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

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

492 And the change in net working capital was: Change in net working capital Ending NWC – Beginning NWC Change in NWC $29.624 OCF2008 = $85.195 129. we need to find the capital spending and change in net working capital.401 $91.180 OCF2009 = $69.661 Total liab.250 Owners' equity $272.581 – 10.217 – 12.611 . so: Equity = $89.680 + 40. 2009 $27.404 15.216 Current liabilities $81.326 + 15.250 156.717 Notes payable 37.734 4. The capital spending for the year was: Capital spending Ending net fixed assets – Beginning net fixed assets + Depreciation Net capital spending $191.853 + 35.065 3.139 + 24.163 OCF2009 = $97. To calculate the cash flow from assets.975 40.661 The owner’s equity for 2009 is the beginning of year owner’s equity.CHAPTER 2 C-3 Cash Accounts receivable Inventory Current assets Net fixed assets Total assets Balance sheet as of Dec.399 $17. plus the addition to retained earnings.600 Equity = $129. & equity $36.065 $272. 31.478 Accounts payable 16.217 $74.010 11.997 $52.411 Long-term debt $191. plus the new equity. Using the OCF equation: OCF = EBIT + Depreciation – Taxes The OCF for each year is: OCF2008 = $60.

The firm invested $17. companies do need capital to grow.866 11. The cash flow to stockholders was: Cash flow to stockholders Dividends paid – Net new equity raised Cash flow to stockholders Answers to questions 1.492 in new fixed assets. but a large portion of the operating cash flow is already going to capital spending. $97. and paid $8.631 to its stakeholders. The company has had to raise capital from creditors and stockholders for its current operations.631 $8.492 17. The firm gave $5. Before investing or loaning the company money. The company does have a positive cash flow. The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. On the other hand. The cash flow to creditors was: Cash flow to creditors Interest paid – Net new borrowing Cash flow to creditors 6. It raised $3.326 15.C-4 CASE SOLUTIONS So.611 in new net working capital and $74.094 from bondholders.600 $8. and why the company is spending so much in this area already.726 to stockholders. 2. the cash flow from assets was: Cash flow from assets Operating cash flow – Net capital spending – Change in NWC Cash flow from assets 5. So.734 74.611 $ 5. you would want to know where the current capital spending is going. the expansion plans may be too aggressive at this time.960 –$3.094 $24.726 . The expansion plans may be a little risky.

499.15 times Total asset turnover = $30.000) / $10.366.CHAPTER 3 RATIOS ANALYSIS AT S&S AIR 1.537.120) / $2.000 Cash ratio = 0.420 / $708.000 + 5.537.919.420 Cash coverage = 9.120 Inventory turnover = 21.069.308.919.43 times Receivables turnover = $30.920 / $10.040.224.920 Total debt ratio = 0.660 + 1.920) / $18.040.04% Return on assets = $1.000 Current ratio = 0.36 times Cash coverage = ($3.920 – 10.069.037.660 / $478.240 Times interest earned = 6.037.39 times Cash ratio = $441.499.308.920 Return on assets = 8.520 / $2.22 times Profit margin = $1.40% .920 Debt-equity ratio = 0.186.67 times Inventory turnover = $22.186.308.75 times Quick ratio = ($2.82 times Equity multiplier = $18.920 Total asset turnover = 1.452 / $18.069.420 Profit margin = 5.308.400 Receivables turnover = 43.250 – 1.82 times Times interest earned = $3.308.919.05 times Total debt ratio = ($18.919.680) / $478.920 Equity multiplier = 1.580 / $1.420 / $18. The calculations for the ratios listed are: Current ratio = $2.499.000 Quick ratio = 0.000 / $2.452 / $30.320.45 times Debt-equity ratio = ($2.

452 / $10.069.27% .537.920 Return on equity = 15.C-6 CASE SOLUTIONS Return on equity = $1.

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

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

0840(.40% b = Addition to RE / NI b = $977.64% To find the sustainable growth rate.069.920 ROA = .309.64)] Sustainable growth rate = .1075 or 10.0840(. which is: ROE = NI / TE ROE = $1.75% The internal growth rate is the growth rate the company can achieve with no outside financing of any sort.64)] Internal growth rate = .64)] / [1 – 0.0840 or 8. To calculate the internal growth rate.452 b = 0.452 / $1. the sustainable growth rate is: Sustainable growth rate = (ROE × b) / [1 – (ROE × b)] Sustainable growth rate = [0.0564 or 5.1527 or 15. 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.452 / $10.1527(.1527(.64)] / [1 – 0.537. we need the ROE. .27% Using the retention ratio we previously calculated.537.537.CHAPTER 4 PLANNING FOR GROWTH AT S&S AIR 1. we first need to find the ROA and the retention ratio.920 ROE = .452 / $18. so: ROA = NI / TA ROA = $1.64 Now we can use the internal growth rate equation to get: Internal growth rate = (ROA × b) / [1 – (ROA × b)] Internal growth rate = [0.

197 Balance sheet Assets Current Assets Cash Accounts rec.249.448. it will increase the sustainable growth rate.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 $ 995.530 4.117 $ 19. the EFN is: $ 18.057.569.C-10 CASE SOLUTIONS 2. Inventory Total CA $ 493.408 1.505.680 $ 3. total asset turnover. . or equity multiplier. the ROE increases.193 The company can grow at this rate by changing the way it operates.159.350 24.505.680 2. if profit margin increases. that changing any one of these will have the effect of changing the pro forma financial statements.780 $ 675.030. In general.990 350.301 1.000 10.236. 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. Note however. say by reducing costs.787 EFN = Total assets – Total liabilities and equity EFN = $20.088 $ 20.891.600 1. For example.920 793. as long as the company increases the profit margin.899.161.574 $ 2.541 478.594.331.594.000 3.025.520 $ 1.797 EFN = $911. the higher growth rate is possible.366.990 – 19.117 $ 11.000 $ Fixed assets Net PP&E Total Assets So.583 1.240 $ 3.854.320.091.680 5.179.

400) Pro forma depreciation = $1.122.519 .955 1.600.600 1. we will find the current depreciation as a percentage of fixed assets.667.400 + 5.982 $ 1.122.000 = $21. 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 $ 34.48% The new level of fixed assets with the $5 million purchase will be: New fixed assets = $16.400 Depreciation percentage = .122.366. So. To estimate the new depreciation charge.530 4. the pro forma depreciation will be: Pro forma depreciation = .790.122.891.017. The depreciation as a percentage of assets this year was: Depreciation percentage = $1.0848($21.066. apply this percentage to the new fixed assets.696 478. We will assume that the company will go ahead with the fixed asset acquisition.473 $ 582.350 24.145. then.240 $ 2.000.CHAPTER 4 C-11 3.790. Now we are assuming the company can only build in amounts of $5 million.525 We will use this amount in the pro forma income statement.0848 or 8.400 So.331.159.680 / $16.456 1.525 $ 3.

rather than the growth rate of sales. The fixed asset account will increase by $5 million.433.C-12 CASE SOLUTIONS The pro forma balance sheet will remain the same except for the fixed asset and equity accounts.087.184 Since the fixed assets have increased at a faster percentage than sales.920 793.000 10.581.439 $ 11.320.408 1.433.439 $ 19.030.122.574 $ 2. Inventory Total CA $ 493.302 350.400 $ 23.119 EFN = Total assets – Total liabilities and equity EFN = $23.138. Balance sheet Assets Current Assets Cash Accounts rec.000 3.302 – 19.737.119 EFN = $4.000 $ Fixed assets Net PP&E Total Assets So.448.161. the EFN is: $ 21. the capacity utilization for next year will decrease.025.680 5.571.902 Liabilities & Equity Current Liabilities Accounts Payable $ Notes Payable Total CL $ Long-term debt Shareholder Equity Common stock Retained earnings Total Equity Total L&E $ 995.680 2. .

and how important the prestige of a job is to him.000 = $68.065)/(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.000(1 – . as well as the opportunity cost of the lost salary.03) / (1 + .03) PV = $836. so: Remain at current job: Aftertax salary = $55. or pursue a Mt.0652 = $9. In this analysis.700 / (1.500 + 68. He has three choices: remain at his current job.26) = $40.CHAPTER 6 THE MBA DECISION 1.065 – .819.176.500 / (1. 3. Age is obviously an important factor. With a spouse and/or children.17 Aftertax salary = $98. room and board costs are irrelevant since presumably they will be the same whether he attends college or keeps his current job.500 + 3. job satisfaction.34 Wilton MBA: Costs: Total direct costs = $63.31) = $67. regardless of the salary. The cost includes both the explicit costs such as tuition.500 PV of direct costs = $68.065) = $132.065) + $40.125.700 His salary will grow at 3 percent per year. Perhaps the most important nonquantifiable factors would be whether or not he is married and if he has any children.700(1 + . so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $40.000(1 – .03)]38} / (.000(1 – .065)2 = $75.000 + 2. Other factors would include his willingness and desire to pursue an MBA.700{[1 – [(1 +.00 Salary: PV of aftertax bonus paid in 2 years = $15. pursue a Wilton MBA. The younger an individual is.227.25 PV of indirect costs (lost salary) = $40.620 2.31) / 1. Perry MBA. We need to find the aftertax value of each. . 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.

C-14 CASE SOLUTIONS .

174. so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $67.67 Aftertax salary = $81.26 So.29) = $57.544.29) / 1.125.510 His salary will grow at 3.04)]36} / (.215.250.CHAPTER 6 C-15 His salary will grow at 4 percent per year. so we need to discount this for two years to find the value today.67 + 1.640.370.683.663.000 = $86.590.81 Since the first salary payment will be received two years from today. PV of indirect costs (lost salary) = $40. which will be: PV = $1. so we need to discount this for one year to find the value today.81 / 1.250.056.666. the total value of a Wilton MBA is: Value = –$75.171.370.20 = $1.065 – .215.000(1 – .500.5 percent per year.035)]37} / (. so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $57.0652 PV = $1. We must also remember that he will now only work for 36 years.683.22 / 1.663.000(1 – .813.26 = $1.819.991. the total value of a Mount Perry MBA is: Value = –$86.991.25 + 9.500 + 3.510{[1 – [(1 +. this is also the PV of the direct costs since they are all paid today.554. which will be: PV = $1.065)/(1 + .065)/(1 + .22 Since the first salary payment will be received three years from today.96 + 6.640.065 – .17 + 1.20 So.160 – 132. We must also remember that he will now only work for 37 years.666.065) = $38.000 + 3.90 .04) PV = $1.035) PV = $1.065 PV = $1.500 – 38.174.700 / (1.18 Mount Perry MBA: Costs: Total direct costs = $78.96 Salary: PV of aftertax bonus paid in 1 year = $10.620{[1 – [(1 +.065 = $6. Note.

