P3

15.

a.

Factor risk exposures: b1(Market) = (1/3)× (1.0) + (1/3)× (1.2) + (1/3)× (0.3) = 0.83 b2(Interest rate) = (1/3)× (-2.0) +(1/3)× (0) + (1/3)× (0.5) = -0.50 b3(Yield spread) = (1/3)× (-0.2) + (1/3)× (0.3) + (1/3)× (1.0) = 0.37

b. 16.

rP = (0.83)× (6.4%) + (-0.50)× (-0.6%) + (0.37)× (5.1%) = 7.5%

rCC = 3.5% + (0.82 × 8.8%) + (-0.29 × 3.1%) + (0.24 × 4.4%) = 10.87% rXON = 3.5% + (0.50 × 8.8%) + (0.04 × 3.1%) + (0.27 × 4.4%) = 9.21% rP = 3.5% + (0.66 × 8.8%) + (-0.56 × 3.1%) + (-0.07 × 4.4%) = 7.26% rR = 3.5% + (1.17 × 8.8%) + (0.73 × 3.1%) + (1.14 × 4.4%) = 21.08%

70

Challenge Questions 1. [NOTE: In the first printing of the seventh edition of the text, footnote 4 states that, for the minimum risk portfolio, the investment in Reebok is 21.4%. This figure is incorrect. The correct figure is 16.96%, as shown below.] In general, for a two-security portfolio: σ and: x1 + x2 = 1 Substituting for x2 in terms of x1 and rearranging: σ
p 2 p 2

= x12σ

1

2

+ 2x1x2σ 1σ 2ρ

12

+ x22σ

2

2

1

2

x12 + 2σ 1σ 2ρ
p 2

12

(x1 - x12) + σ

2

2

(1 - x1)2

Taking the derivative of σ zero and rearranging: x1(σ
2 1

with respect to x1, setting the derivative equal to
2 2

- 2σ 1σ 2ρ

12

) + (σ 1σ 2ρ

12

2 2

)=0

Let Coca-Cola be security one (σ 1 = 0.315) and Reebok be security two (σ 2 = 0.585). Substituting these numbers, along with ρ 12 = 0.2, we have: x1 = 0.8304 Therefore: x2 = 0.1696

2.

a.

The ratio (expected risk premium/standard deviation) for each of the four portfolios is as follows: Portfolio A: Portfolio B: Portfolio C: Portfolio D: (34.6 – 10.0)/110.6 = 0.222 (21.6 – 10.0)/30.8 = 0.377 (19.0 – 10.0)/23.7 = 0.380 (13.4 – 10.0)/14.6 = 0.233

Therefore, an investor should hold Portfolio C.

71

b.

The beta for Amazon relative to Portfolio C is equal to the ratio of the risk premium of Amazon to the risk premium of the portfolio times the beta of the portfolio: [(34.6% - 10.0%)/(19% - 10%)] × 1.0 = 2.733 Similarly, the betas for the remainder of the holdings are as follows: β β β β β β
Amazon Boeing

= 2.733 = 0.333 = 1.800 = 0.200 = 0.889 = 0.444 = 0.533 = 1.111

β β

Dell EX-M GE McD

Pfizer

Reebok

c.

If the interest rate is 5%, then Portfolio C remains the optimal portfolio, as indicated by the following calculations: Portfolio A: Portfolio B: Portfolio C: Portfolio D: β β β β β β (34.6 – 5.0)/110.6 = 0.268 (21.6 – 5.0)/30.8 = 0.539 (19.0 – 5.0)/23.7 = 0.591 (13.4 – 5.0)/14.6 = 0.575

The betas for the holdings in Portfolio C become:
Amazon Boeing

= 2.114 = 0.571 = 1.514 = 0.486 = 0.929 = 0.643 = 0.700 = 1.071

β β

Dell EX-M GE McD

Pfizer

Reebok

72

3 Whether the APT can be used to make money is a question related to competition in the financial markets. Given sufficient competition, no widely-known model will provide an advantage (i.e., enable someone to make a return above that expected, given the level of risk undertaken). So, whether an economic model enables one to make money is not relevant to the validity of that model. To put this somewhat differently, the validity of an economic model hinges on whether the model enables us to better identify and understand relationships among key parameters, not whether the model can be used to make money. 4. Let rx be the risk premium on investment X, let xx be the portfolio weight of X (and similarly for Investments Y and Z, respectively). a. rx = (1.75)× (0.04) + (0.25)× (0.08) = 0.09 = 9.0% ry = (-1.00)× (0.04) + (2.00)× (0.08) = 0.12 = 12.0% rz = (2.00)× (0.04) + (1.00)× (0.08) = 0.16 = 16.0% b. This portfolio has the following portfolio weights: xx = 200/(200 + 50 - 150) = 2.0 xy = 50/(200 + 50 - 150) = 0.5 xz = -150/(200 + 50 - 150) = -1.5 The portfolio’s sensitivities to the factors are: Factor 1: Factor 2: c. (2.0)× (1.75) + (0.5)× (-1.00) – (1.5)× (2.00) = 0 (2.0)× (0.25) + (0.5)× (2.00) – (1.5)× (1.00) = 0

Because the sensitivities are both zero, the expected risk premium is zero. This portfolio has the following portfolio weights: xx = 80/(80 + 60 - 40) = 0.8 xy = 60/(80 + 60 - 40) = 0.6 xz = -40/(80 + 60 - 40) = -0.4 The sensitivities of this portfolio to the factors are: Factor 1: Factor 2: (0.8)× (1.75) + (0.6)× (-1.00) – (0.4)× (2.00) = 0 (0.8)× (0.25) + (0.6)× (2.00) – (0.4)× (1.00) = 1.0

The expected risk premium for this portfolio is equal to the expected risk premium for the second factor, or 8 percent.

73

d.

This portfolio has the following portfolio weights: xx = 160/(160 + 20 - 80) = 1.6 xy = 20/(160 + 20 - 80 ) = 0.2 xz = -80/(160 + 20 - 80) = -0.8 The sensitivities of this portfolio to the factors are: Factor 1: Factor 2: (1.6)× (1.75) + (0.2)× (-1.00) - (0.8)× (2.00) = 1.0 (1.6)× (0.25) + (0.2)× (2.00) – (0.8)× (1.00) = 0

The expected risk premium for this portfolio is equal to the expected risk premium for the first factor, or 4 percent. e. The sensitivity requirement can be expressed as: Factor 1: (xx)(1.75) + (xy)(-1.00) + (xz)(2.00) = 0.5 xx + xy + xz = 1 With two linear equations in three variables, there is an infinite number of solutions. Two of these are: 1. 2. xx = 0 xx = (6/11) xy = 0.5 xy = (5/11) xz = 0.5 xz = 0 In addition, we know that:

The risk premiums for these two funds are: r1 = 0× [(1.75 × 0.04) + (0.25 × 0.08)] + (0.5)× [(-1.00 × 0.04) + (2.00 × 0.08)] + (0.5)× [(2.00 × 0.04) + (1.00 × 0.08)] = 0.14 = 14.0% r2 = (6/11)× [(1.75 × 0.04) + (0.25 × 0.08)] +(5/11)× [(-1.00 × 0.04) + (2.00 × 0.08)] +0 × [(2.00 × 0.04) + (1.00 × 0.08)] = 0.104 = 10.4% These risk premiums differ because, while each fund has a sensitivity of 0.5 to factor 1, they differ in their sensitivities to factor 2.

74

f.

Because the sensitivities to the two factors are the same as in Part (b), one portfolio with zero sensitivity to each factor is given by: xx = 2.0 xy = 0.5 xz = -1.5 The risk premium for this portfolio is: (2.0)× (0.08) + (0.5)× (0.14) – (1.5)× (0.16) = -0.01 Because this is an example of a portfolio with zero sensitivity to each factor and a nonzero risk premium, it is clear that the Arbitrage Pricing Theory does not hold in this case. A portfolio with a positive risk premium is: xx = -2.0 xy = -0.5 xz = 1.5

75

CHAPTER 9

Capital Budgeting and Risk
1. It is true that the cost of capital depends on the risk of the project being evaluated. However, if the risk of the project is similar to the risk of the other assets of the company, then the appropriate rate of return is the company cost of capital.

2.

3.

4. a. Both British Petroleum and British Airways had R2 values of 0.25, which means that, for both stocks 25% of total risk comes from movements in the market (i.e., market risk). Therefore, 75% of total risk is unique risk.

b. The variance of British Petroleum is: (25)2 = 625 Unique variance for British Petroleum is: (0.75 × 625) = 468.75 c. The t-statistic for β BA is: (0.90/0.17) = 5.29 This is significant at the 1% level, so that the confidence level is 99%. d. e. rBP = rf + β rBP = rf + β
BP

× (rm - rf) = 0.05 + (1.37)× (0.12 – 0.05) = 0.1459 = 14.59% × (rm - rf) = 0.05 + (1.37)× (0 – 0.05) = -0.0185 = -1.85%

BP

5.

6.

If we don’t know a project’s β , we should use our best estimate. If β ’s are uncertain, the required return depends on the expected β . If we know nothing about a project’s risk, our best estimate of β is 1.0, but we usually have some information on the project that allows us to modify this prior belief and make a better estimate.

76

7. a. The total market value of outstanding debt is 300,000 euros. The cost of debt capital is 8 percent. For the common stock, the outstanding market value is: (50 euros × 10,000) = 500,000 euros. The cost of equity capital is 15 percent. Thus, Lorelei’s weightedaverage cost of capital is:

 300,000 rassets =  300,000 + 500,000 
rassets = 0.124 = 12.4% b.

  500,000 ×(0.08) +   300,000 + 500,000  

 ×(0.15 )  

Because business risk is unchanged, the company’s weighted-average cost of capital will not change. The financial structure, however, has changed. Common stock is now worth 250,000 euros. Assuming that the market value of debt and the cost of debt capital are unchanged, we can use the same equation as in Part (a) to calculate the new equity cost of capital, requity:

 300,000 0.124 =   300,000 + 250,000 
requity = 0.177 = 17.7%

  250,000  ×(0.08) +   300,000 + 250,000  

  ×( requity )  

8.

a.

rBN = rf + β rIND = rf + β

BN

× (rm - rf) = 0.035 + (0.64 × 0.08) = 0.0862 = 8.62% × (rm - rf) = 0.035 + (0.50 × 0.08) = 0.075 = 7.50%
BN

IND

b.

No, we can not be confident that Burlington’s true beta is not the industry average. The difference between β (0.14) is less than one standard error (0.20), so we cannot reject the hypothesis that β BN = β IND.

and β

IND

c.

Burlington’s beta might be different from the industry beta for a variety of reasons. For example, Burlington’s business might be more cyclical than is the case for the typical firm in the industry. Or Burlington might have more fixed operating costs, so that operating leverage is higher. Another possibility is that Burlington has more debt than is typical for the industry so that it has higher financial leverage. Company cost of capital = (D/V)(rdebt) + (E/V)(requity)

d.

Company cost of capital = (0.4 × 0.06) + (0.6 × 0.075) = 0.069 = 6.9%

77

9.

a.

With risk-free debt: β Therefore: β β β
food

assets

= E/V × β

equity

= = =

0.7 × 0.8 0.8 × 1.6 0.6 × 1.2

= 0.56 = 1.28 = 0.72

elec

chem

b.

β

assets

= (0.5 × 0.56) + (0.3 × 1.28) + (0.2 × 0.72) = 0.81

Still assuming risk-free debt: β
assets

= (E/V) × (β

equity

)

0.81 = (0.6) × (β β c.
equity

equity

)

= 1.35

Use the Security Market Line: rassets = rf + β
assets

× (rm - rf)

We have: rfood = relec = rchem = 0.07 + (0.56)× (0.15 - 0.07) = 0.07 + (1.28)× (0.15 - 0.07) = 0.07 + (0.72)× (0.15 - 0.07) = 0.115 = 11.5% 0.172 = 17.2% 0.128 = 12.8%

d.

With risky debt: β β β
food

= = =

(0.3 × 0.2) + (0.7 × 0.8) = (0.2 × 0.2) + (0.8 × 1.6) = (0.4 × 0.2) + (0.6 × 1.2) =

0.62 ⇒ rfood = 1.32 ⇒ relec = 0.80 ⇒ rchem =

12.0% 17.6% 13.4%

elec

chem

10. Ratio of σ ’s Egypt Poland Thailand Venezuela 3.11 1.93 2.91 2.58 Correlation 0.5 0.5 0.5 0.5 Beta 1.56 0.97 1.46 1.29

The betas increase compared to those reported in Table 9.2 because the returns for these markets are now more highly correlated with the U.S. market. Thus, the contribution to overall market risk becomes greater.

11. 12.

Foreign capital investment projects will be evaluated on the basis of the amount of market risk the project brings to the portfolio. Further, the decrease in diversifiable country bias may result in higher overall correlations. The information could be helpful to a U.S. company considering international capital investment projects. By examining the beta estimates, such companies can evaluate the contribution to risk of the potential cash flows.

78

4 x 1.94 115. but only if it increases market risk.37 131.000.000)] = \$187. however. This possibility should affect forecasted cash flows.A German company would not find this information useful.122 = 12.S.122)3 = 150(1.2 × 0) + (0.05 + (1.05/1. See Part (a). Expected daily production = (0.720 barrels Expected annual cash revenues = 2.05/1. company stocks.122) = 150(1. or even primarily.500/1.rf) = 0. They invest the major portion of their portfolios in German company stocks. b.05/1.67 79 .25 × 0) + (0.05/1.000)] = 2. in U.2)× (0.05/1.2% Therefore: CEQ1 = CEQ2 = CEQ3 = CEQ4 = CEQ5 = 150(1. The threat of a coup d’état means that the expected cash flow is less than \$250.122) = 150(1.12 = \$167.37 122.892. a. 15. The expected cash flow is: [(0.122)5 = 2 140.6 x 5.8) × [(0.000) + (0. a.122)4 = 150(1.500 Assuming that the cash flow is about as risky as the rest of the company’s business: PV = \$187.75 × 250. The threat could also increase the discount rate. The opportunity cost of capital is given by: r = rf + β (rm . The possibility of a dry hole is a diversifiable risk and should not affect the discount rate.05 107. German investors do not invest exclusively.720 x 365 x \$15 = \$14. The relevant risk depends on the beta of the country relative to the portfolio held by investors. 13.411 14.000 b.06) = 0.

35. a. we can see that the a t values decline by a constant proportion each year: a2/a1 = a3/a2 = a4/a3 = a5/a4 = 0.205 1. 80 .37/150 = 122.9358 0. CEQ1 = CEQ2 = CEQ3 = c.7001 3 2 Using a constant risk-adjusted discount rate is equivalent to assuming that at decreases at a constant compounded rate.8196 0.205) = 60× (1.52 47.05/150 = 107.07) = 0.8758 0.01 40× (1.07/1. a1 = a2 = a3 = d.07/1.9358 0.01/50 = 40 60 50 + + = 103.09 2 1.205 1.5× (0.94/150 = 115.31 35.7670 0.7885 0.67/150 = 0.0.8880 0.5% Therefore: PV = b.8196 = 0.8758 = 0.37/150 = 131.07)/1.8758/0.9358 16.16 .07 + 1.205 = 20.52/40 = 47. we find the cost of capital: r = 0.7670 = 0.7670/0.7178/0.205) = 0.9358 0.8196/0.205) = 50× (1.9358 0.205 3 35. Using the Security Market Line.7178 From this.31/60 = 35.9358 = 0.a1 = a2 = a3 = a4 = a5 = 140.

at t = 0: 700.000 + (0.000 = \$833.898 1.40 × 0) + (0 . At t = 2.000. there are two possible values for the project’s NPV: NPV 2 ( if test is not successful ) = 0 NPV 2 ( if test is successful ) = − 5.12 NPV0 = − 500.60 ×833.17.40 2 81 .333) = − \$244.333 0.000 + Therefore.

it must have a high beta for anyone receiving them. the less you should worry about them because.S. the closer the present value of these cash flows is to zero. pharmaceutical stocks are less highly correlated with their portfolios than they are with U. If German investors hold a stock portfolio comprised largely of German equities. 82 .e. R&D that simply serves a German parent company may be more highly correlated with the German market.S. a high beta) than the reverse. This result does make sense. and will therefore have lower betas. b. then 13% is the appropriate rate. the higher the discount rate. which is clearly an impossible situation. each asset would have one value for the buyer and one for the seller. Also.S. for a high beta project. It is better to have a series of payments that are high when the market is booming and low when it is slumping (i.S.. This suggests that German investors might require a lower return for investing in U. the higher the risk of the cash outflows. there might be extra costs involved in managing the business in a foreign country. If an investment has a high beta for anyone paying out the cash flows. If the German company holds a portfolio comprised primarily of U. The beta of an investment is independent of the sign of the cash flows. c. The answer here depends on the reason that German investors keep much of their money at home. First. then they are likely to find that U. If there are high costs for shareholders to invest overseas.S. holdings. pharmaceutical companies than U. Not necessarily.S. Thus. If the sign of the cash flows affected the discount rate.Challenge Questions 1. The real issue is the degree of risk relative to the investor’s portfolio. stocks. 2. then the German company may well provide its shareholders with a service by providing them with cheap international diversification. however. a. investors require. That does not necessarily imply that they should move their R&D and production facilities to the U. The German company needs to be remunerated only for the risk it is taking relative to its German portfolio. It is correct that. you should discount all cash flows at a high rate.

Internet exercise.132 = 13. Well 2 will have a smaller “fudge factor” because its cash flows are more distant. using the Security Market Line: rnominal = 0.2 × 0) + (0.300 d.222.4 million Expected income from Well 2: [(0. one can certainly find a discount rate (and hence a “fudge factor”) that. when applied to cash flows of \$3 million per year for 10 years.132 − 1 = 0.85 percent gives. Since the risk of a dry hole is unlikely to be market-related.85% 1.3. these two “fudge factors” will be different. Specifically. For Well 1.4602)] NPV 1 = \$5. Thus. NPV 1 = −10 million + ∑ t =1 10 2. 15 t =1 2million = −10million + [ (2million) × (3.0885 = 8. However.2% We know that: (1 + rnominal) = (1 + rreal) × (1 + rinflation) Therefore: rreal = 1. With more distant cash flows. we can use the same discount rate as for producing wells.4million 1. 83 .4millio n) ×(6. for Well 2.2885 t NPV 1 = − \$425.04 10 b.0885 t = −10 million +[ (2.600 NPV 2 = −10 million + ∑ t 15 1.8 × 2 million)] = \$1.3888)] 1.6million t = 1 1. a.600. will yield the correct NPV of \$5.2 × 0) + (0.1914)] 1. 4.012.08) = 0.100 e. Similarly.504.9)× (.504.0885 = −10million + [ (1. one can find the appropriate discount rate. a smaller addition to the discount rate has a larger impact on present value. NPV 1 = −10 million + ∑ t =1 3million = −10 million + [ (3million) ×(3.06 + (0.2885 t Expected income from Well 1: [(0.1326)] NPV 2 = \$3.800 NPV 2 = −10 million + ∑ NPV 2 = − \$3. answers will vary.8 × 3 million)] = \$2.6millio n) × (8.6 million Discounting at 8.

6 -11.4 3.0 17.3 11. Following the calculations in Section 10.9 -2.75 Years 1-10 84 .00 B 1.02B 2.5 B 26.45 B ¥1.4 3.1 11.95 B ¥15 B t =1 ¥1.7 NPV Expected 3. Tax 7. and unit variable cost.60 B 2. Pre-tax Profit (1-2-3-4) 6.CHAPTER 10 A Project is Not a Black Box Answers to Practice Questions 1.6 Market Size Market Share Unit Price Unit Variable Cost Fixed Cost The principal uncertainties appear to be market share. Revenue 2. Year 0 Investment 1.75 ¥2. Revenue 2. Operating Cash Flow (4+7) ¥30 B ¥37.0 3. Pre-tax Profit 6.75 5. Operating Cash Flow NPV = . Variable Cost 3.2 -10.10 t = − ¥3.4 3.4 3.1 9. Tax @ 50% 7. Year 0 Investment 1. Depreciation 5.0 ¥5. we find: Pessimistic -1. Depreciation 5.90 B 0. Fixed Cost 4.1 of the text.50 B ¥0. Net Operating Profit 8.4 Optimistic 8. Variable Cost 3.00 B 39. unit price.¥15B + ∑ 10 Years 1-10 ¥44.45 B ¥0.5 2.4 -19. Fixed Cost 4.0 3. Net Operating Profit (5-6) 8. a.95B 1. 3.

7 B 1.000 − 260. Depreciation 5.33 B Outflows V.000.7 + 26.00 2.000.8 PV Outflows -30. Variable Cost 3. Net Profit 8.85 (1.00 52. Pre-tax Profit 6.7 353.000 Proof: 1.0 NPV -30.000 = 20.0 -225.00 3. 659 3.F.0 230.0 3.00 .V.783.75 7.000.1 3.50 75.00 30.000 − 260.0 = 84. Fixed Cost 4. Operating Cash Flow NPV = ∑ t =1 10 ¥31.4 460.00 Investment Yr 0 30.000 − 9.0 ¥3. 000 + (6.823.342 3.85 ¥4.3 19.00 3. (See chart on next page.85 − 30 = 29.1 -441.¥30 B + ¥5.00 60.8 B 22. Costs F.Net cash flow b.00 37. 000 + = 58.Cost]× (1 . Cost Yr 1-10 Yr 1-10 0. Tax 7.216.2 (difference 4.000.000) ×(0.144567) ×(375.087.149 .000.00 3. 8 − 30 = − 0.0 5.00 Taxes Yr 1-10 -3.910.8 Note that the break-even point can be found algebraically as follows: NPV = -Investment + [PV × (t × Depreciation)] + [Quantity × (Price . Revenue 2.850.5) 375.) Unit Sales (000’s) 0 100 200 Inflows Revenues Yrs 1-10 0.t)× (PVA10/10%) Set NPV equal to zero and solve for Q: Q= = I − (PV ×D × t) F + (PVA 10/10% ) ×(P − V) ×(1 − t) P −V 30.313 115.000 .00 PV Inflows 0.Cost) .00 26.10) t due to rounding ) 85 .85 ¥1.

find the level of costs at which the project would have zero NPV. To find the level of costs at which the project would earn zero profit.0 – 1.VC – 3. set net profit equal to zero. Using the data in Table 10. the equivalent annual cash flow yielding a zero NPV would be: ¥15 B/PVA10/10% = ¥2. and solve for variable costs: Net Profit = (R . write the equation for net profit.4412 B 86 . including the opportunity cost of capital. d.5) VC = 33.0 This will yield zero profit.5)× (0.t) 0 = (37.FC . yields a zero NPV.Break-Even 500 450 400 350 300 250 200 150 100 50 0 PV (Billions of Yen) c. PV Inflows PV Outflows Break-Even NPV = 0 • 0 100 Units (000's) 200 The break-even point is the point where the present value of the cash flows.VC .5 .1.D)× (1 . Next.

The economic life of the new machine is expected to be 10 years.15 -0.12 = 0. For example. while in practice.77 ii. 6. Sensitivity analysis changes variables one at a time. Sensitivity analysis using scenarios can help in this regard.85 -0.12 This will yield NPV = 0. because the cost of the study is considerably less than the possible annual loss if the pessimistic manufacturing cost estimate is realized. 4. for the “Expected” case.0 + 0. a. the equivalent annual cost savings is: -1.00 iii.VC – 3. all variables change. so the equivalent annual cost of the new machine is: 10/5. It incurs the equivalent annual cost of the \$10 million capital investment. we know that. It reduces manufacturing costs.0 – 1. iii. If Rustic replaces now rather than in one year. we find: Sales Manufacturing Cost Economic Life Equivalent Annual Cost Savings (Millions) Pessimistic Expected Optimistic -0. It earns a return for 1 year on the \$1 million salvage value. analyzing “Sales” we have (all dollar figures in millions): i.VC . assuming the tax credits can be used elsewhere in the company. The reduction in manufacturing costs is: (0. in terms of potential negative outcomes.35 0.35 1. ii. The return earned on the salvage value is: (0.5)] + 1.35 0. ‘Optimistic’ and ‘pessimistic’ rarely show the full probability distribution of outcomes.35 Continuing the analysis for the other cases.4412 = [(37. several things happen: i.56 5.D)× (1 . From the solution to Problem 4. 87 .77 + 2.5 VC = 31.12 Thus.5)× (0.07 0.5 .12) × (1) = 0. b.65 0.FC .05 0.5) × (4) = 2.If we rewrite the cash flow equation and solve for the variable cost: NCF = [(R . and the changes are often interrelated.t)] + D 2.6502 = 1. Rustic should go ahead with the study. manufacturing cost is the key variable.

It will be most useful for a complex project with cash flows that depend on several interacting variables.0 +1.10. so that the decision-maker can make the personal investment necessary to understand the technique and gain experience in interpreting the output. This is an opened-ended question.5 fixed cost + deprecatio n operating profit b.75 .7.5 3.500 Pilot production and market tests Observe demand Low demand (50% probability) Stop: NPV = \$0 [ For full-scale production: NPV = -1000 + (75/0.075 / 3 = 2. % change in operating income % change in sales For a 1% increase in sales. require large investments in research and development.10) = -\$250 ] 88 .5) = 2.5)/10. It is more likely to be worthwhile if a large amount of money is at stake.000 units: Operating leverage = (10.50 0. High demand (50% probability) Invest in full-scale production: NPV = -1000 + (250/0.000 units: Operating leverage = 0. and the answer is a matter of opinion. d. Operating leverage = % change in operating income % change in sales For a 1% increase in sales. forecasting cash flows and assessing risks is likely to be particularly difficult for such projects. or the pharmaceutical industry. such as oil refining.000 units to 202. a.0 c.43 (75.10) = +\$1. c. It is most likely to be useful to large companies in industries that require major investments.000 units to 101. b. chemicals. 9. For example.75) /75 8. capital intensive industries.375 / 37.65 .5 = 1. It is most useful when it can be applied to a series of similar projects. Operating leverage =1 + =1 + Operating leverage = (3. from 100. and mining. However. steel. a satisfactory answer should make the following points regarding Monte Carlo simulation: a. from 200.

\$100 million = -\$5 million Since the expected NPV is negative you would not build the plant. a. Timing option Expansion option Abandonment option Production option Expansion option 11. 89 . b. The expected NPV is now: (0. d.5 × \$140 million) + (0. b. a.5 × \$140 million) + (0. c. you would build the plant.5 × \$50 million) .5 × \$90 million) . The expected value of the NPV for the plant is: (0. e.\$100 million = +\$15 million Since the expected NPV is now positive.10.

which is a revision of Figure 10.08 Thus.9. Similarly. if we purchase the piston plane and demand is low: • The NPV of the ‘Continue’ branch is: (0.) Which plane should we buy? We analyze the decision tree by working backwards. So.6 ×100) = \$137 1. we should expand further at t = 1.\$100 million = +\$40 million Build auto plant (Cost = \$100 million) Observe demand Line is unsuccessful (50% probability) Continue production: NPV = \$50 million – \$100 million = .c.\$10 million 12.4 ×220) +(0 . for example.08 The NPV at t = 1 of the ‘Continue’ branch is: (0.8 ×800) +(0 .2 ×180) = \$337 1.8 in the text.08 90 . (See Figure 10. Line is successful (50% probability) Continue production: NPV = \$140 million . if we purchase the piston plane and demand is high: • The NPV at t = 1 of the ‘Expanded’ branch is: −150 + • (0.\$50 million Sell plant: NPV = \$90 million – \$100 million = .8 × 410) +(0 . This branch has the highest NPV.2 ×100) = \$461 1. if we purchase the piston plane and demand is high.

07 (1.08 Similarly for the ‘Turbo’ branch.8 × 410) +(0 .\$62 = \$139 91 . we first compute the NPV without the option to expand: NPV = −250 + (0.2 × 220) = \$812 If demand is low.6 ×100)] = \$62. if demand is high.4 × 220) + (0.4 × 930) + (0. In order to determine the value of the option to expand.6 ×100) +(0 . for the ‘Turbo’ branch.08) 2 Therefore.08) (1.6)[(0. the expected cash flow is: (0.2 ×180)] + (0. the company should buy the turbo plane.• We can now use these results to calculate the NPV of the ‘Piston’ branch at t = 0: −180 + • (0.6 × 140) = \$456 • • So. the expected cash flow at t = 1 is: (0.4) ×(50 + 137) = \$201 1.6) ×(100 + 461) +(0 .6 ×150) +(0 . the value of the option to expand is: \$201 . the combined NPV is: NPV = −350 + (0.08) (0.8 × 960) + (0.4 ×30) (0.6 ×812) +(0 .4 ×50) + (1.4)[(0.08) 2 Therefore.4 ×456) + = \$319 (1.

FIGURE 10.6) \$140 Hi demand (.2) \$180 Expand -\$150 Piston -\$180 Hi demand (.6) \$100 Continue Hi demand (.9 Continue Hi demand (.2) \$220 Continue Lo demand (.2) \$100 Hi demand (.8) \$410 Lo demand (.6) \$150 Hi demand (.6) \$100 92 .4) Turbo -\$350 \$30 Hi demand (.4) \$930 Lo demand (.8) \$960 Lo demand (.4) Continue Lo demand (.4) \$50 \$220 Lo demand (.8) \$800 Lo demand (.

the NPV at t = 1 is: (0.4) ×(50 + 150) = \$206 1.8 in the text.6 ×140) = \$422 1. if demand is high.08  The NPV of the ‘Quit’ branch is \$150 Thus.08 Similarly for the ‘Turbo’ branch. which is a revision of Figure 10. If demand is low. if we purchase the piston plane and demand is low. we should expand further at t = 1 because this branch has the highest NPV.6 ×100) = \$137 1. for example.6) ×(100 + 461) + (0 .10. c.  The NPV of ‘Continue’ is: (0.4 ×930) +(0 . Putting these results together.2 ×100) = \$461 1.8 × 960) +(0 .4 ×220) +(0 . Thus. Magna should be prepared to sell either plane at t = 1 if the present value of the expected cash flows is less than the present value of selling the plane.2 ×180) = \$337 1.08 93 . the NPV at t = 1 of ‘Quit’ is \$500. if we purchase the piston plane and demand is high. b. Ms. See Figure 10.08 The NPV at t = 1 of the ‘Continue’ branch is: (0.08   The NPV at t = 1 of ‘Quit’ is \$500. We analyze the decision tree by working backwards.13. we calculate the NPV of the ‘Piston’ branch at t = 0: −180 +  (0. a.2 × 220) = \$752 1. if we purchase the piston plane and demand is low:  The NPV of the ‘Continue’ branch is: (0.8 × 800) +(0 . Similarly. if we purchase the piston plane and demand is high:  The NPV at t = 1 of the ‘Expand’ branch is: −150 +  (0.08  The NPV at t = 1 of the ‘Quit’ branch is \$150.8 × 410) + (0 . we should sell the plane at t = 1 because this alternative has a higher NPV. So.

’ Therefore. for the piston plane. NPV at t = 0 is: − 350 + 0. the turbo has the greater NPV. For the piston plane.6 ×(150 + 752) +0 . \$347 compared to \$206 for the piston.6 ×(150 + 752) +0 . the NPV is: − 350 + 0.6 ×(100 + 461) + 0. the abandonment option has a value of: \$347 . without the abandonment option.08 With the abandonment option. The value of the abandonment option is different for the two different planes.08 Thus.4 × (30 + 500) = \$347 1.\$201 = \$5 For the turbo plane. the abandonment option has a value of: \$206 . However. d.4 ×(50 + 137) = \$201 1.In this case. without the abandonment option.4 ×(30 + 422) = \$319 1.08 For the turbo plane. decision trees are not complete solutions to the valuation of real options because they cannot show all possibilities and they do not inform the manager how discount rates can change as we go through the tree. Decision trees can help the financial manager to better understand a capital investment project because they illustrate how future decisions can mitigate disasters or help to capitalize on successes.\$319 = \$28 14. 94 . for the ‘Turbo’ branch at t = 0. ‘Quit’ is better than ‘Continue. NPV at t = 0 is: −180 + 0.

6) \$100 95 .10 Continue Hi demand (.4) Turbo -\$350 \$30 Quit Expand -\$150 Piston -\$180 Hi demand (.8) \$410 Lo demand (.6) \$140 Hi demand (.4) \$930 Lo demand (.8) \$800 Lo demand (.2) \$220 Continue Lo demand (.2) \$100 Hi demand (.4) \$50 Quit \$150 \$220 Lo demand (.2) \$180 \$150 Hi demand (.4) Continue Lo demand (.6) \$150 Quit \$500 Hi demand (.8) \$960 Lo demand (.FIGURE 10.6) \$100 Continue Quit \$500 Hi demand (.

In that case.5 2 ) × (600 + 500 + 500 + 400) − 460] 1.25 probability that the price will be \$400.5 probability that the price will be \$450. we should open the mine at that time. calculate the PV with the mine open: PV = (0 .561) + (0.50 × 0) = 56. where each branch has a probability of 0.817/1. 1. Because this NPV is negative.5) ∑ 1. then.10 t t =1 3 Since it is equally likely that the price will rise or fall by \$50 from its level at the start of the year. the expected price for all future periods is \$500.000) × (550 − 460) = \$123.50 × 112. a. Taking into account the distribution of possible future prices of gold over the next 3 years.280. at t = 1.000 + ∑ (1. when the price is \$500. 2.5) × = \$7.000 + (1.10 2 (1. there is a 0. Further.438 t 1.5 3 ) × (650 + 550 + 550 + 550 + 450 + 450 + 450 + 350) − 460] = −\$526 1. you face the following.10 t =1 2 96 . at t = 0. the expected price for all future periods is then \$550. 1.10 = \$112. The expected NPV of this strategy is: (0. we should not open the mine at t = 0. Assume we wait until t = 1 and then open the mine if the price is \$550.5 × 450) − 460] 1. there is a 0.000) × [(0.5: t=1 t=2 ⇒ ⇒ 450 ⇒ 400 500 ⇒ ⇒ 450 Close mine t=3 550 To check whether you should close the mine at t = 1.10 3 Notice that the answer is the same if we simply assume that the price of gold remains at \$500. At t = 1. of this NPV at t = 1 is: \$123.000) × [(0. At t = 2.000 ×(500 −460) 1.10 + + (1. the mine should be closed.10 1. This is because. since the price at t = 3 cannot rise above the extraction cost. if the price reaches \$550. at t = 0.Challenge Questions 1.5 b.561 If the price rises to \$550 at t = 1. Suppose you open at t = 0. we have: NPV = −100.5 × 550) +(0 . Assume we open the mine at t = 0.000 ×(400 −460) +(0 .817 1. At that point: NPV = − 100. The NPV. Then. we know that it does not make sense to plan to open the mine at any price less than or equal to \$500 per ounce.000) × [(0.

is: NPV = 121. at that time: (\$900 . that is.270 = 10. there is a 20 percent chance it will be low. This has a present value of \$1.152.5 + \$854 = \$57.198) = \$121. with the option to close. and the value of the option to abandon is \$11.25 probability that the price will be \$400 at t = 1. The present value (at t = 1) of \$400 per year for 9 years is \$2.134.000)] + (0. If we buy: See Figure 10. 2. the mine will be abandoned if price reaches \$450 at t = 3 because the expected profit at t = 4 is: [(450 – 460) × 1.5 [the NPV for this strategy from part (a)] plus the value of the option to close: NPV = \$56. The choice is between buying the computer or renting.\$500) = \$200 per year. there is an 80 percent chance that demand will continue high for the remaining time (until t = 10). for the branch with price equal to \$550: PV = ∑ t =0 2 90. There is a 0. Thus.818/1. but you should close if the price is \$400 at t = 2.304. Because there is an 80 percent chance demand will be high for the remaining time.10 3 Now calculate the PV. in which case we will get (\$700 .\$500) = \$400 If demand is high at t = 1.270 1. opening the mine at t = 0 now has a positive NPV. and then you will save an expected loss of \$60.25) × (1. with this strategy.000 at t = 3.000 Thus.000 × 60) = \$11.270 so that the NPV with the option to abandon is: NPV = -\$526 + \$11.280.744). the NPV for this strategy is: \$56.000/1.5 × 246.134. We can verify this result by noting that the NPV from part (a) (without the option to abandon) is -\$526.104) = \$854 Therefore.744 Therefore.818 The NPV at t = 0. Now assume that we wait until t = 1 and then open the mine if the price is \$550 at that time. the value of the option to close is: (0.5 The option to close the mine increases the net present value for each strategy.5) × [7.10 t The expected PV at t = 1.000 at t = 0. but the optimal choice remains the same. if you open the mine when the price is \$500.198 1.10 – 100.125) × (10. For this strategy.000 = \$10.11. you should not close if the price is \$450 at t = 1. at t = 1.000] = -\$10. is: (0.5) is still greater than the NPV for strategy 1 (\$10. the value of the option to close is: (0. The cost is \$2. we will have.Thus. Similar calculations are made for the case of low initial demand. If demand is high at t = 1.744 2. If we rent: 97 .000 = \$246.438 + (450 – 460) × (1. with the option to close.280. strategy 2 is still the preferable alternative because its NPV (\$57.

98 . From the tree (Figure 10. the option to abandon a project has value if there is a chance that demand for a product will not meet expectations.36 or \$100.6) [(0.10 PVBuy = \$8. 3. If demand is low at t = 2. In the extreme case.10 + (0. options have no value because optimal choices can be determined with certainty.152)] 1. we will get: [(\$70 .4) [(0. the option to choose other alternative courses of action has no value to the decision-maker.4) [(0. On the other hand.304) + (0 .2 ×1.4 × 230) +(0 .\$500) – (0. then we will get: [(\$900 .6 × 400) + (0 .4 × 200) 1. This has a present value of \$230.440 PV Rent = (0.6 × 40) + [0 .4× \$900)] = \$40 If demand continues high. it pays to stop renting after low demand in year 2 because we know this low demand will continue.000 + (0. if future cash flows are known with certainty. Or.4 ×( −80)] 1. the option to expand a project has value if there is a chance that demand w ill exceed expectations.6) ×( −80) ] 1. so if demand is high at t = 1. we get \$40 per year for the remaining time.\$500) – (0.8 ×230) + (0 . not purchased.360 The computer should be rented.4 × 2.The cost is 40 percent of revenue per year. Similar calculations are made for the case of low initial demand.44 or \$8.8 × 2.2) ×( −80) ] + (0 .152) ] + (0 .6 ×1.10 PVRent = \$100. Therefore. so that cash flows are below expectations.10 + (0.6) [(0.304) + (0 .4× \$700)] = -\$80 In this case.11): PV Buy = − 2.

4) -\$80 \$230* Lo demand (. 99 .2) \$1152* Lo demand (.6) 1152* Rent Hi demand (.6) \$40 Hi demand (.4) Buy -\$2000 \$200 Hi demand (.4) Lo demand (.8) Hi demand (.6) \$400 \$2304* Lo demand (.8) \$230* Lo demand (.4) 2304* Lo demand (.FIGURE 10.11 Hi demand (.2) \$-80 Stop Hi demand (.6) -\$80 Stop *PV at t = 1 of cash flows from years 2-10.

