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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

Using the OCF equation: OCF = EBIT + Depreciation – Taxes The OCF for each year is: OCF2008 = $60. plus the addition to retained earnings.611 .217 $74.581 – 10.250 156.404 15.326 + 15.478 Accounts payable 16.163 OCF2009 = $97. we need to find the capital spending and change in net working capital.065 $272. 2009 $27.411 Long-term debt $191.401 $91.399 $17. so: Equity = $89.492 And the change in net working capital was: Change in net working capital Ending NWC – Beginning NWC Change in NWC $29. 31.139 + 24.010 11.997 $52.216 Current liabilities $81.975 40.680 + 40.624 OCF2008 = $85.250 Owners' equity $272.853 + 35. To calculate the cash flow from assets.661 Total liab. & equity $36. The capital spending for the year was: Capital spending Ending net fixed assets – Beginning net fixed assets + Depreciation Net capital spending $191.734 4.195 129.217 – 12.661 The owner’s equity for 2009 is the beginning of year owner’s equity.717 Notes payable 37.065 3.180 OCF2009 = $69.600 Equity = $129. plus the new equity.CHAPTER 2 C-3 Cash Accounts receivable Inventory Current assets Net fixed assets Total assets Balance sheet as of Dec.

The cash flow to stockholders was: Cash flow to stockholders Dividends paid – Net new equity raised Cash flow to stockholders Answers to questions 1.C-4 CASE SOLUTIONS So.611 $ 5.492 in new fixed assets.726 .094 $24. The company does have a positive cash flow. $97. The cash flow to creditors was: Cash flow to creditors Interest paid – Net new borrowing Cash flow to creditors 6. the expansion plans may be too aggressive at this time.326 15.094 from bondholders. The firm gave $5.631 to its stakeholders. and paid $8. the cash flow from assets was: Cash flow from assets Operating cash flow – Net capital spending – Change in NWC Cash flow from assets 5. companies do need capital to grow. you would want to know where the current capital spending is going.600 $8. So. It raised $3. The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. On the other hand.960 –$3. Before investing or loaning the company money.734 74. The expansion plans may be a little risky. The company has had to raise capital from creditors and stockholders for its current operations.726 to stockholders. and why the company is spending so much in this area already.611 in new net working capital and $74. 2.492 17. but a large portion of the operating cash flow is already going to capital spending.631 $8. The firm invested $17.866 11.

000 + 5.920) / $18.308.36 times Cash coverage = ($3.499.000 Quick ratio = 0.CHAPTER 3 RATIOS ANALYSIS AT S&S AIR 1.240 Times interest earned = 6.499.45 times Debt-equity ratio = ($2.037.82 times Times interest earned = $3.120 Inventory turnover = 21.499.15 times Total asset turnover = $30.366.920 Return on assets = 8.919.680) / $478.919. The calculations for the ratios listed are: Current ratio = $2.420 / $708.452 / $18.308.67 times Inventory turnover = $22.040.920 Equity multiplier = 1.186.580 / $1.75 times Quick ratio = ($2.420 Cash coverage = 9.920 Total debt ratio = 0.537.920 / $10.04% Return on assets = $1.400 Receivables turnover = 43.537.000) / $10.000 / $2.520 / $2.22 times Profit margin = $1.919.308.069.000 Current ratio = 0.660 + 1.308.000 Cash ratio = 0.037.250 – 1.660 / $478.224.919.43 times Receivables turnover = $30.39 times Cash ratio = $441.420 Profit margin = 5.920 Total asset turnover = 1.069.05 times Total debt ratio = ($18.920 Debt-equity ratio = 0.82 times Equity multiplier = $18.920 – 10.320.186.120) / $2.420 / $18.040.452 / $30.40% .308.069.

452 / $10.C-6 CASE SOLUTIONS Return on equity = $1.27% .920 Return on equity = 15.537.069.

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

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

64% To find the sustainable growth rate.920 ROA = .0840(.0564 or 5.920 ROE = .64)] / [1 – 0.452 b = 0.40% b = Addition to RE / NI b = $977. The sustainable growth rate is the growth rate the company can achieve by raising outside debt based on its retained earnings and current capital structure. .069.27% Using the retention ratio we previously calculated.75% The internal growth rate is the growth rate the company can achieve with no outside financing of any sort. To calculate the internal growth rate.537.CHAPTER 4 PLANNING FOR GROWTH AT S&S AIR 1.537.0840(.64 Now we can use the internal growth rate equation to get: Internal growth rate = (ROA × b) / [1 – (ROA × b)] Internal growth rate = [0.64)] Sustainable growth rate = .64)] / [1 – 0.1075 or 10. we first need to find the ROA and the retention ratio.64)] Internal growth rate = .452 / $10. so: ROA = NI / TA ROA = $1.0840 or 8.452 / $18. we need the ROE.537.1527(. which is: ROE = NI / TE ROE = $1.1527 or 15.452 / $1. the sustainable growth rate is: Sustainable growth rate = (ROE × b) / [1 – (ROE × b)] Sustainable growth rate = [0.1527(.309.

530 4. .236.505.680 $ 3.899. it will increase the sustainable growth rate.569.990 350.594. total asset turnover. For example. the ROE increases.179.000 $ Fixed assets Net PP&E Total Assets So.240 $ 3.902 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. the EFN is: $ 18.000 10.117 $ 19.030. if profit margin increases.920 793.891.C-10 CASE SOLUTIONS 2.088 $ 20.787 EFN = Total assets – Total liabilities and equity EFN = $20. that changing any one of these will have the effect of changing the pro forma financial statements.366.990 – 19.161.520 $ 1.159. as long as the company increases the profit margin.000 3.448.320.331.193 The company can grow at this rate by changing the way it operates. or equity multiplier.583 1. say by reducing costs.780 $ 675.797 EFN = $911.249. In general.408 1.301 1.091.197 Balance sheet Assets Current Assets Cash Accounts rec.541 478.117 $ 11. the higher growth rate is possible.600 1.680 5.057.680 2.574 $ 2.594. Inventory Total CA $ 493.025. Note however.350 24.854.505. 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.

350 24.667.331. then. We will assume that the company will go ahead with the fixed asset acquisition. To estimate the new depreciation charge.600.400 Depreciation percentage = .456 1.530 4.CHAPTER 4 C-11 3.790.122. So.790.525 We will use this amount in the pro forma income statement.145.122.982 $ 1.017.122.519 .000.473 $ 582.122.159.525 $ 3.0848($21. apply this percentage to the new fixed assets.955 1.0848 or 8. 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. The depreciation as a percentage of assets this year was: Depreciation percentage = $1.400) Pro forma depreciation = $1. we will find the current depreciation as a percentage of fixed assets.696 478.680 / $16.891.48% The new level of fixed assets with the $5 million purchase will be: New fixed assets = $16.400 So. the pro forma depreciation will be: Pro forma depreciation = .000 = $21.240 $ 2.366.066. Now we are assuming the company can only build in amounts of $5 million.600 1.400 + 5.

.571.433.439 $ 19.000 10.122.920 793.119 EFN = $4.320. Balance sheet Assets Current Assets Cash Accounts rec.581.902 Liabilities & Equity Current Liabilities Accounts Payable $ Notes Payable Total CL $ Long-term debt Shareholder Equity Common stock Retained earnings Total Equity Total L&E $ 995.400 $ 23.C-12 CASE SOLUTIONS The pro forma balance sheet will remain the same except for the fixed asset and equity accounts.184 Since the fixed assets have increased at a faster percentage than sales. rather than the growth rate of sales.302 350.087.439 $ 11. The fixed asset account will increase by $5 million.574 $ 2.408 1.680 2.680 5. the capacity utilization for next year will decrease.000 3.025.000 $ Fixed assets Net PP&E Total Assets So.161.030.433.119 EFN = Total assets – Total liabilities and equity EFN = $23.448.302 – 19.737.138. Inventory Total CA $ 493. the EFN is: $ 21.

500 PV of direct costs = $68. . regardless of the salary.000 = $68. so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $40. so: Remain at current job: Aftertax salary = $55.227.819.065)2 = $75.065)/(1 + .0652 = $9.700(1 + .03) PV = $836. 3.176.31) = $67.620 2.CHAPTER 6 THE MBA DECISION 1.700 / (1. The cost includes both the explicit costs such as tuition. or pursue a Mt.03)]38} / (.125. job satisfaction. Perhaps the most important nonquantifiable factors would be whether or not he is married and if he has any children.700 His salary will grow at 3 percent per year.17 Aftertax salary = $98.25 PV of indirect costs (lost salary) = $40. Age is obviously an important factor. We need to find the aftertax value of each.26) = $40.00 Salary: PV of aftertax bonus paid in 2 years = $15. Other factors would include his willingness and desire to pursue an MBA.31) / 1. room and board costs are irrelevant since presumably they will be the same whether he attends college or keeps his current job.000(1 – . In this analysis.700{[1 – [(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 + 2. He has three choices: remain at his current job.000(1 – . he may be less inclined to return for an MBA since his family may be less amenable to the time and money constraints imposed by classes.34 Wilton MBA: Costs: Total direct costs = $63. and how important the prestige of a job is to him. The younger an individual is.000(1 – .500 + 3.500 + 68.065) + $40. pursue a Wilton MBA.065 – .03) / (1 + .500 / (1. as well as the opportunity cost of the lost salary.065) = $132. Perry MBA. With a spouse and/or children.