065 – .17 = $1. .176. the pretax salary must be: Pretax salary = $45. The cost (interest rate) of the decision depends on the riskiness of the use of funds. Calculating the future value of each decision will result in the option with the highest present value having the highest future value. He is somewhat correct. However.51 / (1 – .035.035. Thus.42 = C {[1 – [(1 +.C-16 CASE SOLUTIONS 4. add the costs of attending Wilton. the necessary PV to make the Wilton MBA the same as his current job will be: PV = $836. whether he can pay cash or must borrow is irrelevant.42 This PV will make his current job exactly equal to the Wilton MBA on a financial basis. Therefore. 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.57 6.021. the aftertax salary needed is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] $1.065)/(1 + .097.227.819.25 + 75. This is an important concept which will be discussed further in capital budgeting and the cost of capital in later chapters.31) = $65. Since his salary will still be a growing annuity.04) C = $45.51 This is the aftertax salary. not the source of the funds. So.00 – 9.248.097. 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. So.04)]36} / (.34 + 132. and the PV of the bonus on an aftertax basis. we need to take the PV of his current job.125. 5.021.

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

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

The downside of a floating-rate coupon is that if interest rates rise. Remember. if interest rates fall. the company cannot sell any collateral. The positive covenant may force the company into actions in the future that it would rather not undertake. The presence of negative covenants protects bondholders from actions by the company that would harm the bondholders. Examples of negative covenants would be: the company cannot increase dividends. 8. 10. This says nothing about bondholders. A negative covenant would reduce the coupon rate. The negative side of positive covenants is that the company is restricted in its actions. the company must maintain a minimum specified level of working capital or a minimum specified current ratio. the goal of a corporation is to maximize shareholder wealth. or at least increase beyond a specified level. The downside of negative covenants is the restriction of the company’s actions. the company must maintain any collateral in good working order. The presence of positive covenants protects bondholders by forcing the company to undertake actions that benefit bondholders. The conversion feature would permit bondholders to benefit if the company does well and also goes public. a conversion feature would likely lower the coupon rate. Even though the company is not public. The downside is that the company may be selling equity at a discounted price.CHAPTER 7 C-19 7. . the company cannot issue new bonds senior to the current bond issue. the company has to pay a higher interest rate. Examples of positive covenants would be: the company must maintain audited financial statements. 9. the company pays a lower interest rate. However. A positive covenant would reduce the coupon rate.

26 Now we can find the stock price.72) = . the company’s growth rate is: g = ROE × b = . Since Expert HVAC had a write off which affected its earnings per share.1806 or 18.3715 or 37. we need to recalculate the industry EPS.000. which is: P0 = D1 / (R – g) P0 = $1. the retention ratio was: Retention ratio = 1 – .40/$1.CHAPTER 8 STOCK VALUATION AT RAGAN.72 Using the retention ratio. So.06% The dividend per share paid this year was: D0 = $63.79 + 1.08 = .000 / 50.3715 = .000/$454.20 – .26(1. 1.15% So.08 Using this industry EPS.000 shares outstanding.06) / 3 = $1. the industry retention ratio is Industry retention ratio = 1 – .28 So.6285 or 62.1806) P0 = $76. The total dividends paid by the company were $126.38 + 1. the total earnings for the company were: Total earnings = 100.54) = $454.000 = 0.000($4.28 = 0. the industry EPS is: Industry EPS = ($0. INC. Since there are 100.1806) / (.28(.000 This means the payout ratio was: Payout ratio = $126.000 D0 = $1.85% . the industry payout ratio is: Industry payout ratio = $0.75 2.

CHAPTER 8 C-21 .

C-22 CASE SOLUTIONS This means the industry growth rate is: Industry g = .1233(.6285) = .0775 or 7.75% The company will continue to grow at its current pace for five years before slowing to the industry growth rate. So, the total dividends for each of the next six years will be: D1 = $1.26(1.1806) = $1.49 D2 = $1.49(1.1806) = $1.76 D3 = $1.76(1.1806) = $2.07 D4 = $2.07(1.1806) = $2.45 D5 = $2.45(1.1806) = $2.89 D6 = $2.89(1.0849) = $3.11 The stock price in Year 5 with the industry required return will be: Stock value in Year 5 = $3.11 / (.1167 – .0775) = $79.54 This means the total value of the stock today is: P0 = $1.149/1.1167 + $1.76/1.11672 + $2.07/1.11673 + $2.45/1.11674 + ($2.89 + 79.54) / 1.11675 P0 = $53.28 3. Using the revised industry EPS, the industry PE ratio is: Industry PE = $13.09 / $1.08 = 12.15 Using the original stock price assumption, Ragan’s PE ratio is: Ragan PE (original assumptions) = $76.75 / $4.54 = 16.90 Using the revised assumptions, Ragan’s PE = $53.28 / $4.54 = 11.74 Obviously, using the original assumptions, Ragan’s PE is too high. The PE using the revised assumptions is close to the industry PE ratio. Using the industry average PE, we can calculate a stock price for Ragan, which is: Stock price implied by industry PE = 12.15($4.32) = $55.18 4. If the ROE on the company’s projects exceeds the required return, the company should retain earnings and reinvest. If the ROE on the company’s projects is lower than the required return, the company should pay dividends. This makes logical sense. Consider a company with a 10 percent required return. If the company can keep retained earnings and reinvest those earnings at 15 percent, shareholders would be better off since the dividends in future years would be more than needed for the required return.

CHAPTER 8 C-23 5. Again, we will assume the results in Question 2 are correct. The growth rate of the company we calculated in this question was the industry growth rate of 7.75 percent. Since the growth rate is: g = ROE × b If we assume the payout ratio remains constant, the ROE is: .0775 = ROE(.72) ROE = .1073 or 10.73% 6. The most obvious solution is to retain more of the company’s earnings and invest in profitable opportunities. This strategy will not work if the return on the company’s investment is lower than the required return on the company’s stock.

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

CHAPTER 8 C-25 Note, there is no Excel function to directly calculate the payback period. We used “If” statements in our spreadsheet. The IF statement we used is: =IF(-D8>(D9+D10+D11+D12+D13+D14),"Greater than 6 years",IF(D>(D9+D10+D11+D12+D13),(5+(-D8-D9-D10-D11-D12-D13)/D14),IF(D8>(D9+D10+D11+D12),(4+(-D8-D9-D10-D11-D12)/D13),IF(-D8>(D9+D10+D11),(3+(-D8-D9D10-D11)/D12),IF(-D8>(D9+D10),(2+(-D8-D9-D10)/D11),IF(-D8>D9,(1+(-D8-D9)/D10),IF(D8<D9,-D8/D9," "))))))) 2. Since the NPV of the mine is positive, the company should open the mine. We should note, it may be advantageous to delay the mine opening because of real options, a topic covered in more detail in a later chapter. There are many possible variations on the VBA code to calculate the payback period. Below is a VBA program from http://www.vbaexpress.com/kb/getarticle.php?kb_id=252. Function PAYBACK(invest, finflow) Dim x As Double, v As Double Dim c As Integer, i As Integer x = Abs(invest) i=1 c = finflow.Count Do x=x-v v = finflow.Cells(i).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.

000 Sales New Lost sales Lost revenue Net sales VC New Lost sales Year 1 $26.685.000.000 × $360) – (15.000 4.275.000 $28.000 4.878 $9. In this case.265.950 $8.265.573 $14.650 900.164.000 –1.700.000 $11.400.000 4.375.000 4.000 $45.000 $12.765.000 –2.000 4.015.919.884.276.350 $5.000 $12.033 1.000 2.640.700.000 Year 2 $34. The initial cash outlay at Time 0 is simply the cost of the new equipment.000 –4.428 $1.373 $19.350 $11.157.CHAPTER 10 CONCH REPUBLIC ELECTRONICS.670.000 16.000 $28.000 × $290) – [(60.700.572.000 –1.275.373 $16.000 $28.023 5.000 – 15.000 $45.000 Year 2 = (95.000 5.123 $12.200.470.350 $14.800.050 3.223 3.000 $19.700.400.000 9.000 –1.917.672.275.650 1.350.072.375.375.670.000 $37.500.007.350 $2. The sales each year are a combination of the sales of the new PDA. the lost sales each year.000 $20.950 $9.384.800.018 $6. the total change in sales is: Sales = New sales – Lost sales – Lost revenue Year 1 = (74.139.023 3.919.780.760. PART 1 This is an in-depth capital budgeting problem.000 $20.500.000 3.725.650 4.275. $21.350 $14.800.925.700.275.800.650 6.983 Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF .423.575.800.000 × $360) – (15.000 –4.400.000 – 15.000 $16.000 Year 3 $45.628 $3.760.628 $11.000 1.000 $28.350 $4.000 12.876.744.190.000 $37.000.000.000 12.948.015.000 Year 5 $28.925.072.357.800.275.000) × ($290 – 255)] = $28.350 $8. and the lost revenue.800. So. the lost sales are 15.000 units of the old PDA each year for two years at a price of $290 each.350 $17.000) × ($290 – 255)] = $20.000.685. 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 3.800.773 2.000 19.015.350.000 × $290) – [(80.000 Year 4 $37.275.000 $9.

122 + $11.123 $7.000 –$4.000 741.113.373 11.180.650 – 4.000 0 $7.950) BV of equipment = $4.123 + $13.796.373 / (1 + IRR)2 + $11.123 / (1 + IRR)4 + $20.000 5.500 – 5.123) + ($13.652.125 NPV = $12.000 $11.100.180.573 7.316.000 $1.316.573 $4.62% 4.316. The project IRR is: IRR: –$21.072.000 $7.316.124) + ($20.572.123 20.683 / $13.316.373 13.000 –$3.810 / 1.000 $15.572.373 / (1 + IRR)3 + $13.919.573 / (1 + IRR) + $7.000)(.350 – 2.810 / 1.000 = $741.983 BV of equipment = ($21.655.000 – 3.000 Profitability index = 1.572.500.156 years 2.373 $5.000 + 243. The project NPV is: NPV = –$21.373 / 1.560.560.000 –$1.180.345.373 / 1.000 $741.655.828 So.000 9.113.000 $13.611.573 / 1.123 / 1.350 – 1.343. the cash flows of the project are: Time 0 1 2 3 4 5 1.316.000.124 + $20.123 / 1.000 + $741.265.000 7.836.440.500.500.572.100.000.113.003. The payback period is: Payback period = 3 + ($2.113.604 3.760.573 / 1.572.810 .373 / 1.072.12 + $7.373 $9.003.500.123) Payback period = 3.828 CF on sale of equipment = $4.35) = $243.113.500.62 Cash flow –$21.685.828 = $4.12) + ($7.650 Taxes on sale of equipment = (BV – MV)(tC) = (4.003.796. The profitability index is: Profitability index = [($741.350 – 3.373 / 1.125)] / $21.180.122) + ($11.983.CHAPTER 8 C-27 NWC Beg End NWC CF Net CF $0 4.560.810 / (1 + IRR)5 IRR = 27.

