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Solutions Guide
for

Case Studies in Finance


Written by

Dr. Michael J. Seiler


Associate Professor of Finance
Hawaii Pacific University

Case 1
Insider Trading
Purpose: This case discusses a new and potentially alarming trend in the area of illegal
insider trading. The Internet is giving people a false sense of anonymity which does not
discourage them from sharing private corporate information. This case also makes
students aware of how easy it is becoming to gain access to illegal inside information and
how to avoid breaking securities law when the information comes to them.
1. This question is not as straightforward as it may seem on the surface. But an acceptable
definition is as follows: Information becomes public when a company representative
officially makes an announcement via a major media.
2. Absolutely anyone can come into contact with inside information. You do not have to
work for the firm to have private information. In fact, it seems that private information is
often readily volunteered these days.
3. If someone conveys to you information that could be useful in making buy or sell
decisions, that information would be illegal to trade upon. Private information only
becomes illegal trading when (1) you actually trade on the information, or when (2) you
convey the information to someone else and they trade on the information. No matter
how long the chain of passing along information gets, if you are identified as one of the
links in the chain, in the eyes of the court you are just a guilty as the one who eventually
trades.
4. For some reason people think the Internet is a secure place to discuss secretive issues.
Despite reports that your employer monitors your e-mail and Internet usage, and despite
the fact that the persons responsible for sending out the I love You virus were tracked
down on the other side of the world in a matter of days, people still think there is no way
to learn of the Internet users identity.
5. If you come in contact with non-public information, the best thing to do is ignore it.
You cant help what you hear, but you can control what you do, or do not do, with the
information.

Case 2
The Tobacco Industry
Purpose: Everyone knows that ethics are a part of business decision making. In
classroom discussions, students find the unethical hypothetical debate to be rather clearcut. However, in the real world, when ethical decisions hurt one party to help another,
there are no easy answers. This case centers around the tobacco industry's alleged
increase in nicotine levels in cigarettes in an attempt to induce addiction amongst
smokers. This case also addresses the government's role in regulating smoking in the
work place.
Ethics questions are possibly the most difficult to answer. One must consider all
sides of the argument and attempt to remain objective. Instead of stating my personal
opinions, I will try to objectively present both sides of each argument.
1. Any time a consumer purchases a product he/she has a right to know the ingredients of
the product. If tobacco companies alter nicotine levels (either with the intent to induce
addiction or without) without notifying consumers, most people feel this would be
extremely unethical.
2. As long as customers know what they are smoking, the practice of providing high or
low nicotine cigarettes is generally deemed acceptable by most. The alcoholic beverage
industry sells various types of beers based on the level of alcohol or the fullness of the
beer, etc. Hence, it is reasonable to allow tobacco firms to market different strengths of
cigarettes. Since nicotine is argued by the tobacco industry to be the source of flavor,
cigarette manufacturers could easily justify the need for various nicotine levels.
3. Fine print warnings on the side of cigarette packs have been frowned upon because
they are hard to notice and even harder to read. Most people do not read their product's
container, although in the case of cigarettes, most people are fully aware of the inherent
dangers of smoking.
4. Smokers will argue that they have a right to engage in an activity that does not affect
others. Non-smokers will argue that smoking in not one such activity.
5. The government will never agree to help pay for the installation of ventilation systems
for smokers. Therefore, a problem will most surely rise when small business owners
argue that the smoking ban will adversely affect their business relative to other forms of
ownership. This is a major problem because 90% of all firms are small businesses.
6. The result that small businesses (and large businesses to a lesser extent) will find
employing smokers too costly will surely cause firms to prefer non-smokers over
smokers, everything else constant. This is discrimination, pure and simple.
There is a difference, however, between unwarranted and warranted
discrimination. Warranted discrimination is based on an economic or otherwise rational
reason for preferring one type of worker over another. This is clearly a case of warranted
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discrimination. As economically rational as it may be, law suits are sure to be a result of
the ban.

Case 3
Connect Cable Contractors
Purpose: This case allows students to work on the typical small business situation where
no existing model or framework is available. That is, the student cannot just plug
numbers into an existing formula. They must devise a plan themselves that will get the
job done.
1.
Table 1
Calculations Worksheet for New Prices
(1)

Type of job
Overhead Install
Underground Install
A/O(unwired-w/)
A/O( wired-w/)
VCR (w/ install)
Long Drop
Replace Drop
Relocate; A/O Only:
Wired
Unwired
Reconnect
VCR (w/ reconnect)
VCR Hook-Up Only
Upgrades
Trip Charge

(2)

(3) = {[(2)-(1)(1-.12)]/ (1)(1-.12)}*100

Bobs price
$14.50
$14.50
$5.50
$5.50
$1.50
$10.00
$14.50

Steves price
$13.76
$13.25
$5.50
$4.75
$1.50
$10.00
$13.00

Percentage increase in pay


+7.8%
+3.8%
+12.0%
-1.9%
+12.0%
+12.0%
+2.0%

$10.00
$10.00
$10.50
$1.50
$6.50
$6.50
$5.00

$9.00
$9.50
$9.75
$1.50
$6.25
$6.25
$4.50

+2.3%
+8.0%
+5.5%
+12.0%
+9.3%
+9.3%
+2.3%

The numbers in column four of this table are somewhat subjective. There are, however,
specific guidelines which must be followed. First, there must be a significant price
differential between overhead installs, underground installs, and replaced drops.
Additionally, there must be a difference in pay between the wired and unwired outlets in
order to encourage extra work by the sub-contractors. Secondly, there must be an overall
increase in real pay of between 7%-8% for both Burt and Chris.
2. Under Bob's old system, Chris would have earned $569.49 (just multiply Bob's real
price by the average number of jobs Chris performs per week). Burt would have earned
$514.77.
3. From Table 2, add the numbers in the third column to find the average increase in pay

per week for Chris. Doing this yields an answer of $41.02. From Table 3, Burt's increase
in pay per week under the new system would be $38.43.
Table 2
Calculations Worksheet for Increases in Weekly Earnings
Under the New Pricing System for Chris
Type of job
Overhead Install
Underground Install
A/O(unwired-w/)
A/O( wired-w/)
VCR (w/ install)
Long Drop
Replace Drop
Relocate; A/O Only:
Wired
Unwired
Reconnect
VCR (w/ reconnect)
VCR Hook-Up Only
Upgrades
Trip Charge

Average number of
each job per week
8.1
7.6
18.5
9.9
11.9
3.7
0.9

Dollar increase
in pay per job
$0.99
$0.49
$0.66
-$0.09
$0.18
$1.20
$0.24

Total dollar increase


In pay per type of job
$8.02
$3.72
$12.21
-$0.89
$2.14
$4.44
$0.22

0.8
8.4
7.2
3.8
0.0
1.0
2.4

$0.20
$0.70
$0.51
$0.18
$0.53
$0.53
$0.10

$0.16
$5.88
$3.67
$0.68
$0.00
$0.53
$0.24

Table 3
Calculations Worksheet for Increases in Weekly Earnings
Under the New Pricing System for Burt
Type of job
Overhead Install
Underground Install
A/O(unwired-w/)
A/O( wired-w/)
VCR (w/ install)
Long Drop
Replace Drop
Relocate; A/O Only:
Wired
Unwired
Reconnect
VCR (w/ reconnect)
VCR Hook-Up Only

Average number of
each job per week
11.8
1.6
17.6
11.6
11.6
4.6
2.8

Dollar increase
in pay per job
$0.99
$0.49
$0.66
-$0.09
$0.18
$1.20
$0.24

Total dollar increase


In pay per type of job
$11.68
$0.79
$11.62
-$1.04
$2.09
$5.52
$0.68

0.4
3.4
6.8
2.8
0.0

$0.20
$0.70
$0.51
$0.18
$0.53

$0.08
$2.38
$3.47
$0.51
$0.00

Upgrades
Trip Charge

1.0
1.2

$0.53
$0.10

$0.53
$0.12

4. Multiplying the $41.02 by 52, results in a forecasted increase in pay per year for Chris
of $2,133.04. Burt's annual increase in pay would be $2,000 ($38.43 times 52).
5. Since Chris had 19 of the 20 week's records, the analysis is almost as accurate as
possible. Burt, on the other hand, only kept records for 5 out of 20 weeks, thus
extrapolating those few weeks into predictions concerning the rest of the year may led to
a low level of reliability.
6. By hiring more sub-contractors, each person would save money because they would
not have to cover nearly as large of a geographic area. Also, since the contractors would
not have to spend as much time traveling, they could opt to install more additional outlets
and perform other additional jobs that in the past they would bypass due to time
constraints imposed by the time windows.
If the work load for which Steve is responsible does not increase as additional
workers are hired, it is probable that as the same sized pie is cut into more pieces, each
worker will be earning less. Thus, the answer to this question depends on the relative
strength of these two competing effects.
7. Only data dating back to January of this year has been used to perform the analysis
because this is when the new time windows were invoked. Using data before this period
would be good in that a larger sample of weeks would lead to more reliable results,
everything else constant. The problem with using data prior to January is that since the
windows have been in use, the number of jobs each sub-contractor performs has been
greatly altered.
While it is clear that only post January data should be used, there still exist other
biases in the numbers. For example, the data used in this study is for winter. While the
cable industry is not extremely seasonal, there are fluctuations associated with people
spending winters in the south.
8. The reason for asking this question is to provoke the students to generate suggestions
instead of just responding to the suggestions made in the case. One of the reasons why
Bob lost the contract was because his workers were not happy and this dissatisfaction
showed in their work. Therefore, it is important that Steve ensures that the subcontractors are paid fairly. Steve should, therefore, perform periodic analyses to see that
each sub-contractor continues to make more than they did under Bob's contract and more
importantly that they get the same percentage raise.

Case 4
IBP
Purpose: The purpose of this case is to provide students with the practice of constructing
a Balance Sheet.
IBP's Balance Sheet
Assets
Current Assets
Cash and cash equivalents
Marketable securities
Accounts receivable
Inventories
Deferred income tax benefits
Prepaid expenses
Total Current Assets

27,254
1,400
599,999
405,418
51,781
10,983
1,096,815

Property, plant, and equipment


Land and improvements
Buildings and stockyards
Equipment

Construction in progress

106,492
544,711
1,096,571
1,747,774
(843,937)
903,837
168,256

Net Property, plant, and equipment

1,072,093

Accumulated depreciation and amortization

Other assets
Goodwill
Other
Total other assets

724,089
115,099
839,096

Total Assets

$3,008,096

Liabilities and Stockholder's Equity


Current Liabilities
Accounts payable and accrued expenses
Notes payable to banks
Federal and State income taxes
deferred income taxes
other
Total current liabilities

565,517
140,967
152,122
1,818
5,388
865,812

Total Long-term Obligations

575,522

Deferred credits and other liabilities


deferred income taxes
other
Total deferred credits and other liabilities

17,037
148,811
165,848

Commitments and Contingencies


Stockholders' Equity
Preferred stock
Common stock, $.05 par value per share
Additional paid-in capital
Retained earnings
Other
Treasury stock

0
4,750
405,278
1,067,725
(16,456)
(60,383)

Total Stockholder's Equity

1,400,914

Total Liabilities and Stockholder's Equity

$3,008,096

Case 5
Chrysler
Ratio Analysis
Before Chysler merged to become Daimler Chrysler AG, they were presented with a take
over bid of $55 per share by MGM billionaire Kirk Kerkorian and former Chrysler
chairman LeeIacocca. Kirk Kerkorian was a stockholder in Chrysler and an experienced
takeover financier who apparently found Chrysler to be a good buy. Chrysler rejected the
offer, however, stating that the firm was not for sale. Further, many Wall Street experts
felt that Kerkorian could not come up with the $20 billion necessary to complete the
deal.After Chrysler rejected Kirk Kerkorian's bid of $55 per share, Kerkorian decided to
have his people repeat the analysis of the firm's financial performance over the two most
recent years to determine if he should increase his bid in this friendly takeover attempt.
To measure the financial performance of Chrysler over the past two years, key financial
ratios will have to be computed and compared with industry averages. To help in this
endeavor, Chrysler's financial statements are found on the following pages.

10

11

Questions
1. Compute Chrysler's financial ratios for the past two years.
2. Compare these ratios to the industry's average. Comment on Chrysler's strengths
and weaknesses by ratio category.
3. Should Kerkorian have pursued the purchase of Chrysler?
4. If Kerkorian did not want to takeover Chrysler, what other reasons might he have
had for trying to convince other people that Chrysler was a takeover candidate?