C-14 CASE SOLUTIONS .

000 + 3.991.991. so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $57.5 percent per year.065 PV = $1.500 + 3.666. so the present value of his aftertax salary is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] PV = $67.663.056.125.510 His salary will grow at 3.22 / 1.90 .25 + 9.81 Since the first salary payment will be received two years from today.CHAPTER 6 C-15 His salary will grow at 4 percent per year.500.666. this is also the PV of the direct costs since they are all paid today.67 + 1.000 = $86.544.26 = $1.18 Mount Perry MBA: Costs: Total direct costs = $78.04) PV = $1.250.174.370.590.065 = $6.17 + 1.20 = $1.819.29) = $57. We must also remember that he will now only work for 36 years.215.663.065) = $38.500 – 38.065)/(1 + .29) / 1.96 Salary: PV of aftertax bonus paid in 1 year = $10.065 – .035)]37} / (.250.065 – .065)/(1 + .22 Since the first salary payment will be received three years from today.700 / (1. so we need to discount this for one year to find the value today. which will be: PV = $1. the total value of a Mount Perry MBA is: Value = –$86.67 Aftertax salary = $81.510{[1 – [(1 +.04)]36} / (.035) PV = $1.640.620{[1 – [(1 +. which will be: PV = $1. PV of indirect costs (lost salary) = $40.174.171. the total value of a Wilton MBA is: Value = –$75.813.683.0652 PV = $1.26 So.81 / 1. so we need to discount this for two years to find the value today.160 – 132. We must also remember that he will now only work for 37 years.20 So.640.370.215.000(1 – .683.000(1 – .96 + 6. Note.554.

the aftertax salary needed is: PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)] $1. not the source of the funds.021. However. Therefore.17 = $1. Since his salary will still be a growing annuity. and the PV of the bonus on an aftertax basis.819. This is an important concept which will be discussed further in capital budgeting and the cost of capital in later chapters.04)]36} / (.227.021.097.42 = C {[1 – [(1 +. the necessary PV to make the Wilton MBA the same as his current job will be: PV = $836.097.31) = $65.248.04) C = $45. a future value analysis will result in the same decision.C-16 CASE SOLUTIONS 4.065 – .51 / (1 – . the pretax salary must be: Pretax salary = $45. .176. So. 5. To find the salary offer he would need to make the Wilton MBA as financially attractive as the as the current job. we need to take the PV of his current job.035. Calculating the future value of each decision will result in the option with the highest present value having the highest future value.035.125. 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. Thus.57 6. The cost (interest rate) of the decision depends on the riskiness of the use of funds.42 This PV will make his current job exactly equal to the Wilton MBA on a financial basis.065)/(1 + . add the costs of attending Wilton. So.34 + 132.00 – 9.25 + 75. whether he can pay cash or must borrow is irrelevant.51 This is the aftertax salary. He is somewhat correct.

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

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

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

So.000 / 50.1806 or 18.28 = 0. The total dividends paid by the company were $126.72) = .000. the industry EPS is: Industry EPS = ($0. INC.38 + 1.79 + 1.3715 or 37. the company’s growth rate is: g = ROE × b = . the industry retention ratio is Industry retention ratio = 1 – .000($4.06% The dividend per share paid this year was: D0 = $63.72 Using the retention ratio. the total earnings for the company were: Total earnings = 100.20 – .40/$1.3715 = . we need to recalculate the industry EPS.28 So. 1. the retention ratio was: Retention ratio = 1 – .000 shares outstanding.28(.1806) P0 = $76.000/$454.000 D0 = $1.06) / 3 = $1.000 This means the payout ratio was: Payout ratio = $126.CHAPTER 8 STOCK VALUATION AT RAGAN.08 = .75 2.85% .6285 or 62.54) = $454. which is: P0 = D1 / (R – g) P0 = $1.26 Now we can find the stock price.15% So. Since there are 100.08 Using this industry EPS. Since Expert HVAC had a write off which affected its earnings per share.26(1. the industry payout ratio is: Industry payout ratio = $0.1806) / (.000 = 0.

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.

650 900.000 – 15.000 –1.190.423.072.765.000 $37.000 4.925.000 3.685.500.919.800.000 units of the old PDA each year for two years at a price of $290 each.700. 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.685.725. and the lost revenue.925.000 $20.000. PART 1 This is an in-depth capital budgeting problem.760.275.000 1.000 $20.072.015.878 $9.015.800.373 $19.000 5.917.018 $6.000) × ($290 – 255)] = $20.164.050 3.000 $37.265.000 Year 3 $45. the total change in sales is: Sales = New sales – Lost sales – Lost revenue Year 1 = (74. the lost sales are 15.876.000 12.350 $14.650 6.000 Year 2 = (95.350.350 $8.375.800.670. In this case.000 $28.884.033 1.700.000 Year 4 $37.223 3.000 4.628 $11.950 $9.000 × $290) – [(60.000 9.744.350 $14.000 $28. So.640.265.000 $9.000 × $290) – [(80.023 5.000 $45.000 $19.700. The initial cash outlay at Time 0 is simply the cost of the new equipment.800.000 Sales New Lost sales Lost revenue Net sales VC New Lost sales Year 1 $26.672.470.575.950 $8.384.000 4.000.800.000 4.400.948.350.919.000 –1.276.023 3.350 $17.350 $2.000 16.275.000 –4.700.628 $3.000 $11. The sales each year are a combination of the sales of the new PDA.650 1.275.015.800.000 19.572.400.000.275.139.350 $11.200.000 –4.000 $28.350 $4.773 2.700.670.650 4.CHAPTER 10 CONCH REPUBLIC ELECTRONICS.000 $12.375.500.000 $16.373 $16.000 3.000 Year 5 $28.123 $12.780.275.800.000 Year 2 $34.357. $21.000) × ($290 – 255)] = $28.350 $5.000 $12.000 –2.275.983 Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF .000 × $360) – (15.000 – 15.428 $1. the lost sales each year.000 $28.000.760.800.000 2.007.000 $45.275.000 4.375.000 12.400.000 × $360) – (15.000 –1.157.573 $14.

572.113.000 –$1.123 / (1 + IRR)4 + $20.350 – 3.62% 4.000 $1.440.611.572.CHAPTER 8 C-27 NWC Beg End NWC CF Net CF $0 4.000 –$4.373 / (1 + IRR)3 + $13.373 / (1 + IRR)2 + $11.000 –$3.950) BV of equipment = $4.373 11.123) Payback period = 3.000 9.560.604 3.828 = $4.000 5.000 0 $7.000 Profitability index = 1.316.124 + $20.373 $9.156 years 2.836.655.350 – 2.919.000 – 3.000 $15.113.100.000 $7.810 / (1 + IRR)5 IRR = 27. The payback period is: Payback period = 3 + ($2.572.316.072.180. The project IRR is: IRR: –$21.123 / 1.373 / 1.560.122) + ($11.828 So.123 $7.180.35) = $243.560.113.500.100.072.810 / 1.123 / 1.760.350 – 1.316.000)(.796.113.000 $11.003.983 BV of equipment = ($21.573 / 1.124) + ($20.000.500 – 5.373 / 1.123 + $13.655.12) + ($7.003. The profitability index is: Profitability index = [($741.500.125 NPV = $12.000 $741.983.113.810 / 1.180.265.500.12 + $7.62 Cash flow –$21.000 = $741.122 + $11.573 / (1 + IRR) + $7.123 20.000 741.345.000 $13.828 CF on sale of equipment = $4.650 Taxes on sale of equipment = (BV – MV)(tC) = (4.572. The project NPV is: NPV = –$21.000 + 243.572.000.180.650 – 4.683 / $13.343.123) + ($13.373 13.810 .000 + $741.373 $5.573 $4.373 / 1.500.652.685.796.003.573 / 1.316.316.316.573 7.125)] / $21.373 / 1.500.000 7. the cash flows of the project are: Time 0 1 2 3 4 5 1.

400.275.350.000) × ($290 – 255)] Year 1 sales = $20.000 1.000 $46. but remember that the price we choose is irrelevant: The final answer we want.000 – 15.800.350.000 $20.225.000 $14. minus the lost dollar sales from the price reduction of the existing PDA.000 Year 2 $35.755.850. The calculations for sensitivity to changes in price are similar to the original cash flows.000 × $370) – (15.000 $38.000 Year 3 $46. or: Sales = New sales – Lost sales – Lost revenue Year 1 sales = (74.000 Sales New Lost sales Lost revenue Net sales VC New Lost sales Year 1 $27.150.000 × $370) – (15.380. We will use a price of $370 per unit.000 $19.800.600.000 × $290) – [(80.000 Year 5 $29.470.000 1.000 – 15.275.000 $12.000 Year 4 $38.000 $16.000 .000 $11.000 4. Here we want to examine the sensitivity of NPV to changes in the price of the new PDA. minus the lost sales of the existing PDA.000 2. The projections with the new prices are: The sales figure for the first two years will be the sales of the new PDA.725.250.000 $12.925.000 4.375.000 $19.670. the sensitivity of NPV to a one dollar change in price will be the same no matter what price we use.250.000 $9.225.575.375. PART 2 1.CHAPTER 11 CONCH REPUBLIC ELECTRONICS.275.400. The only difference is that we will change the price of the PDA.000 × $290) – [(60.000 $29.000 1.000 $16.000 $12.600.755.000) × ($290 – 255)] Year 2 sales = $29.000 Year 2 sales = (95.850.000 $29.