000 is made.000. The 757 must be a zero-NPV investment for the marginal user.000. full competition will exist and thus any new entrant into the market for BGs will earn the 9% cost of capital. (This assumes the competition does not begin construction until the patent expires. production begins. competition is not a factor until t = 7. including the cost of building and maintaining terminal facilities. consider the sequence of events:  At t = 0. how quickly would competition spring up?). a critical component of costs.000) ×(P − 65) (200. Forecasting revenues. 6: Sale of 200. Delta will earn economic rents if the 757 is particularly well suited to Delta’s routes (and competition does not force Delta to pass the cost savings through to customers in the form of lower fares). Calculating the net present value. c. After t = 5. etc. The price of \$280 per ounce represents the discounted value of expected future gold prices. with costs of \$65 each. 4.09 12 100 . the NPV of new investment must be zero.000.000 units at \$100 each. to find the selling price per unit (P) solve the following for 0 = − 25. Thus. Hence. Forecasting costs. it becomes somewhat more feasible to ignore cash flows beyond the first few years and to substitute the expected residual value of the plane.  At t = 5. the present value of 1 million ounces produced 8 years from now should be: (\$280 × 1 million) = \$280 million 4.CHAPTER 11 Where Positive Net Present Value Comes From Answers to Practice Questions 1. With a good secondary market and information on past changes in aircraft prices. If the Akron-Yellowknife project is attractive and growth occurs at the Ulan Bator hub. Sometimes careful thought about economic rents clarifies whether NPV is truly positive. 2. 3.000 At t = 1: \$0 At t = 2. so the first year of revenue and expenses is recorded at t = 2. 5. a. Unless Boeing can charge different prices to different users (which is precluded with a secondary market). The leasing market comes into play because it tells Gamma Airlines the opportunity cost of the planes.000.000. advertising. To a baby with a hammer. everything looks like a nail. The key question is: Will Gamma Airlines be able to earn economic rents on the Akron-Yellowknife route? The necessary steps include: a.000 + (200. First. the decision focuses on the issue of whether the plane is worth more in Delta’s hands than in the hands of the marginal user. c. b. all necessary training. equipment. The point is that financial managers should not mechanically apply DCF to every problem.09 1. part or all of a valuation problem can be solved by direct observation of market values. 3.000) ×(P − 65) + + 2 1. the patent expires and competition may enter.)  After t = 7. Next. the investment of \$25. Hence. 5.  At t = 1. Sometimes. The existence of a secondary market makes it more important to take note of the abandonment option (see Chapter 10). which includes a detailed market demand analysis (what types of travelers are expected and what prices can be charged) as well as an analysis of the competition (if Gamma is successful. b. Gamma Airlines should simply lease additional aircraft. Since it takes one year to achieve full production. Past aircraft prices may be used to estimate systematic risk (see Chapter 9). calculate the cash flows:     P: At t = 0: -\$25. yearly cash flow = \$7.

02 so that.\$65)] = \$4.02 . for years t = 7 through t = 12.690. the yearly cash flow will be: [(200.004 4.Solving. Finally. the net present value (in millions): NPV = − 25 + 7 7 7 4.000.09 1.000)× (\$85. we find P = \$85.09 1.004.004 + + + + + + 2 3 6 7 1.69 or \$10.000 101 .09 1.09 1.09 12 NPV = \$10.

000) ×(P − 65) + + 2 1.09 1.438.468.468. management might not proceed with the Polyzone project.03)5] = \$21.09 1. Unless there is some factor unaccounted for in the analysis (e.09 1.20 48 30 4 20 -6 80 1.19 (200.000.20 0 0 0 20 -20 40 1.18 or \$9.000 × (\$82. the yearly cash flow will be: [200.20 96 30 8 20 38 80 1.6. t=0 Investment Production Spread Net Revenues Prod.95 76 30 8 20 18 102 .000 7.09 1.180.20 96 30 8 20 38 80 1.351 + P = \$82.20 0 0 0 0 -100 \$3. and hence the selling price per unit (P) is found by solving the following equation for P: 0 = − 21. the NPV of new investment must be zero.351 After t = 5. However.\$65)] = \$3.438 3. strategic position such that the project creates an option for future expansion). this seems like a very small margin.19 .g.76 million. Costs Transport Other Costs Cash Flow NPV (at 8%) = 100 0 1. The selling price after t = 6 now changes because the required investment is: [\$25.000× (1 .0. Finally. the net present value (in millions) is: NPV = − 25 + 7 7 7 3.) The net present value is positive at \$3.09 12 NPV = \$9. (See the table below.438 + + + + + + 2 3 6 7 1.000. for years t = 7 through t = 12. a.76 t=1 t=2 t=3 t=4 t=5 t = 6-10 0 1..09 1.000) ×(P − 65) (200.10 88 30 8 20 30 80 0.09 12 Thus.

Then:   NPV =−100. that the PV of silver delivered (with certainty) in the future is approximately today’s spot price.000 per year for five years and is valued at the nominal rate of interest because it applies to nominal cash flows. There are four components that contribute to this project’s NPV: The initial investment of \$100.) We conclude.20 0 0 0 0 -100 \$14.000.000 + ∑ t =1 5 (0.11 t −∑ t =1 10 (1 − .20 0 0 0 20 -20 40 1. Costs Transport Other Costs Cash Flow NPV (at 8%) = 100 0 1.95 76 30 8 20 18 c.20 48 25 4 20 -1 80 1. therefore.000 ×20) 1.68 million. and so there is no need to forecast the price of silver and then discount.35) ×(10 ×5.  The after-tax value of the increase in silver yield.000) = \$226. Like gold.20 96 30 8 20 38 80 1. (You can verify this by checking that the difference between the futures price and the spot price is approximately the interest saving from buying the futures contract. the assumption that the technological advance will elude the competition for ten years seems questionable.20 48 30 4 20 -6 80 1. This cost is \$80.20 0 0 0 0 -100 \$18.) The net present value is \$14.35) ×( 20.68 t=1 t=2 t–3 t=4 t = 5-10 40 1. t=0 Investment Production Spread Net Revenues Prod. Costs Transport Other Costs Cash Flow NPV (at 8%) = 100 0 1.) The net present value is \$18. The depreciation tax shield.10 88 25 8 20 35 80 0.64 0 1. We are concerned only with the after-tax cost. silver has low convenience yield and storage cost. Depreciation expense is \$20.000) +(1 − .95 76 25 8 20 23 8. (See the table below.. However. (See the table below.947 1.20 96 60 8 20 8 80 1.08 t 103 .000 per year for ten years and is not valued at the real company cost of capital because we do not assume any future increase in cost due to inflation.20 96 25 8 20 43 80 1. Assume that the nominal interest rate is 11 percent. i.b.e.64 million.  The cost of operating the equipment. and so the project is acceptable. t=0 t=1 t=2 t–3 t=4 t = 5-10 Investment Production Spread Net Revenues Prod. earnings.10 88 30 8 20 30 80 0. and so the project is acceptable.35) (80.

9.

Assume we can ignore dividends paid on the stock market index. On June 30, 2005, each ticket must sell for \$100 because this date marks the base period for the return calculation. At this price, investment in a ticket will offer the same return as investment in the index. On January 1, 2005, you know that each ticket will be worth \$100 in 6 months. Therefore, on January 1, 2005, a ticket will be worth: 100/(1.10)1/2 = \$95.35 The price will be the same for a ticket based on the Dow Jones Industrial Average.

10.

If available for immediate occupancy, the building would be worth \$1 million. But because it will take the company one year to clear it out, the company will incur \$200,000 in clean-up costs and will lose \$80,000 net rent. Assume both rent and costs are spread evenly throughout the year. Thus (all dollar amounts are in millions): PV = 1,000 - PV(200 + 80) = 1,000 - 280(0.962) = 731 Since the selling price at each date is the present value of forecasted rents, the only effect of postponing the sale to year 2 is to postpone the sales commission. The commission is currently (0.05 × 1000) = 50 and grows in line with property value. To estimate the growth rate of value, we can use the constant-growth model: PV = 1000 = 80/(0.08 - g) so that g = 0% Thus, the commission in year 2 is: (50 × 1.002) and: PV (commission) = 50 × (1.002/1.082) = 43 The value of the warehouse, net of the sales commission, is: 731 - 43 = 688 or \$688,000

104

Challenge Questions

1. a. The NPV of such plants is likely to be zero, because the industry is competitive and, after two years, no company will enjoy any technical advantages.

b. c.

The PV of each of these new plants would be \$100,000 because the NPV is zero and the cost is \$100,000. The PV of revenue from such a plant is: [100,000 tons × (Price - 0.85)]/0.10 = 100,000 Therefore, the price of polysyllabic acid will be \$0.95 per ton.

d.

At t = 2, the PV of the existing plant will be: [100,000 tons × (0.95 - 0.90)]/0.10 = \$50,000 Therefore, the existing plant would be scrapped at t = 2 as long as scrap value at that time exceeds \$50,000.

e. f. g.

No. Book value is irrelevant. NPV of the existing plant is negative after year 2. Yes. Sunk costs are irrelevant. NPV of the existing plant is negative after year 2. Phlogiston’s project causes temporary excess capacity. Therefore, the price for the next two years must be such that the existing plant’s owners will be indifferent between scrapping now and scrapping at the end of year 2. This allows us to solve for price in years 1 and 2. Today’s scrap value is \$60,000. Also, today’s scrap value is equal to the present value of future cash flows. Therefore:

100,000 ×(Price − 0.90) 100,000 ×(Price − 0 .90) 57,900 + + = 60,000 1.10 1.10 2 1.10 2
Solving, we find that the price is \$0.97 per ton. Knowing this, we can calculate the PV of Phlogiston’s new plant:

0.97 − 0 .85 0.97 − 0 .85 0.95 − 0 .85  PV =100,000 ×  + +  = \$103,471 1.10 1.10 2 0.10 ×1.10 2  

2.

Aircraft will be deployed in a manner that will minimize costs. This means that each aircraft will be used on the route for which it has the greatest comparative advantage. Thus, for example, for Part (a) of this problem, it is clear that Route X will be served with five A’s and five B’s, and that Route Y will be served with five B’s and five C’s. The remaining C-type aircraft will be scrapped. The maximum price that anyone would pay for an aircraft is the present value of the total additional costs that would be incurred if that aircraft were withdrawn from service. Using the annuity factor for 5 time periods at 10 percent, we find the PV of the operating costs (all numbers are in millions):

Type A

X 5.7

Y 5.7

105

B C

9.5 17.1

7.6 13.3

Again, consider Part (a). The cost of using an A-type aircraft on Route X (Cost = Price of A + 5.7) must be equal to the cost of using a B-type aircraft on Route X (Cost = Price of B + 9.5). Also, the cost of using a B-type aircraft on Route Y (Price of B + 7.6) equals the cost of using a C-type on Route Y (Price of C + 13.3). Further, because five C-type aircraft are scrapped, the price of a C-type aircraft must be \$1.0, the scrap value. Therefore, solving first for the price of B and then for the price of A, we find that the price of an A-type is \$10.5 and the price of a B-type is \$6.7. Using this approach, we have the following solutions: Usage X a. b. c. d. 5A+5B 10A 10A 10A Y 5B+5C 10B 5A+5B 10A Scrap 5C 10C 5B+10C 10B+10C A \$10.5 10.5 2.9 2.9 Aircraft Value (in millions) B \$6.7 6.7 1.0 1.0 C \$1.0 1.0 1.0 1.0

3.

a.

PV of 1 − year − old plant =
PV of 2 − year − old plant =

43.33 58.33 + = \$76.62 1.20 1.20 2
58.33 =\$48.61 1.20

106

b.

Given that the industry is competitive, the investment in a new plant to produce bucolic acid must yield a zero NPV. First, we solve for the revenues (R) at which a new plant has zero NPV. 0 1 2 3 1. 2. 3. 4. 5. Initial investment Revenues net of tax Operating costs net of tax Depreciation tax shield Salvage value net of tax -100 0.6R -30 +40 +15 0.6R -30 0.6R -30

Therefore:

NPV =−100 +

(0.6R −30 +40) (0.6R −30) (0.6R −30 +15) + + =0 1.20 1.20 2 1.20 3
−2 .1 1 1 8

0 =−1 0 + .2 4 0 1 6R R =\$9 .87 5

We can now use the new revenue to re-compute the present values from Part (a) above. (Recall that existing plants must use the original tax depreciation schedule.).

PV of 1 − year − old plant =

40.93 55.93 + = \$72.95 1.20 1.20 2
55.93 =\$46.61 1.20

PV of 2 − year − old plant =

c.

Existing 2-year-old plants have a net-of-tax salvage value of: 50 – [(0.4)× (50.0 - 33.3)] = \$43.33

d.

Solve again for revenues at which the new plant has zero NPV: 0 1. 2. 3. 4. Initial investment Revenues Operating costs Salvage value -100 +R -50 +R -50 +R -50 +25 1 2 3

NPV =−100 +

(R −50) (R −50) (R −50 +25) + + =0 1.20 1.20 2 1.20 3
−9 .8 6 0 5

0 =−1 0 +2 0 R 0 .1 6 R =\$1 9

107

With revenues of \$91:

PV of 1 − year − old plant =

41 66 + =\$80 1.20 1.20 2
66 =\$55 1.20

PV of 2 − year − old plant =

108

CHAPTER 12 Making Sure Managers Maximize NPV
Answers to Practice Questions 1. Post-audits provide information on problems that may need to be corrected in order for newly completed projects to operate as intended. Also, the postaudit provides preliminary data on the validity of the forecasts for the project and the corrections that may be needed in this process.

The postaudit should be performed by a disinterested party. It should not be done by someone involved in the operations of the project or someone responsible for its planning. The postaudit should be performed after resolving any minor “bugs” that occur during the start-up process. Once this stage has been reached, the postaudit should investigate all phases of the project, both financial and technical. The issue of which projects to audit depends on the cost of performing audits and on the value of the information obtained. Larger projects usually require audits in order to be certain that everything performs as expected. If there are unexpected problems, it is generally advisable to find out about them as soon as possible. Postaudits for smaller projects might make sense when a series of projects of a given type can be investigated. Standardized postaudit procedures can be developed and statistical analyses performed. 2. Outline of steps in capital budgeting process: (1) Plant manager gets idea, does some very rough estimates, and determines whether idea is worth pursuing. (2) Staff of plant manager develops detailed proposal, including: Discussion of reason that the company should invest in this machine Economic forecasts Demand forecasts Cash flow forecasts, both revenue and expenses Estimate of cost of capital (unless specified at a higher level) Net present value or internal rate of return calculation (3) Proposal is evaluated by division level staff. If approved, proposal is evaluated at company level. (4) Project authorization is requested, which may require a final check/revision of the numbers in the original proposal. (5) Purchase and installation proceed. If there are significant cost overruns, these must be re-approved by the division and company staff. (6) When the machine is up and running, say after one year, a postaudit might be conducted to evaluate the entire process. 109

• • • • • •

This is done because they are directly responsible for day-to-day performance and this valuation method provides an absolute standard of performance.55m = -\$0. They may choose second-best investments to reward existing employees rather than the alternative that requires outside personnel but has a higher NPV. Tying the manager’s compensation to EVA attempts to ensure that assets are deployed efficiently and that earned returns exceed the cost of capital. 5. They may reduce their efforts to find and implement projects that add value. Hence.03m . as opposed to a standard that is relative to shareholder expectations. overspending on expense accounts. the greater the EVA. This is usually done to align as closely as possible the interests of the manager with the interests of the shareholders. When paid a fixed salary without incentives to act in shareholders’ best interest. Further.3. tickets to social events. EVA = Income earned – (Cost of capital x Investment) = \$8.\$8.03m – (0. They may extract benefits-in-kind from the corporation in the form of a more lavish office. 2.04m EVA = \$8. Plant and divisional managers are usually paid a fixed salary plus a bonus based on accounting measures of performance.52m The market value of the assets should be used to capture the true opportunity cost of capital. 110 .09 x \$95m) = \$8. The more the manager works in the interests of the shareholder.09 x \$55. In order to maintain their comfortable jobs. These managers are usually responsible for corporate strategy and policies that can directly affect the future of the entire firm. a. a. managers may invest in safer rather than riskier projects.99m = \$3. 5. 1.03m – (0. The typical compensation and incentive plans for top management include salary plus profit sharing and stock options. managers often act sub-optimally. b. 3. actions taken by the manager to shirk the duty of maximizing shareholder wealth generally result in a return that does not exceed the minimum required rate of return (cost of capital).\$4. They may expand the size of the operation just for the prestige of running a larger company 4.03m . 4. b.4m) = \$8. etc. it allows for the evaluation of junior managers who are only responsible for a small segment of the total corporate operation.

in addition to the problem of expectations discussed in Part (a). b. this information should be immediately reflected in the stock price. Entrenching investment: Favoring projects to reward existing managers instead of pursuing higher value-added projects requiring new expertise. Thus. it is a measure of performance. For example. because they are industry experts and are paid by potential investors. EVA = Income earned – (Cost of capital x Investment) = \$1. Perks: Exploiting the benefits of the managerial position in order to get benefits from the corporation for personal use. This is particularly true for firms with large numbers of shareholders. Another alternative would be to compare the performance with the performance of competitive firms. higher value-added projects. If the manager then performs as expected. Also.2m – [0. One solution might be to index the price changes and then compare the actual raw material price paid with the indexed value.9m 8. in looking-out for their own shareholders’ or customers’ interests. Security analysts generate business for their own firms based upon the accuracy of their recommendations.15 x (\$4m + \$2m + \$8m)] = \$1. Avoiding risk: Choosing safer projects over more risky. A motivated monitoring agent reduces the free-rider problem by assuming the delegated monitoring duties.2m . If a firm announces the hiring of a new manager who is expected to increase the firm’s value. there should not be much change in the share price since this performance has already been incorporated in the stock value. such as federal monetary policy or new environmental regulations. 9. the stock price does tend to increase or decrease depending on whether the firm does or does not exceed the required cost of capital.1m = -\$0. the analysts examine the performance of the firm’s      111 .6. c. This could potentially be a very serious problem since the manager could lose money for reasons out of her control. Empire building: Obtaining and running larger operations merely for personal prestige. there are numerous factors outside the manager’s control. Agency problems likely to be encountered in capital investment decisions: Reduced effort: Shirking the responsibility of finding and implementing valueadded projects. they are also working in the best interests of the shareholders of the firms they analyze. It is not necessarily an advantage to have a compensation scheme tied to stock returns. a. 7. However.\$2. To this extent.

which is the same as the sum of the Book Income figures from the table (i. t=0 Investment 100 Depreciation Book Value End of Year Net Revenue 0 Production Costs 0 Transport & Other 0 Book Income 0 Book Rate of Return Cash Flow -100 PV at Start of Year PV at End of Year Change in PV Economic Depreciation Economic Income t=1 10. and every year we close one and begin construction on another.0 80.9 10. usually the Board of Directors and independent outside auditors.0 120. The total book income is \$76.0 20. False.8 -16.9 -22.1 1. Thus.0% 26.0 16.0 -22.4 112 .0 10.4 135. the sum of -\$30.0 76.0 30. The biases rarely wash out.. a.1 67.0 12. True. 10.2 10.1 -20.0 70. 11.9% 26. Because a plant lasts for 10 years.0 20. etc.0 60.0% 53.0 46. ‘steady state’ for a mature company implies that we are operating ten plants.4 -14. Thus.0 20. even in the steady state.0 16. steady state income may not be much affected by investments in R & D but book asset value is understated.6 t=6 t=7 10. (We assume straight-line depreciation.2 15.6 6.capital investment program.0 0.4 16.0 -30.0 -30.0 30. -\$22.4 -19.0 76.0 t=9 10.4 24.0 20. The year-by-year book and economic profitability and rates of return are calculated in the table below.0 30.0 76.8 t=5 10.0 26.2 7.0 t=4 10.0 16.9 22. who are elected and/or paid to meet with top management in order to determine whether the firm is being operated in a fashion consistent with the best interests of the shareholders. Firms are eager to have more investors since it makes raising capital easier for future projects. Similarly.e.0 30.0 76.0 40.0 14.0 67. book profitability is too high.0 16. the total book investment is \$550.4% -20. Delegated monitoring refers to a group of individuals.0 16.2 103. which is 8 percent.4 27.).2 30.1 24.3 22.0 30.0 30. b.2 127.0 -24.0 -12.0 160.0% 26.0 20.1 0.2 149.0 20.0 30.0 149.1 -22.0 20.1 20.0 46.7 t=10 10.3% 26.0 20.0 76. Note that this is considerably different from the economic rate of return.0 26.0% 26.3 3. For example. \$10 per year for years one through ten).4 120.0 16.8%.0 0.0 24.0 99.0 t=8 10.0 76.0 50.0 80.2 -27.0 86. the steady state book rate of return for a mature company producing Polyzone is: (76/550) = 13.0 76. \$16.3 127.0 22.0 16.0 t=2 t=3 10.0 20.4 9. All biases in book profitability can be traced to accounting rules governing which assets are put on the balance sheet and the choice of book depreciation schedules.9 5.0 20.0 20.0 135.9 90.7% 26. 12.0 30.6 19.0% -24.2 -15.0 0.

67 -0.00 666. Hence.1720 Internet exercise. economic depreciation in this case is accelerated.1000 0.0 125.0996 5 138.5 125.33 0.0 114.00 833.1313 2 298.7 Economic return 99.7 103.66 -0.0 138.9 239.1000 0. a.3 Rate of return 0. The book ROI is calculated in Panel B (using straight-line depreciation).66 166.67 166.66 -28.67 -28. Forecasted Book Income and ROI Year Cash Flow BV at start of year BV at end of year Change in BV Book depreciation Book income Book ROI 14.66 166.66 0.1 217.67 131.66 131.67 per year.33 -166.5 -114.2 239.1002 6 138.33 666.8 582.00 833.1 -217.0% 8. answers will vary. The true rate of return is found by dividing economic income by the start-of-period present value.0 298.0573 A.7 -103.9 343.66 -166.00 166.67 131.9 -239.67 166.00 333.0999 B.0 PV at start of year 998.9 800.0 -125.67 -0.00 1000. b.0% 8.66 -166. Straight-line depreciation would be \$166.1 58.0% 8.00 -166.0 298.9 80.00 500.0% 8.0% 8. 5 138.5 12.1000 0.33 166.0 0.66 500. this will always be 10 percent.0 24.0 239. As stated in the text.00 333.Economic Rate of Return 8.0% 8. relative to straight-line depreciation.1576 3 298.7 Economic depreciation 198.9 343.0% 8.0860 6 138.8 582.67 -28.00 -166.34 0.3 34. See table below.5 125. 1 298. 113 .33 0.67 166. Forecasted Economic Income and Rate of Return Year 1 2 3 4 Cash Flow 298.0% 8.5 0.67 166.5 Change in PV -198.5 0.33 -166.1970 4 138.2 PV at end of year 800.0% 13.

the ability to expand production in the future). No. 3.e. 3 667 916 1210 4 500 734 1008 1331 3573 0.g..021 *This is the steady state rate of return. 2. ROI for Nodhead is given in the table below.Challenge Questions.100* 114 . The problem in managing performance is the difficulty in obtaining economic values for some activities (e. Book Income for Assets Put in Place During Year 1 2 3 4 5 6 Total Book Income: 1 -67 2 33 -74 3 83 36 -81 4 131 91 40 -89 5 131 144 100 44 -98 321 -67 -41 38 173 6 131 144 159 110 48 -108 484 Book Value for Assets Put in Place During Year 1 2 1 1000 833 2 1100 3 4 5 6 Total Book Income: 1000 1933 Book ROI: -0. As a result. we are left with accounting figures derived from arbitrary rules governing the assets or expenditures that should be put on the balance sheet. the economic rate of return and book ROI are the same.048 5 333 550 807 1109 1464 4263 0. For a 10 percent expansion in book investment.014 6 167 366 605 888 1220 1610 4856 0. there would be no need for EVA. 1. When the steady-state growth rate is exactly equal to the economic rate of return (i. The optimal level of agency costs is the point at which the marginal return derived from monitoring top management and ensuring they are working in the best interests of the shareholders equals the marginal cost of any shirking and other acts that do not maximize value. and how these assets are treated for deprecation purposes. 10 percent)..067 -0.075 2793 0.

10 Year 2 4.20 0.80 8 4 -4 4 0.10 4 0.80 0.40 0.40 4 0 -4 4 0.10 115 .10 4 0.40 0.10 Year 3 4.20 0.80 0. Year 1 Cash Flow PV at start of year PV at end of year Change in PV Economic depreciation Economic income Economic rate of return Book depreciation Book income Book rate of return 5.10 4 1.4.20 12 8 -4 4 1.

First calculate present value and economic income of one parlor (figures in thousands): Year 1 Year 2 Year 3 Year 4 Cash flow 0 40 80 120 PV start of year 200 240 248 218 Change in PV +40 +8 -30 -76 Economic income +40 +48 +50 +44 Economic return 0. i.20 Given that the cost of capital is 20 percent. the rate of return equals the cost of capital (or investing \$200. Now consider what happens to Kipper’s book income and return. these parlors are break-even investments..20 Year 5 5 410 600 200 210 0. If Kipper’s sole asset in 2001 was one parlor.000 buys an asset worth \$200.000). Year 5 170 142 -142 +28 0.11 0 0.20 0.14 The steady-state book return of 35 percent is reached in year 5. The value of Kipper’s stock should not be affected by the announcement that it intends to make more zero-NPV investments. the market value of the common stock should be \$200.000.20 0.e.5. the rate of expansion is immaterial. For the first expansion plan: Year 1 Year 2 Year 3 Year 4 Number of parlors 1 2 3 4 Cash flow 0 40 120 240 BV start of year 200 360 480 560 Book depreciation 40 80 120 160 Book income -40 -40 0 80 Book ROI -0.35 116 .20 0. In that case.20 -0.

18. Thus. not to true value.00 – 1. Note that the book rate of return exceeds the true rate in only the first year. Of course.05) = 2. a.20 Year 2 3 40 560 120 -80 -0.21.2 × 19. Of course. just so long as it is the same each year). for a total book income of 15. It would also reduce earnings per share. book income will be (3. Because the economic return from investing in one airplane is 10 percent each year. economic depreciation is accelerated in this case. Kipper’s book profitability has crept up to only 10 percent. Perhaps this explains the market letter’s change of heart.62 from the airplane in its first year.05 Thus. In order to calculate the book return.69)]/15 = 1. Kipper’s rate of expansion under the second plan must slow down eventually. 117 . The point is that.95) = 1. etc. more rapid growth in zero-NPV investments hurts book profitability. (3. 6. because economic depreciation is decelerated. while book depreciation (per year) is: [19. for a total book value of 185. See table on next page. c. Note that economic depreciation is simply the change in market value. b. Book value is calculated similarly: 19.95 from the airplane in its second year. the steady-state book rate of return is 8.08 Year 4 10 400 1600 400 0 0 Year 5 15 810 2200 600 210 0. assume that we invest in one new airplane each year (the number of airplanes does not matter.69 – (0..10 By year 5. the economic return from investing in a fixed number per year is also 10 percent each year.14 Year 3 6 160 1040 240 -80 -0..For the second expansion plan: Year 1 Number of parlors 1 Cash flow 0 BV start of year 200 Book depreciation 40 Book income -40 Book ROI -0. Thus. See table on next page. which understates the true (economic) rate of return (10 percent). the market letter has responded to book prospects.67 – 1. the rate at which you add zero-NPV investments does not affect economic return or economic earnings per share.69 for the airplane just purchased. relative to book depreciation.22 percent. Then.64 for the airplane that is one year old.10. etc.

78 1.49 10.5% 8 12.63 1.1% 13 9.55 1.05 0.0% 18.64 1.04 1.46 0.0% 10.05 1.52 1.4% 118 .2% 19.32 5.05 0.41 5.39 0.05 0.89 0.6% 11 10.3% 12 10.21 10.99 1.44 1.68 2.3% 5 14.80 10.48 1.34 10.05 0.68 0.00 1.6% 6 14.62 13.59 1.69 2 17.0% 6.01 0.42 8.52 1.89 2.41 10.09 10.39 1.91 0.37 0.05 1.90 10.3% 16 8.49 1.09 0.0% 3.85 6.05 0.73 2.15 10.54 1.59 0.69 1.46 0.44 0.0% 4.75 6.43 1.56 6.94 1.24 1.0% 14.05 0.70 1.05 1.67 1.05 0.36 0.05 1.24 8.02 1.14 1.68 10.3% 3 16.70 3.9% 10 11.0% 17.09 1.20 3.29 1.80 1.14 1.0% 12.8% 15 9.32 0.34 1.05 0.27 5.0% 11.99 10.99 1.0% 9.0% 8.47 1.Year Market value Economic depreciation Cash flow Economic income Economic return Book value Book depreciation Book income Book return 1 19.79 1.64 9.04 10.59 1.47 1.42 1.0% 7.19 1.29 1.58 10.27 10.61 1.90 1.0% 13.8% 14 9.47 5.01 2.80 2.5% 4 15.05 0.0% 7 13.97 7.05 2.05 1.09 7.05 0.94 10.97 10.0% 15.65 6.69 Year Market value Economic depreciation Cash flow Economic income Economic return Book value Book depreciation Book income Book return 9 12.91 0.0% 16.95 10.

there are different risks involved. When the shortterm note is due. this may not be possible. and that there is some as-yet-unidentified risk factor. b.U. there is always a possibility.g. well-known companies.versus long-term rates. Thus. dollar exchange rate will change during the period of time for which we have invested. we should be very skeptical. 11. Some key points are as follows: a.. They are both under the illusion that markets are predictable and they are wasting their time trying to guess the market’s direction. The decision as to when to issue stock should be made without reference to ‘market cycles. mutual funds and pension funds) are biased toward holding the securities of larger. Thus. Thus.S is not very efficient. it is likely that the market for small stocks is fundamentally different from the market for larger stocks and hence. in other words. when such an opportunity seems to present itself.’ The efficient-market hypothesis says that there is no easy way to make money. 12. Coincidence: In statistical inference. For example. Unidentified Risk Factor: From an economic standpoint. Not true. 121 . there is the risk that the Japanese yen . and borrowing short-term versus long-term. suppose that we need the money long-term but we borrow short-term. Market Inefficiency: One key to market efficiency is the high level of competition among participants in the market.S. Thus. For example:  In the case of short. it is quite plausible that the small-firm effect is simply a reflection of market inefficiency. however slight. given the information available and the number of participants. no matter what the outcome of a statistical test. that the small-firm effect is simply the result of statistical chance or. the most likely explanation for the small-firm effect is that the model used to estimate expected returns is incorrect. However. or may only possible at a very high interest rate. Remember the first lesson of market efficiency: Markets have no memory. 13. For small stocks. we never prove an affirmative fact. it is hard to believe that any securities market in the U. all will look for these patterns and all will trade based on such patterns. Remember that we cannot all get rich simultaneously.  In the case of Japanese versus United States interest rates. c. a coincidence. But such trading itself will destroy the patterns.10. we must somehow refinance. the level of competition is relatively low because major market participants (e. The best we can do is to accept or reject a specified hypothesis with a given degree of confidence. If everyone believes that patterns exist.

74.5)] = 8. the average abnormal return of the two stocks during the month of the dividend announcement was 8..01 (As a point of interest.1 – [-0.01 × (-9.) The abnormal return for Executive Cheese in September 2000 was: 5.S. which is relatively low for a regression of this type. 15.34% For Paddington Beer in January 2000 the abnormal return was: -11. We have chosen to use the regression analysis function of an electronic spreadsheet program to calculate the alpha and beta for each security.082.51 Beta 0. There are several ways to approach this problem. a relatively high value.6 – [-0. In the U. Stocks are bought at (higher) ask prices and sold at (lower) bid prices.11) is revenue for the broker. the R2 for the Executive Cheese regression is 0. For Paddington Beer. Goldman Sachs is providing an intermediary service for which they should be remunerated.7)] = 9. The government of Kuwait is not likely to have non-public information about the BP shares. The ‘profit’ of \$15 million reflects the size of the order more than any mispricing.51 + 2.89 + 0.125) was not uncommon.50 2.50 × (-5.14.93 percent. 122 . a bid-ask spread of 1/8 (\$0. it is 0. at that time.89 -0. The market is most likely efficient. but all (when done correctly!) should give approximately the same answer. The regressions are in the following form: Security return = alpha + (beta × market return) + error term The results are: Alpha Executive Cheese Paddington Beer -0. The spread between the two (\$0.51% Thus.

c.05 per share.260 million shares = \$1.851 million = \$8.416 million]/4. it would be very difficult to determine the firm’s opportunity cost of capital or to assess the firm’s financial performance. a. million The shares were sold at an average price of: [\$213 million + \$5. Average repurchase price: \$6.59 per share. Well-functioning capital markets allow the firm to serve all its stockholders simply by maximizing value. Market values reflect not only the firm’s current operations but also the market’s expectations of future operations.851 million/413 million shares = \$16.416 million + \$10.109 million . Internet exercise.260 million shares b.CHAPTER 14 An Overview of Corporate Financing Answers to Practice Questions 1. capital markets also provide managers with information. It appears that par value is approximately \$0.32 The company has repurchased: 4. 2. This occurs because the book value of equity reflects historical values at the time of the original stock issues. they are willing to invest in companies that retain earnings rather than paying out earnings as dividends.\$6.887 3. Capital markets provide liquidity for investors. answers will vary. In general. Because individual stockholders can always recover retained earnings by selling shares. Besides the function of providing funds to industry. d.3. Without this information. using market values of equity results in lower debt-to-total capital ratios. 4. which is computed as follows: \$213 million/4. The value of the net common equity is: \$213 million + \$5.260 million .847 million = 413 million shares. 124 . e.

125 .

0 (3. Common shares (\$0.5 4.0) (652.0 7.0) (652.791.5 4.397.10 par value) Additional paid-in capital Retained earnings Treasury shares at cost Net common equity \$ 50.5.000 1.950.0) \$2. After 2 years of operation: Common shares (\$0.097. The day after the founding of Inbox: Common shares (\$0.10 par value) Additional paid-in capital Retained earnings Treasury shares at cost Net common equity \$ 50.757.000 c.000 6.5 1.950.0) \$3.120. a.791.0 \$ 120.000 1.000 0 \$2.25 par value) Additional paid-in capital Retained earnings Treasury shares Other adjustments Net common equity b.757. After 3 years of operation: Common shares (\$0.5 1.0 (2.370.000.000 6. Common shares (\$0.000 370.000 0 0 \$2. One would expect that the voting shares have a higher price because they have an added benefit/responsibility that has value.000 b.000 0 \$7.10 par value) Additional paid-in capital Retained earnings Treasury shares at cost Net common equity \$ 50.920.620.000 120.850. 126 . a.25 par value) Additional paid-in capital Retained earnings Treasury shares Other adjustments Net common equity \$ 120.

000 9.000 \$ 660.000 80. Less valuable More valuable More valuable Less valuable 127 .000 \$ 429.000 100. answers will vary.8. d.000 \$ 660.000 100. a. Internet exercise.000 231. Gross profits Interest EBT Tax (at 35%) Net income Preferred dividend Funds available to common shareholders \$ 760. b.000 \$ 760. c.000 \$ 429.000 \$ 349.000 231. a. Gross profits Interest EBT Tax (at 35%) Funds available to common shareholders b. 10.

is allowed to trade unregistered securities with other qualified institutional buyers. c. In Marvin’s case. a. A qualified institutional buyer is a large financial institution which. First-stage and second-stage financing comes from funds provided by others (often venture capitalists) to supplement the founders’ investment. b. A best efforts offer is an underwriter’s promise to sell as much as possible of a security issue. after the financing provided by venture capitalists. management was increasing its own risk and reducing that of First Meriam. A road show is a presentation about the firm given to potential investors in order to gauge their reactions to a stock issue and to estimate the demand for the new shares. the managers are the shareholders. a.CHAPTER 15 How Corporations Issue Securities Answers to Practice Questions 1. under SEC Rule 144A. e. g. The cost of management perks comes out of the shareholders’ pockets. Zero-stage financing represents the savings and personal loans the company’s principals raise to start a firm. 2. Marvin’s management agreed not to accept lavish salaries. By accepting only part of the venture capital that would be needed. Management’s willingness to invest in Marvin’s equity was a credible signal because the management team stood to lose everything if the new venture failed. b. Blue-sky laws are state laws governing the sale of securities within the state. d. 129 . Mezzanine financing comes from other investors. This decision would be costly and foolish if Marvin’s management team lacked confidence that the project would get past the first stage. f. and thus they signaled their seriousness. An after-the-money valuation represents the estimated value of the firm after the first-stage financing has been received.

the issue may be auctioned off. The share price is higher but the entire issue may not be sold. Large issues have lower proportionate costs.  The risk of the security is less for debt and hence the price is less volatile.3. d. so it is not correct that flotation costs increase the cost of external equity capital by ten percentage points. among them:  The cost of complying with government regulations may be lower for debt. flotation costs do increase the cost of external equity capital. lowest acceptable) price. the firm may place a reserve (i. the issue is oversubscribed and investors receive only a portion of their desired shares. the price of the shares is fixed and the number of shares sold is in question. In these cases. 130 . he will receive only a portion of the shares he applies for. Underwriters demand higher spreads in compensation. b. Firm commitment underwriting in which the investment bankers buy the entire issue before reselling it to the public. but both price and the number of shares sold are not known in advance. not enough shares will be sold. If the price is too high. but at a price below the offering price. This increases the probability that the issue will be mis-priced and therefore increases the underwriter’s. If he bids on under-subscribed stocks.e. Hence. Debt issues have lower costs than equity issues. which no one else is willing to buy. the stocks may be under-priced but once the weighting of all stocks is considered. 4. Some possible reasons for cost differences: a. 7. There are several possible reasons why the issue costs for debt are lower than those of equity.. 6. not an annual cost. he will receive his full allotment of shares. Initial public offerings involve more risk for underwriters than issues of seasoned stock. c. on average. The issuing company receives the money immediately. b. In some countries. Best efforts offers in which the investment banker tries to sell as much of the issue as possible. if the price is too low. Alternative procedures for initial public offerings of common stock include: a. However. c. it may not be profitable. In a fixed price offer. If he is bidding on under-priced stocks. This is a one-time cost. 5.

c.17 = \$0. This would be the case only if investors believe that a stock has no close substitutes (i. b. there should be a subsequent price recovery. therefore. even if it means foregoing a good investment opportunity.000. mark down the price when companies issue stock. If (a) is the reason. there are 100 shares outstanding at \$10 per share. but the fall should be greater for large issues. while old shareholders lose: (100 × \$0. If (c) is the reason. a. If a shareholder sells his right. managers of a company with undervalued stock become even more reluctant to issue stock because their actions can be misinterpreted. we would not expect a price recovery.83 cash and the value of each share declines by \$10 . b. Inelastic demand implies that a large price reduction is needed in order to sell additional shares. Thus. 5 × (10. If a company’s stock is undervalued.17 (100 +20) 120 Note that new shareholders gain: (20 × \$4.20 N +1 4 +1 131 . and for firms that may later require a re-negotiation of the terms of the debt contract.\$9.. there are 100 shares outstanding at \$10 per share.83. a.] a. Investors know this and. Example: Before issue. b.17. The converse is true if the stock is overvalued. Company value increases by: (20 x \$5) = \$100.100 = = \$9. Price pressure may be inconsistent with market efficiency. the price fall will depend only on issue size (assuming the information is correlated with issue size). they value the stock for its unique properties).17) = \$83. A private placement is preferable to a public issue for firms that face high public issue costs.8. each share is worth: (100 ×\$10) +\$100 \$1.83) = \$83. 9. The new share price is \$9.5 million Value of right = (rights on price) −( issue price) 6 −5 = = \$0. The company makes a rights issue of 20 shares at \$5 per share. Example: Before issue.000/4) = \$12. The company sells 20 shares for cash at \$5 per share. after issue. (Of course. The shareholder’s total wealth is unaffected. he receives \$0. managers will be reluctant to sell new stock. Each right is worth: Value of right = (rights on price) −(issue N +1 price) = 10 −5 = \$0.e.) If (b) is the reason for the price fall.83 6 11. 10. It implies that the stock price falls when new stock is issued and subsequently recovers. [Note: The parts of this problem were labeled incorrectly in the first printing of the seventh edition.