12

Solution:
Purpose: The purpose of this case is to familiarize students with the calculations and
interpretation of basic financial ratio analysis.
1.
Liquidity
Net Working Capital
Current Ratio
Quick Ratio (Acid Test)
Activity
Inventory Turnover
Average Age of Inventory
Average Collection Period
Fixed Asset Turnover
Total Asset Turnover
Debt
Debt Ratio
Times Interest Earned
Profitability
Gross Profit Margin
Net Profit Margin
Return on Total Assets
Return on Equity

This year

Last year

$9,527
1.48
1.26

$8,321
1.44
1.26

9.29
.026
13.56
4.22
.99

11.32
.031
11.68
4.72
1.05

80%
4.47

78%
7.22

22%
3.9%
3.8%
18.9%

27%
6.7%
7.1%
32.7%

2.
Liquidity
Chrysler has lower than average liquidity ratios. Their inventory levels appear to
be in line with industry standards, but their current assets are a bit too low relative to their
liabilities.
Activity
Chrysler's inventory and asset turnover ratios are much higher than the industry
average, which is good. This may be due in part to their fast collection period.
Debt
The debt ratio seems to be right in line with industry figures, but the times interest
earned ratio is lower than average. Still, the number is high enough to relieve concern
over Chrysler's ability to meet its debt obligations.
Profitability
Gross and Net Profit Margins are slightly lower than average. Returns are lower
as well. But, the differences are small enough not to cause concern.
13

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

14

Case 6
Moog
Purpose: The purpose of this case is to have students practice constructing the
Consolidated Statement of Earnings.
MOOG
Consolidated Statement of Earnings
Net Sales
Cost of Sales
Gross Profit

$704,378
$493,235
$211,143

Research and Development


Selling, general and administrative
Interest
Other

$26,461
$110,679
$32,054
($64)

Earnings Before Income Taxes


Income Taxes
Net Earnings
Net Earnings Per Share
Basic
Diluted

$42,013
$14,075
$27,938
$2.13
$2.11

15

Case 7
Kate Myers
Purpose: The time value of money is a fundamental concept that must be understood by
all business students. This case emphasizes the important variables to consider when
saving for a down payment on a house and shows how these variables should dictate the
actions of an individual.
1. Let,
PV = $98,000,
n = 8 years,
i = 4%.
Solving for future value via a calculator yields $134,119.77. 20% of this amount is
Kate's required down payment.
($134,119.77)(.20) = $26,823.95.
2. Let,
FV = $26,823.95, the answer from question 1,
i = .6666% (8%/12), the monthly return from the Merrill Lynch account,
n = 96, (8*12), 8 years times 12 payments per year.
Solving for payment yields an answer of $200.38 per month.
3. This is the same procedure as question 2 with the exception that the compounding
frequency has changed.
Let,
FV = $26,823.95, the answer from question 1,
i = 8%, the annual return from the Merrill Lynch account,
n = 8, 8 years of payments.
Solving for payment yields an answer of $2,521.85 per year. This amount is greater than
12 times the monthly payment because when Kate deposits funds at the end of each
month, those funds are earning interest throughout the year, while funds deposited only at
year's end are not accumulating interest.
For example, (12)($200.38) = $2,404.50.
$2,521.85 - $2,404.50 = $117.35. This additional amount represents the interest that the
eleven $200.38 deposits would accrue throughout the year.
4-5. A table will better represent the sensitivity analysis performed in questions 4 and 5.
16

The calculations are the same as those from question 2.


Home
Appreciation
2%
2%
2%

Return on Merrill
Lynch account
4%
8%
12%

End-of-Month
Required Deposit
$203.37
$171.55
$143.59

4%
4%
4%

4%
8%
12%

$237.55
$200.38
$167.73

6%
6%
6%

4%
8%
12%

$276.65
$233.36
$195.34

This sensitivity analysis clearly demonstrates the relationship among the three
variables. (1) The more Lakewood home prices appreciate, the more Kate will have to
raise to make a down payment in the future. (2) The greater the return on her Merrill
Lynch account, the lower the monthly deposit required.

17

Case 8
Quilici Family
Purpose: The time value of money is a fundamental concept that must be understood by
all business students. This case emphasizes the important variables to consider when
saving up for a child's education and shows how these variables should dictate the actions
of an individual striving to achieve this goal.
1. A simple future value calculation is necessary to determine the amount of tuition and
living expenses per year when Brady is ready to attend.
Stanford
To find the future costs of tuition,
Let,
n = 13,
i = 5%,
PV = $20,000.
Solve for FV. FV = $37,712.98
To find the future costs of living expenses,
Let,
n = 13,
i = 3%,
PV = $6,000.
Solve for FV. FV = $8,811.20
Total Expenses = $37,712.98 + $8,811.20 = $46,524.18
UNC
To find the future costs of tuition,
Let,
n = 13,
i = 5%,
PV = $2,500.
Solve for FV. FV = $4,714.12
To find the future costs of living expenses, the calculation is the same as above by
assumption.
Let,
18

n = 13,
i = 3%,
PV = $6,000.
Solve for FV. FV = $8,811.20
Total Expenses = $4,714.12 + $8,811.20 = $13,525.32
2. Stanford
tuition
Year 1:
Year 2:
Year 3:
Year 4:

$37,712.98 (1.05)0 = $37,712.98


$37,712.98 (1.05)1 = $39,598.63
$37,712.98 (1.05)2 = $41,578.56
$37,712.98 (1.05)3 = $43,657.49

living expenses
Year 1: $8,811.20 (1.03)0 = $8,811.20
Year 2: $8,811.20 (1.03)1 = $9,075.54
Year 3: $8,811.20 (1.03)2 = $9,347.80
Year 4: $8,811.20 (1.03)3 = $9,628.24
Total Expenses
Year 1:
Year 2:
Year 3:
Year 4:

$37,712.98 + $8,811.20 = $46,524.18


$39,598.63 + $9,075.54 = $48,674.17
$41,578.56 + $9,347.80 = $50,926.36
$43,657.49 + $9,628.24 = $53,285.73

UNC
tuition
Year 1:
Year 2:
Year 3:
Year 4:

$4,714.12 (1.05)0 = $4,714.12


$4,714.12 (1.05)1 = $4,949.83
$4,714.12 (1.05)2 = $5,197.32
$4,714.12 (1.05)3 = $5,457.18

living expenses
Year 1: $8,811.20 (1.03)0 = $8,811.20
Year 2: $8,811.20 (1.03)1 = $9,075.54
Year 3: $8,811.20 (1.03)2 = $9,347.80
Year 4: $8,811.20 (1.03)3 = $9,628.24
Total Expenses
Year 1: $4,714.12 + $8,811.20 = $13,525.32
Year 2: $4,949.83 + $9,075.54 = $14,025.37

19

Year 3: $5,197.32 + $9,347.80 = $14,545.12


Year 4: $5,457.18 + $9,628.24 = $15,085.42
3. To determine the monthly payment to cover college expenses, the present value (i.e. at
the time Brady starts college) of the four year expenses must be calculated. Using the
answers from question 2, combine both costs and find the present value keeping in mind
that the stream of payments to Brady is a monthly annuity.
Stanford
FV
i
n
PMT ???

Year 1
$46,524.18
1
156
$124.99

Year 2
$48,674.17
1
168
$112.65

Year 3
$50,926.36
1
180
$101.94

Year 4
$53,285.73
1
192
$92.57

Year 3
$14,545.12
1
180
$29.11

Year 4
$15,085.42
1
192
$26.21

Adding all four amounts yields: $432.15


UNC
FV
i
n
PMT ???

Year 1
$13,525.32
1
156
$36.34

Year 2
$14,025.37
1
168
$32.46

adding all four amounts yields: $124.12


4. This is the same problem as number three with the exception that the interest rate is
different. The only adjustment is in the interest rate used.
i = 10/12 = .833333333
Stanford
FV
i
n
PMT ???

Year 1
$46,524.18
.8333
156
$146.33

Year 2
$48,674.17
.8333
168
$133.79

Year 3
$50,926.36
.8333
180
$122.87

20

Year 4
$53,285.73
.8333
192
$113.27

Adding all four amounts yields: $516.26


UNC
FV
i
n
PMT ???

Year 1
$13,525.32
.8333
156
$42.54

Year 2
$14,025.37
.8333
168
$38.55

Year 3
$14,545.12
.8333
180
$35.09

Year 4
$15,085.42
.8333
192
$32.07

Adding all four amounts yields: $148.25


5. There is clearly a positive relationship between the amount the parents must invest and
the increases in future tuition and living expenses.

21

Case 9
WalMart
Purpose: The purpose of this case is to teach the student to calculate actual returns for an
individual stock from past stock price and dividend data. The risk of the company will
also be determined as proxied by the standard deviation. The student must then calculate
the required rate of return on the stock to determine if the stock is over or under-valued.
1. To calculate the quarterly returns, the following formula should be used:

kt =

P t - P t -1 + Dt
P t -1

where,
kt = return during period t,
Pt = price of asset at time t,
Pt-1 = price of asset at time t-1,
Dt = dividends received throughout the quarter.
June 2002:
($55.01 - $61.22 +$0.08) / $61.22 = -10.01%
March 2002:
($61.22 - $57.41 +$0.08) / $57.41 = 7.25%
December 2001:
($57.41 - $49.32 +$0.07) / $49.32 = 16.55%
September 2001:
($49.32 - $48.54 +$0.07) / $48.54 = 1.75%
June 2001:
($48.54 - $50.16 +$0.07) / $50.16 = -3.09%
March 2001:
($50.16 - $52.69 +$0.07) / $52.69 = -4.67%
December 2000:
($52.69 - $47.67 +$0.06) / $47.67 = 10.66%
2. The standard deviation is a measure of dispersion about a mean. In an investing
context, it refers to a measure of total risk. To calculate the standard deviation, use any
22

calculator or spreadsheet, such as Excel. The standard deviation is 9.36%.


3. Assuming Beta = 1.2; Rf = 5.25%; Rm = 12.2%, the required rate of return can be
determined by employing CAPM.
kj = Rf + [bj x (km - Rf)]
= 5.25% + 1.2 (12.2% - 5.25%)
= 5.25% + 8.34%
= 13.59%
4. If WalMart had an expected rate of return of 14%, Marv should buy WalMart's stock
because it is expected return an amount in excess of what is required based on its risk
level. As long as WalMart is expected to return a rate of greater than 13.59%, Marv
should buy the stock. In a perfectly efficient market, the expected return always equals
the required rate of return.
5. The time period studied here is very short. Returns considered over such a short time
period are not as reliable because the sample size is much too small. Furthermore, the
economy goes in cycles. Therefore, while WalMart may have performed well or poorly
in the short-run is not necessarily indicative of their long-run performance. A better
performance time period would be over the last ten years or more. That way we would
be able to observe how WalMart performed during both expansions and contractions in
the economy.

