Case Solutions

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

CHAPTER 1 THE McGEE CAKE COMPANY
1. The advantages to a LLC are: 1) Reduction of personal liability. A sole proprietor has unlimited liability, which can include the potential loss of all personal assets. 2) Taxes. Forming an LLC may mean that more expenses can be considered business expenses and be deducted from the company’s income. 3) Improved credibility. The business may have increased credibility in the business world compared to a sole proprietorship. 4) Ability to attract investment. Corporations, even LLCs, can raise capital through the sale of equity. 5) Continuous life. Sole proprietorships have a limited life, while corporations have a potentially perpetual life. 6) Transfer of ownership. It is easier to transfer ownership in a corporation through the sale of stock. The biggest disadvantage is the potential cost, although the cost of forming a LLC can be relatively small. There are also other potential costs, including more expansive record-keeping. 2. 3. Forming a corporation has the same advantages as forming a LLC, but the costs are likely to be higher. As a small company, changing to a LLC is probably the most advantageous decision at the current time. If the company grows, and Doc and Lyn are willing to sell more equity ownership, the company can reorganize as a corporation at a later date. Additionally, forming a LLC is likely to be less expensive than forming a corporation.

CHAPTER 2 CASH FLOWS AND FINANCIAL STATEMENTS AT SUNSET BOARDS
Below are the financial statements that you are asked to prepare. 1. The income statement for each year will look like this: Income statement 2008 Sales Cost of goods sold Selling & administrative Depreciation EBIT Interest EBT Taxes Net income Dividends Addition to retained earnings 2. The balance sheet for each year will be: Balance sheet as of Dec. 31, 2008 $18,187 Accounts payable 12,887 Notes payable 27,119 Current liabilities $58,193 Long-term debt $156,975 Owners' equity $215,168 Total liab. & equity

2009

$247,259 126,038 24,787 35,581 $60,853 7,735 $53,118 10,624 $42,494
$21,247 21,247

$301,392 159,143 32,352 40,217 $69,680 8,866 $60,814 12,163 $48,651
$24,326 24,326

Cash Accounts receivable Inventory Current assets Net fixed assets Total assets

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

In the first year, equity is not given. Therefore, we must calculate equity as a plug variable. Since total liabilities & equity is equal to total assets, equity can be calculated as:

C-2 CASE SOLUTIONS Equity = $215,168 – 46,794 – 79,235 Equity = $89,139

065 $272.478 Accounts payable 16.680 + 40.734 4. To calculate the cash flow from assets. 2009 $27.217 – 12.404 15. The capital spending for the year was: Capital spending Ending net fixed assets – Beginning net fixed assets + Depreciation Net capital spending $191.399 $17.401 $91.217 $74. & equity $36.717 Notes payable 37.180 OCF2009 = $69. Using the OCF equation: OCF = EBIT + Depreciation – Taxes The OCF for each year is: OCF2008 = $60.661 Total liab. so: Equity = $89. plus the addition to retained earnings.411 Long-term debt $191.250 156.163 OCF2009 = $97.853 + 35. we need to find the capital spending and change in net working capital.997 $52.010 11.065 3.581 – 10.624 OCF2008 = $85.326 + 15.216 Current liabilities $81.250 Owners' equity $272.600 Equity = $129.CHAPTER 2 C-3 Cash Accounts receivable Inventory Current assets Net fixed assets Total assets Balance sheet as of Dec. 31.611 .139 + 24.492 And the change in net working capital was: Change in net working capital Ending NWC – Beginning NWC Change in NWC $29. plus the new equity.661 The owner’s equity for 2009 is the beginning of year owner’s equity.975 40.195 129.

094 $24. and why the company is spending so much in this area already.492 in new fixed assets. The cash flow to stockholders was: Cash flow to stockholders Dividends paid – Net new equity raised Cash flow to stockholders Answers to questions 1.600 $8. the cash flow from assets was: Cash flow from assets Operating cash flow – Net capital spending – Change in NWC Cash flow from assets 5. The company does have a positive cash flow.631 to its stakeholders. you would want to know where the current capital spending is going. The company has had to raise capital from creditors and stockholders for its current operations. companies do need capital to grow.326 15.C-4 CASE SOLUTIONS So. The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm gave $5.611 in new net working capital and $74.726 to stockholders.734 74.960 –$3. So. 2. and paid $8. but a large portion of the operating cash flow is already going to capital spending. On the other hand. The firm invested $17. the expansion plans may be too aggressive at this time.866 11. $97.726 . Before investing or loaning the company money.492 17.094 from bondholders. The cash flow to creditors was: Cash flow to creditors Interest paid – Net new borrowing Cash flow to creditors 6. The expansion plans may be a little risky. It raised $3.631 $8.611 $ 5.

308.660 / $478.452 / $18.920 – 10.920 Total debt ratio = 0.520 / $2.000 Cash ratio = 0.420 Profit margin = 5.366.920 Return on assets = 8.250 – 1. The calculations for the ratios listed are: Current ratio = $2.919.39 times Cash ratio = $441.75 times Quick ratio = ($2.240 Times interest earned = 6.920 Equity multiplier = 1.308.000 / $2.000) / $10.537.186.499.069.069.040.452 / $30.22 times Profit margin = $1.580 / $1.000 Quick ratio = 0.43 times Receivables turnover = $30.82 times Times interest earned = $3.000 Current ratio = 0.000 + 5.400 Receivables turnover = 43.186.420 / $708.120 Inventory turnover = 21.069.919.040.CHAPTER 3 RATIOS ANALYSIS AT S&S AIR 1.36 times Cash coverage = ($3.037.920) / $18.308.224.308.920 Debt-equity ratio = 0.15 times Total asset turnover = $30.45 times Debt-equity ratio = ($2.308.920 Total asset turnover = 1.920 / $10.420 / $18.499.420 Cash coverage = 9.919.660 + 1.320.680) / $478.40% .05 times Total debt ratio = ($18.919.120) / $2.67 times Inventory turnover = $22.537.82 times Equity multiplier = $18.04% Return on assets = $1.037.499.

920 Return on equity = 15.069.452 / $10.27% .537.C-6 CASE SOLUTIONS Return on equity = $1.

while the quick ratio is above the industry median. This may mean that S&S Air is more efficient than the industry. Even though both companies manufacture airplanes. S&S Air manufactures small airplanes. S&S Air generally has less debt than comparable companies. Additionally. in fact. military. freight. as well as Boeing Capital. It may be a good aspirant company. both ratios are above the lower quartile. Cirrus is the world's second largest manufacturer of single-engine. The company produces business jets. This implies the company has less liquidity than the industry in general. and ROE are all slightly below the industry median. Bombardier and Embraer are probably not good aspirant companies because of the diverse range of products and manufacture of larger aircraft. S&S Air would have a ratio that is lower than the industry median. so there are companies in the industry with lower liquidity ratios than S&S Air. These are two different markets. The company may want to examine its costs structure to determine if costs can be reduced. piston-powered aircraft. Embraer is a Brazilian manufacturer than manufactures commercial. but more accounts receivable than the industry since the cash ratio is lower than the industry median. Its SR22 is the world's best selling plane in its class. The turnover ratios are all higher than the industry median. its products could be considered too broad and diversified since S&S Air produces only small personal airplanes. The financial leverage ratios are all below the industry median. not dramatically lower. The company may have more predictable cash flows. Bombardier is a Canadian company that builds business jets. commercial aircraft. or price can be increased. Boeing is heavily involved in the defense industry. It is the third largest commercial aircraft manufacturer in the world. but still within the normal range. Boeing is probably not a good aspirant company. The company is noted for its innovative small aircraft and is a good aspirant company. S&S is below the median industry ratios for the current and cash ratios. 3. S&S Air has less inventory than the industry median. S&S Air’s performance seems good. The current ratio is below the industry median.CHAPTER 3 C-7 2. Overall. Additionally. however. all three turnover ratios are above the upper quartile. the Brazilian government is a part owner of the company. The profit margin. however. Cessna is a well known manufacturer of small airplanes. while Boeing manufactures large. ROA. personal and small-business single engine pistons. or more access to short-term borrowing. and corporate airplanes. although the liquidity ratios indicate that a closer look may be needed in this area. . short-range airliners and fire-fighting amphibious aircraft and also provides defense-related services. which finances airplanes. but above the lower quartile.and passenger-hauling utility Caravans. This implies that S&S Air has less inventory to current liabilities than the industry median. However. If you created an Inventory to Current liabilities ratio.

Company may have newer assets than the industry. Better at managing current accounts. The PM is slightly below the industry median. Increasing the amount of debt can increase shareholder returns. Increasing the amount of debt can increase shareholder returns. Increasing the amount of debt can increase shareholder returns. Assets may be older and depreciated. Higher quality materials could be increasing costs. Less debt than industry median means the company is less likely to experience credit problems. Especially notice that it will increase ROE. Better at inventory management. Profit margin and EM are lower than industry. May have credit terms that are too strict. Bad May be having liquidity problems. Ratio Current ratio Quick ratio Cash ratio Total asset turnover Inventory turnover Receivables turnover Total debt ratio Good Better at managing current accounts. Company may have newer assets than the industry. but merely one possible explanation for each ratio. which results in the lower ROE. Especially notice that it will increase ROE. possibly due to better procedures. Could be experiencing inventory shortages. The company may have more difficulty meeting interest payments in a downturn. Increasing the amount of debt can increase shareholder returns. Better at managing current accounts. It could be a result of higher quality materials or better manufacturing. Especially notice that it will increase ROE. Debt-equity ratio Equity multiplier TIE Cash coverage Profit margin ROA ROE . Less debt than industry median means the company is less likely to experience credit problems. requiring extensive investment soon. Note that the list is not exhaustive. May be having liquidity problems.C-8 CASE SOLUTIONS Below is a list of possible reasons it may be good or bad that each ratio is higher or lower than the industry. Company may be having trouble controlling costs. Decreasing receivables turnover may increase sales. Better at utilizing assets. Less debt than industry median means the company is less likely to experience credit problems. Better at collecting receivables. May be having liquidity problems. Especially notice that it will increase ROE. Lower profit margin may be a result of higher quality. Less debt than industry median means the company is less likely to experience credit problems.

which is: ROE = NI / TE ROE = $1.27% Using the retention ratio we previously calculated.920 ROA = .64 Now we can use the internal growth rate equation to get: Internal growth rate = (ROA × b) / [1 – (ROA × b)] Internal growth rate = [0.0564 or 5. .069.0840 or 8.64)] Sustainable growth rate = .0840(. To calculate the internal growth rate.452 / $1.1075 or 10. the sustainable growth rate is: Sustainable growth rate = (ROE × b) / [1 – (ROE × b)] Sustainable growth rate = [0. we first need to find the ROA and the retention ratio.537.75% The internal growth rate is the growth rate the company can achieve with no outside financing of any sort.64)] / [1 – 0.64% To find the sustainable growth rate.920 ROE = .40% b = Addition to RE / NI b = $977. The sustainable growth rate is the growth rate the company can achieve by raising outside debt based on its retained earnings and current capital structure.537.537.452 / $10.309.452 b = 0.64)] Internal growth rate = .1527 or 15.1527(. so: ROA = NI / TA ROA = $1.64)] / [1 – 0. we need the ROE.CHAPTER 4 PLANNING FOR GROWTH AT S&S AIR 1.0840(.452 / $18.1527(.

236.179. as long as the company increases the profit margin.057. Inventory Total CA $ 493.530 4.117 $ 11.193 The company can grow at this rate by changing the way it operates.320.902 Liabilities & Equity Current Liabilities Accounts Payable $ Notes Payable Total CL $ Long-term debt Shareholder Equity Common stock Retained earnings Total Equity Total L&E $ 995.583 1.117 $ 19.600 1. say by reducing costs. the higher growth rate is possible.000 10.331.797 EFN = $911.899.159.574 $ 2. Note however.448. that changing any one of these will have the effect of changing the pro forma financial statements.520 $ 1.594.091. total asset turnover.854.408 1.891.030. For example. the EFN is: $ 18.990 350. Pro forma financial statements for next year at a 12 percent growth rate are: Income statement Sales COGS Other expenses Depreciation EBIT Interest Taxable income Taxes (40%) Net income Dividends Add to RE $ 34.505.301 1. the ROE increases.C-10 CASE SOLUTIONS 2. if profit margin increases.240 $ 3.787 EFN = Total assets – Total liabilities and equity EFN = $20.161.505.366. it will increase the sustainable growth rate.680 5.000 3.990 – 19.025.594.541 478.780 $ 675.350 24.249. or equity multiplier.680 2.088 $ 20. In general.569. .197 Balance sheet Assets Current Assets Cash Accounts rec.000 $ Fixed assets Net PP&E Total Assets So.680 $ 3.920 793.