2 × \$6) = \$19.00 0 = \$5.2 shares with a value of: (4.00 0 × \$6) + \$12. The share price would have to fall to the issue price per share.000.000/3.500.125.500.2 × \$5.000/\$4) = 3.500.00 0 = \$5. so that the total value is: (\$19.80 (10.52 (10.20 + \$4) = \$23.20.00 0 + 2.18 (difference due to rounding).48 N +1 3.52) = \$23.000.20 rights per share Value of right = (rights on price) −( issue price) 6 −4 = = \$0. or \$5 per share.20.c.125.000) A stockholder who previously owned 3. This stockholder has now paid \$5 for a fifth share so that the total value is: (\$24 + \$5) = \$29.000) A stockholder who previously owned four shares had stocks with a value of: (4 × \$6) = \$24.2 shares had stocks with a value of: (3. This stockholder now owns 4.000. This stockholder has now paid \$4 for an additional share. This stockholder now owns five shares with a value of: (5 × \$5. 132 .00 0 × \$6) + \$12. Firm value would then be: (10 million × \$5) = \$50 million 12. Stock price = (10.00 0 + 3.500.000 shares (\$10.000) = 3.2 +1 Stock price = (10. (\$12.80) = \$29.125. d.000.000. so that she is no better or worse off than she was before.

000 shares of common stock are issued at \$40 per share. it would not have the incentive to maximize the price at which it sells the new shares. a. Assuming that the 8% return is received in the form of a perpetuity. The right of first refusal could make sense if First Meriam was making a large up-front investment that it needed to be able to recapture in its subsequent investments.000) are then invested at 8%. With hindsight.000 + (0. 133 . Venture capital companies prefer to advance money in stages because this approach provides an incentive for management to reach the next stage. Marvin is likely to get the best deal from First Meriam. 3. but rather due to the fact that the NPV is negative. First Meriam loses because it has to pay more for the shares at each stage.Challenge Questions 1. while Marvin would have an incentive to ensure that the option was exercised. b. The problem with this arrangement would be that. Pisa proposes a scenario in which 2. 2. Pisa Construction’s return on investment is 8%. and it allows First Meriam to check at each stage whether the project continues to have a positive NPV. A uniform-price auction provides for the pooling of information from bidders and reduces the winner’s curse. c. In practice. all successful bidders pay the same price. In a discriminatory auction. whereas investors require a 10% rate of return. and the proceeds (\$80.08 × \$80. each successful bidder pays a price equal to his own bid. Marvin is happy because it signals their confidence. In a uniform-price auction.000)/0.10 = -\$16. not because the company sells shares for less than book value.000 Share price would decline as a result of this project. then the NPV for this scenario is computed as follows: -\$80.

40) = 2.000/\$38. Pisa will not be able to sell shares at \$40 per share. then share price remains unchanged. Rather. One can show that. This question is a matter of opinion. Pisa will have to issue (\$80.000)/10. after the announcement of the project. for example. the share price will decline to: (\$400. 134 .Note that.000 = \$38.083 new shares.000 .\$16. if investors know price will decline as a consequence of Pisa’s undertaking a negative NPV investment. 4. Students might discuss whether there are likely to be shortages of venture capital. Another issue to be discussed is whether there are side benefits to the rest of the economy from an active venture capital industry. in some countries there might not be an active market for small firm IPOs.40 Therefore. if the proceeds of the stock issue are invested at 10%.

10 = 10. Distributes a relatively low proportion of current earnings to offset fluctuations in operational cash flow. answers will vary depending on the stocks chosen. the total value of the shares at t = 1 (after the t = 1 dividend is paid and after N new shares have been issued) is given by: V1 = 1. zero) and a lower adjustment rate (e. each share in the company will enjoy a perpetual stream of growing dividends: \$1.0% Beginning at t = 2. and increasing by 5% in each subsequent year. using the Lintner model. lower 3. Thus.05 m illion = \$21 m illion 0. 2. Newspaper exercise. zero) reduce the variance of dividend changes. 4.g. it is easy to show. Distributes a relatively low proportion of current earnings in order to fund expected growth.. d. a. Distributes a relatively low proportion of current earnings in order to offset anticipated declines in earnings. The available evidence is consistent with the observation that managers believe shareholders prefer a steady progression of dividends. P/E ratio.g. higher P/E ratio. that a lower target payout (e.. Thus. lower P/E ratio.05 at t = 2. a.05 If P1 is the price per share at t = 1. c. b.CHAPTER 16 The Dividend Controversy Answers to Practice Questions 1. Distributes a relatively high proportion of current earnings since the decline is unexpected. A t = 0 each share is worth \$20. This value is based on the expected stream of dividends: \$1 at t = 1. then: 135 . and increasing by 5% in each subsequent year.10 −0 . higher P/E ratio. we can find the appropriate discount rate for this company as follows: P0 = D 1 IV r −g 1 2 = 0 ⇒ r −g r = 0. For managers of risky companies whose earnings have high variability.

000 new shares.000 1. the firm will sell 50. dividends per share are: \$1 at t = 2. c. The risk stems from the decision to not invest.000 = \$20.10) 0 d.000 + N) = \$21. then the new shareholders are getting a bargain.000. If an investor consumes the dividend instead of reinvesting the dividend in the company’s stock. Restricting dividends does not restrict the investor’s ‘wages. From Question 4.000 = 21.000.000. she is also ‘selling’ a part of her stake in the company.00 b.. 6.000.000 and: P1 × N = \$1. No.000.000 so that P1 = \$20. 5.000 shares outstanding.000. increasing by 5% in each subsequent year. With 1. this does not make sense.000 × P1) + 1.000 at t = 2.10 − 0 . As pointed out in the text.000. increasing by 5% in each subsequent year. With P1 equal to \$20. then shareholders are clearly not indifferent to dividend policy.’ For the policy to be effective.000. i. If this stock issue cannot be made at a fair price.00 (0.000.V1 = P1 × (1. Thus. the new shareholders win and the old shareholders lose. In this scenario.000.000.000 Substituting from the second equation: (1. total dividends paid to old shareholders are: \$1.000 From the first equation: (1.050. The expected dividends paid at t = 2 are \$1. 136 7.000.e. increasing by 5% in each subsequent year. .000 × P1) + (N × P1) = 21.000 to raise. she will suffer an equal opportunity loss if the stock price subsequently rises sharply.000. it would also have to restrict capital gains. the fair issue price is \$20 per share.050. and \$1. If these shares are instead issued at \$10 per share. For the current shareholders: PV (t = 0) = \$2. and it is not a result of the form of financing. any increase in cash dividend must be offset by a stock issue if the firm’s investment and borrowing policies are to be held constant.05) ×(1.000.10 + \$1.

9. a.500 + NPV \$5. Since the share price is \$80.500 + NPV Debt Equity Because the new stockholders receive stock worth \$1. the company will look like this next year: Net profit: Number of shares: Earnings per share: Price-earnings ratio: Share price: 10. in order to raise the cash necessary to repurchase the shares.500 + NPV If the company pays a \$1.500 1. One problem with this analysis is that it assumes the company’s net profit remains constant even though the asset base of the company shrinks by 20%. and so the company has \$400.500 + NPV Debt Value of new stock Value of original stock 0 5. the company must sell assets.500 + NPV 0 1. then share price will remain at \$80. 137 .000. If the assets sold are representative of the company as a whole.8 million \$10 20 \$200 If we ignore taxes and there is no information conveyed by the repurchase when the repurchase program is announced. which exactly offsets the dividends.000 + NPV \$5. The regular dividend has been \$4 per share.8. \$8 million 0.000 dividend: Cash Existing fixed assets New project 0 4.500 1. we would expect net profit to decrease by 20% so that earnings per share and the P/E ratio remain the same.000.000 cash on hand. If the company does not pay a dividend: Cash Existing fixed assets New project 0 4.000 4. That is.000 shares.500 + NPV \$5.000 + NPV \$5. After the repurchase. b. the value of the original stock declines by \$1. the company will repurchase 5.

so the stock price (immediately prior to the dividend payment) will be \$80 in all years. Total asset value (before each dividend payment or stock repurchase) remains at \$8. These assets earn \$400. or a return of 5.000 95.250 85.000.31 Shares Repurchased 5.000 available to repurchase shares. As noted above. 5.21 \$88. At t = 1. the shareholders would prefer a share repurchase to a negative-NPV project. share repurchase is detrimental to those stockholders who sell and beneficial to those who do not. 12.000. Suppose that the trade-off is between an investment in real assets or a share repurchase. If markets are efficient.750 4.00 \$84. Thus. These shares will be worth \$8.000. Using this reasoning.000. Because companies are reluctant to reduce their dividends. whereby every year assets worth \$7. The quoted statement seems to imply that firms have only negative-NPV projects available. \$400.000 (the asset value immediately after the dividend) earn \$400. they will normally increase dividends only when management is fairly certain that the increases can be sustained. however.000. under either policy. Another possible interpretation is that managers have inside information indicating that the firm’s stock price is too low.000 shares outstanding.000 4. we can generate the following table: Time t=0 t=1 t=2 t=3 Shares Outstanding 100. In this case.000 90.000 per year. It is difficult to see how this could be beneficial to the firm. Obviously.c.000 is available for share repurchase. Old Policy: The annual dividend is \$4.750. 11. With \$400.600.513 4.21 per share.64 \$93.26%. the total number of shares repurchased will be 4. there will be 95. which never changes. immediately prior to the repurchase.737 Share Price \$80. an increase in dividends signals 138 .000 shares will be repurchased at t = 0.287 Note that the stock price is increasing by 5. This is consistent with the rate of return to the shareholders under the old policy. New Policy: Every year.26% each year. then a share repurchase is a zero-NPV investment. or \$84.

the stock price will fall by the amount of the dividend. Earnings per share is irrelevant. This conclusion. there will be no effect on capital investment. companies that pay no dividend would have a zero cost of equity capital. The stock price will thus fall by the amount of the aftertax dividend. a. Because this is a regular dividend.0. here \$1 × (1 . In other words. Thus. 15. Retained earnings carry the full cost of equity capital (although issue costs associated with raising new equity capital are avoided). One way to think of retained earnings is that. 139 .70. then the restriction on dividends would increase capital gains. With no taxes. b. that is. the stock price will fall on the ex-dividend date. the company earns money on behalf of the shareholders. from an economic standpoint. b. thus. who then immediately re-invest the earnings in the company. the other. With taxes on dividends but no taxes on capital gains. if we assume that dividends would have risen in the absence of the constraint. retained earnings do not represent free capital. If we assume that the constraint on dividends is binding. a capital gain of the same magnitude. here \$1.management’s confidence about the company’s future earnings potential. investors will require the same after-tax return from two comparable companies. however. the conclusion of this statement is correct. a stock repurchase is always preferred over dividends. a. c. Hence. 13. c. stock prices would increase. and the firm’s overall cost of capital is also unchanged. b. The total return to equity capital is unchanged. but capital gains would increase to offset the reduction in dividends. Dividends would be lower than otherwise. the total return to shareholders would not change. one of which pays a dividend.e. This statement implicitly equates the cost of equity capital with the stock’s dividend yield. a. If the tax on capital gains is less than that on dividends. and it is this signal that causes the stock price to rise.. which is clearly not correct. Thus. Thus. 14. the announcement is not news to the stock market. i. If this were true. is strictly because of taxes.30) = \$0. the stock price will adjust only when the stock begins to trade without the dividend and.

the after-tax gain is \$7. if shareholders are able to freely trade securities around the time of the dividend payment. which is subject to taxes of 30%. (i) The tax-free investor should buy on the with-dividend date because the dividend is worth \$1 and the price decrease is only \$0. b. (ii) The dividend is worth only \$0. this investor increases the capital gain that is eventually reported upon the sale of the asset. and so the after-tax gain is \$111.000.] 140 . the price will be: (100 × 1.d. On an initial investment of \$100. over a 10-year time period.37 is taxed at the 30% rate. Therefore. [Actually.000. If an investor sells share B after 10 years. 17. however. On an initial investment of \$100.90) = \$0.90.78%.60 to the taxable investor who is subject to a 40% marginal tax rate. 18. then your wealth is \$10. you are indifferent between a dividend and a share repurchase program. With no taxes. there should be no tax effects associated with dividends. At most. After the dividend payment. After-tax Return on Share B: If an investor sells share B after 2 years. If you own 100 shares at \$100 per share. the after-tax rate of return is 7%. 16. the taxable investor’s problem is a little more complicated. this investor should buy on the ex-dividend date.102) = \$121. a shareholder in company A will receive a dividend of \$10.000. After-tax Return on Share A: At t = 1. this is an after-tax annual rate of return of 7. and so the after-tax gain is \$14. In either case.56. The capital gain of \$21 is taxed at the 30% rate. the price will be: (100 × 1. over a 2-year time period. this will cost: (0.10%. Therefore.14 This is not enough to offset the tax on the dividend.70. then they should not demand any extra return for holding stocks that pay dividends.37. If dealers are taxed equally on capital gains and dividends. your total wealth will remain at \$10. Since the initial investment is \$100. a. The capital gain of \$159. this is an after-tax annual rate of return of 7.1010) = \$259. By buying at the ex-dividend price.16 × 0. Thus. it does not matter how the company transfers wealth to the shareholders. or \$10. a. each share will be worth \$99 and your total wealth will be the same: 100 shares at \$99 per share plus \$100 in dividends. that is.

We would expect the high-payout stocks to show the largest decline per dollar of dividends paid because these stocks should be held by investors in low.227 = 22. it is difficult to interpret their result as indicative of marginal tax rates.85 + [(1 . in that case. These investors should be prepared to buy any amount of stock withdividend as long as the fall-off in price is fractionally less than the dividend. Some investors (e. If we let T represent the marginal tax rate on dividends..7% c.85)] = 0 T = 0. we would expect that the payment of a \$1 dividend would result in a \$1 decrease in price. 19. If investors are now indifferent between dividends and capital gains. per dollar of dividend: -0. transactions costs or IRS restrictions). shareholders pay income tax on dividends received. In order for the net extra return from buying withdividend (instead of ex-dividend) to be zero: .00)] + [(0. regardless of whether the income is a capital gain or a dividend.g. The marginal investor.4T) × (0. but they can deduct from their tax bill their share of the corporate tax on pre-tax earnings paid by the company.g. Under Australia’s imputation tax system.4T). Therefore. because they do not receive anything after tax. This is true regardless of the corporate tax rate. marginal tax brackets. the tax advantage to capital gains has been reduced. all Australian investors prefer dividends because the 141 . the only investors who are indifferent to the dividend payout ratio are those who pay the same tax rate on dividends as on capital gains.Extra investment + After-tax dividend + Reduction in capital gains tax = 0 Therefore. must be indifferent between buying with-dividend or ex-dividend. by definition. or perhaps even zero.T) × (1. Elton and Gruber’s result suggests that there must be some impediment to such tax arbitrage (e. then the marginal tax rate on capital gains is (0.. But. Since the passage of the Tax Reform Act. pension funds and security dealers) are indifferent between \$1 of dividends and \$1 of capital gains. d. The only investors who would be indifferent with regard to the payout ratio are those whose marginal tax rate is 100%. e.b. Under the tax system in the United States.

142 . in effect. then the Tax Reform Act would not affect the demand for dividends. Even if the middle-of-the-road party is correct about the supply of dividends. then we would expect investors to demand more dividends after the Tax Reform Act. So. If the apparent tax disadvantage were irrelevant because there were too many loopholes in the tax system. pays part of the personal tax on dividends but pays no part of the personal tax on capital gains. it is difficult to be sure about the effect of the tax change. we still do not know why investors wanted the dividends they got. In any case. If there is some non-tax advantage to dividends that offsets the apparent tax disadvantage. the middle-of-the-roaders would argue that once companies adjusted the supply of dividends to the new equilibrium. dividend policy would again become irrelevant.corporation. 20.

Conversely.574 0.009 2. if the repurchase made the firm substantially more risky. But 143 . It is true that researchers have been consistent in finding a positive association between price-earnings multiples and payout ratios.Challenge Questions 1.043)× (1.309 For Merck. The stock is a good value even at 20% above the current market share price. or if managers were having their own shares repurchased. if we regress dividends at time t against earnings per share (also at time t) and dividends (at time t – 1).574)× (5.0. Management desires to Increase the debt:equity ratio.009)× (2.0. and/or. 4. if EPS in 2001 is \$3.043)× (1. b. the share price would likely increase.00) + (1 . Nice try!  Generally. the adjustment rate and the target rate can be found as follows: Adjustment Rate = 1 – (coefficient of DIVt . 3.009)× (1. if EPS in 2001 is \$5.50 For International Paper.043 1. or if the action was interpreted as an inability to find positive NPV projects for the future.309)× (3. a share repurchase is viewed as a signal that:: a.00) + (1 . c. and/or.00) = \$1 2. DIVt We make use of Lintner’s model. then the share price might either remain unchanged or decrease.21) = \$1. suitably rearranged: DIVt = Adjustment Rate x Target Ratio x EPS t + (1 – Adjustment Rate) x -1 Thus. Under any or all of these conditions. Management desires to avoid excess cash. then the predicted dividend in 2001 is: DIV2001 = (0. The results are: Merck International Paper Adjustment Rate Target Ratio 0.1) Target Ratio = (coefficient of EPS t )/Adjustment Rate These two regressions were performed using Excel®(forcing the constant to be zero). then the predicted dividend in 2001 is: DIV2001 = (0.

Again. Companies whose prospects are uncertain therefore tend to be conservative in their dividend policies. King Coal’s labor troubles create both a high payout ratio and a high price-earnings ratio. Thus. The stock price may drop because of this year’s disappointing earnings. The payout ratio for that year turns out to be 100 percent. Under such circumstances. but it stems from the common association with risk and not from a market preference for dividends. so that the stocks of such companies are likely to sell at low multiples. as has sometimes been suggested. It would not reflect a preference for high dividends as such. but it does not drop to one-half its pre-strike value. which customarily distributes half its earnings. For example. Another reason that earnings multiples may be different for high-payout and low-payout stocks is that the two groups may have different growth prospects. the result is an association between the price of the stock and the payout ratio. not 50 percent. that management is careless in the use of retained earnings but exercises appropriately stringent criteria when spending external funds. 144 . they create a spurious association between dividend policy and market value. investors would be correct to value stocks of high-payout firms more highly. In other words. so management maintains the normal dividend. we know that firms seek to maintain stable dividend rates. however. and the ratio of price to this year’s earnings increases. Suppose. or whenever reported earnings underestimate or overestimate the true long-run earnings on which both dividends and stock prices are based. Suppose that King Coal Company. The temporary earnings drop also affects King Coal’s price-earnings ratio. Investors recognize the strike as temporary. The same thing happens whenever a firm encounters temporary good fortune. The setback is regarded as temporary. suffers a strike that cuts earnings in half. A second source of error is omission of other factors affecting both the firm’s dividend policy and its market valuation. and no company could achieve a lasting improvement in its market value simply by increasing its payout ratio. so the evidence is not convincing.simple tests like this one do not isolate the effects of dividend policy. Investors are also likely to be concerned about such uncertainty. But the reason would be that the companies have different investment policies.

then the original strategy of investing in Company A would provide a larger dollar return at the same time that it would cost less than the alternative.004V This investment requires a net cash outlay of (0. Guildenstern could buy two percent of Company A’s equity and lend an amount equal to: 0.007VB).DB) = 0.002V This investment requires a net cash outlay of (0.02 × (DA . The dollar return to Rosencrantz’ alternative strategy is: (0. Since the firms are the same except for capital structure. c. Rosencrantz could buy one percent of Company B’s equity and borrow an amount equal to: 0.002 × rf × V) Thus the two investments are identical.003 × rf × VB) Also.01 × Profits) – (0.01 × C) – (0. the cost of the original strategy is (0. no rational investor would invest in Company B if the value of Company A were less than that of Company B.DB) = 0.003 × rf × V) where rf is the risk-free rate of interest on debt.CHAPTER 17 Does Debt Policy Matter? Answers to Practice Questions 1. The expected dollar return to Rosencrantz’ original investment in A is: (0. b.01 × C) – (0.01 × (DA .007V) and provides a net cash return of: (0.003 × rf × VA) where C is the expected profit (cash flow) generated by the firm’s assets.007VA) while the cost of the alternative strategy is (0. Thus. Thus.02 × Profits) – (0. If VA is less than VB.018V) and provides a net cash return of: (0. C must also be the expected cash flow for Firm B. the two investments are identical. let V represent the total value of the firm. a. The two firms have equal value. 145 .

8 × 0. If the cream and skim milk go into the same pail. It is similar with Carruther’s cows.50 1.00 0. MM’s Proposition I states that this does not affect firm value if the investor can reconstitute a firm’s cash flow stream by creating personal leverage or by undoing the effect of the firm’s leverage by investing in both debt and equity.2 and the accompanying discussion.2.06) = 0.) In the same vein. MM’s Proposition II explicitly allows for the rates of return for both debt and equity to increase as the proportion of debt in the capital structure increases. When a firm issues debt. 146 .2× 0.108 rE rA 4. the firm does not add value by splitting the cash flows into the two streams. the rate for common stock increases because of increasing financial leverage.132 0. With the bonds remaining at the 6 percent default-risk free rate. The rate for debt increases because the debt-holders are taking on more of the risk of the firm.00 2. This is not a valid objection. The company cost of capital is: rA = (0. (If an investor holds both the debt and equity.108 0.00 See figure on next page. (Firm borrowing does not add value if investors can borrow on their own account.108 0.204 0.108 0. it shifts its cash flow into two streams.) Carruther’s cows will have extra value if consumers want cream and skim milk and if the dairy cannot split up whole milk.113 0. 3. this is unaffected by capital structure changes. See Figure 17. 0.8% Under Proposition I. or if it is costly to do so.156 0.12) + (0.10 0.108 0.108 0. we have: Debt-Equity Ratio 0.108 = 10.108 0. the cows have no special value.252 0. the cows have no special value if a dairy can costlessly split up whole milk into cream and skim milk.00 3.

108 .060 1 2 3 Debt / Equity 147 .200 .Rates of Return .250 rE .150 rA rD .

Note also that the statement ignores the effect on the stockholders of an increase in financial leverage. such securities must both meet regulatory requirements and appeal to an unsatisfied clientele. However. The overall effect is to leave the firm’s cost of capital unchanged. In any case. This additional risk must be offset by a higher average return to stockholders. Note that. As the debt-equity ratio increases. 7. preferred equity redemption cumulative stock and floating-rate notes. a. the increasing interest rates may signal an increasing probability of financial distress—and that can be important. a. but a smaller proportion of the firm is financed by equity. if firm value is independent of leverage. b. this would be a good deal. Moderate borrowing does not significantly affect the probability of financial distress. If the opportunity were the firm’s only asset. b. it is true that both the cost of equity and the cost of debt increase. rational lenders will not advance 100 percent of the asset’s value for an 8 percent promised return unless other assets are put up as collateral. 6. So long as MM’s Proposition I holds. the company’s overall cost of capital is unchanged despite increasing interest rates paid as the firm borrows more. Sometimes firms find it convenient to borrow all the cash required for a particular investment. would have nothing to lose. Examples of such securities are given in the text and include unbundled stock units. therefore. but it does increase the variability (and market risk) borne by stockholders. This is not an important reason for conservative debt levels. lenders are protected by the firm’s other assets too. in order to succeed. the firm’s cost of capital (rA) is not affected by the choice of capital structure. (However. The reason the quoted statement seems to be true is that it does not account for the changing proportions of the firm financed by debt and equity. Stockholders would put up no money and. Under Proposition I. 148 .5. then any asset’s contribution to firm value must be independent of how it is financed. Such investments do not support all of the additional debt.

we know that:  D   E  r = ) D + E × rD  + D + E × rE = (0. as leverage is increased.8. the firm’s past financing decisions are bygones. the firm’s income before interest is independent of the firm’s financing.0 . is a ‘fair’ return. it can not decrease beyond a certain point. As the debt/equity ratio increases.2 ) = 0 7 =1 . the cost of equity capital rises. The cost of debt capital increases because increasing the debt/equity ratio increases the risk of default so that bondholders require a higher rate of return to compensate for the increase in risk. the market value of the firm first increases and then decreases. we have the cost of debt capital increasing and approaching (but never being equal to. Hence. the more debt a firm has. the greater the percentage decline in the value of its shares as a result of a recession or any other unfortunate event. For higher levels of the debt/equity ratio. Suppose that a recession hits and stock price declines. MM’s Proposition I holds in recessions as well as booms. as a result.10 + 1. a higher rate of return is required to compensate for this increase in risk. 9.1 7 % 149 .18 – 0. b. Assume the traditionalists are correct. or greater than) the cost of capital for the firm. a.0% Similarly for debt: rD = rf + β D (ii) 11.10) = 0.) The stock price will decline to the point where the expected return to the stock. Thus. b.22 = 22.rf) D 0. as leverage increases. 10. use the following: +(0 . the ratio of the market value of the equity to income after interest decreases. the ratio of the market value of the firm to firm income before interest first increases and then decreases. not how it is divided among the firm’s security holders. the firm’s cost of capital first decreases and then increases. a. the ratio of the income after interest (which is the cash flow stockholders are entitled to) to the value of equity increases. Moreover. (rm .12 = 0. Would the cost of capital for new investment be less if the firm had used more debt in the past? No. the ratio is a constant. the cost of equity capital will also continue to rise. The cost of equity capital increases because increasing the debt/equity ratio increases the financial risk borne by the stockholders.5 (0. Similarly. Thus.25 Also.5 ×0 2 . Also. as leverage increases.18 . Thus. both the cost of debt capital and the cost of equity capital increase. We begin with rE and the capital asset pricing model: rE = rf + β E (rm .rf) rE = 0. Incidentally.10) = 0. The firm’s overall cost of capital is independent of its debt ratio. This is the same as saying that.10 + β β D (0. given the amount of debt.5 ×0. The firm’s income before interest is independent of leverage. (i) Assume MM are correct. As leverage is increased. Why does share price drop during a recession? Because forecasted cash flows to stockholders decline. The market value of the firm is determined by the income of the firm.0. As leverage increases.12    A     To solve for β A. in particular. (Stockholders may also perceive higher risks and demand a higher expected rate of return. both the value of the firm and the value of the firm’s income before interest remain constant as leverage is increased.

18 . the stock’s required return is 8% and the risk-free rate is 5%. will change. so that.5 × 0) + (0.11 = 0.0. E (0. However. We know that these overall firm values will not change after the refinancing and that the debt is risk-free.5 ×0.8 and the firm’s cost of capital is 8%. 150 .5 ×1. We know that rD is 11%. the risk premium for the stock is 3%. for debt: rD = rf + β D (rm .8 = (0.125 For equity:  D   E  r = D +E × rD  + D +E × rE     A     0.11) + (0.05) + (0.25) +(0. D    E βA =  D + E × βD  + D + E × βE  = (0.0.10 + β β 13. Before the refinancing. the expected return for equity and for debt. We know from Proposition I that the value of the firm will not change.10) = 0. Schuldenfrei is all equity financed.5) = 0.5 × rE) rE = 0. because the expected operating income is unaffected by changes in leverage.17 = (0. a.7 × rE) rE = 0.  D    E β A = D +E × βD  + D +E ×βE         0.10 + β β D (0.196 = 0. Also.rf) D 0.8 and the expected return on equity is 8%.196 = 19.3 × 0.08 = (0. thus. risk and. Thus. the risk premium for the stock is 6%. In other words.60 b. the firm’s asset beta is 0.0% After the refinancing.11 = 11.6% Also: rE = rf + β E (rm . The equity beta is 0. the firm’s overall cost of capital will not change.875        12.10) = 1.  D   E  r = D +E × rD  + D +E × rE     A     0.875.5 × 0.18 . rA remains equal to 17% and β A remains equal to 0. After the refinancing: c.5 × β E) β E = 1. hence.20 Before the refinancing.rf) E 0.

we know that E is (0.08V – (0.09.d. e. the new P/E ratio is 9. The price of the common stock is the same before and after the refinancing. Thus. Before the refinancing.11V/N It follows that earnings per share has increased by 37.5%.5 × V)]/(0. which is (0. the earnings per share after the refinancing is: EPSA = [0.5 × N). Thus. Let E be the operating profit of the company and N the number of shares outstanding before the refinancing. (See Part (f) above.08V/N) to (0. f. the risk-free rate. 151 . but the earnings per share has increased from (0. Also.08V/N After the refinancing the operating profit is still E and the number of shares is (0.11V/N). Interest on the debt is 5% of the value of the debt. The required return for the company remains at 8%. The required return for the debt is 5%. g.05 × 0.5 × N) = 0.) Thus.5.5 × V). the P/E ratio is 12.08V). the earnings per share before the refinancing is: EPSB = 0.

are entitled to (0. and [0.04 × \$100) = \$4.420 .26 0.04 × \$50) = \$2 if there is a slump.20 × (\$150 .10 0.10 0.04 × \$150) = \$6 if there is a boom and (0.14.25 .10 rD . If you own \$20 of U’s common stock.10 × \$16) + (0. you are entitled to: [(0.\$40)] = \$22 if there is a boom.18 0. which will cost (0.180 0. and in a slump you are entitled to: [(0. We make use of the basic relationship:  D   E  r = D +E × rD  + D +E × rE     A     If the company is all-equity-financed and the cost of equity capital (rE) is 18%. which costs: (0.20 . which will not change as the capital structure changes. a.\$40)] = \$2. b.10 0.18 0.40 .18 0.20 rA . Because the firms are identical except for capital structure.04) × (\$150 \$40)] = \$6.18 rD 0.20 × (\$50 . you own 4% of the outstanding shares and.18 0.75 D/V .04) × (\$50 .10 0.18 0.10 rA rD 1 2 3 D/E rE Return D/V 0 0. In a boom you are entitled to: 152 .\$400) = \$100.207 0. the total values of these companies must be the same. The equivalent investment is to purchase 20% of U’s outstanding stock. then the company cost of capital (rA) is 18%.34 0. The total invested is the same (\$20). you own 20% of the outstanding shares and. thus. and to invest \$16 at the risk-free rate. Thus.50 . c. Thus: Return D/E 0 1 2 3 rA 0. and there are no taxes or other market imperfections.50 0. are entitled to [0.20 × \$500) = \$100 and to borrow \$80 at the risk-free rate.75 rA 0. In addition. we know that the risk-free rate (rf) is 10% and that Gamma’s debt is risk-free.260 0. If you own \$20 of L’s common stock.18 rD 0.18 0.42 .30 rE 15. L’s stock is worth: (\$500 .25 0.18 0. The equivalent investment is to purchase 4% of L’s outstanding stock. In a boom.10 × \$16) + (0.10 rE 0. The total amount invested is the same (\$20).10 rE 0. thus.40 .10 0.\$40) = \$2 if there is a slump.30 .10 0.

[(-0.5 × \$50) + (0 .20 × \$50)] = \$2. rA is 20%.0% \$500 \$500 Thus.5 × (\$50 − \$40)] +[0 . for both companies.5 × \$150) \$100 = =0 .20 .10) = 0. For L. the expected return on assets is: (0. d.0. the expected return on equity is: [0.10) × (\$80) + (0.10) × (\$80) + (0.60 = 60% 153 .20 =20.20 × \$150)] = \$22 and in a slump you are entitled to: [(-0.20 + [4 × (0.0% \$100 \$100 This is the same result we derive from the Proposition II formula: rE = 0.60 = 60. Proposition II can be stated as follows: rE = rA + D (r A − rD ) E For U.5 ×(\$150 − \$40)] \$60 = =0 .

This is costly. the guaranteed payoff from holding all three tickets is \$10. Some shoppers may want only the chicken drumstick. 2. It is far more efficient for the store to cut up the chicken and sell the pieces separately. Assume the election is near so that we can safely ignore the time value of money. Thus. In fact. the three tickets. unbundled they may sell for more than \$10. could never sell for less than \$10. This is true whether they are bundled into one composite security or unbundled into three separate securities. The sum of the parts is worth more than the whole. Investors can also repackage cash flows cheaply for themselves. of three events will occur. However. b. Because one. and only one. taken together.Challenge Questions 1. The proportionate costs to companies of repackaging the cash flow stream are generally small. specialist financial institutions can often do so more cheaply than the companies can do it themselves. The same considerations affect financial products. and sell off the other parts in the supermarket parking lot. but: a. But this also has some cost. Proposition I fails. hence the observation that supermarkets charge more for chickens after they have been cut. They could buy a whole chicken. 154 . cut it up. If this is indeed the case. This will occur if the separate tickets fill a need for some currently unsatisfied clientele.

35× \$1)] = \$0.350 0.20× 0.440 For \$1 of equity income. and invest in the unlevered firm.350 0. and has an interest rate for debt of rD.35× \$1 = \$0.44× 0. The personal and corporate tax rates are Tp and Tc.35× \$1)] = \$0.493 2.5× [\$1 – (0.143 \$0.440 \$0. their cash flow each year is: [(X ) (1 −Tc ) (1 −Tp )] − ( rD ) ( D (1 −Tp )] [ ) 155 .5× [\$1 – (0. with all capital gains deferred forever: Corporate tax = Personal tax = Total = 0. For \$1 of debt income: Corporate tax = Personal tax = Total = \$0 0.35× \$1 = \$0.208 Total = \$0.44× 0. Consider a firm that is levered.44× \$1 = \$0.558 For \$1 of equity income. with all capital gains realized immediately: Corporate tax = Personal tax = 0.35× \$1)] + 0.rDD)(1 . If the stockholders borrow D at the same rate rD. the value of the stockholders’ position is: VL = (X (1 − Tc ) (1 − Tp ) ) (r) (1 − Tp ) (X (1 − Tc ) (1 − Tp ) ) (r) (1 − Tp ) − (rD ) ( D (1 − Tc ) (1 − Tp ) ) (r D ) (1 − Tp ) VL = − ( D (1 − Tc )] [ ) where r is the opportunity cost of capital for an all-equity-financed firm.CHAPTER 18 How Much Should a Firm Borrow? Answers to Practice Questions 1. has perpetual expected cash flow X.Tc)(1 .Tp) Therefore. The cash flow to stockholders each year is: (X . respectively.5× [\$1 – (0.

612 – (\$2. The market value balance sheet is: Net working capital Market value of long-term assets Total Assets \$5. The corporate tax rate is 35 percent. so firm value increases by: 0.123 + \$4.612 This is [\$8. for investment in the same assets. The book value of Pfizer’s assets is \$21.159 = \$756 million The market value of the firm is now: (\$296. 3.35 × \$2.247 + \$756) = \$297.3(a).003 \$4. With a 40 percent book debt ratio: Long-term debt + Other long-term liabilities = 0.529 million.003 Long-term debt Other long-term liabilities Equity Firm market value 156 .The value of the stockholders’ position is then: VU = (X (1 − Tc ) (1 − Tp ) ) (r) (1 − Tp ) (X (1 − Tc ) (1 − Tp ) ) (r) (1 − Tp ) − (rD ) ( D (1 − Tp ) ) (rD ) (1 − Tp ) VU = −D The difference in stockholder wealth.159 more than shown in Table 18. If individuals could not deduct interest for personal tax purposes.797 \$297.282 4. is: VL – VU = DTc This is the change in stockholder wealth predicted by MM.391 \$297. then: VU = Then: (X (1 − Tc ) (1 − Tp ) ) (r) (1 − Tp ) − (r D )( D ) (r D ) (1 − Tp ) VL −VU = (r D ) ( D −[ ( rD )( D (1 − Tc ) (1 − Tp )] ) ) (r D ) (1 − Tp )   Tp  VL −VU =( D Tc ) + D  (1 − Tp )    So the value of the shareholders’ position in the levered firm is relatively greater when no personal interest deduction is allowed.206 291.330)] = \$2.40 × \$21.003 million.529 = \$8.330 288.

c. and not have to repay. Playing for Time \$20 10 \$30 \$25 5 \$30 Bonds outstanding Common stock Total liabilities \$50 50 \$100 Bonds outstanding Common stock Total liabilities Suppose Circular File foregoes replacement of \$10 of capital equipment.4. has value to the shareholders since it is a more efficient transfer of wealth. 5. Assume the following facts for Circular File: Book Values Net working capital Fixed assets Total assets \$20 80 \$100 Market Values Net working capital Fixed assets Total assets a. b. Bait and Switch Market Values Net working capital \$30 \$20 New Bonds outstanding 157 . When a firm defaults. The ability to assign the assets to the creditors.  The amount of non-interest tax shields 6. Answers here will vary depending on the company chosen. the cause (absent fraud) is usually an operating problem. so that the new balance sheet may appear as follows: Market Values Net working capital Fixed assets Total assets \$30 8 \$38 \$29 9 \$38 Bonds outstanding Common stock Total liabilities Here the shareholder is better off but has obviously diminished the firm’s competitive ability. The combined positions of stockholders and bondholders in limited liability and unlimited liability firms are the same.  The ability to carry-forward and carry-back excess credits  The ability to maintain debt levels on an on-going basis. Although both shareholders and debtholders are worse off. The value of interest tax shields is determined by:  The on-going degree of profitability.  The rates of personal and corporate taxes. but the bondholders bear part of the burden. their respective expected rates of return are determined in a manner that compensates for this risk. Cash In and Run Suppose the firm pays a \$5 dividend: Market Values Net working capital Fixed assets Total assets \$15 10 \$25 \$23 2 \$25 Bonds outstanding Common stock Total liabilities Here the value of common stock should have fallen to zero. 7.

it might increase stockholder wealth by more than the money invested. Section 18. even though it has a negative NPV. Under these conditions. a. firms often issue equity to pay off excess debt. undertaken by a firm with a significant risk of default. b. This is a result of the fact that. stockholders benefit if a more favorable outcome is actually realized. c. Static trade-off theory reduces the debt-equity decision to a trade-off between interest tax shields and the costs of financial distress. However.20 Fixed assets Total assets 20 \$50 10 \$50 Old Bonds outstanding Common stock Total liabilities 8. Similarly. These conflicts of interest are severe only when the company is in financial distress. while the cost of unfavorable outcomes is borne by bondholders. SOS stockholders could lose if they invest in the positive NPV project and then SOS becomes bankrupt. Answers here will vary according to the companies chosen. Stockholders get all of the assets. 10. and individual managers have different attitudes toward debt. think of the extreme case: Suppose SOS pays out all of its assets as one lump-sum dividend. High-tech growth firms with risky assets tend to be equity financed while low risk mature businesses tend to have more debt. the benefits of the project accrue to the bondholders. Adherence to a moderate target debt ratio limits the conflicts. 158 . for a very risky investment. matters are not so simple because there are costs to adjusting the firm’s capital structure. In the real world. 9. however. and the bondholders are left with nothing. the important considerations are given in the text. many profitable firms have very little debt and changes in tax rates have little effect on debt-equity ratios. Again.3. then. If the new project is sufficiently risky.