800.000 $29.350.000 $16.000 4.000 $12.225.000 $19.670.000) × ($290 – 255)] Year 2 sales = $29.000 4.000 $46.000 Year 5 $29.000 × $370) – (15.000 × $370) – (15.000 $12.275.000 $9.925.000 $11.400.000 1.350.150.850.000 Year 4 $38. The only difference is that we will change the price of the PDA. minus the lost sales of the existing PDA. the sensitivity of NPV to a one dollar change in price will be the same no matter what price we use. We will use a price of $370 per unit.CHAPTER 11 CONCH REPUBLIC ELECTRONICS.000 $38.375.000 $20. 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.000 $19.000 1.380.000 . or: Sales = New sales – Lost sales – Lost revenue Year 1 sales = (74.225.250.000 Year 2 $35.600.470.755.000) × ($290 – 255)] Year 1 sales = $20.000 $16.250.000 $12.000 Sales New Lost sales Lost revenue Net sales VC New Lost sales Year 1 $27.000 × $290) – [(80.850. PART 2 1.000 – 15.000 $14. minus the lost dollar sales from the price reduction of the existing PDA.575.000 × $290) – [(60.275.755. but remember that the price we choose is irrelevant: The final answer we want.400.000 $29.275.000 Year 2 sales = (95.000 1.000 2.800.000 Year 3 $46.600.725.375. The projections with the new prices are: The sales figure for the first two years will be the sales of the new PDA.000 – 15.

334.445.151.650 2.000 $1.038.125 NPV = $15.873 / 1.123 + $14.623 / 1.685.400.033 1.000 4.828 So.250.151.350 – 1.000 2.688.650 Taxes on sale of equipment = (BV – MV)(tC) = (4.500 – 5.950 $10.845.000 4.700.375.850.350 $6.000 $16.000)(.919.623 $29.580.000 4.600.000 –$3.796.189.074.623 20. the cash flows of the project under this price assumption are: Time 0 1 2 3 4 5 Cash flow –$21.573 $29.873 14.000 7.350 $15.523 3.072.324.074.414.873 $46.688.265.000 5.018 $6.217.700.128 $4.074.685.124 + $20.810 The NPV with this sales price is: NPV = –$21.072.983 BV of equipment = ($21.700.716.350 $18.670.153.CHAPTER 11 C-29 Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF $20.000 –$4.969.000 12.700.350 – 2.000 –$1.796.770.770.760.250.500.151.700.873 12.265.350 $9.760.925.312.877.250.324.000 4.350 $12.000 $14.000 1.910.828 CF on sale of equipment = $4.405.275.12 + $7.558.000 + $1.382.873.480.265.729.950) BV of equipment = $4.694.159.225.770.000 9.755.000 19.623 $7.072.000 $7.350 $15.000 0 $7.650 5.100.760.000 12.100.273 2.873 / 1.18 .573 / 1.796.324.117.000 1.650 – 4.523 5.573 $4.919.128 $11.343.122 + $12.000 3.050 3.950 $8.316.000 3.350 – 3.828 = $4.000 + 243.038.148.428 $2.000 $1.350 $3.223 3.919.688.225.650 1.000 4.038.703.000 – 3.350 $5.810 / 1.000 16.000 9.983 NWC Beg End NWC CF Net CF $0 4.35) = $243.650 6.378 $9.566.873 $9.685.873 $38.910.873 $5.845.000 $12.000 5.573 7.500.500.

311.46 For every dollar change in price of the new PDA. We will increase unit sold by 100 units per year. minus the lost dollar sales from the price reduction of the existing PDA. . The only difference is that we will change the quantity sold of the new PDA.000 × $290) – [(80.46 in the same direction.510. Remember that the quantity we choose is irrelevant: The final answer we want. or: Sales = New sales – Lost sales – Lost revenue Year 1 sales = (74. the NPV of the project changes $216. the sensitivity of NPV to a one unit per year change in sales.62) / ($370 – 360) ΔNPV/ΔP = $216. The projections with the quantity are: The sales figure for the first two years will be the sales of the new PDA.100 × $360) – (15.000) × ($290 – 255)] Year 2 sales = $28.100 × $360) – (15.510.051.000) × ($290 – 255)] Year 1 sales = $20.148.C-30 CASE SOLUTIONS And the sensitivity of changes in the NPV to changes in the price is: ΔNPV/ΔP = ($15.000 Year 2 sales = (95.716.000 – 15.000 – 15.983.18 – 12. Here we want to examine the sensitivity of NPV to changes in the quantity sold.000 × $290) – [(60.000 Note. minus the lost sales of the existing PDA. the variable costs must also be increased to account for additional units sold. 2.611. The calculations for sensitivity to changes in quantity are similar to the original cash flows.

204.698 $5.329.828 CF on sale of equipment = $4.685.740.567.308 Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF NWC Beg End NWC CF Net CF $0 4.000 19.007.350 $17.000 Year 4 $37.290.265.567.150 907.000 + 243.652.919.150 4.390.000 $7.836.500 4.956.345.700.500 $16.343.700.500 – 5.585.036.072.010.700.350 $2.500 $45.35) = $243.350 $4.200 7.000 $13.350 $8.800.350 $14.676.000 $9.919.836.415.350 – 1.200 –$1.405.567.500 4.370.500 $12.000 16.757.950 $9.950 $8.000 $45.760.200 5.800.000 4.778.760.485.898 $14.350 – 3.000 $28.650 – 4.036.500 4.100.265.350 $5.796.275.000 Year 3 $45.500 $28.290.698 $9.950) BV of equipment = $4.500 $28.548 3.053 $9.311.889.800.200 –$4.575.415.265.000 $28.836.796.500 $20.448 $7.685.051.836.072.358 1.193 $6.072.000 4.007.000 3.098 2.000 – 3.014.662.000 2.200 9.500 1.828 = $4.010.685.500.051.650 Taxes on sale of equipment = (BV – MV)(tC) = (4.000 Year 5 $28.160.940.803 $3.000 12.700.891.930.000 $20.185.000 $37.348 5.CHAPTER 11 C-31 Sales New Lost sales Lost revenue Net sales VC New Lost sales Year 1 $26.390.415.685.698 $16.500 $19.150 1.698 $19.236.662.700.940.500 $37.000 1.350.803 $11.430.760.126.170.000 1.500 4.000 $11.685.836.200 –$3.685.200 $1.000 $11.828 .000 9.350 $14.350 – 2.000 12.440.311.200 $747.508 BV of equipment = ($21.348 3.000 3.290.000 5.100.036.448 $12.000)(.000 Year 2 $34.513.857.390.350 $11.010.500 1.919.000 $12.200 $15.550 3.698 $4.593.603 $1.500 4.836.000 2.200 0 $7.150 6.350.290.

12 + $7. 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 = –$21.125 NPV = $13.124 + $20. Cash flow –$21.448 20.585.122 + $11.302.698 11.302.698 / 1.201.585.126.335 .91 For a one unit per year change in quantity sold of the new PDA. the NPV of the project changes $456.17 – 12.698 13.448 / 1.17 So.500.201.329.611.029.91 in the same direction.000 747.C-32 CASE SOLUTIONS So.500.329.698 / 1.62) / 100 ΔNPV/ΔQ = $456.698 / 1. the sensitivity of NPV to units sold is: ΔNPV/ΔQ = ($13.029.123 + $13.000 + $747.983.335 / 1.126.698 7.

49) / 19. using the information from Table 10.83% = . The returns are the most volatile for the small cap fund because the stocks in this fund are the riskiest. the expected return is higher.0497 + . we should use the average risk-free rate over the same period.5703 S&S Air stock = (18% – 3.0480 + .68% – 3.0161 +. So. 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.5422 Bledsoe Bond Fund = (9.48% – 3.49) / 15. In general. small cap funds have higher expenses.41% = . The advantage of the actively managed fund is the possibility of outperforming the market.CHAPTER 12 A JOB AT S&S AIR 1. Both the APR and EAR are infinite. The mutual funds have a number of assets in the portfolio. so the number of periods in a year is infinite.0094 +. 5.67% – 3.49) / 15.0279 + . just that the risk is higher.49) / 70% = .64% = .82% = .0349 or 3. The higher expenses of the fund are expected. in large part due to the greater cost of running the fund.0114 + .49) / 10.49% The Sharpe ratio for each of the mutual funds and the company stocks are: Bledsoe S&P 500 Index Fund = (11.0452) / 10 Risk-free rate = .0486 + . including researching smaller stocks.6714 Bledsoe Large Company Stock Fund = (11. 3. and therefore. Since we are given the average return for each fund over the past 10 years. which the fund has done six of the last eight years. One factor that makes outperforming the market even more difficult is the management fee charged by the fund.2072 4. In general.0333 +. and finding the funds that will outperform the market in the future beforehand is a daunting task. most mutual funds do not outperform the market for an extended period of time. the 10-year average risk-free rate is: Risk-free rate = (. 2. The match is instantaneous. This does not imply the fund is bad.1.85% – 3. The biggest advantage the mutual funds have is instant diversification. .0598 + . The major disadvantage is the likelihood of underperforming the market.5048 Bledsoe Small-Cap Fund = (16.

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

employees face layoffs. Unfortunately. Investing heavily in company stock does not create a diversified portfolio. Age is a determinant in the decision. there should be little. This is especially true since income comes from the company as well. money allocated to the company stock. In any case. so in this case. if any.CHAPTER 12 C-35 6. this rule of thumb tends to result in an underinvestment in stocks. 5 to 10 percent of the portfolio should be allocated to company stock. So. not only does the investment perform poorly. but income may be reduced as well. Older individuals should be less heavily weighted toward stocks. . most students will be young. The principle of diversification indicates that an individual should hold a diversified portfolio. However. This is a very open-ended question. If times get bad for the company. At most. the portfolio allocation should be more heavily weighted toward stocks. The asset allocation depends on the risk tolerance of the individual. We only have to look at employees of Enron or WorldCom to see the potential for problems with investing in company stock. A commonly used rule of thumb is that an individual should invest 100 minus their age in stocks. or reduced work hours.