000 7.650 1.950) BV of equipment = $4.000 $16.350 $3.573 7.350 – 1.35) = $243.000 4.566.919.873 $5.378 $9.919.265.350 $15.074.000 3.405.703.500 – 5.828 = $4.000 –$3.000 – 3.558.038.275.000 9.685.350 $15.000 4.074.375.770.000)(.845.623 / 1.650 6.100.623 $7.153.650 – 4.688.159.000 $14.919.850.400.950 $10.217.969.072.760.151.000 4.223 3.273 2.250.038.350 $6.770.700.845.688.128 $11.500.125 NPV = $15.334.700.796.770.122 + $12.324.000 1.623 $29.760.CHAPTER 11 C-29 Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF $20.072.983 BV of equipment = ($21.700.828 CF on sale of equipment = $4.910.000 12. the cash flows of the project under this price assumption are: Time 0 1 2 3 4 5 Cash flow –$21.000 4.151.910.033 1.000 16.828 So.873 $9.128 $4.265.000 12.873 $38.350 $18.623 20.000 –$4.000 4.350 $12.250.873 12.523 5.124 + $20.796.573 $4.343.000 1.312.700.117.688.350 – 3.000 –$1.685.000 $1.000 3.650 Taxes on sale of equipment = (BV – MV)(tC) = (4.000 + 243.000 $1.873 / 1.925.050 3.382.038.12 + $7.873.729.350 $9.700.151.189.074.580.873 $46.573 / 1.000 $7.018 $6.000 2.18 .100.414.500.650 2.877.000 19.650 5.000 5.000 + $1.600.250.670.000 5.873 14.000 9.324.148.000 0 $7.873 / 1.123 + $14.480.755.225.225.265.694.810 / 1.983 NWC Beg End NWC CF Net CF $0 4.445.350 – 2.000 $12.316.950 $8.500.072.810 The NPV with this sales price is: NPV = –$21.760.350 $5.523 3.428 $2.685.573 $29.324.796.716.

. We will increase unit sold by 100 units per year. 2.100 × $360) – (15.000 Year 2 sales = (95. The only difference is that we will change the quantity sold of the new PDA. Remember that the quantity we choose is irrelevant: The final answer we want. the sensitivity of NPV to a one unit per year change in sales.100 × $360) – (15.983.000 – 15.000 Note.C-30 CASE SOLUTIONS And the sensitivity of changes in the NPV to changes in the price is: ΔNPV/ΔP = ($15.46 For every dollar change in price of the new PDA.62) / ($370 – 360) ΔNPV/ΔP = $216. minus the lost dollar sales from the price reduction of the existing PDA. or: Sales = New sales – Lost sales – Lost revenue Year 1 sales = (74. minus the lost sales of the existing PDA.148.000 × $290) – [(80. The calculations for sensitivity to changes in quantity are similar to the original cash flows.716.311.510.000) × ($290 – 255)] Year 1 sales = $20.510.46 in the same direction.051. the variable costs must also be increased to account for additional units sold.18 – 12. Here we want to examine the sensitivity of NPV to changes in the quantity sold.000 × $290) – [(60.611. The projections with the quantity are: The sales figure for the first two years will be the sales of the new PDA.000 – 15. the NPV of the project changes $216.000) × ($290 – 255)] Year 2 sales = $28.

170.185.051.000 3.500 $28.836.803 $3.000 12.000 2.010.603 $1.836.150 4.311.500 $45.014.200 –$3.275.350 $17.500 4.889.350 $14.290.940.550 3.800.930.919.650 – 4.000 1.007.950 $9.485.100.500 $37.940.500 1.000 $11.836.308 Sales VC Fixed costs Depreciation EBT Tax NI + Depreciation OCF NWC Beg End NWC CF Net CF $0 4.290.500 $19.700.236.500 $12.448 $12.036.760.000 4.343.098 2.200 0 $7.390.898 $14.956.740.836.150 6.350.000 5.350 $14.500 4.508 BV of equipment = ($21.685.000)(.700.950) BV of equipment = $4.803 $11.350.000 16.000 $28.200 –$4.700.000 4.007.448 $7.265.204.500.415.796.160.290.000 3.500 – 5.000 Year 3 $45.676.500 1.150 907.010.100.072.000 + 243.348 5.685.329.700.350 – 3.200 5.685.919.000 1.200 $747.265.567.348 3.593.440.000 $45.513.662.000 $13.265.000 Year 4 $37.891.685.836.350 – 2.000 $37.828 CF on sale of equipment = $4.000 19.358 1.036.698 $9.500 $28.200 9.370.700.662.390.430.757.053 $9.051.800.698 $5.950 $8.796.575.698 $19.836.010.350 $4.000 – 3.000 $11.760.200 $15.857.126.500 4.072.567.193 $6.350 – 1.200 –$1.778.350 $11.000 $9.350 $2.311.200 $1.652.200 7.290.828 = $4.500 $20.345.760.000 2.000 Year 2 $34.800.390.585.685.698 $4.CHAPTER 11 C-31 Sales New Lost sales Lost revenue Net sales VC New Lost sales Year 1 $26.685.650 Taxes on sale of equipment = (BV – MV)(tC) = (4.500 4.415.036.000 $7.000 $28.500 $16.828 .698 $16.415.405.000 12.000 Year 5 $28.350 $5.548 3.000 $20.350 $8.35) = $243.567.072.000 $12.500 4.150 1.000 9.919.

125 NPV = $13.585.698 13.C-32 CASE SOLUTIONS So.029.000 747.91 in the same direction.201.448 / 1.302.500.302. Cash flow –$21.698 / 1.329.335 .124 + $20.62) / 100 ΔNPV/ΔQ = $456.335 / 1.126.698 7.611.17 So.698 11.585.983.698 / 1.17 – 12.123 + $13.201. the NPV of the project changes $456.12 + $7.000 + $747.448 20.500. the sensitivity of NPV to units sold is: ΔNPV/ΔQ = ($13.698 / 1.122 + $11.029.126.329. 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 = –$21.91 For a one unit per year change in quantity sold of the new PDA.

and therefore. just that the risk is higher. In general. 5.5703 S&S Air stock = (18% – 3.82% = . so the number of periods in a year is infinite. using the information from Table 10.68% – 3. The higher expenses of the fund are expected.0279 + . Since we are given the average return for each fund over the past 10 years. This does not imply the fund is bad.0114 + .49) / 15. 3. Both the APR and EAR are infinite. The match is instantaneous.83% = .0598 + . we should use the average risk-free rate over the same period. So. the expected return is higher. in large part due to the greater cost of running the fund. 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.49) / 15. most mutual funds do not outperform the market for an extended period of time.0333 +.0349 or 3.85% – 3.5048 Bledsoe Small-Cap Fund = (16.0161 +.CHAPTER 12 A JOB AT S&S AIR 1.5422 Bledsoe Bond Fund = (9. small cap funds have higher expenses.48% – 3.41% = . the 10-year average risk-free rate is: Risk-free rate = (.0452) / 10 Risk-free rate = . and finding the funds that will outperform the market in the future beforehand is a daunting task.49) / 70% = . 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. The returns are the most volatile for the small cap fund because the stocks in this fund are the riskiest.0480 + . . The mutual funds have a number of assets in the portfolio.1.0094 +.0497 + .49) / 10.6714 Bledsoe Large Company Stock Fund = (11.67% – 3. including researching smaller stocks.0486 + .49) / 19. The advantage of the actively managed fund is the possibility of outperforming the market.64% = .49% The Sharpe ratio for each of the mutual funds and the company stocks are: Bledsoe S&P 500 Index Fund = (11. The biggest advantage the mutual funds have is instant diversification. In general. 2. The major disadvantage is the likelihood of underperforming the market.2072 4.