) (ii) Investors may not be aware of the project at all. It is likely that the restrictions would be less costly than the higher interest rate. (However. 13.11. Therefore. say. The bondholders benefit. If the stock is not overvalued. bondholders charge a higher rate of interest to ensure that they receive a fair deal. The fine print limits actions that transfer wealth from the bondholders to the b. The firm would probably issue the bond with standard restrictions. stockholders. But. therefore. (iii) Investors may believe that the firm’s decision to issue equity rather than debt signals management’s belief that the stock is overvalued. based on past evidence. It is likely. Other things equal. 159 . management expects equity value to fall by \$30 million. In the absence of fine print. management needs to consider whether it could release some information to convince investors that its stock is correctly valued. the fall in value is not an issue cost in the same sense as the underwriter’s spread. which come out of the shareholders’ pockets. that the actual bankruptcy filing conveyed some negative information to the market about Caldor’s future prospects and that part of the drop must. If the stock is indeed overvalued. There may be several reasons for the discrepancy: (i) Investors may have already discounted the proposed investment. a. be attributed to this negative information. The stockholders benefit. or whether it could finance the project by an issue of debt. the announcement of a new stock issue to fund an investment project with an NPV of \$40 million should increase equity value by \$40 million (less issue costs). Certainly part of this drop must be attributed to bankruptcy costs. however. the stock issue merely brings forward a stock price decline that will occur eventually anyway. 12. this alone would not explain a fall in equity value. but they may believe instead that cash is required because of. low levels of operating cash flow.

. the firm’s debt ratio will likewise not be expected to change over time. c. Let us assume that. i. High-tech. and mature. they stick to the same line of business and are consistently profitable. the pecking order theory explains intra-industry debt levels since less profitable firms end up borrowing more because they have lower internal cash flow.g. In the tradeoff theory. the company’s debt ratio will tend to decrease over time because the company will fund projects from retained earnings. However. 15. exchange offers would be undertaken to move the firm’s debt level toward the optimum. Then. for example. 160 . because the types of assets the company has do not change over time. if the tradeoff theory is correct. That ought to be good news. Management would only be willing to take on more debt if they were quite confident about future cash flow. One explanation is that the exchange offers signal management’s assessment of the firm’s prospects. The results are consistent with the evidence regarding the announcement effects on security issues and repurchases. but are not consistent with the ‘tradeoff’ theory. In general. 17. utilities) often do not pay down debt but pay the cash out as dividends.14. grow. if anything. If the pecking-order theory is correct.. and stable. as companies are started. and would want to decrease debt if they were concerned about the firm’s ability to meet debt payments in the future. which holds that management strikes a balance between the tax advantage of debt and the costs of possible financial distress.e. a. the argument seems to fail on an inter-industry basis. Bondholders require a higher interest rate than they would otherwise in order to compensate for the fact that interest attracts more tax than equity returns. internally generated cash. mature industries (e. 16. Masulis’ results are consistent with the view that debt is always preferable because of its tax advantage. regardless of whether leverage is increased or decreased. b. high growth firms have low debt levels even though they need cash.

we find that: X = 11.6 b. Internet exercise. Break even will occur when Ms. a. answers will vary. Ketchup would undertake Project 2. Challenge Questions 1.4× 10) + (0. Ketchup’s payoff from Project 1).18. 19. and solving. Ketchup will borrow less than the present value of this payment.0 Ms. answers will vary. 161 .6× 0)=+5. a.5 Therefore. Ketchup’s expected payoff from Project 2 is equal to her expected payoff from Project 1. If X is Ms. Ketchup’s payment on the loan. then her payoff from Project 2 is: 0. Expected Payoff to Bank Project 1 Project 2 +10. Expected Payoff to Ms. Ketchup +5 (0.6× 0) = +4. Internet exercise. Ms.4 (24 – X) Setting this expression equal to 5 (Ms.0 (0.4× 14)+(0.

18× 0.360 The after-tax weighted-average cost of capital formula.35)× 0.0% WACC* = [0.35)× (75.096 = 9.600 343.360)] 162 . If the bank debt is treated as permanent financing.604] + [0.4% 1800 60.CHAPTER 19 Financing and Valuation Answers to Practice Questions 1.46 million x \$46) 3.2 \$2980 100. 4. Interest is not included. the capital structure proportions are: Bank debt (rD = 10 percent) Long-term debt (rD = 9 percent) Equity (rE = 18 percent. the forecasts assume an all-equity financed firm.0. Calculate APV by subtracting \$4 million from base-case NPV.0.6% 2. 90 x 10 million shares) \$280 9.10× (1 .35)× (208.06× (1 . Forecast after-tax incremental cash flows as explained in Section 6.09× (1 .0.160 \$627. this is an accounting entry and represents neither a liability nor a source of funds ‘Net out’ accounts payable against current assets Use the market value of equity (7.4 900 30.1. is: WACC = [rD-ST× (1 – Tc)× (D-ST/V)]+[rD-LT× (1 – Tc)× (D-LT/V)]+[rE × (E/V)] WACC = [0. We make three adjustments to the balance sheet: Ignore deferred taxes.600/627.600 208.360)] + [0.08× (1 0. with one element for each source of funding.35)× 0.302] = 0. • • • Now the right-hand side of the balance sheet (in thousands) looks like: Short-term debt Long-term debt Share holder equity Total \$75.094] + [0.600/627.

1235 .1235 Step 2: rE = r + (r – rD) (D/E) = 0.5/0.378) + (0.6 = \$627.082049 = 0.160 \$551.1409 Step 3: WACC = [rD × (1 – TC) × (D/V)] + [rE × (E/V)] = (0.714) = 0.760 163 .3 + \$75.6 + \$208.760) = 0.017290 + 0.360)] = 0.5 7.65 × 0.622) = 0. Assume that short-term debt is temporary.+ [0.4) = 0.5 Long-term interest 16..160/\$551. The only way to account for issue costs in project evaluation is to use the APV formulation and adjust directly by subtracting the issue costs from the base case NPV. while adjusting the WACC implies a correction every year.600/\$551.160/627.600 343.8 Net income \$51.004700 + 0.1235 + (0.15× (343. The problem here is that issue costs are a one-time expenditure.1155 = 11.5 Value of equity = \$51.760) = 0. From Practice Question 4: Long-term debt Share holder equity Total Therefore: (D/V) = (\$208.7 Earnings before tax \$79.1409 × 0.1040 = 10.08 × 0.40% 5. Pre-tax operating income \$100. \$208.622 Step 1: r = rD (D/V) + rE (E/V) = (0.15 = \$343.3 Tax 27.5 Short-term interest 4.286) + (0.3 Value of firm = \$343.55% 6.378 (E/V) = (\$343.08) × (0.08 × 0.15 × 0.

925 = \$339. [\$100. 11.748 APV = -\$150.000 = -\$52.000 PV(tax shields) = 0.000 APV = -\$150. The immediate source of funds (i.000 × (1 .925 10. and therefore must be discounted at the project’s opportunity cost of capital. exact) = \$98.0.0.07 × \$400. Here. and the adjusted cost of capital r* equals the opportunity cost of capital with all-equity financing.10/1. Base case NPV = -1.35)] + [\$100. the university should not invest. 12.000 × (1 . An adjusted discount rate does not equal the WACC when it takes into account major changes in expected capital structure or costs. the interest tax shields are as uncertain as the value of the project.10 = \$98.750 Debt Outstanding at Interest PV Year Start Of Year Interest Tax Shield (Tax Shield) 1 300 24 7.67 + 3.10) = -\$150.35 × 0.35) × (Annuity Factor5/9 (1 – 0. PV(tax shields. r* is the after-tax adjusted weighted average cost of capital.67 2 150 12 3.5 or \$103.000 + \$140.000 b.000/0.000 PV(tax shields.8. then base-case NPV equals APV. both the proportion borrowed and the expected return on the stocks sold) is irrelevant. 164 . If borrowing is a zero-NPV activity for a taxexempt university.500 9. Base-case NPV = -\$1.35)%)] = \$65.000 = -\$10..07) = \$100.000 + (\$85. When borrowing a constant proportion of the market value of the project.000 + \$100.000)/0.75 or \$93.60 3.75 + 6.e.000 + \$98.20 6.000 = \$140.122) = \$93.35 × \$400.000.000 + (600/1.000 APV = -\$150.09 = 103.252 The present value of the tax shield is higher when the debt is fixed and therefore the tax shield is certain.09 APV = 93.748 = -\$49. a.000 × (1. a. The project would not be any more valuable if the university sold stocks offering a lower return.000 + \$274. base-case NPV is negative. approximate) = (0.12) + (700/1.

015 × \$1. If stock will be issued to regain the target debt ratio.000 = \$272.6. what matters is the project’s contribution to the firm’s overall borrowing power.016.1022 The issue costs are: Stock issue: Bond issue: (0. an additional issue cost is incurred.07 × (1 .000 + \$130. However.14 × 0.35) × (0. not just at issue.\$15. 14.5% and 19%.4)] + [0.1022 = 10. we can use the firm’s weighted-average cost of capital.TC) × (D/V)] + [rE × (E/V)] WACC = [0. Project NPV net of issue costs is reduced to: (\$272. Because it is a perpetuity.000) = \$15. solving for β A.. If we ignore issue costs: WACC = [rD × (1 .016 0. if debt is used. The project is expected to support debt in perpetuity. If debt financing can be obtained using retaining earnings. The fact that the first debt issue is for only 20 years is irrelevant. A careful estimate of the issue costs attributable to this project would require a comparison of Bunsen’s financial plan ‘with’ as compared to ‘without’ this project. Assume the project has the same business risk as the firm’s other assets. footnote 29.6] = 0. The cost of capital does not depend on the immediate source of funds. then there are no other issue costs to consider.050 × \$1. These figures assume the issue costs are paid every year. From the text. Section 19.000.22% Using this discount rate: NPV = −\$1. respectively.000.000. we find that:     D E β A = (1 − TC )(βD )   V − ( T D )  + (βE )  V − ( T D )     C C     165 . • • • Note the following: The costs of debt and equity are not 8.13. and more equity will have to be raised later.000) = \$257.016 . The fact that Bunsen can finance the entire cost of the project with debt is irrelevant.000 Debt is clearly less expensive.000) = \$50.000 (0. the firm’s debt ratio will be above the target ratio.

7 106. Tax or financing side effects in international projects: Project financing issues.     17.0 567.0 574. Year 1 2 3 4 5 6 Principal at Start of Year 5000.2 Interest Less Tax 162.147 = 14. Guaranteed contracts for output.2 581.3 Interest 250.9 590.0 230.6738 × 0. a.5 Principal Repayment 397.0 121.1 209.09) )   0. we 16.35)(0. Subsidized financing rates. The former assumption is appropriate while the latter is not.55    + (1.3 187.2 507.4 166 .1187 or approximately 12% This matches the consultant’s estimate for the weighted-average cost of capital.7 2803.3 140.5 4185.45   1 − (0.35 × 0.3 164. The Banker’s Tryst calculations are based on the assumption that the cost of debt will remain constant. A (rm – rf) = 0.2 460.55    = 0.55 β A = (1 − 0. 15. Disagree.6 136.09 + (0. Government restrictions on the flow of funds.085) = 0. and that the cost of equity capital will not change even though the firm’s financial structure has changed.9 3286.8 91. D/V β A = (1 − TC )(βD )  1 − ( T D/V) C    E/V  + (βE )    1 − ( T D/V) C        0.35 × 0.5 417.5 149.1 3746.15 )   1 − (0.6738 )  Using the Security Market Line.1 Net Cash Flow On Loan 560.35 × 0.147 × [1 – (0.4 438.0 598.7% Following MM’s original analysis and considering only corporate taxes.55)] = 0. such as early cash flows going to debt service resulting in a non-constant debt ratio.2 483. we calculate the opportunity cost of capital for Sphagnum’s assets: rA = r f + β have: r* = r (1 – TC L) r* = 0.0 4602.

3 587. The value of the subsidy measures the additional value to the firm from a government loan at 5 percent.3 616.08) 10 = \$4.2 30.9 Therefore: 532.0 607. the company should calculate APV. Therefore.530.2 1763.7 8 9 10 2296.7 559.5 1204.\$4.8 74.6 57.2 60.530.9 PV of loan = 560. including PV (tax shields) on the unsubsidized loan.4 636.000 .000 b.35) (.2 616.8 88.000 Value of subsidy = \$5.35) (.3 39. Yes.1 20.9 1 + (1 −.08) 1 + + 636.9 114.6 626.0 1 + (1 −.000. 167 . compared to an unsubsidized loan at 10 percent. and then add in the value of subsidy.000 = \$470.3 616.

75) = 9.293 E/V = \$15.28% × 0.7.383.268/\$21. using the CAPM.73% Step 2.25 × 0.rD) × (D/E) = 8. WACC = (0.4%) = 7.rf] = 4% + (0.28% Market value of equity (E) is equal to: 256.73% + (8.8 = 0.65 × 7. Assume that the expected future Treasury-bill rate is equal to the 20-year Treasury bond rate (5.25/0.11% Opportunity cost of capital = r = rD × (D/V) + rE × (E/V) A × [rm .8 = 0. 168 .8 = \$21.18. If the project in question is more like the industry as a whole than it is like the company.65 × 7.8%).28%) + (0.2%) = 8. Step 1.25% Step 3.707 = 8. The company weighted-average cost of capital is appropriate for evaluating capital budgeting projects that are exact replicas of the firm as it currently exists.707 WACC = (0.2% so that: rE = r + (r .2 × \$59 = \$15. Assume that the interest rate on the debt falls to 7. Recalculate WACC.115.268 + \$15.4% × 0.8 D/V = \$6.115.293 + 9. then the industry weightedaverage cost of capital would be a better choice.2%) × (0. Then. = 7.66 × 8%) = 9.25%) + (0. we find rE as follows: rE = r f + β that: V = \$6. Also assume that the market risk premium (rm – rf) is 8%.383. Calculate the opportunity cost of capital.293 × 0. a.8/\$21. so that the risk-free rate (rf) is 4%.73% .115.75 × 9.383.97% b.8%) less the average historical premium of Treasury bonds over Treasury bills (1.707 × 9.8 so 19. Estimate the cost of debt and calculate the new cost of equity.

at r*. when we are at period 1. the left-hand side of this equation is the project IRR. In other words. For a company that follows Financing Rule 2. For example. We know from part (a) that the formula is correct for a one-period cash flow. we would discount the period 3 cash flow. So the value. in period 2 to give: PV2 = C3/(1 + r * ) Therefore. in period 1. Also. so that the adjusted cost of capital (r*) is also constant over time.Challenge Questions 1. the Miles-Ezzell formula gives the same value for r* as at period 0. For a one-period project to have zero APV: APV = C0 + C1 (T * ×rD ×D) + =0 1+r 1 + rD      1+r  1 + r  D     Rearranging gives:  D C1 − 1 = r −( T * × rD )   −C − C0 0  For a one-period project. Therefore. the value today is: PV0 = C3/(1 + r * )3 169 . of the period 2 cash flow is: PV1 = C2/(1 + r * ) The value today is: PV0 = PV1/(1 + r * ) = C2/(1 + r * )2 By analogy. a. (D/ -C0) is the project’s debt capacity. we know that debt is assumed to be a constant proportion of market value. all of the variables in the Miles-Ezzell formula are constant. the minimum acceptable return is:  1 +r r * = −( T * × D × ) r r L   1 + rD     b.

thus.667 1.40 T* = TC = 0. hence.00% 10. The expected cash flow from the firm is: (Vu r + Tc rD D) where r is the return on assets and rD is the rate on debt (the interest tax shield has the same level of risk).00% 12.84% 9.00% 8.00% WACC 11.00% 14.2.Tc)D:  E + (1 − Tc )D  r * = ( r) −[ (1 − Tc ) rDL] E   r * =r + (r −rD ) (1 −Tc ) L] [ a. This is much more realistic since it recognizes the uncertainty of future events.44% 10.00% 12. Whenever r > rD. next year’s interest tax shields are fixed and.80 0.00% rd 8. b. The following year’s interest is not known with certainty for one year and. D/V E/V 0.40 0.00% rE 13.86% Different values result because the Miles-Ezzell formula assumes debt is rebalanced at the end of every period (Financing Rule 2).35 D/E 0.60 0. Note that. r* increases with leverage. discounted at a lower rate.20 0. 170 . when the debt is rebalanced.88% 9. is discounted for one year at the higher risky rate and for one year at the lower rate. The formulas for levering and relevering the cost of equity implicitly assume on-going corporate profitability so that the interest tax shields can be exploited. 4.250 0.67% 15. The cash flow to the stockholders and bondholders is: Er* + DrD Because the firm generates a perpetual cash flow stream: Er* + DrD = Vur + Tc rD D Divide by E and subtract DrD: V  D  r * =  u r  − (1 − Tc ) rD  E  E  Substitute L = D/E V  r * =  u r  − (1 − Tc )(r DL) E  We know that: Vu = E + (1 .500 r 12. 3.60 0. This is not necessarily true.90% ME 11.42% 10.

Investor gains from increase in stock price. the two positions are not identical. a. Investor exchanges uncertain upside changes in stock price for the known up-front income from the option premium. 171 . f. Statement (a) incorporates a put option. but loses entire investment if stock price is less than exercise price at expiration. while the seller of a put will find his loss decreasing and then remaining at zero as the stock price rises (see text Figure 20. The buyer of a call will find her profit changing from zero and increasing as the stock price rises (see text Figure 20.e. b.3). While it is true that both the buyer of a call and the seller of a put hope the price will rise. Safe investment if the debt is risk free. but also lose on the downside. Statement (d) incorporates a call option. A naked option position is riskier than the underlying asset. high-risk position with known up-front income but exposure to down movements in stock price. The risk reduction comes at the cost of the option premium. Statement (b) uses ‘option’ in the sense of choice. Benefit from upside. e.. The put places a floor on value of investment. this is equivalent (for European options) to ‘buy bond. Another naked.’ Therefore. Statement (c) uses ‘option’ in the sense of choice. 3. g. i. From put-call parity. this is a safe investment. 2. d.2). c.CHAPTER 20 Understanding Options Answers to Practice Questions 1. less risky than buying stock.

exercise the call immediately in order to purchase a share of Pintail stock for \$50. then you would let the call expire and buy back the stock.50)] = \$7. 172 . deposit in the bank an amount equal to the present value of the exercise price. [Note: In the first printing of the seventh edition. the cash flows are positive now and zero or positive one year from now. from put-call parity: C3 + [EX/(1 + r)0.50 is less than EX/(1 + r)0.25 = S From put-call parity for the six-month options.25.25. The net gain is: [\$200 – (\$75 + \$50)] = \$75. At the maturity of the call. 5. This produces a current cash flow equal to: [\$200 – \$75 – (\$50/1 + r))]. you should buy the call. answers will vary. Then. Therefore. and EX = the exercise price of the options. S = the market value of a share of stock. The cash flow at maturity is the greater of zero (if the stock price is greater than \$50) or [\$50 – stock price] (if the stock price is less than \$50). the action depends on whether the stock price is greater than or less than the exercise price. Let P3 = the value of the three month put.50] = P + S P = -S + C + [EX/(1 + r)0. then: EX/(1 + r)0. we have: C6 + [EX/(1 + r)0.0390. The price should be \$12.4. If the stock price is greater than \$50.50] = -27. 6.50] = P6 + S Since S = EX/(1 + r)0.27 + 12. If the call is a European call. Internet exercise. and then sell the share of Pintail stock for \$200.] From put-call parity: C + [EX/(1 + r)0. the call option price is shown incorrectly as \$2. You would buy the American call for \$75. If the stock price is less than \$50.10 7. C3 = the value of the three month call.30 + [22.25] = P3 + S Since both options have an exercise price of \$60 and both are worth \$10.30.30. then you would exercise the call (using the cash from the bank deposit) and buy back the stock. then the value of the six-month call is greater than the value of the six-month put. and sell the stock short.50/(1. and EX/(1 + r)0.

4.8. b. 2. Cable evaluates her prospects of generating income greater than this amount. Rank and File has an option to put the stock to the underwriter. After reading Chapter 23. 3. Dilution has a similar effect on the valuation of standby underwriting. This is because. The \$100 million threshold can be viewed as an exercise price. the underwriter pays the issue price. The payoffs at expiration for the two options are shown in the following position diagram: Option value 150 100 50 50 -50 -100 100 150 Share price 173 . EX = exercise price of the rights t = time from rights agreement to final exercise date for right σ 2 = variance of stock returns rf = interest rate [Note: The answer to (b) ignores dilution. a. Whether this provides an adequate incentive depends on how achievable the \$100 million threshold is and how Ms. 10. if the option is exercised. but also obtains an equity stake in this new money.] 9. it is comparable to a call option. Chapter 23 discusses how dilution affects the valuation of warrants and convertibles. students might return to the issue of the effect of dilution on the value of standby agreements. Since she gains 20% of all profits in excess of this level. a. 1.

Colleoni the same payoffs is:   Buy a call with an exercise price of \$150 Sell a call with an exercise price of \$50 Buy a put with an exercise price of \$150 Buy a share of stock Borrow the present value of \$150 Sell a call with an exercise price of \$50 Similarly.Value of put (EX = 50) .Value of call (EX = 50) Thus. another combination with the same set of payoffs is:     174 . price Here we can use the put-call parity relationship: Value of call + Present value of exercise price = Value of put + Share The value of Mr.Taking into account the \$100 that must be repaid at expiration.50) Using the put-call parity relationship.PV (150 . one combination that gives Mr. we find that this is equal to: Value of call (EX = 150) . the net payoffs are: Option value 150 100 50 50 -50 -100 100 150 Share price b. Colleoni’s position is: Value of put (EX = 150) .

Value of call . in order to replicate the payoffs of a bond.24 15.5 shows the payoffs for the strategy: Buy a call and lend an amount equal to the exercise price. you buy a put. Answers here will vary depending on the options chosen. sell a call. Use the put-call parity relationship for European options: Value of call + Present value of exercise price = Value of put + Share price Solve for the value of the put: Value of put = Value of call + PV(EX) . The second row of diagrams in Figure 20. Using the put-call parity relationship. the European put will sell for: 8 + (100/1. but the formulas will work very well. you would purchase a put. 12.90 = \$13. a. you would buy a 26-week call with an exercise price of \$100. 13. 14. sell a call. a. invest the present value of the exercise price in a 26-week risk-free security.Share price) = Value of put . and sell the stock short. and buy the stock. and borrow the present value of the exercise price.5 in the text. b. Statement (b) is correct. discrepancies should be on the order of 5 percent or so. we have: (.Share price Thus. to replicate the payoffs for the put. Again we rearrange the put-call parity relationship: PV(EX) = Value of put .PV(EX) This implies that. The appropriate diagrams are in Figure 20.5 shows the payoffs for the strategy: Buy a share of stock and buy a put.11. at most. b. We make use of the put-call parity relationship: Value of call + Present value of exercise price = Value of put + Share price a.Value of call + Share price This implies that. Rearranging the put-call parity relationship to show a short sale of a share of stock. in order to replicate a short sale of a share of stock. The third row of Figure 20. From the put-call parity relationship: 175 .05) .

EX = 100 Payoff to buy call. a. EX = 110.Value of call + Present value of exercise price = Value of put + Share price Equity + PV(Debt. this is a bet on low variability. and hence. Value of default put = \$350 . The buyer of the butterfly profits if the stock price doesn’t move very much. EX = 120 Share price 100 120 Payoff to sell call.93 176 . 17. at risk-free rate) = Default option + Assets \$250 + \$350 = \$70 + \$530 b. valued at the risk-free rate: Bond value = (\$50 + \$5)/1. hence. the straddle is a bet on high variability. The bond value increases to the present value of the guaranteed payoff.\$280 = \$70 Straddle Payoff 100 Payoff to put Payoff to call Calcall 100 Share price Butterfly Payoff Payoff to buy call.08 = \$50. 16.sell two The buyer of the straddle profits if the stock price moves substantially in either direction.

b. The payoffs to stockholders are unaffected. but shareholders get nothing. payments to shareholders do not change. 177 . just as before. If the firm defaults. its bondholders are paid off. If the firm does not default.

each with a market price of \$100. For each stock. and sell the stock short. Answers here will vary according to the stock and the specific options selected. The firm effectively acquires a new asset. After the transaction. the left-hand side [52 + (50/1.93 5. 20. This is an example of a general rule: An option on a portfolio is less valuable than a portfolio of options on the individual stocks because. the call expires worthless. To take advantage of this situation. By issuing 10-percent bonds with \$50 face value.93 Bonds Stock Firm value d.93 value of the government guarantee.00 25. which is used to repurchase stock.93 (the difference between the previous and new bond values). Imagine two stocks. there is a slight mispricing.c.62 at the risk-free rate. one should buy the call.93 \$55. you can choose which options to exercise. Rectangular raises \$50. Therefore. the market value balance sheet is the same as Circular’s. Here.62] is less than the right-hand side [20 + 80 = 100]. The value of your portfolio of call options is now: Value Call on A 0 Call on B 50 Total \$50 Now compare this with the value of an at-the-money call to buy a portfolio with equal holdings of A and B. of \$55). you have an at-the-money call option with an exercise price of \$100. Shareholders have pocketed the \$25. Stock A’s price now falls to \$50 and Stock B’s rises to \$150. Since the average change in the prices of the two stocks is zero.93 \$50.93 cash (the present value. in the latter case. at 8 percent. 18. invest \$47. Consider each company in turn. sell the put. but all should exhibit properties very close to those predicted by the theory described in the chapter. The firm’s balance sheet could be expressed this way: Asset value Government’s guarantee \$30.00 \$55. the government guarantee worth \$25. making use of the put-call parity relationship: Value of call + Present value of exercise price = Value of put + Share price Drongo Corp.05) = 99. 19. 178 .

If investor’s have underestimated volatility.02] and the right-hand side [7 + 50 = 57] are essentially equal. However. if the price falls.05) = 110. buy the put. Therefore. and buy the stock. If the asset price does not change. 179 . the left-hand side [17 + (40/1. the put will be valuable and. an alternative strategy is to buy a call (or a put) and hedge against changes in the asset price by simultaneously selling (or. the left-hand side [15 + (100/1. both options become worthless. Here. you will prefer the riskier proposal. the left-hand side [18 + (40/1.05) = 57. For the first six-month option.24) is greater than the right-hand side [10 + 80 = 90]. Wombat Corp.24 at the risk-free rate. Inc. 22. one should sell the call. in the case of the put. One strategy might be to buy straddle.05) = 55. To take advantage of this situation. The value of the options increases if the variance of the cash flows increases. so there is no mispricing.025) = 57. and so there is a slight mispricing. the greater the profit.62] is slightly less than the right-hand side [8 + 50 = 58]. if price rises. borrow \$95. For the three-month option. the option prices will be too low. buying) delta shares of stock. For the second six-month option. so there is a slight mispricing. there is a significant mispricing. buy a call and a put with exercise price equal to the asset’s current price. 21. the left-hand side [10 + (50/1.10] is slightly greater than the right-hand side [5 + 50 = 55]. Thus. that is. Therefore. The larger the price movement in either direction.Ragwort. the call will be valuable.

(This is known as a ‘Butterfly Spread.Challenge Questions 1. (2) sold a put. Bond will exercise its call option. a. (This is known as a ‘Short Straddle. c.’) Borrow money and use this money to buy a put and buy the stock.’) Buy one call with a given exercise price. (3) Price of land (2) (1) 180 . Purchase a call with a given exercise price and sell a call with a higher exercise price.’) Sell a put and sell a call with the same exercise price. and buy one call with a still higher exercise price. Letter the diagrams in Figure 20. If the land is worth more than \$110 million. d. Therefore: Payoff b. (This is known as a ‘Bull Spread. Bond has: (1) sold a share. Then we have the following diagram interpretations: a.13 (a) through (d). borrow the difference necessary. b. 2. the buyer will exercise its put option. beginning in the upper-left corner and proceeding clockwise. If the land is worth less than \$110 million. and (3) purchased a call. sell two calls with a higher exercise price.

and sell two call options with an exercise price of \$100. One way to profit from Hogswill options is to purchase the call options with exercise prices of \$90 and \$110.(5 + 15)] = \$2 Immediately prior to maturity. the land has not really been sold. the value of this position and the net profit (at various possible stock prices) is: Stock Price 85 90 95 100 105 110 115 Position Value 0 0 5 10 5 0 0 Net Profit 0+2=2 0+2=2 5+2=7 10 + 2 = 12 5+2=7 0+2=2 0+2=2 181 . 3.2% d. we know that Bond will end up owning the land after the expiration of the options. Bond has borrowed money. In effect. Thus. The interest rate can be deduced using the put-call parity relationship.This is equivalent to: Payoff Price of land c. the exercise price is \$110. We know that the call is worth \$20.222 = 22. not sold an asset. From the answer to Part (a). and it seems misleading to declare a profit on a sale that did not really take place. respectively. and the combination [sell share and sell put option] is worth \$110. The immediate benefit is a cash inflow of: [(2 × 11) . in an economic sense. Therefore: Value of call + Present value of exercise price = Value of put + Share price Value of call + PV(EX) = Value of put + Share price 20 + [110/(1 + r)] = 110 r = 0.

that you can identify such opportunities from data published in the newspaper. such trading tends to eliminate these profit opportunities. Option Value 500.  Sell 4.000 call options with an exercise price of \$119. 182 . much less distributed to you) and traded on the information.000. no matter what the final stock price.000. It is possible.Thus.000 120 b. but very unlikely.875. Someone else has most likely already noticed (even before the paper was printed. Stock Price This incentive scheme is a combination of the following options:  Buy 4. we can make a profit trading in these Hogswill options. 4.000 call options with an exercise price of \$120. a.

41 \$57.01 \$32.97 183 . d =1 / u =0.33 \$45. d =1 / u =0.CHAPTER 21 Valuing Options Answers to Practice Questions 1.40 \$35.14 \$57.8 4 8 4 \$63.98 \$45.06 u =e 0.60 \$64.1 5 .97 \$35.41 \$31.91 \$44.40 \$27.24 0.24 0.41 \$44.92 \$35.72 \$45 \$39.16 \$50. a.14 \$44.2 5 =1.5 =1.98 \$39.01 \$45 \$37. u =e 0.1 7 .19 \$53.8 7 2 8 \$72.70 \$57.86 \$50.

75 \$55.77 \$45.72 \$45.3 0. d =1 / u =0.1 2 .73 \$52.41 \$45.05 \$33.60 \$60.75 \$33.79 \$45.8 1 6 6 \$82.5 =1.36 \$28.04 \$70.2 5 =1.8 9 3 0 \$68.3 0.76 \$52.62 \$45.00 \$45 \$36.00 \$29.b.02 \$38. d =1 / u =0. u =e 0.29 \$45 \$38.2 6 .79 \$60.32 \$60.46 u =e 0.05 184 .38 \$24.38 \$33.

σ = 50% Then. if investors are risk-neutral: (p × 0.87 = \$52.98 11.04 29.p)× (-0. the value of the put is \$16.00 \$60 × 0. using the Black-Scholes model.a.04 185 Base case P = 120 EX = 120 rf = 10% t=2 σ = 100% . the value of the put if exercised immediately equals the value of the put if it is held to next period. the value of the put option decreases.94 35.15 = \$69.13) = 0.63 21. If there is an increase in: Stock price (P) Exercise price (EX) Interest rate (rf) Time to expiration (t) Volatility of stock price (σ ) The change in the put option price is: Negative Positive Negative Positive Positive Consider the following base case assumptions: P = 100.10 That is.15) + (1 . we find that the break-even exercise price is \$61.52. Let p equal the probability of a rise in the stock price. Solving for X. If the interest rate is increased. Then the following must be true: X – 60 = (p)(\$0) + [(1 – p)(X – 52.10 p = 0.821 The possible stock prices next period are: \$60 × 1. EX = 100. rf = 5%.20)]/1. t = 1.03 14.20 Let X equal the break-even exercise price. Then.98 The base case value along with values computed for various changes in the assumed values of the variables are shown in the table below: Black-Scholes put value: 16. b.

42 1.67 × 45) + (0.10 Therefore.67 ×51. If the call is not exercised. then. If stock price increases to SFr125. it is preferable to exercise the call.a.33 × 0) = SFr27.25 If stock price decreases to SFr80 in month 6.33 × 4) = SFr32.42 4 51. if investors are risk-neutral: (p × 0.41 1.10 p = 0. Then. The value of the call in month 0 is: (0.10 b. if it is exercised at that time.25 Let p equal the probability of a rise in the stock price.67 Now. The future stock prices of Matterhorn Mining are: 100 With dividend Ex-dividend 51. The future stock prices of Matterhorn Mining are: 100 With dividend Ex-dividend 48 80 60 75 84 125 105 131.2 80 64 80 125 100 125 186 .20) = 0.p)× (-0. then its value is: (0.25) + (0. it has a value of (125 – 80) = SFr45. ? 0 0 0 32. then the call is worthless. calculate the expected value of the call in month 6.25) + (1 .

187 .

10 p = 0.41 1. The possible prices of Buffelhead stock and the associated call option values (shown in parentheses) are: 220 (?) 110 (?) 55 (0) 220 (55) 440 (?) 880 (715) Let p equal the probability of a rise in the stock price.Let p equal the probability of a rise in the price of the stock. then.41 1. calculate the expected value of the call in month 6.10 Therefore.10 p = 0.67 × 45) + (0. If the call is not exercised. Then.50) = 0. then the call is worthless.4 188 .25) + (1 . it is preferable to exercise the call.67 Now.10 a.41 0 45 If stock price decreases to SFr80 in month 6.p)× (-0. The value of the call in month 0 is: (0.00) + (1 .20) = 0.33 × 0) = SFr27.p)(-0. ? 0 0 0 27. then its value is: (0. if investors are risk-neutral: (p × 0. if investors are risk-neutral: p (1. it has a value of (125 – 80) = SFr45.33 × 0) = SFr27. Then.67 ×45) + (0. if it is exercised at that time. If stock price increases to SFr125.

If the stock price is \$110 at 6 months. it will be worth: [(0.4 × 290) + (0.6 × 0)]/1.10 = \$290 Therefore. if it is exercised. 189 .10 = \$20 Similarly.6 × 20)]/1.33.4 × 715) + (0.0 8 80 −2 0 2 (ii) If the price falls to \$110: D lta e = 5 −0 5 =0 . the option delta is 0. we buy three calls and lend. if the stock price is \$440 in month 6. as follows: Initial Outlay Buy 3 calls -60 Lend PV(55) -50 -110 This strategy Is equivalent to: Buy stock -110 Stock Price = 55 0 +55 +55 +55 Stock Price = 220 165 +55 +220 +220 d. in order to replicate the stock. then the option will not be exercised so that it will be worth: [(0.6 × 55)]/1. it is equivalent to buying the stock with a partly deferred payment.If the stock price in month 6 is \$110. Therefore.\$165) = \$275. At the other extreme. The option delta is 1.36 b. so that its value today is: [(0. the call option will not be exercised. If the option is not exercised.0 when the call is certain to be exercised and is zero when it is certain not to be exercised. then. If the call is certain to be exercised.10 = \$116. (i) If the price rises to \$440: D elta = 7 5 −5 1 5 =1.4 × 55) + (0. regardless of the change in the stock price.3 3 22 −5 0 5 c. it will be worth (\$440 . when the call is certain not to be exercised. So a one-dollar change in the stock price must be matched by a one-dollar change in the option price. it is valueless.

The investor should not exercise early. Similarly.4 × 0) + (0. the value today of the American put option is: [(0. if the stock price in month 6 is \$440. Thus..6 × 90)]/1.a. it is rational to consider the early exercise of an American put option. if it is exercised after 6 months.6 × 110)]/1.10 p = 0. Yes.4 × 0) + (0. it will cost the investor \$220. the investor should exercise the put early. and if the American put option is not exercised.. We noted in part (b) that. if it is exercised after 6 months. Therefore.10 = \$60 c. it will be worth: [(0.00) + (1 . the American put would be exercised because its value if exercised (i.10 = \$0 On the other hand.50) = 0. and if the American put option is not exercised.4 × 0) + (0. Unlike the American put in part (b). however. the value at that point is \$90 because the European put can not be exercised early.09 190 .e.4 × 0) + (0. b.p)(-0.10 = \$90 On the other hand.10 = \$49. Then. The possible prices of Buffelhead stock and the associated American put option values (shown in parentheses) are: 220 (?) 110 (?) 55 (165) 220 (0) 440 (?) 880 (0) Let p equal the probability of a rise in the stock price. it is worth \$110. For the European put. it will be worth: [(0.4 If the stock price in month 6 is \$110. Finally.6 × 0)]/1. if investors are risk-neutral: p (1. If the stock price in month 6 is \$110. the value of the European put is: [(0. the European put can not be exercised prior to expiration.6 × 165)]/1. \$90). \$110) is greater than its value if not exercised (i.e.

5 (42. the value of the option is \$265.36 1. The option values in month 6. in this case.99 1.5) 830 (665) We calculate the option value as follows: 1.10 If the stock price in month 6 is \$110. the value of the European option is less than the value of the American option.4 ×665) + (0.4 ×275) + (0. if the price rises to \$440 at month 6. with option values in parentheses: 220 (100.5 (0) 110 85 (1.10 b. If the option were European.5) = 265 1. then it would not pay to exercise the option. Therefore.The following tree shows stock prices.165) = 275. if the option is not exercised.82 1. we find the option value as follows: Option value = (0.10 191 . Working back to month 0. The value of the European option is computed as follows: Option value = (0.82) 170 (5) 440 415 (275) 207. are computed as follows: (0.6 ×1.6 ×42.6 ×1. then the call is worth: (440 .10 (0.4 ×265) + (0.82) = 100.4 ×5) + (0.6 ×0) = 1. If the stock price in month 6 is \$440.99) With dividend Ex-dividend 42. Therefore. it would not be possible to exercise early.82) = 97. the option would be exercised at that time. 2. not \$275 as is the case for the American option. Therefore.

71 192 . the investor would not exercise the put since it would cost \$275 to exercise.6 ×55) = \$135.4 (0) Let p equal the probability that the stock price will rise. for a risk-neutral investor: (p × 0.4 ×715) + (0. is determined as follows: (0. the month 0 value of the option is: Option value = (0.0 (7. Thus. with the values for the one-year option values in parentheses: 220 110 (55) 55 (0) 220 (55) 440 (290) 880 (715) The put option is worth \$55 in month 6 if the stock price falls and \$0 if the stock price rises.10 9. The following tree shows stock prices (with put option values in parentheses): 100 (2. With a price in month 6 of \$440.1 (.35) 90.p)× (-0. it pays to exercise the put (value = \$55).05 p = 0. if it is not exercised.15) 81.0 (21) 100 (2) 111. with a 6-month stock price of \$110. a.111) + (1 .10) = 0.55) 123.The following tree (see Practice Question 5) shows stock prices. Then.4 ×290) + (0.10 Therefore. The value of the option in month 6.45 1.6 ×55) = 290 1.