0071 -0.0093 0.0094 0.6 1180.0139 -0.1106 0.0023 0.0808 -0.5 990.00212 0.0466 0.0094 0.94 1126.00111 0.0092 0.0180 -0.0320 0.0165 0.0104 0.0116 0.CHAPTER 13 THE BETA FOR AMERICAN STANDARD NOTE: The example below shows the results from May 2008.45 $42.0118 0.40 $48.84 1101.50 $47.00147 0.0353 0.00078 0.0142 -0.0171 -0.0110 -0.0126 0.0163 -0.0179 -0.0443 -0.00078 0.0071 0.0219 -0.00183 0.0302 0.20 $50.0151 -0.40 $49.0164 -0.0207 0.0113 0.00228 Stock risk premium -0.87 $45.0371 0.00077 0.97 $50.00138 0.71 1058.72 1104.0125 0.0124 0.0176 0.27 1203.0155 0.0095 0.0508 0.0127 0.0064 0.0549 -0.0102 -0.0173 0.00106 0.82 1211. Monthl y Riskfree 0.58 $50.1123 0.0284 0.0280 -0.92 1131.0253 0.0474 0.0072 0.53 $49.0500 0.0162 0.0092 0.00075 0.0191 -0.00078 0.0224 .0451 -0.0233 0.0870 0.0052 -0.16 $49.0425 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 0.25 $52.009 0. The actual answer to the case will change based on current market conditions 1.21 1107.00089 0.0093 0.0309 0. The information used for the analysis is presented below.0086 0.75 $41.0140 0.0088 0.31 1008.48 $53.73 $47.0176 0. It is necessary to find the monthly rate.0307 -0.00077 0.1646 -0.0165 0.91 $52.0291 0.00079 0.0170 -0.00078 0.0201 S&P risk premium 0.0102 0.92 1181.0115 -0.00173 0.0289 -0.00194 0.0081 0.0546 0.0012 0.74 Return -0.009 0.13 1144.0538 0.63 $53.58 1130.0294 0.78 $49.00078 0.0171 -0.68 1140.0274 Stock price $53.0121 0.0219 0.0271 0.0325 -0.0138 -0. so this rate is divided by 12.01 995.00075 0.0542 0.00123 0.0063 0.05 $49.0127 0.0171 -0.1633 -0.59 974.0859 0.0094 0.0148 0.2 1173.00085 0.59 1156.0402 S&P 500 963.3 1120.0541 -0.0122 -0.0189 -0.0071 0.0343 0.0210 -0.24 1114.70 $46.75 $48. Note that the risk-free rate (3-month T-bill rate) is expressed as an annual rate.85 S&P 500 return 0.0815 -0.90 $41.0130 -0.0212 -0.0386 0.97 1050.0254 0.0168 0.64 $46.0550 0.0094 0.80 $50.0133 0.0119 0.2 1111.00073 0.0113 0.0107 0.

0643 -0.0278 0.0284 0.00268 $46.0036 0.0111 0.0360 -0.0001 0.CHAPTER 13 C-37 May-05 Jun-05 Jul-05 Aug-05 0.0025 0.0013 0.0335 -0.00248 0.85 $49.33 0.0112 0.00232 0.56 0.0013 -0.5 1191.33 1234.0297 0.91 $46.00237 0.0139 .0276 -0.0036 -0.98 $49.0322 0.0300 -0.0084 1191.18 1220.0668 -0.

0348 -0.0060 0.0193 0.99 1526.00324 0.62 $63.0494 0.86 1482.39 $52.27 1473.51 $79.0260 0.0371 -0.0440 -0.57 $65.00413 0.0074 0.0376 0.00402 0.37 1530.00394 0.00 $54.0424 0.046 0.0001 0.0126 0.0334 0.28 $66.0389 0.31% S&P 500 0.18 $76.00287 0.0718 0.0472 0.00324 0.00369 0.0342 0.0315 0.03 0.0172 -0.042 0.0465 0.0325 -0.0389 0.0165 -0.0114 -0.65% 2.35 0.0194 0.61 1270.0169 0.00105 0.82 1335.0086 -0.7 1385.0321 -0.82 1420.70 $77.0327 0.0041 -0.58% 4.0031 0.81 1207.00419 0.75 $59.0344 0.62 1503.0275 0.00393 0.0148 -0.0100 -0.38 $65.25% 0.0358 0.0498 0.70 $72.0075 0.0352 -0.0009 0.38 1481.00376 0.00404 0.0355 0.55 $65.0218 0.0010 0.0047 0.0482 0.0140 -0.0155 -0.0126 0.0487 0.0052 Using the Excel functions for the average return and standard deviation.00108 $49.15 0.0204 0.0753 0.0879 0.00325 0.0058 0.0355 0.0715 0.0263 0.0155 -0.92 $57.0053 0.0358 0.0131 -0.0122 -0.0285 -0.0206 -0.0069 -0.0246 0.63 1322.0494 0.0388 0.0473 -0.2 1276.0050 0.26 $75.0481 0.0309 0.0028 0.00384 0.0481 0.0375 0. the table below shows the averages and standard deviations for each of the series. Last 60 months Average return Standard deviation Risk-free 0.0116 -0.0029 -0.10 $66.0473 0.0091 0.0433 0.36 1378.0320 0.00406 0.0451 0.0213 0.66 1294.0492 0.0315 0.28 $51.0088 0.0218 -0.0231 0.0520 -0.0178 -0.75 $57.0221 -0.54% .0124 0.02 $65.63 1418.00412 0.0087 0.00399 0.0114 -0.13% Coach 0.10 $75.0077 0.0222 -0.59 1394.0100 0.0085 0.00177 0.87 1310.0212 0.0265 -0.0315 0.00415 0.0461 0.0013 0.24 1406.0206 0.0063 0.0042 0.0444 0.0495 0.0111 0.0747 0.55 1330.09 1270.05 $63.14 1468.0637 -0.0141 -0.0051 0.48 1248.0294 0.66 1303.0443 0.0074 0.0323 0.01 1249.00229 0.0889 0.0035 0.0056 0.94 1400.50 $56.0239 -0.0255 0.0128 -0.0168 -0.0060 0.00401 0.0061 -0.70 $65.0467 -0.34 $70.00412 0.75 1549.0005 0.0177 0.0171 0.0612 -0.0479 0.0129 0.039 0.00309 0.0112 -0.0088 0.0028 0.0371 0.0060 0.29 1280.0485 0.0133 0.0292 -0.0110 0.00413 0.3 1438.0165 0.00273 0.76 $52.0205 1228.0091 0.00285 0.0499 -0.00353 0.0496 0.0197 -0.0084 -0.0038 0.0503 0.0073 -0.0413 0.50 $57.0041 0.C-38 CASE SOLUTIONS Sep-05 Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 0.00383 0.84 $50.0475 0.92 $62.00323 0.08 1280.35 1455.28 $77.51 $70.0049 0.0275 0.0348 -0.0392 0.23 $57.0129 0.07 $52.0029 0.10 $63.85 1377.0025 0.0479 -0.0011 0.

Jensen’s alpha represents the excess return not explained by the beta of the stock.020695 Adjusted R Square -0.035552 Standard Error 0. Intercept X Variable 1 t Stat 1.718487 Significance F 0.213349 MS 0.18 and is insignificant.102834 0. The residual plot is: .676392 0. A positive alpha plots above the Security Market Line and has a return in excess of its systematic risk. The residual is the error in the estimation.143856 R Square 0.402568 3.034816 0.001024 F 0.000736 0.180843 SS 0. and is the portion of the return not explained by the market model.000736 0.008954 0. while the β estimate 0.032 Observations 36 ANOVA df Regression Residual Total 1 34 35 Coefficients 0.402568 The α is barely insignificant at 10%.847636 P-value 0. The relevant output from Excel for this period is: SUMMARY OUTPUT Regression Statistics Multiple R 0.CHAPTER 13 C-39 2.005341 0.00811 Standard Error 0.

52028 The α and β are both insignificant at any reasonable level of significance.084631 R Square 0. The relevant output from Excel for this period is: SUMMARY OUTPUT Regression Statistics Multiple R 0.646851 P-value 0.227495 MS 0.000776 0.418416 Significance F 0.108386 Standard Error 0.10761 0.005635 0.486983 0.C-40 CASE SOLUTIONS 4.628106 0.52028 Intercept X Variable 1 t Stat 0. The residual plot is: .007162 Adjusted R Square -0.00996 Standard Error 0.001855 F 0.002744 0.000776 0.043074 Observations 60 ANOVA df Regression Residual Total 1 58 59 Coefficients 0.147156 SS 0.

.CHAPTER 13 C-41 5. Possible reasons for the difference could be different data. For example Yahoo! Finance uses 36 months of returns. The beta for Colgate-Palmolive on Yahoo! Finance at the time was 0. or the market proxy the use. which is similar to these estimates.16. but they do not specify the risk-free rate.

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

We gathered all the information from finance. We can use the dividend growth model or the CAPM.05 billion Most recent dividend = $0 Beta = 1.53 3-month Treasury bill rate = 1.CHAPTER 14 C-43 2. so we will attempt to use both. The following information is necessary for our calculations. The screen shots below show this information.10 billion Book value per share = $1.813 Shares outstanding = 2.06 Market capitalization = $47. We need various pieces of information to estimate the cost of equity.83% .yahoo.com. Market price = $23.

We do have the information to estimate the cost of equity with the CAPM.org/marketdata.53[.0183 + 1.54% 3. we get: RE = Rf + β[E(RM) – Rf] RE = .C-44 CASE SOLUTIONS Dell has never paid a dividend so we cannot use the dividend growth model to estimate the cost of equity. we went to www. We gathered the following information: .07] RE = 12. To get the yield to maturity on Dell’s bonds. Using the market risk premium of 7 percent from the textbook.finra.

00 1.93% 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. in millions) $300 $300 Percentage of total 1.00 Market value (in millions) $305.43 $305.10 Total Book value (face value.93% 6. the weighted average cost of debt for Dell using both the book value and the market value is: Coupon Rate 7.00 1.43 Percentage of total 1.93% Weighted book values 6.00 Yield to maturity 6.CHAPTER 14 C-45 So.93% 6.93% Weighted market values 6. .

C-46 CASE SOLUTIONS 4. Dell generates sales almost exclusively from its internet site.55 percent. The biggest potential problem with HCI using Dell’s cost of capital is that HCI operates stores that generate the company’s sales.717/$4. while Hubbard Computer is private.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. Another factor that could affect the cost of capital is Dell’s access to capital since it is a public company.41B So.717B V = $4.94% Using the market value weights. This could potentially be a risk factor that affects the cost of capital.43M + $47.35) WACC = 11.0693)($0.10B V = $47.0693)($0. . Using book value weights. 5.1254)($47.305/$47. the WACC based on book value weights is: WACC = RE(E/V) + RD(D/V)(1 – t) WACC = (.1254)($3. the total value of Dell is: V = $305. the WACC based on market value weights is: WACC = RE(E/V) + RD(D/V)(1 – t) WACC = (.300/$4.41) + (.017B So.35) WACC = 12.10/$47. The difference in this case is 0.017) + (.41)(1 – .017)(1 – . the total value of Dell is: V = $300M + $3.