23

Case 10
Intel
Purpose: The purpose of this case is to teach the student to calculate actual returns for an
individual stock from past stock price and dividend data. The risk of the company will
also be determined as proxied by the standard deviation. The student must then calculate
the required rate of return on the stock to determine if the stock is over or under-valued.
1. The expected return on a portfolio is equal to the weighted average of the return from
each component in the portfolio. Mathematically,
n

k p = wj k j
j=1

Year
1 ( 6.2)(.20) + ( 0.1)(.35) + (-4.2)(.45) = - .62%
2 ( 7.8)(.20) + ( 2.8)(.35) + ( 6.6)(.45) = 5.51%
3 ( 6.9)(.20) + (-1.9)(.35) + (12.2)(.45) = 6.21%
4 (-4.1)(.20) + ( 2.9)(.35) + ( 7.8)(.45) = 3.71%
5 ( 8.9)(.20) + ( 7.7)(.35) + ( 4.3)(.45) = 6.41%
6 (10.2)(.20) + (15.1)(.35) + (-2.1)(.45) = 6.38%
7 (15.3)(.20) + (19.3)(.35) + ( 8.4)(.45) = 13.60%
8 ( 9.2)(.20) + (14.2)(.35) + (10.2)(.45) = 11.40%
2. With Intel included,
Year
1 (.714)(-0.62) + (.2857)( 4.8) = .93%
2 (.714)( 5.51) + (.2857)(10.2) = 6.85%
3 (.714)( 6.21) + (.2857)(11.3) = 7.66%
4 (.714)( 3.71) + (.2857)(18.1) = 7.83%
5 (.714)( 6.41) + (.2857)( 6.6) = 6.46%
6 (.714)( 6.38) + (.2857)(-1.8) = 4.04%
7 (.714)(13.60) + (.2857)( 2.7) = 10.48%
8 (.714)(11.40) + (.2857)(10.9) = 11.26%
3. The standard deviation of a portfolio is equal to the square root of: the sum of each
term minus the average return quantity squared divided by n-1.
Mathematically,

24

( k - k )

k =

i=1

n-1

The average return = 52.6/8 = 6.58%


The terms (xi - x)2, are generated as follows:
(-.62 - 6.58)2 + (5.51 - 6.58)2 + ... + (11.4 - 6.58)2 = 133.94
[(133.94)/(8-1)]1/2 = 4.374% = p
4. Using the same equation, the standard deviation with Intel included = 3.322% = p
5. The beta of a portfolio is equal to the weighted average of the betas for each asset.
n

b p = wi bi
i=1

Without Intel
bp = (.2)(.7) + (.35)(1.6) + (.45)(1.0) = 1.15
With Intel
bp = (.714)(1.15) + (.286)(1.1) = 1.14
6. Beta tends not to be constant over time. For the eight year period under consideration,
it would be unlikely that each firm's beta would be the same year after year. When betas
vary, however, they do not normally jump around. Instead, there will normally be a
gradual trend. For shorter periods of time, beta can be assumed to be stable.
7. Standard deviation is a measure of total risk, whereas beta is a measure of systematic
risk. In portfolio theory, beta is the relevant measure because with proper diversification,
all unsystematic risk can be removed. Therefore, investors are not compensated for
taking unsystematic or diversifiable risk.

25

Case 11
Amber Plank
Term Structure of Interest Rates
Amber Plank is a high school senior who plans to attend college next year and major in
Astronomy. Her first choice is to attend the University of Charleston, which is highly
regarded in her intended field. However, to do so she will have to take out a substantial
amount of loans as this is a private university with high tuition costs. While loan rates
today are not high by historical standards, Amber will be charged the one-year rate that
exists at the time she takes out the loans. That is, each year when she borrows to pay for
her tuition, she will be assessed interest at a rate consistent with the short-term rate that
exists in the future. Amber's second collegiate choice is to attend the University of
Florida. The benefit of doing so is that she will receive a full scholarship and thus will not
have to borrow in order to attend this institution. The drawback is that while this is a fine
university, it does not specialize in her major. Selecting which university to attend is an
extremely important decision to make. In order to perform a complete cost comparison
between the two universities, Amber must determine the future one-year interest rates
that are likely to exist. Since they are the rates at which she will have to borrow in the
future, accuracy is extremely important as these interest costs will eventually be used in a
cost-benefit analysis. Table 1 lists today's rates that exist for U.S. Treasury securities of
various maturities.

Questions
1. What are the four most important variables that determine a bond's yield to
maturity?
2. Define a Yield Curve.
3. Explain the Expectations Hypothesis and use the theory to try to predict what the
one-year interest rates will be over the next five years.
4. Explain the Liquidity Preference Hypothesis and use the theory to try to predict
what the one-year interest rates will be over the next five years.
5. Explain the Market Segmentation Hypothesis and use the theory to try to predict
whatthe one-year interest rates will be over the next five years.

26

Solution:
Purpose: Interest rates affect everyone in the economy whether it be on an individual
level or through the workplace. This case gives one such example to which all students
can relate.
1. Default risk, liquidity, tax considerations, and time to maturity.
2. A Yield Curve shows the yield to maturity for similar (same risk, liquidity, and tax
considerations) types of bonds, but with different times to maturity at a specific point in
time.
3. The Expectations Hypothesis states that today's long-term rates are an average of
future short-term rates. Therefore, if rates in the future are expected to increase, then
today's yield curve will be upward sloping. Based on Table 1,
Time To
Maturity
1 year
2 years
3 years
4 years
5 years

Today's
Long-term Rates
7.0%
7.5%
8.0%
8.5%
8.6%

Future
Short-term Rates
7.0% (same)
8.0%
9.0%
10.0%
9.0%

Today's short-term rate is already given, so no calculation is needed.


To calculate the second year's short-term rate, solve the equation: (7 + x)/2 = 7.5%.
Here x = 8%
To calculate the third year's short-term rate, solve the equation: (7 + 8 + x)/3 = 8.0%.
Here x = 9%
To calculate the fourth year's short-term rate, solve the equation: (7 + 8 + 9 + x)/4 =
8.5%. Here x = 10%
To calculate the fifth year's short-term rate, solve the equation: (7 + 8 + 9 + 10 + x)/5 =
8.6%. Here x = 9%
4. The Liquidity Preference Hypothesis states that today's long-term rates are an average
of future short-term rates PLUS a premium, or reward, for holding a less liquid asset.
Exactly how much the premium amounts to is unknown. Moreover, the premium
changes over time. For this reason, each student will likely have a different set of future
short-term interest rate forecasts. There should, however, be consistency between their

27

answers to questions 3 and 4. The answers to question 4 should be lower than those for
question 3 because the "liquidity premiums" need to be removed from all of the
estimates. For example,
Time To
Maturity
1 year
2 years
3 years
4 years
5 years

Today's
Long-term Rates
7.0%
7.5%
8.0%
8.5%
8.6%

Future
Short-term Rates
7.0% (same)
8.0 0.25 = 7.75%
9.0 0.50 = 8.50%
10.0 0.75 = 9.25%
9.0 1.00 = 8.00%

5. The Market Segmentation Hypothesis states that Supply and Demand in different term
to maturity markets are responsible for determining interest rates and these markets are
separate from each other. For example, insurance companies invest primarily in longterm markets because of the maturity matches with their liabilities or pay-outs, whereas
banks tend to invest short-term so as to match short-term deposits. Unfortunately, this
hypothesis does little in the way of inferring future short-term rates from today's longterm rates.

28

Case 12
Fruit of the Loom
Purpose: The purpose of this case is to introduce students to bond rating systems and to
show them the effect it has on the corporation.
1. Pecking Order refers to the chain of priority that stakeholders in a company have on
the company's assets. The order is as follows: senior debenture holders, junior debenture
holders, preferred stockholders, and finally, common stockholders. This order represents
which investor group has first through last claim when it comes to receiving coupon or
dividend payments and even in the event of collecting in liquidation.
2. The 8.875% bonds received a downgrade because it effectively slipped down in the
Pecking Order. This is important because these bondholders cannot receive coupon
payments or the return of principle in the event of maturity or default until all of the other
debt holders receive their money first. This lowers the probability that these bondholders
will receive their promised payments which effectively increases the risk of the bonds.
Higher risk translates into a lower bond rating.
3. As the case states, since this represents a mere shuffling within the pecking order, Fruit
of the Loom's overall corporate credit rating remained at BB-. Therefore, it is unlikely
that the stock price will be affected. Moreover, even if the overall company were to be
downgraded, financial studies have shown that rating companies take time to make
changes to corporate bond ratings. Therefore, by the time a rating change has been made,
the change was already anticipated by the stock market, and therefore, its effect is already
imbedded into the stock's price.
4. Capital structure and level of Earnings Per Share (EPS) will definitely affect a
corporation's bond ratings. However, what the question did not include is the volatility in
EPS. Firms with more stable earnings, like utility companies, can afford to take on more
debt than firms in a less stable industry, like the technology sector, and still have the same
bond rating. It is all a function of the probability of default.

29

Case 13
Nations Bank
Purpose: The purpose of this case is to calculate a stock's price using its past dividends
as an indicator of future dividend growth rates. The student must determine the stock's
required rate of return (CAPM) and future expected dividend growth rate and use the
Gordon Growth Model to calculate a current price.
1. The equation for CAPM is kj = Rf + [bj x (Rm - Rf)]
where,
kj = required return on asset j,
Rf = risk-free rate of return,
bj = beta coefficient for asset j,
Rm = market return.
kj = 6% + 1.75(10% - 6%)
kj = 13%
2. The equation for the Gordon Growth Model is,

P0 =

D1 = D0 (1 + g)
( k s - g) ( k s - g)

where,
P0 = price of the common stock,
D1 = per share dividend expected at the end of year 1,
D0 = most recently paid dividend,
Ks = required return on common stock,
g = growth rate in dividends.
To calculate g, we have to assume that future dividend payments will grow at a constant
rate into the future forever. This constant rate can be estimated by examining the average
growth rate in the past. On a calculator,
Let,
PV = $ .86,
FV = $2.00,
n = 8.
Solve for i. i = the average growth rate. In this case i = g = 11.13%.

30

Plugging this growth rate into the Gordon Growth Model,


P0 = $2.00(1 + .1113) = $118.86
.13 - .1113
3. This time,
Let,
PV = $1.42,
FV = $2.00,
n = 5.
Solve for i. i = g = 7.09%.
Plugging this growth rate into the Gordon Growth Model,
P0 = $2.00(1 + .0709) = $36.24
.13 - .0709
4. The Gordon Growth Model, or any other dividend based pricing model, has major
drawbacks in that we are not sure what the true future growth rate in dividends is. As we
have just demonstrated, depending on the period we consider, the stock's price can
fluctuate wildly.
5. The required rate of return calculation has an enormous effect on the stock's price
using these types of models. If we assume that Nations Bank's required rate of return on
its common stock is 12% instead of 13%, the Gordon Growth Model will yield a price of
P0 = $2.00(1 + .0709) = $43.62
.12 - .0709
This value is not much different, but consider the result when the growth rate in
dividends is near the required rate of return on the common stock as is the case from
1987-1995.
P0 = $2.00(1 + .1113) = $255.47
.12 - .1113
In general, the calculated stock price will be extremely sensitive to the required rate of
return when the required rate of return is close to g.
6. This would be an example of a zero growth stock. The stream of payments would be
constant (annuity) and they would last forever (perpetuity). When this special case
occurs, a simplified equation can be used.
P0 = D1/Ks = $2.00/.13 = $15.38
7. The further out into the future the dividend payments are received, the less valuable
they are in today's dollars. Using a dividend amount of $1.00 and a discount rate of .13,
the present value of these three dividends are $.88, $.29, and $.000004922, respectively.

31

Case 14
AMR - American Airlines
Purpose: The purpose of this case is to help the student to understand the behavior of
bonds. For example, they will learn of the relationship between interest rates and time to
maturity (TTM) and the sensitivity of a bond's price to TTM.
1. To calculate the price of the bond, use the equation:

I
=
B0 ( PVIFAkd / 2 ,2n )+ M ( PVIF k d / 2 ,2n )
2
where,
B0 = value of the bond at time zero,
I = annual bond coupon payment,
I/2 = semi-annual bond coupon payment,
PVIFAkd/2,2n = present value of the coupon payments,
M = par value of bond,
PVIFkd/2,2n = present value of par which will be received by the bondholder when
the bond matures.
Plugging into the equation,
B0 = $100/2 x 12.642 + $1,000 x .377
= $632.10 + $377
= $999.10 $1,000
Because this method of looking up values in a table suffers from rounding errors, the
amount is slightly different from $1,000, but when a calculator is used, the answer is
exactly $1,000.
Using a calculator,
Let,
FV = $1,000,
PMT = $50,
i = 5% (10%/2 because we want the interest rate per period),
n = 20 (10 years times 2 payments per year),
PV = ??? = $1,000

32

When the maturity is increased to 20 and 30 years, the answers also come out to be
$1,000.
2-4. The answers from questions 2 through 4 are better represented in a table. The
calculation procedure is the same as that shown in question 1.

Maturity
8%
10 years $1,135.90
20 years $1,197.93
30 years $1,226.23

Interest rates
10%
12%
$1,000
$885.30
$1,000
$849.54
$1,000
$838.39

5. As the time to maturity increases, the sensitivity of a bond's price to changes in


interest rates increases. It is not actually the time to maturity that is driving the bond's
sensitivity. It is the bond's duration. The longer a bond's duration, the more sensitive its
price will be to changes in interest rates.
6. Whenever the current market interest rate equals the coupon rate, bonds will sell at
par. The time to maturity will have nothing to do with the price of the bond in this very
specific situation.