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

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

00075 0.0139 -0.0110 -0.0180 -0.0176 0.00078 0.53 $49.0072 0.0071 -0.0233 0.0325 -0.13 1144.0023 0.0092 0.0500 0.0171 -0.92 1181.0289 -0.CHAPTER 13 THE BETA FOR AMERICAN STANDARD NOTE: The example below shows the results from May 2008.0474 0.0124 0.0815 -0.75 $41.00077 0.70 $46.45 $42.0071 0.00194 0.0291 0.0127 0.0168 0.0142 -0.0164 -0.0307 -0.0162 0.0451 -0.0115 -0.00106 0.0284 0.6 1180.00228 Stock risk premium -0.0207 0.85 S&P 500 return 0.0102 0.80 $50.58 $50.97 $50.0094 0.24 1114.0064 0.0859 0.0113 0.0173 0.59 974.2 1173.0212 -0.0102 -0.0170 -0.0081 0. Monthl y Riskfree 0.00079 0.1646 -0.0165 0.0140 0.0550 0.0302 0.0121 0.00183 0.0402 S&P 500 963.0122 -0.0104 0.0092 0.0189 -0.00111 0.0094 0.21 1107.0191 -0.0130 -0.01 995.0093 0.0133 0.87 $45.90 $41.1106 0.1633 -0.97 1050.94 1126.0320 0.31 1008.0119 0.009 0.75 $48.0179 -0.2 1111.0012 0.00078 0.00077 0.0371 0.0063 0.0219 -0.00089 0.0148 0.0386 0.82 1211.48 $53. It is necessary to find the monthly rate.1123 0.0254 0.25 $52.0095 0.74 Return -0.0542 0.0052 -0.00123 0.0870 0.05 $49.0176 0.73 $47.0309 0.0094 0.00073 0.0271 0.00173 0.71 1058.0116 0.0088 0.0549 -0.0343 0.50 $47.0086 0.20 $50.0071 0.0353 0.00147 0.0127 0.00138 0.27 1203.0219 0.0138 -0.00075 0.00078 0.63 $53.59 1156.0280 -0.40 $48.0210 -0.68 1140.0118 0.0155 0.0546 0.00212 0.16 $49.0171 -0.0163 -0.0425 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. The actual answer to the case will change based on current market conditions 1.0443 -0.0274 Stock price $53.0538 0.72 1104.00078 0. Note that the risk-free rate (3-month T-bill rate) is expressed as an annual rate.64 $46.009 0.00085 0.58 1130.0224 .0093 0.0466 0.3 1120.0171 -0.92 1131.0201 S&P risk premium 0.0151 -0.0126 0.5 990. so this rate is divided by 12.0113 0.0808 -0.0541 -0.0107 0.0253 0.0294 0.0094 0.40 $49.84 1101.0125 0.0165 0.0508 0.91 $52. The information used for the analysis is presented below.78 $49.00078 0.

00248 0.0297 0.33 0.5 1191.91 $46.98 $49.0278 0.33 1234.0139 .0284 0.00237 0.56 0.0668 -0.0084 1191.00268 $46.85 $49.0036 0.0276 -0.0112 0.0322 0.0025 0.00232 0.0111 0.0036 -0.0013 0.CHAPTER 13 C-37 May-05 Jun-05 Jul-05 Aug-05 0.0013 -0.0335 -0.0300 -0.0001 0.0360 -0.0643 -0.18 1220.

0088 0.00394 0.0013 0.81 1207.0371 0.00406 0.0475 0.0086 -0.82 1420.0114 -0.0325 -0.35 1455.0060 0.0285 -0.00177 0.7 1385.0084 -0.0263 0.61 1270.05 $63.25% 0.63 1322.0126 0.0467 -0.0327 0.0879 0.0028 0.00419 0.0074 0.0389 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 0.0060 0.0128 -0.00413 0.0178 -0.00105 0.0011 0.70 $72.92 $62.0100 -0.0169 0.0444 0.0358 0.29 1280.0472 0.66 1303.0440 -0.0111 0.0495 0.34 $70.00309 0.0492 0.039 0.54% .75 $57.0334 0.0100 0.0001 0.00353 0.0063 0.28 $66.09 1270.0294 0.00325 0.0221 -0.37 1530.0355 0.0465 0.38 1481.62 1503.0056 0.0197 -0.0028 0.50 $56.0031 0.0053 0.00415 0.0035 0.0485 0.0029 -0.39 $52.13% Coach 0.0348 -0.0177 0.0047 0.0131 -0.0315 0.0481 0.07 $52.00404 0.0246 0.0077 0.0155 -0.0193 0.10 $66.0075 0.0424 0.85 1377.0194 0.51 $70.00229 0.0496 0.0058 0.0637 -0.0038 0.0222 -0.0114 -0.00 $54.65% 2.0133 0.0482 0.10 $75.0443 0.00402 0.57 $65.00285 0.00384 0.55 1330.36 1378.0315 0.0051 0.0309 0.0052 Using the Excel functions for the average return and standard deviation.0042 0. the table below shows the averages and standard deviations for each of the series.0413 0.0116 -0.27 1473.0218 -0.18 $76.0204 0.51 $79. Last 60 months Average return Standard deviation Risk-free 0.0213 0.2 1276.0205 1228.0315 0.0110 0.59 1394.0129 0.0494 0.0255 0.0218 0.0358 0.00323 0.0323 0.0352 -0.00287 0.0155 -0.0375 0.75 $59.3 1438.0049 0.02 $65.0473 -0.0091 0.0212 0.0206 0.00108 $49.23 $57.00412 0.0889 0.0085 0.0499 -0.0376 0.0231 0.0025 0.0498 0.0292 -0.0060 0.26 $75.0069 -0.0718 0.03 0.00401 0.84 $50.0126 0.0451 0.0389 0.0165 -0.0206 -0.0129 0.0388 0.82 1335.0503 0.01 1249.0050 0.00383 0.0433 0.00412 0.0171 0.70 $77.28 $77.0494 0.0275 0.0520 -0.0753 0.28 $51.0029 0.0487 0.0141 -0.00324 0.0715 0.0371 -0.86 1482.94 1400.0355 0.92 $57.0473 0.0481 0.0321 -0.0112 -0.0344 0.0041 -0.0124 0.76 $52.0342 0.0612 -0.08 1280.58% 4.99 1526.50 $57.66 1294.0148 -0.00399 0.0239 -0.87 1310.15 0.0061 -0.0168 -0.0747 0.00376 0.00393 0.00369 0.0140 -0.0088 0.55 $65.0172 -0.31% S&P 500 0.62 $63.0009 0.0320 0.0041 0.0275 0.0265 -0.0074 0.00324 0.0479 -0.48 1248.24 1406.0348 -0.046 0.10 $63.00273 0.0392 0.0479 0.0010 0.0091 0.0122 -0.0461 0.0260 0.63 1418.00413 0.0165 0.0087 0.70 $65.75 1549.35 0.14 1468.38 $65.0073 -0.042 0.0005 0.

The residual plot is: . A positive alpha plots above the Security Market Line and has a return in excess of its systematic risk.402568 The α is barely insignificant at 10%. Intercept X Variable 1 t Stat 1.00811 Standard Error 0.034816 0. Jensen’s alpha represents the excess return not explained by the beta of the stock.001024 F 0.718487 Significance F 0.032 Observations 36 ANOVA df Regression Residual Total 1 34 35 Coefficients 0. and is the portion of the return not explained by the market model.008954 0.213349 MS 0.020695 Adjusted R Square -0. The relevant output from Excel for this period is: SUMMARY OUTPUT Regression Statistics Multiple R 0.000736 0.180843 SS 0.035552 Standard Error 0.102834 0.18 and is insignificant. The residual is the error in the estimation.CHAPTER 13 C-39 2.000736 0. while the β estimate 0.676392 0.005341 0.402568 3.847636 P-value 0.143856 R Square 0.

628106 0.005635 0.52028 The α and β are both insignificant at any reasonable level of significance.486983 0.10761 0.418416 Significance F 0.52028 Intercept X Variable 1 t Stat 0.227495 MS 0.084631 R Square 0.043074 Observations 60 ANOVA df Regression Residual Total 1 58 59 Coefficients 0. The residual plot is: .147156 SS 0.00996 Standard Error 0.000776 0.001855 F 0.108386 Standard Error 0.002744 0. The relevant output from Excel for this period is: SUMMARY OUTPUT Regression Statistics Multiple R 0.000776 0.C-40 CASE SOLUTIONS 4.007162 Adjusted R Square -0.646851 P-value 0.

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

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

CHAPTER 14 C-43 2.yahoo.813 Shares outstanding = 2. We need various pieces of information to estimate the cost of equity.83% .05 billion Most recent dividend = $0 Beta = 1. We can use the dividend growth model or the CAPM. The following information is necessary for our calculations.53 3-month Treasury bill rate = 1. so we will attempt to use both. We gathered all the information from finance.com.06 Market capitalization = $47. The screen shots below show this information. Market price = $23.10 billion Book value per share = $1.

53[.org/marketdata.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.finra. we get: RE = Rf + β[E(RM) – Rf] RE = .07] RE = 12. Using the market risk premium of 7 percent from the textbook. To get the yield to maturity on Dell’s bonds.54% 3. We do have the information to estimate the cost of equity with the CAPM.0183 + 1. We gathered the following information: .

00 Market value (in millions) $305.93% 6. in millions) $300 $300 Percentage of total 1.10 Total Book value (face value.00 1.00 1. .43 Percentage of total 1.43 $305.00 Yield to maturity 6.93% Weighted book values 6.CHAPTER 14 C-45 So.93% Weighted market values 6.93% 6. the weighted average cost of debt for Dell using both the book value and the market value is: Coupon Rate 7.93% 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.