48% The new level of fixed assets with the $5 million purchase will be: New fixed assets = $16.667. The depreciation as a percentage of assets this year was: Depreciation percentage = $1. We will assume that the company will go ahead with the fixed asset acquisition.366.122.000.122.530 4.519 .456 1.0848($21.0848 or 8.CHAPTER 4 C-11 3. the pro forma income statement will be: Income statement Sales COGS Other expenses Depreciation EBIT Interest Taxable income Taxes (40%) Net income Dividends Add to RE $ 34. To estimate the new depreciation charge.350 24.066.696 478.600. Now we are assuming the company can only build in amounts of $5 million.400) Pro forma depreciation = $1.331.400 So.240 $ 2. the pro forma depreciation will be: Pro forma depreciation = . then.159.122.017.790. So.955 1.600 1.000 = $21. apply this percentage to the new fixed assets.790.400 + 5.525 We will use this amount in the pro forma income statement.680 / $16.122.400 Depreciation percentage = .891. we will find the current depreciation as a percentage of fixed assets.982 $ 1.525 $ 3.473 $ 582.145.

680 2.C-12 CASE SOLUTIONS The pro forma balance sheet will remain the same except for the fixed asset and equity accounts. rather than the growth rate of sales.571.000 $ Fixed assets Net PP&E Total Assets So.184 Since the fixed assets have increased at a faster percentage than sales.025. The fixed asset account will increase by $5 million. the capacity utilization for next year will decrease.408 1.581.448. Balance sheet Assets Current Assets Cash Accounts rec.000 10.000 3.119 EFN = Total assets – Total liabilities and equity EFN = $23.920 793.737. the EFN is: $ 21.302 – 19.400 $ 23.574 $ 2. . Inventory Total CA $ 493.439 $ 11.030.902 Liabilities & Equity Current Liabilities Accounts Payable $ Notes Payable Total CL $ Long-term debt Shareholder Equity Common stock Retained earnings Total Equity Total L&E $ 995.439 $ 19.433.302 350.320.087.122.119 EFN = $4.138.433.680 5.161.

700 / (1. he may be less inclined to return for an MBA since his family may be less amenable to the time and money constraints imposed by classes. We need to find the aftertax value of each.065)/(1 + .31) / 1.00 Salary: PV of aftertax bonus paid in 2 years = $15.17 Aftertax salary = $98.000 + 2.0652 = $9.125. Perry MBA.26) = $40. He has three choices: remain at his current job.065 – .000(1 – . job satisfaction.000(1 – . Other factors would include his willingness and desire to pursue an MBA. In this analysis. With a spouse and/or children.620 2.34 Wilton MBA: Costs: Total direct costs = $63. so: Remain at current job: Aftertax salary = $55.700(1 + . the more time there is for the (hopefully) increased salary to offset the cost of the decision to return to school for an MBA.065) = $132. as well as the opportunity cost of the lost salary. The younger an individual is.500 + 3.176. Perhaps the most important nonquantifiable factors would be whether or not he is married and if he has any children.227.500 PV of direct costs = $68. .500 + 68. room and board costs are irrelevant since presumably they will be the same whether he attends college or keeps his current job.31) = $67. pursue a Wilton MBA.000(1 – . 3.700{[1 – [(1 +. or pursue a Mt.819.CHAPTER 6 THE MBA DECISION 1.000 = $68.03)]38} / (.03) / (1 + .03) PV = $836. and how important the prestige of a job is to him.065) + $40. so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $40. Age is obviously an important factor.065)2 = $75.25 PV of indirect costs (lost salary) = $40.500 / (1. regardless of the salary.700 His salary will grow at 3 percent per year. The cost includes both the explicit costs such as tuition.

04)]36} / (.174.035)]37} / (.035) PV = $1.510 His salary will grow at 3.17 + 1.663.67 + 1.370.160 – 132.22 / 1.0652 PV = $1.544.620{[1 – [(1 +. We must also remember that he will now only work for 36 years.215.991.819.29) / 1.065 = $6.813.174.5 percent per year.000 = $86.96 Salary: PV of aftertax bonus paid in 1 year = $10. so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $57. the total value of a Wilton MBA is: Value = –$75. this is also the PV of the direct costs since they are all paid today.96 + 6. PV of indirect costs (lost salary) = $40.065)/(1 + .22 Since the first salary payment will be received three years from today.81 / 1.065 – .666.67 Aftertax salary = $81.991.20 So.250.065 – .C-14 CASE SOLUTIONS His salary will grow at 4 percent per year. so we need to discount this for two years to find the value today.683.590.056.640.171.683.510{[1 – [(1 +.26 So.29) = $57. which will be: PV = $1.065)/(1 + .81 Since the first salary payment will be received two years from today.666.125.500 – 38. the total value of a Mount Perry MBA is: Value = –$86.500 + 3.500. We must also remember that he will now only work for 37 years.20 = $1.000 + 3. so we need to discount this for one year to find the value today.663.370.26 = $1.215. which will be: PV = $1.000(1 – . Note.065 PV = $1.18 Mount Perry MBA: Costs: Total direct costs = $78.554.640.90 . so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $67.700 / (1.250.000(1 – .065) = $38.04) PV = $1.25 + 9.

00 – 9.227. not the source of the funds.04) C = $45. the pretax salary must be: Pretax salary = $45. we need to take the PV of his current job.248. the necessary PV to make the Wilton MBA the same as his current job will be: PV = $836. However.34 + 132.065 – . Since his salary will still be a growing annuity.42 = C {[1 – [(1 +. Thus.035.819.31) = $65.04)]36} / (.097.065)/(1 + .51 This is the aftertax salary.125.176. 5. a future value analysis will result in the same decision. To find the salary offer he would need to make the Wilton MBA as financially attractive as the as the current job.035. So. add the costs of attending Wilton. whether he can pay cash or must borrow is irrelevant. This is an important concept which will be discussed further in capital budgeting and the cost of capital in later chapters.51 / (1 – . Calculating the future value of each decision will result in the option with the highest present value having the highest future value.021. The cost (interest rate) of the decision depends on the riskiness of the use of funds. He is somewhat correct. the aftertax salary needed is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] $1. and the PV of the bonus on an aftertax basis. his statement that a future value analysis is the correct method is wrong since a present value analysis will give the correct answer as well. Therefore.25 + 75.CHAPTER 6 C-15 4.57 6. So.17 = $1.42 This PV will make his current job exactly equal to the Wilton MBA on a financial basis. .021.097.

that is. The more senior the bond is. If we compare this to a bond with a specific call price. investors rarely receive the full market value of the future cash flows. 2. which they can reinvest in another bond with similar characteristics. Since the bondholders are made whole. the lower the coupon rate. yet the company is unable to do so. Collateral provides an asset that bondholders can claim. This offers the bondholders protection for this period. If a bond with a make-whole provision is called. they should be indifferent between a plain vanilla bond and a make-whole bond. bondholders receive the market value of the bond. A provision with a specific call date and prices would increase the coupon rate. the bond will have a higher coupon rate. A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. A make-whole call provision should lower the coupon rate in comparison to a call provision with specific dates since the make-whole call repays the bondholder the present value of the future cash flows. . Senior bonds get full payment in bankruptcy proceedings before subordinated bonds receive any payment. which lowers their risk in default. the bond will have a lower coupon rate. The call provision would only be used when it is to the company’s advantage. A potential problem may arise in that the bond covenant may restrict the company from issuing any future bonds senior to the current bonds. If the company benefits. Bondholders have the claim on the collateral. However. Interest rates could potentially fall to the point where it would be beneficial for the company to call the bond. a make-whole call provision should not affect the coupon rate in comparison to a plain vanilla bond. 4. The company benefits by being able to refinance at a lower rate if interest rates fall significantly. even in bankruptcy. The deferred call means that the company cannot call the bond for a specified period. 1. The bond will still have a higher rate relative to a plain vanilla bond.CHAPTER 7 FINANCING S&S AIR’S EXPANSION PLANS WITH A BOND ISSUE A rule of thumb with bond provisions is to determine who benefits by the provision. and they will generally have to keep the asset in good working order. 5. A bond with collateral will have a lower coupon rate. The downside of collateral is that the company generally cannot sell the asset used as collateral. enough to offset the call provision cost. The downside is the higher coupon rate. thus the bondholder’s disadvantage. The problem with a sinking fund is that the company must make the interim payments into a sinking fund or face default. 3. The disadvantage of a deferred call is that the company cannot call the bond during the call protection period. A deferred call would reduce the coupon rate relative to a call provision with a deferred call. If the bondholders benefit. 6. This means the company must be able to generate these cash flows.

CHAPTER 7 C-17 .

This says nothing about bondholders. 10. A positive covenant would reduce the coupon rate. However.CASE 3 C-18 7. the company must maintain a minimum specified level of working capital or a minimum specified current ratio. The presence of negative covenants protects bondholders from actions by the company that would harm the bondholders. The positive covenant may force the company into actions in the future that it would rather not undertake. A negative covenant would reduce the coupon rate. The downside of a floating-rate coupon is that if interest rates rise. The conversion feature would permit bondholders to benefit if the company does well and also goes public. the company has to pay a higher interest rate. The negative side of positive covenants is that the company is restricted in its actions. or at least increase beyond a specified level. the company pays a lower interest rate. the goal of a corporation is to maximize shareholder wealth. The presence of positive covenants protects bondholders by forcing the company to undertake actions that benefit bondholders. the company cannot sell any collateral. Even though the company is not public. Examples of positive covenants would be: the company must maintain audited financial statements. if interest rates fall. The downside of negative covenants is the restriction of the company’s actions. the company must maintain any collateral in good working order. 9. a conversion feature would likely lower the coupon rate. the company cannot issue new bonds senior to the current bond issue. Remember. 8. . Examples of negative covenants would be: the company cannot increase dividends. The downside is that the company may be selling equity at a discounted price.

72) = . we need to recalculate the industry EPS.08 Using this industry EPS.000 This means the payout ratio was: Payout ratio = $126.000 D0 = $1.54) = $454.000 / 50. So. The total dividends paid by the company were $126.85% .6285 or 62.28 = 0.28 So.3715 or 37. the industry retention ratio is Industry retention ratio = 1 – .79 + 1.28(.000.1806) / (.000/$454.08 = . Since Expert HVAC had a write off which affected its earnings per share.06% The dividend per share paid this year was: D0 = $63.000 = 0. the company’s growth rate is: g = ROE × b = . the industry EPS is: Industry EPS = ($0.CHAPTER 8 STOCK VALUATION AT RAGAN.1806 or 18.15% So. INC.26 Now we can find the stock price.06) / 3 = $1. the industry payout ratio is: Industry payout ratio = $0.3715 = .26(1.20 – . which is: P0 = D1 / (R – g) P0 = $1.72 Using the retention ratio. the retention ratio was: Retention ratio = 1 – . the total earnings for the company were: Total earnings = 100. Since there are 100.000 shares outstanding.1806) P0 = $76. 1.75 2.40/$1.38 + 1.000($4.

Ragan’s PE ratio is: Ragan PE (original assumptions) = $76. .1806) = $2.75 / $4.49(1.09 / $1. Ragan’s PE = $53. we can calculate a stock price for Ragan.1167 + $1. which is: Stock price implied by industry PE = 12.C-20 CASE SOLUTIONS This means the industry growth rate is: Industry g = .1233(. Using the revised industry EPS.11673 + $2. If the ROE on the company’s projects is lower than the required return.90 Using the revised assumptions.07/1. Ragan’s PE is too high.11 / (.11672 + $2.54 = 16.1806) = $1. If the ROE on the company’s projects exceeds the required return.0775) = $79.76/1. the company should pay dividends.54) / 1.45/1.49 D2 = $1. the company should retain earnings and reinvest. This makes logical sense.45(1.32) = $55. Consider a company with a 10 percent required return.28 / $4.75% The company will continue to grow at its current pace for five years before slowing to the industry growth rate.07 D4 = $2.1167 – .15($4.89 D6 = $2.28 3.45 D5 = $2. The PE using the revised assumptions is close to the industry PE ratio.11675 P0 = $53. the total dividends for each of the next six years will be: D1 = $1. shareholders would be better off since the dividends in future years would be more than needed for the required return.89 + 79.54 = 11.1806) = $2.149/1. using the original assumptions.07(1.0849) = $3.6285) = .89(1.08 = 12. Using the industry average PE.54 This means the total value of the stock today is: P0 = $1. If the company can keep retained earnings and reinvest those earnings at 15 percent.74 Obviously.76 D3 = $1.26(1. the industry PE ratio is: Industry PE = $13.76(1.15 Using the original stock price assumption.1806) = $1.0775 or 7.18 4.11 The stock price in Year 5 with the industry required return will be: Stock value in Year 5 = $3. So.1806) = $2.11674 + ($2.