33

Case 15
Mirage Resorts
Purpose: When interest rates decrease after the issuance of a corporate bond, the firm
may find it advantageous to recall the issue and refund the old bonds with new bonds that
have a lower coupon rate. The student is given information necessary for the refunding
analysis. They must decide if and when the old issue should be refunded with a new
issue.
1. Floatation Costs:
$120,000 + [(.004 + .003)($40,000,000)] = $400,000
2. Initial Investment:
Floatation Costs
Overlapping interest before taxes
(.11)(2/12)($40,000,000)
minus taxes
(.35)($733,333)
after taxes
Call Premium before taxes
($1,110 - $1,000)(40,000 bonds)
minus taxes
(.35)($4,400,000)
after taxes

$400,000
$733,333
$256,666
$476,667
$4,400,000
$1,540,000
$2,860,000

Unamortized discount on old bond


[(7/20)($40,000,000-$39,065,000)(.35)]

($114,538)

Unamortized floatation cost of old bond


[(7/20)($200,000)(.35)]

($24,500)

Initial Investment

$3,597,629

3. Annual cash flows from the old issue:


Interest costs before taxes
(.11)($40,000,000)
minus taxes
($4,400,000)(.35)

$4,400,000
$1,400,000
34

after taxes

$3,000,000

Tax savings from amortization of F.C.


[($200,000)/(20)] x (.35)

($16,363)

Tax savings from amortization of discount


[($935,000)/(20)] x (.35)

($3,500)

Total annual after tax cash flow

$2,980,137

4. Annual cash flows from the new issue:


Interest costs before taxes
(.085)($40,000,000)
minus taxes
($3,400,000)(.35)
after taxes

$3,400,000
$1,190,000
$2,210,000

Tax savings from amortization of F.C.


[($400,000)/(13)] x (.35)

($10,769)

Total annual after tax cash flow

$2,199,231

5. Annual cash flow savings:


$2,980,137 - $2,199,231 = $780,906
6. Present value of annual cash flow savings:
($780,906 ) x PVIFAk=6%,n=13
($780,906 ) x 8.853 = $6,913,361
7. Mirage Resorts should refund the bond issue because the present value of the savings
exceeds the costs involved with issuing the new bonds.
$6,913,361 - $3,597,628 = $3,315,733
8. Interest rates, in general, have decreased over this seven year period. Therefore, it
makes sense that new bond issues can have lower coupon rates, everything else constant.
Mirage is wise to invest in new hotels/projects independent of current interest rates
because a firm cannot just stop investing because they feel interest rates are too high.
Interest rates are somewhat unpredictable, especially the further out in time you try to
predict them.

35

9. There are several factors that affect the refunding decision. The movement in the
interest rates is likely the most important. A small change in interest rates causes a large
change in the annual cash flow from a new issue. Also, the after-tax cost of debt (which
is used to calculate the present value of the annual cash flows) is extremely critical. Try
assuming the after-tax cost of debt is only 5% and you will see that the present value of
the savings has increased to $7,335,831. Finally, the floatation costs, both fixed and
variable, will affect the refunding decision. The greater the floatation costs, the less
likely the firm will be to refund the old issue.

36

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

37

Case 17
Aether Systems
Purpose: The purpose of this case is to have students work through the Variable Growth
Model. Along the way, they will have to use the Gordon Growth Model. An additional
wrinkle is thrown in here. The stream of dividends will not start right way.
1. Starting with the dividend of $2.50, simply multiply by (1 + i)n
t = 10
t = 11
t = 12
t = 13
t = 14
t = 15

$2.50(1.09)0 = $2.50
$2.50(1.09)1 = $2.73
$2.50(1.09)2 = $2.97
$2.50(1.09)3 = $3.24
$2.50(1.09)4 = $3.53
$2.50(1.09)5 = $3.85

2. $3.85(1.04)/(.13-.04) = $44.45. This represents the present value equivalent at time t =


15 of all the dividends starting at time t = 16 and going through to infinity.
3. Discounting all 6 amounts, then adding them together yields a (t = 0) stock price of
$11.17.
$2.50 /(1.13)10 = $0.74
$2.73 /(1.13)11 = $0.71
$2.97 /(1.13)12 = $0.69
$3.24 /(1.13)13 = $0.66
$3.53 /(1.13)14 = $0.64
$3.85 /(1.13)15 = $0.62
$44.45/(1.13)15 = $7.11
$11.17
4. Since the intrinsic value of $11.17 is greater than the market price of $10, this
represents a buy signal. Shares should be purchased up until the point where the present
value of the dividends is exactly equal to the trading price of the stock.

38

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

39

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

40

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

41

Case 21
Vanguard
Purpose: This case discusses the too often swept under the rug problems associated with
index mutual fund investing. In most classes, students are explained the concept of index
investing, but are never told of the tax related dangers.
1. While I understand Vanguards desire to maintain the funds objective, it is
unacceptable to manage their portfolio with a complete disregard for the tax ramifications
it will have on their clients.
The problem is that mutual funds report performance based on pre-tax total
returns. For this reason, they are not affected when their clients are stuck with a huge tax
bill. They simply blame it on small investor sentiment and move on.
2 & 3. There is an old adage on Wall Street that says, If you want to know what to do, do
the exact opposite of what the small investor does. Stated another way, money chases
performance, it does not drive it.
Small investors are known for jumping on the bandwagon usually long after it is
a good idea to do so. By the time the market makes a large enough run up to catch
sufficient media attention, it is usually time for a correction. This is when the uninformed
investor gets in.
The problem with being a disciplined mutual fund investor is that the people
whose funds have been pooled with yours are typically very poor market timing decision
makers. This affects you because in bad times, they will pull all their money out, the fund
will be forced to sell off shares, and you will be left with a huge tax bill.
4. This is a tough problem to correct. Lets illustrate through an example. Assume a
mutual fund buys General Motors (GM) for $20 per share. They hold the stock for 40
years and eventually have to sell it for liquidity purposes. At that time, the stock is trading
for $300. The tax basis is only $20, so the realized capital gain is $280 ($300 - $20).
Logically, that amount should be pro rated and allocated to each investor who owned
shares in the mutual fund during the 40 years. However, this does not work from a
practical perspective.
How will the mutual fund locate the investor who bought 38 years ago and sold
all her shares 35 years ago? Where will they mail the notice? Has the person passed away
in the last 35 years? If so, does their estate now owe the taxes?
Now consider you are that old investor. You are now 95 years old living on a fixed
and extremely tight budget. Will you have the money to pay a tax bill on an investment
you owned 35 years ago? Will you ever remember even owning the mutual fund?
Since there is no reasonable way to locate many of the historical investors and
because it would seem unreasonable to ask them to pay ancient tax bills even if you could
find them, this is not how taxes are determined. Instead, they are spread out over the
current mutual fund shareholders. The implicit argument being made is that the fund is
using new money over time to purchase new shares. Moreover, you, the new investor,
42

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

43

Case 22
Florida Power & Light
Purpose: At some point in time, firms will be faced with the decision to either replace or
fix up a piece of machinery, a building, or any other physical asset. This case makes the
student consider the cost and intangible advantages and disadvantages associated with the
two alternatives.
1.
Alternative 1
Initial investment
Cost of asset
Installation costs
Total cost of installation
Change in net working capital
Total Initial Investment

$80,000
$5,000
$85,000
$20,000
$105,000

Alternative 2
Initial investment
Cost of asset
Installation costs
Total cost of installation
Proceeds from sale of old asset
Tax on sale of asset
Total after-tax proceeds
Change in net working capital
Total Initial Investment

$100,000
$5,000
$105,000
($10,000)
$4,000
($6,000)
$15,000
$114,000

2. Net after-tax cash flows: All cash flows are in units of $1,000.
Alternative 1
Net increase
Year
in profits
1
$650
2
$425
3
$317
4
$220

Depreciation
$16.0
$25.6
$15.2
$9.6

Taxable
increase in
profits
$634.0
$399.4
$301.8
$210.4
44

Net profit
before taxes
$253.6
$159.8
$120.7
$84.2

Operating net
cash flows
$396.4
$265.2
$196.3
$135.8

5
6

$129
$0

$9.6
$4.0

$119.4
-$4.0

$47.8
-$1.6

$81.2
$1.6

Depreciation
$20
$32
$19
$12
$12
$5

Taxable
increase in
profits
$330
$318
$331
$338
$338
-$5

Net profit
before taxes
$132.0
$127.2
$132.4
$135.2
$135.2
-$2.0

Operating net
cash flows
$218.0
$222.8
$217.6
$214.8
$214.8
$2.0

Alternative 2
Net increase
Year
in profits
1
$350
2
$350
3
$350
4
$350
5
$350
6
$0
3.
Alternative 1
Proceeds from sale of asset
Taxes on sale
After-tax proceeds
Change in net working capital
Additional year 5 cash flow

$5,000
($2,000)
$3,000
$20,000
$23,000

Alternative 2
Proceeds from sale of asset
Taxes on sale
After-tax proceeds
Change in net working capital
Additional year 5 cash flow

$10,000
($4,000)
$6,000
$15,000
$21,000

4. The present value of each cash flow is found by discounting each future cash flow at
10%. The stream of cash flows for each project is:
Alternative 1
Year
0
1
2

Net cash flow


($105,000)
$396,400
$265,240

45

3
4
5
6

$196,280
$135,840
$81,240 + $23,000
$1,600

The net present value of this stream at 10% is $780,446.86.


Alternative 2
Year
0
1
2
3
4
5
6

Net cash flow


($114,000)
$218,000
$222,800
$217,600
$214,800
$214,800 + $21,000
$2,000

The net present value of this stream at 10% is $726,053.64.


Since the NPV of alternative 1 is higher than the NPV of alternative 2, Paul
should chose to renew the existing reactimeter instead of replacing it with a new one.
5. Many computer experts would argue that a new computer which is built for expanded
memory is better than an old computer that has been expanded. A bigger issue to
consider is the fact that our analysis is based on numerous assumptions. For example, we
are assuming that five years from now we will be able to sell the renewed or new
reactimeter for $5,000 and $10,000, respectively. Since these two amounts are so far off
into the future, how certain are we?
Another example is our estimates concerning the increase in profitability for both
alternatives. If any of these very large amounts are wrong, our decision may change.
The further out into the future we try to predict, the less accurate we will be.
6. The NPV's of the two alternatives are only separated by $54,393.22. While this
sounds like a large difference, when we consider the magnitude of the cash flows, it
really is not. With such a small amount separating the two choices, Paul is more likely to
allow the qualitative issues to weigh on his decision.

46

Case 23
Southwest Airlines
Purpose: This basic case requires that the student calculate the payback period, the
internal rate of return, the modified internal rate of return, and the net present value of a
proposed project. The student must chose to either accept or reject the project based on
the above criteria which will conflict. They therefore must also decide which criteria has
priority over the others.

1. NPV = -$20.8 +

$4.5
$6.3
$2.1
$1.3
$0.5
+
+ ... +
+
+
1
2
5
6
(1.1 ) (1.1 )
(1.1 ) (1.1 ) (1.1 )7

NPV = -$2,637,560
NPV is the present value of all future net cash flows associated with a project
minus the initial investment. If the NPV is greater than 0, the firm will increase its value
by accepting the project. In this case, the NPV is negative which means that if the firm
accepts the project, the overall value of Southwest will decrease by $2.637 million.
2. The IRR is the discount rate that makes the present value of the future net cash flows
equal to the initial investment. The calculated solution is 4.77%. This measure differs
from the NPV methods in two major ways. First, IRR is a percentage, while NPV is a
dollar amount. Managers often prefer to think in terms of percentages instead of absolute
dollars. Second, IRR assumes that when the cash flows are received year after year, they
can be reinvested at the IRR. The NPV method assumes these intermediate cash flows
can be reinvested at the discount rate.
3. The Payback Period is the number of years it takes to recoup the project's initial
investment.
PP = 4 years + 0.9/2.1
PP = 4.43 years
4. Since the project's payback period is less than the 5 year maximum, based on PP, the
project should be accepted. However, because the calculated IRR is below the hurdle
rate, the IRR criterion indicates that the project should not be accepted. Finally, the NPV
of the project is negative. Therefore, based on NPV, it should not be accepted. When the
criteria conflict, the NPV should be most trusted - followed by the IRR, then PP.
5. Conflicts between the PP and either NPV or IRR can occur at any time. This is
because PP suffers from three mathematical flaws. It does not consider the timing of the
cash flows, the time value of money, and any cash flows beyond the payback period.