Dell generates sales almost exclusively from its internet site. the WACC based on market value weights is: WACC = RE(E/V) + RD(D/V)(1 – t) WACC = (.41) + (.305/$47. Another factor that could affect the cost of capital is Dell’s access to capital since it is a public company.717B V = $4.41B So.717/$4.55 percent.017)(1 – .1254)($47.10/$47.C-46 CASE SOLUTIONS 4.10B V = $47.35) WACC = 11. This could potentially be a risk factor that affects the cost of capital.41)(1 – .300/$4. the total value of Dell is: V = $305. 5.43M + $47.49% The cost of capital for Dell using Book value weights and market value weights is similar because Dell has such a small portion of debt in its capital structure. the total value of Dell is: V = $300M + $3. The biggest potential problem with HCI using Dell’s cost of capital is that HCI operates stores that generate the company’s sales.35) WACC = 12. the WACC based on book value weights is: WACC = RE(E/V) + RD(D/V)(1 – t) WACC = (. Using book value weights.0693)($0.0693)($0.94% Using the market value weights.017B So. while Hubbard Computer is private.1254)($3.017) + (. . The difference in this case is 0.

the fees as a percentage of the net amount to the company are: Fee percentage = $7. Whether the underpricing is as severe in a Dutch auction as it would be in a traditional underwritten offer is unknown. so whether Mark is correct or Kim is correct will only be told in time.000.500 / $69. cash and short-term investments are a zero NPV investment.250. The advantages of the increased IPO size include the increased liquidity for the company. The increased size will also reduce the costs of the IPO on a percentage of funds raised.750. The extra cash may encourage management to act carelessly.000 Total other fees = $2. or: Net amount raised = $75.000 Fee percentage = .250.250.000 + 12. .750.500 The net amount raised is the IPO offer size minus the underwriter fee. So.07) Underwriter fee = $5.500 Total fees = $7.563. In theory.000 So. or: Underwriter fee = $75. although this may not be a large advantage.563. the audit costs are not incremental costs and should not be included in the calculation of the fees.000 + 2.000 Net amount raised = $69.CHAPTER 15 S&S AIR GOES PUBLIC 1.20% 2. The extra cash will also earn a small return unless invested in income producing assets. as Google shows.000 Since the company must currently provide audited financial statements due to the bond covenants. The main difference in the costs is the reduced possibility of underpricing in a Dutch auction.000 – 5.500 This means the total fees are: Total fees = $5.813.813. At best. 3.000 + 100. There is no way to calculate the optimum size of the IPO. and the lower probability that the company will have to go back to the primary market in the near term future. the Dutch auction should be better since it should eliminate underpricing.1120 or 11.000(. As to which is better. the sum of the other fees is: Total other fees = $1. The underwriter fee is 7 percent of the amount raised. underpricing can still exist in a Dutch auction.500 + 520.800. we don’t actually know.000 + 110. However.000.000 + 15. The disadvantages of raising the extra cash in the IPO include the agency costs of excess cash.000 + 6.

C-48 CASE SOLUTIONS .

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

Assets Total assets 3.000 + ($16.000.20(15. the firm’s pre-tax earnings will increase by $27 million per year in perpetuity. so the NPV of the purchase is: NPV = –$110.000.000 / . the purchase increases the annual expected earnings of the firm by: Earnings increase = $27. These earnings are taxed at a rate of 40 percent.125) NPV = $19. after taxes. the appropriate discount rate is the firm’s unlevered cost of equity. the market value of the firm is: Market value of equity = $35.000 Equity $528. debt in the firm’s capital structure will decrease the firm’s taxable income.000) Market value of equity = $528.000 So.CHAPTER 16 STEPHENSON REAL ESTATE RECAPITALIZATION 1.000. the market value balance sheet before the land purchase is: Market value balance sheet $528. $528.000.600. creating a tax shield that will increase the overall value of the firm. worth $35.000.000 Since Stephenson is an all-equity firm. it should use debt to finance the $110 million purchase.000.000 As a result of the purchase.000(1 – .200. If Stephenson wishes to maximize the overall value of the firm.200.20 per share. a.000 $528. Since Stephenson is an all-equity firm with 15 million shares of common stock outstanding.000. Since interest payments are tax deductible.40) Earnings increase = $16.000 Debt & Equity 2. Therefore.000.000 .

000 Equity value = $507.CHAPTER 16 C-51 b.600.000.148 Total shares outstanding = 18.51 Since Stephenson must raise $110 million to finance the purchase and the firm’s stock is worth $36.000 Debt & Equity Old assets NPV of project Total assets $507.000 + 19. This will increase the firm’s assets and equity by $110 million. the net present value of the purchase.000.51 Shares to issue = 3.000 Since the market value of the firm’s equity is $547. the new market value balance sheet after the stock issue will be: Market value balance sheet $110.000 $547.000 + 3.148 So. the share price is: Share price = $657.000 Equity $547. To show this.000. Stephenson’s stock price after the announcement will be: New share price = $547.000 New share price = $36.600.51 .000 Debt & Equity Cash Old assets NPV of project Total assets $657.600.000 Market value balance sheet $528.000 528. So.000.000.500.013.600.500.51 per share.000 $657.600.013.000 19.600 / 18.013.000. the market value of Stephenson’s equity after the announcement will be: Equity value = $528.000 Equity $657. Stephenson will now have: Total shares outstanding = 15.600. Stephenson will receive $110 million in cash as a result of the equity issue.000 / 15.000. After the announcement.000 The stock price will remain unchanged.031.148 Share price = $36. the market value of the firm’s equity will immediately rise to reflect the NPV of the project. Stephenson must issue: Shares to issue = $110.600.600.600.000 19.600.148 c. Under the efficient-market hypothesis. the value of Stephenson will increase by $20 million.000 / $36.000 and the firm has 15 million shares of common stock outstanding. Therefore.

6 million if it finances the purchase with equity. .40($110.600. debt financing maximizes the per share stock price of the firm’s equity.000 Since the market value of the Stephenson’s equity is $591.000.000. the firm’s stock price will rise to $39.000. the project increases the annual earnings of the firm by $16.600. If the firm uses debt in order to finance the project.000) VL = $701.000 b.600.600. the firm’s stock price will remain at $36.000 Stock price = $39. So.000 Debt 44. we can calculate the market value of Stephenson’s equity.000.000 Equity $701. So.000 591. Stephenson’s stock price after the debt issue will be: Stock price = $591.000 / . If it were to finance the initial outlay of the project with debt.000 So.125 PVProject = $129.44 per share.2 million.000 Modigliani-Miller Proposition I states that in a world with corporate taxes: VL = VU + tCB As was shown in Question 3.000 $657. Stephenson will be worth $657.600.000 129.51 per share.600. the value of the company if it financed with debt is: VL = $657. $648. the firm would have $110 million worth of 8 percent debt outstanding.000 Debt & Equity Value unlevered Tax shield Total assets $110.6 million and the firm has 15 million shares of common stock outstanding.600.600.600. a. Since the market value of the firm’s debt is $110 million and the value of the firm is $692 million.000.600.000 Debt & Equity Old assets PV of project Total assets 4. Stephenson’s market-value balance sheet after the debt issue will be: Market value balance sheet $657. Therefore. If Stephenson uses equity in order to finance the project. Therefore. the market value balance sheet of the company will be: Market value balance sheet $528. the aftertax present value of the earnings increase is: PVProject = $16. The project will generate $27 million of additional annual pretax earnings forever.C-52 CASE SOLUTIONS d.000 / 15. After the announcement.000 Equity $657.000 $701.200.000.44 5. the value of Stephenson will immediately rise by the present value of the project. after taxes. These earnings will be taxed at a rate of 40 percent.600.000 + .

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

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

000.555.000.56 476.666.444.67 103.00 –100.111.000.000.00 94.11 $235.78 0 1.000.22 98.22 $2.000.383.888.666.44 39.00 $100.000.00 $100.56 423.290.722.56 100.00 –202.67 –309.000.00 $3.22 –4.622.777.78 $32.02 0 $103.22 Q3 $606.00 $193.444.67 138.444.555.22 0 0 0 0 0 0 0 0 $100.500.00 $135.00 –95.000.44 372.555.166.00 946.22 –3.722.000.384.000.000.333.00 –95.56 –202.00 39.68 40.111.33 –269.11 Q4 $683.22 $193.094.777.722.944.000.22 $196.111.290.000.333.00 100.44 900.384.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 $484.67 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 $100.000.00 –100.11 –40.333.000.00 –95.67 –330.622.668.91 0 0 0 0 $100.000.56 Q4 $235.055.78 100.00 –95.111.000.26 0 0 $100.44 –211.00 –309.103.094.02 982.777.22 0 $0 $94.000.33 –271.722.722.33 –372.22 3.68 0 $0 $100. the cash balance each quarter is: Cash Balance Q1 Q2 $190.00 3.000.622.00 $93.103.00 –100.89 –270.000.11 509.22 $96.00 $0 $98.722.777.000.67 –348.00 $0 $0 $90.26 .722.290.000.222.00 –100.00 $0 $138.000.33 –274.00 –370.78 –289.00 –$202.85 98.333.000.000.00 $39.444.78 So.666.722.22 2.44 100.22 2.777.00 $532.67 –240.44 Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit) Q3 $196.22 The short-term financial plan looks like this: Short-term Financial Plan $100.000.00 –$67.722.555.