Again.73% 6. we will assume the results in Question 2 are correct.75 percent. The growth rate of the company we calculated in this question was the industry growth rate of 7.1073 or 10.CHAPTER 8 C-21 5. the ROE is: . The most obvious solution is to retain more of the company’s earnings and invest in profitable opportunities.72) ROE = . Since the growth rate is: g = ROE × b If we assume the payout ratio remains constant. This strategy will not work if the return on the company’s investment is lower than the required return on the company’s stock.0775 = ROE(. .

CHAPTER 9 BULLOCK GOLD MINING 1. An example spreadsheet is: .

there is no Excel function to directly calculate the payback period. finflow) Dim x As Double.Value If x = v Then PAYBACK = i Exit Function ElseIf x < v Then P=i-1 Z=x/v PAYBACK = P + Z Exit Function End If i=i+1 Loop Until i > c PAYBACK = "no payback" End Function 3. . We used “If” statements in our spreadsheet.Cells(i). v As Double Dim c As Integer.(4+(-D8-D9-D10-D11-D12)/D13).(3+(-D8-D9D10-D11)/D12).IF(D8>(D9+D10+D11+D12)." "))))))) 2.IF(-D8>D9.(5+(-D8-D9-D10-D11-D12-D13)/D14).IF(-D8>(D9+D10+D11).com/kb/getarticle.Count Do x=x-v v = finflow.vbaexpress.IF(D8<D9. We should note.php?kb_id=252. it may be advantageous to delay the mine opening because of real options. Since the NPV of the mine is positive.CHAPTER 8 C-23 Note. There are many possible variations on the VBA code to calculate the payback period. Below is a VBA program from http://www."Greater than 6 years". a topic covered in more detail in a later chapter. Function PAYBACK(invest.(2+(-D8-D9-D10)/D11).(1+(-D8-D9)/D10).-D8/D9.IF(-D8>(D9+D10). The IF statement we used is: =IF(-D8>(D9+D10+D11+D12+D13+D14). i As Integer x = Abs(invest) i=1 c = finflow.IF(D>(D9+D10+D11+D12+D13). the company should open the mine.

000 4.650 900.950 $9.500.072.650 6.007.123 $12.015.800.000 $28.357.000 4.000 $28.773 2.000 Year 2 = (95.000 3.700.275.350 $4.000.876. In this case. the total change in sales is: Sales = New sales – Lost sales – Lost revenue Year 1 = (74.428 $1.000 units of the old PDA each year for two years at a price of $290 each.023 5.000 Year 2 $34.000 19.015.000 16.884.925.164.000 4.000 4.000 $37.CHAPTER 10 CONCH REPUBLIC ELECTRONICS. The company will also be forced to reduce the price of the old PDA on the units they will still sell for the next two years.000 $20.373 $16.275.725.670.000 – 15.800.023 3.350 $2.650 4.948.265.000 12.000 Year 3 $45.800.000 $28.373 $19.000 –1.265.400.275.000 –1.765.000 $20.700.350 $14.000 –1.000 5.350.375.000 3.275.423.700.000 12.000 Sales New Lost sales Lost revenue Net sales VC New Lost sales Year 1 $26.878 $9.983 Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF .072.000 $37.000 × $290) – [(80.919.000 –4.760.033 1.950 $8.000 4.000 $28. The initial cash outlay at Time 0 is simply the cost of the new equipment.000) × ($290 – 255)] = $20.400.275.000 Year 5 $28.650 1.157.800.190.744.917.000 $12.350.000 –4.000.760.200.670. the lost sales each year.000 $12. the lost sales are 15.800.276.000 $19.000 $45.400.925.685.628 $11.628 $3.672. So.800.275.350 $11.575.000 Year 4 $37.000 –2.640.000 $9.000.470.275.139.700. and the lost revenue.375.000 9. PART 1 This is an in-depth capital budgeting problem.350 $8.350 $17.223 3.000 $11.919.350 $5.384.000 – 15.000 $45.700.685.015. The sales each year are a combination of the sales of the new PDA.800.000) × ($290 – 255)] = $28.000 2.572.350 $14.000 × $360) – (15.800.000.000 1.000 × $360) – (15.375.018 $6. $21.000 × $290) – [(60.573 $14.780.500.050 3.000 $16.

000 0 $7.000 –$3.650 – 4.650 Taxes on sale of equipment = (BV – MV)(tC) = (4.000 = $741.950) BV of equipment = $4.983 BV of equipment = ($21.500.000 –$4.373 / 1.604 3.343.810 / (1 + IRR)5 IRR = 27.113.983.125)] / $21.CHAPTER 8 C-25 NWC Beg End NWC CF Net CF $0 4.655.572.123 / 1.373 / 1.373 / 1.000 –$1.373 $9.573 / (1 + IRR) + $7.560.000)(.000 Profitability index = 1.316.122 + $11.440.373 11.836.316. The project NPV is: NPV = –$21.796.180.345.113.500.62 Cash flow –$21.180.35) = $243.810 / 1.156 years 2.373 $5.685. The profitability index is: Profitability index = [($741.828 = $4.573 $4.828 CF on sale of equipment = $4.810 / 1.265.123 20.919.000 7.000 741.123 + $13.180.573 / 1.560.12 + $7.000 $741.810 .000 $15.500.573 7.000 + 243.123 $7.000 $11.652.000 $7.072.655.125 NPV = $12.373 / (1 + IRR)3 + $13.316.373 13. The payback period is: Payback period = 3 + ($2.113.796.003.122) + ($11.683 / $13.123 / 1. the cash flows of the project are: Time 0 1 2 3 4 5 1.573 / 1.373 / 1.572.113.072.500.500 – 5.12) + ($7.316.000.124 + $20.113.123) + ($13.828 So.000 + $741.560.000 $1.572.100.003.373 / (1 + IRR)2 + $11.123 / (1 + IRR)4 + $20.180.000 5.000.62% 4. The project IRR is: IRR: –$21.000 9.572.003.500.316.123) Payback period = 3.611.316.350 – 2.572.760.100.350 – 3.000 – 3.000 $13.124) + ($20.350 – 1.

CHAPTER 11 CONCH REPUBLIC ELECTRONICS, PART 2
1. Here we want to examine the sensitivity of NPV to changes in the price of the new PDA. The calculations for sensitivity to changes in price are similar to the original cash flows. The only difference is that we will change the price of the PDA. We will use a price of $370 per unit, but remember that the price we choose is irrelevant: The final answer we want, the sensitivity of NPV to a one dollar change in price will be the same no matter what price we use. The projections with the new prices are: The sales figure for the first two years will be the sales of the new PDA, minus the lost sales of the existing PDA, minus the lost dollar sales from the price reduction of the existing PDA, or: Sales = New sales – Lost sales – Lost revenue Year 1 sales = (74,000 × $370) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)] Year 1 sales = $20,755,000 Year 2 sales = (95,000 × $370) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)] Year 2 sales = $29,225,000 Sales New Lost sales Lost revenue Net sales VC New Lost sales Year 1 $27,380,000 4,350,000 2,275,000 $20,755,000 Year 2 $35,150,000 4,350,000 1,575,000 $29,225,000 Year 3 $46,250,000 Year 4 $38,850,000 Year 5 $29,600,000

$46,250,000

$38,850,000

$29,600,000

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

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

$19,375,000 $19,375,000

$16,275,000 $16,275,000

$12,400,000 $12,400,000

CHAPTER 11 C-27

Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF

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

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

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

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

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

NWC Beg End NWC CF Net CF

$0 4,151,000 –$4,151,000 $1,074,573

$4,151,000 5,845,000 –$1,694,000 $7,688,873

$5,845,000 9,250,000 –$3,405,000 $12,324,873

$9,250,000 7,770,000 $1,480,000 $14,038,623

$7,770,000 0 $7,770,000 $16,566,983

BV of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950) BV of equipment = $4,796,650 Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828 CF on sale of equipment = $4,100,000 + 243,828 = $4,343,828 So, the cash flows of the project under this price assumption are: Time 0 1 2 3 4 5 Cash flow –$21,500,000 1,074,573 7,688,873 12,324,873 14,038,623 20,910,810

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

C-28 CASE SOLUTIONS And the sensitivity of changes in the NPV to changes in the price is: ΔNPV/ΔP = ($15,148,716.18 – 12,983,611.62) / ($370 – 360) ΔNPV/ΔP = $216,510.46 For every dollar change in price of the new PDA, the NPV of the project changes $216,510.46 in the same direction. 2. Here we want to examine the sensitivity of NPV to changes in the quantity sold. The calculations for sensitivity to changes in quantity are similar to the original cash flows. The only difference is that we will change the quantity sold of the new PDA. We will increase unit sold by 100 units per year. Remember that the quantity we choose is irrelevant: The final answer we want, the sensitivity of NPV to a one unit per year change in sales. The projections with the quantity are: The sales figure for the first two years will be the sales of the new PDA, minus the lost sales of the existing PDA, minus the lost dollar sales from the price reduction of the existing PDA, or: Sales = New sales – Lost sales – Lost revenue Year 1 sales = (74,100 × $360) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)] Year 1 sales = $20,051,000 Year 2 sales = (95,100 × $360) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)] Year 2 sales = $28,311,000 Note, the variable costs must also be increased to account for additional units sold.

CHAPTER 11 C-29

Sales New Lost sales Lost revenue Net sales VC New Lost sales

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

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

Year 3 $45,036,000

Year 4 $37,836,000

Year 5 $28,836,000

$45,036,000

$37,836,000

$28,836,000

$11,485,500 1,800,000 $9,685,500 $20,051,000 9,685,500 4,700,000 3,072,350 $2,593,150 907,603 $1,685,548 3,072,350 $4,757,898

$14,740,500 1,800,000 $12,940,500 $28,311,000 12,940,500 4,700,000 5,265,350 $5,405,150 1,891,803 $3,513,348 5,265,350 $8,778,698

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

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

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

Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF NWC Beg End NWC CF Net CF

$0 4,010,200 –$4,010,200 $747,698

$4,010,200 5,662,200 –$1,652,000 $7,126,698

$5,662,200 9,007,200 –$3,345,000 $11,585,698

$9,007,200 7,567,200 $1,440,000 $13,329,448

$7,567,200 0 $7,567,200 $15,857,508

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

448 / 1.585.500.698 / 1. the cash flows of the project under this quantity assumption are: Time 0 1 2 3 4 5 The NPV under this assumption is: NPV = –$21.124 + $20.698 11.335 / 1.698 13.122 + $11.000 747.335 .91 in the same direction. the NPV of the project changes $456.585.91 For a one unit per year change in quantity sold of the new PDA.000 + $747.17 – 12.302.201.302.125 NPV = $13.611.123 + $13.029.698 / 1.983.029.17 So.62) / 100 ΔNPV/ΔQ = $456.329.448 20.201. the sensitivity of NPV to units sold is: ΔNPV/ΔQ = ($13. Cash flow –$21.698 / 1.329.12 + $7.698 7.126.126.C-30 CASE SOLUTIONS So.500.