55) + (0. then the value of the European put is: (0. it can not be exercised at month 6.0 = 1.223 × 1. Thus.21)]/ EX = 180 t +σ t /2 σ = 0.0 ) +(0. 1 + upside change = u = eσ h = e0.35 1.55) + (0. then.2498 1 + downside change = d = 1/u = 1/1.15) =C\$ 2. a.91 193 .223 t = 1.9249 × 200] – [0.8880 Call value = [N(d1) × P] – [N(d2) × PV(EX)] = [0.71 ×2) + (0. Since the American put can be exercised at month 6.223 × 1. P = 200 d1 = log[P V /P (E = log[200/(1 d2 = d1 −σ X σ )]/ 80/1.8880 × (180/1.1.69 1.29 ×21) =C\$ 7.29 ×2) =C\$0 .25) + (1 .223 × 1.0 ) /2 =1. if the stock price is C\$90. the put is worth (102 – 90) = \$12 if exercised.0.71 ×0) + (0.71 × 0 . Then. for a risk-neutral investor: (p × 0.21)] = \$52.55 1.4388) = 0. then the value of the put is: (0.2498 = 0.21 (0. the value of the American put in month 0 is: (0.4388 −(0.9249 N(d2) = N(1.2158) = 0.05 If the stock price in month 6 is C\$90.0 rf = 0.29 ×12) =C\$ 3.2158 t =1. The value of the put at month 0 is: (0.15 if not exercised.05 10.29 ×7.223 1.88 b.20) = 0.05 b.0 ) =1. compared to \$7.If the stock price in month 6 is C\$111.p)× (-0.05 Since this is a European put.4388 N(d1) = N(1.21 p = 0.8001 Let p equal the probability that the stock price will rise.15 1.0.71 ×0 .

223 0.2 (94.8541 Let p equal the probability that the stock price will rise.8 (14.53 1.21 c.776 ×20) + (0. the stock price will be either \$250 or \$160.776 The following tree gives stock prices.2) = \$70.146) = 0.10 194 .9 (0) 200. with option values in parentheses: 200 (52. (0.5 = 1.64 1. the value of the option is: (0.91 × 7 0) +(0.2) Option values are calculated as follows: 1.10 p = 0.2 (70.776 ×94.p)× (-0. respectively.63 1.10 (0. for a risk-neutral investor: (p × 0.171) + (1 .53) = \$52. 3.776 ×70. and the option values will be \$70 or \$0.224 ×20) + (0.11 1.224 ×0) = \$14.1708 = 0.11) + (0. Then.10 (0.09 × 0) = \$52 .1708 1 + downside change = d = 1/u = 1/1.0 (20) 234.53) 274.63) 170.In one year. Therefore.224 ×14.11) 145. 2. 1 + upside change = u = eσ h = e0.

buy 0. If you want to minimize the number of times you rebalance an option hedge.63] = \$125.14. Here are the possible stock prices: 100 50 200 55 110 220 Now consider the effect on option delta: Option Deltas In-the-money At-the-money Out-of-the-money (EX = 60) (EX = 100) (EX = 140) Current Stock Price 100 110 140/150 = 0. 195 .70.37 To replicate a call.67 120/165 = 0. buy 0.52. for a given difference in stock price.89 shares and borrow: [(0.93 160/165 = 0.40 80/165 = 0.2 −170.48 Note that.0 × 200) .53 −14. we will look at a simple one-period binomial problem with different starting stock prices.37 (ii) O ption delta = 94.00 274.89 234.89 × 200) .8 O ption delta = To replicate a call.2 − 200 To replicate a call.2 − 20 = 1.89 11.11] = \$59.d. buy one share and borrow: [(1.97 100/150 = 0.9 =0 . use in-the-money options.47 (iii) O ption delta = 20 − 0 200 −145.53] = \$129. To hold time to expiration constant. out-of-the-money options result in a larger change in the option delta.37 × 200) .73 60/150 = 0.11 =0 .37 shares and borrow: [(0. (i) Option delta = spread of possible option prices spread of possible stock prices 70.

(You never exercise a call if the stock price is below exercise price. The put when the interest rate is high. Naturally. 14.e.) c. you purchase the stock for the exercise price. 196 . in order to maximize your profit. the exercise price. Internet exercise. i.] We can value the call by using the put-call parity relationship: Value of put = value of call – share price + present value of exercise price Then we must purchase two items of information [value of European put and PV(Exercise price)] and.) b. If we use the Black-Scholes model. a. will spend \$20. hence. (You can invest the exercise price.) 13. b. we must also purchase two items [standard deviation times square root of time to maturity and PV(exercise price)] and. a. (You would delay the exercise of the put until after the dividend has been paid and the stock price has dropped. When you exercise a put. your gain is the difference between the price of the stock and the amount you receive upon exercise. 15. and so you would exercise on the with-dividend date in order to capture the dividend.. answers will vary. Therefore. hence.12. will spend \$20. The call option. you want to maximize what you receive for this price. The put option. When you exercise a call. [Note: the answer to this question is based on the assumption that the stock price is known. you want to minimize the price of the stock and so you would exercise on the ex-dividend date.

the dollar change in the value of the option will be much smaller than the dollar change in the price of the stock. But. Both of these announcements may convey information about company prospects. assume that the exercise price of the options (EX) is between u and d. so that. 3. stock price decreases by an amount approximately equal to the amount of the dividend. 4. a stock repurchase at the market price does not affect the price of the stock. the spread of possible option prices is: For the call: [(u – EX) – 0] For the put: [(d – EX) – 0] The option deltas are: Option delta(call) = [(u – EX) – 0]/(u – d) = (u – EX)/(u – d) Option delta(put) = [(d – EX) – 0]/(u – d) = (d – EX)/(u – d) Therefore: [Option delta(call) – 1] = [(u – EX)/(u – d)] – 1 = [(u – EX)]/(u – d)] – [(u – d)/(u – d)] = [(u – EX) – (u – d)]/(u – d) = [d – EX]/(u – d) = Option delta(put) 2. so that the option delta is close to zero. you would buy one call option. then the option value remains low even if there is a large percentage change in the price of the stock. Between these two extreme cases. if the exercise price is zero. This price decrease reduces the value of the option. 197 . Therefore. For the one-period binomial model. Spreadsheet exercise. and thereby affect the price of the stock. Therefore. you should hope that the board will decide to announce a stock repurchase program. On the other hand. when the dividend is paid. If the exercise price of a call is zero. then the option is equivalent to the stock. If the exercise price of a call is indefinitely large. the option delta is one. Therefore.Challenge Questions 1. Then. in order to replicate the stock. the option delta varies between zero and one.

these are discussed in Chapter 27. The annual market standard deviation is 21 percent. Thus the only difference between the call option and the stock is that the option holder misses out on any dividends.03 4 888.112 1.114 = 929.76 25.85 = 1. While it is true that the value of an option approaches the upper bound as maturity increases and dividend payments on the stock decrease. Salomon needs to replicate the purchase of an equivalent option. The risk-free interest rate is 3 percent.2 1 4 = .5.. 2. a.90 − − − 1. the value of the call option = 172.49 Therefore.113 1. i.5 percent. the present value of the exercise price becomes infinitesimal. To hedge this position.00 21. Salomon Brothers has sold a four-year call option on the market. the value of the option approaches its upper bound. rather than the underlying stocks.000 + 172. 4.78 = \$980. It could do this by a series of levered investments in a diversified stock portfolio.e. a stock that never pays dividends is valueless.00 1.055 4 b. (A more practical alternative would be to use index futures.) 6. 3.11 1.047 1000 / 1. and grow by 9 percent per year to give a total return of 11 percent. Dividends equal 2 percent of the index value.4 0 2 Asset value − PV (dividends ) PV (Exercise price) = 1000 − 20. the stock price. 198 . Assume the following: 1. As the life of the call option increases. The yield on a 4-year bond is 5. Then: σ tim e =0 .78 Value of SPINS = 1. b. If dividends are negligible.80 23. a.

35 t = 3. however.000/r). c.1132 0 )]/(0. Thus. f.000 + (\$300. The annual standard deviation of the changes in the value of the restaurant as a going concern is 15 percent. as in (b).000. d.0 ) /2 = − . An in-the-money American option to choose between two assets. a.7194 0 0 N(d1) = N(-0.CHAPTER 22 Real Options Answers to Practice Questions 1. e. A put option. By waiting. b. A complex option that allows the company to abandon temporarily (an American put) and (if the put is exercised) to subsequently restart (an American call).4549 199 .0 ) +(0. the exercise price is: \$5.0 rf = 0.000.10 t +σ 3 3. EX = 800 X σ )]/ 00/1. the developer loses the cash flows from immediate development. but the exercise price rises by 5 percent per year. A commitment to invest in the Mark II would have a negative NPV. 2. The value of the option more than offsets the negative NPV of the Mark I.10 t /2 × 3. P = 467 d1 = log[P V /P (E = log[467/(8 d2 = d1 −σ σ = 0. The option to invest has a positive NPV.1132) = 0. with annual standard deviation of 10.35 × 3. A call option that allows Air France to fix the delivery date and price.000. that is.000/0.1132 −(0. A five-year American call option on oil. The restaurant’s current value is (\$700. the developer can defer exercise and then determine whether it is more profitable to build a hotel or an apartment building.0 ) = − .10) = \$8. except that the exercise price should be interpreted as \$5 million in real estate value plus the present value of the future fixed costs avoided by closing down the restaurant.35 × 3.35 t = − . Note: The underlying asset is now PV(revenue – variable cost). An American put option to abandon the restaurant at an exercise price of \$5 million. The initial exercise price is \$32 a barrel.5 percent. a.

15 × 1.35 × 3.7] – [0.8953 −(0.103)] = \$70.1072 Call value = [N(d1) × P] – [N(d2) × PV(EX)] = [0.20 t = 3.35 t = 3.2417) = 0.0 ) +(0.0 ) = − 0.4228 × 500] – [0.1948) = 0.4549 × 467] – [0.0 rf = 0.7/(2 d2 = d1 −σ /1.103)] = \$68.32 c.0 ) = − .N(d2) = N(-0. P = 1.10 t /2 × 3.12 σ = 0. P = 467 d1 = log[P V /P (E = log[467/(9 d2 = d1 −σ X σ )]/ 00/1.900 200 .15 × 1.0 ) /2 = − 0.3435 Call value = [N(d1) × P] – [N(d2) × PV(EX)] = [0.2529) = 0.2529 −(0.4029) = 0.2116 Call value = [N(d1) × P] – [N(d2) × PV(EX)] = [0.2116 × (900/1.2417 N(d1) = N(-0.0 ) = − 1.15 X σ )]/ 1 t = 1.4002 × 1.2359 Call value = [N(d1) × P] – [N(d2) × PV(EX)] = [0.4029 0 N(d1) = N(-0.8953) = 0.20 × 3.0 ) +(0.12 t +σ )]/(0.7 EX = 2 d1 = log[P V /P (E = log[1.20 t =− 0.10 EX = 900 t +σ 3 σ = 0.4228 N(d2) = N(-0.20 × 3.0 ) +(0. P = 500 X)]/ σ 00/1.1948 N(d1) = N(-0.15 × 1.8010 t =− 0.0 ) /2 = − 0.1853 × 467] – [0.0 t /2 rf = 0.35 × 3.4002 N(d2) = N(-0.103)] = \$14.0 rf = 0.1072 × (900/1.0 ) /2 = − 0.7194) = 0.65 b.10 EX = 900 t +σ 3 σ = 0.2359 × (800/1.1948 −(0.121)] = \$0.0669 million or \$66.35 × 3.3435 × (2/1.8010) = 0.8953 )]/(0.2529 t =− 0.05 4.1853 N(d2) = N(-1.10 d1 = log[P/P V(E = log[500/(9 d2 = d1 −σ t /2 )]/(0.

1710 Call value = [N(d1) × P] – [N(d2) × PV(EX)] = [0. For the case where the investment can be postponed for two years.5.121)] = \$0.300 6.15 t /2 t = 1. and hence.0 ) = − . the value of the option is: (0. then there would be minimal advantage to shifting from one to the other.7 – 0.8003) = 0. If the cash flows are delayed one year.8003 t =− 0.8003 −(0. if the prices of both oil and gas were very variable.12 = 0.0 ) /2 = − 0.2118 N(d2) = N(-0. a. the asset value is now (1.566] – [0.566/ d2 = d1 −σ t +σ )]/(0. b.12 d1 = log[P V(E /P = log[1. The asset value from Practice Question 4 is now reduced by the present value of the rents: PV(rents) = 0.8 million 1.134) = 1.9503 0 N(d1) = N(-0.0 rf = 0.2118 × 1.15/1. 7.657 ×0) = \$21. the option would be less valuable.343 ×70) + (0.15 × 1.12 1 σ = 0.9503) = 0.1710 × (2/1.0263 million or \$26. In general. an increase in variability increases the value of an option. Hence. If the prices of coal and gas were highly correlated. the end-of-period values and intermediate cash flows are: 200 16 160 16 160 25 16 250 160 25 250 25 250 201 .0 ) +(0.15 × 1.15 × 1.566 P = 1. the option to burn either oil or gas would be more valuable.134 Therefore.566 EX = 2 X σ )]/ (2/1.05 2 8.

overall project Net Present Value would change because choices would be constrained.a. a. If. The option values in the binomial tree above are computed using the risk neutral method. Let p equal the probability of a rise in asset value. if investors are risk-neutral: p (0.10) + (1 . Then. Because the option to delay has value.581 202 . The values in the binomial tree below are the ex-dividend values. At the end of the first year. for example. the decision about whether or not to invest should be postponed if demand at that time is low. 3428 (978) 3162 (712) 2920 (491) 2700 (327) 2405 (115) 2605 (208) 2595 (202) 2136 (0) 2825 (375) 2815 (365) 2318 (0) 2805 (355) 2309 (0) 2300 (0) 1892 (0) b. c. 9. the intermediate cash flow of \$25 will be lost.0909) = 0.02 p = 0. but the project cannot be undertaken until t = 2. overall project Net Present Value will be higher. with the option values shown in parentheses. b.p)(-0. demand is high at t = 1. If you could undertake the project only in years 0 and 2.

At each asset value in month 3 and in month 6.212 then the option value is: (\$3.500) = \$712. If you exercise the option early.5 million. it is worth the with-dividend value less \$2. this difference does not affect any of our results and conclusions.\$2.5 million – (\$0. asset value at month 6 is \$3. The value of the option today is \$327.\$8 million) = \$2 million if demand is sluggish and \$0 if demand is buoyant 10.162 (this is the value after the \$50 cash flow is paid to the current owners).5 million) = \$11. if you exercise in month 3 when the with-dividend value is \$2. the option would be worth: (\$2. Since the option is worth \$490 if not exercised. you should exercise the put option and receive \$10 million.419 × 375) + (0. Then.212 . you are better off keeping the option open. (As noted above in part (b) there is one minor exception to this conclusion. as shown in the binomial tree above. c. the option value if the option if not exercised is greater than or equal to the option value if the option is exercised. For example. Due to rounding. a. Since PV(A) = \$11. under the condition specified in part (b).07) = \$11. you should wait rather than exercise today.500) = \$470.03 million b.) Therefore. Technology B is equivalent to Technology A less a certain payment of \$0. then the option value will be: [(0.970 \$2. So.5 million then.5 million/1.If. At each point before month 9. 203 . for example. (The one minor exception here is the calculation above where we show that the value is \$712 if the option is exercised and \$711 if it is not exercised. you should not exercise the option now because its value if not exercised (\$327) is greater than its value if exercised (\$200).581 × 978)]/1. If demand is buoyant. you should continue with the project and receive \$18 million.970.02 = \$711 If the option is exercised at month 6 when asset value is \$3.500. Therefore. ignoring abandonment value: PV(B) = PV(A) – PV(certain \$0. if demand is sluggish. you receive the \$10 million salvage value but no operating cash flows. if you abandon Technology B. the put would be worth: (\$10 million .) Therefore. the option is worth more unexercised than exercised. the option value is \$712. in year 1. Assume that.

07 p = 0. the value of the abandonment option would be: (7 – 5.275) = 0.97 \$9. Then.167) = 0. if investors are risk-neutral: p (0. if value declines in each of the four quarters).08 \$22.5% Let p equal the probability of a rise in asset value. a.50 \$9. In this case.38 \$11.p)(-0. if investors are risk-neutral: p (0.38 × 2)]/1.03 million) = -27. using the quarterly risk-free rate.38 Therefore.e.54 (i.632) + (1 .97 \$18.54) = 1.46 \$17.65 \$11.25) + (1 .47 7 \$8.71 \$12. we find that. If demand is buoyant.97 \$12..31 \$8.441 204 \$14.p)(-0.2% If demand is sluggish. the value of the option to abandon is: [(0. The only case in which one would want to abandon at the end of the year is if project value is \$5. Then.We can value the put using the risk-neutral method.62 × 0) + (0. \$28.47 .58 \$7.017 p = 0. then the gain in value is: (\$18 million/\$10 million) –1 = 63.98 \$6.31 \$5.46 Let p equal the probability of a rise in asset value.71 million 11.07 = \$0. the loss is: (\$8 million/\$11.97 \$14.54 b.71 \$18.

which is an application of the certainty-equivalent concept. (See the end of Section 22. The valuation approach proposed by Josh Kidding will not give the right answer because it ignores the fact that the discount rate within the tree changes as time passes and the value of the project changes.The risk-neutral probability of a fall in value in each of the four quarters is: (1 – 0.06 = 0.441)4 = 0. 14. but we can use the risk-neutral method. We can no longer rely on arbitrage arguments for assets that are not traded in financial markets.) 205 .6.0967 or \$96.06)/1.0976 × 1. 13.1035 The present value of the abandonment option is: (0.700 12. while the binomial trees in Chapter 22 are used for valuation purposes.0976 The expected risk-neutral value of the abandonment option is: 0. Furthermore. decision trees are used to help decision-makers to understand the alternative courses of action available.07 = 0.0976 × 1. decision trees might recognize three or more outcomes at each stage. For example. Decision trees are potentially more complex that the simple binomial trees.

the project has a positive Net Present Value. You don’t take delivery of the new plant until month 36.667 = \$667 Considered by itself.Challenge Questions 1. Now consider the option to wait one year. b. This is a call option with an exercise price of \$1. Thus. And so on. 2. you have an option on the option to buy the plant. the firm has the option to abandon the project and receive the unspent balance in the escrow account.000. The exercise price of this option is the amount in the escrow account in month 2.000 + 1. you get another option to abandon it in month 2. The exercise price of this second call option is the construction cost in the next to last month. in month 1. If you do not exercise the put in month 1.667 The net present value is: NPV = -1. a.000 206 . Alternatively. Think of the situation one month before completion. you can think of the firm as agreeing to construction and putting the present value of the construction cost in an escrow account. The present value of the investment is: PV = 250/0. You have a call option to get the plant by paying the final month’s construction costs to the contractors. And so on.15 = \$1. The possible cash flows and end-of-period values for the first year are: 1. One month before that.667 Cash flow = 50 333 Cash flow = 450 3. you have a put option on the project with an exercise price equal to the amount in the escrow account. Each month.

today the option to invest in energy-saving equipment is worth: (0. if fuel savings are \$50 per year. the option will be worth: (\$3.If fuel savings are \$450 per year. Consequently. The total return is: [(450 + 3. consider its possible values. However.000.3% To value the call option. 3. Thus.473 = 47.473) ×0] = \$860 1.0 = 1.000) + [(1 −0 .000)/1. If fuel prices fall to \$50.667] – 1. then the project has a cash flow of \$50 the first year and an end-of-year value equal to: (\$50/0.\$1. then the project has a cash flow of \$450 the first year and an end-of-year value equal to: (\$450/0. the rate will be too high.473 × 2.p) × (-0. An increase in PVGO increases the stock’s risk. it makes sense for consumers to wait. b. If fuel prices rise to \$450.677] – 1.000. the expected return would be equal to the risk-free interest rate.77 = -77%. The total return is: [(50 + 333)/1. 207 . Since PVGO is a portfolio of expansion options. its value is \$667. The cost of capital derived from the CAPM is not the correct hurdle rate for investments to expand the firm’s plant and equipment.15) = \$3. the option is worthless.000) = \$2.77)] = 0. under the assumption of riskneutrality: (p × 1. Let p be the probability that fuel prices are high.07) + [(1 .0 = -0. The expected return will reflect the expected return on the real options as well as the assets in place. On the other hand.000 . the value of the option to wait is \$860.15) = \$333.10 p = 0.10 If the energy-efficient investment is undertaken today. In a risk-neutral world. or to introduce new products.07 = 107%. Hence. it has higher risk than the risk of the assets currently in place. a.

However.20 × 5. you forgo the interest you could have earned on the exercise price: (0. If the stock has high variability. a. Total equity value after the warrant issue (V) is (\$40 million + \$5 million) = \$45 million.9907 t =1.08 5 b.79 2 = \$12.5435 N(d1) = N(1.9386 × (30/1.\$12. a. 2. Also. If the dividend is \$5.9767 × 45] – [0.20 σ = 0.79 W arrant  1  value = 1 + q  × (Call    value) = \$24.9907 −(0. (V/N) = (\$45 million/1 million shares) = 45. If the stock has low variability.395) = \$32. by exercising now.605 208 .9386 Call value = [N(d1) × P] – [N(d2) × PV(EX)] = [0.5435) = 0. By exercising now.085)] = \$24. you gain a dividend of \$3. P = (V/N) = 45 0. the income gain may outweigh the loss from shortening the option life. The market value of each share of common stock is: (\$45 . you pick up \$1 of extra income by exercising. you give up the option to own the bond and not own the stock.0 ) =1.9767 N(d2) = N(1. so the dilution adjustment is correspondingly important. but you still give up the option. In that case. it is unlikely that the share price will change very much.20 × 5.0 ) +(0.0 rf = × 5.395 b.CHAPTER 23 Warrants and Convertibles Answers to Practice Questions 1.9907) = 0.10 × \$40) = \$4. it may be better to keep the option alive because of the higher option value. The Moose Stores warrant issue is large relative to the value of the firm. Thus. Exercise later.08 d1 = log[P V /P (E = log[45/(30 d2 = d1 −σ X σ )]/ /1. EX = 30 t +σ )]/(0.20 t /2 t = 5.0 ) /2 =1.

the new warrants are given to the old warrant holders at no charge.27 = 33.3.07 W arrant  1  value = 1 + q  × (Call    value) = \$14. Warrant holders would then lose the first four dividends. bondholders will be forced to convert in order to escape the call. 209 . suppose the warrants are not exercised before year five. In essence.0 rf = 0.07 2 = \$7. That is.000/25) = 40 shares.20 t =1.000 face value for the bonds. 5.8989 N(d1) = N(1. a bondholder can convert one bond into: (1.8156 × (30/1.3461 −(0. if the interest on the convertible exceeds the dividends on forty shares of common stock.8989) = 0. We recalculate the warrant value as follows: P = (V/N) – PV(dividends) = 45 – 11.3461) = 0.9109 N(d2) = N(0. The market value of each share of common stock is: (\$45 .20 × 5. c. The cost of extending the warrant life is the same as issuing a new warrant with maturity equal to the time of extension.8156 Call value = [N(d1) × P] – [N(d2) × PV(EX)] = [0.0 ) /2 =1.0 ) +(0. By not calling.200 A convertible sells at the conversion value only if the convertible is certain to be exercised. The price of the convertible bond exceeds the conversion value by the value of this put.08 d1 = log[P V /P (E = log[33.73] – [0. a.0 ) = 0. Surplus is handing b. When Surplus calls.965 4. You can think of owning the convertible as equivalent to owning forty shares plus an option to put the shares back to the company in exchange for the value of the bond. the convertible’s value reflects this additional income.20 t = 5.73 EX = 30 σ = 0.085)] = \$14.73/ d2 = d1 −σ X σ )]/ (30/1.035) = \$37. The conversion value is: (40 × \$30) = \$1.9109 × 33. a. With a \$1.20 × 5. An approximate solution can be derived here by assuming that the warrant holder pre-commits to exercising at a specified future date.08 t +σ 5 t /2 × 5.035 b. Yes. Also. For example.3461 )]/(0. the price of the convertibles will fall to the conversion value.\$7.

19) = \$36. b. bond value = (\$1. 9.00 . c. c. then the price would be: \$1.25 (i.30% 7.000/1.19) = \$86.15 = 1. The conversion price is: (\$1.8792(1/15) = 1.19 b. Investors are paying (\$550. If the fair rate of return on a 10-year zero-coupon non-convertible bond is 8%.000/27) = \$37. d. if you do not convert. and the bond is no longer convertible in the future.105). Then the value of the convertible bond is: (\$500.10)15 = \$239.000/(1. 8. a.000.04 The conversion value is: (27 × \$47) = \$1. a. bondholders a ‘free gift’ worth 25 percent of the bond’s face value (i.0430 = (1 + r) r = 0. b.000/532.e. a. 130 .000/1.\$463.e.39 210 . the value of a comparable non-convertible bond).269) is greater than the maturity value of the bond.6.. Stock Straight bond Straight bond Stock The yield to maturity on the bond is computed as follows: 1. Yes. b.0430 = 4. Otherwise. sell the ten shares for \$500. a.81) = \$587.089) = \$500. The value of the non-convertible bond would be: 1. That is.81 for the option to buy ten shares.0810 = \$463. By converting. In one year..8792 = (1 + r)15 1.19 The conversion value is: (10 × \$50) = \$500. you should convert because the value of the shares (\$1.25 + \$86. and then buy a comparable straight bond for \$463.19. you could convert.000 = 532.81. you would gain: (\$500 . you will own a non-convertible Piglet bond worth \$463.\$463. at the expense of the shareholders. c.269.15 × (1 + r)15 1.06 Assume a face value of \$1.

04306) = \$777.15/8.71 × (1. If investors act rationally.72 The increase in the conversion price reflects the accreted value of the bond since it has a zero coupon. the option buyer saves interest 11. d.39 = \$292.38 The initial conversion price was: \$532.36.15 .50 = \$442. 10. In other words. Marriott can call the bonds at \$810. they should put the bond back to Marriott as soon as the market price falls to the put exercise price.76 c.20 Therefore. the conversion price is: \$777. The expected return affects the price of the stock. A convertible feature in a bond is analogous to a call option. Issuing a convertible effectively lets the firm ‘sell’ shares at a higher price. or par. Disagree. but it does not affect the relative values of the stock and the option.76 × \$50.\$239. Marriott should call the bonds if the price is greater than \$810.75 Call price in 2005 is: 603. the value of the conversion feature also increases.000. The present value of these missed payments is subtracted from the present value of the bond (which is \$1.20/8. Remember that the investor can construct a package of debt and warrants that gives exactly the same return as the stock. These companies have a need for cash but the current share price often does not allow for large issuances of equity.The conversion option was worth: \$532.76 = \$88. The option holder misses out on the bond’s interest payments. g. When the riskiness of the stock increases. 211 . The value of this package does not depend on the stock return. 12. e. f. because the coupon rate is equal to the interest rate).76 = \$60. Conversion value of the bonds at time of issue was: 8.36. 13.

12 2 P = 797.26 212 .20 × 3.123)] = \$87.19] – [0.19 d1 = log[P /PV(E = log[797.20 t = 3.0260 −(0.19 1.000 − 120 120 − = 797.3724 0 0 N(d1) = N(-0.0 rf = 0.20 × 3.0260 0 t = − .1 23 )]/(0.12 /(1200/1.by not having to buy the bond immediately but loses out by not receiving the next two years’ interest payments on the bond. Thus: Asset value = 1.200 t +σ t /2 σ = 0.0 ) +(0.0 ) /2 = − .4896 N(d2) = N(-0.0 ) = − .4896 × 797.12 1.3724) = 0.20 × 3.0260) = 0.3548 × (1200/1.3548 Call value = [N(d1) × P] – [N(d2) × PV(EX)] = [0.19 d2 = d1 −σ X σ )]/ EX = 1.

The value of the alternative share = (V/N) where V is the total value of equity (common stock plus warrants) and N is the number of shares outstanding.000 + 5. Given an estimate of the appropriate standard deviation and risk-free rate of return. b. To take dilution into account. you would need to adjust for dividends. a. 2. The warrant is like a 5-year call option with an exercise price of \$30 on a stock with a value of \$19. The standard deviation for the Black-Scholes formula is the standard deviation of (V/N) rather than the standard deviation of the firm’s common stock. 213 .’ This can be obtained from the following relationship (see chapter footnote 6): The proportion of the firm financed by equity (calculated before the issue of the warrant) times the standard deviation of stock returns (calculated before the issue of the warrant) is equal to the proportion of the firm financed by equity (calculated after the issue of the warrant) times the standard deviation of the alternative share.Challenge Questions 1. where q is the number of warrants issued per share outstanding. At the current price of \$5 the warrants are overvalued.50 N 2. For Electric Bassoon: V 20.5 Therefore: 1/(1 + q) = 1/1. The value of the warrant is equal to the value of [1/(1 + q)] call options on the alternative share.000 b. we use the standard deviation of this alternative ‘share.67 The value of the warrant is [0.67 × 6] = \$4. When valuing the warrant.000 = 0.000 = = \$12. a. the warrant can be valued using the Black-Scholes formula.000/2. However. we note that the warrant value is equal to the value of [1/(1 + q)] call options written on a stock with price (V/N). For Electric Bassoon: q = 1.5 = 0.

Thus.3. There is also a 60% chance the lender will face a choice of \$7 million or 50% of \$8 million. the expected payoff is: (0. a. the lender will want Ms. the lender will choose \$5 million. for the lender. In the case of the risky project. there is a 40% chance the lender will be faced with a choice of \$7 million or 50% of the \$12. Blavatsky to choose the safe project while Ms. which is \$2.5 million. Blavatsky will prefer the risky project. there is a 40% chance of a \$20 million payoff. There is also a 60% chance of a \$5 million payoff.5 million and a 60% chance of receiving (\$8 million . the lender will choose the latter.6 × 5) = \$5. the expected payoff is: (0. For the safe project. the expected payoff to the lender from the safe project is: (0. which is \$10 million. Ms. the lender will choose \$7 million.8 million For Ms. the expected payoff is: (0. the expected payoff to the lender from the risky project is: 214 . Thus.4 × 7) + (0. Blavatsky \$13 million.2 million Thus. For the lender.25 million. In the case of the safe project.4 × 7) = \$7 million For Ms.6 × 0) = \$5. in which case the lender will receive \$7 million and Ms.5 million .6 × 7) = \$7 million For the risky project. the expected payoff is: (0. Blavatsky has a 40% chance of receiving (\$12.4 × 7) + (0. There is also a 60% chance the lender will face a choice of \$5 million or 50% of \$5 million. Blavatsky nothing. Blavatsky.\$7 million) = \$1 million.5) + (0. the payoff always exceeds \$7 million. the lender will choose the former. which is \$4 million. which is \$6. Blavatsky.4 × 5. in which case the lender will receive \$5 million and Ms.4 × 7) + (0.\$7 million) = \$5.4 × 13) + (0.6 × 1) = \$2. so that the lender will always receive the promised payment.5 million. there is a 40% chance the lender will be faced with a choice of \$7 million or 50% of \$20 million.8 million b. Thus. Suppose now that the debt is convertible into 50% of the value of the firm.

The conversion provision will be worth more than the convertible holders pay for it. however. 215 . The new convertible holders will gain less than new shareholders would gain. In general. the lender receives the same expected payoff (i. Remember that options written on risky assets are more valuable than options written on safe ones. the existing shareholders are better off issuing the safest possible asset. The existing shareholders will be harmed by the issue of convertible bonds.(0.e. which may make the convertible issue more attractive than a stock issue. Thus.4 × 10) + (0. 4. \$7 million) from each of the two projects. in this case. This can be seen by considering the convertible as the stock plus a put option.6 × 5) = \$7 million Therefore. if the stock is truly underpriced. The one exception to this result may occur when common stock is undervalued because investors overestimate the firm’s risk. this prevents the new holders of the asset from sharing the rewards of an increase in stock value when an increase in new information becomes known.. investors may overvalue the conversion option.

a portfolio of bonds) that has a cash flow only at t = 6.092.46 2. Some reasons Fisher’s theory might not be true are: a. Therefore.. This forces the prices of goods up and the prices of securities down until real rates are no longer negative. Some goods are impossible to store.32 – (0.6 × 1.092.100) = \$400 Thus: 216 .e.6 × \$1..32 \$1. From the cash flows in years one through five. Taxes are levied on nominal interest. part of the tax is actually on the real principal.e. in turn. Prices of these goods may be expected to rise faster than the interest rate.g.100 Price \$753.060 – (0. The key here is to find a combination of these two bonds (i. knowing the price of the portfolio and the cash flow at t = 6. This portfolio costs: \$753. C5 60 100 C6 1.. may affect real interest rates. However.. which. is equal to: \$1.. it is clear that the required portfolio consists of one 6% bond minus 60% of one 10% bond. if expected inflation is high.. then individuals will be tempted to save by buying and storing real goods. 3. goods are costly to store and expensive to resell if you do not want them. .. e. Inflation may be associated with the level of real economic activity. It ignores uncertainty about inflation. haircuts and appendectomies. We begin by specifying the cash flows of each bond and using these and their yields to calculate their current prices: Investment Yield 6% bond 12% 10% bond 8% C1 60 100 . we should buy the equivalent of one 6% bond and sell the equivalent of 60% of one 10% bond. i. we can calculate the 6-year spot rate. . for year 6.46) = \$97. c. Note also that it is difficult for a country on its own to maintain a very low real rate without imposing exchange controls on its citizens.84 The cash flow for this portfolio is equal to zero for years one through five and. b. Then.CHAPTER 24 Valuing Debt Answers to Practice Questions 1. If expected real interest rates are negative..060 1..

151 × 1.0674) = \$100 million dollars Net cash flow: -\$100 million In five years: Receive amount of investment: (\$77.0% 5. a high coupon bond is a ‘shorter’ bond than a low coupon bond of the same maturity.265 = 26.151 × 1. this borrowing is at the four-year spot rate: r4 = 6. In essence.067)4 = \$77. 6.082) ⇒ r2 = 0. This is because high coupon bonds provide a greater proportion of their cash flows in the early years.070 = 7.84 × (1 + r6)6 = 400 r6 = 0.060) × (1.7% ⇒ r5 = 0. at the five-year spot rate: r5 = 7. Because this money will be received in four years. the firm should:  Borrow the present value of \$100 million. If the expectations hypothesis holds.151 million for 5 years at 7.067)4 × (1. we can infer—from the fact that the forward rates are increasing—that spot interest rates are expected to increase in the future.067 = 6.7% Invest this amount for five years. Using the general relationship between spot and forward rates.151 million Invest \$77.065 = 6.073) (1 + f5) = (1.\$97.5% ⇒ r4 = 0.062 = 6.0%  Thus.2 million Net cash flow: +\$108.064) (1 + f3) = (1.2 million 217 . we have: (1 + r2)2 = (1 + r1) × (1 + r3)3 = (1 + r2)2 × (1 + r4)4 = (1 + r3)3 × (1 + r5)5 = (1 + r4)4 × (1 + f2) = (1.065)3 × (1.0% Net cash flow: Zero In four years: Repay loan: (\$77.071) (1 + f4) = (1.062)2 × (1. In order to lock in the currently existing forward rate for year five (f5). the cash flows are: Today: Borrow (100/1.2% ⇒ r3 = 0.0705) = \$108.5% 4. Downward sloping.

2%). 218 . the firm can cover the payment of \$107 million at t = 5. With \$108. for a time period of one year.2 million available. at today’s forward rate for year 5 (8.Note that the cash flows from this strategy are exactly what one would expect from signing a contract today to invest \$100 million in four years.

52 years 7% Coupon Bond: 1 (70) 2 (70) 3 (70) 4 (70) 5 (1070) + + + + 2 3 4 1.067 1.910% Assuming that the default risk is the same for each bond.062 1.1 7 0 7 0 7 0 7 0 17 00 + + + + + =0 2 3 4 (1 + r) (1 + r) (1 + r) (1 + r) (1 + r) 5 r = 0. 5% Coupon Bond: 1 (50) 2 (50) 3 (50) 4 (50) 5 (1050) + + + + 2 3 4 1. We make use of the usual definition of the internal rate of return to calculate the yield to maturity for each bond.70 = 4.065 1.5 / 1003.067 1.10 = 4.70 DUR = 4157. 5% Coupon Bond: N V = − 2 . we know that the yield curve is rising (the spot rates are those found in Question 5) and that.070 5 DUR = 1.7.06910 = 6. because the bonds have different coupon rates. However. their durations are different.38 years 219 .7 P 90 0 5 0 5 0 5 0 5 0 15 00 + + + + + =0 2 3 4 (1 + r) (1 + r) (1 + r) (1 + r) (1 + r) 5 r = 0.060 1003.062 1.070 5 DUR = 1.065 1.930% 7% Coupon Bond: N V =− 0 3 0 P 1 0 .06930 = 6.06925 = 6.060 920.10 DUR = 4394. one might be tempted to conclude that the bond with the highest yield is the best investment.925% 12% Coupon Bond: N V =−1 0 .5 / 920.2 P 29 0 + 10 2 10 2 10 2 10 2 12 10 + + + + =0 2 3 4 (1 + r) (1 + r) (1 + r) (1 + r) (1 + r) 5 r = 0.

05 (1.058 = 5.063 = 6.0594 /1. this means solving for r in the following equation: 99 4 5 . 5%.12 years Thus.4% c.20 DUR = 4987.900 1/(1. the bond with the longest duration is also the bond with the highest yield to maturity.20 = 4.171.059)4 = 0. First.05 = 0.1 / 1209.064 = 6.05 (1. 10%.795 1/(1.3 5 0 5 0 5 0 5 0 15 00 = + + + + 1 +r (1 + r) 2 (1 +r) 3 (1 + r) 4 (1 +r) 5 r = 0.067 1.79 2.060) 5 = \$1. 1. 5%.0594 ) – 1 = 0. & b. five-year note: PV = 100 100 + 1. given that the yield curve is rising.34 3. five-year note: PV = 50 50 + 1.5% (1.054) 2 + 100 (1.057) 3 + 50 (1.057) 3 + 100 (1.05964 = 5.847 1/(1.060 1209.054) 2 + 50 (1.05) – 1 = 0. a.065 = 6.060) 5 = \$959. For the 5% bond.057)3 = 0.0573 ) – 1 = 0. 8. we calculate the yield for each of the two bonds.05 (1.054) 2 = \$992. We conclude that the bonds are equally attractive.054)2 = 0.0542 /1.12% Coupon Bond: 1 (120) 2 (120) 3 (120) 4 (120) 5 (1120) + + + + 2 3 4 1.0605 /1.059) 4 + 1050 (1.062 1. Year 1 2 3 4 5 Discount Factor 1/1.0542 ) – 1 = 0.747 Forward Rate (1.3% (1.952 1/(1.43 d.8% (1.070 5 DUR = 1.065 1.0573 /1.059) 4 + 1100 (1.060)5 = 0. This is precisely what is expected. two-year note: 50 1050 PV = + 1.964% 220 .