47

Both IRR and NPV take into consideration these concepts. However, IRR may
lead to the wrong accept/reject decision if the projects under consideration are mutually
exclusive and if any of the future net cash flows are negative or if the magnitude of the
cash flows from one project are greatly different from the magnitude of the cash flows
from other projects.
6. MIRR is similar to IRR in that it expresses a project's attractiveness in terms of a
percentage. The difference is that like the NPV, MIRR assumes that the project's
intermediate cash flows are re-invested at the discount rate. This assumption is
methodologically preferred. MIRR is found by taking the future value of each
intermediate cash flow to a terminal point (the last year of the project). It compounds
based on the discount rate as shown below.
Year
0
1
2
3
4
5
6
7

Net Cash
flow
-$20.8
$4.5
$6.3
$5.2
$3.9
$2.1
$1.3
$0.5

Future Value of Net


Cash flow
$7.97 (n=6, i=10%)
$10.15 (n=5, i=10%)
$7.61 (n=4, i=10%)
$5.19 (n=3, i=10%)
$2.54 (n=2, i=10%)
$1.43 (n=1, i=10%)
$.050 (n=0, i=10%)
Sum = $35.59

Plugging into a calculator,


Let,
FV = $35.39,
PV = -$20.8,
n = 7.
Solve for i. i = 7.98%. This is the project's MIRR.
7. With normal cash flows, the MIRR will always fall between the discount rate and the
IRR. Why? When the IRR is below the discount rate, MIRR assumes the intermediate
cash flows are returning a higher amount (discount rate) than the IRR. Conversely, when
the IRR exceeds the discount rate, IRR is actually over estimating the true yield. MIRR
maintains that the IRR is too high and assumes that the intermediate cash flows are
returning a level only equal to the discount rate.

48

Case 24
Acclaim Entertainment
Purpose: This case considers a firm's decision to accept or reject multiple proposed
projects. Both independent and mutually exclusive projects will be considered. Further,
the projects will have unequal lives. Therefore, it is necessary to understand the concept
of annualized net present value.
1. Payback Period is defined as the time required to recover a projects initial investment.
SCE
PP = 1 + $6,000/$10,000 = 1.60 years
Nintendo
PP = $40,000/$44,000 = .91 years
Sega
PP = $40,000/$41,000 = .98 years
Assuming a required payback period of 1 year, Nintendo would be the preferred carrier of
Mortal Combat since it has the shortest PP less than 1 year.
2. NPV is defined as the present value of all future net cash flows minus the initial
investment. When the NPV is greater than 0, investing in the project will add value to the
firm. Mathematically,

CF
NPV = t t -I.I.
t=1(1+ k )
Where CFt is the net cash flow during the given year and k is the appropriate discount
rate. Using a discount rate of 10%,
SCE
NPV = $3,613
Nintendo
NPV = $13,223

49

Sega
NPV = $15,154
Based on NPV, Mortal Combat should be sold through the Sega system because the NPV
under Sega is the greatest amount.
3. Internal Rate of Return (IRR) is the discount rate that forces the NPV to equal zero.
The higher IRR, the better. If the IRR exceeds the company's hurdle rate, the project
should be accepted. IRR can be solved through trial and error, by using an approximation
formula, or via a calculator. The calculator provides the most accurate answer. Therefore,
the following solutions were obtained from a financial calculator.
SCE
IRR = 17.04%
Nintendo
IRR = 38.82%
Sega
IRR = 39.80%
Based on IRR, all three have acceptable IRRs. The highest is Sega.
4. With mutually exclusive projects, only zero or one project can be chosen. With
independent projects, any number of projects can be selected. In this case Acclaim could
sell through none, one, two, or all three companies. Based on the payback period
criterion, Nintendo and Sega would be chosen because both have payback periods under
the required 1 year maximum while SCE does not.
Based on NPV, all three carriers would be used since they all have a positive NPV.
Similarly, all three marketers have an IRR in excess of Acclaim's hurdle rate of 10%.
5. Since the life of Mortal Combat is projected to be different under each of the three
hardware systems, the traditional NPV measure will possibly lead to the wrong
accept/reject decision. Instead, the Annualized Net Present Value (ANPV) measure
should be used. ANPV is calculated by dividing the NPV by the present value interest
factor of an annuity at a given discount rate and for a given number of years (i.e. the life
of the project). Mathematically,

ANPV =

NPV
( PVIFA k,n )

ANPV = NPV/PVIFAk=10%;n=4
= $3,613/3.170 = $1,140
Nintendo
50

SCE

ANPV = NPV/PVIFAk=10%;n=2
= $13,223/1.736 = $7,617
Sega
ANPV = NPV/PVIFAk=10%;n=3
= $15,154/2.487 = $6,093
Based on ANPV, the decision has changed. It is now clear that Nintendo is the hardware
company through which Acclaim should distribute Mortal Combat. Without considering
this more appropriate measure, Acclaim would have lost money by choosing the wrong
interactive hardware company (Sega).

51

Case 25
Philip Morris
Purpose: This case considers a firm's decision to accept or reject multiple proposed
projects. The projects in question are not of similar risk. Therefore, traditional net
present value techniques cannot be used. Instead, the use of Risk Adjusted Discount
Rates (RADRs) and Certainty Equivalents are necessary.
1. To calculate the NPV of the Gourmet Hazel Nut,

NPV = -$4,000,000 +

$1,000,000
$206,000
+ ...+
= $47,534
1
7
(1.10 )
(1.10 )

The NPV of the Post Blueberry Morning is

NPV = -$2,500,000 +

$803,000
$519,000
+ ... +
= $31,349
1
(1.10 )
(1.10 )7

Since the projects are independent and both have a positive NPV, both projects should be
accepted.
2. Using the RADR of 12%, the NPV of the Gourmet Hazel Nut,

NPV = -$4,000,000 +

$1,000,000
$206,000
+ ... +
= $167,098
1
(1.12 )
(1.12 )7

With the more appropriate RADR, the Gourmet Hazel Nut is no longer a positive NPV
project and should therefore be rejected.
3.
Year
0
1
2
3
4

Net cash flow


Gourmet Hazel Nut
-$4,000,000
$1,000,000
$1,200,000
$750,000
$950,000

C.E.
1.00
.80
.70
.60
.50

Certain
cash flow
-$4,000,000
$800,000
$840,000
$450,000
$425,000
52

5
6
7

$880,000
$500,000
$206,000

.40
.30
.20

$352,000
$150,000
$41,200

The NPV of the certain net cash flows is calculated by discounting these cash flows at the
risk-free rate of 5%.

NPV = -$4,000,000 +

Year
0
1
2
3
4
5
6
7

Net cash flow Post


Blueberry Morning
-$2,500,000
$803,000
$521,000
$235,000
$400,000
$498,000
$612,000
$519,000

$800,000
$41,200
+ ...+
= -$1,320,801
1
7
(1.05 )
(1.05 )

C.E.
1.00
.95
.90
.85
.80
.75
.70
.65

Certain
cash flow
-$2,500,000
$762,850
$468,900
$199,750
$320,000
$373,500
$428,400
$337,350

NPV = -$2,500,000 + $762,850 +...+ $337,350 = $390,750


On a certainty equivalents basis, only Post Blueberry Morning has a positive NPV.
4. Certainty equivalents can be defined as the percentage of the cash flow in each period
that the manager would be willing to accept if the amount was 100% certain. For
example, the manager might be indifferent between receiving a somewhat uncertain $100
two years into the future or a certain $80 two years into the future.
5. Certainty equivalents adjust cash flows for risk and time separately. RADRs do not.
They lump the adjustment in together. RADRs are easier to interpret conceptually, but
can be less accurate.

53

Case 26
Computerized Business Systems
Capital Budgeting: Weighted Average Cost of Capital
Computerized Business Systems (CBS) transforms manual accounting and inventory
systems into computerized, more efficient, systems. Many of their customers describe the
transition as an overnight evolution from the dark ages to the 21st century. Manual
systems are far too cumber some with respects to both time and inventory control. CBS's
computerized inventory systems, for example, allow every item in inventory, no matter
how small, to be tracked at all points throughout the production process. Replenishing
stock becomes an automatic process because the CBS system alerts the manager when
supplies reach a pre-programmed level. Vicky Pagel has been a financial analyst with
CBS for over five years. Although she normally does not get involved with sales, her
most recent assignment was to assist Jack Ingram, anew sales representative. Jack is in
the process of trying to sell a CBS system to Corbin Mills,a firm that does not know how
to determine accurately its weighted average cost of capital (WACC). Corbin Mills,
therefore, cannot determine whether the net present value (NPV) of the CBS system is
positive or negative.To calculate Corbin Mills' WACC, Vicky first needed to gather
information on the firm's cost of raising funds from various sources. As she proceeded
with the analysis, she learned that Corbin Mills could issue 20-year corporate bonds at a
coupon rate of 9%. As a result of current interest rates, the bonds could be sold for $1,005
each. These bonds have floatation costs of $35 per bond, pay interest semi-annually, and
have a par value of $1,000. A corporate tax rate of 40% applies. Corbin Mills can raise
additional funds through either retained earnings or new issues of common stock. Their
common stock is currently selling for $68.25 per share. The most recent dividend paid
was in the amount of $2.25. Corbin's dividends have previously grown at a rate of 4%,
but this growth rate is expected to jump to 10% the year after and continue at this rate to
infinity. If the firm wanted to sell new shares of common stock, after under pricing and
floatation costs, they could do so for $62.75 per share. A final source from which funds
could be raised is via preferred stock. $100-par preferred stock can be issued at an 11%
annual dividend rate. After floatation costs, the preferred stock would sell for $95.50 per
share. The final set of information needed to calculate the WACC is the proportion of
total funds that each asset class represents. This information is given in Table 1. In
performing the NPV calculation, net after-tax cash flows must be known. These cash
flows are given in Table 2. All variables such as improvements in efficiency, employee
training costs, and salvage value are already incorporated in the cash flows. Put yourself
in Vicky Pagel's position, and develop the WACC calculation that will be used in
evaluating projects for Corbin Mills. Next, demonstrate whether the NPV for the
proposed CBS system is positive or negative. The following questions will lead you stepby-step to complete the analysis. To perform this type of analysis you are implicitly
making several assumptions. Since Jack will be the only one involved in communicating
with Corbin Mills, he must completely understand all of the assumptions and calculations
that will be made throughout the analysis. For this reason, the analysis must be clear as
well as technically correct.

54

Questions
Table 1 contains the market and book values of each asset class. Table 2 shows the aftertaxcash flows associated with the CBS system. Use these tables to answer the questions
which follow.

1. What is the firm's cost of preferred stock? Is this the same as the after-tax cost of
preferred stock?
2. What is the firm's cost of long-term debt? Is this the same as the after-tax cost of
long-term debt?
3. What is the firm's cost of retained earnings? Is this the same as the after-tax cost
of retained earnings?
4. What is the firm's cost of new common stock? Is this the same as the after-tax cost
of new common stock?
5. Using market values, what is Corbin Mill's WACC?
6. Using book values, what is Corbin Mill's WACC?
7. Using target ratios, what is Corbin Mill's WACC? Explain why the target ratio
will not always be maintained by a firm.
8. Which weights, market, book, or target, should be used in this analysis? Explain.
9. Would Corbin Mills be better off with the new CBS system (i.e. What is the NPV
of the proposed system?)? Does the answer to this question depend upon which
weight isused to calculate the WACC? Explain.