68% – 3. 2.0279 + .0497 + .85% – 3. the 10-year average risk-free rate is: Risk-free rate = (.83% = . In general. The mutual funds have a number of assets in the portfolio. In general. Both the APR and EAR are infinite.49) / 15.49) / 10. 5. and therefore. so the number of periods in a year is infinite. The returns are the most volatile for the small cap fund because the stocks in this fund are the riskiest. small cap funds have higher expenses.0094 +. we should use the average risk-free rate over the same period.64% = . the expected return is higher. including researching smaller stocks.2072 4. and finding the funds that will outperform the market in the future beforehand is a daunting task. 3.5048 Bledsoe Small-Cap Fund = (16.49) / 70% = . The major disadvantage is the likelihood of underperforming the market. The biggest advantage the mutual funds have is instant diversification.0349 or 3.41% = .67% – 3.49% The Sharpe ratio for each of the mutual funds and the company stocks are: Bledsoe S&P 500 Index Fund = (11.0480 + .82% = . using the information from Table 10.0598 + . The higher expenses of the fund are expected. The match is instantaneous. You would want to invest in this fund if your risk tolerance is such that you are willing to take on the additional risk in expectation of a higher return.0114 + .1.5703 S&S Air stock = (18% – 3.49) / 15.5422 Bledsoe Bond Fund = (9. just that the risk is higher.CHAPTER 12 A JOB AT S&S AIR 1. So. This does not imply the fund is bad. One factor that makes outperforming the market even more difficult is the management fee charged by the fund. Since we are given the average return for each fund over the past 10 years. in large part due to the greater cost of running the fund. most mutual funds do not outperform the market for an extended period of time.0161 +.0333 +.49) / 19.48% – 3.0452) / 10 Risk-free rate = . .6714 Bledsoe Large Company Stock Fund = (11. The advantage of the actively managed fund is the possibility of outperforming the market. which the fund has done six of the last eight years.0486 + .

.C-32 CASE SOLUTIONS The Sharpe ratio is most applicable for a diversified portfolio. and is least applicable for the company stock.

not only does the investment perform poorly.CHAPTER 12 C-33 6. This is especially true since income comes from the company as well. Investing heavily in company stock does not create a diversified portfolio. Age is a determinant in the decision. money allocated to the company stock. We only have to look at employees of Enron or WorldCom to see the potential for problems with investing in company stock. Unfortunately. This is a very open-ended question. so in this case. employees face layoffs. most students will be young. if any. So. Older individuals should be less heavily weighted toward stocks. However. the portfolio allocation should be more heavily weighted toward stocks. The principle of diversification indicates that an individual should hold a diversified portfolio. or reduced work hours. 5 to 10 percent of the portfolio should be allocated to company stock. In any case. A commonly used rule of thumb is that an individual should invest 100 minus their age in stocks. this rule of thumb tends to result in an underinvestment in stocks. The asset allocation depends on the risk tolerance of the individual. If times get bad for the company. At most. . but income may be reduced as well. there should be little.

91 $46.0302 0.0102 0.0139 -0.70 $46.72 1104.0425 0. The information used for the analysis is presented below. The actual answer to the case will change based on current market conditions 1.50 $47.0063 0.73 $47.0052 -0.0126 0.20 $50.0081 0.0113 0.0201 0.0012 0.1633 -0.0110 -0.16 $49.2 1111.0165 0.0164 -0.0219 -0.5 990.0278 0.0386 0. Riskfree May-03 Jun-03 Jul-03 Aug-03 Sep-03 Oct-03 Nov-03 Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05 0.0138 -0.24 1114.0125 0.0119 0.0859 0.0093 0.0113 0.87 $45.59 974.0219 0.0546 0.0371 0.00078 0.59 1156.84 1101.0127 0.0163 -0.71 1058.90 $41.0815 -0.85 S&P 500 963. It is necessary to find the monthly rate.0189 -0. Note that the risk-free rate (3-month T-bill rate) is expressed as an annual rate.0212 -0.00089 0.92 1131.009 0.80 $50.0072 0.0289 -0.00232 0.00073 0.0191 -0.0549 -0.00147 0.00123 0.0300 -0.0353 0.25 $52.0171 -0.0466 0.63 $53.58 1130.0115 -0.0233 0.0179 -0.1106 0.00078 0.0320 0.0276 -0.0170 -0.0207 0.74 $46.0165 0.00183 0.0036 -0.00075 0.0271 0.0451 -0.0013 -0.6 1180.0107 0.75 $48.CHAPTER 13 THE BETA FOR AMERICAN STANDARD NOTE: The example below shows the results from May 2008.0071 -0.0121 0.58 $50.00138 0.0171 -0.33 S&P 500 return 0.00173 0.0173 0.64 $46.40 $49.0550 0.0036 S&P risk premium 0.0013 .13 1144.0541 -0.0071 0.0294 0.68 1140.53 $49.0443 -0.0474 0.85 1191.0309 0.75 $41.0023 0.00237 Stock price $53.0094 0.00212 0.0508 0.00106 0.0093 0.0140 0.40 $48.00111 0.0168 0.0180 -0.00078 0.0142 -0.0402 0.0343 0.1646 -0.0176 0.0284 Monthly Riskfree 0.92 1181.0086 0.0130 -0.78 $49.0254 0.009 0.0088 0.00077 0.21 1107.0162 0.0274 0.0122 -0.45 $42.00075 0.0116 0.0094 0.0280 -0.0092 0.0095 0.0133 0.2 1173.0171 -0.31 1008.0870 0.0224 0.0253 0.0104 0.0500 0.0210 -0.48 $53.0284 0.0325 -0.3 1120.1123 0.82 1211.0025 Return -0.0094 0.05 $49.00194 0.0176 0.0307 -0.0155 0.0151 -0.00079 0.01 995. so this rate is divided by 12.0808 -0.00085 0.27 1203.00078 0.0538 0.0127 0.00228 0.0148 0.0124 0.0118 0.97 1050.0001 Stock risk premium -0.00077 0.97 $50.0094 0.91 $52.94 1126.00078 0.0071 0.0102 -0.0092 0.0064 0.5 1191.0542 0.0291 0.

18 1220.CHAPTER 13 C-35 Jul-05 Aug-05 0.00268 $49.0360 -0.0112 0.0643 -0.00248 0.0668 -0.56 0.98 $49.0111 0.33 0.0297 0.0084 1234.0139 .0335 -0.0322 0.

08 1280.00401 0.0479 -0.0498 0.0193 0.0126 0.66 1303.0342 0.0194 0.00323 0.59 1394.58% 4.0084 -0.50 $56.00369 0.54% .38 $65.18 $76.0100 -0.0451 0.0165 -0.0077 0.0100 0.00406 0.0389 0.0091 0.0171 0.50 $57.0050 0.55 1330.0718 0.63 1418.0481 0.51 $79.0172 -0.0376 0.70 $65.0231 0.00413 0.02 $65.0060 0.25% 0.35 1455.0131 -0.0204 0.0197 -0.00285 0.03 0.13% Coach 0.0443 0.0309 0.7 1385.0129 0.38 1481.0035 0.39 $52.10 $75.00376 0.0715 0.05 $63.0061 -0.0637 -0.0355 0.0371 -0.0487 0.0075 0.0246 0.0042 0.37 1530.0052 Using the Excel functions for the average return and standard deviation.0475 0.0473 0.0467 -0.0355 0.0155 -0.0485 0.0041 0.046 0.99 1526.0168 -0.24 1406.0285 -0.66 1294.92 $57.0038 0.0321 -0.0011 0.0440 -0.00 $54.00324 0.0879 0.82 1420.0087 0.70 $77.0110 0.0206 0.26 $75.92 $62.0178 -0.0255 0.0069 -0.00419 0.0520 -0.00402 0.0424 0.0320 0.0294 0.0212 0.0315 0.10 $66.00394 0.0323 0.0060 0.0479 0. the table below shows the averages and standard deviations for each of the series.0114 -0.61 1270.0141 -0.0047 0.0073 -0.0063 0.0049 0.00404 0.00287 0.36 1378.0473 -0.94 1400.10 $63.51 $70.039 0.00229 0.0392 0.70 $72.87 1310.48 1248.0126 0.0111 0.0206 -0.0222 -0.0275 0.0344 0.0074 0.65% 2.0348 -0.0889 0.63 1322.0058 0.34 $70.0465 0.0612 -0.0481 0.0413 0.0116 -0.0292 -0.01 1249.00309 0.0140 -0.81 1207.07 $52.0444 0.0218 0.62 $63.0060 0.75 $57.0128 -0.0433 0.0013 0.00413 0.0129 0.0492 0.00353 0.0275 0.0496 0.0260 0.0169 0.00393 0.0025 0.0010 0.0482 0.042 0.75 $59.0074 0.0472 0.00273 0.0005 0.28 $77.2 1276.0494 0.0334 0.0028 0.0029 0.0348 -0.31% S&P 500 0.84 $50.0461 0.0221 -0.35 0.0041 -0.0358 0.0028 0.00412 0.0029 -0.55 $65.0265 -0.0213 0. Last 60 months Average return Standard deviation Risk-free 0.0091 0.0239 -0.0085 0.0389 0.0009 0.0352 -0.0388 0.76 $52.0086 -0.0001 0.00415 0.0088 0.0327 0.57 $65.C-36 CASE SOLUTIONS Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 0.27 1473.0053 0.00108 $49.23 $57.0358 0.09 1270.62 1503.0375 0.0503 0.0747 0.29 1280.85 1377.0177 0.0124 0.00384 0.0165 0.0148 -0.0051 0.0325 -0.14 1468.00383 0.0218 -0.3 1438.0114 -0.00105 0.0031 0.0133 0.00325 0.82 1335.00177 0.0371 0.00324 0.15 0.0495 0.0315 0.0088 0.28 $51.86 1482.00412 0.75 1549.0056 0.0155 -0.0499 -0.0753 0.0112 -0.0122 -0.0315 0.0205 1228.0263 0.00399 0.0494 0.28 $66.

while the β estimate 0.032 Observations 36 ANOVA df Regression Residual Total 1 34 35 Coefficients 0.180843 SS 0.847636 P-value 0.00811 Standard Error 0.18 and is insignificant.402568 The α is barely insignificant at 10%.035552 Standard Error 0. The residual plot is: .143856 R Square 0.005341 0.213349 MS 0.402568 3. The residual is the error in the estimation.000736 0. Jensen’s alpha represents the excess return not explained by the beta of the stock.676392 0.020695 Adjusted R Square -0. and is the portion of the return not explained by the market model. Intercept X Variable 1 t Stat 1.718487 Significance F 0.000736 0.001024 F 0.034816 0.008954 0. The relevant output from Excel for this period is: SUMMARY OUTPUT Regression Statistics Multiple R 0.CHAPTER 13 C-37 2. A positive alpha plots above the Security Market Line and has a return in excess of its systematic risk.102834 0.

108386 Standard Error 0.001855 F 0.52028 Intercept X Variable 1 t Stat 0.52028 The α and β are both insignificant at any reasonable level of significance.10761 0. The relevant output from Excel for this period is: SUMMARY OUTPUT Regression Statistics Multiple R 0.628106 0.00996 Standard Error 0.147156 SS 0.084631 R Square 0.646851 P-value 0.227495 MS 0.C-38 CASE SOLUTIONS 4.000776 0.000776 0.005635 0.002744 0.418416 Significance F 0.043074 Observations 60 ANOVA df Regression Residual Total 1 58 59 Coefficients 0.007162 Adjusted R Square -0. The residual plot is: .486983 0.

which is similar to these estimates. . or the market proxy the use. Possible reasons for the difference could be different data. The beta for Colgate-Palmolive on Yahoo! Finance at the time was 0. but they do not specify the risk-free rate.CHAPTER 13 C-39 5. For example Yahoo! Finance uses 36 months of returns.16.

sec. NOTE: The example below shows the results during June.CHAPTER 14 THE COST OF CAPITAL FOR HUBBARD COMPUTER. INC. The actual answer to the case will change based on current market conditions. 2008. The book value of debt is the book value of this issue. 2008.gov and found Dell’s Form 10q. or $300 million. The book value of the company’s liabilities and equity can be found from a number of sources. 1. dated May 2. . maturing in 2028. Dell’s Form 10k showed the following: Dell has one outstanding bond issue as of June 2008. We went to http://www.

The screen shots below show this information.813 Shares outstanding = 2. We need various pieces of information to estimate the cost of equity.com. Market price = $23. We gathered all the information from finance. We can use the dividend growth model or the CAPM.05 billion Most recent dividend = $0 Beta = 1.83% .yahoo. so we will attempt to use both.10 billion Book value per share = $1. The following information is necessary for our calculations.06 Market capitalization = $47.53 3-month Treasury bill rate = 1.CHAPTER 14 C-41 2.