00%.057) 3 + 1 (1 . the zero-coupon bond has one payment at the end.01 = -1. we find the price of the five-year annuity. The future value of the amount borrowed is: FV6 = \$1. here 6. Thus.05937 = 5.937% The yield depends upon both the coupon payment and the spot rate at the time of the coupon payment.324. when interest rates are low. That is.0575 = 5.2417 Now we find the yield to maturity for this annuity: 4 47 .8 percent and lend \$990 for 5 years at 6 percent. the annuity has fixed.1 = -0. The 10% bond has a slightly greater proportion of its total payments coming earlier.For the 10% bond: 1 7 .059) 4 + 1 (1. and the bond’s payments are a combination of these. First.054) 2 + 1 (1.4 11 3 10 0 10 0 10 0 10 0 10 10 = + + + + 1 + r (1 + r) 2 (1 + r) 3 (1 + r) 4 (1 +r) 5 r = 0. e.065) .048)6 = \$1.85 The future value of the amount loaned is: 221 . f.75% g.2 1 1 1 1 1 1 = + + + + 2 3 4 1 +r (1 +r) (1 +r) (1 + r) (1 +r) 5 r = 0.000 for 6 years at 4.05 (1.060) 5 = \$4. A 6-year spot rate of 4.0% To make money.000 × (1. equal payments. The yield on the five-year Treasury note lies between the yield on a five-year zero-coupon bond and the yield on a 5-year annuity because the cash flows of the Treasury bond lie between the cash flows of these other two financial instruments. you could borrow \$1.8 percent implies a negative forward rate: (1. The yield to maturity on a five-year zero coupon bond is the fiveyear spot rate. the yield of the 10% bond is slightly lower.0486/1. than does the 5% bond. assuming that the annual payment is \$1: 1 1 PV = + 1. 9.

11.07 38.] PV @4.156 4.4 percent b.123 0.976 percent.25 Totals 14. [Note: The duration stated in Section 24. If the liquidity-preference theory is correct. the expected spot rate is less than 6.84 This ensures enough money to repay the loan by holding cash over from year 5 to year 6.580 Year 1 2 3 4 5 Ct 46.25 46.0594) . The table below provides a result that differs from this figure due to rounding. The minimum sensible rate satisfies the condition that the forward rate is 0%: (1 + r6)6/(1. The duration of a perpetual bond is: [(1 + yield)/yield] The duration of a perpetual bond with a yield of 5% is: 222 .90% 44.00 This implies that r6 = 4.09 42.170 4.045 0. the expected spot rate equals the forward rate. a.4 percent.3 is 4.324.041 0. A sensible starting position is to assume that all debt is fairly priced. c.4 percent. 13. the expected spot is less than 6. and provides an immediate \$10 inflow.574 years.07 Proportion of Value 0.25 1046.06)5 = 1. It may be upward sloping because short-term rates are expected to rise or because long-term bonds are more risky. If the term structure contains an inflation uncertainty premium. yield changes have the greatest impact on long-maturity.FV5 = \$990 × (1.086 0.064 = 6.25 46. 12. In general. which is equal to: (1.065/1.03 40.06)5 = \$1.25 46.834 Proportion of Value x Time 0. lowcoupon bonds.039 0. Under the expectations theory.20 823.043 0. 10.68 988.1 = 0.045 0.

83 = = 2. Investors would buy the medium-term bond at the low price in order to gain from the difference between its value and its price. call or put provisions).10/0. investors would sell the mediumterm bond because it is overpriced relative to the short-term and long-term bonds.D5 = 1. the 5% bond has the longer duration. If the bond price increased to \$115.30%. the zero has a longer duration.83 years T y (1 + y) −1 0. Comparing the 10% bond and the zero. The value of the safe bond depends on risk-free spot rates. differences in tax treatment and differences among countries.09 (1.g. we know that: Volatility (percent) = duration 2.05/0.448) = \$7. On average.60%.09 5 − = − = 12. Other factors that determine the yield on corporate bonds are: differences in features (e. The present value of the annuity is \$583. 223 .28 = 2. The value of a corporate bond can be thought of as the value of a risk-free bond minus the value of a put option on the firm’s assets.09 This tells us that a 1% variation in the interest rate will cause the contract’s value to change by 2.09) 5 −1 Also.448 so the value of the contract decreases by: (0.50 instead of \$111. The formula for the duration of a level annuity is: 1+ y T 1.10 = 11 years Because the duration of a zero-coupon bond is equal to its maturity.0130 × \$583. This will increase the price and decrease the yield.60% 1 + yield 1..50.585 16. comparing the 5% bond and the zero-coupon bond. a 0. then. the 15-year zero-coupon bond has a duration of 15 years.05 = 21 years The duration of a perpetual bond yielding 10% is: D10 = 1.75 instead of \$95. If interest rates rise and the medium-term bond price decreases to \$90. The value of the put decreases as the value of the assets increases relative to the exercise price. The value of the put also decreases with increases in the interest rate. Thus.5% increase in yield will cause the contract’s value to fall by 1. 15.11 − 9. then it will be underpriced relative to the short-term and long-term bonds. and increases with increases in the volatility of the stock. 17.

19. the value of risky debt will also vary as the value of the default option varies. it can cause difficulties when long-term rates are very different from short-term rates.18. each coupon interest payment must be discounted at the appropriate spot rate. However. In order to value Company B’s ten-year coupon bond. However. the payment of \$150 may be reasonably assured while the \$50 is considerably smaller and not due until the distant future. This is not complicated if the term structure is flat so that all spot rates are the same. the risk exposure of Company Y to future events may be greater than that for Company X. Thus. Company Y has a relatively large amount due in an intermediate time frame. 224 . If Company X has successfully matched the terms of its assets and liabilities. If the floating rate debt is risk free. 20. The value of Company A’s zero-coupon bond depends only on the ten-year spot rate. then the price should vary only if the interest rate on the bond is not reset continuously.

55. 2 and 3.74 1 + r1 r1 = 0. Bond G. Cash flows for this position are: [(-2 × \$842. we determine the two-year spot rate directly by finding the yield for Bond G. the spot rates derived above produce the 225 .100) 3 + 1120 (1. we find that the three-year spot rate (r3) is 10.0 percent. We begin with the shortest-term bond. arbitrage opportunities exist.30) + (\$980. Fisher’s hypothesis is that changes in the inflation rate do not change the expected real rate. The yield is 9. Next we use Bonds B and D to find the four-year spot rate.17% Next. Arbitrage opportunities can be identified by finding situations where the implied forward rates or spot rates are different. and for Bond D. the present value is \$1. r4 = 0. The following position in these bonds provides a cash payoff only in year four: a long position in two of Bond B and a short position in Bond D. Using the same approach for Bond A. Since G is a zero-coupon bond.095) 2 + 120 (1. we use r2. [(2 × \$1050) – (\$1100)] = \$1000 in year 4. Similarly.065. The statement that the nominal interest rate equals the real rate plus the expected inflation rate is a tautology.005. we use these spot rates to value the remaining two four-year bonds. r3 and r4 with the one of the four-year coupon bonds to determine r1.Challenge Questions 1.07. the two variables fluctuate independently. Since neither of these values equals the current market price of the respective bonds.03 = 1000 (1 + r4 ) 4 2. We determine the four-year spot rate from this position as follows: 704. For Bond C: 120 120 1. in order to determine whether arbitrage opportunities exist.3867 = 38. and.67% Now.0917) 4 = 120 + 978.28 = + 1 + r1 (1.57)] = -\$704. the present value is \$854. [(2 × \$50) – (\$100)] = \$0 in years 1. in other words.5 percent.0917 = 9. so the implied two-year spot rate (r2) is 9. This produces the following results: for Bond B. which has a two-year maturity.5 percent.03 today.

which is equal to (1/r). To simplify the numerator.following values for the three-year bonds: \$1. We begin with the definition of duration as applied to a bond with yield r and an annual payment of C in perpetuity 1C 2C 3C tC + + + + + 2 3 1 + r (1 + r) (1 + r) (1 + r) t D R = U C C C C + + + + + 2 3 1 + r (1 + r) (1 + r) (1 + r) t We first simplify by dividing each term by C: 1 2 3 t + + + + + 2 3 (1 + r) (1 + r) (1 + r) (1 + r) t D R = U 1 1 1 1 + + + + + 2 3 1 + r (1 + r) (1 + r) (1 + r) t The denominator is the present value of a perpetuity of \$1 per year. for a perpetual bond paying C dollars per year: D R U 1 +r 1 1 +r = 2 × = r (1 / r) r 4. that is:  1  S 1 1 1 = + + + + +  (1 + r) 1 + r (1 + r) 2 (1 + r) 3 (1 + r) t   2 Therefore: S  1 =  (1 + r)  r  2 1 +r ⇒S = 2 r Thus. We begin with the definition of duration as applied to a common stock with yield r and dividends that grow at a constant rate g in perpetuity: 226 . we first denote the numerator S and then divide S by (1 + r): S 1 2 3 t = + + + + 2 3 4 (1 + r) (1 + r) (1 + r) (1 + r) (1 + r) t +1 + Note that this new quantity [S/(1 + r)] is equal to the square of denominator in the duration formula above.22 for Bond E and \$912. 3.77 for Bond F.074.

a. that is:  1  S 1+g (1 + g) 2 (1 + g) t −1 = + + + + +  2 3 t 1 + r  (1 + r)  (1 + r) (1 + r) (1 + r)  2 Therefore:  1  S 1 +r =  r −g  ⇒ S = (r −g) 2  (1 + r)   2 Thus.g)].0700 = 7. we first denote the numerator S and then divide S by (1 + r): S 1 2(1 + g) 3(1 + g) 2 t(1 + g) t −2 = + + + + + (1 + r) (1 + r) 2 (1 + r) 3 (1 + r) 4 (1 + r) t + 1 Note that this new quantity [S/(1 + r)] is equal to the square of denominator in the duration formula above. which is equal to [1/(r . Cash flows for this position are: 227 .46 = 10 0 1 + r1 r1 = 0. We make use of the one-year Treasury bill information in order to determine the one-year spot rate as follows: 93 . for a perpetual bond paying C dollars per year: D R = U 1 +r 1 1 +r × = (r −g) 2 [1 / (r −g)] r −g 5.00% The following position provides a cash payoff only in year two: a long position in twenty-five two-year bonds and a short position in one one-year Treasury bill. To simplify the numerator.1C(1 + g) 2C(1 + g) 2 3C(1 + g) 3 tC(1 + g) t + + + + + 1+r (1 + r) 2 (1 + r) 3 (1 + r) t DUR = C(1 + g) C(1 + g) 2 C(1 + g) 3 C(1 + g) t + + + + + 2 1+r (1 + by (1 + 3 (1 + r) t We first simplify by dividing each term r) [C(1 + g)]: r) 1 2(1 + g) 3(1 + g) 2 t(1 + g) t −1 + + + + + 1+r (1 + r) 2 (1 + r) 3 (1 + r) t DUR = 1 1+g (1 + g) 2 (1 + g) t −1 + + + + + 1+r (1 + r) 2 (1 + r) 3 (1 + r) t The denominator is the present value of a growing perpetuity of \$1 per year.

15 [(1 × \$8) – (8/104) × (\$100 + \$4)] = \$0 in year 1. Hence.0660 = 6. one should sell the 4 percent coupon bond short and purchase the 8 percent coupon bond.54 today. We make use of the spot and forward rates to calculate the price of the 4 percent coupon bond: P= 40 (1.600 in year 2.54 = 2600 (1 + r2 ) 2 r2 = 0.60% The forward rate f3 is computed as follows: f3 = [(1 + 0. [(25 × \$4) – (1 × \$100)] = \$0 in year 1.0620 = 6.92) + (1 × \$93.01).066) + 1040 (1.20% b.0700] = 0.60% The following position provides a cash payoff only in year three: a long position in the three-year bond and a short position equal to (8/104) times a package consisting of a one-year Treasury bill and a two-year bond. and. a profit opportunity exists.[(-25 × \$94.066) = \$931. We determine the three-year spot rate from this position as follows: 89. Cash flows for this position are: today.07) + 40 (1. In order to take advantage of this opportunity. [(1 × \$8) – (8/104) × \$104] = \$0 in year 2.0680 = 6.0660)3/(1. and.0660 = 6. (25 × \$104) = \$2.07) (1. (1 × \$108) = \$108 in year 3.15 = 108 (1 + r3 ) 3 r3 = 0. 228 .062) The actual price of the bond (\$950) is significantly greater than the price deduced using the spot and forward rates embedded in the prices of the other bonds (\$931.92)] = -\$89. We determine the two-year spot rate from this position as follows: 2279.46 + \$94. [(-1 × \$103.46)] = -\$2.0680)2] = 0.279.64) + (8/104) × (\$93.80% The forward rate f2 is computed as follows: f2 = [(1 + 0.01 (1.0680)2/1.07) (1.

The price of the medium-term bond will decrease to \$76. The price of the long-term bond will decrease to \$53 if rates rise and will increase to \$86 if rates fall. if investors are risk-neutral: 83 + (10 × p) + (1 – p) × -6. The expected return for the medium term bond is: 0. The expected return for the Treasury bill is 2%. It is difficult to charge for information because. Let BS. The risk-neutral expectation is 2% per quarter. you cannot stop one person from transmitting it to another for free. or. Then.02 = 2% The expected return for the long-term bond is: 0. companies are willing 8.5/83) = 0.6. a.5 if rates rise and will increase to \$93 if rates fall. until only the lowest quality bonds are left. In essence.4945 × (18/68) + 0. Once the highest quality bonds have been rated. a. And so on. b.and longterm bonds.5055 × (-15/68) = 0.5055 × (-6. buying two medium-term bonds and short-selling one short-term bond gives the same payoffs as buying the long-term bond. respectively. The bond-rating services thus find it much easier to charge the companies.02 = 2% 7. Start with a scenario in which no bonds are rated. Newspaper exercise.4945 × (10/83) + 0. the short-term bond will be worth 100. The price of the bonds should be higher if the government had guaranteed them.5 = 83 × 1. Companies with the highest quality bonds want to demonstrate that fact. companies with the highest quality bonds of those remaining have an incentive to demonstrate that their bonds are the best of the remainder. rather than the investors. Therefore. medium. more precisely: 2/98 = 2.5055 b. Then. BM and BL be the prices of the short-. we find that: p = 0. d.4945 and (1 – p) = 0.02 Solving. e. BL = 2BM – BS = (2 × 83) – 98 = \$68 Whether rates rise or fall.04% per quarter Let p equal the probability of a rate decrease. c. 229 .

the market value of debt is: (\$1. Assuming that the debt earns the same return as the assets.9014 = (1 – x) x = 0.7357 × 1200] – [0.5714 × 1000)] = \$311. It follows from the answer to (b) that only companies with extremely poor quality bonds will not pay to have them rated.5714 Call value = [N(d1) × P] – [N(d2) × PV(EX)] = [0.6302 1090/1. Backwoods will default if the market value of the assets one year from now is less than \$1.45 t +σ 1 t = 1.7357 N(d2) = N(0.1802) = 0.090.09 d1 = log[P (E /PV = log[1200/( d2 = d1 −σ X σ )]/ t /2 × 1.090.44 Thus.86% probability of default 230 .\$311) = \$889. 9. We can consider the value of equity to be the value of a call on the firm’s assets.45 t = 0.0 ) +(0.45 × 1.6302) = 0. 10. Also: P = 1200 σ = 0. we know that the current value of the debt is \$889. the exercise price is \$1. then in one year the expected payoff is: (\$889 × ert ) = (\$889 × e0.1802 N(d1) = N(0.0 rf = 0. For Backwoods.200 .09 )]/(0. From Challenge Question 9. With an asset market value of \$1.50 = \$1090 (1 – x) + \$0 (x) 0. the value of equity is \$311.0 ) = 0.200. with an exercise price equal to the payment due to the bondholders.0986 = 9.50 Let x = the probability of default.to pay to have their bonds rated in order to alleviate investors’ fears that the bonds might be of even lower quality. c.10) = \$982.6302 −(0.0 ) /2 = 0. Then: \$982.45 × 1.

As time passes.CHAPTER 25 The Many Different Kinds of Debt Answers to Practice Questions 1. the price will be \$1. The remaining \$50 million of mortgage bonds then rank alongside the unsecured senior debentures. then. depending on the company chosen. This pattern will be repeated throughout the life of the bond as long as investors continue to demand a return of 9. 3. the mortgage bondholders are paid in full. the extent of the protection depends on the frequency of the rate adjustments and the benchmark rate. and call provision. If the bond is issued at face value and investors demand a yield of 9.5%. but this protection is not complete. but this protection is not absolute.) Similarly. upon payment of the coupon (\$47. Some key areas that should be examined are: coupon rate. If the company’s problems suddenly become public knowledge. First mortgage bondholders will receive the \$200 million proceeds from the sale of the fixed assets. maturity. but yield spreads can shift as well. Thus. immediately after the issue. the value of the company may fall so quickly that bondholders might still suffer losses even if they put their bonds immediately. 2. In practice. the price will gradually rise to reflect accrued interest. the 231 . just before the first (semi-annual) coupon payment. sinking fund provision.000. Answers here will vary. The remaining \$100 million in assets will be divided between the mortgage bondholders and the senior debenture holders. the price will drop to \$1. Floating-rate bonds provide bondholders with protection against inflation and rising interest rates.047. puttable bonds provide the bondholders with protection against an increase in default risk.50). and then. For example. security.5%.50. 4.000. the price will be \$1. (Not only can the yield curve shift.

senior debenture holders receive \$50 million and the subordinated debenture holders receive nothing. 232 .

In Subsidiary A. For a given call price. you can buy a bigger house for the same mortgage payment if you use a variable-rate mortgage. with a fixed-rate mortgage. the price of the coupon bond (all else equal) will be less than the price of the zero. For the coupon bond. b. A sharp increase in interest rates reduces the price of an outstanding bond relative to the price of a newly issued bond. this is not the time that lenders want to be repaid because they do not want to reinvest at the lower rates. In Subsidiary B. but has some value for the coupon bond. a variable-rate mortgage has a lower interest rate than a comparable fixed-rate mortgage. Thus. reflecting the higher probability of call. the company’s option to call is meaningless for the zero-coupon bond. the \$180 million of senior debentures will be paid off and (\$220 million . If the assets are sold and distributed according to strict precedence. the option to prepay has little value if rates are floating. Therefore. For a zero-coupon bond. that the outstanding bond will probably have a lower call price and perhaps a shorter period of call protection. 8. and. In the holding company. there is some probability that the bond will be called. the yield of the more recently issued bonds should be greater. the lending institution assumes the risk.5. The second consideration is risk. hence. 233 . Notice. With a variable-rate mortgage. the following distribution will result. the yield on the coupon bond will be higher. so floating rate mortgages reduce the reinvestment risk for holders of mortgage pass-through certificates. the real estate will be sold and (\$180 million + \$80 million) = \$260 million will be paid in partial satisfaction of the \$400 million senior collateral trust bonds. If the company acts rationally.\$180 million) = \$40 million of the \$60 million subordinated debentures will be paid. whereas. Of course. Other things equal. a. 6. they are likely to do so when interest rates are low. these may be offsetting factors. the borrower assumes the interest rate risk (although in practice this is mitigated somewhat by the use of caps). the \$320 million of debentures will be paid off and (\$500 million .\$320 million) = \$180 million will be remitted to the parent. Typically. 7. If borrowers have an option to prepay on a fixed-rate mortgage. this will never happen because the price will always be below the face value. however. this implies that the value to the firm of the call provision is greater for the newly issued bond. On the other hand. it will call a bond as soon as the bond price reaches the call price. To put this somewhat differently.

Value of puttable bond Putttable bond 100 Straight bond 0 100 Value of straight bond 11. See figure below. but it is still in their interest to have a claim on the money put up by the junior bondholders for the duration of the junior debt. the change in the price of the noncallable bond will be greater than the change in price of the callable bond. we can see that. b. 10. it would decrease the value of unsecured debt because unsecured debt is junior to secured debt in the event of default. Using Figure 25.2 in the text.9. and the bonds will be repaid. the junior debt is similar to equity. The senior bondholders would prefer that the junior debt not have a shorter maturity. it will be in one party’s interest to exercise its option. if interest rates rise. A similar restriction is the negative pledge clause. This restriction is intended to preclude the firm from increasing the default risk borne by existing bondholders. Even if this did not increase the ratio of debt to tangible assets. 12. Most bonds contain covenants that restrict the firm’s ability to issue new debt of equal or greater seniority unless the firm’s tangible assets exceed some multiple of the existing debt. a. On that date. which prevents the firm from issuing more secured debt. As far as senior bondholders are concerned. 234 . The issue of additional junior debt does not harm the senior bondholders.

13.050 1. assume the Christiania Bank issue is a one-year reverse floater. the sale of assets in order to reinvest in more risky ventures harms the bondholders. b. If the firm does not have the cash. 16.050 1. This harms the original debtholders. Alpha Corp. Answers will vary depending on instrument chosen.8% 5. If the existing debt is junior.078 1. Therefore.e. First.078 Normal Floater 1.974 at a fixed rate of 7. Second.030 1.’s net tangible asset limit is 200 percent of senior debt.128 2. c. for three different possible future interest rates.078 1.058 Now consider the payoffs if you borrowed \$1. the payoffs on the reverse floater.098 1. 15.030 1. the bondholders would like the shareholders to put up new money or default.8 percent. But this check has little value if the firm can sell assets to pay the coupon or sinking fund contribution.128 2.8% 5.8%: Payoffs at End of Year Possible Future Interest Rates 9.070 Fixed-Rate 1.078 -1. a fixed-rate loan. coupon and sinking fund payments provide a regular check on the company’s solvency.070 235 .8% Floating Rate Borrowing -1. If the existing debt is senior. Suppose also that the current interest rate on fixed-rate one-year loans is 7. a dividend that is equal to the value of the assets leaves bondholders with nothing. then debt the issuance of additional senior debt means that the same amount of equity supports a greater amount of debt.128 Total 1.. with net tangible assets of \$250 million. Then. 14. then the original debtholders lose by having the new debt rank ahead of theirs. For purposes of illustration.000 at a floating rate and loaned \$1. In the extreme case.098 -1. Alpha’s total debt cannot exceed \$125 million.8% Payoffs at End of Year Reverse Floater 1. The payment of dividends to shareholders reduces assets that can be used to pay off debt.058 Fixed-Rate Lending 2.8% 7. a. Alpha can issue an additional \$25 million in senior debt.8% 7. and the firm faces a greater probability of default. i. the firm’s leverage has increased.078 1. and a normal floating-rate loan are as follows: Possible Future Interest Rates 9. There are two primary reasons for limitations on the sale of company assets.

17. as in Eastern’s case. This is equivalent to borrowing at short-term rates in order to lend long-term. A prepackaged bankruptcy also avoids the problems that can arise. from continuing to operate assets at a loss. The reverse floater is a very volatile bet on future interest rates. 236 . Unlike informal workouts. which is a risky strategy. The best example is in the financing of major foreign projects. A prepackaged bankruptcy avoids the expenses of a bankruptcy court. 18. prepackaged bankruptcies reduce the likelihood of subsequent litigation and get the tax advantages of Chapter 11. and can usually be negotiated more quickly. Project finance makes sense if the project is physically isolated from the parent. where political risk can often be minimized by involving international lenders. buying a reverse floater is equivalent to issuing floating-rate debt and buying fixed-rate debt. The problems of conflicts of interest are the same. and each party can threaten to hold out for a court solution unless the respective parties each believe that the prepackaged bankruptcy provides at least as good a deal. offers the lender tangible security and involves risks that are better shared between the parent and others.Thus.

less annual tax savings of (0.10 10 1.10 10 Thus. The firm could also. immediately pocket the difference (\$103.. if Hubco failed.35 × \$30.880. Now suppose that bondholders are subject to personal income taxes.908 and the market value of the bonds is \$569.880 2 1.000 in the tenth year.) 2. of course.500 19. if Dorlcote issued the 3 percent bonds at face value and then repurchases the bonds for \$569.500 19.000.000 in the tenth year.000. The firm could repurchase the bonds for \$569.000 + ++ + = \$569.908 of new 10 percent debt that would require cash outflows with a present value equal to that of the original debt. then Dorlcote should not repurchase the bonds.065 1.880.000) = \$10.880 today. If the low coupon bonds are worth more to the high-income investor than they are to Dorlcote. then no assets beyond the projects’ could be attached.e.500 1. (Note that. High-income investors (i. those in high income tax brackets) will favor low-coupon bonds and will bid up the prices of those bonds.000 30. the cash outflows associated with the bonds are \$1.500. customers.000. To calculate the amount of new 10 percent debt supported by these cash flows.\$10.500 per year. The existing bonds provide \$30. the net cash outflow is (\$30.000 per year for 10 years and a payment of \$1. By making it a separate entity. and funding sources to meet specific needs and/or concerns.028).000 per year.065 10 1.10 1. From the standpoint of the company.5 percent): 19. then the company will be liable for taxes on the gain. Similarly.000. and \$30. Independence also allowed Hubco to design contracts with suppliers. discount the after-tax cash flows at the after-tax interest rate (6. Assuming that all bondholders are exempt from income taxes. Hubco could also enter into contraction agreements without the need to gain approval from a parent company.Challenge Questions 1. Therefore. the debt could be repurchased with a payment of \$569.000 1. 237 . For example.000 PV = + ++ + = \$672. The advantages of setting up a separately financed company for Hubco stem primarily from the attempt to align the interests of various parties with the successful operation of the plant.908 2 1.065 10 In other words. the construction firm was also a shareholder in order to ensure that the plant would run according to specifications. the value of these bonds to the firm is \$672.10 1.065 1. the market value of the bonds is: PV = 30.880 and then issue \$672.000 .000 30.500) = \$19.

05 × 1.00 1082. the depreciation tax shield amounts do not change because depreciation is based on the initial cost of the desk.00 1082.30 -378.48 2. costs Total PV(at 9%) = -\$3.46 60.00 -50. We further assume that the lease payments grow at the rate of inflation (i.81 703.10 t=4 345.00 -3260.00 76. Then solve for the break-even rent as follows: Break-even rent = \$703.49/(1 – 0.30 -378.80 Break-even rent Tax Break-even rent after tax PV(at 9%) = -\$3.81 703. a. “100 percent financing” is not an advantage unique to the lessee because precisely the same cash flows can be arranged by borrowing as an alternate source of financing for the acquisition of an asset.CHAPTER 26 Leasing Answers to Practice Questions 1.60 120.48 t=6 172.e.81 703.082.49 779.49 564.082 to about \$1.00 201.40 1082.439.30 -378.439.30 If the expected rate of inflation is 5 percent per year.00 1082.. Initial Cost Depreciation Depreciation tax shield After-tax admin.81 703.49 -2556.00 -139.09) – 1 = 0.81 703.82 Cash Flow In the above table.30 -378.60 -260.30 -378. then administrative costs increase by 5 percent per year.81 703. keeping in mind that the annuity begins immediately.49 645.00 -260.30 -378. For comparison purposes. However. we solve for the break-even lease payments by first solving for the after-tax payment that provides a present value. the payments are indexed to inflation).48 60.113: 238 . discounted at 9%.35) = \$1.80 60.46 t=5 345.00 336.00 210.49 653.49 564.50 t=3 576.96 -260. equal to the present value of the costs.50 t=2 960.45% These changes yield the following.60 120. indicating that the initial lease payment has increased from \$1.00 -139.00 -260.96 -260.1445 = 14.00 -58. The appropriate nominal discount rate is now: (1.00 -260.40 1082.51 t=1 600. the solution to Quiz Question 5 is shown below: t=0 -3000.40 1082.

60 120.945 each year.58 738.83 -210.47 60.66 719.00 -273.46 t=4 345.23 923.60 120.53 -2536. equal to the present value of the costs.60 -300.67 -497.10 t=2 960.83 Cash Flow t=0 -3000.84 Cash Flow Here. We use the 9% discount rate in order to find the real value of the payments (i.65 49. costs Total PV(at 14.00 201.45%) = -\$3.00 -63.00 201. Then each of the subsequent payments reflects the 5% inflation rate.07 1353.48 60.71 t=2 960.87 1420.60 -387.75 -2357.83 -210.45%) = -3537.53 797.45%) = -\$3.01 837.48 60.36 853.00 -286.113.60 120.98 -99.70 847.38 1172. With a reduction in real lease rates of 10 percent each year.10 806.83 Break-even rent Tax Break-even rent after tax PV(at 14.00 -63.48 Initial Cost Depreciation Depreciation.537.84 662.43 712.05 × 0.00 1113.35 1227.87 1046.80 60. costs Total PV(at 14.07 1107. Thus.96 -316.00 -3260.34 469.05 t=3 576.35) = \$1. use a discount rate of: [(0.71 696. when we solve for the first after-tax payment.00 1388. the nominal lease amount will decrease by 5. we solve for the break-even lease payments by first solving for the after-tax payment that provides a present value.46 684.25 t=1 600.00 336.68 -366.00 1312. the nominal lease rate is multiplied by a factor of (1.00 -260.20 t=4 345. keeping in mind that the annuity begins immediately.60 -300.98 -99.5 percent each year.Initial Cost Depreciation Depreciation.34 680.00 -3260. we have: t=0 -3000.35 1240.13 b.96 -331.03 -195. tax shield After-tax admin.79 -409. That is.56 t=6 172.60 120.46 -459.2111 = 21.48 60.23 -429.83 Break-even rent Tax Break-even rent after tax PV(at 14.38 1288.00 -273.48 Here.9) = 0.13 -389.94 524. \$723.9/1. discounted at 9%.10 790.59 -451.39 t=5 345.00 -260.96 -331.06 -410.96 -316.53 t=3 576.00 210.80 60.65 49.09) – 1 = 0.53).22 761.08 759.537.18 855.10 902.60 723.45%) = -3537.03 -195.00 1168.85 -486.56 879.11% 239 ..02 -473. tax shield After-tax admin.28 -434.48 t=6 172.e.87 t=5 345.00 336.53/(1 – 0.00 210.47 t=1 600. Solve for the break-even rent as follows: Break-even rent = \$723.00 -286.

71 8. in each case standardization of the asset leased leads naturally to standardization of the contracts.00 t=1 -3.15 -16.47 18.47 -9.38 -14. this.3.48 b.55 28.19 -8.00 -16. the only change is in the break-even rent.82 t=5 -2. namely 5 years.30 -16.70 -8. 5.00 -16.90 Tax shield of lease payment 5.12 10.38 -13.36 t=4 -2.90 3.99 t=4 -7.92 Cash flow of lease NPV (at 6.76 25.00 -16.96 t=2 0. a.97 15.38 Cash flow of lease NPV (at 6.99 13. beginning halfway through the first year. Assume the straight-line depreciation is figured on the same basis as the ACRS depreciation.09 t=5 -4.92 -17. t=0 Cost of new bus 100.38 -17.90 5.49 t=7 0.05 -9.97 -10. but because operating leases are generally much shorter term than financial leases.38 -15. the value of this advantage is not nearly as great as it is for operating leases.00 -16. Total Break-even rent Tax Cash flow NPV (at 7%) = 0.90 5.02 240 .40 -16.90 3.00 t=0 -82.67 t=7 0. t=0 100.510 86.03 4.90 5.50 -16.92 t=3 -3.78 23.90 5.5%) = \$566 89. t=1 -4.5%) = -\$4.92 -14.90 3.90 5.92 -14.54 11.30 -16.29 22.00 -16.90 3.92 -10. If the cost of new limos decreases by 5 percent per year.99 t=5 -7.90 5.90 3.50 -16.38 -17.90 3.49 t=2 -7.80 29.92 -17.78 24.84 -16.29 t=6 -6.92 -17. The leasing of trucks. in turn. or computers is big business because each such asset requires a significant outlay of cash and each is used by many companies that are marginally profitable.52 t=2 -6. In terms of Table 26.90 Tax shield of lease payment 3.92 -17.49 -63.94 t=4 -4.52 6.38 -19.90 3.99 t=3 -7. Also.90 5. airplanes. Yes.99 Cost of new bus Lost depreciation tax shield Lease payment -16.41 -8. then the lease payments also decrease by 5 percent per year.00 -16.00 Lost depreciation tax shield Lease payment -16.18 t=3 -2.82 t=6 -1.60 27.00 -16. provides low administrative and transactions costs.32 t=1 -2.38 -15.1.03 -7.99 t=6 -3.

05 5 1.50 ×100) ×  + + + + +  1. the present value of the depreciation tax shield.3200 0.) Setting this expression equal to zero and solving for P. A lessor tax rate of 50%.3932) = 0 2 1.05 1. the appropriate discount rate is 10 percent.35) × P × 1 + + 1.1152 0.10 1. Cash flows for the lessor are:  0. To find the minimum rental P.21494P = 70.040. We can then use this value for P to calculate the value of the lease to the lessee. set NPV = 0 and solve for P: 4.065  2 + + 1   1. the present value of the depreciation tax shield (\$29.05 1 1 1   + (1− 0 .05 4 1.05 6   1. a.040 This is the maximum amount that Greymare could pay.04 or \$17. In general. The net present value of the cash flows is the cost of the bus saved (\$100) less the present value of the lease payments: 1 1 1   100 − P ×  1 + + + +  2 1.469 + (1 − 0 .05 3 1. we find: P = 17.580 For Greymare.05 7   1.1152 0.73 or \$16. because Greymare pays no taxes.0576  − 100 + (0 .10 1. and the present value of the after-tax lease payments.2000 0.1920 0.58 or \$16. we set the net present value to zero and solve for P. 8.05 P = 16.53 P = 16. the net present value of the lessor’s cash flows consists of the cost of the bus.065 7  To find the minimum rental.469) and the present value of the after-tax lease payments: 1 1  − 100 + 29. The net present value of the lessor’s cash flows consists of the cost of the bus (\$100).065 1. The original cash flows are as given in the text.730 and \$17.05 2 1.10 7   (Note that. the net present value of the cash flows is the cost of the bus saved (100) less the present value of the lease payments: 241 .730 + P(3. the lease payment will be between \$16.50) ×P × 1+ + + +  = −100 + 43.730 Greymare should take the lease as long as the NPV of the lease is greater than or equal to zero.7. Thus.

13 1 1 1   + (1− 0 .2149) = 0 2 + + 1 1.700 2 1.42 or \$15.210 For Greymare.1920 0.13 5 1.2000 0.8684) = 2.70 or \$2.35 ×100) +(1 − 0 . the net present value of the cash flows is 1 1 1   100 − P ×  1+ + +  = 100 − (29.253 + P(3.3715) = 0 2 1.\$3.35) ×P × 1+ + 1. 3-year lease with 4 annual rentals.065 6   1.1920 0.74 × 3.13 7   1.58 × 5.065 1.10 7   1.2000 0.1152 0. the net present value of the cash flows is: 1 1 1   100 − P ×  1+ + ++  = 100 − (15.065 3 1.10 1.5247) = 0 2 1.10 d.065 1.1152 0. Cash flows for the lessor are:  0.065 1 1 1   + (1− 0 .700 2 1. Cash flows for the lessor are:  0.1152 0.13 2 1. Immediate 100% depreciation.10 1.8684) = 9.065 P = 29.13 6   1.0576  − 100 + (0 .51 or \$9. the net present value of the cash flows is: 242 .13 1.10 b.10 3   1. Cash flows for the lessor are: 1 1  −100 + (0.065 7  =  P = 15.065 5 1.35) ×P × 1+ + +  = −100 + 29.065 1.74 or \$29.70 or .10 7   1.4869) = −3.065 4 1.21 or \$21.35) ×P × 1+ + + +  = −100 + 25. An interest rate of 20%.510 2 1.0576  − 100 + (0 .065 3   1.10 c.35 × 100) ×  + + + + +  1.13 4 1.3200 0.065  −100 + 35 + (P × 4.13 3 1.42 × 5.740 For Greymare.469 + P(2.1152 0.35 × 100) ×  + + + + +  2 1.240 For Greymare.3200 0.1 1 1   100 − P ×  1+ + ++  = 100 − (16.13 P = 21.10 1.

2 (-\$35.200). If Greymare pays no taxes. If the interest rate is zero.20 1.6046) = 2.10 7   1. or -\$35.9 at t = 0 through t = 7. its lease cash flows consist of an inflow of \$100 at t = 0 and yearly outflows of \$16.20 9. the NPV of the lease is the sum of these cash flows.21 × 4.1 1 1   100 − P ×  1+ + ++  = 100 − (21. 243 .34 or \$2.340 2 1.

00 13.0 The after-tax interest rate is: [(1 .5% for the lessor.600) = -\$19.00 -7.5%) = 0.0 -21.00 -4.00 -4. c.000. Under the conditions outlined in the text. will be better off.0 17.08 t b. if we decrease the early lease payments and increase the later lease payments in such a way as to leave the lessor’s NPV unchanged.55 16.7 50. The overall gain from leasing is: (\$40.1 t=4 28.500 1.08] = 0.5 or − \$59.03 17.0 28.00 -5.0 -21. One such set of lease payments is shown in the following table: t=0 -100.20 17.4 5.868.00 -7.7 68.00 15.02 t=7 0.0 -21.5 62.8 62.10 Lessor NPV (at 6.77 t=4 4.3 t=3 48.0 16. The NPV of the cash flows for Compulease is: 40.00 Cost of new bus Depreciation tax shield Lease payment Tax on lease payment Cash flow of lease -91.7 57. Because Nodhead pays no taxes: NPV = + 250 − ∑ t =0 5 62 = −59. by virtue of the higher discount rate. 11.0 -21.8 10.1 62.868 (\$1.7 50.02 20.00 17. a.35) × 0.600.0 -21.03 20.08 t=5 4.0 Cost of computer Depreciation Depreciation tax shield Lease payment Tax on lease payment Net Cash Flow 5.052 = 5.0 62.1 62.95 17.25 t=3 6.7 -209.4 t=5 28.000 .00 13.55 t=1 7.00 20.0.4 t=6 14.2%.95 22.00 -7.00 -5. the lessee. Thus.72 17.707 (\$707) Lessee NPV (at 10%) = 1. 244 .8 t=2 80.8 10.00 -5.00 14. The cash flows to Compulease are as follows (assume 5-year ACRS beginning at t = 0): t=0 -250.0 -21.7 t=1 50. The key to structuring the lease is to realize that the lessee and the lessor are discounting at different interest rates: 10% for the lessee and 6. the value to the lessor is \$700 and the value to the lessee is \$820.0 or \$40.7 57.0 62.10.\$59.90 t=2 11.868) The value to the lessor is \$707 and the value to the lessee (still assuming it pays no tax) is \$1.03 t=6 2.95 15.