55

Solution:
Purpose: The purpose of this case is to find the weighted average cost of capital (WACC)
for a firm. The WACC is an essential number to determine because it is the appropriate
discount rate used in net present value (NPV) calculations for all similar-risk, equal-life
projects.
1. The Cost of Preferred Stock:
kp=

Dp
Np

where,
kp = cost of preferred stock,
Dp = annual preferred stock dividend,
Np = net proceeds from the preferred stock issue.
here,
Dp = $100 * 11% = $11.00
Np = $95.50,
Therefore, kp = $11.00/$95.50 = 11.5%. Since preferred stock dividends are paid from
after-tax earnings, this is the after-tax cost of preferred stock.
2. The Cost of Long-Term Debt:
kd = cost of long-term debt. Two methods can be used to find kd.
(1) The first is the calculator method:
Let,
PV = $970 ($1005 - $35)
FV = $1,000
PMT = $45 [($1,000 * 9%)/2)]
N = 40 (20 * 2)
where,
PV = Present Value (the amount the firm receives upon issuing the debt),
FV = Future Value (the amount the firm returns to the bondholder when the bond
matures),
PMT = Payment (this is the amount the bondholder receives at the end of every
six month period until the bond matures),
N = number of periods in which a coupon payment was received.
After plugging these four variables into a financial calculator, solve for "i," the interest
rate. Doing so will yield an answer of 4.667%. This is the interest rate on a semi-annual
basis. To annualized it, simply multiply by two to yield a before tax cost of debt of
56

9.334%.
(2) The second method is to employ a formula such as the following and use financial
tables to generate the answer:
PV = PMT(PVIFAk%,40) + FV(PVIFk%,40)
Here, PVIFAk%,40 is the present value interest factor of an annuity for 40 6-month
periods at an interest for which we are trying to solve. PVIFk%,40 is the present value
interest factor. This portion of the equation will convert the bond's par value from $1,000
20 years into the future to its present value equivalent. Under either method, the answer
should be the same. One problem does arise, however, with the second method. Most
financial tables do not list non-integer interest rates.
Coupon payments are deducted from corporate earnings before taxes are paid.
Therefore, to find the after-tax cost of long-term debt, we must multiply Kd by (1-t),
where t = the corporate tax rate.
ki = 9.334 * (1 - .40) = 5.6%.
3. Cost of Retained Earnings:
Since the dividends in this case are expected to grow at a constant rate into the
future, the constant growth (Gordon Growth) model should be used.

k re =

D1 + g = D0 (1 + g) + g
P0
P0

where,
kre = cost of retained earnings,
D1 = next year's dividend,
P0 = current price of the stock,
g = growth rate in dividends,
D0 = most recent dividend paid.

k re =

2.25(1.10)
+ .10 = 13.63%
68.25

Funds from retained earnings have already been exposed to corporate taxes, so no
adjustment is needed.
4. Cost of Common Stock:
The same formula as was used in question 3, is used here, with one minor
alteration. When new common stock is issued, the full $68.25 is not received. After
floatation costs, the company only receives $62.75. Plugging into the equation:

57

kn =

2.25(1.10)
+ .10 = 13.94%
62.75

Again, no tax adjustment is needed.


5. The WACC can be defined by the following equation:

k a = WACC = wa k a = wi k i + w p k p + wn k n + wr k r
a=1

where,
wa = weight of each type of fund,
ka = after-tax cost of each type of fund.
To calculate the weights of each type of fund, simply divide each proportion by the sum
of all the four sources.
Asset Class
Long-term Debt
Preferred Stock
Common Stock
Retained Earnings

Market Value
$33,400,000 / $92,400,000 =
$7,000,000 / $92,400,000 =
$42,000,000 / $92,400,000 =
$10,000,000 / $92,400,000 =

Weight
.36147
.07575
.45455
.10823

Applying the formula,


WACC = (.36147)(5.6%) + (.07575)(11.5%) + (.45455)(13.94%) + (.10823)(13.63%) =
10.71%
6. The same procedure is used again except now the weights will be slightly altered.
Asset Class
Long-term Debt
Preferred Stock
Common Stock
Retained Earnings

Book Value
$35,000,000 / $90,000,000 =
$5,000,000 / $90,000,000 =
$40,000,000 / $90,000,000 =
$10,000,000 / $90,000,000 =

Weight
.38888
.05555
.44444
.11111

So, WACC = (.38888)(5.6%)+(.05555)(11.5%)+(.44444)(13.94%)+(.11111)(13.63%)


WACC = 10.52%, using book values.

58

7. Using target ratios,


WACC = (.35)(5.6%) + (.05)(11.5%) + (.40)(13.94%) + (.20)(13.63%)
WACC = 10.84%, using target ratios. The firm's target ratio will not be exactly
maintained because when a firm goes to the financial markets to raise funds, they usually
do so by issuing only one type of security. This choice is primarily a function of
floatation costs.
8. In the industry, market weights are typically preferred because financial managers are
concerned more with market values. Book values are usually preferred by the accounting
department. Finally, target weights are more of an idealistic goal, but it is not attempted
or expected to be the exact percentage of weight for each type of funds. The financial
manager wants only to stay relatively close to the target weights over time.
9.
Using

CF t
- I .I .
t
t=1 (1 + k)

NPV =
market weights:
NPV = - $480,000 +

$80,000
$80,000
$10,000
+ ...
+
1
10
(1.1071)
(1.1071 )
(1.1071 )11

NPV = $188.48. Therefore, the company should buy the CBS system. Yes, the discount
rate makes a big difference. It will cause us to accept or reject the project depending on
which rate we use. This is why we need to be as accurate as possible when calculating
the WACC.
WACC
10.84%
10.71%
10.52%

NPV
-$2,460.18
$188.48
$4,101.40

59

Case 27
McLeodUSA
Purpose: The goal of any firm is to maximize shareholder wealth. To do so, they must
determine their optimal capital structure. This case is important not only because it gives
students a chance to approach this very elusive optimization problem, but also because
ALL firms must decide on the level of debt they will carry.
1.
Debt
Ratio
0%
10%
20%
30%
40%
50%
60%

(1)
Expected
EPS
$0.38
$0.43
$0.49
$0.55
$0.60
$0.52
$0.41

(2)
Standard Deviation
of EPS
$0.21
$0.26
$0.33
$0.45
$0.62
$0.84
$1.08

(3) = (2)/(1)
Coefficient of
Variation
0.55
0.60
0.67
0.82
1.03
1.62
2.63

2. The formula is stated as follows:


P0 =

Debt
Ratio
0%
10%
20%
30%
40%
50%
60%

(1)
Expected
EPS
$0.38
$0.43
$0.49
$0.55
$0.60
$0.52
$0.41

(2)
Estimated
Required Return
10.3%
10.6%
11.4%
12.2%
13.4%
16.7%
20.6%

EPS
ks

(3) = (1)/(2)
Estimated
Stock Price
$3.69
$4.06
$4.30
$4.51
$4.48
$3.11
$1.99

60

3. The Gordon Growth model for pricing stocks is as follows:


P0 =

DPS
ks

+g

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

61

Case 28
Lancaster Colony
Purpose: The purpose of this case is to discuss the different dividend payment policy
alternatives and how they might affect stockholders.
1. The Residual Theory of Dividends states that all available cash flow should be
invested in projects with a positive net present value. Then any money left over should
be paid out to stockholders in the form of a dividend so that no free cash flow (FCF) is
left. Since we are not given an investment opportunity set in the case, it is not possible to
say with 100% certainty that Lancaster is not following this policy. However, given the
stable and steady increase in dividend payments, it is certainly unlikely to be the policy
chosen by Lancaster.
2. A Constant Payout Ratio means the company will keep the ratio "DPS divided by
EPS" at the exact same level each year. Table 1 shows that although the number has been
consistent and stable over the last 5 years, it certainly is not the same. Moreover, there
are several drawbacks associated with the Constant Payout Ratio policy and it is therefore
not often used by firms.
3. The Fixed-Dollar or "Regular" dividend payment policy maintains that the firm would
pay the exact same dollar amount every dividend payment period and would only
increase the dividend payment when it was very certain that the new, higher dividend
could be sustained in the long-run as subsequent dividend cuts send a severely negative
signal to the market. In the case of Lancaster Colony, the dividend payment amount is
clearly different each year so this policy is not being followed.
4. The Low-Regular-and-Extra Dividend policy holds that the firm will pay the same
dollar dividend over the first three quarters (dividends in the US are typically paid every
quarter, not just at year's end), then pay a fourth quarter dividend that is at least the same
as, but likely higher than that paid for each of the first three quarters. The amount of the
year end dividend is a function of how well the company has done during the year and
also a function of their investment opportunity set in the near future.
Although the data given in the case does not breakdown dividend payments by
quarter, it is very likely that Lancaster follows this policy coupled with the very
conscience decision to ensure that the annual amount of dividends continues to increase
each year. We can also safely assume that both the firm's investment opportunity set and
how well they performed have also been taken into consideration given that their
dividends do not always increase at the same rate or by the same dollar amount.
5-6. If Lancaster cut its dividend for the first time in 39 years, it would certainly send a
negative signal to the market causing the stock price to drop. However, Lancaster could
mitigate this reaction by coupling their dividend cut announcement with an explanation
that the reason for the cut is to allow the company to earn an even greater rate of return
62

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

63

Case 29
Anheuser-Busch
Short-term Asset Management: The Baumol Model
Brewing beer has always been the core business of Anheuser-Busch Companies, Inc. The
industry leader since 1957, Anheuser-Busch currently owns 45% of the domestic beer
market. This represents annual sales of 88.5 million barrels of beer. Market share has
grown so much that Anheuser-Busch now has a larger portion of the market than their
next four largest competitors combined. International sales are no different. AnheuserBusch International remains the leading exporter of beer from the United States with
sales in more than 65 countries. Microbreweries, or microbrews for short, have been
gaining attention in recent years. Microbrews are defined as breweries that produce less
than 15,000 barrels a year. The strength of microbrews is their philosophy that beer
should be of the highest quality. Microbrews are only made with malted barley, hops,
water, and yeast, the only four ingredients found in the purist German beers. Mass bottled
beers usually add rice and corn to minimize costs. The drawback of microbrews is their
cost. The more expensive ingredients make microbrews cost an average of 60% more
than mass bottled beers. Beer is not like wine which gets better with age. Instead, it is a
food that should be consumed as soon after production as possible. As such, beer pubs or
microbrews that produce beer on the premises, are the hottest new trend with an average
of four new pubs popping up every week. Sales have grown an average of 40% per year.
This figure is extremely impressive when one considers that the beer market as a whole is
shrinking. Even with this success,microbrew sales represent only two percent of the $50
billion dollar beer market. In their relentless pursuit to continue to dominate all sectors of
the beer market, Anheuser-Busch has tapped into the microbrewing trend. They have
recently bought a stake in the Seattle based Red Hook Ale micro-brewery. The new
products introduced into the regionaland mainstream specialty beer segment include Red
Wolf, Elk Mountain Red, Elk Mountain Amber Ale, and Elephant Red.Since microbrews
are typically produced regionally, Anheuser-Busch is developing regional manufacturers
and distributors. As such, they must decide on the best way to handle theirshort-term cash
needs for purchasing inventory in these small plants. Anheuser-Busch has decided to use
the Baumol model to determine the level of cash to keep on hand versus th eamount to
keep in marketable securities .Anheuser-Busch can earn 7% if they keep their funds in
marketable securities. Every time they convert their marketable securities to cash, it costs
them $25. Finally, they anticipatetheir total cash outlays over the next year to be
$2,000,000.
Questions
1. Using the Baumol Model, what is the economic conversion quantity (ECQ) that
will maximize the firm's value given their short-term cash needs? Why is it
important for abusiness to correctly determine their ECQ?
2. Based on your answer from question 1, how many times will Anheuser-Busch
convert marketable securities into cash per year?

64

3. What is the average cash balance the firm will hold throughout the year, assuming
the cash outflows will occur on a consistent or smooth basis?
4. What is the total cost associated with managing these short-term funds? How can
yoube sure this is the optimal ECQ?
5. In the above analysis, we have not considered a level of safety stock. Why is
safetystock so important? What primary factor will determine the amount of
safety stock for each specific firm?
Solution:
Purpose: The Baumol Model is used to determine the optimal amount of cash a business
should keep on hand to minimize the tradeoff between non-interest bearing cash and the
opportunity costs associated with not having ample cash on hand.
1.
ECQ =

(2)(conversion costs)(demand for cash)


opportunity costs(decimal form)

ECQ =

(2)(25)($2,000,000)
= $37,796.45
.07

ECQ is used to minimize the costs associated with the tradeoff between keeping cash on
hand (that does not earn interest) and making sure the firm does not have a liquidity
problem.
2. $2,000,000/$37,796.45 = 52.92 times per year. In practice, Anheuser will round off
and liquidate funds once a week.
3. $37,796.45/2 = $18,898.23. Again this assumes the cash will be used on a continuous
and smooth basis. In practice, salary expenses typically cause cash outflows to be
extremely lumpy.
4. The total cost associated with managing the funds is given by the following formula:
TC = (conversion costs)(# of conversions) + (opportunity costs)(average cash balance)
TC = ($25)(52.92) + (.07)($18,898.23)
= $1,323.00 + $1,322.88
= $2,645.88

65

You can be sure this is the minimum amount because the two components of the cost are
equal. Stated another way, the TC equation will determine the minimum total costs by
considering the tradeoff between keeping unproductive cash balances on hand and
transaction costs associated with liquidating money market accounts.
5. Safety stock is very important because when a firm runs out of money, it cannot
purchase inventory to produce its goods. It cannot pay its employees. It cannot meet its
debt payment obligations. For all these reasons, safety stock is added to the ECQ as a
fudge factor or as a security against unexpected cash needs. The chosen level of safety
stock for each firm is a function of the penalties associated with not being able to meet
their financial obligations. The more severe the penalty, the more safety stock the firm
should keep on hand.