To get the yield to maturity on Dell’s bonds. Using the market risk premium of 7 percent from the textbook.54% 3.finra.0183 + 1.53[.org/marketdata. We gathered the following information: . We do have the information to estimate the cost of equity with the CAPM. we went to www.C-42 CASE SOLUTIONS Dell has never paid a dividend so we cannot use the dividend growth model to estimate the cost of equity. we get: RE = Rf + β [E(RM) – Rf] RE = .07] RE = 12.

00 Market value (in millions) $305.43 Percentage of total 1.10 Total Book value (face value.CHAPTER 14 C-43 So.93% Weighted market values 6.93% It is irrelevant whether we use book or market values to calculate the cost of debt for Dell since the company has only one bond issue outstanding.00 Yield to maturity 6.00 1. in millions) $300 $300 Percentage of total 1.93% 6. the weighted average cost of debt for Dell using both the book value and the market value is: Coupon Rate 7.93% Weighted book values 6.43 $305.00 1.93% 6. .

35) WACC = 11.41B So. the WACC based on book value weights is: WACC = RE(E/V) + RD(D/V)(1 – t) WACC = (.1254)($47.017)(1 – .300/$4.41) + (.305/$47. the total value of Dell is: V = $305.717B V = $4.10B V = $47.0693)($0. Using book value weights. 5.10/$47. The biggest potential problem with HCI using Dell’s cost of capital is that HCI operates stores that generate the company’s sales.94% Using the market value weights. the total value of Dell is: V = $300M + $3.717/$4.1254)($3.C-44 CASE SOLUTIONS 4.49% The cost of capital for Dell using Book value weights and market value weights is similar because Dell has such a small portion of debt in its capital structure.55 percent. The difference in this case is 0. . Another factor that could affect the cost of capital is Dell’s access to capital since it is a public company. This could potentially be a risk factor that affects the cost of capital.0693)($0.35) WACC = 12. while Hubbard Computer is private. the WACC based on market value weights is: WACC = RE(E/V) + RD(D/V)(1 – t) WACC = (.43M + $47. Dell generates sales almost exclusively from its internet site.017B So.41)(1 – .017) + (.

although this may not be a large advantage.000 Total other fees = $2.000 Fee percentage = .500 The net amount raised is the IPO offer size minus the underwriter fee.000 Since the company must currently provide audited financial statements due to the bond covenants. The advantages of the increased IPO size include the increased liquidity for the company. the audit costs are not incremental costs and should not be included in the calculation of the fees. The disadvantages of raising the extra cash in the IPO include the agency costs of excess cash. underpricing can still exist in a Dutch auction. Whether the underpricing is as severe in a Dutch auction as it would be in a traditional underwritten offer is unknown.000 So.813.000 – 5. The extra cash may encourage management to act carelessly. As to which is better.500 / $69. . we don’t actually know. The extra cash will also earn a small return unless invested in income producing assets.750.000 + 12.000 Net amount raised = $69. the Dutch auction should be better since it should eliminate underpricing.000 + 2.500 + 520. The main difference in the costs is the reduced possibility of underpricing in a Dutch auction. and the lower probability that the company will have to go back to the primary market in the near term future.000 + 100.000 + 6. The underwriter fee is 7 percent of the amount raised.250.20% 2. the fees as a percentage of the net amount to the company are: Fee percentage = $7. the sum of the other fees is: Total other fees = $1.500 This means the total fees are: Total fees = $5.07) Underwriter fee = $5. So.000(. so whether Mark is correct or Kim is correct will only be told in time. or: Underwriter fee = $75.563. However.000 + 110.000.563. In theory. as Google shows.000.750. There is no way to calculate the optimum size of the IPO. At best.250. The increased size will also reduce the costs of the IPO on a percentage of funds raised. 3.250.1120 or 11. cash and short-term investments are a zero NPV investment.800.CHAPTER 15 S&S AIR GOES PUBLIC 1.500 Total fees = $7.813. or: Net amount raised = $75.000 + 15.

typically 180 days. Additionally. This could be a significant cost. the employee will lose out on any underpricing. Another risk in not selling in the IPO is that after the lockup period expires. subject to SEC restrictions on selling stock. . However. Because of legal repercussions. you should not provide specific advice on which option the employees should choose. the employees may be considered insiders. and heavy selling by insiders is considered a negative signal by the market. There are advantages and disadvantages to each. during the lockup period. if the employee retains the stock. he/she must hold the stock for the lockup period. If the employee tenders the stock to be sold in the IPO. the employee is legally prohibited from hedging the price risk of the stock with any derivatives.C-46 CASE SOLUTIONS 4.

000) Market value of equity = $528.600. the purchase increases the annual expected earnings of the firm by: Earnings increase = $27.000 + ($16.000 So.000.20 per share. creating a tax shield that will increase the overall value of the firm.20(15.000 / . Therefore.000 Since Stephenson is an all-equity firm. the market value balance sheet before the land purchase is: Market value balance sheet $528. $528.000. These earnings are taxed at a rate of 40 percent.000 Equity $528.200.000. Assets Total assets 3. the firm’s pre-tax earnings will increase by $27 million per year in perpetuity. after taxes. debt in the firm’s capital structure will decrease the firm’s taxable income.000 . worth $35.000 Debt & Equity 2.200.000. it should use debt to finance the $110 million purchase. If Stephenson wishes to maximize the overall value of the firm.000. so the NPV of the purchase is: NPV = –$110.40) Earnings increase = $16.000. Since Stephenson is an all-equity firm with 15 million shares of common stock outstanding. the appropriate discount rate is the firm’s unlevered cost of equity. Since interest payments are tax deductible.125) NPV = $19. the market value of the firm is: Market value of equity = $35.000 $528.000 As a result of the purchase. a.000.000.000(1 – .CHAPTER 16 STEPHENSON REAL ESTATE RECAPITALIZATION 1.

148 Total shares outstanding = 18.000.600 / 18.000 + 19. the market value of the firm’s equity will immediately rise to reflect the NPV of the project.000 / $36.600. Stephenson will now have: Total shares outstanding = 15.000 + 3. This will increase the firm’s assets and equity by $110 million. After the announcement. the market value of Stephenson’s equity after the announcement will be: Equity value = $528. Stephenson’s stock price after the announcement will be: New share price = $547.000 Debt & Equity Old assets NPV of project Total assets $507.000 The stock price will remain unchanged.51 Since Stephenson must raise $110 million to finance the purchase and the firm’s stock is worth $36.000 Debt & Equity Cash Old assets NPV of project Total assets $657.148 c. the net present value of the purchase.000 $657.013. To show this. Stephenson must issue: Shares to issue = $110.000.000.600. the value of Stephenson will increase by $20 million.600.000 Equity $657.000 528.000 New share price = $36.600.000 Market value balance sheet $528.600.000.000.000 19.600. the new market value balance sheet after the stock issue will be: Market value balance sheet $110.000 Equity $547. Therefore. Stephenson will receive $110 million in cash as a result of the equity issue.000 / 15.148 Share price = $36.000 and the firm has 15 million shares of common stock outstanding.148 So.000 Equity value = $507.000.600.600.000.C-48 CASE SOLUTIONS b.51 Shares to issue = 3. Under the efficient-market hypothesis.000 Since the market value of the firm’s equity is $547. the share price is: Share price = $657.013.000 $547.031.600.013.51 per share.500.51 . So.600.500.000 19.

200.000 Debt & Equity Value unlevered Tax shield Total assets $110. So.2 million.CHAPTER 16 C-49 d. After the announcement. Stephenson’s market-value balance sheet after the debt issue will be: Market value balance sheet $657. If the firm uses debt in order to finance the project. So. $648.000 So. .000 / . Therefore.600. Stephenson will be worth $657.600.000 Since the market value of the Stephenson’s equity is $591.6 million if it finances the purchase with equity.600.000 Stock price = $39. Stephenson’s stock price after the debt issue will be: Stock price = $591.125 PVProject = $129.44 5.000 Debt 44. If it were to finance the initial outlay of the project with debt.000.44 per share. after taxes.600. Therefore.600.000 Modigliani-Miller Proposition I states that in a world with corporate taxes: VL = VU + tCB As was shown in Question 3. a. the value of Stephenson will immediately rise by the present value of the project.000. If Stephenson uses equity in order to finance the project.000 Debt & Equity Old assets PV of project Total assets 4. These earnings will be taxed at a rate of 40 percent.000 Equity $701.000 $701. debt financing maximizes the per share stock price of the firm’s equity.000 129.000.600.000 591.000) VL = $701.600.000. the aftertax present value of the earnings increase is: PVProject = $16.000.000 $657. the firm would have $110 million worth of 8 percent debt outstanding. we can calculate the market value of Stephenson’s equity.600.40($110.600. the value of the company if it financed with debt is: VL = $657.000 + .600. the firm’s stock price will rise to $39. the project increases the annual earnings of the firm by $16.000 b.600. The project will generate $27 million of additional annual pretax earnings forever.6 million and the firm has 15 million shares of common stock outstanding. Since the market value of the firm’s debt is $110 million and the value of the firm is $692 million.000. the firm’s stock price will remain at $36.51 per share. the market value balance sheet of the company will be: Market value balance sheet $528.000 / 15.000 Equity $657.

The implication is that the company should not retain earnings unless the ROE of the new project is greater than the shareholders required return on equity. A regular dividend payment is something the company should probably not undertake. Ignoring taxes.CHAPTER 17 ELECTRONIC TIMING. The PE ratio will fall and the ROA and ROE will increase. but the changes are irrelevant. paying off debt can lower the interest rate on debt. the company is lowering shareholder value. capital structure theory argues that increasing debt can increase the value of the company because of the interest tax shield. 1. Cessation of dividend payments is viewed a negative signal by the market. If the company is over-levered. 6. If there are no financial distress costs. This is an intuitive result. INC. The value of the company will decline by the amount of the dividend. If the return on the retained earnings is lower than shareholders required return. A company rarely begins regular dividend payments that it will be unable to continue in the future. Shareholders want the company to retain earnings for future growth if the earnings will earn a greater return than shareholders require. and decrease financial distress costs. 5. 2. The value of the company could increase or decrease. and taxed at the applicable personal income tax rate. shareholders wealth will not be affected because the stock price will drop by the amount of the dividend payment. The decision does depend on the organizational form of the company. . and currently taxed at the lower dividend tax rate. 4. Money paid to shareholders of a corporation are dividends. 3. Money paid to the owners of a LLC is considered income.

So. Accounts receivable from current quarter sales: The company will collect ((90 – 53) / 90) percent of the current quarter sales.50) Purchases for next quarter paid this quarter: Using the same payables period.50) Expenses are simply 30 percent of gross sales. and capital outlays. the company will collect (53 / 90) percent of the previous quarter sales since this is the balance remaining at the end of the quarter. the accounts payable balance at the beginning of each quarter will be: Payments for purchases from last quarter = (42 / 90)(Current quarter sales)(. the company will pay part of the current quarter orders. minus the suppliers paid. interest. expenses. this is simply 90 percent of the beginning A/R balance. while interest is constant. The cash flow each quarter will consist of the sales collection. The individual cash flows are calculated as follows: Accounts receivable collected from the previous quarter: For the 1st quarter. so: Purchase paid for next quarter = ((90 – 42) / 90)(Current quarter sales)(. For the remaining quarters. dividends.CHAPTER 18 PIEPKORN MANUFACTURING WORKING CAPITAL MANAGEMENT 1. The cash flows for each quarter will be: . The current quarter orders are based on next orders sales. Purchases last quarter paid this quarter: The company purchases one-half of next quarter sales in the current quarter and takes 42 days to pay the accounts payable.

