case solution free

© All Rights Reserved

177 views

case solution free

© All Rights Reserved

- Case - Assessing Martin Manufacturing’s Current Financial Position
- HBL Bond
- Case Solutions for Case Studies in Finance Managing for Corporate Value Creation 6th Edition by Bruner
- Finance first part Quiz - Chapter four
- RUD Orders $44,000,000 Bond Election to be held at 9700 Grogans Mill Road
- Discounted Cash Flow Valuation ch 6
- Ross 9thedition CaseSolutions
- Case Solution of Case Study 5
- Sessions 30 Bond, Yield Curve
- Casebook_FINANCE
- Test 9
- Agencies Involved in the GDR Issue.pptx
- Fine Test Bank Ch. 6 7 Rwj
- Mattituck School Board Meeting Agenda Nov. 21, 2013
- Warren Buffett on Stock Market 2001 Fortune Article
- Exemptions Allowed in Indian Income Tax Law
- Morgan v. United States, 113 U.S. 476 (1885)
- Southwest
- Valuation of Shares and Bonds (1)
- Ross Westerfield Jaffe Ch 07 Test Questions

You are on page 1of 86

com/doc/

27594556/CasebookFINANCE#scribd

Solutions Guide

for

Written by

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

3

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)

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

+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

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

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

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

1,072,093

Other assets

Goodwill

Other

Total other assets

724,089

115,099

839,096

Total Assets

$3,008,096

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

575,522

deferred income taxes

other

Total deferred credits and other liabilities

17,037

148,811

165,848

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)

1,400,914

$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

Selling, general and administrative

Interest

Other

$26,461

$110,679

$32,054

($64)

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

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)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:

$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)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 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

UNC

FV

i

n

PMT ???

Year 1

$13,525.32

1

156

$36.34

Year 2

$14,025.37

1

168

$32.46

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

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

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

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 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%

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

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

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

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

($114,538)

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

($24,500)

Initial Investment

$3,597,629

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

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

($16,363)

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

($3,500)

$2,980,137

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

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

($10,769)

$2,199,231

$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

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

($105,000)

$396,400

$265,240

45

3

4

5

6

$196,280

$135,840

$81,240 + $23,000

$1,600

Alternative 2

Year

0

1

2

3

4

5

6

($114,000)

$218,000

$222,800

$217,600

$214,800

$214,800 + $21,000

$2,000

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

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

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 )

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

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

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

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

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

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

WACC = 10.52%, using book values.

58

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

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

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 =

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%

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

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 .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

77

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.

78

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

79

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.

80

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.

81

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

82

83

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.

84

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.

85

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.

86

- Case - Assessing Martin Manufacturing’s Current Financial PositionUploaded byM B Hossain Raju
- HBL BondUploaded bysajid
- Case Solutions for Case Studies in Finance Managing for Corporate Value Creation 6th Edition by BrunerUploaded byGregory Wilson
- Finance first part Quiz - Chapter fourUploaded byBasa Tany
- RUD Orders $44,000,000 Bond Election to be held at 9700 Grogans Mill RoadUploaded byRENTAVOTER
- Discounted Cash Flow Valuation ch 6Uploaded byAnonymous j6i4n9edu
- Ross 9thedition CaseSolutionsUploaded bypun33t
- Case Solution of Case Study 5Uploaded byPrabhu Pareek
- Sessions 30 Bond, Yield CurveUploaded byhitpun
- Casebook_FINANCEUploaded bytripti_verve
- Test 9Uploaded byAnkit Khemani
- Agencies Involved in the GDR Issue.pptxUploaded byAnand Kumar Suman
- Fine Test Bank Ch. 6 7 RwjUploaded bydbjn
- Mattituck School Board Meeting Agenda Nov. 21, 2013Uploaded byTimesreview
- Warren Buffett on Stock Market 2001 Fortune ArticleUploaded byBrian McMorris
- Exemptions Allowed in Indian Income Tax LawUploaded bySai Charan Gv
- Morgan v. United States, 113 U.S. 476 (1885)Uploaded byScribd Government Docs
- SouthwestUploaded byZaimah Mohd Nor
- Valuation of Shares and Bonds (1)Uploaded byCarolyn Nanjala Wangusi
- Ross Westerfield Jaffe Ch 07 Test QuestionsUploaded byAurash Kazemini
- Case SolutionsUploaded byRichard Henry
- BUS 508 Final Exam Answers-All Possible QuestionsUploaded byrebecaprice
- financeUploaded byDuy Binh Tran
- RISK & RETURN.pptUploaded byjhumli
- bab 14Uploaded byDias Farenzo Puth
- June 21- Bonds PayableUploaded byJolo Roman
- Range Accrual NoteUploaded byRox31
- John Marshall Gazette 1983-12-18 Teleconnect Gets New LargerUploaded byThe Gazette
- ifnotes.pdfUploaded bymohammed elshazali
- Ibf Lecture 3Uploaded byMohammad Moosa

- Hebrew and Ugaritic Poetry Jsri_17Uploaded byEmmer Chacon
- 5.1eliotUploaded byMert Öksüz
- Speech Recognition 2Uploaded byMudit Misra
- The 100 - Ranking of Most Influential People in History - Michael Hart Citadel Press 1992Uploaded byweird john
- Hokusai & Hiroshige: The Thirty-six Views of Mount Fuji from Two Different PerspectivesUploaded byAllison Michelle
- Review- Kojin Karatani & the Return of the Thirties-Psychoanalysis in:Of JapaUploaded byrammellzee
- BARINGSUploaded bySalil Saxena
- Florida Lime & Avocado Growers, Inc. v. Paul, 373 U.S. 132 (1963)Uploaded byScribd Government Docs
- Assistive Devices and Technology for Visually and Hearing ImpairementUploaded bymont21
- La Cuisinère Canadienne - The Cookbook as CommunicationUploaded bypoupoudodo
- Professionalizing the CyberSecurity WorkforceUploaded bydarkmagic3030
- Motor Skills Learning and Acquisition ProcessesUploaded byFaiz Moriun
- David DuBois Race and Gener Influcenes on Adjuntment in Early AdolescenseUploaded byElizabeth Pérez Márquez
- 17-UJAHM-14136-RvUploaded byPartheeban
- Test Clasa v a L2 Martie 17Uploaded byLiliana Gheorghe
- Canary Ccda Rider101 Shirokuma Feb2019Uploaded byAnthony Fernandez Mendez
- GGUploaded byazym94
- Confused KingdomUploaded byMadeleine Zoe Buisseret
- Linguistic Imperialism Alive and KickingUploaded byHenda S
- CER Scientific Explanation Handout Packet 6th 5-18-11Uploaded byfoongsin6650
- jurnal peterigiumUploaded byAdedani Nuraini
- The Neurobiology of SorceryUploaded byandre magela
- Varicose Veins of Lower LimbsUploaded bysarangpb
- COPD Registry FormUploaded byCarla Espiritu Retuerma
- lesson planUploaded byapi-284120919
- 2nd PU Maths Model QP 4Uploaded byPrasad C M
- Atlas Copco HB 2500Uploaded bySerhidra SAS
- Predictive MaintenaceUploaded byCebrac Itatiba
- Nativity Script & LyricsUploaded byToddlerApproved
- Linear Programming Chart & Line of BalanceUploaded byvicky91