66

Case 30
Pepsi
Short-term Cash Management: Managing the Cash Conversion Cycle
Pepsi is a multinational company who operates within three primary industry segments:
beverages, snack foods, and restaurants. The primary products sold in the beverage
segment include Pepsi, Diet Pepsi, 7UP, and Mountain Dew. Frito-Lay represents the
domestic snack food business, while PepsiCo's restaurant segment consists primarily of
Taco Bell, Pizza Hut,and Kentucky Fried Chicken (KFC). Pepsi also engages in several
joint ventures around the world, each within one of the three industry segments. Because
Pepsi is such a large manufacturer and distributor, they spend millions of dollars each
year on salaries trying to keep track of orders, payments, and receipts for each of their
three lines of business. Todd Rovelstad, a manager in Financial Services at Pepsi's
Phoenix plant, has discovered away to reduce the time required to log orders, payments,
and receipts. His idea is simple, yet innovative. Todd uses bar codes to sort paper
work.Just as bar codes are used in a grocery store to identify each item and its price, Todd
can usebar codes to identify where orders are sent to and from, the product that is being
referred to,and the amount of the product to be bought, sold, or shipped. This idea has
several positive attributes. First, the Pepsi employees will be able to do their logging up
to four times faster than they are able to under the current system. Today, receipts for
payment are left stacked until a processor can get to them. This also allows employees to
concentrate more on other ways in which the company can save money. Second, the
accuracy rate under the bar code system is 99.99%. While keying in codes is relatively
accurate also, Pepsi has been experiencing problems because their workers are putting in
too much over time and fatigue has increased the error rate. Todd did not stop at bar
codes for processing accounts receivables. He also saw the usefulness of bar codes for
mail. The post office now sorts mail electronically by bar codes for those letters that have
them. Pepsi can use coded envelopes to speed up the return time when its customers pay
for shipments. These funds can then be deposited into PepsiCo's account much sooner
than they currently can be. Even though interest is earned on only one to two additional
days, when considering the size of Pepsi, this will translates into big savings. Pepsi wants
to determine just how much these new programs will save the company. To determine the
amount, they have disclosed the following information concerning the operating cycle.
Pepsi's average payment period is 29 days. Their average age of inventory is 42 days.
And the average collection period is 39 days. Pepsi feels that with the new system in
place, it can speed up the average collection periodby 12 days. This figure reflects the
fact that the employees will not only receive the paymentsearlier, but more importantly,
they will be able to start processing the receipts much soonerthan they are currently able
to do. The average age of the inventory and average paymentperiod are assumed to
remain unchanged. Pepsi currently spends $28,000,000 per year on its operating cycle
investments. Funds usedfor financing the operating cycle cost 12% per annum. Todd feels
the additional annual costof $50,000 will be sufficient to pay for the added hardware
necessary to use bar codes. Thisexpense does not take into consideration the additional
salary expenses that will be avoideddue to a reduction in overtime costs.
Questions

67

1. Calculate Pepsi's current operating cycle, cash conversion cycle, and need for
short-term financing of the cash conversion cycle (i.e. What is Pepsi's negotiated
financing need?).
2. Calculate the operating cycle, cash conversion cycle, and need for shorttermfinancing of the cash conversion cycle if Pepsi decides to implement the use
of barcodes.
3. If the bar codes are used in the future, what will be the annual savings stemming
specifically from the cash conversion cycle financing reduction?
4. Considering the annual costs associated with implementing the bar code
system,should Pepsi change their logging systems?
5. Assume the cost of implementing the bar code system exceeds the savings
inreduction of short-term financing needs. Should Pepsi decide not to change
systems?Discuss.
6. Define the cash conversion cycle and explain why it is so important. Do you think
cash conversion cycles should be different for different industries (HINT consider a manufacturer versus a retailer).
7. What are the three ways to speed up the cash conversion cycle?
Solution:
Purpose: The cash conversion cycle measures the amount of time that a firm's cash is
tied up and is therefore wasting company resources. Students will learn how to reduce
the cash conversion cycle to save a firm money.
Let,
AAI = Average Age of Inventory,
ACP = Average Collection Period,
APP = Average Payment Period,
CCC = Cash Conversion Cycle,
OC = Operating Cycle.
OC = AAI + ACP = APP + CCC
1. OC = AAI + ACP = 42 + 39 = 81 days
OC = 81 = APP + CCC = 29 + CCC
CCC = 52 Days
Financing needs = (total annual outlays)/(365) x CCC

68

= ($28,000,000)/(365) x 52 = $3,989,041
2. OC = AAI + ACP = 42 + 27 = 69 days
OC = 69 = APP + CCC = 29 + CCC
CCC = 40 Days
Financing needs = (total annual outlays)/(365) x CCC
= ($28,000,000)/(365) x 40 = $3,068,493
3. To calculate the annual cost savings, we need to use the answers from questions 1 and
2. Pepsi is charged 12% for short-term funds. Therefore, to determine their annual cost
to cover their CCC, simply multiply the answer from 1 and 2 by .12.
Old System $3,989,041 x .12 = $478,685
Bar Code System $3,068,493 x .12 = $368,219
Annual Savings = $478,685 - $368,219 = $110,466
4. The bar code system will cost $50,000 to implement. Therefore, it should be used
because an additional profit of $60,466 ($110,466 - $50,000) will result.
5. Even if the bar code system did work out to be more expensive, we still have ignored
the reduction in labor costs. These savings, while extremely difficult to estimate, will far
exceed any additional cost of financing.
6. The cash conversion cycle is the amount of time the firm's cash is tied up. That is, the
firm has paid for the goods, but has yet to receive payment for the goods. The lower the
cash conversion cycle, the better because short-term funds cannot be used for otherwise
productive resources. Cash conversion cycles are very different from industry to
industry. Manufacturing firms tend to have longer cash conversion cycles because their
average age of inventory tends to be much greater. Service firms, on the other hand, tend
to have very short and even negative cash conversion cycles.
7. There are three ways to speed up the cash conversion cycle. A firm can increase its
average payment period or decrease either its average collection period or its average age
of inventory. In most cases, the production process is naturally as stream-lined as
possible. Great strides can be made, however, by considering different terms of sales
procedures for both accounts receivable and accounts payable.

69

Case 31
Inn-Room Safe
Purpose: Firms have numerous options to consider when establishing their policy on
accounts receivable. Should discounts be given to buyers who pay within 10 or 15 days?
When should accounts be due even when no discount is offered? These questions are
important to a business because if their terms of sale are favorable, buyers will buy
through them. If the terms of sale are too favorable, they will be losing money by having
their funds tied up at disadvantageous rates of return. This delicate tradeoff directly
affects a firm's profit from operations.
1. Additional profit contribution from increased sales
([1.07 x 1,700] 1,700) x ($234 - $157) = $9,163
2. Cost of marginal investment in accounts receivable
Average investment under proposed plan:
($157 x 1,819) / (360/14) = $11,106.01.
Average investment under proposed plan:
($157 x 1,700) / (360/23) = $17,051.94
.12 x ($17,051.94 - $11,106.01) = $713.51
3. Cost of marginal bad debts
Bad debt expense under new plan:
(.005 x $234 x 1,819) = $2,128.23
(.008 x $234 x 1,700) = $3,182.40
$1,054.17
4. Cost of cash discount
(.02 x .70 x $234 x 1,819) = ($5,959.04)
5. Net profit from implementation of proposed plan
$9,163.00 + $713.51 + $1,054.17 - $5,959.04 = $4,971.64
6. Inn-Room should consider the fact that all of these forecasts about what conditions will
be like under the newly proposed accounts receivable policy are just estimates. InnRoom should take the calculations further and perform a sensitivity analysis to determine
how much results might change if their estimates are off. It is important to recognize that
70

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

71

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

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

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

72

4. The
tables
below

summarize the results using the same formulas from questions 1 & 3.
ACTUAL Costs
30 days
45 days
60 days

1%
2%
24.24% 48.98%
12.12% 24.49%
8.08% 16.33%

3%
74.23%
37.11%
24.74%
ESTIMATED Costs

30 days
45 days
60 days

1%
2%
24.00% 48.00%
12.00% 24.00%
8.00% 16.00%

3%
72.00%
36.00%
24.00%

Approximation Method Error


30 days
45 days
60 days

1%
0.24%
0.12%
0.08%

2%
0.98%
0.49%
0.33%

3%
2.23%
1.11%
0.74%

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

73

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

After-tax
Cash flow
$4,200
$4,200
$4,200
$4,200
$10,200

2. To find the amount of interest paid per year, a table is beneficial.


Year Payment Beginning
Payment
Balance Principle Interest
1
$7,514
$30,000
$5,114 $2,400
2
$7,514
$24,886
$5,523 $1,991
3
$7,514
$19,363
$5,965 $1,549
4
$7,514
$13,398
$6,442 $1,072
5
$7,514
$6,956
$6,958
$556

Ending
Balance
$24,886
$19,363
$13,398
$6,956
$0

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

74

3
4
5

$30,000 x .19 = $5,700


$30,000 x .12 = $3,600
$30,000 x .12 = $3,600

4. The total tax shield is equal to the sum of the maintenance expense, depreciation
expense, and interest expense each year multiplied by the tax rate (.40).
Year Maintenance Depreciation Interest
expense
expense
expense
1
$1,000
$6,000 $2,400
2
$1,000
$9,600 $1,991
3
$1,000
$5,700 $1,549
4
$1,000
$3,600 $1,072
5
$1,000
$3,600
$556

Total Tax
Shield
$3,740
$5,036
$3,300
$2,269
$2,062

5. Total after-tax net cash flows are equal to the payments of $7,514 plus the
maintenance costs minus each year's tax shield as shown in question 4.
Year Total after-tax
net cash flow
1
$4,774
2
$3,478
3
$5,214
4
$6,245
5
$6,452
6. To find the present value, use a discount rate of 5% [(8%)(1 - .4)]. The present value
of the five net after-tax cash outflows associated with purchasing the machinery is equal
to $22,398. The present value of the five net after-tax cash outflows associated with
leasing the machinery is equal to $22,885. Since these figures reflect the present costs
associated with both alternatives, we would want the one with the lower present cost.
Therefore, Hasbro should purchase the machinery instead of leasing it.
7. If putting a down payment on an asset is a problem, leasing is advantageous because it
allows the lessee to finance 100% of the asset. Leasing can also be an advantage if the
asset you need is in an area that is associated with quick obsolescence, such as computer
technology. Of course, once you have entered into a lease, if the asset becomes
obsolescent, you still have to lease it for the remainder of the contract.
In the event your firm goes bankrupt, the lessor only has a legal right to recover
three years of lease payments (and of course, they get their asset returned to them).
Finally, not all assets (land, for example) are depreciable unless they are leased.
Disadvantages associated with leasing include an unpublished interest rate that the
lessee is being charged. You must calculate it to be sure it is not too high. The salvage
75

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

76

Case 34
Microsoft
Purpose: This basic options case helps students read and understand how options behave
with respect to such factors as time, stock price, exercise price, and volatility of the
underlying common stock. The student will also learn the basics of how a put option can
be used to hedge risk.
1. An investor should buy put options when they need protection against downward
movements in a stock's price because long put positions make money when stock prices
decrease. Each options contract is written on 100 shares of common stock. Therefore, 5
put contracts should be purchased. Since Chris feels the downward movement will take
place tomorrow, he should buy the nearest maturing put option (i.e. December). Doing so
will allow him to hedge at the lowest possible cost.
2. a) To develop the hedge will cost: $750 ($1.50 x 500). Since the stock price ($93)
exceeds the exercise price ($90), Chris will not exercise the put option. Technically, the
option still has some value, but this value will decrease dramatically as it just went out of
the money with only a few days to expiration. From a practical standpoint, it is
considered to be zero.
On the up side, Chris' holding of common stock went up in value by $2,000
[($93-$89) x 500}. Overall, he made $1,250 and his new wealth position is $45,750.
b) If the stock price decreases to $85, Chris will make money on the put options, but lose
on the stock. His put options will be worth roughly $2,500 [($90-$85) x 500]. His
underlying shares lost $2,000. With the same options cost of $750, Chris lost $250 from
the announcement. His new wealth position is down to $44,250.
3. No matter which trading cycle options are on, they will always be offered in the
current and following month and also on the next two natural months in the trading cycle.
Since December options contracts had not expired by December 15, options are available
with maturities in December, January, April, and July. On January 1, options will be
trading with maturities in January, February, April, and July.
4. The nearer the option is to its expiration, the greater the trading volume in that option
tends to be. Also, the greater the time to maturity of an option, the greater the value of
the option. Volatility also has a positive relationship with option prices. The above
relationships hold for both puts and calls.
5. Volume tends to be higher when the strike price is above the current stock price
because stock prices tend to increase over time.
6. The further out of the money an option is the cheaper the price should be. This
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follows since the further out of the money an option is the lower the probability it will
ever be exercised. Conversely, the further in the money an option is the more expensive
the price should be because it will most likely be exercised. In fact, in-the-money
American options, by definition, can be exercised immediately for a positive payoff.