44 39.000.290.000.33 –372.00 $3.00 $93.000.722.000.777.055.00 100.888.22 3.000.00 –370.00 –$67.68 0 $0 $100.00 $532.00 39.622.C-52 CASE SOLUTIONS A/R at beginning of Q collected Sales collection in current Q Purchases last Q paid this Q Purchase for next Q paid this Q Expenses Interest and dividends Outlay Net cash inflow Net cash inflow Q1 Q2 $484.555.722.111.44 Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit) Q3 $196.555.22 $193.26 .67 138.000.22 $96.290.91 0 0 0 0 $100.44 100. the cash balance each quarter is: Cash Balance Q1 Q2 $190.11 –40.666.22 0 0 0 0 0 0 0 0 $100.000.67 0 $0 Target cash balance Net cash inflow New short-term investments Income on short-term investments Short-term investments sold New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance Minimum cash balance Cumulative surplus (deficit) Beginning short-term investments Ending short-term investments Beginning short-term debt Ending short-term debt $100.111.384.722.22 The short-term financial plan looks like this: Short-term Financial Plan $100.000.44 –211.722.000.222.722.00 –95.777.111.00 –202.444.000.22 Q3 $606.67 –330.33 –274.00 $193.094.00 –309.444.22 $196.22 –4.00 –95.00 3.000.722.622.444.56 Q4 $235.00 $0 $0 $90.000.00 $100.44 372.777.777.000.00 946.22 2.555.777.11 509.11 Q4 $683.00 –100.666.11 $235.00 $0 $138.000.00 –100.68 40.944.00 94.22 –3.22 $2.668.02 982.444.000.094.78 100.00 –100.00 $135.78 –289.000.555.000.111.000.290.500.000.56 100.000.67 –309.000.56 –202.22 2.722.103.666.00 –95.78 So.67 103.33 –269.78 $32.000.67 –240.00 $100.56 423.22 0 $0 $94.00 $0 $98.000.78 0 1.00 –100.333.333.000.384.00 –95.00 –$202.26 0 0 $100.85 98.103.22 98.333.622.383.33 –271.56 476.000.333.000.02 0 $103.000.89 –270.00 $39.67 –348.722.44 900.722.166.

777.555.00 –80.692.00 –80.44 1.00 946.22 0 0 0 0 0 0 0 0 $80.000.148.11 $235. in income.91 $1.00 114.44 80.04 0 $82.67 $138.444.722.822.722.67 158.000.722.111.444.495.555.22 $196.CHAPTER 18 C-53 The interest calculations for each quarter and the net cash cost are: Q1: Q2: Q3: Q4: Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing 2.00 $155.000.00 –80.589.22 118.000.22 0 $0 $114.22 –3.04 1.822.22 3.000.000. $900.000.000. so they will not be repeated here.722.00 $94.222.000.000.00 39.22 $98.00 $80.692.990.44 Short-term Financial Plan $80.56 80.00 $946.93 0 0 0 0 $80.56 Q4 $235.383.00 1.22 2.298.000.722.91 1.70 0 $0 $80.384.000.00 –$47.22 2.00 80.00 3.22 Target cash balance Net cash inflow New short-term investments Income on short-term investments Short-term investments sold New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance Minimum cash balance Cumulative surplus (deficit) Beginning short-term investments Ending short-term investments Beginning short-term debt Ending short-term debt $80.22 982.11 –40. The cash balance and short-term financial plan will be: Cash Balance Q1 Q2 $190.870.383.000.290.622.67 82.444.212.186.22 $193.00 $80.85 in income.00 $0 $158.22 $982.00 –202.990.20 0 0 $80.000.78 80.70 40.111.91 118.000.22 $116.98 If Piepkorn reduces its target cash balance to $80.000.68 earns earns earns earns $900.722.777.000.00 –80.298.822.722.00 $113.100.78 $32.00 $0 $118. $90.00 $193.56 –202.44 39.495.000.67 0 $0 Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit) Q3 $196.777. in income.85 $4.00 $0 $0 $110.000.692.20 .555.000. the cash flows each quarter will remain the same.22 –4. in income.78 0 1.

025.01) + $905.60) Q3 net sales = $1.030.000)(.360 Q4 net sales = ($1. However.240.000)(.160. the effect of the discount will be to reduce the dollars received from the sales by the discount percentage for the customers who take advantage of the discount. so the net cash inflows each quarter will be: .01) + $1. in income.148.22 1.40)(1 – .93 $1.91 in income.00 $1.00 $114.100.000)(.000(.C-54 CASE SOLUTIONS Q1 : Q2 : Q3 : Q4 : Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of $110. The collections will be based off the lower sales figures.000(.06 If Piepkorn offers the discounted terms. Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing 3. we must assume the sales will remain unchanged. The net sales after the discount each quarter will be: Q1 net sales = ($905.040 In addition to the reduction in sales.000.186.000(. $1.155. This will change the cash flows Piepkorn receives.000)(.186.240.822.589.589.01) + $1.40)(1 – .880 Q3 net sales = ($1.22 $118.692.60) Q2 net sales = $1.380 Q2 net sales = ($1.235.00 1.40)(1 – .60) Q4 net sales = $1.990.91 $5.40)(1 – .160.01) + $1.030.025. the collections period will decrease to 36 days.93 1.70 earns earns earns earns $1. in income.22 $1. in income.148.67 $158.100.000(.60) Q1 net sales = $901.

67 –330.000.67 $22.67 $362.552.333.33 –269.00 –95.333.908.666.00 .000.000.00 59.000.00 –309.33 –372.67 So.000.67 22.33 –271.000.00 741.33 Q3 $410.908.67 Q4 $444.000.67 –309.00 –211.494.528.494.33 $384.333.000.67 Q4 $462.000.142.00 –289.00 $360.67 80.494.000.500.00 540.000.00 $304.142.00 80.00 –$192.00 Q3 $384.67 –192.494.024.828.00 –95.142.00 $59.00 –95.00 172.67 $251.498.00 $364.67 –240.00 –270.000.413.144. the cash balance each quarter will be: Cash Balance Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit) Q1 $190.494.00 –95.234.00 –370.67 Q2 $362.67 –348.216.00 $171.00 693.166.00 $282.00 615.666.644.352.67 $444.CHAPTER 18 C-55 A/R at beginning of Q collected Sales collection in current Q Purchases last Q paid this Q Purchase for next Q paid this Q Expenses Interest and dividends Outlay Net cash inflow Net cash inflow Q1 Q2 $484.000.413.333.644.33 –274.67 80.000.00 $172.666.00 80.908.234.498.

00 0 0 0 $80.000.00 283.95 3.000. in income.323.67 0 $0 $283.00 $80.00 –80.44 0 0 0 0 $80.088.167.835.000.95 371.05 0 $0 $80.787.594.06 0 $0 Q1 : Q2 : Q3 : Q4 : Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of The net cash cost is: $110. Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing $1.67 308.95 $3.28 1.711. in income.100.00 $80.167.95 0 0 0 0 0 0 0 0 $80.67 $308.33 –173.711.835.67 0 3.843.413.00 –80.00 –80.05 earns earns earns earns $1.67 22.000.594.000.835.67 $10.06 The effective annual rate Piepkorn is offering to its customers is: EAR = [1 + (.95 0 $0 Target cash balance Net cash inflow New short-term investments Income on short-term investments Short-term investments sold New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance Minimum cash balance Cumulative surplus (deficit) Beginning short-term investments Ending short-term investments Beginning short-term debt Ending short-term debt The interest earned each quarter is: $80.234.380.594.67 –62.11 3.00 $0 $308.00 59. in income.67 in income.00 $2.000.00 $0 $371.000.000.494.C-56 CASE SOLUTIONS The short-term financial plan under these assumptions will be: Short-term Financial Plan $80.99)]365/30 – 1 EAR = 13.00 –80.05 182.00 172.000.736.44 3.000.000.00 2.000.01/.00 2.711.000.00 $0 $0 $110.594.100.01% .95 $371.167.088.67 188.44 $3.843.00 –192.00 $283.498.843.100.000.088.249.67 –25.

50 54.644.644.33 A/R at beginning of Q collected Sales collection in current Q Purchases last Q paid this Q Purchase for next Q paid this Q Expenses Interest and dividends Outlay Net cash inflow Q3 $410.00 693.67 Q4 $462.345.00 $280. The net cash inflows each quarter will be: Net cash inflow Q1 Q2 $484.17 –476.984.916.833.686. Thus.000.416. we must assume these purchases are for raw materials.33 $360.729.00 –$151.182.67 –348.345.000.330.000.00 540.000.333.00 –95.000.024.330.00 160.00 $160.000. the cash balance each quarter will be: Cash Balance Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit) Q1 $190.17 80.00 –75.17 So.33 –271.00 $270.000.500.17 $10.17 $350.50 80.17 Q4 $415.67 –85.67 $415.984.528.686.00 741.00 $335.00 –96.182.352.CHAPTER 18 C-57 4.00 $54.17 10.50 Q3 $360.00 $183.17 –151.163.33 –414.000. since the purchases from suppliers are a percentage of sales. we will base the purchases off the gross sales figure.00 $360.00 –370.00 80.33 –422.666.00 –95.000.182.000.67 –508.552.163.000.00 –95.000.144. which will not change except for the discount taken. However.17 $263. Piepkorn is now offered a discount from suppliers.00 –309.00 615.520.17 80.00 –103.00 .17 Q2 $350.000.182.000.00 –95.216.83 –372.182.083. In addition to the discount offered to customers.828.345.330.

984.32 $341.000.82 2.15 1. in income. in income.826.17 10.00 –151.158.82 $2.984.000.00 2.282.712.712.419.985)]365/25 – 1 EAR = 24.00 $2.17 284.32 341.015/.58 3.17 0 $0 $271.00 –80.32 0 0 0 $80.718.00 $80.57 0 $0 $80.712.000.17 $284.282.85 $10.000.000.25 The effective annual rate the company’s suppliers are offering to Piepkorn is: EAR = [1 + (.000.25 2.00 –80.17 –12.000.00 $0 $341.00 2.158.000.67 –57.57 193.00 $0 $0 $110.100.00 $271.33 –161.282.00 271.419.58 $3.841.00 $80.000.57 earns earns earns earns $1.00 $0 $284.000.000.00 –80.82 0 0 0 0 0 0 0 0 $80.984.100.182.000. in income.100.58 0 0 0 0 $80.984.074.841. Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing $1.32 0 $0 Target cash balance Net cash inflow New short-term investments Income on short-term investments Short-term investments sold New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance Minimum cash balance Cumulative surplus0deficit Beginning short-term investments Ending short-term investments Beginning short-term debt Ending short-term debt The interest earned each quarter will be: Q1 : Q2 : Q3 : Q4 : Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of And the net cash cost will be: $80.876.282.00 160.266.00 –80.85 148.85 in income.000.163.C-58 CASE SOLUTIONS The short-term financial plan will be: Short-term Financial Plan $80.69% .686.419.000.00 54.841.25 0 $0 $110.17 0 3.158.

0015)(4)($160. which is four since there are four banks. The amount of each transfer is one minus the wire transfer cost.000 – 500)(FVIFA. Setting up this equation where X stands for the ACH transfer cost. the total available in two weeks will be: Amount available = (1 – .02 The company should not go ahead with the plan since the future value is lower. so the company incurs a transfer fee from each collection center.015%.288.14)]/1. The future value of the deposits now will be: Value of ACH = [4($160.015%. we set the amount available we found in Question 1 equal to the cost equation we used in Question 2. 1. we find: [4($160.02 X = $216.04 .955.00015 Value of ACH = $8. The amount the company will have available is the future value of the transfers.939. which are an annuity. times the amount of each transfer.939.13 2.373. 3. times the number of transfers.000)(FVIFA. To find the cost at which the company is indifferent.015%.373. The bank will accept the ACH transfers from the four different banks.14) Amount available = $8.CHAPTER 19 CASH MANAGEMENT AT WEBB CORP. So.00015 = $8.000 – $X)(FVIFA.14)]/1.