000 Since the company must currently provide audited financial statements due to the bond covenants. the Dutch auction should be better since it should eliminate underpricing. However. cash and short-term investments are a zero NPV investment.000 Total other fees = $2.750. or: Net amount raised = $75.250. The extra cash may encourage management to act carelessly.000 Fee percentage = .250.500 / $69.07) Underwriter fee = $5. and the lower probability that the company will have to go back to the primary market in the near term future.563. The main difference in the costs is the reduced possibility of underpricing in a Dutch auction.500 The net amount raised is the IPO offer size minus the underwriter fee. The advantages of the increased IPO size include the increased liquidity for the company.500 This means the total fees are: Total fees = $5.000 + 6. As to which is better. The extra cash will also earn a small return unless invested in income producing assets.250. although this may not be a large advantage.750. 3. The increased size will also reduce the costs of the IPO on a percentage of funds raised.000(. so whether Mark is correct or Kim is correct will only be told in time.000. The disadvantages of raising the extra cash in the IPO include the agency costs of excess cash.CHAPTER 15 S&S AIR GOES PUBLIC 1. Whether the underpricing is as severe in a Dutch auction as it would be in a traditional underwritten offer is unknown.500 + 520. we don’t actually know.000 – 5.813. underpricing can still exist in a Dutch auction.800.1120 or 11.000 + 100.813. the fees as a percentage of the net amount to the company are: Fee percentage = $7. So.000 So. The underwriter fee is 7 percent of the amount raised.000 + 15. In theory. the audit costs are not incremental costs and should not be included in the calculation of the fees.500 Total fees = $7. as Google shows.000 Net amount raised = $69.000 + 12.563. the sum of the other fees is: Total other fees = $1. At best.000 + 2.20% 2. or: Underwriter fee = $75. . There is no way to calculate the optimum size of the IPO.000.000 + 110.

C-48 CASE SOLUTIONS .

Another risk in not selling in the IPO is that after the lockup period expires. during the lockup period. Because of legal repercussions. the employees may be considered insiders. If the employee tenders the stock to be sold in the IPO. Additionally. This could be a significant cost. the employee is legally prohibited from hedging the price risk of the stock with any derivatives. the employee will lose out on any underpricing. . There are advantages and disadvantages to each.CHAPTER 15 C-49 4. and heavy selling by insiders is considered a negative signal by the market. subject to SEC restrictions on selling stock. you should not provide specific advice on which option the employees should choose. he/she must hold the stock for the lockup period. typically 180 days. However. if the employee retains the stock.

40) Earnings increase = $16.000.000. the firm’s pre-tax earnings will increase by $27 million per year in perpetuity.000 .600.000(1 – .000.000 / . debt in the firm’s capital structure will decrease the firm’s taxable income. Assets Total assets 3. If Stephenson wishes to maximize the overall value of the firm. Therefore.000 + ($16. Since Stephenson is an all-equity firm with 15 million shares of common stock outstanding. the market value of the firm is: Market value of equity = $35. Since interest payments are tax deductible.000. These earnings are taxed at a rate of 40 percent. the purchase increases the annual expected earnings of the firm by: Earnings increase = $27.000. $528.000 $528.000 Since Stephenson is an all-equity firm. a.125) NPV = $19.000 Equity $528.000.200.000. it should use debt to finance the $110 million purchase.20(15.20 per share. worth $35.000 As a result of the purchase.000 So. after taxes. creating a tax shield that will increase the overall value of the firm. the appropriate discount rate is the firm’s unlevered cost of equity.000) Market value of equity = $528. so the NPV of the purchase is: NPV = –$110.200.000 Debt & Equity 2. the market value balance sheet before the land purchase is: Market value balance sheet $528.CHAPTER 16 STEPHENSON REAL ESTATE RECAPITALIZATION 1.000.

148 c.600. Under the efficient-market hypothesis.600.148 Share price = $36.031. To show this. the value of Stephenson will increase by $20 million.000.148 So. Therefore.000 The stock price will remain unchanged.000 Market value balance sheet $528.000.000.013.000 19. the new market value balance sheet after the stock issue will be: Market value balance sheet $110.000 Since the market value of the firm’s equity is $547. Stephenson will receive $110 million in cash as a result of the equity issue.600.600 / 18.000 Equity value = $507.000 $547.000 New share price = $36.000 and the firm has 15 million shares of common stock outstanding. This will increase the firm’s assets and equity by $110 million. So.51 Shares to issue = 3.000.CHAPTER 16 C-51 b. the share price is: Share price = $657. Stephenson’s stock price after the announcement will be: New share price = $547.000 / $36. After the announcement.600.000 / 15.000 Debt & Equity Cash Old assets NPV of project Total assets $657.600.000 + 19. Stephenson will now have: Total shares outstanding = 15.51 .013.000 Equity $547.000 19. the market value of the firm’s equity will immediately rise to reflect the NPV of the project. the market value of Stephenson’s equity after the announcement will be: Equity value = $528.000 Debt & Equity Old assets NPV of project Total assets $507.600.000 + 3.148 Total shares outstanding = 18.000 528.500.600.600.500.000 Equity $657.600.000.600.000 $657.000. Stephenson must issue: Shares to issue = $110.51 Since Stephenson must raise $110 million to finance the purchase and the firm’s stock is worth $36. the net present value of the purchase.000.013.51 per share.

000 Equity $657. Stephenson’s stock price after the debt issue will be: Stock price = $591.40($110.000.000 $701.51 per share.000 Debt 44.000 $657.000 Debt & Equity Old assets PV of project Total assets 4. after taxes. Therefore. .600. Since the market value of the firm’s debt is $110 million and the value of the firm is $692 million.125 PVProject = $129.000 / .44 per share.000. If the firm uses debt in order to finance the project. the market value balance sheet of the company will be: Market value balance sheet $528.600.000 129.600.000 591. the value of the company if it financed with debt is: VL = $657.000.000 So. So.000. the project increases the annual earnings of the firm by $16.600.44 5. a. the value of Stephenson will immediately rise by the present value of the project.6 million and the firm has 15 million shares of common stock outstanding. Stephenson’s market-value balance sheet after the debt issue will be: Market value balance sheet $657.200.C-52 CASE SOLUTIONS d.000 Debt & Equity Value unlevered Tax shield Total assets $110.600. After the announcement. the firm would have $110 million worth of 8 percent debt outstanding. Stephenson will be worth $657. So.000 Equity $701.2 million.600.600.6 million if it finances the purchase with equity.000 / 15.000) VL = $701. we can calculate the market value of Stephenson’s equity. The project will generate $27 million of additional annual pretax earnings forever. debt financing maximizes the per share stock price of the firm’s equity. These earnings will be taxed at a rate of 40 percent.600. Therefore.000.000 Modigliani-Miller Proposition I states that in a world with corporate taxes: VL = VU + tCB As was shown in Question 3.600. $648.600. the aftertax present value of the earnings increase is: PVProject = $16.600. the firm’s stock price will rise to $39.000 + .000 Stock price = $39.000 b. If Stephenson uses equity in order to finance the project.000. the firm’s stock price will remain at $36.000 Since the market value of the Stephenson’s equity is $591. If it were to finance the initial outlay of the project with debt.

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

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

00 $532.00 $100.91 0 0 0 0 $100.00 $0 $98.000.000.094.33 –271.00 $0 $0 $90.111.622.555.722.02 982.666.44 Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit) Q3 $196. the cash balance each quarter is: Cash Balance Q1 Q2 $190.00 3.384.000.44 39.000.00 –$67.22 2.00 $93.26 .11 Q4 $683.944.78 $32.22 Q3 $606.44 900.26 0 0 $100.103.00 $193.02 0 $103.166.00 –100.78 So.111.777.33 –372.67 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 $100.67 138.000.000.444.56 –202.000.384.00 $135.00 –370.000.000.22 –3.56 100.290.777.00 –95.888.00 946.00 100.333.00 –$202.11 509.000.00 –95.722.00 39.555.00 –100.78 100.68 40.666.00 $3.777.555.89 –270.722.22 98.22 $96.000.777.000.00 –309.78 –289.622.44 –211.055.000.00 94.290.56 423.000.555.000.722.777.33 –274.22 $2.666.444.00 –95.67 –240.22 0 0 0 0 0 0 0 0 $100.000.722.000.000.00 –202.22 –4.11 $235.000.111.333.000.00 –100.444.500.222.000.383.33 –269.11 –40.722.67 –348.290.722.00 $0 $138.000.56 476.622.000.668.44 100.22 $193.722.00 –100.56 Q4 $235.67 103.22 The short-term financial plan looks like this: Short-term Financial Plan $100.78 0 1.333.111.22 3.67 –330.00 –95.000.094.722.22 0 $0 $94.000.333.00 $39.44 372.67 –309.00 $100.103.22 $196.000.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 $484.68 0 $0 $100.000.85 98.22 2.444.

000.722.00 $155.000.00 $946.68 earns earns earns earns $900.00 $193.000.00 –80.822.98 If Piepkorn reduces its target cash balance to $80.495.44 39.91 $1.777.56 80.00 $0 $0 $110. in income.000.555.000.000.722.22 $982.298.11 –40.383.000. The cash balance and short-term financial plan will be: Cash Balance Q1 Q2 $190.22 982.67 158.000.000.44 1.212.22 2.383.00 $94.00 –80.00 $80.78 0 1.C-56 CASE SOLUTIONS The interest calculations for each quarter and the net cash cost are: Q1: Q2: Q3: Q4: Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing 2. the cash flows each quarter will remain the same.00 1.22 118.000.04 0 $82.589.93 0 0 0 0 $80.000.384.00 $113.444.555.11 $235.000.70 0 $0 $80.000.22 0 $0 $114.00 –$47.56 –202.44 Short-term Financial Plan $80.000.692.78 80.00 –80.000.000.20 0 0 $80. $900. $90.00 39.67 0 $0 Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit) Q3 $196.00 –202.100.722.186.67 82.692.56 Q4 $235.990.000.22 2.111.990.44 80.495.444.85 in income.00 114.290.222.70 40.20 .22 –3.722.00 $0 $158. so they will not be repeated here.111. in income.91 1.00 3.000.722.00 –80.00 $80.777.148.555.692.22 0 0 0 0 0 0 0 0 $80.78 $32.000.722. in income.298.22 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 $80.67 $138.22 $196.00 946.777.22 $98.822.622.870.22 3.00 $0 $118.22 $193.91 118.000.04 1.22 $116.444.85 $4.822.22 –4.00 80.722.