00 946.22 $193.555.870.00 –80.22 0 0 0 0 0 0 0 0 $80.67 158.589. The cash balance and short-term financial plan will be: Cash Balance Q1 Q2 $190.555.22 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 $80.00 $94.822.11 –40.00 3.56 80.000.56 –202.000.186.00 $0 $118.495.00 –80.822.11 $235.44 Short-term Financial Plan $80.85 in income.00 –202.000.00 $0 $0 $110.00 $80.622.67 0 $0 Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit) Q3 $196.20 0 0 $80.444.00 –$47.444.000.22 –4.22 0 $0 $114.22 $98.04 0 $82.692.000.22 2.692. in income.722.91 $1.22 $196.000.000.990.44 1.000.000.68 earns earns earns earns $900.22 2.20 . in income.777.22 3.22 982.111.22 $116.692.00 114.78 0 1.70 0 $0 $80.78 80.00 –80.00 $80.383.000.722.00 $193.000.722.44 39.000.22 $982.000.22 –3.722.298.04 1.777.70 40.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 2.384.44 80.148.85 $4.222.91 1.290.000.444.00 $113.00 $155.722.111.383.00 39.22 118.67 82. $900.98 If Piepkorn reduces its target cash balance to $80.495.00 –80.00 80.722.722.67 $138.777.91 118.78 $32.000.212.93 0 0 0 0 $80.990. so they will not be repeated here.000.000.822. in income.555.298.100.000.00 $946. $90.00 $0 $158.000. the cash flows each quarter will remain the same.56 Q4 $235.000.00 1.

40)(1 – .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 $110.93 1.000)(.880 Q3 net sales = ($1.60) Q2 net sales = $1.360 Q4 net sales = ($1. the collections period will decrease to 36 days. However. so the net cash inflows each quarter will be: .93 $1. in income.589.040 In addition to the reduction in sales.030.40)(1 – .000)(.01) + $1.148.70 earns earns earns earns $1. we must assume the sales will remain unchanged.60) Q3 net sales = $1.025.22 $118.000(.60) Q1 net sales = $901.01) + $905.822.025.030.67 $158.990.91 $5. in income. The net sales after the discount each quarter will be: Q1 net sales = ($905. This will change the cash flows Piepkorn receives. The collections will be based off the lower sales figures.00 1.22 1.100.40)(1 – .91 in income.06 If Piepkorn offers the discounted terms.000)(.148.240.692.000)(.160.000(. Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing 3.000(.589. $1.155. in income.380 Q2 net sales = ($1.60) Q4 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.160.186.000(.00 $114.00 $1.235.40)(1 – .100.186.01) + $1.000.22 $1.01) + $1.240.

000.024.666.142.666.67 $444.494.413.00 –270.000.67 –240.00 $171.000.333.908.000.67 So.216.00 –95.00 741.494.000.828.333.67 80.000.000.67 –330.33 –271.33 $384.67 80.333.333.413.00 –370.33 –372.234.494.908.908.00 –$192.00 –211.00 80.33 –269.552.00 –95.000.67 $251.498.00 –309.142.33 –274.494.644.000.67 $22.000.000.142.67 –348.67 –309.00 $360.00 $304.00 –289.000.234.33 Q3 $410.00 693.000.644.00 615.000.00 540.00 $59.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 $484.500.528.666.67 Q2 $362.00 –95.144.67 Q4 $462.00 Q3 $384.00 .00 $282.00 $364.498.166.67 Q4 $444.67 –192. 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 $190.00 172.00 –95.00 $172.352.67 22.00 59.494.67 $362.00 80.

06 The effective annual rate Piepkorn is offering to its customers is: EAR = [1 + (.843.CHAPTER 18 C-59 The short-term financial plan under these assumptions will be: Short-term Financial Plan $80.249.95 371.000.00 –80.00 0 0 0 $80.95 3.711.000.088.67 in income.44 0 0 0 0 $80.594.835.00 $0 $0 $110.000. in income.711.05 0 $0 $80.44 $3.167.843.835.835.00 283.00 2.594.494.498.594.00 $2.00 $0 $308.67 0 3.28 1.380.000.234.323. in income.00 $80.00 172.00 –80.67 $308.67 0 $0 $283.00 $0 $371.95 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: $80.000.000.787.95 $3.000.01% .000.05 182.594.00 $80.088. Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing $1.000.100.843.67 –62.67 –25.00 59.33 –173.100.67 $10.000.000.000.99)]365/30 – 1 EAR = 13.167.11 3.413.00 $283.00 –192.100.711.05 earns earns earns earns $1.01/.736.67 188.000.67 22. in income.95 $371.44 3.167.000.06 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: $110.00 2.00 –80.95 0 0 0 0 0 0 0 0 $80.00 –80.088.67 308.

333.000.916.000. However.000.17 –476.00 –96.83 –372.644.144.00 80.000.50 54.17 Q4 $415.520.00 –370.345.50 80.000.00 $360.00 –95.500.00 –309.67 –348.17 $263.216.00 $183.163.67 –508.33 –271.686.00 $54. we will base the purchases off the gross sales figure.000.17 10. 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 $190.163.00 693.00 540.182.17 So. which will not change except for the discount taken.330.33 –414.686.552.17 80.00 160.000.729.330.000.17 $10.182.000.330.00 –75.000. The net cash inflows each quarter will be: Net cash inflow Q1 Q2 $484.C-60 CASE SOLUTIONS 4.666.00 741.345.67 $415.000.024.00 –$151.345.000.416. since the purchases from suppliers are a percentage of sales.00 –95.644.083.67 –85.000.833.182.17 –151.352.000.50 Q3 $360.00 $270. In addition to the discount offered to customers.00 $280.33 $360.00 .182.33 –422.67 Q4 $462.17 80.33 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 $410.17 $350.00 615.00 –95.828.00 $160. we must assume these purchases are for raw materials.00 –103. Piepkorn is now offered a discount from suppliers.182. Thus.00 –95.528.00 $335.17 Q2 $350.984.984.

00 –151.00 –80.17 0 $0 $271.000.282.CHAPTER 18 C-61 The short-term financial plan will be: Short-term Financial Plan $80.57 193.00 –80.85 148.282.876.85 in income.000.000.82 2.100.85 $10.57 earns earns earns earns $1.984.69% .32 341.000.00 $80.718.00 –80.182.57 0 $0 $80.00 2.000.282.17 $284. Net cash cost Q1 Q2 Q3 Q4 Cash generated by short-term financing $1.000.686.32 $341.015/.17 284.841.25 2.158.00 2.00 $80.000.33 –161.000.419.25 The effective annual rate the company’s suppliers are offering to Piepkorn is: EAR = [1 + (.00 $0 $0 $110.25 0 $0 $110.419.58 $3.000.984.712. in income.00 $0 $341.712.000.419.32 0 0 0 $80. in income.67 –57.158.00 $2.58 3.00 54.984.00 $271.000.100.00 –80.712.163.266.00 160.58 0 0 0 0 $80.000.841.074.17 10.985)]365/25 – 1 EAR = 24.984.17 0 3.82 0 0 0 0 0 0 0 0 $80.17 –12.000.00 271.841.15 1.00 $0 $284.282.826. in income.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: $80.000.158.100.82 $2.

3. 1. The bank will accept the ACH transfers from the four different banks.13 2.955.000 – $X)(FVIFA. The future value of the deposits now will be: Value of ACH = [4($160.00015 = $8.04 . which is four since there are four banks.0015)(4)($160.14)]/1.373.14) Amount available = $8.939. To find the cost at which the company is indifferent.14)]/1. So.02 X = $216.015%. times the amount of each transfer. which are an annuity. we set the amount available we found in Question 1 equal to the cost equation we used in Question 2.000 – 500)(FVIFA.02 The company should not go ahead with the plan since the future value is lower. The amount of each transfer is one minus the wire transfer cost.000)(FVIFA.373.288. Setting up this equation where X stands for the ACH transfer cost. times the number of transfers. we find: [4($160. so the company incurs a transfer fee from each collection center.015%.015%.CHAPTER 19 CASH MANAGEMENT AT WEBB CORP.939. the total available in two weeks will be: Amount available = (1 – .00015 Value of ACH = $8. The amount the company will have available is the future value of the transfers.

438. we need the average daily costs.74 – 6.900. We will begin with the calculation of the NPV of the current policy.06/365)38 – 1 Interest rate = 0. we need to calculate the average daily sales which are: Average daily sales = $140.36) / 0.602. With a 6 percent annual interest rate.438.45($140.20 . the default rate is 1.99 The current policy has administrative costs equal to 2.609% Since the credit policy will exist into perpetuity.602.561. So.00609 NPV = $32. we need to calculate the NPV of each policy.136. so the average daily defaults will be: Average daily defaults = 0. the periodic rate for the 38 day collection period is: Interest rate = (1 + . We will begin with the average daily variable costs.6 percent.99 – 8. the average daily variable costs are: Average daily variable costs = 0.000. the NPV is: NPV = –$172.000)/365 Average daily variable costs = $172.022($140.2 percent of sales. so the average daily administrative costs are: Average daily administrative costs = 0.101.00609 or 0. Current Policy First.000.136.602.000)/365 Average daily administrative costs = $8.36 We also need the appropriate interest rate for the collection period.016($140.000.000/365 Average daily sales = $383.74 + ($383.74 Under the current policy.CHAPTER 20 CREDIT POLICY AT HOWLETT INDUSTRIES To decide on the optimal credit policy.64 – 172.561.24 Next. which are 45 percent of sales.000)/365 Average daily defaults = $6.000.

C-64 CASE SOLUTIONS .