2149 1.12.065 Thus.1249 .35) ×(100/ 8) ×  + +  = 26.0893 .50% (we assume depreciation expense begins at t = 1): .5%: 1 1   P ×(1− 0 . which is the minimum lease payment the lessor will accept. discounted at the after-tax interest rate of: [(1 . The NPV to the lessor has three components: • Cost of machinery = -100 • PV of after-tax lease payments.065 To find the minimum rental the lessor would accept. we sum these three components. the lessor’s minimum acceptable lease payment becomes \$17.1749 . we find the company’s maximum lease payment is 17. this has no effect on the company’s maximum lease payment. a.10] = .35) × 1+ ++  = P × 4.10 7   1.0445   .35 × 100)  + + + + + + +  = 28. set this total NPV equal to zero.0893 .065 1.2449 (0 .065 • PV of the depreciation tax shield.065 = 6.065 8   1.065 1. then solve for P: -100 + (P × 4. The Safety Razor Company should take the lease as long as the NPV of the financing is greater than or equal to zero.2149) + 28.06 or \$17.10 Setting NPV equal to zero and solving for P.040.04 or \$17. then the net present value of the lease to the company is: 1 1   NPV =100 −P × 1+ + +  1.1429 .095 2 3 4 5 6 7 1.0893 .410.065 1.095 = 0 Thus.0.065 1.065 1. P is equal to 17. b.065 7   1.065 8   1. 245 . The lessor’s PV of the depreciation tax shield becomes: 1   1 PV =(0 .060.065 1.638 1.35) × 0. discounted at the after-tax rate of 6. If P is the annual lease payment. If the lessor is obliged to use straight-line depreciation.

however. The cash flows and NPV for the lessee change. b. The overall gain is zero if the firms have the same discount rate. for example. For example. Consider the difference between the tax rates of the lessor and the lessee.13.. we can use the Greymare bus example from the text. then the cash flows given in the text remain the same but the NPV changes for both parties. then the lessee’s cash flows and NPV do not change. then: Value to lessee = INV −∑ t =0 n [P ×(1 − Tc )] +( D t Tc ) (1 + r*) t [P ×(1 − Tc )] +( D t Tc ) (1 + r*) t Value to lessor = −INV +∑ t =0 n The overall gain from leasing is the sum of these values. For the lessee.e. then the NPV to the lessor does not change. P the lease payment. In general. the appropriate rate of interest is 20%. and the overall gain is now positive. 246 . If. Consider the choice of depreciation schedule. r* = rd × (1 . for both the lessor and the lessee. the lessor uses 5-year ACRS but the lessee uses straight-line depreciation. c. if INV is the value of the leased asset. a. n the appropriate time horizon and r* the after-tax discount rate [i. The NPV of the lease to the lessor is still precisely the negative of the NPV to the lessee and the overall gain is still zero. instead of 10%. then the overall gain from leasing is positive. Consider the rate of interest. If the lessor’s tax rate remains at 35% and the lessee’s tax rate is zero. the same depreciation schedule for tax purposes. both the cash flows and the after-tax discount rate change. Dt the depreciation at time t. and the same corporate tax rates. which is now positive.Tc)]. then the overall gain is not be zero. for example. the effect is to increase the overall gain. In order to illustrate how the gains to the lessee and lessor are affected by changes in these parameters. If. if the lessor’s discount rate is less than the lessee’s discount rate. Tc the corporate tax rate. If the discount rate is different for the lessor and the lessee.

leasing for a company in this position allows for a shifting of tax shields from lessee to lessor. and in practice frequently are. For financial leases. The problems resulting from the use of IRR for analyzing financial leases are the same problems discussed in Chapter 5. A lessee has an immediate cash inflow. With two changes of sign. Another problem arises from the fact that risk is not constant. b. then the IRR should be calculated for the lease cash flows and then compared to the after-tax rate of interest. However. Each cash flow is not implicitly discounted to reflect its risk when the IRR is used. even without leasing. Why make investment incentives like accelerated depreciation credit available only to currently profitable companies? If such companies end up with an 15. then allowing non-taxpaying companies to take advantage of depreciation tax shields. but they are still equal in absolute value. Consider the length of the lease. the cost of capital changes over time. the NPV to each of the parties changes. four of these problems are particularly troublesome here: a. The IRR method cannot be used to choose between alternative lease bids with different lives or payment patterns. is likely to provide an incentive. However. In addition. however. this is often not the case. the salvage value of the asset is probably much riskier. b. Multiple roots occur rarely in capital budgeting because the expected cash flows generally change signs only once. two different values for the IRR. However. If the lessor and lessee do not pay taxes or if both pay at the same rate. a series of outflows for a number of years. 14. If the length of the lease changes. through leasing. The argument for this view is as follows: If the government feels more investment is needed. a. This requires two different discount rates. The overall gain to the lease is still zero. d. Many believe that the combination of these two advantages is more than is necessary to encourage non-taxpaying companies to invest.d. 247 . Proponents of this view note that a firm paying no taxes already has an advantage over tax-paying companies in the development of new projects. and then an inflow in the last year. c. There is no simple standard of comparison. For the lessee. if the company is temporarily in a non-taxpaying position. the lease payments are fairly riskless and the interest rate should reflect this. there may be. The government loses and the lessee and/or lessor gain.

then the solution should be to restrict tax loss carry-forwards rather than to change the tax rules for leasing.excessive tax break. 248 .

if the contract is not renewed.49 -67. it receives the salvage value.14) 1  = \$151.00 -69.75 -35.00 -75. with certainty. if Magna buys the plane.61. This is an optimistic assumption.85%) = \$190.25 -35.00 Lease payment -75.75 -35.25 451.80 ×  5    (1.00 -53.20) = \$39.00 -35.85%) Total PV(at 5.00 -35.\$151.00 Lease payment tax shield 26. Consider first the choice between buying and a five-year financial lease.00 -21.20  (1.20 probability that contract will not be renewed Initial cost of plane 500.00 Depreciation tax shield -35.25 Total cash flow 451.00 We have discounted these cash flows at the firm’s after-tax borrowing rate: 0.00 Expected cash flow PV(at 5.00 -75.80 probability that contract will be renewed for 5 years Initial cost of plane 500.00 Lease payment -75.07 t=3 t=4 t=5 -35.25 26.00 26.25 -74.25 -83.25 -83.00 -75.25 Total cash flow 451.41 (Note that the above calculations assume that.75 -83.00 -56.61 . and thereby zero-out all subsequent lease payments. There is an 80% probability that the plane will be kept for five years and then sold for \$300 (less taxes) and there is a 20% probability that the plane will be sold for \$400 in one year.37 -28.35)   400   + 0 .Challenge Questions 1.0585 = 5.80 -67. charge the same rent on the plane that it is paying.14)     The net gain to a financial lease is: (\$190.75 Buy: 0.) 249 .00 -75.00 Lease payment tax shield 26.00 -59. Ignoring salvage value.0.25 26. Magna can.85% The table above shows an apparent net advantage to leasing of \$190.65 × 0.20 ×  0. However.00 Depreciation tax shield -35.61 451.25 -83. the incremental cash flows from leasing are shown in the following table: t=0 t=1 t=2 Buy: 0.00 26.91 -67.09 = 0. Discounting the expected cash flows at the company cost of capital (these are risky flows) gives:  300 × (1 .

4% per year). discounted at the after-tax borrowing rate (5. 14%). it would require a 250 . and a 20% probability that it will be leased for only one year.25) = -\$65 The present value of these payments. 2. Suppose that.59 -71.e.65 × (-\$125) = -\$81.02 -46.70 -76.97 -66..25 Ignoring the cancellation option. Since there is an 80% probability that the plane will be leased for five years. our assumption about future operating lease costs. The net payments for the cancelable lease are: 0. Therefore.81 -55.80 probability that contract will be renewed for 5 years After-tax lease payment -76. Therefore.36).70 Expected cash flow PV(at 14%) Total PV(at 14%) = \$-272. so it appears that the financial lease is the lower cost alternative. Then the expected payment on an operating lease will also increase by 4% per year.e. Magna would be paying \$122. and that plane prices increase at the inflation rate (i.77 -82.00 These cash flows are risky and depend on the demand for light aircraft. the lessor would not be able to increase lease charges by 4% per year. and the expected value for the subsequent payments is: 0.The after-tax cost of the operating lease for the first year is: 0.20 probability that contract will not be renewed After-tax lease payment -76. however. we discount these cash flows at the company cost of capital (i. compared to -\$184.78 -42. If old planes are less productive than new ones.65 × \$118 = \$76.70 Assume that a five-year old plane is as productive as a new plane.73 t=5 0.70 -79. for example.96 Lease: 0. Notice.90 for the cancellation option. Magna were able to cancel its lease after one year and take out a four-year financial lease with rental payments of \$57 per year. The present value of these payments is greater than the present value of the safe lease payments from the financial lease (\$184.00 0.70 -63.85%) is -\$307.26. the expected cash flows for the operating lease are as shown in the table below: t=0 t=1 t=2 Lease: 0. Therefore.36 for the financial lease. The present value of the cash flows would then be the same as for the financial lease.07 -69.25.28 t=4 -89..00 t=3 -86.50 0.80 × (-\$81.37 -51.83 -76. the first payment is -\$81.

to make the cancellation option worthwhile 251 . from \$75 to \$57.24% reduction in the lease payments.

00 0.02 t=6 -2.90 252 .70 t=4 -4.98 0.72 -16.503 (\$503) t=0 100.90 0.00 -16.90 5.90 5.00 83.3.92 -13.90 t=3 -6.90 -16. Cost of new bus Lost depreciation tax shield Lease payment Tax shield of lease payment Cash Flow of Lease NPV = 0.02 t=5 -4.92 -15.10 -16.90 5.92 -17.92 -15.02 -16.03 -16.90 5.03 -16.90 5.00 -16.00 -16.00 t=1 t=2 0.90 0.00 -16.00 t=7 0.92 -10.

as its vehicle for insuring against large losses. BP Amoco has concluded that insurance industry pricing of coverage for large potential losses is not efficient because of the industry’s lack of experience with such losses. However. In addition. Insurance company experience and the very competitive nature of the insurance industry result in correct pricing of routine risks. without discriminating between high-risk and lowrisk customers. Rarely does it pay for a company to insure against all risks. Typically. however. The stock market can be an efficient risk-absorber for these large but diversifiable risks. In addition. Effectively. 253 . has also chosen to self-insure against very large losses. BP Amoco. large losses result in reductions in the value of BP’s stock. In other words. Moral hazard: Having an insurance policy can make the policyholder less careful with regard to the insured risk and can therefore increase the odds of loss. at least one very large company. Consequently. BP has chosen to self insure against these large potential losses. 3. rather than insurance companies. Adverse selection: When an insurance company offers insurance coverage at a set price. the insurance company is able to pool risks and thereby minimize the cost of insurance. insurance company expertise can be beneficial to large businesses because the insurance company’s experience allows the insurance company to correctly price insurance coverage for routine risks and to provide advice on how to minimize the risk of loss. As we have noted in the answer to Practice Question 1. it will attract more high-risk customers. as described in the answer to Practice Question 1. this means that BP uses the stock market. large companies self-insure against small potential losses. Insurance companies have the experience to assess routine risks and to advise companies on how to reduce the frequency of losses.CHAPTER 27 Managing Risk Answers to Practice Questions 1. 2.

Moral hazard and adverse selection both increase the insurance company’s losses. 254 . the insurance company must increase the premium it charges. Consequently.

19) 1/2 Spot price – PV(dividends) = 13.743 – [(13. Second. If we purchase a 9-month Treasury bill futures contract today.) The yield of a 3-month Treasury bill nine months from today is found as follows (where r denotes a spot rate and the subscripts refer to the time to maturity.330 = = 14.g.) Third.99 t (1 + rf ) (1. we are agreeing to spend a certain amount of money nine months from now for a 3-month Treasury bill.19(1/2)] = 13. Futures price 15. 10. A default swap is a promise to pay a series of fixed rate payments in exchange for receiving a single large payment in the event that a particular issuer defaults on a loan. (iii) Swaps may be used because a company believes it has an advantage borrowing in a particular market or because a company wishes to change the structure of its existing liabilities.743 × 0.491.04 × 0. Futures price = spot price − PV(dividen ds) (1 + rf )t 9. (Note that the yields given in the problem statement are annualized. the exchange of floating-rate payments is linked to different reference rates (e. find the corresponding price of the 3-month Treasury bill 9 months from now (Pf). so step 3 is not a required step for this solution. LIBOR and the commercial paper rate). the valuation of this futures contract involves three steps: First. (Note: Pf is the answer to this Practice Question.04 The futures are not fairly priced.052. So. Also. (ii) An interest rate swap is a promise to make a series of fixedrate payments in exchange for receiving a series of floatingrate payments (or vice versa).8. (i) A currency swap is a promise to make a series of payments in one currency in exchange for receiving a series of payments in another currency. find the corresponding spot price today.. find the expected yield of a 3-month Treasury bill 9 months from now (yf).5)/1. in months):    256 .

Thus. If I buy pulgas in the futures market.07) = 0.900. dollars per pulga). d.50) = \$1.50 0. futures are overpriced as long as the opportunity cost of storage is less than: (\$14. To check whether futures are correctly priced.3964 = 39.06% (annualized rate). c.1106) 1/4 = \$0.50 0.9741 The corresponding spot price today is: P= 0.39 7. Otherwise.589 78.50* * Assumes surplus storage cannot be rented out.200 .07)3/4 × (1 + yf)1/4 = (1 + 0. a futures buyer should demand 7126. I pay (\$1/6900) per pulga and I earn 7% interest on my dollars.18 257 . I pay (\$1/9300) per pulga in the spot market and earn interest of [(1.58 f.950..18 Therefore.00014033 = 1/7126. we find that: yf = 0. the futures and spot currency quotes are indirect quotes (i.08)1 Solving.514 78.39 6..\$13. It follows that the price (per dollar) of a 3-month Treasury bill nine months from now will be: Pf = 1 (1 + 0. e.64% for six months.e.107. pulgas per dollar) rather than direct quotes (i.5) –1] = 0.(1 + r9)3/4 × (1 + yf)1/4 = (1 + r12)1 (1 + 0. a.e.9259 11.3964/(9300 × 1.9741 (1+0.092.00 Value of Future \$2728.54 97.50 Note that for the currency futures in part (d).126. we use the basic relationship: Value of Future = spot price + PV(storage costs) −PV(conveni ence yield) (1 + rf )t This gives the following: Magnoosium Quiche Nevada Hydro Pulgas Establishment Industries stock 97.107.1106 = 11. Actual Futures Price \$2728. Wine 14.200.00 13.07) 3/4 = \$0. If I buy pulgas today. b. the futures price of one pulga should be: 1.18 pulgas for \$1.

12.e. For purposes of illustration. The NPV of a swap at initiation is zero.30) = 42.. If the long-term rate rises.055) 3 + 45 (1.055) 2 + 45 (1. b.34% (1 + rf)t rf 13.055) t + 45 (1.81% 15 1.15% 21 1. A loses as a result of the increase in rates and the dealer gains.000 Swiss Francs (SF). 258 .000 at its 8 percent borrowing rate.15058 8. we assume that A demands a 10% dollar cost of borrowing: Step 1: B borrows \$1. 14.10288 8.00437 5. it pays to buy the future.000 into 2. and invest the receipts in a six-month account. We make use of the basic relationship between the value of futures and the spot price: Futures price = spot price (1 + rf )t This gives the following values: 1 1.e.000 – 957.05799 6. assuming the swap is fairly priced.Where the futures are overpriced [i. and sell the future. or to find a swap for which the gains are shared. then it must be determined how this profit is to be divided between the principals.055) 4 + 1045 (1. Step 2: B changes \$1.70 and the dealer has a corresponding asset.01663 1.055) 5 = 957. we could then rearrange the calculations to find the swap which gives all the gains to A.82% 7. a.30: 45 (1. c. (b) and (d)]. Where they are underpriced [i. (Having shown that there is a profit.) To begin. sell the commodity on the spot market.. (f) above].5% would decline to 957. Once it is clear that a swap is profitable. it is clear that A would have been better off keeping the fixed-rate debt. let us first assume that A will break even and then calculate the profit to B. A now has a liability equal to (1. it pays to borrow. buy the goods on the spot market.30 With hindsight. the value of a five-year note with a coupon rate of 4.37% Contract Length (Months) 3 9 1.

39 1977. In order to minimize your risk.15 = \$924 . and the currency swap is: 1. which is the usual case.75 + = 2000 ⇒ x = 0. A’s SF obligations are paid by B.080 in year 5. and B can borrow Swiss francs more cheaply (5. 259 . A receives \$924.1 percent versus 6 percent). as a result of the swap. where the value of A is the dependent variable and the value of B is the independent variable. and 1.36 SF into \$924.) Step 4: A discounts these promised dollar payments at its 10 percent dollar cost of borrowing: t =1 ∑ 1. As noted above.18 at 10 percent.36 SF This is the amount that A needs to borrow.080 in year 5.e. and \$1. B borrows 2000 SF and is obligated to pay 129.977.75 SF in year 5.75 SF in year 5. and \$1.1 4 80 t + 1080 1. B’s dollar obligations are paid by A.39 SF per year in years 1 through 4. we could rearrange this so that the profit is shared. Step 5: A borrows 1848.Step 3: A promises to pay B \$80 per year in years 1 through 4. i. Sometimes considerable judgement must be used. it may be that hedge you wish to establish has no historical data that can be used in a regression analysis. For example.18 = 1. In practice. Step 6: A changes 1848.39 SF per year in years 1 through 4. delta measures the sensitivity of A’s value to changes in the value of B.1% t (1 + x) (1 + x)5 Thus. The cost. of this loan to B may be calculated from the following: t =1 ∑ 4 129.. Delta is the regression coefficient of B. Step 7: B promises to pay A 129. Suppose you own an asset A and wish to hedge against changes in the value of this asset by selling another asset B. The net effect of B’s dollar loan. This covers A’s cost of servicing its SF debt. or yield. A’s Swiss franc loan. 15.051 = 5. delta can be measured by using regression analysis.18.848 . 2. and 1977. A borrows \$924. you should sell delta units of B.18 and is obligated to pay \$80 per year in years 1 through 4. (This covers B’s cost of servicing its dollar debt.36 SF at its 7 percent borrowing rate. A can borrow dollars on a break-even basis.

16.000 260 .000 \$298.000 \$301.000 \$320.000 \$301.000 (c) Options-Hedged Revenue \$298.000 (b) Futures-Hedged Revenue \$301.000 \$300.000 \$318. Gold Price Per Ounce \$280 \$300 \$320 (a) Unhedged Revenue \$280.

For example.000.000 × (1 + rf ) 1/2 This is exactly what he would receive in six months if he sold his portfolio now and put the money in a six-month deposit. 19. then. the net cash flow six months from today will be [1. Thus.000 portfolio now and put the money in a six-month deposit. which is worth \$500 times the value of the index. Of course.000 × (1 + rp) (because the spot price of the future will increase as the index increases) Thus. exactly what Legs would receive if he sold the \$1.’ So. Legs can ‘cash in’ without selling his portfolio today. at the end of six months. then his cash flows are: Sell portfolio: Sell 7-month future: +1. We find the appropriate delta by using regression analysis.17. Standard & Poor’s index futures are contracts to buy or sell a mythical share. he will receive: 5 × \$500 × price of futures If the relationship between the futures price and the spot price is used.000 × (1 + rp) +1. Legs also agrees to hand over the value of a portfolio of five index ‘shares. If rp is the return on the portfolio and rf is the risk-free rate.000. this is equivalent to receiving: 5 × 500 × (spot price of index) × (1 + rf)1/2 = \$1. each ‘share’ is worth: (\$500 × 400) = \$200.000.000 × (1 + rf)½ (using the relationship between the spot and futures prices) Buy 7-month future: -1. Legs’ portfolio is equivalent to five such ‘shares. Legs can equally well hedge his portfolio by selling seven-month index futures now and liquidating his futures position six months from today. he can sell his portfolio and use the proceeds to settle his futures obligation. with the change in the value of Swiss Roll as the dependent variable and 261 . when he sells the futures. 18.000. if the index is currently at 400.’ If Legs sells five index futures contracts.000.000 × (1 + rf)1/2]. in six months.000. by hedging his portfolio.000.

320 0.256 4 120 76.905 2 0.135 2 1. the average duration of the debt portfolio is:    1. The result is that the regression coefficient.128 0.91 +8. b. a.1 0.4 0.160 0.271 2 1.180 0.935 Proportion Proportion of of Total Total Value Value Times Year 0.013 2 0.91 8.908 For the 6-year debt (value \$8.570 0. You could sell (1.085 0.75 c.000 of gold (or gold futures) to hedge your position.068 0.424 2 1.2 × 100.107 2 120 95.096 0.305 5 120 68.75 × 100. For the lease: Year 1 2 3 4 5 6 7 8 PV(Ct) Ct at 12% 2 1.91 +8. However.03 ×1 +1.143 0.102 0.637 0. or \$50 million. Therefore.180 0.000 = \$75. 21.03   1.5. since the R2 is less (0.612 0.594 2 1.429 0.7 0. the short position in Frankfurter Sausage should be half as large as that in Swiss Roll.340 6 1120 567. In other words.the change in the value of Frankfurter Sausage as the independent variable.601 The duration of the one-year debt (value \$1.000) = \$120.03 ×4.03 million): Proportion Proportion of PV(Ct) of Total Total Value Year Ct at 12% Value Times Year 1 120 107.512 0.0 Duration = 4.567 3.91 years   262 .648 Duration = 3.191 3 120 85.91 million) is one year.076 0.4 0. a. which is the delta. is 0.808 V = 9.114 0.786 2 1. 20.1 0.402 V = 1000.6 for Stock B).6        =3.107 0.091 0.3 0. you would be less well hedged.5 versus 0. 0.081 0.000 δ = 0.

This is equal to the duration of the lease. 263 .

Duration of the liability: Proportion Proportion of PV(Ct) of Total Total Value Year Ct at 12% Value Times Year 3 20 15.039 3. See the table below.75 11.421x + 0 (1 –x) = 3. To maintain the hedge. the financial manager would adjust the debt package to have the same duration as the lease.74 2.067 Debt Package Value Change 14. that the mismatch is negligible and should not give the manager sleepless nights.319 +2.33 12.103 0.877 Duration = 3.103 0.945 145. 6-Year Debt Price Value 152. a.667 1-Year Debt Price Value 109.572 4 20 13.5% 13.03 0.054% Lease Yield Value Change 2.29 11.03 million face value (b) \$1. PV = [-20/(1.0% 14.91 9.5% 14.144% 3.92 9.254 0.904 V = 28.69 Duration = 3.476/3. Ct 12 12 12 112 V= PV(Ct) at 12% 10.748 -2.02 million) is now less than the value of the asset (\$14. however.21 2.10)4] = -\$28.476 1.476 Proportion Proportion of of Total Total Value Value Times Year 0.35 Let x = the proportion invested in the note so that (1 – x) is the proportion invested in the bank deposit.085 0.719 2.02 76. The value of the liabilities (\$14.077 108.073% (a) \$8.016 264 .524 1.27 2.118% 14.734 -2. Then: 3. A one percent change in interest rates affects the value of the asset more than the value of the liabilities.087b 108.421 = 1.04 million).232a 148.340 +2.187 0.093 0.b.421 Duration of the note: Year 1 2 3 4 c. Note. Potterton is no longer fully hedged.69 b.016 1 – x = -0.10)3] – [20/(1.50 106.476 x = 3.91 million face value 22.66 0.022 13.

No. the cost of the option). as follows: • • Invest \$15.69 million) = \$29.69 million) = \$0. 25.149 million . and the option exercise price is \$16. it will pay \$20 million. invest (1.e.\$28. he will still be hedged by selling futures and borrowing. once in place. it will pay \$20 million. Hedging removes all uncertainty. we must invest so that the cash flows from the investment exactly match the cash flows of the liability. In order to perfectly hedge this liability. compared to hedging with options. Hedging with options has a cost (i. If there is uncertainty about the fairness of the repurchase price. the futures price is \$16. 23.149 million in the note and borrow (\$29. Oil Price Per Barrel \$14 \$16 \$18 Futures-Hedged Expense \$16 \$16 \$16 Options-Hedged Expense \$14 \$16 \$16 The advantages of using futures are that risk is eliminated and that the hedge. An example is the delta hedge set up by the miller. 265 . not perfectly. Assume the current price of oil is \$14 per barrel.459 million. but he will make a known loss (the amount of the underpricing). he will not be fully hedged. The disadvantage. If futures are underpriced.016 × \$28.03 million in a 3-year zero-coupon note paying 10% Invest \$13. he not only needs to know that they are fairly priced now but also that they will be fairly priced when he buys them back in six months. Think of Legs Diamond’s problem (see Practice Question 17).d. If he hedges by selling seven-month futures (see Practice Question 18). However. Insurance eliminates downside risk by providing a put option. and when the 4-year zero-coupon note matures. is that options allow for the possibility of a gain. the imbalance would generally be relatively small. as described in the chapter.. 24. Therefore. e. One way to do this is with zero-coupon notes. can be safely ignored. Option hedging therefore requires a dynamic strategy.66 million in a 4-year zero-coupon note paying 10% When the 3-year zero-coupon note matures.

Speculators like mispriced futures. speculators can make arbitrage profits by selling futures.’ 266 . borrowing and buying the spot asset. For example. if six-month futures are overpriced. This arbitrage is known as ‘cashand-carry.

Challenge Questions 1. a. Phillips is not necessarily stupid. The company simply wants to eliminate interest rate risk. b. The initial terms of the swap (ignoring transactions costs and dealer profit) will be such that the net present value of the transaction is zero. Phillips will borrow \$20 million for five years at a fixed rate of 9% and simultaneously lend \$20 million at a floating rate two percentage points above the three-month Treasury bill rate which is currently a rate of 7%. Under the terms of the swap agreement, Phillips is obligated to pay \$0.45 million per quarter (\$20 million at 2.25% per quarter) and, in turn, receives \$0.40 million per quarter (\$20 million at 2% per quarter). That is, Phillips has a net swap payment of \$0.05 million per quarter. Long-term rates have decreased, so the present value of Phillips’ long-term borrowing has increased. Thus, in order to cancel the swap, Phillips will have to pay the dealer. The amount paid is the difference between the present values of the two positions: The present value of the borrowed money is the present value of \$0.45 million per quarter for 16 quarters, plus \$20 million at quarter 16, evaluated at 2% per quarter (8% annual rate, or two percentage points over the long-term Treasury rate). This present value is \$20.68 million. The present value of the lent money is the present value of \$0.40 million per quarter for 16 quarters, plus \$20 million at quarter 16, evaluated at 2% per quarter. This present value is \$20 million, as we would expect. Because the rate floats, the present value does not change.

c.

d.

Thus, the amount that must be paid to cancel the swap is \$0.68 million. 2. a. Cash flows (in thousands) for the two alternatives are as follows: Hoopoe’s International Issue Year 0 1 2 Cash Flow C\$99,800 -10,625 -10,625 100,000 – (100,000 × 0.002) -(100,000 × 0.10625)

267

3 4 5

-10,625 -10,625 -110,625

(-10,625 - 100,000)

The ‘all-in cost’ (yield to maturity) implicit in these cash flows is 10.68%. Hoopoe’s Swiss Franc (SF) Issue: Year 0 1 2 3 4 5 Cash Flow SF 199,600 -10,750 -10,750 -10,750 -10,750 -210,750 200,000 – (200,000 × 0.002) -(200,000 × 0.05375)

(-10,750 - 200,000)

For the swap to be successful the counterparty must pay Hoopoe’s Swiss franc costs (10,750 in years 1 through 4 and 210,750 in year 5). Further, the counterparty requires an all-in cost in Swiss francs of 6.45%. Using 6.45% as the discount rate, we can calculate the net proceeds required from the counterparty’s dollar issue:
t =1

∑ (1.0645)

4

10,750

t

+

210,750 = 191,053 SF or \$95,527 (1.0645) 5

With these net proceeds, we can calculate the required dollar face value (x) of the counterparty’s debt issue: x (1 – 0.002) = 95,527 ⇒ x = \$95,718 We can now calculate the cash flows related to the counterparty’s issue of dollar debt. Year 0 1 2 3 4 5 Cash Flow \$95,527 -10,170 -10,170 -10,170 -10,170 -105,888 95,718 – (95,718 × 0.002) (95,718 × 0.10625)

(-10,170 - 95,178)

Thus, Hoopoe can issue Swiss franc debt and raise 199,600 SF, which is equivalent to \$99,800, and have its SF obligation paid by the counterparty; in turn, it is obligated to pay its counterparty’s dollar obligations. The all-in cost (x) implied by these cash flows is calculated as follows: 4 10,170 105,888 ∑1 (1 + x)t + (1 + x)5 = 99,800 ⇒ x = 0.0951 = 9.51% t =

268

(Note that, by construction, the counterparty’s all-in cost is 6.45 percent for its SF borrowing.) The swap is better than the international bond issue, since the effective interest rate is less: 9.51% versus 10.66% b. Hoopoe must clearly worry that the counterparty may default on the swap agreement. The cost of a replacement swap with a new counterparty could be considerably higher than the first one, for example, if the dollar has fallen sharply relative to the franc. Often, however, the counterparty is a major international bank; in that case, the default risk is probably small.

3. a. For each, we make use of the general relationship:
Futures price =Spot price − PV(convenience yield) (1 + rf )t

or Futures price = (1 + rf) t × [Spot price – PV(convenience yield)] Thus, the six-month futures prices are: Magnoosium: 1.03 × Oat Bran: 1.03 × Biotech: 1.03 × Allen Wrench: 1.03 × 5-Year T-Note: 1.03 × Ruple: * [2800 – (0.04 × 2800)/1.03] = \$2,722 per ton [0.44 – (0.005 × 0.44)/1.03] = \$0.451 per bushel \$144.4 [140.2 – 0] = \$58.54 [58.00 – (1.2/1.03)] = \$108.20 [108.93 – (4/1.03)] = 3.017 ruples/\$

*Note that, for the currency futures (i.e., the Westonian ruple), the spot currency quote is an indirect quote (i.e., ruples per dollar) rather than a direct quote (i.e., dollars per ruple). If I buy ruples today in the spot market, I pay (\$1/3.1) per ruple in the spot market and earn interest of [(1.120.5) –1] = 0.0583 = 5.83% for six months. If I buy ruples in the futures market, I pay (\$1/X) per ruple (where X is the indirect futures quote) and I earn 6% interest on my dollars. Thus, the futures price of one ruple should be: 1.0583/(3.1 × 1.03) = 0.33144 = 3.017 Therefore, a futures buyer should demand 3.017 ruples for \$1. b. The magnoosium producer would sell 1,000 tons of sixmonth magnoosium futures. 269

c.

Because magnoosium prices have fallen, the magnoosium producer will receive payment from the exchange. It is not necessary for the producer to undertake additional futures market trades to restore its hedge position. No, the futures price depends on the spot price, the risk-free rate of interest, and the convenience yield. The futures price will fall to \$48.24 (same calculation as above, with a spot price of \$48). First, we recalculate the current spot price of the 5-year Treasury note. The spot price given (\$108.93) is based on semi-annual interest payments of \$40 each (annual coupon rate is 8%) and a flat term structure of 6% per year. Assuming that 6% is the compounded rate, the six-month rate is: (1 + 0.06)1/2 - 1 = 0.02956 = 2.956%

d. e. f.

Incorporating similar assumptions with the new term structure specified in the problem, the new spot price of the 5-year Treasury note will be \$113.46. Thus, the futures price of the 5-year T-note will be: 1.02 × [113.46 - (4/1.02)] = \$111.73 The dealer who shorted 100 notes at the (previous) futures price has lost money. g. The importer could buy a three-month option to exchange dollars for ruples, or the importer could buy a futures contract, agreeing to exchange dollars for ruples in three months’ time.

270

CHAPTER 28

Managing International Risks
Answers to Practice Questions 1. Answers here will vary, depending on when the problem is assigned. The dollar is selling at a forward premium on the baht.
 44.555  4× − 1 =0 .0189 = 1.89%  44.345 

2.

a. b. c. d.

Using the expectations theory of exchange rates, the forecast is: \$1 = 44.555 baht 100,000 baht = \$(100,000/44.555) = \$2,244.42

3. We can utilize the interest rate parity theory:
frand 1 +rrand = 1 + r\$ srand
/\$ /\$

1 + rrand 8.4963 = ⇒ rrand = 0.0507 = 5.07% 1.035 8.3693 If the three-month rand interest rate were substantially higher than 5.07%, then you could make an immediate arbitrage profit by buying rands, investing in a three-month rand deposit, and selling the proceeds forward. 4. Answers will vary depending on when the problem is assigned. However, we can say that if a bank has quoted a rate substantially different from the market rate, an arbitrage opportunity exists. 5. Our four basic relationships imply that the difference in interest rates equals the expected change in the spot rate:

271

f E (s L/\$ ) 1 + rL = L/\$ = 1 + r\$ sL/\$ sL/\$

We would expect these to be related because each has a clear relationship with the difference between forward and spot rates. 6. If international capital markets are competitive, the real cost of funds in Japan must be the same as the real cost of funds elsewhere. That is, the low Japanese yen interest rate is likely to reflect the relatively low expected rate of inflation in Japan and the expected appreciation of the Japanese yen. Note that the parity relationships imply that the difference in interest rates is equal to the expected change in the spot exchange rate. If the funds are to be used outside Japan, then Ms. Stone should consider whether to hedge against changes in the exchange rate, and how much this hedging will cost. 7. a. b. c. d. e. Exchange exposure. Compare the effect of local financing with the export of capital from the U.S. Capital market imperfections. Some countries use exchange controls to force the domestic real interest rate down; others offer subsidized loans to foreign investors. Taxation. If the subsidiary is in a country with high taxes, the parent may prefer to provide funds in the form of a loan rather than equity. Government attitudes to remittance. Interest payments, royalties, etc., may be less subject to control than dividend payments Expropriation risk. Although the host government might be ready to expropriate a venture that was wholly financed by the parent company, the government may be reluctant to expropriate a project financed directly by a group of leading international banks. Availability of funds, issue costs, etc. It is not possible to raise large sums outside the principal financial centers. In other cases, the choice may be affected by issue costs and regulatory requirements. For example, Eurodollar issues avoid SEC registration requirements.

f.

8. Suppose, for example, that the real value of the deutschemark (DM) declines relative to the dollar. Competition may not allow Lufthansa to raise trans-Atlantic fares in dollar terms. Thus, if dollar revenues are fixed, Lufthansa will earn fewer DM. This will be offset by the fact that Lufthansa’s costs may be partly set in dollars, such as the cost of fuel and new aircraft. However, wages are fixed in DM. So the net effect will be a fall in DM profits from its trans-Atlantic business. However, this is not the whole story. For example, revenues may not be wholly in dollars. Also, if trans-Atlantic fares are unchanged in dollars, there may be

272

If the firm owns a foreign real asset (like Outland Steel’s inventory). In this case.g. the company can. it may have bills for fuel that are awaiting payment. You cannot so easily hedge against these changes unless. The firm can hedge this risk by selling the foreign currency forward or borrowing foreign currency and selling it spot. 10. however. Note that Lufthansa is partly exposed to a commodity price risk (the price of fuel may rise in dollars) and partly to an exchange rate risk (the rise in fuel prices may not be offset by a fall in the value of the dollar). For example. e. Lufthansa may be exposed to changes in the nominal exchange rate. such as by buying oil futures.. 273 . it still needs at least a rough-and-ready estimate of the hedge ratios..e. In other words. Even if the law of one price holds. 9. say. i. The dealer estimates the following relationship in order to calculate the hedge ratio (delta): Expected change in company value = a + (δ × Change in value of yen) For the Ford dealer: Expected change in company value = a + (5 × Change in value of yen) Thus. to a great extent. if you were less certain about your domestic inflation rate. the firm is at risk if the overseas inflation rate is unexpectedly high and the value of the currency declines correspondingly.. you might prefer to keep the funds in the foreign currency. Note. you can sell commodity futures to fix income in the foreign currency and then sell the currency forward. you are exposed to changes in the real exchange rate. the dealer should sell yen forward in an amount equal to one-fifth of the current company value. In addition. However. fix the dollar cash flows. it would lose from a rise in the dollar. to fully hedge exchange rate risk.) Lufthansa can then hedge in either the exchange markets (forwards.g. In some cases. the percentage change in company value for each 1% change in the exchange rate.extra traffic from German passengers who now find that the DM cost of travel has fallen. a foreign currency receivable). Suppose a firm has a known foreign currency income (e. your worry is that changes in the exchange rate may not affect relative price changes. (Hedge ratios are discussed in Chapter 27. or options) or the loan markets. rather than a currency risk. futures. that this is a relative inflation risk.

inflation in the U. has decreased by 19. has reduced his real earnings.9 roubles 275 .4 1.S. From 1983 to 2000.63) = \$61. a decrease of 38.84 = 3240 roubles ⇒ ⇒ US\$1 = S\$3.3 1.7 1. So.02 = A\$89.2 1.000/1.8 1. If the law of one price holds.rate multiplied by the inflation differential. then the bottle of Scotch will cost the same anywhere. who lives in Australia. his real income in 2000 (measured in 1983 Australian dollars) was: A\$179.349 in 2000.000.000 in 1983 to: (\$100.84 = S\$69 US\$22.6%.7%. 795 of the text. Bruce’s real income. and receives \$100.900 (in 2000 Australian dollars). measured in Australian dollars.000 per year. which was worth A\$110. In 2000.9 1. p. Since 1983. (See footnote 15.02 US\$1 = 141.059 Therefore. Bruce.6 1. was 63%. 15.900/2. his real income (measured in 1983 US dollars) has decreased from \$100.S. a.1 1 19 83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 19 99 A\$/US\$ Nominal Real Year 14. Because of Australian inflation (202% since 1983).5 1.S.) 1.800. George lives in the U. inflation in the U.000 in 1983. he also received US\$100. which implies that: US\$22. which was worth A\$179. received US \$100.

At the time the hedge was initiated. To determine whether arbitrage opportunities exist. For example.019231 1. \$42. we use the interest rate theory.019 loan.064327 0.b.010680 Difference between Spot and Forward Rates 1. With a forward contract to sell these for dollars. and invest at 4.000) is risk-free profit today.96 in Moscow We would prefer to buy our Scotch in Moscow.991304 For Anglosaxophonia and Gloccamorra.194200 1.33 in Singapore \$12. A major point in finance is that risk is undesirable particularly when it can be reduced or eliminated. we check to see whether the following relationship between the U. For example. 276 .394/2. convert \$1.300 wasps. the hedger’s opinion was that sterling was priced correctly (otherwise the hedge would not have been placed) and that any deviations from the expected value were unacceptable.28) = \$1.S.1%. This yields 2. 16.84 in the U. This is just sufficient to repay the \$1.S.048544 1.019417 1. and Costaguana holds: 1 + rpulgas 1 + r\$ = fpulgas spulgas /\$ /\$ For the different currencies. The \$19 difference between the amount borrowed (\$1. one could borrow \$1.019 at 3% today.194175 1. the Scotch costs: \$22. one receives (2. 17. we have: Difference in Interest Rates Costaguana Westonia Gloccamorra Anglosaxophonia 1. Using the actual exchange rates.394 wasps in one year.050 dollars in one year. there are arbitrage opportunities because interest rate parity does not hold.019) and the amount converted to wasps (\$1.000 to 2. This is the purpose of hedging.

10) (1. but the option does have a cost. then the Swiss plant is the better choice.797 24.953 25.10) (1.10 (1.10) (1.10) 6 NPV S =− 80 + 13.18.06   20   1.462  1.10) (1.582 24. Future spot prices are rarely equal to forward prices and ex post rationalization regarding which strategy would have been more successful is irrelevant since the decision must be made before the future spot price is known. 19. However.477 24. a currency option is more appropriate.04  Since both projects have a positive NPV. Recall that forward contract gains or losses are exactly offset by losses or gains in the underlying transaction and the forward contract is costless at inception.462 20. Note that the NPV calculation is in dollars and implicitly assumes currency hedging. NPV G =− 78 + 12.877 19.712 + + + + + = \$10.244 24.5   1. both should be accepted.10) 6 Sample calculations:  1. In these cases.10 (1.10) (1.10) (1.877  1. Nonetheless. If the firm must choose.563 + + + + + = \$10.26 2 3 4 5 1.10) (1. currency options allow the manager to lock in a rate that will be no greater than the exercise price and allows the firm to benefit from favorable currency movements.386 20.05   ×  = 13. if the transaction exposure is uncertain because the volume and/or foreign currency prices of the items bought or sold are unknown.033 24. 277 .10) (1.134 18.12 2 3 4 5 1. a forward contract will not match the transaction exposure.05  (1.3 ×10) ×  = 12.