67 $158.000)(. Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing 3.000)(.160.000)(.40)(1 – .01) + $905.148.22 1.91 $5.240.93 1.01) + $1.40)(1 – .22 $1. The collections will be based off the lower sales figures.40)(1 – . we must assume the sales will remain unchanged.360 Q4 net sales = ($1.60) Q2 net sales = $1.692. so the net cash inflows each quarter will be: .60) Q4 net sales = $1. The net sales after the discount each quarter will be: Q1 net sales = ($905.06 If Piepkorn offers the discounted terms.990.000(.235.CHAPTER 18 C-57 Q1 : Q2 : Q3 : Q4 : Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of Excess funds at start of quarter of $110.000(.025.160.93 $1.60) Q1 net sales = $901. $1.589. in income.100.155.000)(.00 1.589.822.60) Q3 net sales = $1.70 earns earns earns earns $1.01) + $1.186.40)(1 – .91 in income.880 Q3 net sales = ($1. 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. the collections period will decrease to 36 days.000(.148.000(.100.00 $114.00 $1.000.025.22 $118.240.186.01) + $1. This will change the cash flows Piepkorn receives.040 In addition to the reduction in sales.030.380 Q2 net sales = ($1. in income. in income.030. However.

00 –95.644.33 $384.00 80.234.142.67 Q2 $362.000.67 –348.000.494.67 –240.666.413.00 $171.00 –95.67 –192.908.216.00 59.33 –271.024.33 Q3 $410.352.144.908.000.00 $360.00 80.C-58 CASE SOLUTIONS A/R at beginning of Q collected Sales collection in current Q Purchases last Q paid this Q Purchase for next Q paid this Q Expenses Interest and dividends Outlay Net cash inflow Net cash inflow Q1 Q2 $484.33 –274.234.908.33 –372.000. 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 $190.00 615.00 $304.00 Q3 $384.67 Q4 $444.498.000.000.00 $364.67 Q4 $462.000.67 $251.000.00 –95.000.828.00 –370.644.67 22.166.00 –95.666.333.00 .67 So.333.333.000.67 $444.67 $362.67 –309.00 741.00 –270.00 $59.142.00 $172.142.000.552.00 693.666.413.00 –$192.67 –330.494.67 80.333.494.000.33 –269.494.000.00 –309.500.00 540.67 $22.00 $282.00 –211.00 172.528.67 80.000.498.00 –289.494.

in income.99)]365/30 – 1 EAR = 13.167.67 –25.100.28 1.787.088.835.00 $283.67 0 3.67 –62. Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing $1.00 2.249.835.CHAPTER 18 C-59 The short-term financial plan under these assumptions will be: Short-term Financial Plan $80.843.00 –80.00 2.06 The effective annual rate Piepkorn is offering to its customers is: EAR = [1 + (.01/.000.843.67 $308.67 22.00 –80.67 0 $0 $283.95 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: $80.33 –173.835.167.44 $3.95 $3.95 0 0 0 0 0 0 0 0 $80.088.100.000.00 0 0 0 $80.594.000.594.594.00 $0 $0 $110.000.44 3.67 188.380.498.06 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: $110.000.000.088.736.167.05 182.323.00 $0 $308.00 –80.44 0 0 0 0 $80.000.000. in income.000.000.000.00 –80.234.711.494. in income.95 371.00 59.00 283.67 $10.05 earns earns earns earns $1.01% .711.00 $2.00 –192.843.00 172.00 $0 $371.100.413.00 $80.000.95 $371.00 $80.000.05 0 $0 $80.11 3.95 3.67 in income.67 308.711.000.594.

163.330.666.00 –370.17 $263.330.216.33 $360.67 –85.00 –95.984.83 –372.833.352.330.00 –103. since the purchases from suppliers are a percentage of sales. The net cash inflows each quarter will be: Net cash inflow Q1 Q2 $484.17 $350.00 693. 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 $190.67 $415. Piepkorn is now offered a discount from suppliers.416.333.000.00 .33 –422.00 –96.00 $280.17 –476.000.163.00 $335.67 Q4 $462.17 Q2 $350.00 741.50 Q3 $360.00 $270.00 $160.17 So. we must assume these purchases are for raw materials.345.000.17 80. we will base the purchases off the gross sales figure.67 –348.083.000.182.00 $360. In addition to the discount offered to customers.000.17 80.182.644.000.000.686.00 –95.024.C-60 CASE SOLUTIONS 4.000.00 $54. Thus.828.17 10.000.000.345.00 –309.000.33 –414.984.916.00 160. which will not change except for the discount taken.50 80.644.686.00 80.345.000. However.182.17 $10.00 –95.000.33 –271.144.182.00 –75.500.00 –$151.17 Q4 $415.528.000.520.00 615.17 –151.729.50 54.00 540.182.552.33 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 –95.00 $183.67 –508.

419.419.984.00 $271.182.58 $3.00 2.82 0 0 0 0 0 0 0 0 $80.25 0 $0 $110.17 0 3.00 $80.00 $0 $284.000.282.00 160.17 284.17 $284.32 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: $80.000.85 $10.000.85 in income.984.282.876.015/.841.282.158.00 –80.841.100.985)]365/25 – 1 EAR = 24.074.17 –12.32 341.266.686.000.419.100. in income.25 2.712.000.69% .00 2.00 $80.67 –57.17 0 $0 $271.CHAPTER 18 C-61 The short-term financial plan will be: Short-term Financial Plan $80.82 $2.841.712.984.00 $2.00 –80.00 –151.00 271.718.58 3.000. in income.000.15 1.58 0 0 0 0 $80.32 $341.158.32 0 0 0 $80.25 The effective annual rate the company’s suppliers are offering to Piepkorn is: EAR = [1 + (.00 $0 $341. Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing $1.163.000.000.00 $0 $0 $110.17 10.33 –161.00 –80.282.100.826.000.712.000.00 –80.000.57 earns earns earns earns $1.000.000.984.57 0 $0 $80. in income.57 193.82 2.00 54.85 148.158.

373.955. which are an annuity.0015)(4)($160.CHAPTER 19 CASH MANAGEMENT AT WEBB CORP.015%. times the amount of each transfer.00015 Value of ACH = $8.14)]/1. times the number of transfers. which is four since there are four banks. The amount of each transfer is one minus the wire transfer cost.939. The amount the company will have available is the future value of the transfers.000)(FVIFA. Setting up this equation where X stands for the ACH transfer cost. The bank will accept the ACH transfers from the four different banks. The future value of the deposits now will be: Value of ACH = [4($160. we find: [4($160.02 X = $216.02 The company should not go ahead with the plan since the future value is lower.939.00015 = $8.288. 3.015%. To find the cost at which the company is indifferent. so the company incurs a transfer fee from each collection center. the total available in two weeks will be: Amount available = (1 – .000 – 500)(FVIFA.04 .13 2. we set the amount available we found in Question 1 equal to the cost equation we used in Question 2.373. 1.14)]/1. So.000 – $X)(FVIFA.14) Amount available = $8.015%.

438. Current Policy First.561.36) / 0.000)/365 Average daily variable costs = $172. the periodic rate for the 38 day collection period is: Interest rate = (1 + .602.24 Next.561. We will begin with the calculation of the NPV of the current policy.45($140.000. the average daily variable costs are: Average daily variable costs = 0.101.99 – 8.000. so the average daily administrative costs are: Average daily administrative costs = 0.000)/365 Average daily defaults = $6.36 We also need the appropriate interest rate for the collection period.016($140. With a 6 percent annual interest rate.602.6 percent. so the average daily defaults will be: Average daily defaults = 0.438.000/365 Average daily sales = $383. we need to calculate the NPV of each policy.000. the NPV is: NPV = –$172.000.2 percent of sales.99 The current policy has administrative costs equal to 2.74 + ($383.74 Under the current policy.00609 NPV = $32.20 .136.CHAPTER 20 CREDIT POLICY AT HOWLETT INDUSTRIES To decide on the optimal credit policy. So. we need the average daily costs.900. which are 45 percent of sales.136.74 – 6.64 – 172. we need to calculate the average daily sales which are: Average daily sales = $140.602.00609 or 0.022($140.609% Since the credit policy will exist into perpetuity. We will begin with the average daily variable costs. the default rate is 1.000)/365 Average daily administrative costs = $8.06/365)38 – 1 Interest rate = 0.

C-64 CASE SOLUTIONS .

018($157.000. so the average daily administrative costs are: Average daily administrative costs = 0.000)/365 Average daily variable costs = $197.CHAPTER 20 C-65 Option 1 Under Option 1.45($157.00657 NPV = $32.000)/365 Average daily defaults = $10.000.958.23 Option 2 Under Option 2. the default rate is 1.025($160. so the average daily defaults will be: Average daily defaults = 0.2 percent of sales.27 Under the Option 1. so the average daily defaults will be: Average daily defaults = 0.260.742.000)/365 Average daily defaults = $7.032($160.657% Since the credit policy will exist into perpetuity.40 We also need the appropriate interest rate for the collection period.000)/365 Average daily variable costs = $193.561.8 percent.000.99 The average daily variable costs will be: Average daily variable costs = 0.000.958. the average daily sales are: Average daily sales = $160.00657 or 0.260.136.5 percent.06/365)41 – 1 Interest rate = 0.000/365 Average daily sales = $430.27 + ($438.90 Option 1 has administrative costs equal to 3.000. the NPV is: NPV = –$197.260.40) / 0.027.712. With a 6 percent annual interest rate.000)/365 Average daily administrative costs = $14.356.47 .453. the periodic rate for the 41 day collection period is: Interest rate = (1 + .000.000/365 Average daily sales = $438.45($160.64 Under the Option 2.000.16 – 197.90 – 14. the average daily sales are: Average daily sales = $157.27 – 10.16 The average daily variable costs will be: Average daily variable costs = 0. the default rate is 2.027.356.