24 Next. which are 45 percent of sales.561.136.438.000. we need to calculate the average daily sales which are: Average daily sales = $140.000.000. the NPV is: NPV = –$172. the periodic rate for the 38 day collection period is: Interest rate = (1 + .136. we need to calculate the NPV of each policy.101.CHAPTER 20 CREDIT POLICY AT HOWLETT INDUSTRIES To decide on the optimal credit policy.602.74 + ($383.36 We also need the appropriate interest rate for the collection period.36) / 0. the default rate is 1.000)/365 Average daily defaults = $6.00609 NPV = $32.99 – 8.609% Since the credit policy will exist into perpetuity.2 percent of sales.000)/365 Average daily variable costs = $172.602.000)/365 Average daily administrative costs = $8.000.561.06/365)38 – 1 Interest rate = 0. With a 6 percent annual interest rate.74 Under the current policy.74 – 6.99 The current policy has administrative costs equal to 2.438.20 . We will begin with the average daily variable costs.022($140. the average daily variable costs are: Average daily variable costs = 0.64 – 172. so the average daily administrative costs are: Average daily administrative costs = 0. Current Policy First.900.45($140. We will begin with the calculation of the NPV of the current policy. so the average daily defaults will be: Average daily defaults = 0. So.6 percent.00609 or 0.000/365 Average daily sales = $383. we need the average daily costs.602.016($140.

the average daily sales are: Average daily sales = $157.40 We also need the appropriate interest rate for the collection period.000)/365 Average daily administrative costs = $14.45($160.45($157.027.742. the NPV is: NPV = –$197.16 – 197.8 percent.000.657% Since the credit policy will exist into perpetuity.000)/365 Average daily defaults = $10.90 – 14.000/365 Average daily sales = $438.64 Under the Option 2.27 + ($438.000)/365 Average daily defaults = $7.CHAPTER 20 C-61 Option 1 Under Option 1.018($157.958. With a 6 percent annual interest rate. so the average daily defaults will be: Average daily defaults = 0.561.958.000.136.027.000.260.27 Under the Option 1. the default rate is 1. the periodic rate for the 41 day collection period is: Interest rate = (1 + .025($160.47 .000)/365 Average daily variable costs = $193.356.000)/365 Average daily variable costs = $197.06/365)41 – 1 Interest rate = 0.000.712.00657 or 0.16 The average daily variable costs will be: Average daily variable costs = 0.032($160.27 – 10.000.356. the default rate is 2.40) / 0.260. so the average daily defaults will be: Average daily defaults = 0.23 Option 2 Under Option 2.00657 NPV = $32.000. so the average daily administrative costs are: Average daily administrative costs = 0.2 percent of sales.453.260.99 The average daily variable costs will be: Average daily variable costs = 0.90 Option 1 has administrative costs equal to 3.000/365 Average daily sales = $430. the average daily sales are: Average daily sales = $160.5 percent.000.

000.C-62 CASE SOLUTIONS Option 2 has administrative costs equal to 2.561.323. the NPV is: NPV = –$209.00818 or 0.246. the NPV is: NPV = –$193.03($170.535.47 – 10.06/365)51 – 1 Interest rate = 0.54 – 7.136.742.48 Option 3 Under Option 3.000)/365 Average daily variable costs = $209.4 percent of sales. the periodic rate for the 51 day collection period is: Interest rate = (1 + .04 Under the Option 3.29 We also need the appropriate interest rate for the collection period.000.58 Option 3 has administrative costs equal to 3.589.712.2 percent.00785 NPV = $29.42 The average daily variable costs will be: Average daily variable costs = 0. so the average daily defaults will be: Average daily defaults = 0.58 – 13.000)/365 Average daily defaults = $10.06/365)49 – 1 Interest rate = 0.60 We also need the appropriate interest rate for the collection period. With a 6 percent annual interest rate.00818 NPV = $26.99 – 193. With a 6 percent annual interest rate.022($170.04 –10.45($170.000)/365 Average daily administrative costs = $13.972.00785 or 0. so the average daily administrative costs are: Average daily administrative costs = 0.000.996.42 – 209.000/365 Average daily sales = $465.000.325.04 + ($465.024($157.972.589.753.753.000)/365 Average daily administrative costs = $10.246.29) / 0.0 percent of sales.785% Since the credit policy will exist into perpetuity.41 .323. the periodic rate for the 49 day collection period is: Interest rate = (1 + .60) / 0. the average daily sales are: Average daily sales = $170. the default rate is 2.64 + ($430.818% Since the credit policy will exist into perpetuity.589.000.561. so the average daily administrative costs are: Average daily administrative costs = 0.

while Option 3 extends the credit period and relaxes the credit policy. The default rate and administrative costs of Option 2 are below those of Option 3. This in turn will increase the administrative costs of managing the delinquent accounts.CHAPTER 20 C-63 The company should choose Option 1 since it has the highest NPV. Option 2 extends the credit period. The relaxation of the credit policy will increase the default rate since it will include companies with lower credit ratings who are less likely to pay. . This is plausible.

500 If the exchange rate changes to $1.000 At the current exchange rate of $1.30/€.887. 3.750.175. while the biggest risk is exchange rate risk.800.175. The biggest advantage is the increased sales.000 So. the profit will decline.45/€) Dollar EBT = $6. the profit at the current exchange rate is: Profit = $6.000 Profit = $1.000($1.000($1.750.500 S&S Air has production costs equal to 80 percent of dollar sales at this exchange rate: The total sales in dollars are: Total sales = €5.000.500 – 5.05) After-commission sales = €4.250.000 And the production costs are: Production costs = $7.000($1.087.000 .45/€.000. the EBT in euros will be converted to dollars in the amount of: Dollar EBT = €750.45/€) Total sales = $7.80) Production costs = $5.000 Since the production costs are fixed. The company will pay the sales commission out of gross sales.250. 2. If the dollar strengthens.000(1 – .800. so the after-commission sales in euros is: After-commission sales = €5.30/€) Dollar sales = $6. if the dollar weakens. Conversely.000(0. the euros will convert to: Dollar sales = €4. the profit at this exchange rate will be: Profit = $6.000 – 5.CHAPTER 21 S&S AIR GOES INTERNATIONAL 1.800.887. the profit will increase.

CHAPTER 22 C-65 Profit = $375.000 .

So. Over time. .000/€4.800. so: Breakeven exchange rate = $5.CHAPTER 21 C-66 The breakeven exchange rate is the exchange rate that will allow the after-commission costs in euros to convert to a dollar amount that covers the production costs. the company will make a profit unless the exchange rate moves dramatically. the company will gain on some contracts and lose on others. futures. The downside to all three hedging vehicles is the cost.000 Breakeven exchange rate = $1.221/€ 4. Taking this into account. The company could use options. the company should probably pursue international sales further. At the current exchange rate.750. it is likely that hedging is not required at this point. or forwards. 5.

After all. to the Darwinian nature of the business. we should expect that less than 50 percent of all equity mutual funds would outperform the market.CHAPTER 22 YOUR 401k ACCOUNT AT EAST COAST YACHTS 1. Given the amount mutual fund companies would be willing to spend for research.01 percent? If we multiply the fund assets by 0.000(. and all other investors.000. This is due. in general.50 percent before fees in order to achieve a return after fees equal to the market return. We should also consider that mutual funds managers may be able to outperform the market before expenses. etc. We would expect more than 50 percent of mutual funds would underperform the market because of the expenses charged by the mutual funds. mutual fund managers do not seem to be able to outperform the market. So the question is this: What would Fidelity pay for one year to increase the return of the Magellan Fund by 0. This is definitely true if we consider the weighted average return. one of the largest actively managed equity mutual funds at the time this was written. so they do not appear to be able to outperform the market. Consider the following question: What percentage of investors will outperform the market in a given year? Answer: Fifty percent. and the Darwinian nature of the industry. While there could be one really poor investor who takes all of the losses in a given year.50 percent.000. Whether they can outperform the market on an after-expense basis becomes a question of whether mutual fund managers can extract economic rents from the stock market. we get: $55.01 percent.01 percent per year. including private money managers. and poor performing fund managers are fired. such as Peter Lynch’s tenure at Magellan. often very quickly.500. The fund must exceed the market return by 1. 2. in part. if the “best” and definitely best-financed investors cannot outperform the market. As a result.000. it should be willing to pay up to $5. This does not depend on the level of market efficiency. This means that mutual funds as a whole tend to have the market average return before expenses. The results in the graph tend to support the idea of market efficiency. Before the fact. the market average return has to be the average return of all investors’ average return. with assets of about $55 billion. are the bad investors in the market. to get the market average we would expect one-half of investors would outperform the market. research has found that mutual fund managers underperform the market after expenses by the average expense ratio.0001) = $5. pension fund managers. individuals. So. Good performing fund managers are richly rewarded. and one-half would underperform the market. that is. In reality. Consider the case of the Fidelity Magellan Fund. the results support the concept of market efficiency. Whether the market is efficient or inefficient is irrelevant unless mutual funds managers are the best investors in the market. as a whole. the average return of investors weighted by the dollar amount of the investment. you would expect that mutual funds managers would be able to outperform the market. In general. Consider the large-cap stock fund. The evidence tends to support the idea that they cannot. While there have been notable exceptions. .5 million for that year. with and expense ratio of 1. if Fidelity can increase the return of this one fund by only 0. we would expect that mutual fund managers should be able to outperform the market.

this is not the entire answer. Note that a small cap index fund may be the best option. Therefore. However. your portfolio is not diversified since the S&P 500 index includes only large-cap stocks.CHAPTER 22 C-68 3. Given that the evidence presented tends to support market efficiency. part of your equity investment should probably be in the small cap fund for diversification purposes. but there is no small cap index fund available in the 401k account. you should invest in the S&P 500 index fund. By investing the entire equity portion of your account in the S&P 500 index. .

90 for 25 years. The most significant risk that she faces is interest rate risk.533. the futures gain will offset the loss in value of the mortgage.000 exposure to changes in the market interest rate over the next three months a.90(PVIFA8%/12.300) Mortgage value = $457. We can solve for the payment amount so that the present value of the annuity equals $500.533. and the Ian will only be willing to purchase the mortgage for a price less than $500.000 = C(PVIFA7%/12.CHAPTER 23 CHATMAN MORTGAGE.300) C = $3. or: Mortgage value = $3. If the market interest rate is 6 percent on the date that Joi meets with the Ian. Since Joi will be hurt when interest rates rise. The monthly mortgage payment will be: $500.90 for 25 years. INC. a.300) Mortgage value = $548. the fair value of the mortgage is the present value of an annuity that makes monthly payments of $3. as interest rates fall. If the current market rate of interest rises between today and the date the mortgage is sold. Treasury bond prices have an inverse relationship with interest rates.90(PVIFA6%/12.867.484.000. discounted at 6 percent.533. . If the market interest rate is 8 percent on the date that Joi meets with the Ian. Mike’s mortgage payments form a 25-year annuity with monthly payments. 1.91 3.533.90 2.533. The long position will lose and the short position will gain. she is also hurt when Treasury bonds decrease in value. she should take a short position in Treasury bond futures to hedge this interest rate risk. Treasury bonds become more valuable. the fair value of the mortgage is the present value of an annuity that makes monthly payments of $3.55 b. she would take a short position in five 3-month Treasury bond futures contracts in order to hedge her $500. the amount of principal that he plans to borrow.000 of Treasury bonds. the fair value of the mortgage will decrease. she will not be able to loan Mike the full $500. Since three-month Treasury bond futures contracts are available and each contract is for $100. As interest rates rise. Since Joi is short in the futures. discounted at the longterm interest rate of 7 percent. If this is the case. discounted at 8 percent. Treasury bonds become less valuable. or: Mortgage value = $3. An increase in the interest rate will cause the value of the T-bond futures contracts to decrease.000.000 promised. 4. In order to protect herself from decreases in the price of Treasury bonds. 5.

that the loss in one instrument would be similar to the gain in the other instrument. 6.CHAPTER 23 C-70 b. The fact that this is not a perfect hedge simply means that the gain/loss from the futures contracts may not exactly offset the loss/gain in the mortgage. We would expect. The long position will gain and the short position will lose. the Treasury rate could increase 20 basis points. while the mortgage payments are monthly. . If interest rates change. especially given the short-term nature of the hedge. may affect the relative value of the two. Additionally. An increase in the interest rate will cause the value of the Treasury bond futures contracts to increase. the futures lose will be offset by the gain in value of the mortgage. while a change in one of the interest rates will likely coincide with a change in the other interest rate. The biggest risk is that the hedge is not a perfect hedge. the fact that Treasury bond interest is semiannual. Since Joi is short in the futures. the change does not have to be the same. and the mortgage rates could increase by 40 basis points. For example.

bondholders are effectively allowed to purchase stock at the conversion price of $25. the bondholders will have an active market for the stock if they convert. or someone else. In essence. the company may go public in the future. The potential problem with private equity is that the market is not as liquid as the market for a public company.00 So. they would be able to sell them for $656. The conversion value of the bond is given as $800. in this case 25 percent. the bondholders could potentially have an equity interest in the company. 2. how soon it might go public. Todd’s argument is wrong because it ignores the fact that if the company does well.00 This means the conversion premium of the bond is: Conversion premium = ($25 – 20) / $20 = 0. The intrinsic value of the bond is: Intrinsic value = $30(PVIFA5%.50 = Price/$1.60 Price = $20. bondholders will be allowed to participate in the company’s success. The conversion ratio the bond is: Conversion ratio = $800/$25 = 32.82. with the conversion feature the price will be $800. We can use the PE ratio to calculate the current stock price. the conversion price is important. The case does discuss whether the company has plans to go public.40) + $1000(PVIF5%. even if the company does not go public. If the company does goes public. This illiquidity lowers the value of the stock.18 for the conversion feature. This equity interest can be sold to the original owners. . the company is receiving $143. Doing so. However. we get: P/E = Price/EPS 12.CHAPTER 24 S&S AIR’S CONVERTIBLE BOND 1.82 So. If the stock price rises to $25. and if so.40) Intrinsic value = $656. Second. This means that if the company offered bonds with the same coupon rate and no conversion feature. First. Even though the company is not publicly traded.25 or 25% Chris is suggesting a conversion price of $25 because it means the stock price will have to increase before the bondholders can benefit from the conversion. each bond can be converted to 32 shares of stock. the floor value of the bond is $800.