018($157.16 The average daily variable costs will be: Average daily variable costs = 0. the average daily sales are: Average daily sales = $157.000)/365 Average daily variable costs = $193.000.000.99 The average daily variable costs will be: Average daily variable costs = 0.90 Option 1 has administrative costs equal to 3.356.27 Under the Option 1. so the average daily administrative costs are: Average daily administrative costs = 0. the default rate is 2. the periodic rate for the 41 day collection period is: Interest rate = (1 + .64 Under the Option 2.CHAPTER 20 C-65 Option 1 Under Option 1.260.000)/365 Average daily administrative costs = $14.45($160.000/365 Average daily sales = $430.000.40) / 0.40 We also need the appropriate interest rate for the collection period. With a 6 percent annual interest rate.000/365 Average daily sales = $438.025($160.90 – 14.000.2 percent of sales.027.5 percent.000.000. the NPV is: NPV = –$197.27 + ($438.958.23 Option 2 Under Option 2. so the average daily defaults will be: Average daily defaults = 0.8 percent.260.453.00657 or 0.958.032($160.00657 NPV = $32.356. so the average daily defaults will be: Average daily defaults = 0.47 .06/365)41 – 1 Interest rate = 0.000.027.561.45($157.712.000)/365 Average daily defaults = $7.16 – 197.657% Since the credit policy will exist into perpetuity. the default rate is 1.742.27 – 10.000)/365 Average daily defaults = $10. the average daily sales are: Average daily sales = $160.136.000)/365 Average daily variable costs = $197.260.

000.64 + ($430. so the average daily defaults will be: Average daily defaults = 0.45($170.00785 NPV = $29.136.00818 NPV = $26. With a 6 percent annual interest rate.4 percent of sales.753.000.972.00818 or 0.000.2 percent.04 –10.323. so the average daily administrative costs are: Average daily administrative costs = 0.589. the NPV is: NPV = –$209.742.48 Option 3 Under Option 3.04 Under the Option 3.47 – 10.535. With a 6 percent annual interest rate.29 We also need the appropriate interest rate for the collection period.972.000)/365 Average daily administrative costs = $10. the average daily sales are: Average daily sales = $170.29) / 0.818% Since the credit policy will exist into perpetuity. so the average daily administrative costs are: Average daily administrative costs = 0.58 – 13. the periodic rate for the 51 day collection period is: Interest rate = (1 + .712.589.753.022($170.42 – 209. the NPV is: NPV = –$193.99 – 193.000)/365 Average daily administrative costs = $13.000.561.42 The average daily variable costs will be: Average daily variable costs = 0.325. the default rate is 2.00785 or 0.000/365 Average daily sales = $465.03($170.024($157.589.000.04 + ($465.785% Since the credit policy will exist into perpetuity.996.0 percent of sales.06/365)49 – 1 Interest rate = 0.000)/365 Average daily variable costs = $209.41 .06/365)51 – 1 Interest rate = 0. the periodic rate for the 49 day collection period is: Interest rate = (1 + .60 We also need the appropriate interest rate for the collection period.58 Option 3 has administrative costs equal to 3.C-66 CASE SOLUTIONS Option 2 has administrative costs equal to 2.246.323.000)/365 Average daily defaults = $10.246.54 – 7.60) / 0.561.

CHAPTER 20 C-67 The company should choose Option 1 since it has the highest NPV. while Option 3 extends the credit period and relaxes the credit policy. Option 2 extends the credit period. This is plausible. The default rate and administrative costs of Option 2 are below those of Option 3. This in turn will increase the administrative costs of managing the delinquent accounts. 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. .

175.800.000 So.000 Since the production costs are fixed. the profit will decline. the profit will increase.000($1.000 At the current exchange rate of $1. if the dollar weakens.45/€) Total sales = $7.30/€) Dollar sales = $6.000(0.000 Profit = $1. the profit at this exchange rate will be: . the EBT in euros will be converted to dollars in the amount of: Dollar EBT = €750.087. the euros will convert to: Dollar sales = €4.80) Production costs = $5.000.000($1.750.30/€. The company will pay the sales commission out of gross sales.000($1. 3.750.05) After-commission sales = €4.500 If the exchange rate changes to $1.500 S&S Air has production costs equal to 80 percent of dollar sales at this exchange rate: The total sales in dollars are: Total sales = €5.000 And the production costs are: Production costs = $7.500 – 5.887.000.45/€) Dollar EBT = $6.250.887. the profit at the current exchange rate is: Profit = $6. while the biggest risk is exchange rate risk. 2.CHAPTER 21 S&S AIR GOES INTERNATIONAL 1.45/€. If the dollar strengthens. Conversely. so the after-commission sales in euros is: After-commission sales = €5.800.250. The biggest advantage is the increased sales.000(1 – .

CHAPTER 22 C-69 Profit = $6.175.800.000 Profit = $375.000 .000 – 5.

The downside to all three hedging vehicles is the cost. 5. the company will gain on some contracts and lose on others. the company should probably pursue international sales further. So. it is likely that hedging is not required at this point.000 Breakeven exchange rate = $1. the company will make a profit unless the exchange rate moves dramatically. futures.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. . At the current exchange rate.221/€ 4. so: Breakeven exchange rate = $5.000/€4. Over time.800.750. The company could use options. or forwards. Taking this into account.

that is. Before the fact. This does not depend on the level of market efficiency.01 percent per year. So. Whether they can outperform the market on an after-expense basis becomes a question of whether mutual fund managers can extract economic rents from the stock market. the results support the concept of market efficiency.50 percent. including private money managers.01 percent. the market average return has to be the average return of all investors’ average return. While there have been notable exceptions. Consider the following question: What percentage of investors will outperform the market in a given year? Answer: Fifty percent. research has found that mutual fund managers underperform the market after expenses by the average expense ratio. we get: $55. and one-half would underperform the market. one of the largest actively managed equity mutual funds at the time this was written. Consider the large-cap stock fund. to get the market average we would expect one-half of investors would outperform the market.5 million for that year. with assets of about $55 billion. 2. Whether the market is efficient or inefficient is irrelevant unless mutual funds managers are the best investors in the market. In general. so they do not appear to be able to outperform the market. Given the amount mutual fund companies would be willing to spend for research.01 percent? If we multiply the fund assets by 0. The evidence tends to support the idea that they cannot. Good performing fund managers are richly rewarded. with and expense ratio of 1. if the “best” and definitely best-financed investors cannot outperform the market. such as Peter Lynch’s tenure at Magellan. if Fidelity can increase the return of this one fund by only 0. Consider the case of the Fidelity Magellan Fund. we would expect that mutual fund managers should be able to outperform the market. In reality. So the question is this: What would Fidelity pay for one year to increase the return of the Magellan Fund by 0. we should expect that less than 50 percent of all equity mutual funds would outperform the market.500. The results in the graph tend to support the idea of market efficiency. This means that mutual funds as a whole tend to have the market average return before expenses. individuals. in general. We would expect more than 50 percent of mutual funds would underperform the market because of the expenses charged by the mutual funds. etc. to the Darwinian nature of the business.CHAPTER 22 YOUR 401k ACCOUNT AT EAST COAST YACHTS 1.000(.000. The fund must exceed the market return by 1. and poor performing fund managers are fired. As a result. are the bad investors in the market. . it should be willing to pay up to $5.0001) = $5.000.000. pension fund managers. While there could be one really poor investor who takes all of the losses in a given year. the average return of investors weighted by the dollar amount of the investment. you would expect that mutual funds managers would be able to outperform the market.50 percent before fees in order to achieve a return after fees equal to the market return. in part. This is definitely true if we consider the weighted average return. After all. This is due. We should also consider that mutual funds managers may be able to outperform the market before expenses. often very quickly. and the Darwinian nature of the industry. mutual fund managers do not seem to be able to outperform the market. as a whole. and all other investors.

CHAPTER 22 C-72 .

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

533.90 for 25 years.300) Mortgage value = $457. The monthly mortgage payment will be: $500. Treasury bond prices have an inverse relationship with interest rates. or: Mortgage value = $3.000 of Treasury bonds.300) Mortgage value = $548. 4. If this is the case.867. If the market interest rate is 8 percent on the date that Joi meets with the Ian. discounted at the longterm interest rate of 7 percent. If the market interest rate is 6 percent on the date that Joi meets with the Ian. We can solve for the payment amount so that the present value of the annuity equals $500. she would take a short position in five 3-month Treasury bond futures contracts in order to hedge her $500.000. the amount of principal that he plans to borrow. discounted at 8 percent. the fair value of the mortgage is the present value of an annuity that makes monthly payments of $3. and the Ian will only be willing to purchase the mortgage for a price less than $500. the fair value of the mortgage will decrease. If the current market rate of interest rises between today and the date the mortgage is sold.000 exposure to changes in the market interest rate over the next three months a.533.90 2.000 promised. Since Joi is short in the futures. as interest rates fall. 5.90(PVIFA8%/12. INC.CHAPTER 23 CHATMAN MORTGAGE. Treasury bonds become more valuable. a. she is also hurt when Treasury bonds decrease in value. Since three-month Treasury bond futures contracts are available and each contract is for $100.000.000 = C(PVIFA7%/12.91 3. discounted at 6 percent. Treasury bonds become less valuable. As interest rates rise. or: Mortgage value = $3.533. 1.484.55 b.533. The long position will lose and the short position will gain. Mike’s mortgage payments form a 25-year annuity with monthly payments. she will not be able to loan Mike the full $500. Since Joi will be hurt when interest rates rise. the futures gain will offset the loss in value of the mortgage. she should take a short position in Treasury bond futures to hedge this interest rate risk. the fair value of the mortgage is the present value of an annuity that makes monthly payments of $3.90(PVIFA6%/12. In order to protect herself from decreases in the price of Treasury bonds.533. The most significant risk that she faces is interest rate risk.300) C = $3. . An increase in the interest rate will cause the value of the T-bond futures contracts to decrease.90 for 25 years.