With a 6 percent annual interest rate.535.58 – 13.561.64 + ($430.03($170.323.4 percent of sales.561.996.000. the periodic rate for the 51 day collection period is: Interest rate = (1 + .753. the NPV is: NPV = –$209. so the average daily administrative costs are: Average daily administrative costs = 0.00785 NPV = $29.C-66 CASE SOLUTIONS Option 2 has administrative costs equal to 2.00785 or 0.742.589.99 – 193.818% Since the credit policy will exist into perpetuity.022($170. the default rate is 2.0 percent of sales.60) / 0.000.06/365)49 – 1 Interest rate = 0.2 percent. With a 6 percent annual interest rate.000)/365 Average daily defaults = $10. so the average daily defaults will be: Average daily defaults = 0.712.000/365 Average daily sales = $465.785% Since the credit policy will exist into perpetuity.024($157. the average daily sales are: Average daily sales = $170.246.136.972.04 Under the Option 3.48 Option 3 Under Option 3.589.000)/365 Average daily administrative costs = $13.29) / 0.000.45($170.246.000)/365 Average daily variable costs = $209.000)/365 Average daily administrative costs = $10.42 – 209.000.00818 or 0. the NPV is: NPV = –$193. the periodic rate for the 49 day collection period is: Interest rate = (1 + .972.29 We also need the appropriate interest rate for the collection period.04 –10.47 – 10.000.04 + ($465.60 We also need the appropriate interest rate for the collection period.00818 NPV = $26.589.325.06/365)51 – 1 Interest rate = 0.42 The average daily variable costs will be: Average daily variable costs = 0.753.41 .58 Option 3 has administrative costs equal to 3.54 – 7.323. so the average daily administrative costs are: Average daily administrative costs = 0.

This in turn will increase the administrative costs of managing the delinquent accounts.CHAPTER 20 C-67 The company should choose Option 1 since it has the highest NPV. 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. 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. Option 2 extends the credit period.

CHAPTER 21 S&S AIR GOES INTERNATIONAL 1.250.087.000 And the production costs are: Production costs = $7.000.000($1.887. If the dollar strengthens.80) Production costs = $5. 2.45/€) Dollar EBT = $6.500 – 5.000(0.887. so the after-commission sales in euros is: After-commission sales = €5. The company will pay the sales commission out of gross sales. if the dollar weakens.175.000 Profit = $1.30/€.000. the profit at the current exchange rate is: Profit = $6.500 If the exchange rate changes to $1.000(1 – .45/€.750.000($1. the profit will increase.800. the EBT in euros will be converted to dollars in the amount of: Dollar EBT = €750. 3. the euros will convert to: Dollar sales = €4.800.30/€) Dollar sales = $6.000 At the current exchange rate of $1. Conversely.45/€) Total sales = $7.500 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 = €5.05) After-commission sales = €4. the profit at this exchange rate will be: . The biggest advantage is the increased sales. while the biggest risk is exchange rate risk. the profit will decline.000($1.000 So.750.250.000 Since the production costs are fixed.

000 .175.000 Profit = $375.CHAPTER 22 C-69 Profit = $6.800.000 – 5.

the company should probably pursue international sales further.221/€ 4.000 Breakeven exchange rate = $1. The downside to all three hedging vehicles is the cost. futures.000/€4. it is likely that hedging is not required at this point. At the current exchange rate. so: Breakeven exchange rate = $5. Taking this into account. The company could use options. the company will gain on some contracts and lose on others.800.750. Over time. or forwards. . the company will make a profit unless the exchange rate moves dramatically. 5.CHAPTER 21 C-70 The breakeven exchange rate is the exchange rate that will allow the after-commission costs in euros to convert to a dollar amount that covers the production costs. So.

Given the amount mutual fund companies would be willing to spend for research. in general.000(. Good performing fund managers are richly rewarded. As a result. Consider the large-cap stock fund. In reality. We should also consider that mutual funds managers may be able to outperform the market before expenses. are the bad investors in the market. So the question is this: What would Fidelity pay for one year to increase the return of the Magellan Fund by 0. Consider the case of the Fidelity Magellan Fund. the results support the concept of market efficiency. The evidence tends to support the idea that they cannot.01 percent? If we multiply the fund assets by 0. we would expect that mutual fund managers should be able to outperform the market. the average return of investors weighted by the dollar amount of the investment. with assets of about $55 billion. if the “best” and definitely best-financed investors cannot outperform the market. one of the largest actively managed equity mutual funds at the time this was written. While there have been notable exceptions. such as Peter Lynch’s tenure at Magellan. that is. to the Darwinian nature of the business. . Whether the market is efficient or inefficient is irrelevant unless mutual funds managers are the best investors in the market.5 million for that year. This does not depend on the level of market efficiency. and poor performing fund managers are fired. so they do not appear to be able to outperform the market. Before the fact. etc.000. While there could be one really poor investor who takes all of the losses in a given year. the market average return has to be the average return of all investors’ average return. The results in the graph tend to support the idea of market efficiency. we get: $55. including private money managers.50 percent. In general. it should be willing to pay up to $5. to get the market average we would expect one-half of investors would outperform the market.50 percent before fees in order to achieve a return after fees equal to the market return. pension fund managers.CHAPTER 22 YOUR 401k ACCOUNT AT EAST COAST YACHTS 1. This is due. if Fidelity can increase the return of this one fund by only 0. This means that mutual funds as a whole tend to have the market average return before expenses. as a whole.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. often very quickly. We would expect more than 50 percent of mutual funds would underperform the market because of the expenses charged by the mutual funds. in part. and one-half would underperform the market. After all. you would expect that mutual funds managers would be able to outperform the market.000.01 percent per year. we should expect that less than 50 percent of all equity mutual funds would outperform the market. So. and all other investors. This is definitely true if we consider the weighted average return.500. mutual fund managers do not seem to be able to outperform the market. 2. individuals. The fund must exceed the market return by 1. research has found that mutual fund managers underperform the market after expenses by the average expense ratio.0001) = $5. and the Darwinian nature of the industry.01 percent. with and expense ratio of 1. Consider the following question: What percentage of investors will outperform the market in a given year? Answer: Fifty percent.

CHAPTER 22 C-72 .

Note that a small cap index fund may be the best option. Therefore. but there is no small cap index fund available in the 401k account. By investing the entire equity portion of your account in the S&P 500 index. . your portfolio is not diversified since the S&P 500 index includes only large-cap stocks.CHAPTER 22 C-73 3. However. this is not the entire answer. Given that the evidence presented tends to support market efficiency. you should invest in the S&P 500 index fund. part of your equity investment should probably be in the small cap fund for diversification purposes.

she should take a short position in Treasury bond futures to hedge this interest rate risk. If the current market rate of interest rises between today and the date the mortgage is sold. If this is the case. as interest rates fall. Since Joi will be hurt when interest rates rise.90 for 25 years.300) C = $3.533. In order to protect herself from decreases in the price of Treasury bonds.300) Mortgage value = $457. discounted at 8 percent.000 of Treasury bonds.484.000. Treasury bonds become more valuable. If the market interest rate is 6 percent on the date that Joi meets with the Ian.867. the futures gain will offset the loss in value of the mortgage. the amount of principal that he plans to borrow. the fair value of the mortgage will decrease.91 3. she would take a short position in five 3-month Treasury bond futures contracts in order to hedge her $500.000 = C(PVIFA7%/12. 1. discounted at the longterm interest rate of 7 percent. or: Mortgage value = $3. she will not be able to loan Mike the full $500. 4. As interest rates rise. a. Since three-month Treasury bond futures contracts are available and each contract is for $100. If the market interest rate is 8 percent on the date that Joi meets with the Ian. INC. Treasury bond prices have an inverse relationship with interest rates. the fair value of the mortgage is the present value of an annuity that makes monthly payments of $3.90(PVIFA8%/12. or: Mortgage value = $3. Mike’s mortgage payments form a 25-year annuity with monthly payments.90 2. 5.300) Mortgage value = $548. .90(PVIFA6%/12. discounted at 6 percent. and the Ian will only be willing to purchase the mortgage for a price less than $500.000.000 promised. We can solve for the payment amount so that the present value of the annuity equals $500.55 b.533. The monthly mortgage payment will be: $500. she is also hurt when Treasury bonds decrease in value.533. The long position will lose and the short position will gain. Since Joi is short in the futures. An increase in the interest rate will cause the value of the T-bond futures contracts to decrease.CHAPTER 23 CHATMAN MORTGAGE. Treasury bonds become less valuable. the fair value of the mortgage is the present value of an annuity that makes monthly payments of $3.000 exposure to changes in the market interest rate over the next three months a.533. The most significant risk that she faces is interest rate risk.533.90 for 25 years.

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. The biggest risk is that the hedge is not a perfect hedge. We would expect. the Treasury rate could increase 20 basis points. For example. that the loss in one instrument would be similar to the gain in the other instrument. If interest rates change. the futures lose will be offset by the gain in value of the mortgage. An increase in the interest rate will cause the value of the Treasury bond futures contracts to increase. while a change in one of the interest rates will likely coincide with a change in the other interest rate. and the mortgage rates could increase by 40 basis points. the fact that Treasury bond interest is semiannual. Additionally. .CHAPTER 23 C-75 b. while the mortgage payments are monthly. Since Joi is short in the futures. may affect the relative value of the two. The long position will gain and the short position will lose. the change does not have to be the same. especially given the short-term nature of the hedge. 6.

we get: P/E = Price/EPS 12. We can use the PE ratio to calculate the current stock price.82.40) Intrinsic value = $656. bondholders are effectively allowed to purchase stock at the conversion price of $25. Second. even if the company does not go public. the company may go public in the future. If the company does goes public.50 = Price/$1. or someone else. Even though the company is not publicly traded.40) + $1000(PVIF5%. with the conversion feature the price will be $800. in this case 25 percent. the bondholders will have an active market for the stock if they convert. the floor value of the bond is $800. The case does discuss whether the company has plans to go public. This means that if the company offered bonds with the same coupon rate and no conversion feature. The potential problem with private equity is that the market is not as liquid as the market for a public company.82 So.00 This means the conversion premium of the bond is: Conversion premium = ($25 – 20) / $20 = 0. 2.00 So. The conversion ratio the bond is: Conversion ratio = $800/$25 = 32.60 Price = $20. In essence. bondholders will be allowed to participate in the company’s success. This equity interest can be sold to the original owners.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. they would be able to sell them for $656. how soon it might go public. However. This illiquidity lowers the value of the stock. Todd’s argument is wrong because it ignores the fact that if the company does well. The conversion value of the bond is given as $800.CHAPTER 24 S&S AIR’S CONVERTIBLE BOND 1. The intrinsic value of the bond is: Intrinsic value = $30(PVIFA5%. Doing so. and if so. the company is receiving $143. each bond can be converted to 32 shares of stock. the bondholders could potentially have an equity interest in the company.18 for the conversion feature. If the stock price rises to $25. the conversion price is important. First. .

CHAPTER 23 C-77 3. 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.