If the value of the euro falls. its profit will increase. Both revenues and expenses are in a wide range of currencies. none of which is tied directly to the Swiss franc: Nestle stock price will be unaffected. In the short run. expenses are Swiss francs: SwissAir stock price will decline.Challenge Questions 1. Omega has revenues in dollars and expenses in euros. 2. its profit will decrease. Alpha has revenues in euros and expenses in dollars. Alpha could hedge this exchange risk by entering into a forward contract to sell euros for dollars. c. If the value of the euro falls. 278 . Omega could hedge this exchange risk by entering into a forward contract to sell dollars for euros. depending on the nature of the hedge. b. expenses are Swiss francs: Union Bank stock price will be unaffected or may increase. Revenues are dollars. All monetary positions are hedged. a. In the short run.

Patents and trademarks. Research and development expenditures are generally recorded as expenses rather than assets. However. which can be extremely valuable assets. The value of intangible assets generally does not show up on the company’s balance sheet. 279 . 2. since intangible assets may be worthless in the event of financial distress. say. e. Inventory profits can increase. you are interested in what a firm has promised to pay. a. answers will vary. not necessarily in what investors think that promise is worth. again because assets are undervalued. as are asset values. but. 3. offbalance sheet debt. The following are examples of items that may not be shown on the company’s books: intangible assets. 4. if you are concerned with. Internet exercise. answers will vary. The answer. c. the use of book values may be an acceptable proxy. Internet exercise. You may need to look at the market value of debt. is.” For most purposes. are not recorded as assets unless they are acquired from another company. 5. It can also make debt ratios seem high. when calculating the weighted average cost of capital. answers will vary. Equity income is depressed because the inflation premium in interest payments is not offset by a reduction in the real value of debt. as in all questions pertaining to financial ratios. pension assets and liabilities (if the pension plan has a surplus). This affects accounting rates of return because book assets are too low.g.CHAPTER 29 Financial Analysis and Planning Answers to Practice Questions 1. Individual exercise.. derivatives positions. “It depends on what you want to use the measure for. a financial manager is concerned with the market value of the assets supporting the debt. Depreciation is understated. 6. answers will vary. b. Internet exercise. probability of default. thereby understating income and understating assets.

but you need to recognize that there may be other offsetting off-balance-sheet items..000 ten years from now is worth less than a certain payment of \$1.7 days (increase) Interval measure 280 . i. Minority interests reflect the portion of the equity of these subsidiaries that is not owned by the company’s shareholders. for most companies. 4. calculate the present value of the exercise price on the option to default.. 5. Net working capital to total assets = (900 + 300) − (460 + 300) = 0. a. deferred tax reserves are a permanent feature.Looking at the face value of debt may be misleading when comparing firms with debt having different maturities. it may be helpful to discount face value at the riskfree rate.58 (decrease ) 460 + 300 = 1.251 (decrease ) 1450 + 300 2. (Merton refers to this measure as the quasi-debt ratio. e.) You should not exclude items just because they are off-balance-sheet. After all. Liquidity ratios: 1.539 (increase) 460 + 300 = 110 + 300 + 440 1980 ÷ 365 = 156. Deferred tax reserves arise because companies typically use accelerated depreciation for tax calculations while they use straight-line depreciation for financial reporting. Minority interests arise because the company consolidates all the assets of its subsidiaries even though some subsidiaries may be less than 100% owned. if the information is available. a certain payment of \$1. Therefore. it makes sense to exclude deferred tax and minority interests from measures of leverage. but.g. preferred stock is a junior claim on firm assets. Preferred stock is largely a fixed charge that accentuates the risk of the common stock. the pension fund.000 next year. How you treat preferred stock depends upon what you are trying to measure. 3. For most purposes. as far as lenders are concerned. this tax would become payable.12 (decrease) 110 + 300 + 440 460 + 300 Cash ratio = 110 + 300 = 0. In the event that the company’s investment slows down or ceases. On the other hand. 7. Current ratio = Quick ratio = 900 + 300 = 1.e.

none of which is affected by a shortterm loan that increases cash.61 100 + 450 +540 + 300 2. so that the book value of equity is \$333. After the merger. the cost of goods sold will be: (\$90 .50 100 + 450 +540 100 +450 + 300 =0.10 0. assets will be \$70.50 to 0. Times interest earned would decrease because approximately the same amount would be added to the numerator (interest earned on the marketable securities) and the denominator (interest expense associated with the short-term loan).00 0.20 Merged Firm 1. A market-to-book ratio of 1. as shown below: 100 +450 =0. Federal’s cost of goods includes the \$20 it purchases from Sara. After the merger.\$4) = \$16.43 0. Leverage ratios: 1. The firm uses cash to purchase additional inventories ⇒ no effect 9. With sales of \$100.20 Sara Togas 1. or \$33. 8. 10. and Sara’s cost of goods sold is: (\$20 . The firm takes out a bank loan to pay its suppliers ⇒ no effect c.b. The financial ratios for the firms are: Federal Stores Sales-to-Assets Profit Margin ROA 2. These calculations involve only longterm debt. sales will be \$100. therefore.33.3 million. Inventory is sold ⇒ no effect b.\$20 + \$16) = \$86.61. Before the merger. profit will be \$14.45 and 0. The dividend per share is \$2 and the dividend yield is 4%. and profit will be \$14. but in another it is somewhat complicated.20 Note that the calculation of profit is straightforward in one sense.14 0. The effect on the current ratio of the following transactions: a. However. A customer pays its overdue bills ⇒ no effect d.00 0.83. the Debt Ratio (including short-term debt) changes from 0. The Debt Ratio and the Debt-Equity Ratio would be unchanged at 0.20 0. so the stock price per share is \$50. The number of outstanding shares is 10 million.5 indicates that the book value per share is 2/3 of the market price. respectively. leases and equity. 281 .

Times Interest Earned should be 11.2 ⇒ Cash = 0.0 50.53 The result is: Fixed assets Cash Accounts receivable Inventory Total current assets TOTAL Equity \$38 11 44 22 77 \$115 \$36 Sales Cost of goods sold Selling.2 = (EBIT + Depreciation)/Interest ⇒ Interest = 6.] Total liabilities + Equity = 115 ⇒ Total assets = 115 Total current liabilities = 30 + 25 = 55 Current ratio = 1.73 Average total assets = (105 + 115)/2 = 110 Return on total assets = 0.0 6.27 .0 120.18 = (EBIT – Tax)/Average total assets ⇒ Tax = 30.0 ⇒ Cash + Accounts receivable = current liabilities = 55 ⇒ Accounts receivable = 44 Total current assets = 77 = Cash + Accounts receivable + Inventory ⇒ Inventory = 22 Total assets = Total current assets + Fixed assets = 115 ⇒ Fixed assets = 38 Long-term debt + Equity = 115 – 55 = 60 Financial leverage = 0. and Administrative Depreciation EBIT Interest 282 200.4 ⇒ Total current assets = 1.2 Average equity = (30 + 36)/2 = 33 Return on equity = 0.0 = (Cost of goods sold/Average inventory) ⇒ Cost of goods sold = 120 Average receivables = (34 + 44)/2 = 39 Receivables’ collection period = 71.11.2 × 55 = 11 Quick ratio = 1.2 rather than 8.27 = 43.27 Earnings before tax = 50 – 6. Times Interest Earned is incorrectly stated in this practice question.41 = Earnings available for common stock/average equity ⇒ Earnings available for common stockholders = 13.4 × 55 = 77 Cash ratio = 0. [Note: In the first printing of the seventh edition.2 = Average receivables/(Sales/365) ⇒ Sales = 200 EBIT = 200 – 120 – 10 – 20 = 50 Times-interest-earned = 11.0 20.4 = Long-term debt/(Long-term debt + Equity) ⇒ Long-term debt = 24 Equity = 60 – 24 = 36 Average inventory = (22 + 26)/2 = 24 Inventory turnover = 5. general.0 10.

Straight-line versus accelerated depreciation. Research and Development. the second method gives too much weight to Company D.0 E 6. the value of debt (both long-term and short-term). Two obvious choices are: a. f. inflation affects the value of inventory (and.0 50. c. the method of calculation has a substantial impact on the result. Compensation in options rather than cash. Bad debt provisions.0 C 3. g. 13.20 8 -40 E . Rapid inflation distorts virtually every item on a firm’s balance sheet and income statement.Long-term debt Notes payable Accounts payable Total current liabilities TOTAL 12.53 Total industry income over total industry market value: D -1. Given these distortions.125 Share price 100 5 P/E 30 40 Average P/E = 12. which is a small company and has a negative P/E that is large in absolute value. Average of the individual companies’ P/Es: Company A B EPS 3.35 50 15 D -. Profits and losses on foreign exchange. 24 30 25 55 \$115 Earnings before tax Tax Available for common 43.67 10 15 Clearly.67 Market value 300 30 120 Price/earnings = 620/22. e.5 6. h. Standards for capitalizing leases.73 30. the relevance of the numbers recorded is greatly diminished. LIFO versus FIFO for pricing inventory. 14.33 . hence. d. the value of plant and equipment.67 120 Total 22. The first method is generally preferable.84 620 Company A B C Net income 10 0. 283 . Profits on work-in-process. Here. Any of the following can temporarily depress or inflate accounting earnings: a. Capitalizing or expensing investment in intangibles.84 = 27.20 13..1 b. cost of goods sold).g. e. and so on. For example. b.

who include the effects of inflation in their lending decisions.The presence of debt introduces more distortions. 284 . As mentioned above. but so is the rate demanded by bondholders. the value of debt is affected.

In general.15. more information facilitates comparisons between firms. Both the numerator and denominator would increase with a more realistic depreciation schedule. In other words. and any financial analysis that does not do so is poor indeed. All of the financial ratios are likely to be helpful. sales to net working capital). 16.. the cash ratio) while others were overstated.g. For example. 17. one could also argue that the market certainly has already taken the value of these brand names into consideration.g.e. Other accounting measures of risk might be devised by taking five-year averages of these ratios. for example. Answers will vary depending on companies and industries chosen. Then too. equity has been understated. In 1986... the P/E ratio). Others would decrease by using a more realistic depreciation schedule (e. the depreciation charges used were too high. Thus. a more realistic depreciation schedule would result in a lower ratio of net working capital to total assets. the book value of each airplane was \$0. 285 .2 million. while the market value was \$20 million. 18. one must assume that the managers of RHM have correctly estimated their brand names’ value. relative to economic depreciation. likely candidates include the debt-equity ratio and the P/E ratio.g. This has the following effects on the firm’s financial ratios:  Leverage ratios: Because assets were understated. Presumably those ratios that relate directly to the variability of earnings and the behavior of the stock price have the strongest associations with market risk. However. if one expects to use these numbers for meaningful comparisons.g. some would decrease (e... and for some the effect is ambiguous. a more realistic depreciation schedule would result in a lower debt ratio). although to varying degrees.g. and reported earnings have understated actual earnings.. and leverage ratios have been overstated (i. dividend yield). sales to average total assets). More information is needed to determine the impact on return on total assets.  Market value ratios: Some would be unaffected. the book value of assets has understated actual asset value.  Liquidity ratios: Some would be unaffected (e. so the short answer is yes.  Profitability ratios: Some would be unaffected (e. as long as we make the assumption (common in finance) that capital markets can see through the obscurity imposed on the firm’s financial condition by accounting conventions (e.

we would expect conglomerates or companies with individually large projects (e. and a summary of planned financing. the financial plan should provide unbiased forecasts. Thus. markets are changing. Models are often so complicated that it is difficult to use or to efficiently make changes to them. 22. a description of planned capital expenditures. It is easier to express and implement corporate strategy with a top-down model. However. d. Bottom-up models may be excessively detailed and can prevent managers from seeing the forest for the trees. Models are expensive to build and maintain. Most financial models are designed to forecast accounting statements. the financial plan represents the goals of the firm. Many times. and sources and uses of cash). and intangible assets are important.g. income statements. Boeing) to use a bottom-up approach. and the decisions they imply are not considered explicitly once the model has been constructed. 20. Of course. net present value and market risk are ignored. product-by-product developments that are the activities that actually generate profits and growth. 21. Ideally. key concepts like incremental cash flow. 23. Pro forma financial statements (balance sheets. 286 . Often the “rules” embodied in the model are arbitrarily chosen.. such as incremental cash flow or risk. In other words. c. We expect to find such models used for homogeneous businesses. b.19. the danger is that such models lose contact with plant-by-plant. discrete investments. Most models are accounting-based and do not recognize firm value maximization as the objective of the firm. Any discussion of this topic should include the following points: a. They do not focus on the factors that directly determine firm value. however. it may be essential to forecast separately for individual divisions or projects. if the firm has diverse operations or large. which exceed the true expectations. especially where growth is rapid. It is generally easier to evaluate performance if the detail of a bottom-up model is available.

Similarly.6. are subject to the biases inherent in book profitability measures. the financial plan focuses attention on the specific targets that top management deems most important.0) = \$99.4.6 287 .6 . From Table 29. but be rescued by good luck. Manager B may make the wrong decisions. however. If no dividends are paid. 27.\$59. problems multiply as the plan attempts to track more and more detail. A completed plan sets performance targets and governs operating and investment strategies.24. but fail to meet the plan because of events beyond his control. Obviously.6 of external capital (assuming dividends of 59. several dangers. There are. we see that. Since total sources of funds equals 153. 26. b. the firm’s external financing required is: (\$158. in 2000. Moreover. therefore. not scrapped in mid-stream unless a major new problem or opportunity emerges. Managers may sacrifice the firm’s best long-term interests in order to meet the plan’s short. Manager A may make all the right decisions. 25. a. the firm requires 158. at least to some degree. hence. A financial model describes a series of relationships among financial variables. Remember that a plan is the end result of a discussion and bargaining process involving virtually all top and middle management.or medium-run targets. Given these required relationships. Completed plans are. c. The ability to meet or beat the targets embodied in a financial plan is obviously a reassuring signal of management talent and motivation.” at the level required so that the Balance Sheet and the Sources and Uses Statement are reconciled. In other words. then an equation relating borrowing to some other variable would be required. total uses of funds equals 312. called the “balancing item. it might not be possible to find a solution unless one variable is unconstrained.0). Financial plans are usually accounting-based. If dividends were made the balancing item. But keeping it up-to-date is not just a matter of mechanical updating. This allows all stated relationships to be met by setting the unconstrained variable. expensive) task to update financial plans. it may be difficult to separate performance and ability from results. and thus. it is a very time-consuming (and.

9).0 187.0 The borrowing requirement is much greater if revenues increase by 50% (\$439.8 152.8) than it is if revenues increase by 10% (\$64.0 1485.2 1485.0 2000 (+50%) 138.5 49.0 439.0 2178.5 71.0 140.8 439.8 0.1 64.0 2000 (+10%) 2420.0 55.0 55.0 605.3 166.0 193.0 193.0 43.0 540.8 25.0 990.0 550.9 0.8 2000 (+50%) 660.0 2000 (+50%) 3300.7 74.8 220.0 45.9 2000 (+10%) 484.2 55.0 205.0 152.8 632.1 1089.0 55.8 25.8 595.1 205.2 2000 (+10%) 85.0 110.8 85.0 45.0 0.0 450.9 574.28.1 44.0 275.8 1999 74.0 92.0 2970.0 889.8 38.0 51.7 42.0 632.0 825.3 127.2 64.5 53. In the following table.0 1089.0 990.5 127.0 56.0 138. long-term debt is the balancing item: Pro Forma Income Statement Revenues Costs (90% of revenues) Depreciation (10% of fixed assets at start of year) EBIT Interest (10% of long-term debt at start of year) Tax (40% of pretax profit) Net Income Operating cash flow Pro Forma Sources & Uses of Funds Sources Net Income Depreciation Operating cash flow Issues of long-term debt Issues of equity Total sources Uses Investment in net working capital Increase in fixed assets Dividends Total uses External capital required Pro Forma Balance Sheet Net working capital (20% of revenues) Net fixed assets (25% of revenues) Total net assets Long-term debt Equity Total long-term liabilities and equity 1999 2200.2 140.0 1980.0 1999 440.0 330. 288 .0 82.0 514.0 53.

3 127.3 639.0 2574.4 584.4 111. Pro Forma Income Statement Revenues Costs (90% of revenues) Depreciation (10% of fixed assets at start of year) EBIT Interest (10% of long-term debt at start of year) Tax (40% of pretax profit) Net Income Operating cash flow Pro Forma Sources & Uses of Funds Sources Net Income Depreciation Operating cash flow Issues of long-term debt Issues of equity Total sources Uses Investment in net working capital Increase in fixed assets Dividends Total uses External capital required Pro Forma Balance Sheet Net working capital (20% of revenues) Net fixed assets (25% of revenues) Total net assets Long-term debt Equity Total long-term liabilities and equity b.0 220.0 2000 2860.7 42.0 1980.6 55.6 286.5 49.6 1287.296 It would be difficult to financing continuing growth at this rate by borrowing alone. If the firm continued to expand at a 30% rate.8 1673.6 929.6 252.29.2 71.5 127.6 2000 111.8 25.8 25.5 71.6 330. then by 2009 the debt ratio would reach 84%.0 138.0 990.1 71.3 166.0 55.0 0.0 419.3 70.1 1033.0 53.2 92.8 152.1 For the year 2000.5 300.5 209.00 540.0 419.5 53.5 330.0 1287.8 38.0 990.4 2000 572. the firm’s debt ratio is: (\$1033.6 2001 138.0 252. 289 c.0 450. the firm’s debt ratio is: (\$702.4 0.0 132.5 1673.1) = 0.0 715.0 74.7 74.618 and the interest coverage ratio is: (\$300.0 3346.0 540.4/\$1287. 1999 2200.6 166.5)/\$70.1 209.0 550.3/\$1673.0 152.356 For the year 2001.9 2001 743. .0 1999 440.546 and the interest coverage ratio is: (\$231 + \$55)/\$45 = 6.0 45.0 43.0 231.3 + \$71.0 702.2 = 5.5 171.0) = 0.9 540. a.9 0.8 1999 74. The debt ratio is already very high.0 67.0 2001 3718.0 166.0 82.

0 104.0 340.0 53.0 267.0 2001 400.0 270.0 24.0 1680.0 95.0 1428.0 340.30.2 30.0 200.0 80. a.0 140.0 28.2 243.0 200.2 100.0 240.0 960.5 345.2 2002 143.0 36.3 2002 450.0 120.0 1200.3 345.0 1080. This assumption is not stated in the first printing of the seventh edition.0 1200.0 224.3 95.0 1350.0 80. [Note: the following solution is based on the assumption that working capital remains a constant proportion of fixed assets.] Pro Forma Income Statement Revenue Fixed costs Variable costs (80% of revenue) Depreciation EBIT Interest ( at 11.0 2001 120.0 60.5 102. & b.0 2002 2100.0 53.0 72.0 200.5 143.0 200.0 1350.0 80.0 80.0 100.5 50.0 290 .0 243.8%) Taxes (at 40%) Net Income Operating cash flow Pro Forma Sources & Uses of Funds Sources Net Income Depreciation Operating cash flow Issues of long-term debt Issues of equity Total sources Uses Investment in net working capital Increase in fixed assets Dividends Total uses External capital required Pro Forma Balance Sheet Net working capital Net fixed assets Total net assets Long-term debt Equity Total long-term liabilities and equity 2001 1785.0 800.0 900.

0 80.0 120. Also in the first printing.0 1200.0 1125.0 0.0 167.0 56.0 1440.31.0 80.0 2003 174.0 100.0 80. [Note: The references to the year 2007 that appear in the first printing of the seventh edition are incorrect.0 75. Table 29.0 800.0 116.0 24.0 496.0 0.0 116.0 200.0 200.0 120.0 1500. Pro Forma Income Statement Revenue Fixed costs Variable costs (80% of revenue) Depreciation EBIT Interest ( 8% of beginning-of-year debt) Taxes (at 40%) Net Income Operating cash flow Pro Forma Sources & Uses of Funds Sources Net Income Depreciation Operating cash flow Issues of long-term debt Issues of equity Total sources Uses Investment in net working capital Increase in fixed assets Dividends Total uses External capital required Pro Forma Balance Sheet Net working capital Net fixed assets Total net assets Long-term debt Equity Total long-term liabilities and equity 2002 1800. These figures should be Dividends: \$120 and Retained earnings: \$0.0 254.0 1000.0 2002 120.0 314.0 1500.0 80.0 200. the relevant year is 2003.0 900.0 254.0 280.0 80.0 2003 500.0 0.0 0.0 80.0 2002 400.0 174.] a.0 291 .0 1200.0 2003 2250.0 24.0 242.0 56.0 200.0 496.14 incorrectly states that Dividends are \$80 and Retained earnings are \$40.0 224.0 1800.0 375.0 300.

0 116.0 1500.0 1500.0 200.0 174.0 80.0 80.0 0.0 24.0 200.0 1800.0 0.250 For 2003: \$542/\$1500 = 0.0 2003 500.0 1440.0 56.0 1000.0 242.0 80.0 314.0 116.0 280.0 2002 400.0 800.0 0.0 2002 120.0 496.0 496.0 0.0 80.0 542.0 100.b. Pro Forma Income Statement Revenue Fixed costs Variable costs (80% of revenue) Depreciation EBIT Interest ( 8% of beginning-of-year debt) Taxes (at 40%) Net Income Operating cash flow Pro Forma Sources & Uses of Funds Sources Net Income Depreciation Operating cash flow Issues of long-term debt Issues of equity Total sources Uses Investment in net working capital Increase in fixed assets Dividends Total uses External capital required Pro Forma Balance Sheet Net working capital Net fixed assets Total net assets Long-term debt Equity Total long-term liabilities and equity The debt ratios are: For 2002: \$300/\$1200 = 0.0 0.0 200.0 900.0 254.0 254.0 958.0 300.0 2003 2250.0 120.0 292 .0 242.0 1200.0 80.0 80.0 2003 174.0 56.0 224.0 24.0 120.0 1200.361 2002 1800.0 200.

20 ×1. which must increase to \$350.077 = 7.000. With no new shares of stock.40 = \$220.220.115 = 11. implying required funding of \$450. a. With a growth rate of 15%.000 With no dividends. Debt must be the balancing item.5 805.0 Dividends will be: (0. total assets will increase to \$3.\$230) = \$220 b.450.40 = 0.000 × 0. Sustainabl e growth rate = 0.20 × 1.000.32.000) – (0. Sustainabl e growth rate =Plowback ratio × Return on equity = RE NI × NI Equity 33. Dividends will. 293 . Internal growth rate = retained earnings/net assets Internal growth rate = \$230/\$3000 = 0. Eagle’s Income Statement for 2003 will be: Sales Costs EBIT Taxes Net Income \$1.0 230. With a growth rate of 15% and using a tax rate of (200/700) = 28.000. and will increase by \$220 to a total value of \$1.0 = 0.0 and: c.6 × \$575) = \$345 Retained earnings will be: (0. and debt increased by \$100. Internal growth rate = retained earnings Equity = Plowback ratio × ROE × net assets Net assets Internal growth rate = 0.092. c.4 × \$575) = \$230 Thus.000 × 0. a.0 \$575.40 × 0.7% b.5% 2000 34. the plowback ratio becomes 1.6%. thus. the needed external funds will be: (\$450 . The need for external financing is equal to the increase in assets less the retained earnings: (0.08 = 8. be reduced to \$225. a.000.20 ×1.5 287.30 × 1.0% 1. the only other source of the additional \$120 is retained earnings.000 b.4 × 575 = 0.

20 = 20.000 ×1.000 d. Retained earnings will now be \$200.000. 294 .0% 1.000. Clearly.Internal growth rate = 0. the greater the need for external financing. the more generous the dividend policy (i.20 ×1.000 and the need for external funds is reduced to \$100.0 = 0..e.000. the higher the payout ratio).

in effect. Because both current assets and current liabilities are. [It may be of interest to note here that some companies (e. If the debt has a longer maturity. shortterm accounts. deferred taxes. All of these accounts represent long-term obligations of the firm.g. Disney) have recently issued debt with a maturity of 100 years. and the unfunded pension liability) are included in the calculation would depend on the time horizon of interest. a senior obligation.. then they should not be included because the debt is. the key question is: What is the maturity of this debt relative to the obligations represented by these accounts? If the debt has a shorter maturity. then they should be included.Challenge Questions 1. R&R reserve.) 2. Whether or not the other accounts (i. Internet exercise. Having done this..e. answers will vary. If the goal is to evaluate the safety of Geomorph’s debt. ‘netting’ them out against each other and then calculating the ratio in terms of total capitalization is preferable when evaluating the safety of long-term debt. 295 . the bank loan would not be included in debt. by definition.

assume all expenses are for cash. February Sources of cash Collections on cash sales Collections on A/R Total sources of cash Uses of cash Payments on A/P Cash purchases of materials Other expenses Capital expenditures Taxes. Unless otherwise stated in the problem. \$100 90 190 30 70 30 100 10 240 -50 100 -50 50 100 \$50 March \$110 100 210 40 80 30 0 10 160 50 50 50 100 100 \$0 April \$90 110 200 30 60 30 0 10 130 70 100 70 170 100 \$0 30-Day Delay: This quarter it will pay 1/3 of last quarter’s purchases and 2/3 of this quarter’s. dividends Total uses of cash Net cash inflow Cash at start of period + Net cash inflow = Cash at end of period + Minimum operating cash balance = Cumulative short-term financing required 2. interest. 296 .CHAPTER 30 Short-term Financial Planning Answers to Practice Questions 1. 60-Day Delay: This quarter it will pay 2/3 of last quarter’s purchases and 1/3 of this quarter’s.

however. net new borrowing. c. that if any of these events were unforeseen.) 4. b. Rise in interest rates: Interest payments on bank loan and interest on marketable securities Interest on late payments: Stretching payables. (Bear in mind. which is constructed well in advance of the beginning of the first quarter. they would not appear in the financial plan. Sources and Uses of Cash: Sources Sold marketable securities Increased bank loans Increased accounts payable Cash from operations: Net income Depreciation Total sources Uses Increased inventories Increased accounts receivable Invested in fixed assets Dividend Total uses Increase in cash balance Sources and Uses of Funds: Sources Cash from operations Net income Depreciation Total sources Uses Invested in fixed assets Dividend Total uses Increase in net working capital 6 1 7 1 6 3 6 1 16 0 2 1 5 6 2 16 6 2 8 297 . a. Underpayment of taxes: Cash required for operations.3.

Stretching payables 6.00 0.41 0.00 16.23 -24.00 46.00 16. Total 7.59 7. Stretching payables 3.50 0. Net new borrowing 41. Net interest paid 15.00 0.10 0.00 16.10 1.23 Fourth Quarter 0. Interest on securities sold 14.50 0. Stretching payables 13.14 Third Quarter 0.64 24. Bank loan 12.23 1.00 0. Cash required for operations 16. The new plan is shown below: First Quarter New borrowing: 1.00 0. Total cash raised Interest payments: 11.00 -24. Total Repayments: 4.5.00 16.06 8.04 0.43 0.64 16.00 -34.50 Second Quarter 8.94 -35. Less securities bought 10.00 41.00 0.00 0.00 0.00 0.50 0.00 0.84 0. Total cash required 298 .00 0.14 0.14 1.41 0.00 0.00 46. Plus securities sold 9.50 7.41 -33.14 15.50 46.00 41.06 0. Bank loan 2. Bank loan 5.00 33.00 0.00 -24.78 -26.00 0.00 33.14 0.00 0.23 0.00 0.00 0.00 0.10 1.25 0.65 -34.50 5.

5 -29.5 Calculation of short-term financing requirement 1. Change in cash balance -18.5 5.uses 85.0 2.0 1. other Capital expenditures Lease Taxes.0 financing required. dividends Total uses Sources .0 4. Cumulative short-term 18.0 34.5 Third Quarter 108.5 24.0 30. Cash at start of period 5.0 0. First Quarter Sources of cash: Collections on A/R Other Total sources Uses of cash: Payments on A/P Labor.0 -23.0 1.0 2. interest.0 3.0 30. operating cash bal.0 94.0 65.5 4.5 33.0 -16.0 80.5 28.5 1. 299 .5 -5.8 -16.0 Fourth Quarter 128.0 33. Cash at end of period -13.0 55.0 128.3 60.0 85.0 8.0 30.5 -13.0 0. 5. Min.0 96.5 5.0 5. administrative.5 5.3 1.0 30.3 0.0 5.0 103.5 24.0 Second Quarter 80.6.0 5.0 -18.0 10.5 -29.5 1.5 -5.5 12.5 96.5 121.5 4.0 50.5 4.

81 0.81 -22.00 0.00 0.00 0.50 16.00 0. Total cash required 300 .28 -33.10 1. Net interest paid 16.00 13.10 -33.00 18.12 0.43 16.00 0.00 16.00 0.00 5.00 0. Stretching payables 14.00 Second Quarter 16.50 -22.00 0.00 16.22 8.93 0.18 0. Total 7.00 18.93 0.00 22.00 0. Total Repayments: 4.00 0.81 Fourth Quarter 0.12 0.33 0.93 0.00 0.00 22.10 0.81 0.00 0. Net new borrowing 13.First Quarter New borrowing: 1.00 0.00 -22. Stretching payables 3.50 -33.00 0.75 0.85 0.93 Third Quarter 0.00 0. Bank loan 12.00 0.00 18. Less securities bought 10. Total cash raised Interest payments: 11. Interest on securities sold 14.10 0. Stretching payables 6. Bank loan 2. Cash required for operations 16.00 13.00 0. Bank loan 5.69 -24.00 7.00 0.00 0.12 -7.00 26.00 7.00 16.81 0.22 0. Plus securities sold 9.93 0.

e. because it will depreciate quickly. a half-completed luxury yacht – The lender might require the builder to find a committed buyer for the yacht. d ⇒ an inventory of 15. Newspaper exercise.000 cases of Beaujolais Nouveau. a⇒ b⇒ c⇒ d⇒ e⇒ f ⇒ g⇒ h⇒ i ⇒ a tanker load of fuel in transit from the Middle East – The lender would require a bill of lading. because it might depreciate quickly and be difficult to value.000 cases of Beaujolais Nouveau – Might be good collateral for a short-term loan.000 used books. an inventory of 15. i ⇒ a half-completed luxury yacht. answers will vary depending on time period. The following assets are most likely to be good collateral: a ⇒ a tanker load of fuel in transit from the Middle East c ⇒ an account receivable for office supplies sold to the City of New York g ⇒ 100 ounces of gold h ⇒ a portfolio of Treasury bills The following assets are likely to be bad collateral: b ⇒ 1.7. f ⇒ electric typewriters. and would lend only a fraction of the current market value. e ⇒ a boxcar full of bananas. The shorter the term of the loan. because these are difficult to value. a boxcar full of bananas – Might be collateral for a very short-term loan. a portfolio of Treasury bills – The lender would want to hold the Treasury bills. well-known firm. so that the lender does not require collateral and 301 .000 used books – The lender would have to be able to validate the condition and the value of the books. 100 ounces of gold – The bank would require that the gold be held by another financial institution. because it has little value unless completed. electric typewriters – A floor-planning arrangement might be arranged. 8. because they are obsolete. 9. 1. 10. It pays to eliminate the middleman (i.. the bank) when the borrower is a larger. an account receivable for office supplies sold to the City of New York – The lender might require the borrower to obtain credit insurance. the higher the fraction would be.

Internet exercise. and so you would have to compete with finance companies. the scenario described in the question is what finance companies do. which is another way of saying that the profit margins will be very thin and. banks have come under increasing pressure in recent years from the commercial paper market. and have shown a willingness to lower their rates in order to remain competitive. Note that the cost of commercial paper includes the dealer’s commission plus the cost of a stand-by line of credit. Note also that companies may wish to maintain a relationship with the bank in order to be able to obtain other services from the bank. answers will vary. and to ensure a source of funds if commercial paper is no longer a feasible alternative source of financing. First. There are several factors to be considered. 12. answers will vary.11. Therefore. 14. the competition would be intense. perhaps. negative for a new firm. does not incur costs of credit appraisal. Internet exercise. Second. Internet exercise. answers will vary. 302 . 13.

000 × [(1.000.013) – 1] = \$60. however.147. the real interest rate may actually be more certain with successive short-term loans.100.5) – 1] = \$10.000. Axle Chemical’s expected requirement for short-term financing is: (0.000 If Axle Chemical takes out a 90-day unsecured loan for \$2 million.\$1.541 = \$37. This is necessary only once with the longer-term loan.602 Under this arrangement.458 If Axle Chemical uses the credit line.606 + \$16.000 × [(1. then the interest paid at the end of the 90 days is: \$2.602 .000 = \$900. the expected net cost of borrowing is: \$60. Also.000 × [(1.000) = \$1. the average maturity of the loan is 1.5) – 1] = \$16.\$10.00751.Challenge Questions 1.5 months at a 9% annual rate. for total interest of: \$900.011. then the future value of the \$20.3 × \$2.000) + (0. Lenders are more likely to accept such terms if they are not locked into them for a long time.100. long-term lending may carry a higher expected real interest rate if lenders are concerned about uncertain future inflation. The credit line has the lower expected cost. in time and money. Another problem is the cost.000. it is possible to have non-standard terms in the loan contract. Most firms prefer a known stream of payments.013 = \$20. One of the disadvantages of this sort of short-term borrowing is the uncertainty it creates about future interest payments.5 months and the expected interest cost is: \$1. 2. Just as with privately placed debt.000 commitment fee is: \$20.5 × \$1.144 = \$50. There is one advantage to frequent renegotiations. the expected cash surplus is: \$2.000.606 Assuming that the cash requirement accumulates steadily during the quarter.000 × 1.000 This surplus will earn interest for an average period of 1.000 .541 The total cost of the credit line is therefore: \$20.100.144 Therefore. 303 . of having to renegotiate the loan every period.2 × \$0) + (0. However.

that is. commercial paper became very expensive. 304 . it might make sense to borrow at a floating rate. during the Russian crisis in 1998.3. • The floating rate loan from the bank appears to be cheaper than the 11% fixed rate loan from the insurance company. if the firm’s income is positively related to interest rate levels. liquidity in the commercial paper market varies over time. The main points to be considered are: • The commercial paper is cheaper than the bank loan (9% compared to 10%). which will increase its cost. but it is important to remember that the difference between fixed and floating rates may indicate an expectation of a rate rise. its cost of debt service is also low. Also. For example. Large firms with good credit ratings can usually reduce the cost of credit by not borrowing from a bank. It is also important to note that the commercial paper will need to be backed by a line of credit. but commercial paper can be very expensive for companies with poor credit ratings. The advantage of the bank loan is that the company is sure of the availability of the money for five years and is also certain regarding the margin above the prime rate. when the firm’s income is low. That is acceptable as long as the firm’s credit rating remains good. • The choice between the fixed-rate and the floating-rate loans may also depend on whether one or the other better hedges the firm’s exposure to interest rates. For example. and may even dry up entirely. • On the other hand. the firm will need to roll over the commercial paper ten times.

and the cash is available the same day.000 = \$300. then Knob gains by increasing average balances by \$1.000 + \$45. or \$220. Thus.500.000 At an annual rate of 6%. The cost of the new system is \$100.80 plus the loss of interest for three days. The cost of the old system is \$40. (Or.000 per day.5 million.12 = \$180. we find the minimum amount transferred is \$9.000.000.000 – \$60.12 × (3/365) × (amount transferred)] Setting this equal to \$10 and solving. The cost is \$20. or: 0. The lock-box will collect an average of (\$300.000 = \$215. Knob collects \$180 million per year. 5.000 – \$450. the company does not need to keep extra cash in the account to cover contingencies. Reducing the availability float to one day means a gain of: 2 × \$150.000 Net float = \$500. which is \$300. it is the present value of a perpetuity of \$18.000).5 million per day. The cost of a wire transfer is \$10. the company gains several days of additional float.000 Availability float = 3 × \$150.000 = \$15. Knob will save \$120. Therefore.000 c.000 = \$500.000 plus the opportunity cost of the extra float required (\$180.5 million. 4.000.000 = \$450.) 2. which equals \$60.06 × \$300. or (assuming 360 days per year) \$0. The line of credit can be reduced by \$1. Because the bank can forecast early in the day how much money will be paid out.000 b.000 per year. a.000.000 b.000. a.000 per year at an interest rate of 6% per year.000 – \$20.000 . a.000 The present value of these savings is the initial gain of \$300.000.328. but the benefit is \$30.000/30) = \$10.000 = \$50. 6.000 3. the annual savings will be: 0. a. Ledger balance = starting balance – payments + deposits Ledger balance = \$250. for savings per year of: 1. The payment float is the outstanding total of (uncashed) checks written by the firm. The money will be available three days earlier so this will increase the cash available to JAC by \$30.000. 305 . If the float is reduced by three days. The cost of a check is \$0. The net float is: \$60. since zero-balance accounts are not held in a major banking center. if you prefer.\$45.CHAPTER 31 Cash Management Answers to Practice Questions 1. Payment float = 5 × \$100. c. b.80 + [0.000 × 0. Also.000 per year by switching to the new system.000 = \$18. JAC will be better off accepting the compensating balance offer.

there are 852 days (365 + 365 + 30 + 31 +30 + 31). and so here we need to know the interest rate.467. the compensating balance arrangement is less costly. In part (b). The interest foregone by holding the compensating balance is compared to the cost of processing checks. Then.06/12) These costs are equal if x = \$300. one cost is compared to another. Let x equal the average check size for break-even. In part (a). if the average check size is greater than \$300. per day. paying per check is less costly. we compare available dollar balances: the amount made available to JAC compared to the amount required for the compensating balance. The monthly cost is the lost interest. In the 28-month period encompassing September 1976 through December 1978.000) (0. which is equal to: (20. if the average check size is less than \$300.000/x) and the monthly cost of the lock-box is: (300. the number of checks written per month is (300.10) The alternative is the compensating balance of \$20. Merrill Lynch disbursed: \$1. Thus. 7.b.000 306 .000/852 = \$1. c. a. Thus.000.250.000/x) (0.000.

d. The optimal amount to transfer is: Q = [(2 × 100.5 × \$1. An increase in interest rates should decrease cash balances.083 per check.500 The gain per day to Merrill Lynch was: 1.4) = \$1.b.000/14. The problem here is a straightforward application of the Baumol model.142 This implies that the average number of transfers per month is: 100.000 × [1. An increase in transaction costs should increase cash balances and decrease the number of transactions.08(1.08(28/12)] = \$361.000 × 10)/(0.5/365) . Firms may choose to pay by check because of the float available. 10.500 × (1. Remote disbursement delayed the payment of: 1. 9.08(28/12) – 1)]/[1.4 checks per day Therefore. remote disbursement shifted the stream of payments back by 1½ days. 307 .1] = \$464 Merrill Lynch writes (365.01)]1/2 = \$14.142 = 7. At an annual interest rate of 8%. a.500 That is.07 This represents approximately one transfer every four days. the present value of the gain to Merrill Lynch was: PV = [2. Also. A decrease in volatility of daily cash flow should decrease cash balances.000/852