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

how soon it might go public. the company may go public in the future. the conversion price is important.00 This means the conversion premium of the bond is: Conversion premium = ($25 – 20) / $20 = 0. each bond can be converted to 32 shares of stock.00 So. This illiquidity lowers the value of the stock. the floor value of the bond is $800.40) Intrinsic value = $656. However. with the conversion feature the price will be $800. The intrinsic value of the bond is: Intrinsic value = $30(PVIFA5%. they would be able to sell them for $656. The conversion ratio the bond is: Conversion ratio = $800/$25 = 32. We can use the PE ratio to calculate the current stock price. even if the company does not go public.CHAPTER 24 S&S AIR’S CONVERTIBLE BOND 1. First. Todd’s argument is wrong because it ignores the fact that if the company does well. bondholders are effectively allowed to purchase stock at the conversion price of $25. If the stock price rises to $25. the company is receiving $143. 2. or someone else.18 for the conversion feature. in this case 25 percent. The conversion value of the bond is given as $800. we get: P/E = Price/EPS 12.60 Price = $20. . and if so.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. the bondholders will have an active market for the stock if they convert.82 So. bondholders will be allowed to participate in the company’s success. This equity interest can be sold to the original owners. 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. In essence.50 = Price/$1. If the company does goes public. the bondholders could potentially have an equity interest in the company. Even though the company is not publicly traded.40) + $1000(PVIF5%. Doing so. The case does discuss whether the company has plans to go public. Second.

. Mark’s argument is incorrect because the company is issuing debt with a lower coupon rate than they would have been able to otherwise. If the company does poorly.CHAPTER 23 C-77 3. it will receive the benefit of a lower coupon rate.

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

044 + .8020 3 ) = –1.38/$50) + (.602/2) × 10] / (.55 Assuming expiration in ten years. assuming expiration in three years. So. Whether you should exercise the options in three years depends on several factors.1367 Putting these values into the Black0Scholes model.1354) = $5.38/$50) + (.1011 3 ) = –.60 × N(d1) = .60 × N(d1) = .0618 – (.7887 N(d2) = .7887) – ($50e–.038 + . If you are planning to leave next week.1354 Putting these values into the Black-Scholes model. 10 ) = –1.0618 .038(3))(. we find the option value is: C = $24.38(.8020 – (. A primary factor is how long you plan to stay with the company.60 × d2 = –.1367) = $14. the value of the stock options per share of stock is: d1 = [ln($24.38(.0953 10 ) = .044(10))(. We can use the Black-Scholes equation to value the employee stock options. the value of the stock options per share of stock is: d1 = [ln($24.83 2.602/2) × 3] / (. we find the option value is: C = $24. A second factor is how the option exercise will affect your taxes. you should exercise the options. We need to use the risk-free rate that is the same as the maturity as the options.60 × d2 = .4753) – ($50e–.4753 N(d2) = .CHAPTER 25 EXOTIC CUISINE EMPLOYEE STOCK OPTIONS 1.

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

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

800. so the cash flows for the next five years will be: Year 1 $38.00 0 Year 4 $41.CHAPTER 26 THE BIRDIE GOLF-HYBRID GOLF MERGER 1.000 Using the information provided.848.366. or: Acquisition of Hybrid Dividends from Hybrid Total –$550.00 0 Year 3 $29.848.848.64 3 $22.366.64 3 Year 4 $22. The present value of each year’s cash flows.000 $659.800.000 Dividends from Hybrid Terminal value of equity Total To discount the cash flows from the merger.466.025.168.07 .578 Year 3 $18.441.403.578 $18.610.856 334.168. As with any other merger analysis.000 600. along with the appropriate discount rate for each cash flow is: Discoun t rate 16. we must discount each cash flow at the appropriate discount rate.00 0 Year 5 $59.000 $150.00 0 $29.000. we need to examine the present value of the incremental cash flows.9% Dividends PV of value Total 12.139 $361.403.578 + 18.000.00 0 $38.168.58 9 Year 2 $9.000.00 0 $41.466.403.400.643 + 22.000. All earnings not retained are paid as dividends.58 9 $9.000.000 + 32.995 NPV = $44.400.400. while the dividends are equity cash flows. The cash flow today from the acquisition is the acquisition costs plus the dividends paid today.4% $32.000.000 –$400.995 And the NPV of the acquisition is: NPV = –$400.00 0 Year 2 $12. should be discounted at the cost of equity.000.806 + 361.366. we can determine the cash flows to Birdie Golf from acquiring Hybrid Golf.400.400. and as such.589 + 9.80 6 Year 1 $32. The terminal value of the company is subject to normal business risk and should be discounted at the cost of capital.254.80 6 Year 5 $27.400.00 0 $12.

CHAPTER 25 C-83 .

000.75 / $94 Exchange ratio = .000.C-84 CASE SOLUTIONS 2.28 3.000.07 Highest offer = $594.07) / 18.610.46 Exchange ratio = . The highest exchange ratio Birdie would accept is an exchange ratio that results in a zero NPV acquisition.75 / $96.000 PNew = $96.46 So.000.254.07 The highest share price is the total high offer price. so the exchange ratio is: Exchange ratio = $68. This implies the share price of Birdie remains unchanged after the merger.610.7314 .610. the most Birdie would offer is to increase the current cash offer by the current NPV. To determine the current exchange ratio which would make a cash offer and a share offer equivalent.254. we need to determine the new share price under the original cash offer.000 + 44. divided by the shares outstanding.254.610.000 + $44.7127 4. Since the acquisition is a positive NPV project. or: Highest offer = $550. the exchange ratio which would make the cash offer and share offer equivalent is: Exchange ratio = $68. or: Highest share price = $594. The new share price of Birdie after the merger will be: PNew = ($94 × 18.07 / 8.254.000 shares Highest share price = $74.

the lease payments.622.675/1.11(1 – .300.875 –$259. tax shield Security deposit Lease payment Tax on lease payment Cash flow from leasing –$583.000 Saved purchase Lost salvage value Lost dep.000 455.000 455.CHAPTER 27 THE DECISION TO LEASE OR BUY AT WARF COMPUTERS 1.0715 – $1.428.000 455.07153 – $219.000 –129. The lease payments are due at the beginning of each year.875/1. and the lost salvage value.000 455.428.07152 – $1.000 – $1. The incremental cash flows from leasing the machine are the security deposit.000 Year 1 Year 2 Year 3 Year 4 –$390.855.308.000 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.35) Aftertax salvage value = $390.0 The company should lease the equipment.175 –1.675 The aftertax cost of debt is: Aftertax cost of debt = . the lost depreciation tax shield.000 –1.0715 or 7.175/1. the saved purchase price of the machine.15% And the NAL of the lease is: NAL = $3.275/1.622.000 – $600.000 –1.300.275 –300.675 300. The salvage value of the equipment in four years will be: Aftertax salvage value = $600.000 –$1.000.104.104.300.875 –1.000 –$1.000 $3.35) Aftertax cost of debt = .000(. .275 –$777.175 –$219.07154 NAL = $44.000 –$1.300. so the incremental cash flows are: Year 0 $5. the tax savings on the lease.855. The decision to buy or lease is made by looking at the incremental cash flows.

However.111.07152 NAL = –$583.275 –2.725 So.000(.000.111.11 PV of lease payments = $4. the present value of the lease payments is: PV of lease payments = $2.000. the FAS 13 conditions for a capital lease are not met.3333 + .466.805. Using the company’s cost of debt.35) Aftertax salvage value = $1. the aftertax salvage value in year 2 will be: Aftertax salvage value = $2.275 –$2.0715 – $2. notice that the question also states that if the lease is renewed in two years. the NAL of the lease under these terms is: NAL = $3.000 – $5. the lessor will allow for the increased lease payments made over the first two years. The lease is now for two years. This is also an indication that the revision is for less than ethical reasons.505.4445) Book value = $1. the reason for suggesting the revised lease terms is unethical on Nick’s part.000 + ($1.000 –$2.466.000)(. tax shield Lease payment Tax on lease payment Cash flow from leasing –2.000.875 Saved purchase Lost salvage value Lost dep.C-86 CASE SOLUTIONS 2.000 805.300.078. Also. As such.850 So.000 So.300.099.000 Year 1 Year 2 –$1.372.000 – 2.850 –777.000 + $2.07 This is less than 90 percent of the price of the equipment.11 The NAL of the lease is negative under these terms.000.000 805. so it appears the terms are less favorable for the lessee. the lease will likely be classified as an operating lease.000 – $2.688.000 $3.688.000/1.300. the NAL of the lease under the new terms would be: Year 0 $5.078. . or allow for a purchase at a bargain price.072.275/1. which is less than 75 percent of the equipment’s life according.300.000. The book value of the equipment in year 2 will be: Book value = $5.725/1. As long as the lease contract does transfer ownership to the lessee at the end of the contact.000 –$583.

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