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Case 35
REITs
Purpose: This case introduces a type of security that is too often ignored in finance. It is
important to make students aware of REITs because they have repeatedly been shown to
warrant inclusion in mixed-asset portfolios.
1. For commercial properties, rents are determined based on supply and demand in the
local economy. When the economy is good, businesses flourish and office space is
demanded. This higher demand allows the building owners to keep rents at a very high
level as firms are competing for space. The REITs that own these building are therefore
receiving higher revenues and are thus more profitable.
When the economy is bad, businesses trim down or even go out of business,
which frees up office space. The widely available space gives renters (lessees) the upper
hand. Landowners compete for tenants by lowering rents. These lower rents mean lower
revenues for REIT shareholders.
2. REITs have historically returned 7.0%-8.0% in dividends and a more modest 3%-5%
in capital gains. Due to tax consequences, the individuals who own REITs are same
investor class as those who own utility stocks retirees.
Tax-exempt institutional investors, like pension funds, also own REITs. Since
they do not pay taxes, all they care about is total return, not whether the total return came
from dividends or capital gains. REITs have been shown to generate sufficient returns on
a risk-adjusted basis to warrant inclusion in mixed-asset portfolios.
3. The correlation between asset classes is typically measured by examining indexes
(benchmarks). For example, to calculate the correlation between large cap stocks and
REITs, the S&P 500 would be compared to the NAREIT (National Association of Real
Estate Investment Trusts) index. In 1998-1999, technology stocks soared in value which
caused their weight to be very high in the S&P 500 index. So as the technology stocks
went through the roof, they drug the S&P 500 index along with them. REITs, on the other
hand, continued their steady returns. Conversely, after the technology stocks crashed, so
too did the S&P 500.
The appearance, therefore, is that REITs had a low correlation with the stocks in
the S&P 500. The reality was that REITs had a low correlation with technology stocks
and a much higher correlation with the other stocks in the market which showed the same
general return pattern throughout that REITs did.
Do to these extreme events, it is likely that REITs will be observed to have a
higher correlation in the future.
4. While it is impossible to measure directly or with a high degree of accuracy, the total
market value of all commercial real estate in the United States is around $5 trillion. Half
of this is owned directly by corporations, leaving the other half available for ownership.
Currently, only $250 billion of this real estate is controlled by REITs. Since the average
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REIT has roughly a 40% debt ratio, the total market capitalization of all REITs sums to
$141.8 billion. Thus, only a small percentage (approximately 10%) of commercial real
estate is securitized.
Given that there are numerous property types (Apartments, Industrial, Office,
Retail, Warehouse, etc.), the ability of a portfolio manager to find enough REITs to make
a significant rebalance in a portfolio is dubious. Moreover, while it is far beyond the
scope of this simple case, REITs are not exactly unsecuritized real estate. Thus, using
them as substitutes can be misleading. Several researchers have found them to be so
different that they should be considered a separate asset class.

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Case 36
HOLDRs
Purpose: This case introduces a new type of security that is being traded on the American
Stock Exchange. It is important to make students aware of new offerings as quickly as
possible not only because they will soon be entering the work force, but also because they
may want to use them in their portfolios.
1. When a firm like Merrill Lynch offers a new security, it is usually out of customer
demand, or at least perceived customer demand. Like any product, however, if consumers
are not interested in buying it, HOLDRs would stop trading and eventually go away. For
this reason, a firm offering a new security should feel very confident that it will have
staying power.
2. Day traders are defined as traders who enter and exit trades within one trading session
(day). Since UITs, like mutual funds, only calculate their price once each day, day traders
would not include them as part of their portfolio. HOLDRs, however, have intrinsic price
changes as soon as any of their underlying securities change in price. As such, they can
and likely will be used by day traders who wish to speculate on the direction of a
particular industry.
3. UITs are no different from any other area of finance. Competition causes increased
efficiency which is ultimately better for consumers. An analogy can be drawn from the
former telecommunications industry. When the monopoly was broken up and competitors
were allowed to offer long distance services, prices dropped precipitously. With the
advent of HOLDRs, which offer several advantages to investors, watch for UITs to
improve upon the transparency and availability of price data.
4. No. HOLDRs are diversified only within a particular industry. Portfolio theory clearly
maintains that to remove all unsystematic risk, diversification across industry sectors in
necessary. Therefore, if an investor were to purchase the HOLDR of only one industry,
his portfolio would not be fully diversified.

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Case 37
Reynolds
Purpose: Merger mania is alive and well. In the mid 1980's and now again, firms are
joining forces for all types of strategic reasons. Students should be made aware of the
factors that contribute to merger and acquisition activity and how these activities affect
industries and the overall economy.
1. One of the main reasons is to reduce competition by making the competitors part of the
same company.
2. It is the job of the regulators to prevent firms from having absolute or virtual
monopolies. This is good for us as customers because monopoly firms eventually raise
prices once they drive out all competitors who can offer the same product at reduced
prices.
3. There are several reasons why firms merge: economies of scale and scope, growth,
diversification, tax benefits, greater access to the capital markets, to tap into unused debt
potential, to remove inefficient management, to gain market share, to gain prestige by
being seen as a larger company, to be listed on a larger exchange, and many other
synergistic reasons.
4. To avoid a takeover attempt, firms have the following colorfully named options: seek a
white knight, take a poison pill, use a shark repellent, send greenmail, organize a
leveraged recapitalization, or save at least the management by having them pull the cords
on their golden parachutes.
5. The ways to raise capital for mergers and acquisitions include leveraged buyouts
(LBO), a management buyout (MBO), a cash offer to tender shares, leveraged ESOPs,
and stock swaps.
6. Research has shown that the target of a takeover or merger receives a substantial
premium for their shares while bidding firms have zero and even insignificantly negative
returns from winning the bidding war. At first glance this seems unreasonable, but there
are several explanations that shed light on this surprising result.
(1) Takeover firms must gain voting control in order to elect their own managers.
This means owning shares of the target's common stock. In order to entice current target
stockholders to sell, a premium must be paid to them.
(2) The bidding firm must have some value creation potential otherwise the
merger would not be on the table in the first place. Target firm stockholders understand
this and also know that their shares are needed to make the deal happen. Therefore, they
simply want their piece of the pie.
(3) Finally, it can be argued that the feeding frenzy that eventually results from a
few sharks swimming around in bloody chum-filled waters turns into a free-for-all where
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rational pricing gives way to the "winner's curse".

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Case 38
Adaptec
Purpose: This case introduces the fundamentals of a corporate spin-off. Most introductory
courses do not discuss corporate spin-offs. However, today more so than ever, students
already own stocks before they get into class. So, students receive statements in the mail
related to their common stock ownership that discuss concepts of which they are
completely unaware. The purpose of this case is to create that basic awareness.
1. Brian does not have to do anything to own these shares in the new company, Roxio,
because effectively, he already owns them. That is, Roxio is currently a wholly-owned
subsidiary of Adaptec, which Brian owns. The analogy is if you take a whole pie and cut
a piece out of it, the person who owned the whole pie should now own the piece of pie
and the remainder of the pie as well. Cutting a pie into many pieces does not make its
total size larger or smaller.
2. 100 x 0.1646 = 16.46 shares.
3. The leftover or fraction of a share, 0.46, cannot be owned by Brian because it is not
possible to own fractional shares in a common stock. The Adaptec statement reads, The
transfer agent will not deliver any fractional shares of Roxio common stock in connection
with the spin-off. Instead, the transfer agent will aggregate all fractional shares and sell
them on behalf of those holders who otherwise would be entitled to receive a fractional
share. Such holders will then receive a cash payment in an amount equal to their pro rata
share of the total net proceeds of that sale.
4. Tax consequences may vary. In this case, the Information Statement for Adaptec reads,
Adaptec has received an opinion from Pricewaterhouse Coopers LLP that the
distribution of its shares of Roxio common stock to the holders of its common stock will
be tax-free to Adaptec and its stockholders for United States federal income purposes.

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Case 39
Roxio
Purpose: This case is an extension of the Adaptec case. This case opens the door to the
discussion of corporate spin-offs and may best be used as a conversation/discussion
starter in class as opposed to an assignment.
1. Roxios desire to operate independently is not much different from most other firms.
Roxio states their reasons for the separation by saying, The separation will allow us to
have our own business and strategic opportunities. After the separation, we will be able to
implement a marketing strategy that focuses on our business. Furthermore, our business
and engineering resources will be dedicated solely to our business the motivation of
our employees and the focus of our management team will be strengthened and our
ability to attract and retain qualified personnel will be enhanced. As a separate company,
we will have direct access to the capital markets, and we believe that securities analysts
will be more likely to provide research coverage of our business.
2. There are several potential new risks. (1) Roxio will be operating under a new brand
which does not already carry wide brand name recognition. This could hurt sales. (2)
Departure from Adaptecs infrastructure and implementation of their own new structure
could hurt efficiency. (3) Roxio may be required to indemnify Adaptec for tax liabilities
associated with the distribution of Roxio common stock. (4) There is a potential increase
in stock return volatility due to difficulty in pricing new shares as well as operating a
smaller business whose sales are reliant on a few large customers within similar markets.
(5) Ability to raise capital is limited as Roxio is a small firm. Moreover, smaller firms
often find it more expensive to raise funds because of economies of scale. (6) Many of
the new Roxio board members still own a substantial number of shares (or options to buy
shares) in Adaptec. This can cause actual or perceived conflicts of interest at least until all
connections to Adaptec have been severed. (7) Roxio stock has never been traded before.
They plan to list on the NASDAQ, but if they are unable to meet the listing requirements,
they will be forced to list on the lower perceived quality OTCBB. This may result in a
lack of analyst coverage, institutional ownership, and low trading volume.
3. Yes. Because of prior executive compensation requirements, Adaptec will continue to
hold 190,941 of the 16,309,059 total Roxio shares.
4. It is extremely unlikely that Roxio will plan to pay a dividend in the foreseeable future.
The primary reason is the growth orientation of Roxio. A primary benefit of being
publicly listed is to gain access to the capital markets. For this reason, it makes no sense
for Roxio to distribute cash when they are trying so hard to raise cash through the issuing
of securities.

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Case 40
Tyco
Purpose: As the world continue to become more globally oriented, it is important for
students to understand the ramifications of being a multinational firm. This case is a first
step in that direction.
1. The following table will be used to demonstrate the weighted average cost of capital:
Source of funds
Equity
Debt
Working Capital

After-tax cost
11.4%
5.6%
6.0%

Amount
Weight Weighted cost
$6,500,000 44.8%
5.11%
$6,500,000 44.8%
2.51%
$1,500,000 10.4%
0.62%

WACC = 8.24%
2. Sales x 17% = profits
$35,000,000 x .17 = $5,950,000 per year for the next four years.
PV = $5,950,000 x PVIFAk=8.24%,n=4
Using a calculator, the present value is
PV = $19,602,333
3. If the dollar were to appreciate or strengthen relative to the guilder, the sales revenue
in guilders would be worth less in terms of U.S. dollars. Therefore, profits from foreign
sales would decrease.
4. From a financial viewpoint, the foreign exchange rate risk could be hedged by using
futures or forward contracts. A short position would be taken by Tyco so that if the dollar
strengthened, it would reduce the profits in the spot market, but cause offsetting gains by
making money in the futures/forwards market.
5. From a production standpoint, Tyco could purchase more input components with
guilders or sell more units in dollars. They could also finance future cash flow needs
with guilders instead of dollars. Western Europe's financial markets are not nearly as
risky as markets in other parts of the world.

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