If the company does poorly. Mark’s argument is incorrect because the company is issuing debt with a lower coupon rate than they would have been able to otherwise. . it will receive the benefit of a lower coupon rate.CHAPTER 23 C-72 3.

If the company does poorly Low stock price and no conversion Cheap financing because coupon rate is lower (good outcome). Reconciling the two arguments requires that we remember our central goal: to increase the wealth of the existing shareholders. The reason is that the firm will have benefited from the lower coupon payments on the convertible bonds. if a company does poorly. the company can call the outstanding bonds. It could be possible that the bondholders would benefit from converting the bonds at that point. Expensive financing because firm could have issued common stock at high prices (bad outcome). Both of the arguments have a grain of truth. with 20-20 hindsight. The reason is that the prosperity has to be shared with bondholders after they convert. issuing convertible bonds will turn out to be better than issuing straight bonds and worse than issuing common stock. The call provision allows the company to redeem the bonds at the company’s discretion. The table below illustrates this point. Cheap financing because firm issues stock at high prices when bonds are converted (good outcome). . which dilutes existing equity (bad outcome).CHAPTER 23 C-73 4. Thus. If the company prospers High stock price and conversion Expensive financing because bonds are converted. Ultimately. which option is better for the company will only be known in the future and will depend on the performance of the company. Convertible bonds issued instead of straight bonds Convertible bonds issued instead of common stock 5. we see that issuing convertible bonds will turn out to be worse than issuing straight bonds and better than issuing common stock if the company prospers. In contrast. but it would eliminate the potential future gains to the bondholders. If the company’s stock appears to be poised to rise. we just need to combine them.

4753 N(d2) = . ignoring the premium.0618 3. the value of the stock options per share of stock is: d1 = [ln($24. it 1 ) = –1.1011 3 ) = –.7887 N(d2) = .CHAPTER 25 EXOTIC CUISINE EMPLOYEE STOCK OPTIONS 1.038 + .60 × N(d1) = .0618 – (. So.044 + .8020 – (. A basic way to understand this is to realize that an option always has value since. we find the option value is: C = $24.1354 Putting these values into the Black-Scholes model.8020 0 3 ) = –1. If you are planning to leave next week.7887) – ($50e–.60 × d2 = . .044(10))(.602/2) × 3] / (.4753) – ($50e–.1367 Putting these values into the Black0Scholes model.38/$50) + (.038(3))(.38(. We need to use the risk-free rate that is the same as the maturity as the options.1367) = $14.0953 0 1 ) = . Whether you should exercise the options in three years depends on several factors.83 2. A primary factor is how long you plan to stay with the company. The fact that the employee stock options are not traded decreases the value of the options. We can use the Black-Scholes equation to value the employee stock options. the value of the stock options per share of stock is: d1 = [ln($24.38(.55 Assuming expiration in ten years. we find the option value is: C = $24.60 × N(d1) = . A second factor is how the option exercise will affect your taxes. you should exercise the options.1354) = $5.38/$50) + (.602/2) × 10] / (.60 × d2 = –. assuming expiration in three years.

The right to sell an option also has to have value. it decreases the price of the option. If the right to sell is removed. .CHAPTER 24 C-75 can never lose money.

which means the employee actions are actually part of the company performance. and underwater employee stock option provides little incentive since it may be unlikely that the stock price will reach the strike price before expiration. Consider an extreme: A company announces the employee stock options will be worth a minimum of $10 at expiration. the stock price can increase because of a general market increase. Vesting requires employees to work at a company for a specified time. the company’s stock will likely fall as well. it provides less incentive. The evaluation of the argument for or against repricing is open-ended. if the stock price does decline dramatically. Employee stock options increase in value if the stock price increases. However. if the market falls. 6. however. Repricing increases the value of the employee stock option. The company’s stock should closely mirror the market return. Vesting is also a “golden handcuff. A better method of valuing employee stock options might be to reward employees for company performance in excess of the market performance.” The employee is less likely to leave the company if in-the-money employee stock options will vest soon. . the value of the option increases.CHAPTER 25 C-76 4. They must often be exercised shortly after an employee leaves the company so that they may no longer participate in any potential stock price increase. even if the company is doing well. If an employee knows the option will be repriced if the stock declines. There are valid reasons on both sides of the discussion. even though most of the stock price increase is due to the general market increase. Consider a company of average risk in a bull market that has a large return for several years. Since all values less than $10 are no longer possible. The rationale for employee stock options is to reduce agency costs by better aligning employee and shareholder interests. 5. adjusted for the company’s level of risk. Similarly. Repricing can be viewed as a negative.

000.80 6 Year 5 $27.00 0 $41. The present value of each year’s cash flows.254.00 0 Year 2 $12.139 $361.CHAPTER 26 THE BIRDIE GOLF-HYBRID GOLF MERGER 1. All earnings not retained are paid as dividends.000 $659. so the cash flows for the next five years will be: Year 1 $38.848.168.400.995 NPV = $44.800.4% $32.000 –$400.995 And the NPV of the acquisition is: NPV = –$400.000 Using the information provided.64 3 Year 4 $22.400.000 + 32.403.578 $18.80 6 Year 1 $32. we need to examine the present value of the incremental cash flows.466.589 + 9. we must discount each cash flow at the appropriate discount rate.366.00 0 Year 3 $29.168.000.466.848.00 0 Year 5 $59.610.800.000.64 3 $22.856 334.366.00 0 $29. and as such.366. we can determine the cash flows to Birdie Golf from acquiring Hybrid Golf.025. As with any other merger analysis.848.643 + 22.07 .400. along with the appropriate discount rate for each cash flow is: Discoun t rate 16.403.58 9 $9.00 0 $12.000 $150.000 Dividends from Hybrid Terminal value of equity Total To discount the cash flows from the merger.403.000. The terminal value of the company is subject to normal business risk and should be discounted at the cost of capital. or: Acquisition of Hybrid Dividends from Hybrid Total –$550.578 Year 3 $18.400. should be discounted at the cost of equity. while the dividends are equity cash flows. The cash flow today from the acquisition is the acquisition costs plus the dividends paid today.441.168.00 0 Year 4 $41.58 9 Year 2 $9.400.00 0 $38.000 600.9% Dividends PV of value Total 12.000.400.000.578 + 18.806 + 361.000.

28 3. This implies the share price of Birdie remains unchanged after the merger. divided by the shares outstanding.75 / $96.000.254.07 The highest share price is the total high offer price.000 shares Highest share price = $74.7314 . the most Birdie would offer is to increase the current cash offer by the current NPV. The new share price of Birdie after the merger will be: PNew = ($94 × 18.C-78 CASE SOLUTIONS 2.07 Highest offer = $594.610.07) / 18.46 Exchange ratio = .254.610. we need to determine the new share price under the original cash offer. The highest exchange ratio Birdie would accept is an exchange ratio that results in a zero NPV acquisition.46 So.000 + $44. To determine the current exchange ratio which would make a cash offer and a share offer equivalent. or: Highest offer = $550. the exchange ratio which would make the cash offer and share offer equivalent is: Exchange ratio = $68.610. Since the acquisition is a positive NPV project.610.75 / $94 Exchange ratio = .000 + 44. or: Highest share price = $594.000.000.07 / 8.000.000 PNew = $96.254. so the exchange ratio is: Exchange ratio = $68.7127 4.254.

300. The lease payments are due at the beginning of each year. The salvage value of the equipment in four years will be: Aftertax salvage value = $600.855.000 –1.875 –$259.675/1.000 –1.000.104.000 455. the lease payments.0715 – $1.275 –$777.104.000 Year 1 Year 2 Year 3 Year 4 –$390.300.175 –1.000 455.000 Saved purchase Lost salvage value Lost dep.275 –300.11(1 – .CHAPTER 27 THE DECISION TO LEASE OR BUY AT WARF COMPUTERS 1.000 $3.300.675 The aftertax cost of debt is: Aftertax cost of debt = .428.15% And the NAL of the lease is: NAL = $3.875 –1.855.622.000 455. the tax savings on the lease.07154 NAL = $44. The incremental cash flows from leasing the machine are the security deposit. tax shield Security deposit Lease payment Tax on lease payment Cash flow from leasing –$583.428. so the incremental cash flows are: Year 0 $5.07153 – $219. and the lost salvage value.000 455.000 – $600.875/1.000 This is an opportunity cost to Warf Computers since if the company leases the equipment it will not be able to sell the equipment in four years.000 – $1.0715 or 7.35) Aftertax salvage value = $390.07152 – $1. . The decision to buy or lease is made by looking at the incremental cash flows.675 300.000 –129.308.0 The company should lease the equipment.175 –$219.175/1.35) Aftertax cost of debt = .000 –$1.275/1.622.300.000(.000 –$1. the saved purchase price of the machine. the lost depreciation tax shield.000 –$1.

000 + $2. the NAL of the lease under the new terms would be: Year 0 $5. the lessor will allow for the increased lease payments made over the first two years. The book value of the equipment in year 2 will be: Book value = $5.300.000 – $2.099.111.000 –$2. which is less than 75 percent of the equipment’s life according. .000 Year 1 Year 2 –$1. As such.000/1.688.35) Aftertax salvage value = $1.072.850 –777.000.07152 NAL = –$583.688.875 Saved purchase Lost salvage value Lost dep. the aftertax salvage value in year 2 will be: Aftertax salvage value = $2.11 The NAL of the lease is negative under these terms.000.805.000.111.000)(.466. the reason for suggesting the revised lease terms is unethical on Nick’s part. However.000 –$583. the lease will likely be classified as an operating lease. so it appears the terms are less favorable for the lessee.000(.078. the NAL of the lease under these terms is: NAL = $3. Using the company’s cost of debt.000. The lease is now for two years.000 – 2.505.C-80 CASE SOLUTIONS 2. This is also an indication that the revision is for less than ethical reasons.275/1.3333 + . or allow for a purchase at a bargain price. tax shield Lease payment Tax on lease payment Cash flow from leasing –2.300. the FAS 13 conditions for a capital lease are not met.725 So.0715 – $2. notice that the question also states that if the lease is renewed in two years.07 This is less than 90 percent of the price of the equipment.078.000 So. Also.000 805.000 + ($1.466.000.300.000 805.725/1.4445) Book value = $1.275 –$2.11 PV of lease payments = $4.372.300.275 –2.850 So. the present value of the lease payments is: PV of lease payments = $2. As long as the lease contract does transfer ownership to the lessee at the end of the contact.000 $3.000 – $5.

This contract condition will definitely ensure the lease is classified as a capitalized lease. c. This is a real option. The cancellation option is also a real option. It will increase the value of the lease since the lessee will only exercise the option when it is to the lessee’s advantage. The right to purchase the equipment at a bargain price is also a real option for the lessee. and therefore will have value until it expires or is exercised. it will save money. it can go on the market and purchase identical equipment at the same price. it must have a value until it expires or is exercised. It is a call option. or at a minimum. . It is a call option on the equipment. therefore has value to the lessee. As such. 4.CHAPTER 27 C-81 3. If the company can purchase the equipment at the end of the lease at below market value. and will increase the value of the lease. The inclusion of a right to purchase the equipment will have no effect on the value of the lease. a. b. can purchase the equipment at the fixed price and resell it in the open market. It is also important to note that this would likely make the lease contract a capitalized lease. The right to purchase the equipment at a fixed price will increase the value of the lease. If the company does not purchase the equipment. The cancellation option is a put option on the equipment.

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