The reason is that the firm will have benefited from the lower coupon payments on the convertible bonds.CHAPTER 23 C-78 4. we just need to combine them. which dilutes existing equity (bad outcome). The call provision allows the company to redeem the bonds at the company’s discretion. Reconciling the two arguments requires that we remember our central goal: to increase the wealth of the existing shareholders. The table below illustrates this point. the company can call the outstanding bonds. Convertible bonds issued instead of straight bonds Convertible bonds issued instead of common stock 5. In contrast. If the company’s stock appears to be poised to rise. It could be possible that the bondholders would benefit from converting the bonds at that point. 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. but it would eliminate the potential future gains to the bondholders. Cheap financing because firm issues stock at high prices when bonds are converted (good outcome). issuing convertible bonds will turn out to be better than issuing straight bonds and worse than issuing common stock. Both of the arguments have a grain of truth. Thus. if a company does poorly. If the company prospers High stock price and conversion Expensive financing because bonds are converted. Expensive financing because firm could have issued common stock at high prices (bad outcome). which option is better for the company will only be known in the future and will depend on the performance of the company. The reason is that the prosperity has to be shared with bondholders after they convert. If the company does poorly Low stock price and no conversion Cheap financing because coupon rate is lower (good outcome). with 20-20 hindsight. Ultimately. .

83 2.602/2) × 10] / (.38(.1367 Putting these values into the Black0Scholes model.60 × N(d1) = .60 × d2 = –.38/$50) + (. If you are planning to leave next week. we find the option value is: C = $24. the value of the stock options per share of stock is: d1 = [ln($24. the value of the stock options per share of stock is: d1 = [ln($24.0953 10 ) = .7887 N(d2) = . A second factor is how the option exercise will affect your taxes.55 Assuming expiration in ten years. A primary factor is how long you plan to stay with the company.044 + .60 × d2 = .0618 – (.602/2) × 3] / (.1011 3 ) = –. we find the option value is: C = $24.38/$50) + (.038 + . So.038(3))(.7887) – ($50e–.4753 N(d2) = . Whether you should exercise the options in three years depends on several factors.8020 3 ) = –1. We can use the Black-Scholes equation to value the employee stock options.38(. you should exercise the options. We need to use the risk-free rate that is the same as the maturity as the options.4753) – ($50e–.1367) = $14.1354 Putting these values into the Black-Scholes model. 10 ) = –1.0618 .CHAPTER 25 EXOTIC CUISINE EMPLOYEE STOCK OPTIONS 1.1354) = $5. assuming expiration in three years.044(10))(.60 × N(d1) = .8020 – (.

it can never lose money.CHAPTER 25 C-80 3. ignoring the premium. The fact that the employee stock options are not traded decreases the value of the options. it decreases the price of the option. If the right to sell is removed. A basic way to understand this is to realize that an option always has value since. . The right to sell an option also has to have value.

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. A better method of valuing employee stock options might be to reward employees for company performance in excess of the market performance. Vesting requires employees to work at a company for a specified time. The company’s stock should closely mirror the market return. adjusted for the company’s level of risk. however. There are valid reasons on both sides of the discussion.CHAPTER 24 C-81 4. even though most of the stock price increase is due to the general market increase. Employee stock options increase in value if the stock price increases. Repricing can be viewed as a negative. and underwater employee stock option provides little incentive since it may be unlikely that the stock price will reach the strike price before expiration. 6. Repricing increases the value of the employee stock option. . Vesting is also a “golden handcuff. the stock price can increase because of a general market increase. the value of the option increases.” The employee is less likely to leave the company if in-the-money employee stock options will vest soon. Similarly. the company’s stock will likely fall as well. However. 5. Consider an extreme: A company announces the employee stock options will be worth a minimum of $10 at expiration. it provides less incentive. Consider a company of average risk in a bull market that has a large return for several years. if the market falls. The rationale for employee stock options is to reduce agency costs by better aligning employee and shareholder interests. which means the employee actions are actually part of the company performance. The evaluation of the argument for or against repricing is open-ended. If an employee knows the option will be repriced if the stock declines. even if the company is doing well. if the stock price does decline dramatically. Since all values less than $10 are no longer possible.

As with any other merger analysis.00 0 Year 5 $59.610.400.578 + 18.466.58 9 Year 2 $9.578 $18.168.400.80 6 Year 1 $32.4% $32.589 + 9.000 + 32.000 $659.400.00 0 $38. while the dividends are equity cash flows.995 NPV = $44. we need to examine the present value of the incremental cash flows.366.139 $361.9% Dividends PV of value Total 12.07 .578 Year 3 $18.00 0 Year 4 $41. The terminal value of the company is subject to normal business risk and should be discounted at the cost of capital.CHAPTER 26 THE BIRDIE GOLF-HYBRID GOLF MERGER 1.00 0 Year 2 $12.806 + 361.000.400.000 –$400. should be discounted at the cost of equity.466.00 0 Year 3 $29.366.400.995 And the NPV of the acquisition is: NPV = –$400. The present value of each year’s cash flows.80 6 Year 5 $27.400.64 3 $22.366.403.848. we must discount each cash flow at the appropriate discount rate.000 600. so the cash flows for the next five years will be: Year 1 $38.441.848.000.000. and as such.800. we can determine the cash flows to Birdie Golf from acquiring Hybrid Golf.00 0 $12.168.000.64 3 Year 4 $22. The cash flow today from the acquisition is the acquisition costs plus the dividends paid today.025.000 Using the information provided.848.856 334.800.58 9 $9.403.000 $150.00 0 $41.000.00 0 $29.403.000 Dividends from Hybrid Terminal value of equity Total To discount the cash flows from the merger.000.254.168.000.643 + 22. or: Acquisition of Hybrid Dividends from Hybrid Total –$550. along with the appropriate discount rate for each cash flow is: Discoun t rate 16. All earnings not retained are paid as dividends.

CHAPTER 25 C-83 .

7127 4.610.610. or: Highest share price = $594.254. so the exchange ratio is: Exchange ratio = $68. the exchange ratio which would make the cash offer and share offer equivalent is: Exchange ratio = $68. the most Birdie would offer is to increase the current cash offer by the current NPV.07 Highest offer = $594.07 The highest share price is the total high offer price.46 Exchange ratio = .000.000 shares Highest share price = $74.000 PNew = $96.000.610.75 / $96.000.610. or: Highest offer = $550.7314 .C-84 CASE SOLUTIONS 2.75 / $94 Exchange ratio = .254.46 So. The highest exchange ratio Birdie would accept is an exchange ratio that results in a zero NPV acquisition.000.254.07) / 18. This implies the share price of Birdie remains unchanged after the merger.07 / 8. Since the acquisition is a positive NPV project. To determine the current exchange ratio which would make a cash offer and a share offer equivalent.000 + 44.000 + $44. divided by the shares outstanding. The new share price of Birdie after the merger will be: PNew = ($94 × 18.254. we need to determine the new share price under the original cash offer.28 3.

15% And the NAL of the lease is: NAL = $3.000 –$1.000 –1.35) Aftertax salvage value = $390.0 The company should lease the equipment. the tax savings on the lease.428.275/1.000 $3.175 –$219.000 455.000 Saved purchase Lost salvage value Lost dep.675/1.275 –$777. .300.07154 NAL = $44.175/1. The salvage value of the equipment in four years will be: Aftertax salvage value = $600. The lease payments are due at the beginning of each year. The decision to buy or lease is made by looking at the incremental cash flows.000.675 300.0715 or 7.275 –300.000 – $600.875/1.300.175 –1.855. so the incremental cash flows are: Year 0 $5. the lease payments.675 The aftertax cost of debt is: Aftertax cost of debt = .07153 – $219.000 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.CHAPTER 27 THE DECISION TO LEASE OR BUY AT WARF COMPUTERS 1.000 –$1.35) Aftertax cost of debt = .855.000 455.104.11(1 – .000 455.622.300. The incremental cash flows from leasing the machine are the security deposit.428. tax shield Security deposit Lease payment Tax on lease payment Cash flow from leasing –$583.07152 – $1.875 –1.000 –$1.308.300. the saved purchase price of the machine. and the lost salvage value.000 455. the lost depreciation tax shield.000 – $1.875 –$259.104.000(.0715 – $1.000 –129.000 –1.000 Year 1 Year 2 Year 3 Year 4 –$390.622.

11 PV of lease payments = $4.000 –$2.07 This is less than 90 percent of the price of the equipment. notice that the question also states that if the lease is renewed in two years.078. the FAS 13 conditions for a capital lease are not met.0715 – $2.688.300.000/1.300.111. Using the company’s cost of debt.725 So.35) Aftertax salvage value = $1.000.000.000 – 2.275 –2.07152 NAL = –$583.805.275 –$2.000 – $5.4445) Book value = $1.099.000. the lease will likely be classified as an operating lease. the present value of the lease payments is: PV of lease payments = $2.505.300. the lessor will allow for the increased lease payments made over the first two years.466.000 – $2. which is less than 75 percent of the equipment’s life according. the aftertax salvage value in year 2 will be: Aftertax salvage value = $2. Also.000 $3. However. the reason for suggesting the revised lease terms is unethical on Nick’s part.372. This is also an indication that the revision is for less than ethical reasons. the NAL of the lease under these terms is: NAL = $3.000 805.072.000(.000 So.850 So. or allow for a purchase at a bargain price.875 Saved purchase Lost salvage value Lost dep.000 Year 1 Year 2 –$1. The lease is now for two years.11 The NAL of the lease is negative under these terms. The book value of the equipment in year 2 will be: Book value = $5.850 –777. .275/1.300. tax shield Lease payment Tax on lease payment Cash flow from leasing –2. As such.000.466. As long as the lease contract does transfer ownership to the lessee at the end of the contact.000 –$583.3333 + .725/1. so it appears the terms are less favorable for the lessee.C-86 CASE SOLUTIONS 2.111.000 + ($1. the NAL of the lease under the new terms would be: Year 0 $5.000.000)(.078.688.000 805.000 + $2.

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 bargain price is also a real option for the lessee. can purchase the equipment at the fixed price and resell it in the open market. c.CHAPTER 27 C-87 3. and therefore will have value until it expires or is exercised. . it will save money. or at a minimum. If the company does not purchase the equipment. a. 4. The cancellation option is a put option on the equipment. and will increase the value of the lease. If the company can purchase the equipment at the end of the lease at below market value. It is a call option. This contract condition will definitely ensure the lease is classified as a capitalized lease. It is a call option on the equipment. b. therefore has value to the lessee. it can go on the market and purchase identical equipment at the same price. As such. 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 cancellation option is also a real option. The inclusion of a right to purchase the equipment will have no effect on the value of the lease. This is a real option. it must have a value until it expires or is exercised. The right to purchase the equipment at a fixed price will increase the value of the lease.

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